warren sm_ch.17_final.doc

CHAPTER 17FINANCIAL STATEMENT ANALYSIS

EYE OPENERS

1. Horizontal analysis is the percentage analy-sis of increases and decreases in corre-sponding statements. The percent change in the cash balances at the end of the pre-ced-ing year from the end of the current year is an example. Vertical analysis is the percentage analysis showing the relation-ship of the component parts to the total in a single statement. The percent of cash as a portion of total assets at the end of the current year is an example.

2. Comparative statements provide information as to changes between dates or periods. Trends indicated by comparisons may be far more significant than the data for a single date or period.

3. Before this question can be answered, the increase in net income should be compared with changes in sales, expenses, and assets devoted to the business for the current year. The return on assets for both periods should also be compared. If these comparisons indicate favorable trends, the operating per-formance has improved; if not, the apparent favorable increase in net income may be off-set by unfavorable trends in other areas.

4. You should first determine if the expense amount in the base year (denominator) is significant. An 80% or more increase of a very small expense item may be of little con-cern. However, if the expense amount in the base year is significant, then over an 80% increase may require further investigation.

5. Generally, the two ratios would be very close, because most service businesses sell services and hold very little inventory.

6. The amount of working capital and the change in working capital are just two indi-cators of the strength of the current position. A comparison of the current ratio and the quick ratio, along with the amount of working capital, gives a better analysis of the current

position. Such a comparison shows:

Current Preceding Year Year

Working capital....... $100,000 $90,000Current ratio........... 2.0 2.5Quick ratio.............. 0.8 1.4

It is apparent that, although working capital has increased, the current ratio has fallen from 2.5 to 2.0, and the quick ratio has fallen from 1.4 to 0.8.

7. The bulk of Wal-Mart sales are to final cus-tomers that pay with credit cards or cash. In either case, there is no accounts receivable. Procter & Gamble, in contrast, sells almost exclusively to other businesses, such as Wal-Mart. Such sales are “on account,” and thus, create accounts receivable that must be collected. A recent financial statement showed Wal-Mart’s accounts receivable turning 64 times, while Procter & Gamble’s turned only 6 times.

8. No, an accounts receivable turnover of 5 with sales on a n/45 basis is not satisfac-tory. It indicates that accounts receivable are collected, on the average, in one-fifth of a year, or approximately 73 days from the date of sale. Assuming that some customers pay within the 45-day term, it indicates that other accounts are running beyond 73 days. It is also possible that there is a substantial amount of past-due accounts of doubtful collectibility on the books.

9. a. A high inventory turnover minimizes the amount invested in inventories, thus freeing funds for more advantageous use. Storage costs, administrative expenses, and losses caused by obso-lescence and adverse changes in prices are also kept to a minimum.

b. Yes. The inventory turnover could be high because the quantity of inventory on hand is very low. This condition might result in the lack of sufficient goods on hand to meet sales orders.

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c. Yes. The inventory turnover relates to the “turnover” of inventory during the year, while the number of days’ sales in inventory relates to the amount of inven-tory on hand at the beginning and end of the year. Therefore, a business could have a high inventory turnover during the year, yet have a high number of days’ sales in inventory based on the beginning and end-of-year inventory amounts.

10. The ratio of fixed assets to long-term liabili-ties increased from 3.0 for the preceding year to 4.0 for the current year, indicating that the company is in a stronger position now than in the preceding year to borrow additional funds on a long-term basis.

11. a. The rate earned on total assets adds in-terest expense to the net income, which is divided by average total assets. It measures the profitability of total assets, without regard for how the assets are fi-nanced. The rate earned on stock-hold-ers’ equity divides net income by aver-age total stockholders’ equity. It mea-sures the profitability of the stockhold-ers’ investment.

b. The rate earned on stockholders’ equity is normally higher than the rate earned on total assets. This is because of lever-age, which compensates stockholders for the higher risk of their investments.

12. a. Due to leverage, the rate on stockhold-ers’ equity will often be greater than the rate on total assets. This occurs because the amount earned on assets acquired through the use of funds pro-vided by creditors exceeds the interest charges paid to creditors.

b. Higher. The concept of leverage applies to preferred stock as well as debt. The rate earned on common stockholders’ equity ordinarily exceeds the rate earned on total stockholders’ equity be-cause the amount earned on assets ac-quired through the use of funds provided by preferred stockholders normally ex-ceeds the dividends paid to preferred stockholders.

13. The earnings per share in the preceding year were $40 per share ($80/2), adjusted for the stock split in the latest year.

14. A share of common stock is currently selling at 12 times current annual earnings.

15. The dividend yield on common stock is a measure of the rate of return to common stockholders in terms of cash dividend distri-butions. Companies in growth industries typ-ically reinvest a significant portion of the amount earned in common stockholders’ eq-uity to expand operations rather than to re-turn earnings to stockholders in the form of cash dividends.

16. During periods when sales are increasing, it is likely that a company will increase its inventories and expand its plant. Such situa-tions frequently result in an increase in current liabilities out of proportion to the increase in current assets and thus lower the current ratio.

17. One report is the Report on Internal Control, which verifies management’s conclusions on internal control. Another report is the Report on Fairness of the Financial Statements, where the Certified Public Accounting (CPA) firm that conducts the audit renders an opin-ion on the fairness of the statements.

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PRACTICE EXERCISES

PE 17–1A

Accounts payable $8,400 increase ($78,400 – $70,000), or 12%Long-term debt $5,760 increase ($101,760 – $96,000), or 6%

PE 17–1B

Temporary investments $10,800 increase ($70,800 – $60,000), or 18%Inventory $11,000 decrease ($99,000 – $110,000), or –10%

PE 17–2A

Amount Percentage

Sales $500,000 100% ($500,000 ÷ $500,000)Gross profit 140,000 28 ($140,000 ÷ $500,000)Net income 40,000 8 ($40,000 ÷ $500,000)

PE 17–2B

Amount Percentage

Sales $600,000 100% ($600,000 ÷ $600,000)Cost of goods sold 480,000 80 ($480,000 ÷ $600,000)Gross profit $120,000 20 % ($120,000 ÷ $600,000)

PE 17–3A

a. Current Ratio = Current Assets ÷ Current Liabilities

Current Ratio = ($190,000 + $150,000 + $260,000 + $300,000) ÷ $600,000

Current Ratio = 1.5

b. Quick Ratio = Quick Assets ÷ Current Liabilities

Quick Ratio = ($190,000 + $150,000 + $260,000) ÷ $600,000

Quick Ratio = 1.0

PE 17–3B

a. Current Ratio = Current Assets ÷ Current Liabilities

Current Ratio = ($140,000 + $60,000 + $40,000 + $80,000) ÷ $160,000

Current Ratio = 2.0

b. Quick Ratio = Quick Assets ÷ Current Liabilities

Quick Ratio = ($140,000 + $60,000 + $40,000) ÷ $160,000

Quick Ratio = 1.5

PE 17–4A

a. Accounts Receivable Turnover = Net Sales ÷ Average Accounts Receivable

Accounts Receivable Turnover = $560,000 ÷ $40,000

Accounts Receivable Turnover = 14.0

b. Number of Days’ Sales in Receivables = Average Accounts Receivable ÷Average Daily Sales

Number of Days’ Sales in Receivables = $40,000 ÷ ($560,000 ÷ 365)

= $40,000 ÷ $1,534

Number of Days’ Sales in Receivables = 26.1 days

PE 17–4B

a. Accounts Receivable Turnover = Net Sales ÷ Average Accounts Receivable

Accounts Receivable Turnover = $600,000 ÷ $60,000

Accounts Receivable Turnover = 10.0

b. Number of Days’ Sales in Receivables = Average Accounts Receivable ÷Average Daily Sales

Number of Days’ Sales in Receivables = $60,000 ÷ ($600,000 ÷ 365) = $60,000 ÷ $1,644

Number of Days’ Sales in Receivables = 36.5 days

PE 17–5A

a. Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

Inventory Turnover = $510,000 ÷ $60,000

Inventory Turnover = 8.5

b. Number of Days’ Sales in Inventory = Average Inventory ÷ Average Daily Cost of Goods Sold

Number of Days’ Sales in Inventory = $60,000 ÷ ($510,000 ÷ 365)

= $60,000 ÷ $1,397

Number of Days’ Sales in Inventory = 42.9 days

PE 17–5B

a. Inventory Turnover = Cost of Goods Sold ÷ Average Inventory

Inventory Turnover = $480,000 ÷ $80,000

Inventory Turnover = 6.0

b. Number of Days’ Sales in Inventory = Average Inventory ÷ Average Daily Cost of Goods Sold

Number of Days’ Sales in Inventory = $80,000 ÷ ($480,000 ÷ 365)

= $80,000 ÷ $1,315

Number of Days’ Sales in Inventory = 60.8 days

PE 17–6A

a. Ratio of Fixed Assets to Long-Term Liabilities = Fixed Assets ÷

Long-Term Liabilities

Ratio of Fixed Assets to Long-Term Liabilities = $600,000 ÷ $400,000

Ratio of Fixed Assets to Long-Term Liabilities = 1.5

b. Ratio of Liabilities to Stockholders’ Equity = Total Liabilities ÷

Total Stockholders’ Equity

Ratio of Liabilities to Stockholders’ Equity = $600,000 ÷ $400,000

Ratio of Liabilities to Stockholders’ Equity = 1.5

PE 17–6B

a. Ratio of Fixed Assets to Long-Term Liabilities = Fixed Assets ÷

Long-Term Liabilities

Ratio of Fixed Assets to Long-Term Liabilities = $1,000,000 ÷ $500,000

Ratio of Fixed Assets to Long-Term Liabilities = 2.0

b. Ratio of Liabilities to Stockholders’ Equity = Total Liabilities ÷ Total

Stockholders’ Equity

Ratio of Liabilities to Stockholders’ Equity = $800,000 ÷ $800,000

Ratio of Liabilities to Stockholders’ Equity = 1.0

PE 17–7A

Number of Times Interest Charges Are Earned = (Income Before Income Tax +

Interest Expense) ÷ Interest Expense

Number of Times Interest Charges Are Earned = ($2,000,000 + $80,000) ÷ $80,000

Number of Times Interest Charges Are Earned = 26.0

PE 17–7B

Number of Times Interest Charges Are Earned = (Income Before Income Tax +

Interest Expense) ÷ Interest Expense

Number of Times Interest Charges Are Earned = ($1,500,000 + $200,000) ÷ $200,000

Number of Times Interest Charges Are Earned = 8.5

PE 17–8A

Ratio of Net Sales to Assets = Net Sales ÷ Average Total Assets

Ratio of Net Sales to Assets = $2,400,000 ÷ $1,600,000

Ratio of Net Sales to Assets = 1.5

PE 17–8B

Ratio of Net Sales to Assets = Net Sales ÷ Average Total Assets

Ratio of Net Sales to Assets = $1,200,000 ÷ $1,000,000

Ratio of Net Sales to Assets = 1.2

PE 17–9A

Rate Earned on Total Assets = (Net Income + Interest Expense) ÷Average Total Assets

Rate Earned on Total Assets = ($400,000 + $20,000) ÷ $3,500,000

Rate Earned on Total Assets = $420,000 ÷ $3,500,000

Rate Earned on Total Assets = 12.0%

PE 17–9B

Rate Earned on Total Assets = (Net Income + Interest Expense) ÷Average Total Assets

Rate Earned on Total Assets = ($600,000 + $75,000) ÷ $4,500,000

Rate Earned on Total Assets = $675,000 ÷ $4,500,000

Rate Earned on Total Assets = 15.0%

PE 17–10A

a. Rate Earned on Stockholders’ Equity = Net Income ÷ Average Stockholders’

Equity

Rate Earned on Stockholders’ Equity = $120,000 ÷ $600,000

Rate Earned on Stockholders’ Equity = 20.0%

b. Rate Earned on Common Stockholders’ Equity = (Net Income – Preferred Divi-dends) ÷ Average Common Stockholders’ Equity

Rate Earned on Common Stockholders’ Equity = ($120,000 – $20,000) ÷$500,000

Rate Earned on Common Stockholders’ Equity = 20.0%

PE 17–10B

a. Rate Earned on Stockholders’ Equity = Net Income ÷ Average Stockholders’

Equity

Rate Earned on Stockholders’ Equity = $180,000 ÷ $1,200,000

Rate Earned on Stockholders’ Equity = 15.0%

b. Rate Earned on Common Stockholders’ Equity = (Net Income – Preferred Divi-dends) ÷ Average Common Stockholders’ Equity

Rate Earned on Common Stockholders’ Equity = ($180,000 – $12,000) ÷$800,000

Rate Earned on Common Stockholders’ Equity = 21.0%

PE 17–11A

a. Earnings per Share on Common Stock = (Net Income – Preferred Dividends) ÷Shares of Common Stock Outstanding

Earnings per Share = ($340,000 – $40,000) ÷ 40,000

Earnings per Share = $7.50

b. Price-Earnings Ratio = Market Price per Share of Common Stock ÷Earnings per Share on Common Stock

Price-Earnings Ratio = $60.00 ÷ $7.50

Price-Earnings Ratio = 8.0

PE 17–11B

a. Earnings per Share on Common Stock = (Net Income – Preferred Dividends) ÷Shares of Common Stock Outstanding

Earnings per Share = ($140,000 – $20,000) ÷ 60,000

Earnings per Share = $2.00

b. Price-Earnings Ratio = Market Price per Share of Common Stock ÷Earnings per Share on Common Stock

Price-Earnings Ratio = $50.00 ÷ $2.00

Price-Earnings Ratio = 25.0

EXERCISES

Ex. 17–1

a.

ROGAN TECHNOLOGIES CO.Comparative Income Statement

For the Years Ended December 31, 2010 and 2009

2010 2009 Amount Percent Amount Percent

Sales............................................ $500,000 100.0% $440,000 100.0%Cost of goods sold.................... 325,000 65 .0 242,000 55 .0 Gross profit................................. $175,000 35 .0 % $198,000 45 .0 %Selling expenses........................ $ 70,000 14.0% $ 79,200 18.0%Administrative operating

expenses............................... 75,000 15 .0 70,400 16 .0 Total expenses........................... $145,000 29 .0 % $149,600 34 .0 %Income from operations............ $ 30,000 6.0% $ 48,400 11.0%Income tax expense................... 25,000 5 .0 26,400 6 .0 Net income.................................. $ 5,000 1 .0 % $ 22,000 5 .0 %

b. The vertical analysis indicates that the cost of goods sold as a percent of sales increased by 10 percentage points (65.0% – 55.0%), while selling expenses de-creased by 4 percentage points (14% – 18%), administrative expenses de-creased by 1% (15% – 16%), and Income Tax Expense decreased by 1 percent -age point (5% – 6%). Thus, net income as a percent of sales dropped by 4% (4% + 1% + 1% – 10%).

Ex. 17–2

a.

SPEEDWAY MOTORSPORTS, INC.Comparative Income Statement (in thousands of dollars)


2006 2005

Revenues:Admissions...................................... $175,208 30.9% $177,352 32.6%Event-related revenue..................... 183,404 32.3 168,359 30.9NASCAR broadcasting revenue..... 162,715 28.7 140,956 25.9Other operating revenue................. 46,038 8 .1 57,401 10 .6

Total revenue.............................. $567,365 100 .0 % $544,068 100 .0 %Expenses and other:

Direct expense of events................ $ 95,990 16.9% $ 97,042 17.8%NASCAR purse and sanction fees. 105,826 18.7 96,306 17.7Other direct expenses..................... 113,141 19.9 102,535 18.8General and administrative............ 78,070 13 .8 73,281 13 .5

Total expenses and other.......... $393,027 69 .3 % $369,164 67 .8 %Income from continuing operations. . . $174,338 30 .7 % $ 174,904 32 .2 %

b. While overall revenue increased some between the two years, the overall mix of revenue sources did change somewhat. The NASCAR broadcasting revenue in-creased as a percent of total revenue by almost three percentage points, while the percent of admissions revenue to total revenue decreased by almost two percentage points. All three of the major expense categories (Direct expense of events, NASCAR purse and sanction fees, and Other direct expenses) as a per-cent of total revenue increased by approximately 1 percentage point. Overall, the income from continuing operations decreased 1.4 percentage points of total revenue between the two years, which is a slightly unfavorable trend. However, the income from continuing operations as a percent of sales exceeds 25% in the most recent year, which is excellent. Apparently, owning and operating motor speedways is a business that produces high operating profit margins.

Note to Instructors: The high operating margin is probably necessary to com-pensate for the extensive investment in speedway assets.

Ex. 17–3

a.

SORENSON ELECTRONICS COMPANYCommon-Sized Income Statement

For the Year Ended December 31, 20—

Sorenson ElectronicsElectronics Industry

Company Average Amount Percent

Sales................................................................. $ 2,050,000 102.5% 102.5%Sales returns and allowances........................ 50,000 2 .5 2 .5 Net sales........................................................... $ 2,000,000 100.0% 100.0%Cost of goods sold.......................................... 1,100,000 55 .0 61 .0 Gross profit...................................................... $ 900,000 45 .0 % 39 .0 %Selling expenses............................................. $ 560,000 28.0% 23.0%Administrative expenses................................ 220,000 11 .0 10 .0 Total operating expenses............................... $ 780,000 39 .0 % 33 .0 %Operating income............................................ $ 120,000 6.0% 6.0%Other income.................................................... 44,000 2 .2 2 .2

$ 164,000 8.2% 8.2%Other expense.................................................. 20,000 1 .0 1 .0 Income before income tax.............................. $ 144,000 7.2% 7.2%Income tax expense........................................ 60,000 3 .0 5 .0 Net income....................................................... $ 84,000 4 .2 % 2 .2 %

b. The cost of goods sold is 6 percentage points lower than the industry average, but the selling expenses and administrative expenses are five percentage points and 1 percentage point higher than the industry average. The combined impact is for net income as a percent of sales to be 2 percentage points better than the industry average. Apparently, the company is managing the cost of manufactur-ing product better than the industry but has slightly higher selling and adminis-trative expenses relative to the industry. The cause of the higher selling and administrative expenses as a percent of sales, relative to the industry, can be investigated further.

Ex. 17–4

HANES COMPANYComparative Balance SheetDecember 31, 2010 and 2009


Current assets............................. $ 320,000 32.0% $200,000 25.0%Property, plant, and equipment. 560,000 56.0 560,000 70.0Intangible assets......................... 120,000 12 .0 40,000 5 .0 Total assets.................................. $ 1,000,000 100 .0 % $800,000 100 .0 %

Current liabilities......................... $ 210,000 21.0% $120,000 15.0%Long-term liabilities.................... 350,000 35.0 300,000 37.5Common stock............................. 100,000 10.0 100,000 12.5Retained earnings....................... 340,000 34 .0 280,000 35 .0 Total liabilities and

stockholders’ equity.............. $ 1,000,000 100 .0 % $800,000 100 .0 %

Ex. 17–5

a. GRENDEL IMAGES COMPANYComparative Income Statement


2010 2009 Increase (Decrease)Amount Amount Amount Percent

Sales............................................ $196,000 $160,000 $36,000 22.5%Cost of goods sold.................... 170,100 140,000 30,100 21.5Gross profit................................. $ 25,900 $ 20,000 $ 5,900 29.5Selling expenses........................ $ 12,200 $ 10,000 $ 2,200 22.0Administrative expenses........... 9,750 8,000 1,750 21.9Total operating expenses.......... $ 21,950 $ 18,000 $ 3,950 21.9Income before income tax......... $ 3,950 $ 2,000 $ 1,950 97.5Income tax expense................... 2,000 1,000 1,000 100.0Net income.................................. $ 1,950 $ 1,000 $ 950 95.0

b. The net income for Grendel Images Company increased by approximately 95% from 2009 to 2010. This increase was the combined result of an increase in sales of 22.5% and lower expenses. The cost of goods sold increased at a slower rate than the increase in sales, thus causing gross profit to increase more than the increase in sales.

Ex. 17–6

a. (1) Working Capital = Current Assets – Current Liabilities

2010: $1,000,000 = $1,500,000 – $500,000

2009: $644,000 = $1,104,000 – $460,000

(2) Current Ratio =

2010: = 3.0 2009: = 2.4

(3) Quick Ratio =

2010: = 1.8 2009: = 1.5

b. The liquidity of Bock Suppliers has improved from the preceding year to the cur-rent year. The working capital, current ratio, and quick ratio have all increased. Most of these changes are the result of an increase in current assets.

Ex. 17–7

a. (1) Current Ratio =

Dec. 30, 2006: = 1.3 Dec. 31, 2005: = 1.1

(2) Quick Ratio =

Dec. 30, 2006: = 1.0 Dec. 31, 2005: = 0.9

b. The liquidity of PepsiCo has increased some over this time period. Both the cur-rent and quick ratios have increased. The current ratio increased from 1.1 to 1.3, and the quick ratio increased from 0.9 to 1.0. PepsiCo is a strong company with ample resources for meeting short-term obligations.

Ex. 17–8

a. The working capital, current ratio, and quick ratio are calculated incorrectly. The working capital and current ratio incorrectly include intangible assets and prop-erty, plant, and equipment as a part of current assets. Both are noncurrent. The quick ratio has both an incorrect numerator and denominator. The numerator of the quick ratio is incorrectly calculated as the sum of inventories, prepaid ex-penses, and property, plant, and equipment ($40,000 + $60,000 + $92,000). The denominator is also incorrect, as it does not include accrued liabilities. The de-nominator of the quick ratio should be total current liabilities.

The correct calculations are as follows:

Working Capital = Current Assets – Current Liabilities

$50,000 = $550,000 – $500,000

Current Ratio =

= 1.1

Quick Ratio =

= 0.9

b. Unfortunately, the working capital, current ratio, and quick ratio are all below the minimum threshold required by the bond indenture. This may require the com-pany to renegotiate the bond contract, including a possible unfavorable change in the interest rate.

Ex. 17–9

a. (1) Accounts Receivable Turnover =

2010: = 6.4 2009: = 5.6

(2) Number of Days’ Sales in Receivables =

2010: = 57.2 days

2009: = 65.5 days

1$152,750 = ($147,500 + $158,000) ÷ 22$2,671 = $975,000 ÷ 365 days3$161,500 = ($158,000 + $165,000) ÷ 24$2,466 = $900,000 ÷ 365 days

b. The collection of accounts receivable has improved. This can be seen in both the increase in accounts receivable turnover and the reduction in the collection period. The credit terms require payment in 60 days. In 2009, the collection pe-riod exceeded these terms. However, the company apparently became more ag-gressive in collecting accounts receivable or more restrictive in granting credit to customers. Thus, in 2010, the collection period is within the credit terms of the company.

Ex. 17–10

a. (1) Accounts Receivable Turnover =

Xavier: = 11.2

Lestrade: = 5.0

(2) Number of Days’ Sales in Receivables =

Xavier: = 32.6 days

Lestrade: = 73.0 days

1$76.71 = $28,000 ÷ 365 days2$178.08 = $65,000 ÷ 365 days

b. Xavier’s accounts receivable turnover is much higher than Lestrade’s (11.2 for Xavier vs. 5.0 for Lestrade). The number of days’ sales in receivables is lower for Xavier than for Lestrade (32.6 days for Xavier vs. 73.0 days for Lestrade). These differences indicate that Xavier is able to turn over its receivables more quickly than Lestrade. As a result, it takes Xavier less time to collect its receivables.

Ex. 17–11

a. (1) Inventory Turnover =

Current Year: = 7.4

Preceding Year: = 9.2

(2) Number of Days’ Sales in Inventory =

Current Year: = 49.3 days

Preceding Year: = 39.7 days

1$1,561 = $569,800 ÷ 365 days2$1,815 = $662,400 ÷ 365 days

b. The inventory position of the business has deteriorated. The inventory turnover has decreased, while the number of days’ sales in inventory has increased. The sales volume has declined faster than the inventory has declined, thus resulting in the deteriorating inventory position.

Ex. 17–12

a. (1) Inventory Turnover =

Dell: = 76.8

HP: = 9.5

(2) Number of Days’ Sales in Inventory =

Dell: = 4.8 days

HP: = 38.5 days

1$131 = $47,904 ÷ 365 days2$190 = $69,427 ÷ 365 days

b. Dell has a much higher inventory turnover ratio than does HP (76.8 vs. 9.5 for HP). Likewise, Dell has a much smaller number of days’ sales in inventory (4.8 days vs. 38.5 days for HP). These significant differences are a result of Dell’s make-to-order strategy. Dell has successfully developed a manufacturing process that is able to fill a customer order quickly. As a result, Dell does not need to prebuild computers to inventory. HP, in contrast, prebuilds computers, printers, and other equipment to be sold by retail stores and other retail chan-nels. In this industry, there is great obsolescence risk in holding computers in inventory. New technology can make an inventory of computers difficult to sell; therefore, inventory is costly and risky. Dell’s operating strategy is considered revolutionary and is now being adopted by many both in and out of the com-puter industry. Apple Computer, Inc., also employs similar manufacturing tech-niques, and thus enjoys excellent inventory efficiency.

Ex. 17–13

a. Ratio of Liabilities to Stockholders’ Equity =

Dec. 31, 2010: = 0.6 Dec. 31, 2009: = 0.8

b. =

Dec. 31, 2010: = 4.0

Dec. 31, 2009: = 3.0

*($2,000,000 + $400,000) × 10% = $240,000

**($2,400,000 + $400,000) × 10% = $280,000

c. Both the ratio of liabilities to stockholders’ equity and the number of times bond interest charges were earned have improved from 2009 to 2010. These results are the combined result of a larger income before taxes and lower serial bonds payable in the year 2010 compared to 2009.

Ex. 17–14


Hasbro: = 0.9

Mattel, Inc.: = 1.0

b.

=

Hasbro: = 14.7

Mattel, Inc.: = 10.1

c. Both companies carry a moderate proportion of debt to the stockholders’ equity, near 1.0 times stockholders’ equity. The companies’ debt as a percent of stockholders’ equity is similar. Both companies also have very strong interest coverage, earning in excess of 10 times interest charges. Together, these ratios indicate that both companies provide creditors with a margin of safety, and that earnings appear more than enough to make interest payments.

Ex. 17–15


H.J. Heinz: = 4.4

Hershey: = 4.7

b. Ratio of Fixed Assets to Long-Term Liabilities =

H.J. Heinz: = 0.35

Hershey: = 0.95

c. H.J. Heinz uses more debt than does Hershey. While the total liabilities to stock-holders’ equity ratio is similar for both companies (4.4 vs. 4.7), the ratio of fixed assets is very different. H.J. Heinz has a much lower ratio of fixed assets to long-term liabilities than Hershey. This ratio divides the property, plant, and equipment (net) by the long-term debt. The ratio for H.J. Heinz is ag-gressive with only 35% of fixed assets covering the long-term debt. That is, the creditors of H.J. Heinz have 35 cents of property, plant, and equipment covering every dollar of long-term debt. The same ratio for Hershey shows fixed assets covering 0.95 times the long-term debt. That is, Hershey’s creditors have $0.95 of property, plant, and equipment covering every dollar of long-term debt. This would suggest that Hershey has stronger creditor protection and borrowing ca-pacity than does H.J. Heinz.

Ex. 17–16

a. Ratio of Net Sales to Total Assets:

YRC Worldwide: = 1.7

Union Pacific: = 0.4

C.H. Robinson Worldwide, Inc.: = 4.3

b. The ratio of net sales to assets measures the number of sales dollars earned for each dollar of assets. The greater the number of sales dollars earned for every dollar of assets, the more efficient a firm is in using assets. Thus, the ratio is a measure of the efficiency in using assets. The three companies are different in their efficiency in using assets, because they are different in the nature of their operations. Union Pacific earns only 40 cents for every dollar of assets. This is because Union Pacific is very asset intensive. That is, Union Pacific must invest in locomotives, railcars, terminals, tracks, right-of-way, and information systems in order to earn revenues. These investments are significant. YRC Worldwide is able to earn $1.70 for every dollar of assets, and thus, is able to earn more rev-enue for every dollar of assets than the railroad. This is because the motor car-rier invests in trucks, trailers, and terminals, which require less investment per dollar of revenue than does the railroad. Moreover, the motor carrier does not in -vest in the highway system, because the government owns the highway system. Thus, the motor carrier has no investment in the transportation network itself unlike the railroad. C.H. Robinson Worldwide, Inc., the transportation arranger, hires transportation services from motor carriers and railroads, but does not own these assets itself. The transportation arranger has assets in accounts re-ceivable and information systems but does not require transportation assets; thus, it is able to earn the highest revenue per dollar of assets.

Ex. 17–16 Concluded

Note to Instructors: Students may wonder how asset-intensive companies over-come their asset efficiency disadvantages to competitors with better asset effi -ciencies, as in the case between railroads and motor carriers. Asset efficiency is part of the financial equation; the other part is the profit margin made on each dollar of sales. Thus, companies with high asset efficiency often operate on thinner margins than do companies with lower asset efficiency. For example, the motor carrier must pay highway taxes, which lowers its operating margins when compared to railroads that own their right-of-way, and thus do not have the tax expense of the highway. While not required in this exercise, the railroad has the highest profit margins, the motor carrier is in the middle, while the transporta-tion arranger operates on very thin margins.

Ex. 17–17

a. Rate Earned on Total Assets =

2010: = 12.0% 2009: = 16.0%

*($3,000,000 + $2,700,000) ÷ 2 **($2,700,000 + $2,400,000) ÷ 2

Rate Earned on Stockholders’ Equity =

2010: = 15.0% 2009: = 22.8%

*($1,726,000 + $1,496,000) ÷ 2 **($1,496,000 + $1,200,000) ÷ 2

=

2010: = 16.3% 2009:

= 25.8%

*($1,526,000 + $1,296,000) ÷ 2 **($1,296,000 + $1,000,000) ÷ 2

b. The profitability ratios indicate that The Sigemund Group’s profitability has de-teriorated. Most of this change is from net income falling from $308,000 in 2009 to $242,000 in 2010. The cost of debt is 10%. Since the rate of return on assets exceeds this amount in either year, there is positive leverage from use of debt. However, this leverage is greater in 2009 because the rate of return on assets exceeds the cost of debt by a greater amount in 2009.

Ex. 17–18


Fiscal Year 2006: = 9.5%


b. Rate Earned on Stockholders’ Equity =



c. Both the rate earned on total assets and the rate earned on stockholders’ equity have increased over the two-year period. The rate earned on total assets in-creased from 6.0% to 9.5%, and the rate earned on stockholders’ equity in-creased from 8.3% to 13.7%. The rate earned on stockholders’ equity exceeds the rate earned on total assets due to the positive use of leverage.

d. During fiscal 2006, Ann Taylor’s results were strong compared to the industry average. The rate earned on total assets for Ann Taylor was more than the in-dustry average (9.5% vs. 8.2%). The rate earned on stockholders’ equity was more than the industry average (13.7% vs. 10.0%). These relationships suggest that Ann Taylor has more leverage than the industry, on average.

Ex. 17–19

a. Ratio of Fixed Assets to Long-Term Liabilities =

= 1.6

b. Ratio of Liabilities to Stockholders’ Equity =

= 0.4

c. Ratio of Net Sales to Assets =

= 5.0

*[($4,000,000 + $4,200,000) ÷ 2] – $2,100,000. The end-of-period total assets are equal to the sum of total liabilities ($1,200,000) and stockholders’ equity ($3,000,000).

d. Rate Earned on Total Assets =

= 12.2%

*($4,000,000 + $4,200,000) ÷ 2

e. Rate Earned on Stockholders’ Equity =

= 13.8%

*[($1,000,000 + $1,000,000 + $800,000) + $3,000,000] ÷ 2

f. =

= 15.8%

* [($1,000,000 + $1,000,000) + ($1,000,000 + $800,000)] ÷ 2

Ex. 17–20

a. =

= 3.5 times

b. Number of Times Preferred Dividends Are Earned =

= 17.0 times

c. Earnings per Share on Common Stock =

= $4.00

d. Price-Earnings Ratio =

= 10.0

e. Dividends per Share of Common Stock =

= $1.00

f. Dividend Yield =

= 2.5%

Ex. 17–21

a. Earnings per Share =

= $1.60

b. Price-Earnings Ratio =

= 12.5

c. Dividends per Share =

= $0.50

d. Dividend Yield =

= 2.5%

Appendix Ex. 17–22

a. Price-Earnings Ratio =

Bank of America: = 11.5

eBay: = 58.8

Coca-Cola: = 22.1

Dividend Yield =

Bank of America: = 4.0%

eBay: = 0%

Coca-Cola: = 2.6%

b. Bank of America has the largest dividend yield, but the smallest price-earnings ratio. Stock market participants value Bank of America common stock on the ba-sis of its dividend. The dividend is an attractive yield at this date. Because of this attractive yield, stock market participants do not expect the share price to grow significantly, hence the low price-earnings valuation. This is a typical pat-tern for companies that pay high dividends. eBay shows the opposite extreme. eBay pays no dividend, and thus has no dividend yield. However, eBay has the largest price-earnings ratio of the three companies. Stock market participants are expecting a return on their investment from appreciation in the stock price. Some would say that the stock is priced very aggressively at 58.8 times earn-ings. Coca-Cola is priced in between the other two companies. Coca-Cola has a moderate dividend producing a yield of 2.6%. The price-earnings ratio is near 22, which is close to the market average at this writing. Thus, Coca-Cola is expected to produce shareholder returns through a combination of some share price ap-preciation and a small dividend.


a. Earnings per share on income before extraordinary items:

Net income...................................................................... $2,500,000Less gain on condemnation.......................................... (500,000)Plus loss from flood damage........................................ 200,000 Income before extraordinary items............................... $2,200,000

Earnings Before Extraordinary Items per Share on Common Stock =

= $20.40 per share

b. Earnings per Share on Common Stock =

= $23.40 per share


a. NR e. E

b. NR f. NR

c. E g. NR

d. NR


a.

BRADY, INC.Partial Income Statement

For the Year Ended December 31, 2010

Income from continuing operations before income tax................. $500,000Income tax expense........................................................................... 200,000 Income from continuing operations................................................. $300,000Loss from discontinued operations................................................. 90,000 Income before extraordinary item..................................................... $210,000Extraordinary item:

Loss due to hurricane................................................................. 60,000 Net income.......................................................................................... $150,000

b.

BRADY, INC.Partial Income Statement

For the Year Ended December 31, 2010

Earnings per common share:Income from continuing operations................................................. $7.501

Loss from discontinued operations................................................. 2 .25 2

Income before extraordinary item..................................................... $5.25Extraordinary item:

Loss due to hurricane................................................................. 1 .50 3

Net income.......................................................................................... $3 .75 1$7.50 = $300,000 ÷ 40,0002$2.25 = $90,000 ÷ 40,0003$1.50 = $60,000 ÷ 40,000


a. Baxter Company reported this item correctly in the financial statements. This item is an error in the recognition, measurement, or presentation in the financial statements, which is correctly handled by retroactively restating prior-period earnings.

b. Baxter Company did not report this item correctly. This item is a change from one generally accepted accounting principle to another, which is correctly han-dled by retroactively restating prior-period earnings. In this case, Baxter reports this change cumulatively in the current period, which is incorrect.

PROBLEMS

Prob. 17–1A

1.

WIGLAF TECHNOLOGY COMPANYComparative Income Statement


Increase (Decrease ) 2010 2009 Amount Percent

Sales............................................... $560,000 $500,000 $ 60,000 12.0%Sales returns and allowances..... 37,500 25,000 12,500 50.0Net sales........................................ $522,500 $475,000 $ 47,500 10.0Cost of goods sold....................... 372,000 300,000 72,000 24.0Gross profit................................... $150,500 $175,000 $ (24,500 ) (14.0)Selling expenses........................... $ 52,000 $ 40,000 $ 12,000 30.0Administrative expenses............. 30,500 25,000 5,500 22.0Total operating expenses............ $ 82,500 $ 65,000 $ 17,500 26.9Income from operations............... $ 68,000 $110,000 $ (42,000) (38.2)Other income................................. 3,000 2,000 1,000 50.0Income before income tax........... $ 71,000 $112,000 $ (41,000) (36.6)Income tax expense...................... 5,500 5,000 500 10.0Net income..................................... $ 65,500 $ 107,000 $ (41,500 ) (38.8)

2. Net income has declined from 2009 to 2010. Net sales have increased by 10.0%; however, cost of goods sold has increased by 24.0%, causing the gross profit to grow at a rate less than sales relative to the base year. In addition, total operat-ing expenses have increased at a faster rate than sales (26.9% increase vs. 10.0% net sales increase). Increases in costs and expenses that are higher than the increase in sales have caused the net income to decline by 38.8%.

Prob. 17–2A

1.

OTHERE TECHNOLOGY COMPANYComparative Income Statement



Sales............................................ $ 714,000 102.0% $ 612,000 102.0%Sales returns and allowances... 14,000 2 .0 12,000 2 .0 Net sales..................................... $ 700,000 100.0% $ 600,000 100.0%Cost of goods sold.................... 322,000 46 .0 312,000 52 .0 Gross profit................................. $ 378,000 54 .0 % $ 288,000 48 .0 %Selling expenses........................ $ 154,000 22.0% $ 120,000 20.0%Administrative expenses........... 70,000 10 .0 66,000 11 .0 Total operating expenses.......... $ 224,000 32 .0 % $ 186,000 31 .0 %Income from operations............ $ 154,000 22.0% $ 102,000 17.0%Other income.............................. 28,000 4 .0 24,000 4 .0 Income before income tax......... $ 182,000 26.0% $ 126,000 21.0%Income tax expense................... 70,000 10 .0 60,000 10 .0 Net income.................................. $ 112,000 16 .0 % $ 66,000 11 .0 %

2. The vertical analysis indicates that the costs other than selling expenses (cost of goods sold and administrative expenses) improved as a percentage of sales. As a result, net income as a percentage of sales increased from 11.0% to 16.0%. The sales promotion campaign appears to have been successful. While selling expenses as a percent of sales increased slightly (2%), the increased cost was more than made up for by increased sales.

Prob. 17–3A

1. a. Working Capital = Current Assets – Current Liabilities

$1,120,000 – $400,000 = $720,000

b. Current Ratio =

= 2.8

c. Quick Ratio =

= 1.8

2.

Supporting Calculations Working Current Quick Current Quick Current

Transaction Capital Ratio Ratio Assets Assets Liabilities

a. $ 720,000 2.8 1.8 $1,120,000 $ 720,000 $400,000b. 720,000 3.3 2.0 1,040,000 640,000 320,000c. 720,000 2.6 1.6 1,170,000 720,000 450,000d. 720,000 3.4 2.1 1,020,000 620,000 300,000e. 640,000 2.3 1.5 1,120,000 720,000 480,000f. 720,000 2.8 1.8 1,120,000 720,000 400,000g. 920,000 3.3 2.3 1,320,000 920,000 400,000h. 720,000 2.8 1.8 1,120,000 720,000 400,000i. 1,120,000 3.8 2.8 1,520,000 1,120,000 400,000j. 720,000 2.8 1.7 1,120,000 680,000 400,000

Prob. 17–4A

1. Working Capital: $1,116,000 – $360,000 = $756,000

CalculatedRatio Numerator Denominator Value

2. Current ratio................... $1,116,000 $360,000 3.13. Quick ratio..................... $864,000 $360,000 2.44. Accounts receivable

turnover.......................... $1,602,080 ($260,000 + $211,200) ÷ 2 6.85. Number of days’

sales in receivables...... ($260,000 + $211,200) ÷ 2 ($1,602,080 ÷ 365) 53.76. Inventory turnover......... $480,200 ($208,000 + $66,400) ÷ 2 3.57. Number of days’

sales in inventory..........($208,000 + $66,400) ÷ 2 ($480,200 ÷ 365) 104.38. Ratio of fixed assets to

long-term liabilities....... $1,539,200 $1,184,000 1.39. Ratio of liabilities to

stockholders’ equity..... $1,544,000 $1,316,000 1.210. Number of times

interest charges earned............................ $477,160 + $110,720 $110,720 5.3

11. Number of times preferred dividends earned............................ $428,000 $4,000 107.0

12. Ratio of net sales to assets............................. $1,602,080 ($2,655,200 + $1,768,000) ÷ 2 0.7

13. Rate earned on total assets............................. $428,000 + $110,720 ($2,860,000 + $2,024,000) ÷ 2 22.1%

14. Rate earned on stock-holders’ equity............... $428,000 ($1,316,000 + $904,000) ÷ 2 38.6%

15. Rate earned on common stock-holders’ equity............... ($428,000 – $4,000) ($1,216,000 + $804,000) ÷ 2 42.0%

16. Earnings per shareon common stock.......... ($428,000 – $4,000) 40,000 $10.60

17. Price-earnings ratio...... $60.00 $10.60 5.718. Dividends per share

of common stock........... $12,000 40,000 $0.3019. Dividend yield................ $0.30 $60.00 0.5%

Prob. 17–5A

1. a.

Rate Earned on Total Assets =

2010: = 22.9% 2007: = 19.3%

2009: = 20.9% 2006: = 19.4%

2008: = 21.5%

Prob. 17–5A Continued

1. b.


2010: = 33.4% 2007: = 29.2%

2009: = 30.9% 2006: = 30.3%

2008: = 32.1%


1. c.

=

2010: = 7.0 2007: = 4.4

2009: = 5.7 2006: = 4.1

2008: = 5.1


1. d.

Ratio of Liabilities to Stockholders’ Equity =

2010: = 0.7 2007: = 1.0

2009: = 0.8 2006: = 1.2

2008: = 0.9

Note: The total liabilities are the difference between the total assets and total stockholders’ equity ending balances.

Prob. 17–5A Concluded

2. Both the rate earned on total assets and rate earned on stockholders’ equity are above the industry average for all five years. The rate earned on total assets is actually improving gradually. The rate earned on stockholders’ equity exceeds the rate earned on total assets, providing evidence of the positive use of lever-age. The company is clearly growing earnings as fast as the asset and equity base. In addition, the ratio of liabilities to stockholders’ equity indicates that the proportion of debt to stockholders’ equity has been declining over the period. The firm is adding to debt at a slower rate than the assets are growing from earnings. The number of times interest charges were earned ratio is improving during this time period. Again, the firm is increasing earnings faster than the increase in interest charges. Overall, these ratios indicate excellent financial performance coupled with appropriate use of debt (leverage).

Prob. 17–1B

1.

EGILS INC.Comparative Income Statement


Increase (Decrease) 2010 2009 Amount Percent

Sales................................................. $126,200 $100,000 $26,200 26.2%Sales returns and allowances........ 2,426 2,000 426 21.3Net sales........................................... $123,774 $ 98,000 $25,774 26.3Cost of goods sold.......................... 58,800 50,000 8,800 17.6Gross profit...................................... $ 64,974 $ 48,000 $ 16,974 35.4Selling expenses............................. $ 17,310 $ 15,000 $ 2,310 15.4Administrative expenses................ 13,464 12,000 1,464 12.2Total operating expenses............... $ 30,774 $ 27,000 $ 3,774 14.0Income from operations.................. $ 34,200 $ 21,000 $13,200 62.9Other income................................... 1,000 1,000 0 0.0Income before income tax.............. $ 35,200 $ 22,000 $13,200 60.0Income tax expense........................ 12,000 6,000 6,000 100.0Net income....................................... $ 23,200 $ 16,000 $ 7,200 45.0

2. The profitability has significantly improved. Net sales have increased by 26.3% over the 2009 base year. However, cost of goods sold, selling expenses, and ad-ministrative expenses grew at a slower rate. Increasing sales combined with costs that increase at a slower rate results in strong earnings growth. In this case, net income grew 45.0% over the base year.

Prob. 17–2B

1.

EINAR INDUSTRIES INC.Comparative Income Statement



Sales............................................. $ 525,000 105.0% $ 420,000 105.0%Sales returns and allowances.... 25,000 5 .0 20,000 5 .0 Net sales....................................... $ 500,000 100.0% $ 400,000 100.0%Cost of goods sold...................... 280,000 56 .0 220,000 55 .0 Gross profit.................................. $ 220,000 44 .0 % $ 180,000 45 .0 %Selling expenses......................... $ 130,000 26.0% $ 80,000 20.0%Administrative expenses............ 65,000 13 .0 56,000 14 .0 Total operating expenses........... $ 195,000 39 .0 % $ 136,000 34 .0 %Income from operations.............. $ 25,000 5.0% $ 44,000 11.0%Other income............................... 30,000 6 .0 24,000 6 .0 Income before income tax.......... $ 55,000 11.0% $ 68,000 17.0%Income tax expense (benefit)..... 35,000 7 .0 28,000 7 .0 Net income (loss)........................ $ 20,000 4 .0 % $ 40,000 10 .0 %

2. The net income as a percent of sales has declined. All the costs and expenses, other than selling expenses, have maintained their approximate cost as a percent of sales relationship between 2009 and 2010. Selling expenses as a percent of sales, however, have grown from 20.0% to 26.0% of sales. Apparently, the new advertising campaign has not been successful. The increased expense has not produced sufficient sales to maintain relative profitability. Thus, selling expenses as a percent of sales have increased.

Prob. 17–3B

1. a. Working Capital = Current Assets – Current Liabilities

$1,400,000 – $1,000,000 = $400,000

b. Current Ratio =

= 1.4

c. Quick Ratio =

= 0.9

2.

Supporting Calculations Working Current Quick Current Quick Current

Transaction Capital Ratio Ratio Assets Assets Liabilities

a. $ 400,000 1.4 0.9 $1,400,000 $ 900,000 $1,000,000b. 400,000 1.5 0.9 1,200,000 700,000 800,000c. 400,000 1.4 0.8 1,480,000 900,000 1,080,000d. 400,000 1.5 0.9 1,200,000 700,000 800,000e. 275,000 1.2 0.8 1,400,000 900,000 1,125,000f. 400,000 1.4 0.9 1,400,000 900,000 1,000,000g. 800,000 1.8 1.3 1,800,000 1,300,000 1,000,000h. 400,000 1.4 0.9 1,400,000 900,000 1,000,000i. 1,200,000 2.2 1.7 2,200,000 1,700,000 1,000,000j. 400,000 1.4 0.9 1,400,000 880,000 1,000,000

Prob. 17–4B

1. Working capital: $2,080,000 – $520,000 = $1,560,000

CalculatedRatio Numerator Denominator Value

2. Current ratio................... $2,080,000 $520,000 4.03. Quick ratio..................... $1,404,000 $520,000 2.74. Accounts receivable

turnover.......................... $4,210,000 ($390,000 + $283,600) ÷ 2 12.55. Number of days’ sales

in receivables................ ($390,000 + $283,600) ÷ 2 ($4,210,000 ÷ 365) 29.26. Inventory turnover......... $1,866,150 ($631,000 + $500,000) ÷ 2 3.37. Number of days’ sales

in inventory.................... ($631,000 + $500,000) ÷ 2 ($1,866,150 ÷ 365) 110.68. Ratio of fixed assets to

long-term liabilities....... $3,780,000 $1,800,000 2.19. Ratio of liabilities to

stockholders’ equity..... $2,320,000 $3,864,450 0.610. Number of times interest

charges earned.............. $692,850 + $196,000 $196,000 4.511. Number of times

preferred dividends earned............................ $482,850 $24,000 20.1

12. Ratio of net sales to assets............................. $4,210,000 ($5,860,000 + $4,256,100) ÷ 2 0.8

13. Rate earned on total assets............................. $482,850 + $196,000 ($6,184,450 + $4,631,100) ÷ 2 12.6%

14. Rate earned on stock-holders’ equity............... $482,850 ($3,864,450 + $3,453,600) ÷ 2 13.2%

15. Rate earned on common stock-holders’ equity............... ($482,850 – $24,000) ($3,064,450 + $2,653,600) ÷ 2 16.0%

16. Earnings per share on common stock.......... ($482,850 – $24,000) 120,000 $3.82

17. Price-earnings ratio...... $40.00 $3.82 10.518. Dividends per share

of common stock........... $48,000 120,000 $0.4019. Dividend yield................ $0.40 $40.00 1.0%

Prob. 17–5B

1. a.

Rate Earned on Total Assets =

2010: = 9.6% 2007: = 21.2%

2009: = 11.1% 2006: = 23.4%

2008: = 15.3%

Prob. 17–5B Continued

1. b.


2010: = 7.1% 2007: = 38.5%

2009: = 10.4% 2006: = 55.1%

2008: = 20.7%


1. c.

=

2010: = 1.5 2007: = 3.3

2009: = 1.8 2006: = 3.5

2008: = 2.5


1. d.

Ratio of Liabilities to Stockholders’ Equity =

2010: = 1.3 2007: = 1.6

2009: = 1.3 2006: = 2.1

2008: = 1.3

Note: Total liabilities are determined by subtracting stockholders’ equity (ending balance) from the total assets (ending balance).

Prob. 17–5B Concluded

2. Both the rate earned on total assets and the rate earned on stockholders’ eq-uity have been moving in a negative direction in the last five years. Both mea-sures have moved below the industry average over the last two years. The cause of this decline is driven by a rapid decline in earnings. The use of debt can be seen from the ratio of liabilities to stockholders’ equity. The ratio has declined over the time period and has declined below the industry average. Thus, the level of debt relative to the stockholders’ equity has gradually im-proved over the five years. Unfortunately, the earnings have declined at a faster rate, causing the rate earned on stockholders’ equity to decline. The rate earned on total assets ran below the interest cost on debt in 2009 and 2010, causing the rate earned on stockholders’ equity to drop below the rate earned on total assets. This is an example of negative leverage. The number of times interest charges were earned has been falling below the industry av-erage for several years. This is the result of low profitability combined with high interest costs. The number of times interest is earned has fallen to a dan-gerously low level in 2010. The low profitability and time interest charges are earned in 2010, as well as the five-year trend, should be a major concern to the company’s management, stockholders, and creditors.

NIKE, INC., PROBLEM

1. a. 2007 2006

Total current assets.................................................... $8,076.5 $7,346.0Total current liabilities................................................ 2,584 .0 2,612 .4

Working capital........................................................ $5,492 .5 $4,733 .6

b. 2007 2006 Total current assets.................................................... $8,076.5 $7,346.0/ Total current liabilities.............................................. 2,584 .0 2,612 .4

Current ratio............................................................. 3 .1 2 .8

c. 2007 2006 Cash.............................................................................. $1,856.7 $ 954.2Short-term investments.............................................. 990.3 1,348.8Accounts receivable................................................... 2,494 .7 2,382 .9

Total quick assets................................................... $5,341.7 $4,685.9/ Total current liabilities.......................................... $2,584 .0 $2,612 .4

Quick ratio.................................................................... 2 .1 1 .8

d. Net sales....................................................................... $16,325.9 $14,954.9Accounts receivable (net):

Beginning of year.................................................... 2,382.9 2,249.9End of year............................................................... 2,494 .7 2,382 .9

Total.............................................................................. $4,877.6 $4,632.8Average (Total / 2)....................................................... 2,438.8 2,316.4Accounts receivable turnover

(Net sales/Average accounts receivable).............. 6 .7 6 .5

e. Accounts receivable (average): 2,438.8 2,316.4Net sales................................................................... $16,325.9 $14,954.9Average daily sales (Sales / 365)........................... 44.7 41.0

Number of days sales in receivables........................ 54 .6 56 .5

f. Cost of goods sold...................................................... $9,165.4 $8,367.9Inventories:

Beginning of year.................................................... 2,076.7 1,811.1End of year............................................................... 2,121 .9 2,076 .7 Total.......................................................................... $4,198.6 $3,887.8

Average (Total / 2)....................................................... 2,099.3 1,943.9Inventory turnover

(Cost of goods sold/Average inventory)............... 4 .4 4 .3

NIKE, Inc., Problem Continued

g. Inventory (average)..................................................... 2,099.3 1,943.9Cost of goods sold...................................................... 9,165.4 8,367.9Average daily cost of goods sold.............................. 25.1 22.9Number of days sales in inventory (Average

inventory/Average daily cost of goods sold)........ 83 .6 84 .9

h. Total liabilities............................................................. 3,662.9 3,584.4/ Total stockholders’ equity........................................ 7,025 .4 6,285 .2 Ratio of liabilities to stockholders’ equity................ 0 .5 0 .6

i. Net sales....................................................................... $16,325.9 $14,954.9Total assets (excluding long-term investments):

Beginning of year.................................................... $ 9,869.6 $ 8,793.6End of year............................................................... 10,688 .3 9,869 .6 Total.......................................................................... $20,557.9 $18,663.2

Average total assets................................................... 10,279.0 9,331.6Ratio of net sales to assets........................................ 1 .6 1 .6

j. Net income................................................................... $ 1,491.5 $ 1,392.0Plus interest expense................................................. 20 .5 21 .0

Total.......................................................................... $ 1,512.0 $ 1,413.0Total assets:


Average total assets................................................... 10,279.0 9,331.6Rate earned on total assets

(Net income/Average total assets)......................... 14 .5 % 14.9%

k. Net income................................................................... $ 1,491.5 $ 1,392.0Stockholders’ equity:


Average stockholders’ equity.................................... 6,655.3 5,964.7Rate earned on stockholders’ equity........................ 22 .4 % 23 .3 %

l. Market price per share of common stock................. 56.75 40.16Earnings per share on common stock...................... $2.96 $2.69Price-earnings ratio on common stock..................... 19.2% 14.9%

NIKE, Inc., Problem Concluded

m. Net income................................................................... $1,491.5 $1,392.0Net sales....................................................................... $16,325.9 $14,954.9Net income to net sales.............................................. 9.1% 9.3%

2. Before reaching definitive conclusions, each measure should be compared with past years, industry averages, and similar firms in the industry.

a. The working capital increased significantly.

b. and c. The current ratio increased during 2007.

d. and e. The accounts receivable turnover and number of days’ sales in receiv-ables indicate a slight increase in efficiency of collecting accounts receivable. The accounts receivable turnover increased from 6.5 to 6.7. The number of days’ sales in receivables decreased slightly from 56.5 to 54.6. Thus, it takes the company about two months to collect its accounts receivable from credit sales. These numbers should be compared to their competitors, industry aver-ages, and Nike’s credit policy to determine draw definitive conclusions.

f. and g. The results of these two analyses show a very slight increase in inventory turnover, and reduction in the number of days sales in inventory. Both trends are small. Inventory management is critical to Nike, so this ratio trend should be watched in the future.

h. The margin of protection to creditors dropped during 2007. While this trend is in the wrong direction, the company still provides sound protection to its credi-tors.

i. These analyses indicate that the effectiveness in the use of assets to generate revenues remained constant across both years.

j. The rate earned on average total assets decreased slightly during 2007. Overall, rates earned on assets that exceed 10% are usually considered good perfor-mance.

k. The rate earned on average common stockholders’ equity increased slightly. This is also evidence of the positive use of leverage, since the rate earned on stockholders’ equity exceeds the rate earned on assets. The rates earned on average common stockholders’ equity shown for these two years would be con-sidered excellent performance.

l. The price-earnings ratio increased significantly from 2006 to 2007. This in-crease was driven by a significant increase in Nike’s stock price, from $40.16 at the end of fiscal 2006 to $56.75 at the end of 2007. This increase accompanied an overall increase in the price-earnings ratios for the whole market during this time. In addition, market participants are revaluing Nike’s growth prospects up-ward.

m. The percent of net income to sales dropped very slightly during 2007.

SPECIAL ACTIVITIES

Activity 17–1

This position does not allow the shareholders to take advantage of leverage. As a result, the return on shareholders’ equity cannot be improved by using debt. In con-trast, a low or no debt load does provide the company great flexibility in the case of a national calamity. However, the “no debt” position only makes sense within the “national calamity” scenario. Within normal business operations, most companies can assume some debt without much loss of flexibility or control. Garden Isle Brew-ery is competing against companies that will not be so inclined to avoid debt. As a result, they will likely be able to grow faster than Garden Isle. The Garden Isle man -agement should consider the risk of not being able to keep up with the competition because of their conservative financing policies.

Activity 17–2

Holly is concerned about the inventory and accounts receivable levels because she must determine their value. Inventory that cannot be sold (or sold at a large dis-count) or accounts receivable that cannot be collected must be written down to re-flect their reduced value. Holly has conducted the ratio analysis and interviewed Doug to help make this determination. The inventory and accounts receivable levels have grown alarmingly. Doug’s response to Holly is not reassuring. The inventory represents obsolete technology that is left over after the holiday season. The ac-counts receivable have apparently grown from loosening the credit standards. Holly may need to insist on write-downs of the inventory and accounts receivable bal-ances to reflect their net realizable values. Doug is correct in pointing out that the current ratio has probably improved. Thus, although Doug calls this “good,” it is only such if the current assets in the numerator are fairly valued. Under these cir-cumstances, the current ratio is probably overstated because the inventory and ac-counts receivable balances are inflated relative to their net realizable values.

Activity 17–3

DELL INC. AND APPLE COMPUTER, INC.

Common-Sized Statements

Dell Inc. Apple Computer, Inc.

Sales (net)................................................... 100.0% 100.0%Cost of sales............................................... 78 .2 66 .0 Gross profit................................................. 21 .8 % 34 .0 %Operating expenses:

Selling, general, and administrative. . . 10.4% 12.3%Research and development................. 0 .9 3 .3

Total operating expenses................ 11 .2 %* 15 .6 %Operating income....................................... 10 .6 % 18 .4 %

*Rounded to the nearest tenth of a percent.

The common-sized analysis indicates that Dell and Apple are very different computer companies. Dell’s income from operations was 10.6% of sales, while Apple’s was 18.4% of sales. There is almost an 8 percentage point difference between the two companies. What explains this difference? The gross profit for Dell was 21.8% of sales, which is fairly narrow. Apple, in contrast, had a gross profit of 34.0% of sales, which is over 12 points better than Dell’s. This suggests Apple is able to charge higher prices than Dell for its products (assuming that they are both equally efficient in making products). Apple’s selling, general, and administrative expenses were at about 12.3% of sales, while Dell’s are only 10.4% of sales. Dell designed the business for efficiency; thus, it operates on a low-cost structure. The selling, general, and ad-ministrative expenses do not include expensive advertising campaigns, complex sales channel administration, or complex product support activities. Apple, in con-trast, has larger selling, general, and administrative costs as a percent of sales. It at-tempts to sell a unique machine to a unique audience. This requires significant SG&A effort. Another big difference between the two companies is in research and devel-opment. Dell’s R&D was a narrow 0.9% of sales, while Apple’s was 3.3% of sales. Es-sentially, Dell focuses its R&D effort on the final assembly of the computer. Dell relies on its suppliers to develop innovation in the components and operating system soft-ware (Microsoft). Apple, on the other hand, must constantly spend R&D on comput-ers, peripherals, and its own operating system software. This is because Apple chooses not to follow the industry standards and thus must pave its own way on both hardware and software. This feature of Apple also contributes to its larger sell-ing, general, and administrative costs as a percent of sales. The higher gross profit as a percentage of sales for Apple carries through to its income from operations, gen-erating a significantly higher operating income as a percentage of sales compared to Dell.

Activity 17–4

1. a. Rate Earned on Total Assets =

2006: = 18.6%

2005: = 17.5%

2004: = 17.7%

b. Rate Earned on Total Stockholders’ Equity =

2006: = 30.5%

2005: = 28.8%

2004: = 29.3%

c. Earnings per Share =

2006: = $3.43

2005: = $3.02

2004: = $2.52

Activity 17–4 Continued

d. Dividend Yield =

2006: = 1.1%

2005: = 0.8%

2004: = 0.4%

e. Price-Earnings Ratio =

2006: = 16.4%

2005: = 17.9

2004: = 18.6

2. Ratio of Average Liabilities to Average Liabilities/Average Stockholders’ Equity = Average Stockholders’ Equity

2006: = 0.7

Activity 17–4 Concluded

3. Harley-Davidson’s profitability, as measured by earnings per share, dramatically improved from 2004 levels. The rate earned on total assets improved moderately, as did the rate earned on stockholders’ equity. The dividend yield doubled from 0.4% in 2004 to 0.8% in 2005, indicating that the company has a greater amount of cash available to distribute to common stockholders. The price-earnings ratio is interesting. During the three-year period, the price-earnings ratio has de-creased somewhat. This is predominantly due to the significant increase in earn-ings per share during the period. The company’s stock price has also increased during this period, but at a slower rate than the increase in earnings per share. The rate of the decrease in the price-earnings ratio is lower than the rate of in -crease in earnings per share. Thus, the market does not appear to expect Harley-Davidson’s profitability to continue at the rate it has experienced in recent years.

4. Apparently, stock market participants are not willing to pay as high a price for fu-ture earnings because of concern that Harley-Davidson will not be able to con-tinue to grow earnings at the rate it has in recent years. It appears that Harley-Davidson’s expansion to international markets has been quite successful, but the market is not convinced that this strategy will be able to continue to grow at its current rate.

Activity 17–5

1.


Marriott: = 10.6%

Hilton: = 8.5%

b. Rate Earned on Total Stockholders’ Equity =

Marriott: = 20.7%

Hilton: = 17.5%

=

Marriott: = 8.2

Hilton: = 2.7

d. Ratio of Liabilities to Stockholders’ Equity =

Marriott: = 2.3

Hilton: = 3.4

c.

Activity 17–5 Concluded

Summary Table:

Marriott Hilton

Rate earned on total assets 10.6% 8.5%

Rate earned on total stockholders’ equity 20.7% 17.5%

Number of times interest charges are earned 8.2 2.7

Ratio of liabilities to stockholders’ equity 2.3 3.4

2. Marriott has a higher rate earned on total assets (10.6% vs. 8.5%), and a higher rate on stockholders’ equity (20.7% vs. 17.5%), compared to Hilton. Hilton’s weaker performance relative to Marriott appears to be due to its inability to manage its debt. Hilton has much more leverage than Marriott. This is confirmed by the ratio of liabilities to stockholders’ equity, which shows the rel-ative debt held by Marriott is 2.3 times stockholders’ equity, compared to 3.4 times for Hilton. The number of times interest charges are earned shows that Marriott covers its interest charges 8.2 times. The comparable number for Hilton is 2.7, which is marginally sufficient. Hilton’s higher debt level is generating large interest expense, which is negatively affecting the rate earned on total assets and stockholders’ equity. In summary, Hilton’s high debt level is affecting the company’s ability to earn returns for stockholders.

warren sm_ch.17_final.doc

Documents

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