Chapter 2 Financial Statement and Cash Flow Analysis 27

Chapter 2 Financial Statement and Cash Flow Analysis

Answers to Concept Review Questions
1. What role do the FASB and SEC play with regard to GAAP?
The FASB is a nongoern!ental" pro#essional standards $ody that e%a!ines &ontroersial a&&o'nting
topi&s and then iss'es (r'lings) that al!ost hae the #or&e o# law" at least in ter!s o# their i!pa&t on
a&&o'nting pra&ti&es. *n the +.S. the FASB has deeloped the GAAP ,Generally A&&epted A&&o'nting
Prin&iples- as the set o# a&&o'nting r'les #or &o!panies to &o!ply with in the preparation o# their
#inan&ial state!ents. The Se&'rities and E%&hange Co!!ission ,SEC- is responsi$le #or reg'lating
p'$li&ly traded +.S. &o!panies" as well as the nation.s sto&/ and $ond !ar/ets. *t !onitors the
&o!plian&e o# p'$li&ly traded &o!panies with the GAPP. The #o'r /ey #inan&ial state!ents re0'ired
$y the SEC are ,1- the $alan&e sheet" ,2- the in&o!e state!ent" ,1- the state!ent o# retained earnings"
and ,2- the state!ent o# &ash #lows.
2. Are $alan&e sheets and in&o!e state!ents prepared with the sa!e p'rpose in !ind? 3ow are these
two state!ents di##erent" and how are they related?
Balan&e sheets and in&o!e state!ents $oth are prepared #or the p'rpose o# proiding #inan&ial
in#or!ation a$o't a &o!pany at a point in ti!e. A $alan&e sheet proides a pi&t're o# the &o!pany.s
assets and lia$ilities" or net worth at a point in ti!e" and s'!s all o# the &o!pany.s past earnings in
the shareholder e0'ity a&&o'nt. An in&o!e state!ent proides a pi&t're o# the &o!pany.s reen'es
and e%penses #or a spe&i#ied period o# ti!e. Both state!ents are ery 'se#'l in analy4ing the
&o!pany.s past and #'t're.
1. Whi&h state!ents are o# greatest interest to &reditors" and whi&h wo'ld $e o# greatest interest to
sto&/holders?
Creditors wo'ld !ost li/ely $e interested in the $alan&e sheet" whi&h states how !'&h in lia$ilities
the &o!pany has" $'t they also wo'ld want to see an in&o!e state!ent" whi&h tells the &o!pany.s
a$ility to !eet its pay!ent &o!!it!ents. Shareholders will &ertainly $e interested in the $alan&e
sheet and in&o!e state!ent" whi&h will allow the! to &o!p'te ratios #or the &o!pany" in the
state!ent o# retained earnings whi&h states how !'&h their share o# the &o!pany has in&reased or
de&reased and in the state!ent o# &ash #lows" whi&h des&ri$es where &ash is &o!ing into and going
o't o# the &o!pany.
2. 3ow do depre&iation and other non&ash &harges a&t as so'r&es o# &ash in#low to the #ir!? Why does a
depre&iation allowan&e e%ist in the ta% laws? For a pro#ita$le #ir!" is it $etter to depre&iate an asset
0'i&/ly or slowly #or ta% p'rposes? E%plain.
5epre&iation and other non6&ash &harges are so'r&es o# &ash to the #ir!. These &harges are s'$tra&ted
#ro! the #ir!.s reen'es" de&reasing &ash #low in order to get a &orre&t esti!ate o# ta%es owed. They
need to $e added $a&/ to &o!p'te an a&&'rate &ash #low. These &harges are not real &ash #lows 7 no
dollars e%&hange hands when a &o!pany ta/es a depre&iation e%pense 7 and are only s'$tra&ted
$e&a'se they red'&e the &o!pany.s ta% $ill" and ta%es are a real dollar &ash #low. The ta% &ode does
28 Instructors Manual
not allow a &o!pany to e%pense its &apital e0'ip!ent in the year it was p'r&hased. *t re0'ires
&o!pany.s to &harge this e%pense oer the li#eti!e o# the e0'ip!ent" ta/ing a per&entage o# the total
&ost ea&h year. For a pro#ita$le #ir!" it is $etter to depre&iate assets as 0'i&/ly as possi$le. The larger
the depre&iation e%pense" the lower the ta%a$le in&o!e and the lower the ta%es owed.
9. What is operating cash flow (OCF) What is free cash flow (FCF)! and how is it related to OCF?
:perating &ash #low is earnings $e#ore interest or ta%es !in's ta%es and pl's depre&iation. Free &ash
#low is operating &ash #low ,reen'es !in's operating &osts" depre&iation and ta%es" with
depre&iation added $a&/ in- !in's &hange in #i%ed assets !in's &hange in wor/ing &apital ,&'rrent
assets !in's operating &'rrent lia$ilities" a&&o'nts paya$le and a&&r'als-. Free &ash #low ta/es
operating &ash #low and s'$tra&ts any short ter! and long ter! &apital inest!ents needed to s'pport
operating &ash #low.
;. Why is the #inan&ial !anager li/ely to hae great interest in the #ir!.s state!ent o# &ash #lows? What
type o# in#or!ation &an $e o$tained #ro! this state!ent?
The #inan&ial !anager is ery interested in the state!ent o# &ash #lows $e&a'se &ash #lows are the
li#e$lood o# the #ir!. A #ir! that does not hae s'##i&ient &ash #low to !eet its o$ligations will soon
get into #inan&ial di##i&'lty. Cash #lows are also 'sed in al'ation o# the #ir!. The #ir! wants to
!a%i!i4e &ash #lows in order to !a%i!i4e #ir! al'e.
7. Whi&h o# the &ategories and indiid'al ratios des&ri$ed in this &hapter wo'ld $e o# greatest interest to
ea&h o# the #ollowing parties?
a. E%isting and prospe&tie &reditors ,lenders-
$. E%isting and prospe&tie shareholders
&. The #ir!.s !anage!ent
a. E%isting and prospe&tie lenders wo'ld $e !ost interested in li0'idity ratios ,how !'&h in li0'id
assets the #ir! has to pay its $ills- and de$t ratios ,how !'&h o# a &o!!it!ent the #ir! has
oerall to de$t-.
$. E%isting and prospe&tie shareholders will $e interested in !ost ratios. *n parti&'lar" they will
want to /now the a&tiity ratios ,how e##i&iently the &o!pany is 'sing its assets-" pro#ita$ility
ratios and !ar/et ratios.
&. The #ir!.s !anage!ent sho'ld $e interested in all ratios" identi#ying the #ir!.s strengths and
wea/nesses and loo/ing at how to &ontin'e the strengths and i!proe the wea/ areas.
8. 3ow &o'ld the aaila$ility o# &ash in#low and &ash o't#low data $e 'sed to i!proe on the a&&'ra&y
o# the li0'idity and de$t &oerage ratios presented preio'sly? What spe&i#i& ratio !eas'res wo'ld
yo' &al&'late to assess the #ir!.s li0'idity and de$t &oerage" 'sing &ash #low rather than #inan&ial
state!ent data?
Cash in#low and o't#low data &an $e 'sed to i!proe li0'idity ratios. For e%a!ple" ti!es interest
earned is earnings $e#ore interest and ta%es diided $y interest. *# &ash #low were 'sed instead" it
&o'ld proide a !ore a&&'rate !eas're o# how !'&h &ash the #ir! had aaila$le to pay its interest
e%pense. 5e$t ratios &o'ld $e &al&'lated 'sing !ar/et al'e n'!$ers rather than $oo/ al'e n'!$ers"
as the share pri&e represents the dis&o'nted al'e o# all #'t're &ash #lows to the &o!pany.
<. Ass'!e that a #ir!.s total assets and sales re!ain &onstant. Wo'ld an in&rease in ea&h o# the ratios
$elow $e asso&iated with a &ash in#low or a &ash o't#low?
Chapter 2 Financial Statement and Cash Flow Analysis 2<
a. C'rrent ratio d. Aerage pay!ent period
$. *nentory t'rnoer e. 5e$t ratio
&. Aerage &olle&tion period #. =et pro#it !argin
a. &ash in#low
$. &ash in#low 7 de&rease in inentory
&. &ash o't#low 7 in&rease in A>
d. &ash in#low 7 in&rease in AP" de&rease in inentory
e. no e##e&t on &ash
#. no e##e&t on &ash
1?. +se the "u#ont system to e%plain why a slower6than6aerage inentory t'rnoer &o'ld &a'se a #ir!
with an a$oe6aerage net pro#it !argin and an aerage degree o# #inan&ial leerage to hae a $elow6
aerage ret'rn on &o!!on e0'ity.
*n order to eal'ate the i!pa&t o# the di##erent ratios on the &o!pany.s >:E" we need to de&o!pose
the >:E $y !eans o# the 5'Pont syste!. >:E @ Pro#it !argin A Asset t'rnoer A E0'ity !'ltiplier.
*# the &o!pany has an a$oe6aerage net pro#it !argin and an aerage leerage" the only way that the
&o!pany &an hae a $elow6aerage >:E is #or its asset t'rnoer to $e lower ,slower- than the
ind'stry aerage.
11. 3ow &an yo' re&on&ile inestor e%pe&tations #or a #ir! with an a$oe6aerage BCB ratio and a
$elow6aerage PCE ratio? Co'ld the age o# the #ir! hae any i!pa&t on this ratio &o!parison?
Sin&e the BCB ratio &o!pares !ar/et and $oo/ al'es" it is possi$le that the ratio is high not so !'&h
d'e to high !ar/et pri&e as d'e to a low $oo/ al'e. The BCB ratio shows how inestors iew the
&o!pany.s past and how they proDe&t it to the &o!pany.s #'t're. There#ore" a high BCB and a low PCE
do not ne&essarily !ean that there is a dis&repan&y in the inestors. e%pe&tations. *t !ay $e e%plained
$y the #a&t that sin&e inestors do not e%pe&t the &o!pany to per#or! well in the #'t're" they are
willing to pay less #or its earnings th's $ringing the PCE ratio down. *n the sa!e ti!e" howeer" i# the
&o!pany has e%isted #or a long ti!e it !ay hae initially sold its shares at a low #or the &'rrent period
al'e. There#ore" a low al'e o# &o!!on sto&/ on the &o!pany.s $oo/s &o!$ined with de&reasing
retained earnings" leads to a high BCB ratio d'e to the s!all deno!inator o# the ratio.
12. 3ow are &orporations ta%ed on ordinary in&o!e? What is the di##eren&e $etween the a$erage ta% rate
and the marginal ta% rate on ordinary &orporate in&o!e?
:rdinary &orporate in&o!e is in&o!e res'lting #ro! the sale o# the #ir!.s goods and seri&es. +nder
&'rrent ta% laws the appli&a$le ta% rates are s'$De&t to progressie ta% rate s&hed'le. Aerage ta% rate
is &al&'lated $y diiding the &o!pany.s ta% lia$ility $y its preta% in&o!e. Barginal ta% rate is the ta%
rate appli&a$le to the #ir!.s ne%t dollar o# earnings.
11. What are &orporate capital gains and capital losses? 3ow are they treated #or ta% p'rposes?
Capital gains o&&'r when &o!panies sell &apital assets" s'&h as e0'ip!ent or sto&/ held as an
inest!ent" #or !ore than their original p'r&hase pri&e. The a!o'nt o# the &apital gain wo'ld $e
e0'al to the di##eren&e $etween the sale pri&e and initial p'r&hase pri&e. *# the sale pri&e is less than
the initial p'r&hase pri&e" the di##eren&e is &alled capital loss. +nder &'rrent ta% law" &orporate &apital
gains are !erely added to operating in&o!e and ta%ed at the ordinary &orporate ta% rates. The ta%
1? Instructors Manual
treat!ent o# &apital losses on depre&ia$le $'siness assets inoles a ded'&tion #ro! preta% ordinary
in&o!e" whereas any other &apital losses !'st $e 'sed to o##set &apital gains.
Answers to Self-Test Problems
ST2-1. +se the #inan&ial state!ents $elow to answer the 0'estions &on&erning SEB Ban'#a&t'ring.s
#inan&ial position at the end o# the &alendar year 2??;.
a. 3ow !'&h &ash and near &ash does SEB hae at year6end 2??;?
$. What was the original &ost o# all o# the #ir!.s real property that is &'rrently owned?
&. 3ow !'&h in total lia$ilities did the #ir!s hae at year6end 2??;?
d. 3ow !'&h did SEB owe #or &redit p'r&hases at year6end 2??;?
e. 3ow !'&h did the #ir! sell d'ring 2??;?
#. 3ow !'&h e0'ity did the &o!!on sto&/holders hae in the #ir! at year6end 2??;?
g. What is the &'!'latie total o# earnings reinested in the #ir! #ro! its in&eption thro'gh the
end o# 2??;?
h. 3ow !'&h operating pro#it did the #ir! earn d'ring 2??;?
i. What is the total a!o'nt o# diidends paid o't $y the #ir! d'ring the year 2??;?
D. 3ow !any shares o# &o!!on sto&/ did SEB hae o'tstanding at year6end 2??;?
SEB Ban'#a&t'ring" *n&.
Balan&e Sheet
At 5e&e!$er 11"2??; ,F???-
Assets Liabilities and Equity
C'rrent assets C'rrent lia$ilities
Cash F 12?"??? A&&o'nts paya$le F 28?"???
Bar/eta$le se&'rities 2;?"??? =otes paya$le 9??"???
A&&o'nts re&eia$le ;9?"??? A&&r'als 8?"???
*nentories 8??"??? Total &'rrent lia$ilities F1"?;?"???
Total &'rrent assets F1"89?"??? Gong6ter! de$t
Fi%ed assets Bonds o'tstanding F1"1??"???
Gross #i%ed assets F1"78?"??? Ban/ de$t ,long6ter!- 2;?"???
GessH A&&'!'lated depre&iation 1"22?"??? Total long6ter! de$t F1"9;?"???
=et #i%ed assets F2"9;?"??? Shareholders. e0'ity
Total assets $4,410,000 Pre#erred sto&/ F 18?"???
Co!!on sto&/ ,at par- 2??"???
Paid6in &apital in e%&ess o# par 81?"???
>etained earnings ;??"???
Total shareholders. e0'ity F1"7<?"???
Total liabilities and equity $4,410,000
Chapter 2 Financial Statement and Cash Flow Analysis 11
SEB Ban'#a&t'ring" *n&.
*n&o!e State!ent #or year ended 5e&e!$er 11" 2??; ,F???-
Sales reen'e F;"<??"???
GessH Cost o# goods sold

2"2??"???
Gross pro#its F2"7??"???
GessH :perating e%penses
Sales e%pense F 79?"???
General and ad!inistratie e%pense 1"19?"???
Geasing e%pense 21?"???
5epre&iation e%pense 219"???
Total operation e%penses F2"129"???
Earnings $e#ore interest and ta%es F 199"???
GessH *nterest e%pense 89"???
=et pro#it $e#ore ta%es F 27?"???
GessH Ta%es 81"???
Net profits after taes $ 1!",000
GessH Pre#erred sto&/ diidends 1?"8??
Earnin#s a$ailable for %o&&on sto%'(olders $ 1)!,200
GessH 5iidends 79"???
To retained earnings $ 10*,200
Per share dataH
Earnings per share ,EPS- F1.21
5iidends per share ,5PS- F?.;?
Pri&e per share F19.89
Answers
a. F2??"??? ,only &ash and !ar/eta$le se&'rities sho'ld $e in&l'ded F12?"??? I F2;?"???-
$. F1"78?"??? ,net asset position I depre&iation-
&. F2";2?"??? ,&'rrent lia$ilities I long6ter! de$t-
d. F28?"??? ,a&&o'nts paya$le-
e. F;"<??"??? ,sales-
#. F1"?1?"??? ,&o!!on sto&/ at par I paid6in &apital-
g. F;??"??? ,retained earnings-
h. F199"??? ,EB*T-
i. F89"8?? ,pre#erred I &o!!on sto&/ diidends-
D. 122";19 shares o'tstanding ,178"2??C1.21-
ST2-2. The partially &o!plete 2??; $alan&e sheet and in&o!e state!ent #or Challenge *nd'stries are
gien $elow #ollowed $y sele&ted ratio al'es #or the #ir! $ased on its &o!pleted 2??; #inan&ial
state!ents. +se the ratios along with the partial state!ents to &o!plete the #inan&ial state!ents.
3intH +se the ratios in the order listed to &al&'late the !issing state!ent al'es that need to $e
installed in the partial state!ents.
12 Instructors Manual
Challenge *nd'stries" *n&.
Balan&e Sheet
At 5e&e!$er 11" 2??;
,in F tho'sands-
Assets Liabilities and Equity
C'rrent assets C'rrent lia$ilities
Cash F 92"??? A&&o'nts paya$le F19?"???
Bar/eta$le se&'rities ;?"??? =otes paya$le ?
A&&o'nts re&eia$le 2??"??? A&&r'als 8?"???
*nentory ? Total &'rrent lia$ilities ?
Total &'rrent assets ? Gong6ter! de$t 229"???
Fi%ed assets ,gross- ? Total lia$ilities ?
GessH A&&'!'lated depre&iation 22?"??? Shareholders. e0'ity
=et #i%ed assets ? Pre#erred sto&/ ?
Total assets + Co!!on sto&/ ,at par- 19?"???
Paid6in &apital in e%&ess o# par ?
>etained earnings 1<?"???
Total shareholders. e0'ity ?
Total liabilities and
s(are(olders, equity +
Challenge *nd'stries" *n&.
*n&o!e State!ent
For the Jear Ended 5e&e!$er 11" 2??;
,in F tho'sands-
Sales reen'e F 2"8??"???
GessH Cost o# goods sold

?
Gross pro#its ?
Gess operating e%pensesH
Selling e%pense F;<?"???
General and ad!inistratie e%pense 19?"???
5epre&iation 12?"???
Total operating e%penses F1"9;?"???
Earnings $e#ore interest and ta%es ?
GessH *nterest e%pense 19"???
Earnings $e#ore ta%es ?
GessH Ta%es ?
Net in%o&e -Net profits after taes. ?
GessH Pre#erred diidends 19"???
Earnin#s a$ailable for %o&&on sto%'(olders ?
GessH 5iidends ;?"???
To retained earnings ?
Chapter 2 Financial Statement and Cash Flow Analysis 11
Challenge *nd'stries" *n&.
>atios #or the Jear Ended 5e&e!$er 11" 2??;
/atio 0alue
Total asset t'rnoer 2.??
Gross pro#it !argin 2?K
*nentory t'rnoer 1?
C'rrent ratio 1.;?
=et pro#it !argin 1.79K
>et'rn on &o!!on e0'ity 12.9K
Challenge *nd'stries" *n&.
Balan&e Sheet
At 5e&e!$er 11" 2??;
,in F tho'sands-
Assets Liabilities and Equity
C'rrent assets C'rrent lia$ilities
Cash F 92"??? A&&o'nts paya$le F 19?"???
Bar/eta$le se&'rities ;?"??? =otes paya$le 129"???
A&&o'nts re&eia$le 2??"??? A&&r'als 8?"???
*nentory 288"??? Total &'rrent lia$ilities F 179"???
Total &'rrent assets F ;??"??? Gong6ter! de$t 229"???
Fi%ed assets ,gross- F2"?2?"??? Total lia$ilities F 8??"???
GessH A&&'!'lated depre&iation 22?"??? Shareholders. e0'ity
=et #i%ed assets F1"8??"??? Pre#erred sto&/ F 1;?"???
Total assets $2,400,000 Co!!on sto&/ ,at par- 19?"???
Paid6in &apital in e%&ess o# par <??"???
>etained earnings 1<?"???
Total shareholders. e0'ity F1";??"???
Total liabilities and
s(are(olders, equity $2,400,000
12 Instructors Manual
Challenge *nd'stries" *n&.
*n&o!e State!ent
For the year ended 5e&e!$er 11" 2??;
,in F tho'sands-
Sales reen'e F2"8??"???
GessH Cost o# goods sold

2"88?"???
Gross pro#its F1"<2?"???
Gess operating e%penses
Selling e%pense F;<?"???
General and ad!inistratie e%pense 19?"???
5epre&iation 12?"???
Total operation e%penses 1"9;?"???
Earnings $e#ore interest and ta%es F 1;?"???
GessH *nterest e%pense 19"???
Earnings $e#ore ta%es F 129"???
GessH Ta%es 11?"???
Net in%o&e -Net profits after taes. F 1<9"???
GessH Pre#erred diidends 19"???
Earnin#s a$ailable for %o&&on sto%'(olders F 18?"???
GessH 5iidends ;?"???
To retained earnings F 12?"???
ST2-*. +se the &orporate in&o!e ta% rate s&hed'le in Ta$le 2.; o# the &hapter to &al&'late the ta% lia$ility
#or ea&h o# the #ollowing #ir!s with the a!o'nts o# 2??; preta% in&o!e noted.
1ir& 2002 3reta 4n%o&e Ta Liability
A F12"9??"???
B 2??"???
C 8?"???
a. Cal&'late" &o!pare" and dis&'ss the aerage ta% rates #or ea&h o# the #ir!s d'ring 2??;.
$. Find the !arginal ta% rates #or ea&h o# the #ir!s at the end o# 2??;.
&. What relationship e%ists $etween the aerage and !arginal ta% rates #or ea&h #ir!.
d. What ta% rate 7 aerage or !arginal 7 is releant to #inan&ial de&isions #or these #ir!s?
a.
1ir&
2002 3reta
4n%o&e Ta Liability A$era#e Ta /ate
A F12"9??"??? 9?"??? ?.19 @ 7"9??
,79"???69?"???- ?.29 @ ;"29?
,1??"???679"???- ?.12 @ 8"9??
,119"???61??"???- ?.1< @ <1";9?
,1?"???"???6119"???- ?.12 @ 1"28;"1??
,12"9??"???61?"???"???- ?.19 @ 879"???
Total 2"279"???
2"279"???C12"9??"??? @ 12.2K
B F2??"??? 9?"??? 19 @ 7"9??
,79"???69?"???- ?.29 @ ;"29?
,1??"???679"???- ?.1 2 @ 8"9??
,2??"???61??"???- ?.1< @ 1<"???
Total ;1"29?
;1"29?C2??"??? @ 1?.;1K
Chapter 2 Financial Statement and Cash Flow Analysis 19
C F8?"??? 9?"??? ?.19 @ 7"9??
,79"???69?"???- ?.29 @ ;"29?
,8?"???679"???- ?.12 @ 1"7??
Total 19"29?
19"29?C8?"??? @ 1<.11K
Co!panies A" B and C pay on aerage 12.2" 1?.;1 and 1<.11 &ents respe&tiely on ea&h
dollar o# preta% in&o!e earned.
$. Barginal ta% rateH The ta% &o!panies will hae to pay i# they earn one !ore dollar 7 AH 19KL
BH 1<KL CH 12K
&. The o$sera$le pattern is that the higher the aerage ta% rate the less the !arginal ta% rate
in&reases and i&e ersa.
d. +s'ally the !arginal ta% rate is releant to #inan&ial de&isions $e&a'se any new &ash #low that
the &o!pany !ay generate will $e ta%ed at that rate.
1; Instructors Manual
Answers to End-of-Chapter Questions
52-1. What in#or!ation ,e%pli&it and i!pli&it- &an $e deried #ro! #inan&ial state!ent analysis? 5oes
the standardi4ation re0'ired $y GAAP add greater alidity to &o!parisons o# #inan&ial data
$etween &o!panies and ind'stries? Are there possi$le short&o!ings to relying solely on #inan&ial
state!ent analysis to al'e &o!panies?
Finan&ial state!ent analysis proides in#or!ation a$o't the &o!pany.s #inan&ial health" and its
strengths and wea/nesses. +sing standardi4ed GAAP r'les does add alidity $y !a/ing
&o!parisons $etween &o!panies easier. Possi$le short&o!ings in&l'deH
*# a &o!pany is in !'ltiple lines o# $'siness it !ay $e di##i&'lt to !a/e &o!parisons
The a&&o'nting data !ay not $e a&&'rate
Aerage per#or!an&e !ay not $e a good !eas're" espe&ially i# the ind'stry is in a sl'!p
*t is possi$le to !anip'late a&&o'nting n'!$ers.
52-2. 5isting'ish a!ong the types o# #inan&ial in#or!ation &ontained in the ario's #inan&ial
state!ents. Whi&h state!ents proide in#or!ation on a &o!pany.s per#or!an&e oer a reporting
period" and whi&h present data on a &o!pany.s &'rrent position? What sorts o# al'a$le
in#or!ation !ay $e #o'nd in the notes to #inan&ial state!ents? 5es&ri$e a sit'ation in whi&h the
in#or!ation &ontained in the notes wo'ld $e essential to !a/ing an in#or!ed de&ision a$o't the
al'e o# a &orporation.
5ata on a &o!pany.s per#or!an&e oer a reporting periodH in&o!e state!ent" state!ent o# &ash
#lows" state!ent o# retained earnings ,how !'&h additional retained earnings will $e added to
e%isting retained earnings-
5ata on a &o!pany.s per#or!an&e a$o't the &o!pany.s &'rrent positionH $alan&e sheet
=otes to the #inan&ial state!ents &ontain details a$o't the &o!position and &ost o# the &o!panies
de$t" any lia$ilities s'&h as laws'its that are still pending" reen'e re&ognition" ta%es" signi#i&ant
&lients" detailed $rea/downs o# #i%ed asset a&&o'nts" e%e&'tie &o!pensation" des&riptions o#
e!ployee $ene#it plans. An e%a!ple o# a sit'ation in whi&h the notes wo'ld $e essential to
al'ation wo'ld $e a &o!pany that relied on a #ew &lients" rather than a wide $ase o# &lients. The
notes wo'ld detail &'rrent and e%pe&ted reen'e #ro! those &lients and how that reen'e wo'ld
$e re&ogni4ed. An analyst wo'ld need this in#or!ation to deelop a set o# &ash #lows #or the
&o!pany whi&h wo'ld proide the $asis o# a &o!pany al'ation.
52-*. *# yo' were a &o!!er&ial &redit analyst &harged with the responsi$ility o# !a/ing an
a&&eptCreDe&t de&ision on a &o!pany.s loan re0'est" with whi&h #inan&ial state!ent wo'ld yo' $e
!ost &on&erned? Whi&h #inan&ial state!ent is !ost li/ely to proide pertinent in#or!ation a$o't
a &o!pany.s a$ility to repay its de$t?
An analyst loo/ing at granting a loan re0'est wo'ld $e !ost interested in the &o!pany.s $alan&e
sheet" whi&h she &o'ld 'se to &o!p'te li0'idity ratios ,&'rrent and 0'i&/ ratios- and de$t ratios. A
&redit analyst wo'ld also want an in&o!e state!ent with EB*T and interest with whi&h to
&o!p'te ti!es interest earned. Ti!es interest earned is a !eas're o# how well a &o!pany &an pay
its interest o$ligations" while li0'idity and de$t ratios show what assets are aaila$le to repay
de$t.
Chapter 2 Financial Statement and Cash Flow Analysis 17
52-4. What is operating cash flow (OCF) 3ow is it &al&'lated? What is free cash flow (FCF) 3ow is
it &al&'lated #ro! operating &ash #low ,OCF-? Why do #inan&ial !anagers #o&'s attention on the
al'e o# FCF?
:perating &ash #low is earnings $e#ore interest and ta%es !in's ta%es pl's depre&iation. Finan&ial
analysts li/e this !eas're $e&a'se it 'ses only operating #lows" with no #inan&ing &ash #lows li/e
interest. This !a/es it easier to separate the e##e&ts o# operating de&isions #ro! those #ro!
#inan&ing de&isions. Free Cash Flow ,FCF- is the :perating Cash Flow ,:CF- !in's the a!o'nt
o# &apital e%pendit'res re0'ired to !aintain the #ir!.s prod'&tie a&tiities. The larger the #ir!s
FCF" the $etter positioned the &o!pany is #or growth" de$t repay!ent" and diidend payo'ts.
52-6. 5es&ri$e the &o!!on de#initions o# (in#lows o# &ash) and (o't#lows o# &ash) 'sed $y analysts to
&lassi#y &ertain $alan&e sheet &hanges and in&o!e state!ent al'es. What three &ategories o# &ash
#low are 'sed in the state!ent o# &ash #lows? To what al'e sho'ld the net al'e in the state!ent
o# &ash #lows re&on&ile?
A &ash in#low is an in&rease in lia$ilities or a de&rease in assets. A &ash o't#low o&&'rs when
there is a de&rease in lia$ilities or an in&rease in assets. A state!ent o# &ash #lows is diided into
operating &ash #lows" #inan&ing &ash #lows and inest!ent &ash #lows. For a histori&al state!ent
o# &ash #lows" the &ash o't#lows #or the period !'st e0'al the &ash in#lows #or the period.
52-2. What pre&a'tions !'st one ta/e when 'sing ratio analysis to !a/e #inan&ial de&isions? Whi&h
ratios wo'ld $e !ost 'se#'l #or a #inan&ial !anager.s internal #inan&ial analysis? For an analyst
trying to de&ide on whi&h sto&/s are !ost attra&tie within an ind'stry?
With ratio analysis it is i!portant to /now the relia$ility o# the data and the !ethods o#
a&&o'nting 'sed to proide data #or the analysis. A !anager interested in internal &ontrol will
#o&'s on a&tiity ratios" whi&h !eas're the #ir!.s e##i&ien&y in its 'se o# its assets" and
pro#ita$ility ratios" whi&h show a #ir!.s ret'rns. A #inan&ial analyst !ay $e !ore interested in
!ar/et ratios s'&h as pri&e to earnings" pri&e to sales" or pri&e to $oo/ al'e" whi&h show how the
!ar/et is eal'ating the #ir!.
52-). 3ow do analysts 'se ratios to analy4e a #ir!.s financial le$erage Whi&h ratios &oney !ore
i!portant in#or!ation to a &redit analystMthose reoling aro'nd the leels o# inde$tedness or
those !eas'ring the a$ility to !eet the &ontra&t'al pay!ents asso&iated with de$t? What is the
relationship $etween a #ir!.s leels o# inde$tedness and ris/? What !'st happen in order #or an
in&rease in #inan&ial leerage to $e s'&&ess#'l?
Analysts 'se de$t ratios to deter!ine the #ir!.s #inan&ial leerage66its 'se o# de$t #inan&ing. A
&redit analyst is going to $e &on&erned with a #ir!.s a$ility to repay its o$ligations. She will &are
a$o't ti!es interest earned whi&h de!onstrates the #ir!.s a$ility to pay its interest" and &'rrent
and 0'i&/ ratio" whi&h show how !'&h in short ter! assets the #ir! has &o!pared to its short
ter! lia$ilities. Finan&ial leerage adds ris/ to a #ir! 7 the !ore de$t" the !ore ris/" $'t also the
!ore potential reward to shareholders. For an in&rease in #inan&ial leerage to $e s'&&ess#'l" the
#ir! !'st $e pro#ita$le and earn eno'gh to D'sti#y the additional interest e%pense.
52-!. 3ow is the "u#ont system 'se#'l in analy4ing a #ir!.s &OA and &O'? What in#or!ation &an $e
in#erred #ro! the de&o!position o# &O' into &ontri$'ting ratios? What is the !athe!ati&al
relationship $etween ea&h o# the indiid'al &o!ponents ,net pro#it !argin" total asset t'rnoer"
and assets6to6e0'ity ratio- and &O'? Can &O' $e raised witho't a##e&ting &OA? 3ow?
18 Instructors Manual
The 5'Pont syste! is 'se#'l in $rea/ing down >:E and >:A into its &o!ponent parts. *# >:E is
in&reasing ,de&reasing-" a !anager &an see i# the &a'se is a higher ,lower- pro#it !argin" a higher
,lower- asset t'rnoer or a higher ,lower- e0'ity !'ltiplier. *# one o# the &o!ponents is
i!proing ,de&lining- the #ir! &an ta/e steps to pay attention to that area o# the $'siness. >:E is
e0'al to >:A ti!es the e0'ity !'ltiplier. *t wo'ld $e possi$le to raise >:E $y &hoosing to
#inan&e the #ir! !ore aggressiely" een i# >:A re!ained the sa!e.
52-". Proide a general des&ription o# the ta% rates appli&a$le to +.S. &orporations. What is the
di##eren&e $etween the aerage ta% rate and the !arginal ta% rate? Whi&h rate is releant to
#inan&ial de&ision !a/ing? Why? 3ow do &apital gains di##er #ro! ordinary &orporate in&o!e?
+nder &'rrent ta% laws the appli&a$le ta% rates to +.S &orporations are progressie. The aerage
ta% rate is &al&'lated $y diiding the &o!pany. ta% lia$ility $y its preta% in&o!e. The !arginal ta%
rate is the a!o'nt o# ta% paid on an additional dollar o# in&o!e generated. The !arginal ta% rate
is releant to #inan&ial de&isions $e&a'se it shows the ta% the &o!pany will hae to pay in &ase it
generates any new &ash #lows. :rdinary &orporate in&o!e is in&o!e res'lting #ro! the sale o# the
#ir!.s goods and seri&es" whi&h is the &orporation.s &ore $'siness. Capital gains arise when
&o!panies sell &apital assets" s'&h as e0'ip!ent or sto&/ held as an inest!ent" #or !ore than
their original p'r&hase pri&e. The a!o'nt o# the &apital gain wo'ld $e e0'al to the di##eren&e
$etween the sale pri&e and initial p'r&hase pri&e. Basi&ally" &apital gains play the role o#
additional" e%traordinary in&o!e.
Solutions to End-of-Chapter Problems
1inan%ial State&ents
32-1. :$tain #inan&ial state!ents #or Bi&roso#t #or the last #ie years either #ro! its we$ site
,httpHCCwww.!i&roso#t.&o!- or #ro! E5GA> online
,httpHCCwww.se&.goCedgarCsear&hedgarCwe$'sers.ht!-. First" loo/ at the state!ents witho't
reading the notes. Then" read the notes &are#'lly" &on&entrating on those regarding e%e&'tie sto&/
options. 5o yo' hae a di##erent perspe&tie a#ter analy4ing these notes?
*nternet e%er&ise 7 answers will ary.
7as( 1lo8 Analysis
32-2. Gien the $alan&e sheets and sele&ted data #ro! the in&o!e state!ent o# SBG *nd'stries that
#ollow" answer parts ,a-7,&-.
a. Cal&'late the #ir!.s operating cash flow (OCF) #or the year ended 5e&e!$er 11" 2??;" 'sing
E0'ation 2.1.
$. Cal&'late the #ir!.s free cash flow (FCF) #or the year ended 5e&e!$er 11" 2??;" 'sing
E0'ation 2.2.
&. *nterpret" &o!pare" and &ontrast yo'r &ash #low esti!ates in parts ,a- and ,$-.
SBG *nd'stries
Balan&e Sheets
,in F !illions-
Assets
9e%e&ber
*1, 2002
9e%e&ber
*1, 2006
Liabilities and Sto%'-
(olders, Equity
9e%e&ber
*1, 2002
9e%e&ber
*1, 2006
Chapter 2 Financial Statement and Cash Flow Analysis 1<
Cash F 1"9?? F 1"??? A&&o'nts paya$le F 1";?? F 1"9??
Bar/eta$le se&'rities 1"8?? 1"2?? =otes paya$le 2"8?? 2"2??
A&&o'nts re&eia$le 2"??? 1"8?? A&&r'als 1"2?? 1"1??
*nentories 2"<?? 2"8?? Total &'rrent lia$ilities F <";?? F <"???
Total &'rrent assets F1;"2?? F12"8?? Gong6ter! de$t ;"??? ;"???
Gross #i%ed assets F11"9?? F1?"1?? Total lia$ilities F19";?? F19"???
GessH A&&'!'lated
depre&iation 12"7?? 11"1?? Co!!on sto&/ F11"??? F11"???
=et #i%ed assets F1;"8?? F17"??? >etained earnings ;"2?? 9"8??
Total assets $**,000 $*1,!00 Total sto&/holders.
e0'ity F17"2?? F1;"8??
Total liabilities and
sto%'(olders, equity $**,000 $*1,!00
*n&o!e State!ent 5ata ,2??;" in F!illions-
5epre&iation e%pense F1";??
Earnings $e#ore interest and ta%es ,'(I)- 2"9??
Ta%es 1"1??
=et pro#its a#ter ta%es 2"2??
Answers
a. :perating &ash #low @ EB*T 7 Ta%es I 5epre&iation
: F2"9?? 7 F1"1?? I F1";??
@ F2"8??
b. Free &ash #low @ :CF 7 FA 7 ,CA 7 ACP 7 A&&r'als-
@ 2"8?? 7 ,11"9?? 7 1?"1??- 7 N,1;"2?? 7 12"8??- 7 ,1";?? 7 1"9??- 7 ,1"2?? 7 1"1??-O
@ F2"???
%. :perating &ash #low is higher than CFF: $e&a'se operating does not in&l'de interest
e%pense" while this is part o# net in&o!e. Free &ash #low not only loo/s at operations $'t all
loo/s at whether a &o!pany has added assets or red'&ed lia$ilities 'ses o# &ash- or red'&ed
assets and in&reased lia$ilities ,so'r&es o# &ash-.
32-*. Classi#y ea&h o# the #ollowing ite!s as an in#low ,*- or an o't#low ,:- o# &ash" or as neither ,=-.
4te& 7(an#e -$. 4te& 7(an#e -$.
Cash I;?? A&&o'nts re&eia$le P<??
A&&o'nts paya$le P1"2?? =et pro#its I7??
=otes paya$le I8?? 5epre&iation I2??
Gong6ter! de$t P2"9?? >ep'r&hase o# sto&/ I9??
*nentory I2?? Cash diidends I1??
Fi%ed assets I;?? Sale o# sto&/ I1"1??
Answers
Cash I ;?? ,:- A&&o'nts re&eia$le 7<?? ,*-
A&&o'nts paya$le 71"2?? ,:- =et pro#its I7?? ,*-
2? Instructors Manual
=otes paya$le I8?? ,*- 5epre&iation I2?? ,*-
Gong6ter! de$t 72"9?? ,:- >ep'r&hase o# sto&/ I9?? ,:-
*nentory I 2?? ,:- Cash 5iidends I1?? ,:-
Fi%ed assets I;??,:- Sale o# Sto&/ I1"1?? ,*-
Analy;in# 1inan%ial 3erfor&an%e <sin# /atio Analysis
32-4. Ban'#a&t'rers Ban/ is eal'ating Al'!in'! *nd'stries" *n&." whi&h has re0'ested a F1 !illion
loan" to assess the #ir!.s #inan&ial leerage and ris/. :n the $asis o# the de$t ratios #or
Al'!in'!" along with the ind'stry aerages and Al'!in'!.s re&ent #inan&ial state!ents ,whi&h
#ollow-" eal'ate and re&o!!end appropriate a&tion on the loan re0'est.
Al'!in'! *nd'stries" *n&.
*n&o!e State!ent
For the Jear Ended 5e&e!$er 11" 2??;
Sales revenue $30,000,000
Less: Cost of goods sold 21,000,000
Gross profit $ 9,000,000
Less operating expenses:
Selling expense $ 3,000,000
General and administrative expenses 1,800,000
Lease expense 200,000
Depreciation expense 1,000,000
Total operating expenses $ 6,000,000
Operating profit $ 3,000,000
Less: Interest expense 1,000,000
Net profit before taxes $ 2,000,000
Less: Taxes (rate = 40%) 800,000
Net profits after taxes $ 1,200,000
Chapter 2 Financial Statement and Cash Flow Analysis 21
Al'!in'! *nd'stries" *n&.
Balan&e Sheet
5e&e!$er 11" 2??;
Assets Liabilities and Sto%'(olders, Equity
C'rrent assets C'rrent lia$ilities
Cash F 1"???"??? A&&o'nts paya$le F 8"???"???
Bar/eta$le se&'rities 1"???"??? =otes paya$le 8"???"???
A&&o'nts re&eia$le 12"???"??? A&&r'als 9??"???
*nentories 7"9??"??? Total &'rrent lia$ilities F1;"9??"???
Total &'rrent assets F21"9??"??? Gong6ter! de$t ,in&l. #inan&ial leases- F2?"???"???
Fi%ed assets ,at &ost- Sto&/holders. e0'ity
Gand and $'ildings F11"???"??? Pre#erred sto&/ ,29"??? shrs" F2 di.- F 2"9??"???
Ba&hinery and e0'ip!ent 2?"9??"??? Co!!on sto&/ ,1 !illion shrs" F9 par- 9"???"???
F'rnit're and #i%t'res 8"???"??? Paid6in &apital in e%&ess o# par 2"???"???
Gross #i%ed assets F1<"9??"??? >etained earnings 2"???"???
GessH A&&'!'lated depre&iation 11"???"??? Total sto&/holders. e0'ity F11"9??"???
=et #i%ed assets F2;"9??"??? Total lia$ilities and sto&/holders.
Total assets $60,000,000 e0'ity $60,000,000
4ndustry A$era#es
Debt ratio 0.51
Debt-equity ratio 1.07
Times interest earned ratio 7.1?
/atio 9efinition 7al%ulation Alu&inu& 4ndustry A$#.
5e$t 5e$t F1;"9??"??? 71 .91
Total Assets F9?"???"???
5e$t6E0'ity Gong6Ter! 5e$t F2?"???"??? 1.28 1.?7
E0'ity F11"9??"???
Ti!es *nterest Earned EB*T F1"???"??? 1.?? 7.1?
*nterest F1"???"???
Be&a'se Al'!in'! *nd'stries" *n&. has a !'&h higher degree o# inde$tedness and !'&h lower a$ility to
seri&e de$t than the aerage #ir! in the ind'stry" the loan sho'ld $e reDe&ted.
22 Instructors Manual
32-6. +se the #ollowing in#or!ation to answer the 0'estions that #ollow.
*n&o!e State!ents
For the Jear Ended 5e&e!$er 11" 2??;
=ea$y >etal
>anufa%turin# -=>>.
>etalli% Sta&pin#
4n%. ->S.
=i#(-Te%( Soft8are
7o. -=TS.
Sales $75,000,000 $50,000,000 $100,000,000
Operating expenses 65,000,000 40,000,000 60,000,000
Operating profit $10,000,000 $10,000,000 $ 40,000,000
Interest expenses 3,000,000 3,000,000 0
Earnings before taxes $ 7,000,000 $ 7,000,000 $ 40,000,000
Taxes 2,800,000 2,800,000 16,000,000
Net income $ 4,200,000 $ 4,200,000 $ 24,000,000
Balan&e Sheets
As o# 5e&e!$er 11" 2??;
=ea$y >etal
>anufa%turin# -=>>.
>etalli% Sta&pin#
4n%. ->S.
=i#(-Te%( Soft8are
7o. -=TS.
Current assets $ 10,000,000 $ 5,000,000 $ 20,000,000
Net fixed assets 90,000,000 75,000,000 80,000,000
Total assets $100,000,000 $80,000,000 $100,000,000
Current liabilities $ 20,000,000 $10,000,000 $ 10,000,000
Long-term debt 40,000,000 40,000,000 0
Total liabilities $ 60,000,000 $50,000,000 $ 10,000,000
Common stock $ 15,000,000 $10,000,000 $ 25,000,000
Retained earnings 25,000,000 20,000,000 65,000,000
Total common equity $ 40,000,000 $30,000,000 $ 90,000,000
Total liabilities and
common equity $100,000,000 $80,000,000 $100,000,000
a. +se the 5'Pont syste! to &o!pare the two heay !etal &o!panies shown a$oe ,33B and
BS- d'ring 2??;. Whi&h o# the two has a higher ret'rn on &o!!on e0'ity? What is the &a'se
o# the di##eren&e $etween the two?
$. Cal&'late the ret'rn on &o!!on e0'ity o# the so#tware &o!pany" 3TS. Why is this al'e so
di##erent #ro! those o# the heay !etal &o!panies &al&'lated in part a.?
&. Co!pare the leerage leels $etween the ind'stries. Whi&h ind'stry re&eies a greater
&ontri$'tion #ro! ret'rn on total assets? Whi&h ind'stry re&eies a greater &ontri$'tion #ro!
the #inan&ial leerage as !eas'red $y the assets6to6e0'ity ratio?
d. Can yo' !a/e a !eaning#'l 5'Pont &o!parison a&ross ind'stries? Why or why not?
Chapter 2 Financial Statement and Cash Flow Analysis 21
a. >:E @ =et Pro#it Bargin ,=PB- Total Asset T'rnoer ,TAT- Finan&ial leerage
!'ltiplier ,ACE-
>:E 33B @ F2"2??"??? F79"???"??? F1??"???"???
F79"???"??? F1??"???"??? F2?"???"???
>:E 33B @ .?9; .79 2.9?
>:E 33B @ 1?.9K
>:E BS @ F2"2??"??? F9?"???"??? F8?"???"???
F9?"???"??? F8?"???"??? F1?"???"???
>:E BS @ .?82 .;29 2.;7
>:E BS @ 12.?K
Betalli& Sta!ping ,BS- has an >:E o# 12K as &o!pared to 1?.9K #or 3eay Betal ,3B-.
While 3eay Betal 'tili4es its assets !ore e##i&iently ,TAT@ ?.79 s. ?.;29 #or Betalli&
Sta!ping-" Betalli& &onerts a greater per&entage o# sales into net in&o!e ,=PB @ ?.?82 s.
?.?9; #or 3eay Betal- and !a/es greater 'se o# #inan&ial leerage" gien its slightly higher
#inan&ial leerage !'ltiplier ,2.;7 s 2.9? #or 3eay Betal-.
$. >:E 3TS @ F22"???"??? F1??"???"??? F1??"???"???
F1??"???"??? F1??"???"??? F<?"???"???
>:E 3TS @ .22 1 1.11
>:E 3TS @ 2;.7K
3eay Betal has a lower >:A ,.?9; % .79 @ .?22 s .22 %1 @ .22 #or 3TS- and a higher
#inan&ial leerage !'ltiplier ,2.9? s. 1.11 #or 3TS- than 3igh Te&h So#tware" *n&. Be&a'se
the aerage al'es o# the three >:E &o!ponents are ind'stry6spe&i#i&" 5'Pont analysis
a&ross ind'stries is not ery !eaning#'l
32-2. >e#er $a&/ to Pro$le! 269" and per#or! the sa!e analysis with real data. 5ownload last year.s
#inan&ial data #ro! Ford Botor Co!pany ,httpHCCwww2.#ord.&o!-" General Botors
,httpHCCwww.g!.&o!-" and Bi&roso#t ,httpHCCwww.!i&roso#t.&o!-. Whi&h ratios de!onstrate the
greatest di##eren&e $etween Ford and General Botors? Whi&h o# the two is !ore pro#ita$le?
Whi&h ratios drie the greater pro#ita$ility?
*nternet e%er&ise 7 answers will ary.
32-). A &o!!on6si4e in&o!e state!ent #or Al'!in'! *nd'stries. 2??9 operations #ollows. +sing the
#ir!.s 2??; in&o!e state!ent presented in Pro$le! 262" deelop the 2??; &o!!on6si4e in&o!e
state!ent ,see #ootnote 2- and &o!pare it to the 2??9 state!ent. Whi&h areas re0'ire #'rther
analysis and inestigation?
22 Instructors Manual
Al'!in'! *nd'stries" *n&.
Co!!on6Si4e *n&o!e State!ent
For the Jear Ended 5e&e!$er 11" 2??9 .
Sales revenue ($35,000,000)
100.0%
Less: Cost of goods sold
65.9 %
Gross profit
34.1%
Less: Operating expenses
Selling expense
12.7%
General and administrative expenses
6.3
Lease expense
0.6
Depreciation expense
3.6
Total operating expense
23.2 %
Operating profit
10.9%
Less: Interest expense
1.5 %
Net profit before taxes
9.4%
Less: Taxes (rate = 40%)
3.8 %
Net profits after taxes
5.6%
Al'!in'! *nd'stries
*n&o!e State!ent
For the Jear Ended 5e&e!$er 11" 2??; .
7o&&on Si;e ?
Sales F1?"???"??? 1??K
Cost o# goods sold 21"???"??? 7?K
Gross pro#it F <"???"??? 1?K
Selling e%pense 1"???"??? 1?K
GEA e%pense 1"8??"??? ;K
Gease e%pense 2??"??? ?.;7K
5epre&iation 1"???"??? 1.11K
Total operating e%pense ;"???"??? 2?K
:perating pro#its F 1"???"??? 1?K
*nterest e%pense 1"???"??? 1.11K
=et pro#it $e#ore ta%es F 2"???"??? ;.;7K
Ta%es 8??"??? 2.;7K
=et pro#it a#ter ta%es F 1"2??"??? 2.??K
Sales hae de&lined #ro! F19 !illion to F1? !illion and &ost o# goods sold has in&reased as a
per&entage o# sales ,#ro! ;9.<K in 2??9 to 7?K in 2??;-" pro$a$ly d'e to a loss o# prod'&tie
e##i&ien&y. Total operating e%penses hae de&reased as a per&ent o# sales ,#ro! 21.2K in 2??9 to
2?.?K in 2??;-L this appears #aora$le 'nless this de&line has &ontri$'ted toward the #all in sales.
The leel o# interest as a per&entage o# sales has in&reased signi#i&antly ,#ro! 1.9K in 2??9 to
1.1K in 2??;-L this is li/ely attri$'ta$le to the #ir!.s relatiely high de$t leels in 2??;. F'rther
analysis sho'ld $e there#ore #o&'s on the #ir!.s in&reased &ost o# goods sold and its high leel o#
de$t.
Chapter 2 Financial Statement and Cash Flow Analysis 29
32-!. +se the #ollowing #inan&ial data #or Greta.s Gadgets" *n&." to deter!ine the i!pa&t o# 'sing
additional de$t #inan&ing to p'r&hase additional assets. Ass'!e that an additional F1 !illion o#
assets is p'r&hased with 1?? per&ent de$t #inan&ing with a 1? per&ent ann'al interest rate.
Greta.s Gadgets" *n&.
*n&o!e State!ent
For the Jear Ended 5e&e!$er 11" 2??;
Sales F2"???"???
7 Costs and e%penses Q <?K 1";??"???
Earnings $e#ore interest E ta%es F 2??"???
7 *nterest ,.1?AF1"???"???- 1??"???
Earnings $e#ore ta%es F 1??"???
Ta%es Q 2?K 12?"???
=et in&o!e F 18?"???
Greta.s Gadgets" *n&.
Balan&e Sheet
As o# 5e&e!$er 11" 2??;
Assets Liabilities and Sto%'(olders, Equity
C'rrent assets F ? C'rrent lia$ilities F ?
Fi%ed assets 2"???"??? Gong6ter! de$t Q 1?K 1"???"???
Total assets F2"???"??? Total lia$ilities F1"???"???
Co!!on sto&/ e0'ity 1"???"???
Total lia$ilities and sto&/holders.
e0'ity F2"???"???
a. Cal&'late the &'rrent ,2??;- net pro#it !argin" total asset t'rnoer" assets6to6e0'ity ratio"
ret'rn on total assets" and ret'rn on &o!!on e0'ity #or Greta.s.
$. =ow" ass'!ing no other &hanges" deter!ine the i!pa&t o# p'r&hasing the F1 !illion in assets
'sing 1?? per&ent de$t #inan&ing with a 1? per&ent ann'al interest rate. F'rther" ass'!e that
the newly p'r&hased assets generate an additional F2 !illion in sales and that the &osts and
e%penses re!ain at <? per&ent o# sales. For p'rposes o# this pro$le!" #'rther ass'!e a ta% rate
o# 2? per&ent. What is the e##e&t on the ratios &al&'lated in part ,a-? *s the p'r&hase o# these
assets D'sti#ied on the $asis o# the ret'rn on &o!!on e0'ity?
&. Ass'!e that the newly p'r&hased assets in part ,$- generate only an e%tra F9??"??? in sales. *s
the p'r&hase D'sti#ied in this &ase?
d. Whi&h &o!ponent ratio,s- o# the 5'Pont syste! is not a##e&ted $y the &hange in sales? What
does this i!ply a$o't the 'se o# #inan&ial leerage?
a. =et Pro#it Bargin @ F18?"??? @ .?29 @ 2.9K
F2"???"???
Total Asset T'rnoer @ F2"???"??? @ 2.??
F2"???"???
Finan&ial Geerage B'ltiplier @ F2"???"??? @ 2.??
F1"???"???
2; Instructors Manual
Chapter 2 Financial Statement and Cash Flow Analysis 27
>et'rn on Total Assets ,>:A- @ =et Pro#it Bargin Total Asset T'rnoer
@ ?.?29 2.??
@ ?.?< @ <K

>et'rn on E0'ity ,>:E- @ >et'rn on Total Assets Finan&ial Geerage B'ltiplier
@ ?.?< 2.??
@ .18 @ 18K
$. Sales F;"???"??? C'rrent assets F ?
E%penses ,.<? % F;"???"???- 9"2??"??? Fi%ed assets 1"???"???
EB*T F ;??"??? Total assets F1"???"???
*nterest ,.1? % F2"???"???- 2??"???
EBT F 2??"??? C'rrent lia$ilities F ?
Ta%es Q 2?K 1;?"??? Gong6ter! de$t ,Q 1?K- 2"???"???
=et in&o!e F 22?"??? Total lia$ilities F2"???"???
Co!!on e0'ity 1"???"???
Total lia$. E SC3 e0'ity F1"???"???
=et Pro#it Bargin @ F22?"??? @ .?2 @ 2K
F;"???"???
Total Asset T'rnoer @ F;"???"??? @ 2.??
F1"???"???
Finan&ial Geerage B'ltiplier @ F1"???"??? @ 1.??
F1"???"???
>et'rn on Total Assets ,>:A- @ 2K 2.?? @ 8K
>et'rn on E0'ity ,>:E- @ 8K 1.?? @ 22K
As !eas'red $y >:E" whi&h in&reases #ro! 18K to 22K" the p'r&hase o# the assets is a
s'&&ess.
&. Sales F2"9??"??? C'rrent assets F ?
E%penses ,.<? F2"9??"???- 2"?9?"??? Fi%ed assets 1"???"???
EB*T F 29?"??? Total assets F1"???"???
*nterest ,.1? % F2"???"???- 2??"??? C'rrent lia$ilities F ?
EBT F 29?"??? Gong6ter! de$t 2"???"???
Ta%es Q 2?K 1??"??? Total lia$ilities F2"???"???
=et in&o!e F 19?"??? Co!!on e0'ity 1"???"???
Total lia$. E SC3 e0'ity F1"???"???
=et Pro#it Bargin @ F19?"??? @ .?111 @ 1.11K
F2"9??"???
Total Asset T'rnoer @ F2"9??"??? @ 1.9?
F1"???"???
28 Instructors Manual
E0'ity B'ltiplier @ Assets R E0'ity @ F1"???"??? R F1"???"??? @ 1.??
>et'rn on Total Assets ,>:A- @ 1.11K 1.9? @ 9K
>et'rn on E0'ity ,>:E- @ 9K 1.?? @ 19K
*n this &ase" the a&0'isition o# assets lowers >:E ,#ro! 18Kto 19K- and there#ore is not a
good inest!ent.
d. T(e equity &ultiplier is a##e&ted only $y the #inan&ing de&ision 7 not $y &hanges in sales.
This i!plies that >:E &an $e enhan&ed $y an in&rease in #inan&ial leerage only i# the assets
p'r&hased with the de$t are 'tili4ed at least as e##i&iently as e%isting assets in generating sales
and in earning net in&o!e on those sales.
32-". Tra&ey White" the owner o# the B'44 Co##ee Shop &hain" has de&ided to e%pand her operations.
3er 2??; #inan&ial state!ents #ollow. Tra&ey &an $'y two additional &o##eeho'ses #or F1 !illion"
and she has the &hoi&e o# &o!pletely #inan&ing these new &o##eeho'ses with either a 1? per&ent
,ann'al interest- loan or the iss'an&e o# new &o!!on sto&/. She also e%pe&ts these new shops to
generate an additional F1 !illion in sales. Ass'!ing a 2? per&ent ta% rate and no other &hanges"
sho'ld Tra&ey $'y the two &o##eeho'ses? Why or why not? Whi&h #inan&ing option res'lts in the
$etter &O'?
@u;; 7offee S(ops, 4n%. 2002 1inan%ial State&ents
Balance Sheet
4n%o&e State&ent
Current assets $ 250,000 Sales F9??"???
Fixed assets 750,000 P Costs and e%penses Q 2?K 2??"???
Total assets $1,000,000 Earnings $e#ore interest and
ta%es ,EB*T- F1??"???
Current liabilities $ 300,000 P *nterest e%pense ?
Long-term debt 0 =et pro#it $e#ore ta%es F1??"???
Total liabilities $ 300,000 P Ta%es Q 2?K 12?"???
Common equity 700,000 =et in&o!e F18?"???
Total liabilities and
stockholders equity $1,000,000
Answer
@alan%e S(eet 4te&s 7urrently 9ebt 1inan%in# Sto%' 1inan%in#
C'rrent assets F 29?"??? F 29?"??? F 29?"???
Fi%ed assets 79?"??? 1"79?"??? 1"79?"???
Total assets F1"???"??? F2"???"??? F2"???"???
C'rrent lia$ilities F 1??"??? F 1??"??? F 1??"???
Gong6ter! de$t ? 1"???"??? ?
Total lia$ilities F 1??"??? F1"1??"??? F 1??"???
Co!!on e0'ity 7??"??? 7??"??? 1"7??.???
Total lia$ilities E
SC3 e0'ity F1"???"??? F2"???"??? F2"???"???
Chapter 2 Financial Statement and Cash Flow Analysis 2<
4n%o&e State&ent 4te&s 7urrently 9ebt 1inan%in# Sto%' 1inan%in#
Sales F9??"??? F1"9??"??? F1"9??"???
E%penses Q 2?K 2??"??? ;??"??? ;??"???
EB*T F1??"??? F <??"??? F <??"???
*nterest e%p. ,?.1? GT5e$t- ? 1??"??? ?
=et pro#it $e#ore ta%es F1??"??? F ;??"??? F <??"???
Ta%es Q 2?K 12?"??? 22?"??? 1;?"???
=et in&o!e F18?"??? F 1;?"??? F 92?"???
>:E ,=et in&o!e R SC3.s e0'ity- 29.71K 91.21K 12.9<K
All else re!aining the sa!e" Tra&ey sho'ld e%pand her operations 'sing de$t #inan&ing $e&a'se this
strategy will do'$le her #ir!.s >:E.
32-10. The #inan&ial state!ents o# A&&ess Corporation #or the year ended 5e&e!$er 11" 2??;" #ollow.
A&&ess Corporation
*n&o!e State!ent
For the Jear Ended 5e&e!$er 11" 2??;
AAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAA .
Sales revenue $160,000
Less: Cost of goods sold
a
106,000
Gross profit $ 54,000
Less operating expenses:
Selling expense $16,000
General and administrative expense 10,000
Lease expense 1,000
Depreciation expense 10,000
Total operating expenses 37,000
Operating profit $17,000
Less: Interest expense 6,100
Net profit before taxes $10,900
Less: Taxes @ 40% 4,360
Net profits after taxes $ 6,540
a
A&&ess Corporation.s ann'al p'r&hases are esti!ated to e0'al 79 per&ent o# &ost o# goods sold.
9? Instructors Manual
A&&ess Corporation
Balan&e Sheet
As o# 5e&e!$er 11" 2??;
Assets Liabilities and Sto%'(olders, Equity
Cash F 9?? A&&o'nts paya$le F 22"???
Bar/eta$le se&'rities 1"??? =otes paya$le 27"???
A&&o'nts re&eia$le 29"??? Total &'rrent lia$ilities F ;<"???
*nentories 29"9?? Gong6ter! de$t 22"<9?
Total &'rrent assets F 72"??? Total lia$ilities F <1"<9?
Gand F 2;"??? Co!!on sto&/
a
11"9??
B'ildings and e0'ip!ent F <?"??? >etained earnings 2;"99?
GessH A&&'!'lated depre&iation 18"??? Total lia$ilities and sto&/holders.
=et #i%ed assets F 78"??? e0'ity F19?"???
Total assets F19?"???
a
The #ir!.s 1"??? o'tstanding shares o# &o!!on sto&/ &losed 2??; at a pri&e o# F29 per share.
a. +se the pre&eding #inan&ial state!ents to &o!plete the #ollowing ta$le. Ass'!e that the
ind'stry aerages gien in the ta$le are appli&a$le #or $oth 2??9 and 2??;.
$. Analy4e A&&ess Corporation.s #inan&ial &ondition as it relates to ,1- li0'idity" ,2- a&tiity"
,1- de$t" ,2- pro#ita$ility" and ,9- !ar/et al'e. S'!!ari4e the &o!pany.s oerall #inan&ial
&ondition.
A%%ess 7orporation,s 1inan%ial /atios
Industry
Average
Actual
Ratio 2005
Actual
Ratio 2006
Current ratio
1.80 1.84
Quick (acid-test) ratio
.70 .78
Inventory turnover
2.50 2.59
Average collection period
a 37 days 36 days
Average payment period
a 72 days 78 days
Debt-to-equity ratio
50% 51%
Times interest earned ratio
3.8 4.0
Gross profit margin
38% 40%
Net profit margin
3.5% 3.6%
Return on total assets (ROA)
4.0% 4.0%
Return on common equity (ROE)
9.5% 8.0%
Market/book (M/B) ratio
1.1 1.2
a
Based on a 1;96day year and on end6o#6year #ig'res.
Chapter 2 Financial Statement and Cash Flow Analysis 91
a. A&&ess Corporation 7 >atio Analysis
A%tual
2002
C'rrent ratio 1.?2
S'i&/ ratio ?.18
*nentory t'rnoer 2.11
Aerage &olle&tion period 9; days
Aerage pay!ent period 7; days
5e$t6e0'ity ratio 2?K
Ti!es interest earned 2.8
Gross pro#it !argin 12K
=et pro#it !argin 2.1K
>et'rn on total assets ,>:A- 2.2K
>et'rn on e0'ity ,>:E- 11.1K
Bar/etC$oo/ ,BCB- ratio 1.1
$. ,1- LiquidityB A&&ess Corporation.s li0'idity position has deteriorated #ro! 2??9 to 2??;
and is in#erior to the ind'stry aerage. The #ir! !ay not $e a$le to satis#y short6ter!
o$ligations as they &o!e d'e.
,2- A%ti$ityB A&&ess. a$ility to &onert assets into &ash has deteriorated #ro! 2??9 to 2??;.
E%a!ination into the &a'se o# the 2?6day in&rease in the aerage &olle&tion period is
warranted. *nentory t'rnoer has also de&reased #or the period 'nder reiew and is :T
when &o!pared to the ind'stry. The #ir! !ay $e holding slightly e%&essie inentory.
Aerage pay!ent period has stayed a$o't the sa!e.
,1- 9ebtB A&&ess. long6ter! de$t position has i!proed sin&e 2??9 and is signi#i&antly
$elow the ind'stry aerage. A&&ess Corp..s a$ility to seri&e interest pay!ents has
deteriorated and is well $elow the ind'stry aerage.
,2- 3rofitabilityB Altho'gh the &o!pany.s gross pro#it !argin is $elow its ind'stry aerage"
indi&ating high &ost o# goods sold" the #ir! has a s'perior net pro#it !argin in &o!parison
to the ind'stry aerage. The #ir! has lower than aerage operating e%penses. The #ir!
has a s'perior ret'rn on inest!ent and ret'rn on e0'ity in &o!parison to the ind'stry
and shows an 'pward trend.
,9- >ar'etB The #ir!.s in&reasing and a$oe6ind'stry6aerage !ar/etC$oo/ ratio indi&ates
that inestors are willing to pay an in&reasing and a$oe6ind'stry6aerage a!o'nt #or
ea&h dollar o# $oo/ al'e. Clearly inestors hae possi$le e%pe&tations o# the #ir!.s
#'t're s'&&ess.
:erall" the #ir! !aintains s'perior pro#ita$ility at the ris/ o# illi0'idity. *nestigation into
the !anage!ent o# a&&o'nts re&eia$le and inentory is warranted. >egardless" inestors
appear to #eel positiely a$o't the #ir!.s #'t're prospe&ts.
32-11. Gien the #ollowing #inan&ial state!ents" histori&al ratios" and ind'stry aerages" &al&'late the
+G Co!pany.s #inan&ial ratios #or 2??;. Analy4e its oerall #inan&ial sit'ation $oth in
&o!parison to ind'stry aerages and oer the period 2??272??;. Brea/ yo'r analysis into an
eal'ation o# the #ir!.s li0'idity" a&tiity" de$t" pro#ita$ility" and !ar/et al'e.
92 Instructors Manual
+G Co!pany
*n&o!e State!ent
For the Jear Ended 5e&e!$er 11" 2??;
AAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAA
Sales revenue $10,000,000
Less: Cost of goods sold
a
7,500,000
Gross profit $ 2,500,000
Less operating expenses:
Selling expense
F1??"???
General and administrative expense
;9?"???
Lease expense
9?"???
Depreciation expense
2??"???
Total operating expense 1,200,000
Operating profit (EBIT) $1,300,000
Less: Interest expense 200,000
Net profits before taxes $1,100,000
Less: Taxes (rate = 40%) 440,000
Net profits after taxes $ 660,000
Less: Preferred stock dividends 50,000
Earnings available for common stockholders $ 610,000
Earnings per share (EPS) $3.05
a
Ann'al &redit p'r&hases o# F;.2 !illion were !ade d'ring the year.
+G Co!pany
Balan&e Sheet
As o# 5e&e!$er 11" 2??;
Assets Liabilities and Sto%'(olders, Equity
C'rrent assets C'rrent lia$ilities
Cash F 2??"??? A&&o'nts paya$le F <??"???
Bar/eta$le se&'rities 9?"??? =otes paya$le 2??"???
A&&o'nts re&eia$le 8??"??? A&&r'als 1??"???
*nentories <9?"??? Total &'rrent lia$ilities F 1"2??"???
Total &'rrent assets F 2"???"??? Gong6ter! de$t ,in&l'ding #inan&ial
leases- F 1"???"???
Gross #i%ed assets F12"???"??? Sto&/holders. e0'ity
GessH A&&'!'lated depre&iation 1"???"??? Pre#erred sto&/ ,29"??? shares" F2 F 1"???"???
=et #i%ed assets F <"???"??? diidend-
Co!!on sto&/ ,2??"??? shrs" F1 par-
a
;??"???
:ther assets F 1"???"??? Paid6in &apital in e%&ess o# par 9"2??"???
Total assets F12"???"??? >etained earnings 1"???"???
Total sto&/holders. e0'ity F 7"8??"???
Total lia$ilities and sto&/holders. e0'ity F12"???"???
a
:n 5e&e!$er 11" 2??;" the #ir!.s &o!!on sto&/ &losed at F27.9?.
Chapter 2 Financial Statement and Cash Flow Analysis 91
+G Co!pany
3istori&al and *nd'stry Aerage >atios
UUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUU
Industry Ratio Actual 2004 Actual 2005
Industry
Average
2006
Current ratio 1.4 1.55 1.85
Quick (acid-test) ratio 1.00 0.92 1.05
Inventory turnover 9.52 9.21 8.60
Average collection period
a
45.0 days 36.4 days 35.0 days
Average payment period
a
58.5 days 60.8 days 45.8 days
Fixed asset turnover 1.08 1.05 1.07
Total asset turnover 0.74 0.80 0.74
Debt ratio 0.20 0.20 0.30
Debt-to-equity ratio 0.25 0.27 0.39
Times interest earned ratio 8.2 7.3 8.0
Gross profit margin 0.30 0.27 0.25
Operating profit margin 0.12 0.12 0.10
Net profit margin 0.067 0.067 0.058
Return on total assets (ROA) 0.049 0.054 0.043
Return on common equity (ROE) 0.066 0.073 0.072
Earnings per share (EPS) $1.75 $2.20 $1.50
Price/earnings (P/E) ratio 12 10.5 11.2
Market/book (M/B) ratio 1.20 1.05 1.10
a
Based on a 1;96day year and on end6o#6year #ig'res.
92 Instructors Manual
Complete &atio Analysis*
+G Co!pany
>atio Analysis
AAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAAA
LiquidityB +G Co!pany.s oerall li0'idity as re#le&ted $y the &'rrent ratio and 0'i&/ ratio appears to
hae re!ained relatiely sta$le $'t $oth are $elow the ind'stry aerage. The 0'i&/ ratio is parti&'larly
poor.
A%ti$ityB The a&tiity o# a&&o'nts re&eia$le has i!proed" $'t inentory t'rnoer has deteriorated and is
&'rrently $elow the ind'stry aerage. *t has $ro'ght its long paya$les down to $elow the ind'stry aerage.
A%tual A%tual A%tual 4ndustry Ti&e Series -TS.
/atio 2004 2006 2002 2002 7ross-Se%tional -7S.
C'rrent ratio 1.2? 1.99 1.;7 1.89 TSH *!proing
CSH Fair
S'i&/ ratio 1.?? ?.<2 ?.88 1.?9 TSH 5eteriorating
CSH Poor
*nentory t'rnoer <.92 <.21 7.8< 8.;? TSH 5eteriorating
CSH Fair
Aerage &olle&tion period 29.? days 1;.2 days 28.8 days 19 days TSH *!proing
CSH Good
Aerage pay!ent period 98.9 days ;?.8 days 21.8 days 29.8 days TSH *!proing
CSH Good
Fi%ed asset t'rnoer 1.?8 1.?9 1.11 1.?7 TSH Sta$le
CSH Good
Total asset t'rnoer ?.72 ?.8? ?.81 ?.72 TSH *!proing
CSH Good
5e$t ratio ?.2? ?.2? ?.19 ?.1? TSH *n&reasing
CSH Fair
5e$t6e0'ity ratio ?.29 ?.27 ?.18 ?.1< TSH *n&reasing
CSH Good
Ti!es interest earned 8.2 7.1 ;.9 8.? TSH 5eteriorating
CSH Poor
Gross pro#it !argin ?.1? ?.27 ?.29 ?.29 TSH 5eteriorating
CSH Good
:perating pro#it !argin ?.12 ?.12 ?.11 ?.1? TSH *!proing
CSH Good
=et pro#it !argin ?.?;7 ?.?;7 ?.?;; ?.?98 TSH Sta$le
CSH Good
>et'rn on total assets
,>:A-
?.?2< ?.?92 ?.?99 ?.?21 TSH *!proing
CSH Good
>et'rn on e0'ity ,>:E- ?.?;; ?.?71 ?.?89 ?.?72 TSH *!proing
CSH Good
Earnings per share ,EPS- F1.79 F2.2? F1.?9 F1.9? TSH *!proing
CSH Good
Pri&eCearnings ,PCE- 12.? 1?.9 11.? 11.2 TSH *!proing
CSH Good
Bar/etC$oo/ ,BCB- 1.2 1.?9 1.1; 1.1? TSH *!proing
CSH Good
Chapter 2 Financial Statement and Cash Flow Analysis 99
9ebtB The #ir!.s de$t ratios hae in&reased #ro! 2??2 and are ery &lose to the ind'stry aerages"
indi&ating &'rrently a&&epta$le al'es $'t an 'ndesira$le trend.
3rofitabilityB The #ir!.s gross pro#it !argin" while in line with the ind'stry aerage" has de&lined"
pro$a$ly d'e to higher &ost o# goods sold. The operating and net pro#it !argins hae $een sta$le and are
also in the range o# the ind'stry aerages. Both the ret'rn on total assets and ret'rn on e0'ity appear to
hae i!proed slightly and are $etter than the ind'stry aerages. Earnings per share !ade a signi#i&ant
in&rease in 2??1 and 2??2.
>ar'etB The pri&eCearnings ,PCE- ratio indi&ates and i!proed leel o# inestor &on#iden&e in the #ir!.s
#'t're earnings potential" perhaps d'e to the $ene#its o# the #inan&ial leerage re#le&ted in the #ir!.s
in&reased de$t load and higher seri&ing re0'ire!ents. The !ar/etC$oo/ ,BCB- ratio also re#le&ts
i!proed and a$oe6ind'stry6aerage inestor &on#iden&e in the #ir! in 2??2.
*n s'!!ary" the #ir! needs to attend to inentory and sho'ld not in&'r added de$ts 'ntil their
leerage and interest &oerage ratios are i!proed. :ther than these indi&ators" the #ir! appears
to $e doing well66 parti&'larly in generating ret'rn on sales.
.
32-12. Choose a &o!pany that yo' wo'ld li/e to analy4e" and o$tain its #inan&ial state!ents. =ow" sele&t
another #ir! #ro! the sa!e ind'stry" and o$tain its #inan&ial data #ro! the *nternet. Per#or! a
&o!plete ratio analysis on ea&h #ir!. 3ow well does yo'r sele&ted &o!pany &o!pare to its
ind'stry peer? Whi&h &o!ponents o# yo'r #ir!.s &O' are s'perior" and whi&h are in#erior?
*nternet e%er&ise 7 answers will ary.
7orporate Taes
32-1*. Tho!soneti&s" *n&. a rapidly growing early stage te&hnology &o!pany had the preta% in&o!e
noted $elow #or &alendar years 2??262??;. The #ir! was s'$De&t to &orporate ta%es &onsistent
with the rates shown in Ta$le 2.; o# the te%t.
Cear 3reta 4n%o&e
2??2 F 87"???
2??9 F112"???
2??; F7;?"???
a. Cal&'late Tho!soneti&s. ta% lia$ility #or ea&h year 2??2" 2??9" and 2??;.
$. What was the #ir!.s aerage ta% rate in ea&h year?
&. What was the #ir!.s !arginal ta% rate in ea&h year?
d. *# in addition to its ordinary preta% in&o!e" Tho!soneti&s reali4ed a &apital gain o# F8?"???
d'ring &alendar year 2??9" what e##e&t wo'ld this hae on its ta% lia$ility" aerage ta% rate"
and !arginal ta% rate in 2??9?
e. Whi&h ta% rate 7 aerage or !arginal 7 sho'ld Tho!soneti&s 'se in de&ision6!a/ing? Why?
Answers
a. 2??2H
9?"??? ?.19 @ 7"9??
,79"???69?"???- ?.29 @ ;"29?
,87"???679"???- ?.12 @ 2"?8?
Total F17"81?
9; Instructors Manual
2??9H
9?"??? ?.19 @ 7"9??
,79"???69?"???- ?.29 @ ;"29?
,1??"???679"???- ?.12 @ 8"9??
,112"???61??"???- ?.1< @ 82";8?
Total F1?2"<1?
2??;H
9?"??? ?.19 @ 7"9??
,79"???69?"???- ?.29 @ ;"29?
,1??"???679"???- ?.12 @ 8"9??
,119"???61??"???- ?.1< @ <1";9?
,7;?"???6119"???- ?.12 @ 122"9??
Total F298"2??
$. 2??2H 17"81?C87"??? @ 2?.2<K
2??9H 1?2"<1?C112"??? @ 11.;1K
2??;H 298"2??C7;?"??? @ 12K
&. 2??2H 12K
2??9H 1<K
2??;H 12K
d. Total in&o!e in 2??9 wo'ld $e 112"??? I 8?"??? @ 1<2"???. Conse0'ently" ta% lia$ility
wo'ld $e&o!eH
9?"??? ?.19 @ 7"9??
,79"???69?"???- ?.29 @ ;"29?
,1??"???679"???- ?.12 @ 8"9??
,119"???61??"???- ?.1< @ <1";9?
,1<2"???6119"???- ?.12 @ 1<"18?
Total F111"28?
The aerage ta% rate $e&o!es 111"28?C1<2"??? @ 12K
The !arginal ta% rate $e&o!esH 12K
e. Tho!soneti&s sho'ld 'se their !arginal ta% rate in de&ision !a/ing. *t is the i!portant ta%
rate as it shows what the &o!pany will hae to pay i# it generates new &ash #lows in the
#'t're.
32-14. Trish Foods" *n&. had preta% ordinary &orporate in&o!e d'ring 2??; o# F2.7 !illion. *n addition
d'ring the year" Trish sold a gro'p o# depre&ia$le $'siness assets ,in the 96year depre&iation
&lass- that it had p'r&hased new #or F<8?"??? three years earlier. The #ir! pays &orporate in&o!e
ta%es at the rates shown in te%t Ta$le 2.;.
a. Cal&'late Trish.s 2??; ta% lia$ility" aerage ta% rate" and !arginal ta% rate" ass'!ing the
gro'p o# assets was sold #or F1"19?"???.
$. Cal&'late Trish.s 2??; ta% lia$ility" aerage ta% rate" and !arginal ta% rate" ass'!ing the
gro'p o# assets was sold #or F8<?"???.
Chapter 2 Financial Statement and Cash Flow Analysis 97
&. Co!pare" &ontrast" and dis&'ss yo'r #indings in parts a. and $.
98 Instructors Manual
Answers
The a&&'!'lated depre&iation #or the gro'p o# assets 'p to now is F988"??? ,<8?"???C9 @
1<;"???A1@988"???-" ass'!ing the salage al'e o# the assets is ?. There#ore" the assets. $oo/
al'e is F1<2"??? ,<8?"???6988"???-
a. Trish.s total in&o!e is 2"7??"??? I ,1"19?"??? 7 1<2"???-Nthis is the a!o'nt o# &apital gain
reali4ed #ro! the sale o# the e0'ip!ent @ F798"???O @ 1"298"??? and its ta% lia$ility isH
9?"??? ?.19 @ 7"9??
,79"???69?"???- ?.29 @ ;"29?
,1??"???679"???- ?.12 @ 8"9??
,119"???61??"???- ?.1< @ <1";9?
,1"298"???6119"???- ?.12 @ 1"?;1"82?
Total F1"179"72?
Aerage ta% rate @ 1"179"72?C1"298"??? @ 12K
Barginal ta% rate isH 12K"
$. The ordinary in&o!e is 2"7??"??? pl's the &apital gain reali4ed #or! the sale o# the assets
,8<?"???61<2"???- @ 2<8"??? #or a total o# 1"1<8"???
The ta% lia$ility isH
9?"??? ?.19 @ 7"9??
,79"???69?"???- ?.29 @ ;"29?
,1??"???679"???- ?.12 @ 8"9??
,119"???61??"???- ?.1< @ <1";9?
,1"1<8"???6119"???- ?.12 @ <71"22?
Total F1"?87"12?
Aerage ta% rate @ 1"?87"12?C1"1<8"??? @ 12K
Barginal ta% rate isH 12K
&. The aerage and !arginal ta% rates are 12K in $oth a and $. While &apital gains in&rease the
ordinary ta%a$le in&o!e respe&tiely the ta% lia$ility and &apital losses de&rease ordinary
ta%a$le in&o!e respe&tiely de&rease the ta% lia$ility" the !arginal ta% rate re!ains the sa!e
in $oth &ases d'e to the #a&t that the &o!pany #alls in the $iggest ta% $ra&/et ,119"??? 7
1?"???"???- and the gainsClosses are not s'$stantial eno'gh so as to &hange the !arginal ta%
rate.
Answer to MiniCase
1inan%ial State&ent and 7as( 1lo8 Analysis
Jo' hae $een hired $y First Citi4ens Ban/ as a #inan&ial analyst. :ne o# yo'r #irst Do$ assign!ents
is to analy4e the present #inan&ial &ondition o# Bradley Stores" *n&orporated. Jo' are proided with
the #ollowing 2??; $alan&e sheet and in&o!e state!ent in#or!ation #or Bradley Stores. *n addition"
Chapter 2 Financial Statement and Cash Flow Analysis 9<
yo' are told that Bradley Stores has 1?"???"??? shares o# &o!!on sto&/ o'tstanding" &'rrently
trading at F< per share" and has !ade ann'al p'r&hases o# F21?"???"???.
Jo'r assign!ent &alls #or yo' to &al&'late &ertain #inan&ial ratios and to &o!pare these &al&'lated
ratios with the ind'stry aerage ratios that are proided. Jo' are also told to $ase yo'r analysis on #ie
&ategories o# ratiosH ,a- li0'idity ratios" ,$- a&tiity ratios" ,&- de$t ratios" ,d- pro#ita$ility ratios" and ,e-
!ar/et ratios.
Balan&e Sheet ,in ???s-
UUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUU
Cash F 9"??? A&&o'nts paya$le F 19"???
A&&o'nts re&eia$le 2?"??? =otes paya$le 2?"???
*nentory 2?"??? Total &'rrent lia$ilities F 19"???
Total &'rrent assets F ;9"??? Gong6ter! de$t 1??"???
=et #i%ed assets 119"??? Sto&/holders. e0'ity ;9"???
Total assets F2??"??? Total lia$ilities and e0'ity F2??"???
*n&o!e State!ent ,in ???s-
UUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUUU
=et sales ,all &redit- F1??"???
Gess &ost o# goods sold 29?"???
Earnings $e#ore interest and ta%es F 9?"???
Gess interest 2?"???
Earnings $e#ore ta%es F 1?"???
Gess ta%es ,2?K- 2"???
=et in&o!e F ;"???
*nd'stry Aerages #or Tey >atiosH
=et pro#it !argin ;.2K
Aerage &olle&tion period ,1;9 days- 1? days
5e$t ratio 9?K
PCE ratio 21
*nentory t'rnoer ratio 12.?
&O' 18K
Aerage pay!ent period ,1;9 days- 2? days
Ti!es interest earned ratio 8.9
Total asset t'rnoer 1.2
C'rrent ratio 1.9
Assets6to6e0'ity ratio 2.?
&OA <K
S'i&/ ratio 1.29
Fi%ed asset t'rnoer ratio 1.8
Assi#n&ent
+se the #ollowing g'idelines to &o!plete this Do$ assign!ent. First" identi#y whi&h ratios yo' need to 'se
to eal'ate Bradley Stores in ter!s o# its ,a- li0'idity position" ,$- $'siness a&tiity" ,&- de$t position" ,d-
pro#ita$ility" and ,e- !ar/et &o!para$ility. =e%t" &al&'late these ratios. Finally" &o!pare these ratios to
the ind'stry aerage ratios proided in the pro$le! and answer the #ollowing 0'estions.
;? Instructors Manual
1. Based on the proided ind'stry aerage in#or!ation" dis&'ss Bradley Stores" *n&..s li0'idity position.
5is&'ss spe&i#i& areas in whi&h Bradley &o!pares positiely and negatiely with the oerall ind'stry.
2. Based on the proided ind'stry aerage in#or!ation" what do Bradley Stores" *n&..s a&tiity ratios tell
yo'? 5is&'ss spe&i#i& areas in whi&h Bradley &o!pares positiely and negatiely with the oerall
ind'stry.
1. Based on the proided ind'stry aerage in#or!ation" dis&'ss Bradley Stores" *n&..s de$t position.
5is&'ss spe&i#i& areas in whi&h Bradley &o!pares positiely and negatiely with the oerall ind'stry.
2. Based on the proided ind'stry aerage in#or!ation" dis&'ss Bradley Stores" *n&..s pro#ita$ility
position. As part o# this inestigation o# #ir! pro#ita$ility" in&l'de a 5'Pont analysis. 5is&'ss spe&i#i&
areas in whi&h Bradley &o!pares positiely and negatiely with the oerall ind'stry.
9. Based on the proided ind'stry aerage in#or!ation" how is Bradley Stores" *n&. iewed in the
!ar/etpla&e? 5is&'ss spe&i#i& areas in whi&h Bradley &o!pares positiely and negatiely with the
oerall ind'stry.
;. :erall" what are Bradley.s strong and wea/ points? Tnowing that yo'r $oss will approe new loans
only to &o!panies in a $etter6than6aerage #inan&ial position" what is yo'r #inal re&o!!endation
,approal or denial o# loan-?
Answers
>atios to &al&'lateH
4ndustry A$era#es @radley
=et pro#it !argin ;.2K 2.?K
Aerage &olle&tion period ,1;9 days- 1? days 22.11 days
5e$t ratio 9?K ;7.9K
PCE ratio 21 19
*nentory t'rnoer ratio 12.? ;.29
&O' 18K <.2K
Aerage pay!ent period ,1;9 days- 2? days 2;.1 days
Ti!es interest earned ratio 8.9 9.?
Total asset t'rnoer 1.2 1.9
C'rrent ratio 1.9 1.8;
Assets6to6e0'ity ratio 2.? 1.?8
&OA <K 1.?K
S'i&/ ratio 1.29 ?.71
Fi%ed asset t'rnoer ratio 1.8 2.22
1. >elatie to the ind'stry Bradley Stores has a strong &'rrent ratio indi&ating a $etter6than6aerage
a$ility to !eet &ash o$ligations oer the ne%t year. 3oweer" Bradley Stores 0'i&/ ratio is low
&o!pared to the ind'stry indi&ating that perhaps inentory leels are high. This in#or!ation proides
an indi&ation #or #'rther inestigation into Bradley Stores. inentory. Bradley Stores !ay si!ply
&arry too !'&h inentory. 3oweer" as a $igger &on&ern" perhaps Bradley Stores &arries an inordinate
a!o'nt o# o$solete inentory on their $oo/s.
2. The inentory t'rnoer ratio &on#ir!s that Bradley Stores is &arrying !'&h greater leels o# inentory
than the ind'stry aerage. Colle&tions are good &o!pared to the ind'stry. 3oweer" Bradley Stores
appears to stret&h their pay!ents. This is another area that &alls #or a !ore in6depth inestigation.
Perhaps Bradley Stores is not ta/ing adantage o# trade dis&o'nts. Bore serio'sly" perhaps Bradley
Stores has &ash #low pro$le!s that are !as/ed with the high inentory leels and res'lting strong
&'rrent ratio. Bradley Stores appears to generate $etter6than6aerage sales #or their leel o# #i%ed
Chapter 2 Financial Statement and Cash Flow Analysis ;1
assets and total assets. The relatiely higher #i%ed asset t'rnoer &o!pared to the total assets t'rnoer
&an again $e attri$'ted to high inentory leels.
1. Bradley Stores has greater de$t leels than the ind'stry on aerage" indi&ating greater #inan&ial ris/.
Co!po'nding this &on&ern is a low ti!es6interest6earned ratio. Bradley Stores $'##er in &oering
their interest &osts is less than the ind'stry. This is another area that needs #'rther inestigation. Co'ld
Bradley Stores raise their sales pri&e on &ertain ite!s? Alternatiely" does Bradley Stores need to
$etter &ontrol &osts?
2. Pro#ita$ility is low &o!pared to the ind'stry. These ratios highlight that Bradley Stores needs to either
in&rease reen'es or red'&e &osts. A 5'Pont Analysis proides additional insight.
4ndustry @radley Stores
=PB TAT ACE @ >:E =PB TAT ACE @ >:E
;.2K 1.2 2.? @ 18.?K 2.?K 1.9 1.?8 @ <.?K
As seen in the 5'Pont Analysis" Bradley Stores. >:E is !'&h lower d'e to a low net pro#it !argin.
This highlights the &on&ern o# reen'es and &osts. *t is also i!portant to point o't that Bradley Stores
has a low >:E despite haing a high e0'ity !'ltiplier ,asset to e0'ity ratio-. A greater e0'ity
!'ltiplier indi&ates greater #inan&ial ris/" where all else $eing e0'al" we wo'ld e%pe&t a higher >:E
to &o!pensate #or this greater ris/.
9. The PE ratio shows that inestors al'e Bradley Stores at a lower !'ltiple than they do other #ir!s in
the ind'stry. *t appears that !ar/et parti&ipants hae also 'n&oered these operational pro$le!s
asso&iated with Bradley Stores.
;. The &on&erns with Bradley Stores in&l'de high inentory leels" slow pay!ents to endors" high de$t
leels" low interest &oerage" and low pro#it !argins. F'rther inestigation is ne&essary" $'t $ased on
this analysis Bradley Stores does not appear to $e in a strong $orrowing position.