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Chapter 16
How Well Am I Doing?
Financial Statement Analysis
Solutions to Questions
16-1
Horizontal analysis examines how a
particular item on a financial statement such as
sales or cost of goods sold behaves over time.
Vertical analysis involves analysis of items on an
income statement or balance sheet for a single
period. In vertical analysis of the income
statement, all items are typically stated as a
percentage of sales. In vertical analysis of the
balance sheet, all items are typically stated as a
percentage of total assets.
16-2
By looking at trends, an analyst hopes
to get some idea of whether a situation is
improving, remaining the same, or deteriorating.
Such analyses can provide insight into what is
likely to happen in the future. Rather than
looking at trends, an analyst may compare one
company to another or to industry averages
using common-size financial statements.
16-3
Price-earnings ratios reflect investors
expectations concerning future earnings. The
higher the price-earnings ratio, the greater the
growth in earnings investors expect. For this
reason, two companies might have the same
current earnings and yet have quite different
price-earnings ratios. By definition, a stock with
current earnings of $4 and a price-earnings ratio
of 20 would be selling for $80 per share.
16-4
A company in a rapidly growing
technological industry would probably have
109
17.5%
14.6%
32.1%
7.9%
1.0%
6.9%
111
Price-earnings ratio =
$39,610
41,080
40,345
1,000
$39,345
$1,980 - $60
= 4.9%
$39,345
113
Current ratio =
115
$4,100
= 5.1
$800
Debt-to-equity ratio =
Current assets:
Cash..................................
Accounts receivable...........
Inventory............................
Total current assets..............
80.0
140.0
112.0
118.8
90.0
124.0
110.0
113.1
105.0
108.0
102.0
104.1
110.0
104.0
108.0
106.9
100.0
100.0
100.0
100.0
Current liabilities...................
130.0
106.0
108.0
110.0
100.0
2. Sales:
Assets:
117
$533,000
= 10.9% (rounded)
$4,900,000
$470,000
$56,000
$470,000 - $56,000
= 18.8% (rounded)
$2,200,000
$1,300,000
520,000
$ 780,000
$80,000 + $0 + $460,000 + $0
= 1.04 (rounded)
$520,000
$1,200,000
420,000
$ 780,000
Current assets
Current liabilities
$1,200,000
= 2.9 (rounded)
$420,000
119
2. Current ratio:
Current ratio=
Current assets
$490,000
=
= 2.45
Current liabilities $200,000
3. Acid-test ratio:
Cash + Marketable securities
+ Accounts receivable + Short-term notes
Acid test ratio=
Current liabilities
=
$21,000 + $0 + $160,000 + $0
= 0.91 (rounded)
$200,000
Sales on account
Average accounts receivable
$2,100,000
= 14
($160,000 + $140,000)/2
365 days
Accounts receivable turnover
365 days
= 26.1 days (rounded)
14
$1,260,000
= 4.5
($300,000 + $260,000)/2
365 days
= 81.1 days (rounded)
4.5
6. Debt-to-equity ratio:
Debt-equity ratio=
=
Total liabilities
Stockholders' equity
$500,000
= 0.63 (rounded)
$800,000
$180,000
= 6.0
$30,000
*$100,000 total par value $5 par value per share = 20,000 shares
121
4. Price-earnings ratio:
Price-earnings ratio=
$126,000
= 10.5%
$1,200,000
$105,000 - $0
( $725,000 + $800,000) /2 - $0
$105,000
= 13.8% (rounded)
$762,500
123
This Year
Last Year
$2,060,000 $1,470,000
1,100,000
600,000
$ 960,000 $ 870,000
b.
$2,060,000 $1,470,000
$1,100,000
$600,000
1.87
2.45
$740,000
$1,100,000
0.67
$7,000,000 $6,000,000
$525,000
$375,000
13.3
16.0
c.
d.
g.
27.4 days
$650,000
$600,000
1.08
22.8 days
$5,400,000 $4,800,000
$1,050,000
$760,000
5.1
6.3
71.6 days
57.9 days
$1,850,000 $1,350,000
$2,150,000 $1,950,000
0.86
0.69
$630,000
$90,000
7.0
$490,000
$90,000
5.4
2.3%
0.0%
16.3%
32.5%
0.5%
51.5%
48.5%
100.0%
6.1%
1.5%
12.1%
24.2%
0.6%
44.5%
55.5%
100.0%
27.5%
18.8%
46.3%
18.2%
22.7%
40.9%
5.0%
12.5%
36.3%
53.8%
100.0%
6.1%
15.2%
37.9%
59.1%
100.0%
125
3. The following points can be made from the analytical work in parts (1)
and (2) above:
The company has improved its profit margin from last year. This is
attributable to an increase in gross margin, which is offset somewhat by
an increase in operating expenses. In both years the companys net
income as a percentage of sales equals or exceeds the industry average
of 4%.
Although the companys working capital has increased, its current
position actually has deteriorated significantly since last year. Both the
current ratio and the acid-test ratio are well below the industry average,
and both are trending downward. (This shows the importance of not just
looking at the working capital in assessing the financial strength of a
company.) Given the present trend, it soon will be impossible for the
company to pay its bills as they come due.
127
$2.16
$45.00
4.8%
$1.20
$36.00
3.33%
$2.16
$6.16
35.1%
$1.20
$4.48
26.8%
d.
$45.00
$6.16
7.3
$36.00
$4.48
8.0
This Year
Last Year
$2,150,000 $1,950,000
200,000
200,000
$1,950,000 $1,750,000
50,000
$39.00
50,000
$35.00
A market price in excess of book value does not mean that the price
of a stock is too high. Market value is an indication of investors
perceptions of future earnings and/or dividends, whereas book value
is a result of already completed transactions.
2.
a.
Net income............................................
Add after-tax cost of interest paid:
[$90,000 (1 0.40)]........................
Total (a).................................................
This Year
Last Year
$ 324,000 $ 240,000
54,000
54,000
$ 378,000 $ 294,000
$3,650,000 $3,000,000
10.4%
9.8%
Net income............................................
Less preferred dividends......................
Net income remaining for common (a).
This Year
Last Year
$ 324,000 $ 240,000
16,000
16,000
$ 308,000 $ 224,000
b.
$2,050,000 $1,868,000
200,000
200,000
$1,850,000 $1,668,000
16.6%
13.4%
129
$70,000
12,000
350,000
460,000
8,000
900,000
Current liabilities:
Accounts payable.......................
Accrued liabilities........................
Notes due in one year................
Total current liabilities (b)...............
200,000
60,000
100,000
360,000
$540,000
Current assets
$900,000
=
= 2.5
Current liabilities $360,000
131
The Effect on
Working
Current
Acid-Test
Transaction
Capital
Ratio
Ratio
Declared a cash dividend....... Decrease Decrease Decrease
Paid accounts payable........... None
Increase
Increase
Collected cash on accounts
receivable............................ None
None
None
Purchased equipment for
cash..................................... Decrease Decrease Decrease
Paid a cash dividend previously declared..................... None
Increase
Increase
Borrowed cash on a shortterm note............................. None
Decrease Decrease
Sold inventory at a profit........ Increase Increase
Increase
Wrote off uncollectible accounts.................................. None
None
None
Sold marketable securities at
a loss................................... Decrease Decrease Decrease
Issued common stock for
cash..................................... Increase Increase
Increase
Paid off short-term notes........ None
Increase
Increase
b.
This Year
Last Year
$ 280,000 $ 168,000
84,000
70,000
$ 364,000 $ 238,000
$5,330,000 $4,640,000
6.8%
5.1%
Net income..............................................
Less preferred dividends.........................
Net income remaining for common (a)....
$ 280,000 $ 168,000
48,000
48,000
$ 232,000 $ 120,000
$3,120,000 $3,028,000
600,000
600,000
$2,520,000 $2,428,000
9.2%
4.9%
c.
Leverage is positive for this year because the return on common equity (9.2%) is greater than the return on total assets (6.8%). For last
year, leverage is negative because the return on the common equity
(4.9%) is less than the return on total assets (5.1%).
2.
a.
b.
$232,000
$120,000
50,000
$4.64
50,000
$2.40
$1.44
$36.00
4.0%
$0.72
$20.00
3.6%
133
This Year
$1.44
$4.64
31.0%
d.
$36.00
$4.64
7.8
Last Year
$0.72
$2.40
30.0%
$20.00
$2.40
8.3
Notice from the data given in the problem that the typical P/E ratio for
companies in Hedricks industry is 10. Hedrick Company presently
has a P/E ratio of only 7.8, so investors appear to regard it less well
than they do other companies in the industry. That is, investors are
willing to pay only 7.8 times current earnings for a share of Hedrick
Companys stock, as compared to 10 times current earnings for a
share of stock for the typical company in the industry.
e.
Stockholders equity................................
Less preferred stock...............................
Common stockholders equity (a)............
Number of common shares outstanding
(b).........................................................
Book value per share (a) (b)................
$3,200,000 $3,040,000
600,000
600,000
$2,600,000 $2,440,000
50,000
$52.00
50,000
$48.80
Note that the book value of Hedrick Companys stock is greater than
its market value for both years. This does not necessarily indicate that
the stock is selling at a bargain price. Market value is an indication of
investors perceptions of future earnings and/or dividends, whereas
book value is a result of already completed transactions.
Gross margin (a).....................................
Sales (b)..................................................
Gross margin percentage (a) (b)..........
$1,050,000
$860,000
$5,250,000 $4,160,000
20.0%
20.7%
b.
$2,600,000 $1,980,000
$1,300,000 $920,000
2.0
2.15
c.
$1,220,000 $1,120,000
$1,300,000 $920,000
0.94
1.22
d.
e.
g.
$5,250,000 $4,160,000
$750,000 $560,000
7.0
7.4
$4,200,000 $3,300,000
$1,050,000 $720,000
4.0
4.6
$2,500,000 $1,920,000
$3,200,000 $3,040,000
0.78
0.63
52 days
91 days
$520,000
$120,000
4.3
49 days
79 days
$340,000
$100,000
3.4
135
Hedrick Company
Comparative Balance Sheets
This
Year
Current assets:
Cash................................................
Marketable securities......................
Accounts receivable, net.................
Inventory.........................................
Prepaid expenses...........................
Total current assets............................
Plant and equipment, net...................
Total assets........................................
Current liabilities................................
Bonds payable, 10%..........................
Total liabilities.....................................
Stockholders equity:
Preferred stock, 8%, $30 par value.
Common stock, $40 par value........
Retained earnings...........................
Total stockholders equity...................
Total liabilities and equity...................
Last Year
5.6%
0.0%
15.8%
22.8%
1.4%
45.6%
54.4%
100.0%
8.5%
2.0%
12.1%
16.1%
1.2%
39.9%
60.1%
100.0%
22.8%
21.1%
43.9%
18.5%
20.2%
38.7%
10.5%
35.1%
10.5%
56.1%
100.0%
12.1%
40.3%
8.9%
61.3%
100.0%
137
Hedrick Company
Comparative Income Statements
Sales..................................................
Cost of goods sold..............................
Gross margin......................................
Selling and administrative expenses. . .
Net operating income..........................
Interest expense.................................
Net income before taxes.....................
Income taxes (30%)............................
Net income..........................................
This
Year
Last Year
100.0%
100.0%
80.0%
79.3%
20.0%
20.7%
10.1%
12.5%
9.9%
8.2%
2.3%
2.4%
7.6%
5.8%
2.3%
1.7%
5.3%
4.0%
3. Increase
A sale of inventory on account will increase the quick assets (cash, accounts receivable, marketable securities) but
have no effect on the current liabilities. For this reason, the
acid-test ratio will increase.
4. No effect
5. Decrease When a customer pays a bill, the accounts receivable balance is reduced. This increases the accounts receivable
turnover, which in turn decreases the average collection period.
6. Decrease Declaring a cash dividend will increase current liabilities,
but have no effect on current assets. Therefore, the current
ratio will decrease.
7. Increase
8. No effect
139
11. Increase
12. Increase
13. No effect
14. Decrease A decrease in net income would mean less income available to cover interest payments. Therefore, the times-interest-earned ratio would decrease.
15. No effect
16. Decrease A purchase of inventory on account will increase current liabilities, but will not increase the quick assets (cash, accounts receivable, marketable securities). Therefore, the
ratio of quick assets to current liabilities will decrease.
17. Increase
141
Current ratio =
$435,000
= 1.8 (rounded)
$246,000
$105,000 + $0 + $75,000 + $0
= 0.7 (rounded)
$246,000
Current ratio =
$435,000 + $68,000
= 2.0 (rounded)
$246,000
$105,000 + $0 + $75,000 + $0
= 0.7 (rounded)
$246,000
Even if this tactic had succeeded in qualifying the company for the loan,
we strongly advise against it. Inventories are assets the company has
acquired to sell to customers in the normal course of business. Used
production equipment is not inventoryeven if there is a clear intention
to sell it in the near future. The loan officer would not expect used
equipment to be included in inventories; doing so would be intentionally
misleading.
143
Current assets
Current liabilities
$435,000 + $68,000
= 2.0 (rounded)
$246,000
= 1.0 (rounded)
However, other options may be available. The old equipment is being
used to relieve bottlenecks in the heat-treating process and it would be
desirable to keep this standby capacity. We would advise Jurgen to fully
and honestly explain the situation to the loan officer. The loan officer
might insist that the equipment be sold before any loan is approved, but
she might instead grant a waiver of the current ratio and acid-test ratio
requirements on the basis that they could be satisfied by selling the old
equipment. Or she may approve the loan on the condition that the
equipment is pledged as collateral. In that case, Jurgen would only have
to sell the equipment if he would otherwise be unable to pay back the
loan.
$2,700,000
1,800,000
900,000
585,000
315,000
45,000
270,000
108,000
$ 162,000
(h)
(i)
(j)
(a)
(b)
(c)
(d)
Tanner Company
Balance Sheet
December 31
Current assets:
Cash.......................................................
Accounts receivable, net........................
Inventory.................................................
Total current assets...................................
Plant and equipment.................................
Total assets...............................................
Current liabilities........................................
Bonds payable, 10%.................................
Total liabilities............................................
Stockholders equity:
Common stock, $2.50 par value.............
Retained earnings..................................
Total stockholders equity..........................
Total liabilities and equity...........................
$ 80,000
200,000
320,000
600,000
900,000
$1,500,000
(f)
(e)
(g)
(g)
(q)
(p)
$ 250,000
450,000
700,000
(k)
(l)
100,000
700,000
800,000
$1,500,000
(m)
(o)
(n)
(p)
145
= 7.0
Earnings before interest and taxes= $45,000 7.0= $315,000
b. Net income before taxes = $315,000 $45,000 = $270,000.
c. Income taxes = $270,000 40% tax rate = $108,000.
d. Net income = $270,000 $108,000 = $162,000.
e. Accounts receivable
Sales on account
=
turnover
Average accounts receivable balance
=
$2,700,000
= 15.0
Average accounts receivable balance
g.
Current ratio=
=
Current assets
Current liabilities
Current assets
= 2.4
$250,000
I nventory turnover=
147
Debt-to-equity ratio =
=
Total liabilities
Stockholders' equity
$700,000
= 0.875
Stockholders' equity
$189,000
= 14.0%
Average total assets
149
2004
$45,682
$1,885
2003
$40,928
$1,619
2002
$36,519
$1,376
Sales....................................................
Earnings from continuing operations....
2004
155%
196%
2003
139%
168%
2002
124%
143%
2001
2000
$32,602 $29,462
$1,101
$962
2001
111%
114%
2000
100%
100%
The data reveal that Target has increased sales by 55% over the last five years. More importantly,
the sales growth has been profitable; Targets earnings from continuing operations have increased
96% over the same time period. Also, Target has consistently improved its performance. There were
no unexpected drops in sales or earnings. This type of consistency is valued by investors.
Assets
Current assets:
Cash and cash equivalents..........................
Accounts receivable, net..............................
Inventory.......................................................
Other current assets.....................................
Current assetsdiscontinued......................
Total current assets......................................
Property and equipment:
Land.............................................................
Buildings and improvements........................
Fixtures and equipment................................
Construction-in-progress..............................
Accumulated depreciation............................
Property and equipment, net...........................
Other non-current assets................................
Non-current assetsdiscontinued..................
Total assets.....................................................
Common-Size
Percentages
2004
2003
2004
2003
$ 2,245
5,069
5,384
1,224
0
13,922
$ 708
4,621
4,531
1,000
2,092
12,952
7.0%
15.7%
16.7%
3.8%
0%
43.1%
2.3%
14.7%
14.4%
3.2%
6.7%
41.2%
3,804
12,518
4,988
962
( 5,412)
16,860
1,511
0
$32,293
3,312
11,022
4,577
969
( 4,727)
15,153
1,377
1,934
$31,416
11.8%
38.8%
15.4%
3.0%
( 16.8%)
52.2%
4.7%
0.0%
100.0%
10.5%
35.1%
14.6%
3.1%
( 15.0%)
48.2%
4.4%
6.2%
100.0%
151
Common-Size
Percentages
2004
2003
2004
2003
$ 5,779
1,633
304
504
0
8,220
9,034
973
1,037
0
19,264
$ 4,956
1,288
382
863
825
8,314
10,155
632
917
266
20,284
17.9%
5.1%
0.8%
1.6%
0.0%
25.5%
28.0%
3.0%
3.2%
0.0%
59.7%
15.8%
4.1%
1.2%
2.7%
2.6%
26.5%
32.3%
2.0%
2.9%
0.9%
64.6%
74
1,810
11,148
(
3)
13,029
$32,293
76
1,530
9,523
3
11,132
$31,416
0.2%
5.6%
34.5%
( 0.0%)
40.3%
100.0%
0.2%
4.9%
30.3%
0.0%
35.4%
100.0%
2004
$45,682
31,445
$14,237
2003
$40,928
28,389
$12,539
Gross margin...................
Sales...............................
Gross margin rate............
$14,237
$45,682
31.2%
$12,539
$40,928
30.6%
SG&A expense................
Sales...............................
SG&A rate.......................
$9,797
$45,682
21.4%
$8,657
$40,928
21.2%
2004
$1,885
903.8
$2.09
153
2004
$49.49
$2.09
23.68
$0.31
$2.09
14.8%
$0.31
$49.49
0.6%
$1,885
355
$2,240
$31,855
7.0%
*Provision for income taxes ($1,146) divided by earnings before income taxes ($3,031) = 37.8%.
Return on common stockholders equity:
Earnings from continuing operations.............................
Average common stockholders equity
($13,029 + $11,132)/2.................................................
Return on common stockholders equity........................
$12,081
15.6%
$13,029
890.6
$14.63
$1,885
2004
$13,922
8,220
$ 5,702
Current ratio:
Current assets...........................................
Current liabilities........................................
Current ratio...............................................
$13,922
$8,220
1.69
Acid-test ratio:
Quick assets ($2,245 + $5,069)..............
Current liabilities........................................
Acid-test ratio.............................................
$7,314
$8,220
0.89
Inventory turnover:
Cost of sales..............................................
Average inventory ($5,384 + $4,531)/2.....
Inventory turnover......................................
$31,445
$4,958
6.34
365 days
6.34
57.6 days
155
2004
$3,601
$570
6.3
Debt-to-equity ratio:
Total liabilities............................................................
Stockholders equity..................................................
Debt-to-equity ratio....................................................
$19,264
$13,029
1.48