Chapter 14 Financial Ratios and Firm Performance

Chapter 14 Financial Ratios and Firm Performance LEARNING OBJECTIVES 1. Create, understand, and interpret common-size financial statements. 2. Calculate and interpret financial ratios. (Slide 14-2) 3. Compare different company performances using financial ratios, historical financial ratio trends, and industry ratios. IN A NUTSHELL Financial statements can provide vital information for managers and analysts, if they know how to organize the mess of numerical data into a meaningful format which can be used to analyze, and interpret the performance of firms. In this chapter, the author explains how accounting information can be re-cast into common size financial statements and various ratios, which can then be used in conjunction with industry benchmarks, to diagnose the strengths and weaknesses of companies and conduct comparisons among companies. LECTURE OUTLINE 14.1 Financial Statements (Slides 14-3 to 14-9) Just like a doctor takes a look at a patient s x-rays or cat-scan when diagnosing health problems, a manager or analyst can take a look at a firm s primary financial statements i.e. the income statement and the balance sheet, when trying to gauge the status or performance of a firm. As explained in earlier chapters, the income statement provides a periodic recording of the sources of revenue and expenses of a firm, while the balance sheet provides a point in time snap shot of the firm s assets, liabilities and owner s equity. 14.1 (A) Benchmarking: The financial statements by themselves constitute fairly complex documents involving a whole bunch of numbers. The values are absolute in nature, and although they tell us something about the amount of assets, liabilities, equity, revenues, expenses, and taxes of a firm, unless they are benchmarked against some standard, it is difficult to really gauge what s going on, primarily because of size and maturity differences among firms. One common method of benchmarking a is to compare a firm s current performance against that of its own performance over a 3-5 year period (trend analysis), by looking at the growth rate in various key items such as sales, costs, and profits as shown in Table 14.1 below. 470

Chapter 14 n Financial Ratios and Firm Performance 471 Another useful way to make some sense out of this mess of numbers, is to re-cast the income statement and the balance sheet into common size statements, by expressing each income statement item as a percent of sales and each balance sheet item as a percent of total assets as shown in Figures 14.3 and 14.4 (shown below)

472 Brooks n Financial Management: Core Concepts, 2e Benchmarking is a good starting point to detect trends (if any) in a firm s performance and to make quick comparisons of key financial statement values with competitors on a relative basis. More in-depth diagnosis requires individual item analyses and comparisons which are best done by conducting ratio analysis. 14.2 Financial Ratios (Slides 14-10 to 14-25) Financial ratios are relationships between different accounts from financial statements usually the income statement and the balance sheet that serve as performance indicators Being relative values, financial ratios allow for meaningful comparisons across time, between competitors, and with industry averages. This section covers 5 key areas of a firm s performance which can be analyzed using financial ratios: 1. Liquidity ratios: Can the company meet its obligations over the short term? 2. Solvency ratios: (also known as financial leverage ratios): Can the company meet its obligations over the long term? 3. Asset management ratios: How efficiently is the company managing its assets to generate sales? 4. Profitability ratios: How well has the company performed overall? 5. Market value ratios: How does the market (investors) view the company s financial prospects? It also discusses Du Pont analysis which involves a breakdown of the return on equity into its three components, i.e. profit margin, turnover, and leverage.

Chapter 14 n Financial Ratios and Firm Performance 473 14.2 (A) Short- Term Solvency: Liquidity Ratios: measure a company s ability to cover its short-term debt obligations in a timely manner: Three key liquidity ratios include: The current ratio, quick ratio, and cash ratio as shown below: Table14.2 summarizes the 3 liquidity ratios of Cogswell Cola and Spacely Spritzers. It seems like overall, Cogswell has better liquidity and short-term solvency than Spacely, but, higher investment in current assets also means that lower yields are being realized since current assets are typically low yielding. So, we need to look at the other areas and inter-related effects of the firm s various accounting items. 14.2 (B) Long- Term Solvency: Financial Leverage Ratios: measure a company s ability to meet its long-term debt obligations based on its overall debt level and earnings capacity. Failure to meet its interest obligation could put a firm into bankruptcy. Equations 14.4, 14.5, and 14.6 can be used to calculate 3 key financial leverage ratios: the debt ratio, times interest earned ratio, and cash coverage ratio.

474 Brooks n Financial Management: Core Concepts, 2e Table 14.3 indicates that in the area of financial leverage, Cogswell Cola is in a much better position than Spacely Spritzers, since it has relatively less debt and a significantly greater ability to cover its interest obligations by using either its EBIT (times interest earned ratio) or its net cash flow (cash coverage ratio). Leverage must be analyzed as a combination of debt level and coverage. If a firm is heavily leveraged but has good interest coverage, it is using the interest deductibility feature of taxes to its benefit. Having a high leverage with low coverage could put the firm into a risk of bankruptcy. 14.2 (C) Asset Management Ratios: measure how efficiently a firm is using its assets to generate revenues or how much cash is being tied up in other assets such as receivables and inventory. Equations 14.7 14.11 can be used to calculate 5 key asset management ratios. Table 14.4, which lists the 5 asset management ratios for the 2 firms, shows that while Cogswell is more efficient in managing its inventory, Spacely seems to be doing a better job of collecting its receivables and utilizing its total assets in generating revenues.

Chapter 14 n Financial Ratios and Firm Performance 475 14.2 (D) Profitability Ratios: such as net profit margin, returns on assets, and return on equity, measure a firm s effectiveness in turning sales or assets into profits. Table 14.5 indicates that as far as profitability is concerned, Cogswell is outperforming Spacely by about 3%. 14.2 (E) Market Value Ratios: as computed in Equations 14.15-14.18, are used to gauge how attractive or reasonable a firm s current price is relative to its earnings, growth rate, and book value. Potential investors and analysts often use these ratios as part of their valuation analysis. Typically, if a firm has a high price to earnings and a high market to book value ratio, it is an indication that investors have a good perception about the firm s performance. However, if these ratios are very high it could also mean that a firm is over-valued. With the price/earnings to growth ratio (PEG ratio), the lower it is, the more of a bargain it seems to be trading at, vis-à-vis its growth expectation. Ratio Cogswell Cola Spacely Spritzers P/E 15.41 13.01 PEG 1.28 0.86 P/B 5.49 4.17 The ratios seem to indicate that investors in both firms seem to have good expectations about their performance and are therefore paying fairly high prices relative to their earnings book values.

476 Brooks n Financial Management: Core Concepts, 2e 14.2 (F) DuPont analysis: involves breaking down ROE into three components of the firm: 1. operating efficiency, as measured by the profit margin (net income/sales); 2. asset management efficiency, as measured by asset turnover (sales/total assets); and 3. financial leverage, as measured by the equity multiplier (total assets/total equity). Equation 14.19 shows that if we multiply a firm s net profit margin by its total asset turnover ratio and its equity multiplier, we will get its return on equity. The calculations indicate that Cogswell has better operational efficiency, i.e. it is better able to move sales dollars into income, but Spritzer is more efficient at utilizing its assets, and since it uses more debt, it is able to get more of its earnings to its shareholders. Although these 14 ratios are not the only ones that can be used to assess a firm s performance, they are the most popular ones. It is important to look at the overall picture of the firm in all 5 areas and accordingly reach conclusions or make recommendations for changes. 14.3 External Uses of Financial Statements and Industry Averages (Slides 14-26 to 14-29) Financial statements of publicly traded companies and industry averages of key items provide the raw material for analysts and investors to make investment recommendations and decisions. 14.3 (A) Cola Wars: Table 14.6 and 14.7 provide financial information about two key competitors in the soft-drink industry, Coca-Cola and Pepsico.

Chapter 14 n Financial Ratios and Firm Performance 477 One of the first things we notice in looking over the five years of data is how similar many of the ratios are from year to year, showing remarkable consistency for these two companies. We also can see that the gross margin of Coca-Cola is consistently higher than that of PepsiCo. The debt to equity ratio of both firms is mostly falling over the five-year period.

478 Brooks n Financial Management: Core Concepts, 2e We also can see that ROE has been very good for both companies, although slightly better for PepsiCo. Finally, PepsiCo has very strong and growing earnings per share over this period, outperforming Coca-Cola s EPS, but PepsiCo is also more expensive (higher current price per share). Although these ratios don t clearly point out to a winner, they do help the analyst in getting a better picture about each firm s performance. Financial ratio analysis remains more of an art than a science! Industry ratios: such as the ones shown in Table 14.8, are often used as benchmarks for financial ratio analysis of individual firms. There can be significant differences in various key areas across industries, which is why comparing company ratios with industry averages can be very useful and more informative. Questions 1. What is the accounting identity? Assets Liabilities + Owner s Equity 2. What does analyzing companies over time tell a finance manager? Trend analysis tells a financial manager the rate at which the various key items are growing and helps explain why profits are growing or eroding over time. 3. What does restating financial statements into common-size financial statements allow a finance manager or financial analyst to do? Common-size financial statements allow a comparison of companies that are very different in size. It then allows comparison of management choices, such as debt financing or analysis of production costs. 4. What are liquidity ratios? Given an example of a liquidity ratio and how it helps evaluate a company s performance or future performance from an outsider s view.

Chapter 14 n Financial Ratios and Firm Performance 479 Liquidity ratios are ratios that show the short-term cash obligation capabilities of the company. The current ratio is a liquidity ratio and it is current assets divided by current liabilities. When this ratio is greater than one it indicates a company should have sufficient cash from its current assets to pay off its current liabilities. This helps an outsider evaluate potential cash flow problems of the company. 5. What are solvency ratios? Which ratio would be of most interest to a banker considering a debt loan to a company? Why? Solvency ratios are ratios that demonstrate the ability of the company to meet debt obligations over an extended period of time. A banker would probably be most interested in Times Interest Earned to see if the company has sufficient cash from operations to handle more interest payments on a new loan. 6. What are asset management ratios? For retail firms, what is one of the key management ratios? Why? Asset management ratios are ratios that indicate how well the management team is using the assets of the company to generate profits. For retail firms inventory turnover is a key ratio because it tells management how quickly the firm is moving their product from the shelf to the customer. 7. What does the P/E ratio tell an outsider about a company? Why might this ratio not provide very compelling evidence on the firm's performance? The P/E ratio is telling an outsider the number of years it will take to recover the current price of the stock if the earnings remain constant. Some analysts will say the P/E ratio tells you if the firm is a growth firm or a stable firm with growth firms having higher P/E ratios. The ratio is not very compelling because it uses historical earnings with current price and because price is a function of future earnings it should really use the future earnings of the firm against price. 8. What are the three components of the DuPont identity? What do they analyze? The three components of the DuPont analysis are, (1) operating efficiency, (2) asset management efficiency, and (3) financial leverage. They analyze the return on equity or the shareholders return. 9. What does analyzing companies against their industry tell a finance manager or financial analyst? Analyzing companies against their industry will tell the finance manager what direction the company is headed and if there are potential trouble areas ahead for the company if it stays on the same course. Analyzing companies against the industry tells analysts if the company is competitively strong or weak relative to the other players. 10. What does analyzing a company against firms in other industries tell a financial manager or analyst? Analyzing a company against firms in other industries may indicate what areas the company and its industry are falling behind in general. It can also highlight the fundamental differences of the industry that make it more difficult or easier to produce profits, borrow from debt markets, or develop new products.

480 Brooks n Financial Management: Core Concepts, 2e Prepping for Exams 1. c 2. c 3. a 4. t 5. b 6. a 7. a 8. d 9. c 10. a Problems 1. Income statement. Fill in the missing numbers on the following annual income statements for Barron Pizza Inc. ANSWER Year Ending 2011 Year Ending 2010 Year Ending 2009 Revenue $917,378 $946,219 $971, 232 COGS $747,937 $669,382 $656,215 Gross Profit $169,441 $276,837 $315,017 SG&A $70,505 $153,702 $193,000 Research & Dev. $5,469 $7,129 $3,521 Depreciation $32,927 $34,579 $35,713 Operating Income $60,540 $81,427 $82,783 Other Income $672 $1,126 $1,958 EBIT $61,212 $82,553 $84,741 Interest Expense $6,851 $7,677 $8,857 Income Before Tax $54,361 $74,876 $75,884 Taxes $20,385 $28,079 $28,639 Net Income $33,976 $46,797 $47,245 Shares Outstanding 16,740,000 16,740,000 16,740,000 EPS $2.03 $2.78 $2.82

Chapter 14 n Financial Ratios and Firm Performance 481 2. Income statement. Construct the Barron Pizza Inc. income statement for the year ending 2011 with the following information: Shares outstanding: 16,740,000 Tax rate: 37.5% Interest expense: $6,114 Revenue: $889,416 Depreciation: $31,354 Selling, general, and administrative expense: $77,572 Other income: $1,253 Research and development: $4,196 Cost of goods sold: $750,711 ANSWER Income Statement Barron Pizza Incorporated Year Ending 2011 Revenue $889,416 COGS $750,711 Gross Profit $138,705 Operating Expenses SG&A $ 77,572 Research & Development $ 4,196 Depreciation $ 31,354 Operating Income $ 25,583 Other Income $ 1,253 EBIT $ 26,836 Interest Expense $ 6,114 Taxable Income $ 20,722 Taxes $ 7,771 Net Income $ 12,951 Shares Outstanding 16,740,000 EPS $0.77 3. Balance sheet. Fill in the missing information on the annual Balance Sheets Statements for Barron Pizza Inc.

482 Brooks n Financial Management: Core Concepts, 2e ANSWER All $ in Thousands ASSETS At Dec. 31, 2011 At Dec. 31, 2010 At Dec. 31, 2009 Cash $7,071 $9,499 $17,609 Accts. Receivables $26,767 $20,638 $25,877 Inventory $17,030 $16,341 $12,659 Other Current $11,590 $10,955 $8,986 Total Current $62,458 $57,433 $65,131 Long Term Invest. $19,102 $21,864 $20,998 Net PP&E $203,818 $223,599 $238,945 Goodwill $48,577 $48,756 $48,274 Other Assets $13,259 $13,817 $14,091 TOTAL ASSETS $347,214 $365,469 $387,439 LIABILITIES Accounts Payable $80,667 $74,467 $66,209 Short Term Debt $250 $235 $225 Current Liab. $80,917 $74,702 $66,434 Long Term Debt $61,000 $139,850 $185,085 Other Liab. $46,025 $28,970 $20,288 TOTAL LIAB. $187,942 $243,522 $271,807 Owner s Equity Common Stock $119,901 $102,421 $102,107 Retained Earnings $39,371 $19,526 $13,525 Total OE $159,272 $121,947 $15,632 TOTAL LIAB & OE $347,214 $365,469 $387,439

Chapter 14 n Financial Ratios and Firm Performance 483 4. Balance sheet. Construct the Barron Pizza Inc. balance sheet statement for December 31, 2011, with the following information: Retained earnings: $43,743 Accounts payable: $74,633 Accounts receivable: $34,836 Common stock: $119,901 Cash: $8,344 Short-term debt: $210 Inventory: $23,455 Goodwill: $48,347 Long-term debt: $80,207 Other noncurrent liabilities: $42,580 Plant, property, and equipment: $192,465 Other noncurrent assets: $16,838 Long-term investments: $22,331 Other current assets: $14,658 ANSWER Barron Pizza Incorporated Balance Sheet at 12/31/2011 Assets: Liabilities: Current Assets Current Liabilities Cash $ 8,344 Accounts Payable $ 74,633 Accts. Rec. $ 34,836 Short Term Debt $ 210 Inventory $ 23,455 TOTAL Current Liab. $ 74,843 Other Current $ 14,658 Long Term Debt $ 80,207 Total Current $ 81,293 Other Liabilities $ 42,580 L- T Inv. $ 22,331 Total Liabilities $197,630 PP&E $ 192,465 Owner s Equity Goodwill $ 48,347 Common Stock $119,901 Other Assets $ 16,838 Retained Earnings $ 43,743 Total Assets $361,274 Total OE $163,644 Total Liab. And OE $361,274 5. Predicting net income. Below is an abbreviated income statement for Wal-Mart. Predict the net income for the period ending January 31, 2010, by determining the growth rates of sales, COGS, SG&A, and interest expense. Use a tax rate of 37%.

484 Brooks n Financial Management: Core Concepts, 2e ANSWER Growth rates; Sales = (405,607 / 348,650) 1/2 1 = 0.0786 or 7.86% COGS = (306,158 / 264,152) 1/2-1 = 0.0766 or 7.66% SG&A = (76,367 / 63,721) 1/2-1 = 0.0947 or 9.47% Interest = (2,184 / 1,809) 1/2-1 = 0.0988 or 9.88% 2010 Predictions Sales = $405,607 1.0786 = $437,485 COGS = $306,158 1.0766 = $329,603 SG&A = $76,367 1.0947 = $83,602 Interest = $2,184 1.0988 = $2,400 EBIT = $437,485 $329,603 $83,602 = $24,280 Taxes = ($24,280 $2,400) 0.37 = $8,096 Wal-Mart, Inc. Abbreviated Income Statements for the Year Ending (In Millions of Dollars) Account Jan. 31, 2007 Jan.31, 2008 Jan. 31, 2009 Jan. 31, 2010 Sales $348,650 $378,799 $405,607 $437,485 COGS $264,152 $286,515 $306,158 $329,603 SG&A $63,721 $69,983 $76,367 $83,602 EBIT $20,777 $22,301 $23,082 $24,280 Interest $1,809 $2,103 $2,184 $2,400 Taxes $7,684 $7,468 $7,498 $8,096 Net Income $11,284 $12,731 $13,400 $13,784

Chapter 14 n Financial Ratios and Firm Performance 485 6. Predicting net income. Below is an abbreviated income statement for Starbucks. Predict the net income for the period ending September 30, 2009, by determining the growth rates of sales, COGS, depreciation, and SG&A. Use a tax rate of 37%. Then look up the numbers for Starbucks for 2009 and see how you did. ANSWER Growth rates; Sales = (10,383 / 7,786) 1/2 1 = 0.1548 or 15.48% COGS = (4,654 / 3,179) 1/2-1 = 0.2100 or 21.00% SG&A = (5,216 / 3,701) 1/2-1 = 0.1872 or 18.72% What to do about forecasting interest? Until you have more information it is probably best to just use 2008 for 2009. 2009 Predictions Sales = $10,383 1.1548 = $11,990 COGS = $4,654 1.2100 = $5,631 SG&A = $5,216 1.1872 = $6,192 EBIT = $11,990 $5,631 $6,192 = $167 Interest = $53 Taxes = ($167 $53) 0.37 = $42 Starbucks Abbreviated Income Statements for the Year Ending (In Millions of Dollars) Account Sep. 30, 2006 Sep. 30, 2007 Sep. 30, 2008 Sep. 30, 2009 Sales $7,786 $9,411 $10,383 $11,990 COGS $3,179 $3,999 $4,654 $5,631 SG&A $3,701 $4,356 $5,216 $6,192 EBIT $906 $1,056 $513 $167 Interest $0 $0 $53 $53

486 Brooks n Financial Management: Core Concepts, 2e Account Sep. 30, 2006 Sep. 30, 2007 Sep. 30, 2008 Sep. 30, 2009 Taxes $342 $384 $145 $42 Net Income $564 $672 $315 $72 7. Common-size financial statements. Prepare common-size income statements for Wal-Mart and Starbucks using the January 2009 and September 2008 information provided in Problems 5 and 6.Which company is doing a better job of getting sales dollars to net income? Where is the one company having an advantage over the other company in turning revenue into net income? ANSWER Wal-Mart Starbucks Account Jan. 31, 2009 Percent Sep. 30, 2008 Percent Sales $405,607 100.00% $10,383 100% COGS $306,158 75.48% $4,654 44.82% SG&A $76,367 18.83% $5,216 50.24% EBIT $23,082 5.69% $513 4.94% Interest $2,184 0.54% $53 0.51% Taxes $7,498 1.85% $145 1.40% Net Income $13,400 3.30% $315 3.03% Both Wal-Mart and Starbucks bring a little over 3 cents of sales revenue to the bottom line. Starbuck s has an advantage over Wal-Mart in the cost of goods sold but Wal-Mart has a much smaller selling, general and administrative expense. Why these companies enjoy these different advantages is a question that will take more financial and economic investigation into the operations of the two companies and the industries in which they operate. 8. Common-size financial statements. Below is the balance sheet information on two companies. Prepare a common-size balance sheet for each company. Review each company's percentage of total assets. Are these companies operating with similar philosophies or in similar industries? What appears to be the major difference in financing for these two companies?

Chapter 14 n Financial Ratios and Firm Performance 487 Account B. Sheet Co. 1 % of Total Assets Current Assets B. Sheet Co. 2 % of Total Assets Cash $5,377 11.14% $299 8.98%

488 Brooks n Financial Management: Core Concepts, 2e Investments $4,146 8.59% $354 10.64% Accts. Rec. $8,100 16.78% $221 6.64% Inventory $5,372 11.13% $494 14.84% Total Current $22,995 47.65% $1,368 41.11% Long Inv. $84 0.17% $307 9.22% PP&E $9,846 20.40% $1,471 44.20% Goodwill $5,390 11.17% $69 2.07% Intangible $6,149 12.74% $27 0.81% Other $3,799 7.87% $86 2.58% Total Assets $48,263 100.00% $3,328 100.00% Liabilities Accts. Pay. $12,309 25.50% $661 19.86% Short Term D $1,139 2.36% $0 0.00% Other Short Lia $0 0.00% $122 3.67% Current. Liab. $13,448 27.86% $783 23.53% Long-Term D $2,955 6.12% $4 0.12% Other Liab. $4,991 10.34% $54 1.62% Total Liab. $21,394 44.32% $841 25.27% Owner s Equity Common Stock $3,120 6.46% $1,026 30.83% Treasury Stock ($6,754) -13.39% $0 0.00% Retained Earn. $30,503 63.20% $1,461 43.90% Total Equity $26,869 55.67% $2,487 74.73% Total Liab. & Owner s Equity $48,263 100.00% $3,328 100.00% While students may find many differences that characterize the different philosophies of these two companies, one major difference is the use of debt financing by company one and the lack of debt financing for company two. Company two has been using equity financing and internally generated cash flow for financing (it is Starbucks). Company one also has much higher intangible assets such as patents and registration rights (it is Johnson and Johnson).

Chapter 14 n Financial Ratios and Firm Performance 489 For Problems 9 through 12, use the following data: 9. Financial ratios: Liquidity. Calculate the current ratio, quick ratio, and cash ratio for Tyler Toys for 2010 and 2011. Should any of these ratios or the change in a ratio warrant concern for the managers of Tyler Toys or the shareholders? ANSWER Current Ratio = Current Assets / Current Liabilities 2011 is, $1,630,300 / $1,857,200 = 0.8778 2010 is, $1,504,700 / $1,787,700 = 0.8417

490 Brooks n Financial Management: Core Concepts, 2e Quick Ratio (or Acid Ratio Test) = Current Assets Inventories / Current Liabilities 2011 is, ($1,630,300 $587,500) / $1,857,200 = 0.5615 2010 is, ($1,504,700 $563,600) / $1,787,700 = 0.5264 Cash Ratio = Cash / Current Liabilities 2011 is, $191,100 / $1,857,200 = 0.1029 2010 is, $188,900 / $1,787,700 = 0.1057 The ratios look reasonable and the change is in the right direction for better liquidity for all ratios except the cash ratio. 10. Financial ratios: Financial leverage. Calculate the debt ratio, times interest earned ratio, and cash coverage ratio for 2010 and 2011 for Tyler Toys. Should any of these ratios or the change in a ratio warrant concern for the managers of Tyler Toys or the shareholders? ANSWER Solvency Ratios Debt Ratio = (Total Assets Total Equity) / Total Assets or Total Liabilities / Total Assets 2011 is, ($14,689,500 $2,711,700) / $14,689,500 = 0.8154 2010 is, ($14,119,500 $3,052,300) / $14,119,500 = 0.7838 Times interest Earned = EBIT / Interest Expense 2010 is, $3,199,300 / $375,000 = 8.5315 2009 is, $2,979,700 / $356,100 = 8.3676 Cash Coverage = EBIT + Depreciation / Interest Expense 2011 is, ($3,199,300 + $1,498,900) / $375,000 = 12.5285 2010 is, ($2,979,700 + $1,473,240) / $356,100 = 12.5047 The debt ratio is very high and would warrant concern if the cash coverage ratio or the times interest earned ratio was low but with high ratios this means they are handling their large debt well. 11. Financial ratios: Asset management. Calculate the inventory turnover, days sales in inventory, receivables turnover, days sales in receivables, and total asset turnover ratios for 2010 and 2011 for Tyler Toys. Should any of these ratios or the change in a ratio warrant concern for the managers of Tyler Toys or the shareholders? ANSWER Asset Management Ratios Inventory Turnover = Cost of Goods Sold / Inventory 2011 is, $8,449,100 / $587,500 = 14.3814 2010 is, $8,131,300 / $563,600 = 14.4274

Chapter 14 n Financial Ratios and Firm Performance 491 Day s Sales in Inventory = 365 / Inventory Turnover 2011 is, 365/14.3814 = 25.3799 Days 2010 is, 365/14.4274 = 25.2990 Days Receivables Turnover = Sales / Accounts Receivable 2011 is, $14,146,700 / $669,400 = 21.1334 2010 is, $13,566,400 / $630,400 = 21.5203 Day s Sales in Receivables = 365/ Receivables Turnover 2011 is, 365 / 21.1334 = 17.2712 Days 2010 is, 365 / 21.5203 = 16.9607 Days Total Asset Turnover = Sales / Total Assets 2011 is, $14,146,700 / $14,689,500 = 0.9630 2010 is, $13,566,400 / $14,119,500 = 0.9608 The company has a very good turnover of assets and collects its receivables quickly thus there are no real concerns from these ratios. 12. Financial ratios: Profitability. Calculate the profit margin, return on assets, and return on equity for 2010 and 2011 for Tyler Toys. Should any of these ratios or the change in a ratio warrant concern for the managers of Tyler Toys or the shareholders? ANSWER Profitability Ratios Profit Margin = Net Income / Sales 2011 is, $2,075,900 / $14,146,700 = 0.1467 2010 is, $1,933,800 / $13,566,400 = 0.1425 Return on Assets = Net Income / Total Assets 2011 is, $2,075,900 / $14,689,500 = 0.1413 2010 is, $1,933,800 / $14,119,500 = 0.1370 Return on Equity = Net Income / Total Owner s Equity 2011 is, $2,075,900 / $2,711,700 = 0.7655 2010 is, $1,933,800 / $3,052,300 = 0.6336 These ratios indicate a very strong firm performance for the equity holders with an ROE of over 75% for 2011. 13. DuPont identity. For the following firms, find the return on equity using the three components of the DuPont identity: operating efficiency, as measured by the profit margin (net income/sales); asset management efficiency, as measured by asset turnover (sales/total assets); and financial leverage, as measured by the equity multiplier (total assets/total equity).

492 Brooks n Financial Management: Core Concepts, 2e ANSWER First find the equity of each company i.e. Total Assets less Total Liabilities: Pepsi s Equity = $35,994 $23,888 = $12,106 Coca-Cola s Equity = $40,519 $20,047 = $20,472 Starbuck s Equity = $5,673 $3,182 = $2,491 Next calculate the three components Company Operating Efficiency Asset Mgmt. Efficiency Financial Leverage Pepsi $5,142/$43,251= 0.1189 Coca-Cola $5,807 / $31,994 = 0.1815 Starbucks $315 / $10,383 = 0.0303 $43,251/$35,994= 1.2016 $35,994 / $12,106 = 2.9732 $31,994 / $40,519 = 0.7896 $10,383 / $5,673 = 1.8302 Last, take the three components to find the ROE, Pepsi = 0.1189 1.2016 2.9732 = 0.4247 or 42.47% ROE Coca-Cola = 0.1815 0.7896 1.9792 = 0.2837 or 23.87% ROE Starbuck s = 0.03034 1.8302 2.2774 = 0.1265 or 12.65% ROE $40,519 / $20,472 = 1.9792 $5,673 / $2,491 = 2.2774 While Coca-Cola is the most operationally efficient and Starbucks is the most efficient in management, Pepsi is the best to its shareholders because it has effectively utilized a very high financial leverage strategy, using debt and not shareholder earnings to finance the profits of the firm. 14. DuPont identity. Go to a Web site such as Yahoo.com and find the sales, net income, total assets, and total equity of the following five actively traded companies: Microsoft (MSFT), Boeing (BA),Wal-Mart (WMT), Procter and Gamble (PG), and Waste Management (WMI). Use the three components of the DuPont identity operating efficiency, as measured by the profit margin (net income/sales); asset management efficiency, as measured by asset turnover (sales/total assets); and financial leverage, as measured by the equity multiplier (total assets/total equity) to find the return on equity for these five companies. Based on these components and the ROE, which company do you think is doing the best job for its shareholders? ANSWER (Note: the dates for the data for each firm are shown in the table below) $ 000s MSFT BA WMT PG WM

Chapter 14 n Financial Ratios and Firm Performance 493 06/30/2011 12/31/2010 01/31/2011 06/30/2011 12/31/2010 Net Income 23,150 3,307 16,389 11,797 953 Sales 69,943 64,306 421,849 82,599 12,515 T. Assets 108,704 68,565 180,663 138,354 21,476 Sh. Equity 57,083 2,766 68,542 68,001 6,260 Net Profit Margin 0.331 0.051 0.039 0.143 0.076 Total Asset T/O 0.643 0.938 2.335 0.597 0.583 Equity Multiplier 1.904 24.789 2.636 2.035 3.431 ROE 40.6% 119.6% 23.9% 17.3% 15.2% Microsoft is the most operationally efficient; Wal-Mart is the most efficient in asset management. However, Bank of America has an unusually high equity multiplier, which is quite typical of a bank, and thus it has the highest ROE. 15. Company analysis. Go to a Web site such as Yahoo.com and find the financial statements of Disney (DIS) and McDonald s (MCD). Compare these two companies using the following financial ratios: times interest earned, current ratio, asset turnover, financial leverage, profit margin, PEG ratio, and return on equity. Which company would you invest in, either as a bond holder or a stockholder? ANSWER Look up these values for each company (2011 year-end figures used here), Sales, EBIT, Interest Expense, Net Income, Current Assets, Total Assets, Current Liabilities, Equity, PE ratio, EPS 5-year expected growth rate Disney McDonalds Sales 40,893 24,074.60 EBIT 8,043 7,451.2 Interest Expense 0 450.9 Net Income 4,807 4,946.3 Current Assets 13,757 4,368.5 Total Assets 72,124 31,975.2 Current Liabilities 12,088 2,924.7

494 Brooks n Financial Management: Core Concepts, 2e Equity 37,385 14,634.20 PE ratio 15 15.8 5-year EPS expected growth rate 12% 9% Times interest Earned = EBIT / Interest Expense Disney is, $8,043 / $0 = Undefined (since Disney had no interest expenses) McDonalds is, $7451.2 / $450.9 = 16.53 Current Ratio = Current Assets / Current Liabilities Disney is, $13,757 / $12,088 = 1.138 McDonalds is, $3,517.6 / $2,537.9 = 1.3860 Asset Turnover = Sales / Total Assets Disney is, $40, 893/ $72,124 = 0.567 McDonalds is, $24, 074.6 / $31,975.2 = 0.75 Financial Leverage = Total Assets / Total Equity Disney is, $72, 124 / $37, 385 = 1.929 McDonalds is, $31, 975 / $14, 634.2 = 2.18 Profit Margin = Net Income / Sales Disney is, $4,807 / $40, 893 = 0.1180 McDonalds is, $4,946.3 / $24,074.6 = 0.21 PEG ratio = Current PE ratio/expected EPS growth rate Disney s PEG = 15/12 = 1.25; McDonald s PEG = 15.8/9 =1.76 Return on Equity = Net Income / Total Owner s Equity Disney is, $4,807 / $37,385 = 0.1286 McDonalds is, $4,946.3 / $14 634.2 = 0.338 The best company to invest in appears to be McDonalds with its higher ROE and strong solvency position as most of the financial ratios are very similar across these firms. 16. Company analysis. Go to a Web site such as Yahoo.com and find the financial statements of General Motors (GM) and Ford Motor Company (F). Compare these two companies using the following financial ratios: times interest earned, current ratio, asset turnover, financial leverage, profit margin, PEG ratio, and return on equity. Which company would you invest in, either as a bond holder or a stockholder? ANSWER Look up these values for each company; Sales, EBIT, Interest Expense, Net Income, Current Assets, Total Assets, Current Liabilities, and Equity(2010 year-end figures used here) 000s General Motors Ford Motor Company

Chapter 14 n Financial Ratios and Firm Performance 495 Sales $135,592 $128,974 EBIT $6,639 $7,149 Interest Expense $1,098 $0 Net Income $6, 172 $6,561 Current Assets $53,053 $48,875 Total Assets $138,898 $164,687 Current Liabilities $102,718 $60,206 Equity $36,180 -$673 Times interest Earned = EBIT / Interest Expense General Motors is$6,639 / $1,098 = 6.05X Ford Motor Company is, $7,149 / $0 = Undefined Current Ratio = Current Assets / Current Liabilities General Motors is, $53,053 / $102,718 = 0.52 Ford Motor Company is, $48,875 / $60,206 = 0.81 Asset Turnover = Sales / Total Assets General Motors is, $134,592 / $138,898 = 0.98 Ford Motor Company is, $128,974 / $164,687 = 0.78 Financial Leverage = Total Assets / Total Equity General Motors is, $138,898 / $36,180 = 3.84 Ford Motor Company is, $164,687 / $-673 = -244 PEG ratio = PE ratio/expected EPS growth rate General Motors = 1.82 (from key statistics) Ford Motor Company = 0.83 Profit Margin = Net Income / Sales General Motors is, $6,172 / $135,592 = 4.5% Ford Motor Company is $6,562 / $128,974 =5.1% Return on Equity = Net Income / Total Owner s Equity General Motors is, $6,172 / $36,180 = 17.06% Ford Motor Company, $6,562 / -$673 = -975.04% Ford Motor Company had a slightly better profit margin, no interest on debt, and was selling at a fairly low PEG ratio. Although General Motors had a better turnover ratio, its low liquidity and fairly high leverage makes it a risky bet.

496 Brooks n Financial Management: Core Concepts, 2e Solutions for Advanced Problems for Spreadsheet Application 1. DuPont analysis. Oil Companies DuPont Analysis Company Data 2009 2008 2007 Exxon Mobil Revenue $ 310,586,000 $ 477,359,000 $ 404,552,000 Net Income $ 19,280,000 $ 45,220,000 $ 40,610,000 Total Assets $ 55,235,000 $ 72,266,000 $ 85,963,000 Total Equity $ 110,569,000 $ 112,965,000 $ 121,762,000 Chevron Revenue $ 171,636,000 $ 273,005,000 $ 220,904,000 Net Income $ 10,483,000 $ 23,931,000 $ 18,608,000 Total Assets $ 164,621,000 $ 161,165,000 $ 148,786,000 Total Equity $ 91,914,000 $ 86,648,000 $ 77,088,000 Conoco Phillips Revenue $ 68,025,000 $ 246,182,000 $ 194,495,000 Net Income $ 7,011,000 $ (16,988,000) $ 11,891,000 Total Assets $ 79,019,000 $ 142,865,000 $ 177,757,000 Total Equity $ 55,991,000 $ 55,165,000 $ 88,983,000 Marathon Oil Revenue $ 54,139,000 $ 78,569,000 $ 65,207,000 Net Income $ 1,463,000 $ 3,528,000 $ 3,956,000 Total Assets $ 47,052,000 $ 42,686,000 $ 42,746,000 Total Equity $ 21,910,000 $ 21,409,000 $ 19,223,000 Occidental Petroleum Revenue $ 15,403,000 $ 24,480,000 $ 20,013,000 Net Income $ 2,915,000 $ 6,857,000 $ 5,400,000 Total Assets $ 44,229,000 $ 41,537,000 $ 36,519,000 Total Equity $ 29,081,000 $ 27,300,000 $ 22,823,000

Chapter 14 n Financial Ratios and Firm Performance 497 Table Of Ratios 2009 Company Operating Efficiency Asset Mgmt Efficency Financial Leverage Return on Equity Exxon Mobil 2009 6.21% 5.6230 0.4996 17.44% 2008 9.47% 6.6056 0.6397 40.03% 2007 10.04% 4.7061 0.7060 33.35% Average 8.57% 5.6449 0.6151 29.77% Chevron 2009 6.11% 1.0426 1.7910 11.41% 2008 8.77% 1.6939 1.8600 27.62% 2007 8.42% 1.4847 1.9301 24.14% Average 7.77% 1.4071 1.8604 20.33% Conoco Phillips 2009 10.31% 0.8609 1.4113 12.52% 2008-6.90% 1.7232 2.5898-30.79% 2007 6.11% 1.0942 1.9977 13.36% Average 3.17% 1.2261 1.9996 7.78% Marathon Oil 2009 2.70% 1.1506 2.1475 6.68% 2008 4.49% 1.8406 1.9938 16.48% 2007 6.07% 1.5255 2.2237 20.58% Average 4.42% 1.5056 2.1217 14.12% Occidental Petroleum 2009 18.92% 0.3483 1.5209 10.02% 2008 28.01% 0.5894 1.5215 25.12% 2007 26.98% 0.5480 1.6001 23.66% Average 24.64% 0.4952 1.5475 18.88% Industry 2009 8.85% 1.8051 1.4741 11.61% 2008 8.77% 2.4905 1.7210 15.69% 2007 11.52% 1.8717 1.6915 23.02% Average 9.71% 2.0558 1.6288 16.77%

498 Brooks n Financial Management: Core Concepts, 2e 50.00% 40.00% 30.00% 20.00% 10.00% 0.00% - 10.00% - 20.00% - 30.00% - 40.00% 2009 2008 2007 ExxonMobil Chevron Conoco Phillips Marathon Occidental 2. Common-size statements: Proctor & Gamble and Johnson & Johnson and their ratios. Income Statements Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Pepsi 2009 2009 2008 2008 2007 2007 Total Revenue $ 30,990,000 $ 43,232,000 $ 31,944,000 $ 43,251,000 $ 28,857,000 $ 39,474,000 Operating Expenses $ 11,088,000 $ 20,099,000 $ 11,374,000 $ 20,351,000 $ 10,406,000 $ 18,038,000 Gross Margin $ 19,902,000 $ 23,133,000 $ 20,570,000 $ 22,900,000 $ 18,451,000 $ 21,436,000 Operating Expenses SG&A $ 11,671,000 $ 15,026,000 $ 11,744,000 $ 15,901,000 $ 11,199,000 $ 14,208,000 Non Recurring $ 350,000 Other $ 63,000 $ 64,000 $ 58,000 Inc. From Cont. Ops $ 8,231,000 $ 8,044,000 $ 8,476,000 $ 6,935,000 $ 7,252,000 $ 7,170,000 Other Inc./Exp. (Net) $ 289,000 $ 67,000 $ 305,000 $ 41,000 $ 1,077,000 $ 685,000 EBIT $ 8,520,000 $ 8,111,000 $ 8,781,000 $ 6,976,000 $ 8,329,000 $ 7,855,000 Interest Expense $ 355,000 $ 397,000 $ 438,000 $ 329,000 $ 456,000 $ 224,000 Income Before Taxes $ 8,165,000 $ 7,714,000 $ 8,343,000 $ 6,647,000 $ 7,873,000 $ 7,631,000 Income Taxes $ 2,040,000 $ 2,100,000 $ 1,632,000 $ 1,879,000 $ 1,892,000 $ 1,973,000 Net Income $ 6,125,000 $ 5,614,000 $ 6,711,000 $ 4,768,000 $ 5,981,000 $ 5,658,000

Chapter 14 n Financial Ratios and Firm Performance 499 Income Statements Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Pepsi Common Common Common Common Common Common Size 09 Size 09 Size 08 Size 08 Size 07 Size 07 Total Revenue 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Operating Expenses 35.78% 46.49% 35.61% 47.05% 36.06% 45.70% Gross Margin 64.22% 53.51% 64.39% 52.95% 63.94% 54.30% Operating Expenses SG&A 37.66% 34.76% 36.76% 36.76% 38.81% 35.99% Non Recurring 1.10% Other 0.15% 0.15% 0.15% Inc. From Cont. Ops 26.56% 18.61% 26.53% 16.03% 25.13% 18.16% Other Inc./Exp. (Net) 0.93% 0.15% 0.95% 0.09% 3.73% 1.74% EBIT 27.49% 18.76% 27.49% 16.13% 28.86% 19.90% Interest Expense 1.15% 0.92% 1.37% 0.76% 1.58% 0.57% Income Before Taxes 26.35% 17.84% 26.12% 15.37% 27.28% 19.33% Income Taxes 6.58% 4.86% 5.11% 4.34% 6.56% 5.00% Net Income 19.76% 12.99% 21.01% 11.02% 20.73% 14.33% Balance Sheets Assets Current Assets Cash and Equivalents $ 6,959,000 $ 3,943,000 $ 4,701,000 $ 2,064,000 $ 4,093,000 $ 910,000 Short Term Investments $ 2,192,000 $ 192,000 $ 278,000 $ 213,000 $ 215,000 $ 1,571,000 Net Receivables $ 3,758,000 $ 4,624,000 $ 3,090,000 $ 4,683,000 $ 3,317,000 $ 4,389,000 Inventories $ 2,354,000 $ 2,618,000 $ 2,187,000 $ 2,522,000 $ 2,220,000 $ 2,290,000 Other Current Assets $ 2,288,000 $ 1,194,000 $ 1,920,000 $ 1,324,000 $ 2,260,000 $ 991,000 TOTAL Current Assets $ 17,551,000 $ 12,571,000 $ 12,176,000 $ 10,806,000 $ 12,105,000 $ 10,151,000 Long-term Investments $ 6,755,000 $ 4,484,000 $ 5,779,000 $ 3,998,000 $ 7,777,000 $ 4,475,000 Plant, Prop. & Equip. (NET) $ 9,561,000 $ 12,671,000 $ 8,326,000 $ 11,663,000 $ 8,493,000 $ 11,228,000 Goodwill $ 4,224,000 $ 6,534,000 $ 4,029,000 $ 5,124,000 $ 4,256,000 $ 5,169,000 Intangible Assets $ 8,604,000 $ 2,623,000 $ 8,476,000 $ 1,860,000 $ 7,963,000 $ 2,044,000 Accumulated Amortization Other Assets $ 1,976,000 $ 965,000 $ 1,733,000 $ 2,324,000 $ 2,675,000 $ 1,356,000 Deferred Long-term assets $ 219,000 $ 205,000 TOTAL ASSETS $ 48,671,000 $ 39,848,000 $ 40,519,000 $ 35,994,000 $ 43,269,000 $ 34,628,000

500 Brooks n Financial Management: Core Concepts, 2e Balance Sheets Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Pepsi Common Common Common Common Common Common Assets Size 09 Size 09 Size 08 Size 08 Size 07 Size 07 Current Assets Cash and Equivalents 14.30% 9.90% 11.60% 5.73% 9.46% 2.63% Short Term Investments 4.50% 0.48% 0.69% 0.59% 0.50% 4.54% Net Receivables 7.72% 11.60% 7.63% 13.01% 7.67% 12.67% Inventories 4.84% 6.57% 5.40% 7.01% 5.13% 6.61% Other Current Assets 4.70% 3.00% 4.74% 3.68% 5.22% 2.86% TOTAL Current Assets 36.06% 31.55% 30.05% 30.02% 27.98% 29.31% Long-term Investments 13.88% 11.25% 14.26% 11.11% 17.97% 12.92% Plant, Prop. & Equip. (NET) 19.64% 31.80% 20.55% 32.40% 19.63% 32.42% Goodwill 8.68% 16.40% 9.94% 14.24% 9.84% 14.93% Intangible Assets 17.68% 6.58% 20.92% 5.17% 18.40% 5.90% Accumulated Amortization Other Assets 4.06% 2.42% 4.28% 6.46% 6.18% 3.92% Deferred Long-term assets 0.00% 0.61% 0.59% TOTAL ASSETS 100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Pepsi Current Liabilities 2009 2009 2008 2008 2007 2007 Accounts Payable $ 6,921,000 $ 8,292,000 $ 6,152,000 $ 6,494,000 $ 7,173,000 $ 6,209,000 Short/Current Debt $ 6,800,000 $ 464,000 $ 6,531,000 $ 369,000 $ 6,052,000 Other Current Liab. $ - $ 305,000 $ 1,924,000 $ - $ 1,544,000 Total Current Liab. $ 13,721,000 $ 8,756,000 $ 12,988,000 $ 8,787,000 $ 13,225,000 $ 7,753,000 Long-Term Debt $ 5,059,000 $ 7,400,000 $ 2,781,000 $ 7,858,000 $ 3,277,000 $ 4,203,000 Other Liabilities $ 2,965,000 $ 5,591,000 $ 3,401,000 $ 7,017,000 $ 3,133,000 $ 4,792,000 Deferred Long-Term Debt $ 1,580,000 $ 659,000 $ 877,000 $ 226,000 $ 1,890,000 $ 646,000 Minority Interests $ 547,000 $ 638,000 TOTAL LIABILITIES $ 23,872,000 $ 23,044,000 $ 20,047,000 $ 23,888,000 $ 21,525,000 $ 17,394,000 Stockholder's Equity Misc. Options $ (104,000) Redemmable PS $ (97,000) Preferred Stock $ 41,000 Common Stock $ 880,000 $ 30,000 $ 880,000 $ 30,000 $ 880,000 $ 30,000 Retained Earnings $ 41,537,000 $ 33,805,000 $ 38,513,000 $ 30,638,000 $ 36,235,000 $ 28,184,000 Treasury Stock $ (25,398,000) $ (13,383,000) $ (24,213,000) $ (14,122,000) $ (23,375,000) $ (10,519,000) Capital Surplus $ 8,537,000 $ 250,000 $ 7,966,000 $ 351,000 $ 7,378,000 $ 450,000 Other Stock. Equity $ (757,000) $ (3,794,000) $ (2,674,000) $ (4,694,000) $ 626,000 $ (952,000) TOTAL STOCKHOLDER'S EQU.24,799,000 $ $ 16,804,000 $ 20,472,000 $ 12,106,000 $ 21,744,000 $ 17,234,000 TOTAL LIAB. & ST. EQUITY$ 48,671,000 $ 39,848,000 $ 40,519,000 $ 35,994,000 $ 43,269,000 $ 34,628,000

Chapter 14 n Financial Ratios and Firm Performance 501 Coca-Cola Pepsi Coca-Cola Pepsi Coca-Cola Coca-Cola Common Common Common Common Common Common Current Liabilities Size 09 Size 09 Size 08 Size 08 Size 07 Size 07 Accounts Payable 14.22% 20.81% 15.18% 18.04% 16.58% 17.93% Short/Current Debt 13.97% 1.16% 16.12% 1.03% 13.99% Other Current Liab. 0.75% 5.35% 4.46% Total Current Liab. 28.19% 21.97% 32.05% 24.41% 30.56% 22.39% Long-Term Debt 10.39% 18.57% 6.86% 21.83% 7.57% 12.14% Other Liabilities 6.09% 14.03% 8.39% 19.49% 7.24% 13.84% Deferred Long-Term Debt 3.25% 1.65% 2.16% 0.63% 4.37% 1.87% Minority Interests 1.12% 1.60% TOTAL LIABILITIES 49.05% 57.83% 49.48% 66.37% 49.75% 50.23% Stockholder's Equity Misc. Options -0.26% Redemmable PS -0.27% Preferred Stock 0.12% Common Stock 1.81% 0.08% 2.17% 0.08% 2.03% 0.09% Retained Earnings 85.34% 84.83% 95.05% 85.12% 83.74% 81.39% Treasury Stock -52.18% -33.59% -59.76% -39.23% -54.02% -30.38% Capital Surplus 17.54% 0.63% 19.66% 0.98% 17.05% 1.30% Other Stock. Equity -1.56% -9.52% -6.60% -13.04% 1.45% -2.75% TOTAL STOCKHOLDER'S EQU. 50.95% 42.17% 50.52% 33.63% 50.25% 49.77% TOTAL LIAB. & ST. EQUITY100.00% 100.00% 100.00% 100.00% 100.00% 100.00% Ratio or Account 2009 2008 2007 Gross Margin Pepsi 53.51% 52.95% 64.39% Gross Margin Coke 64.22% 64.39% 53.51% Inventory Turnover Pepsi 7.68 8.07 7.88 Inventory Turnover Coke 5.20 7.40 4.69 Current Ratio Pepsi 1.44 1.23 1.31 Current Ratio Coke 1.28 0.94 0.92 Return on Assets Pepsi 14.09% 13.25% 16.34% Return on Assets Coke 12.58% 16.56% 13.82% Return on Equity Pepsi 33.41% 39.39% 32.83% Return on Equity Coke 24.70% 32.78% 27.51% Debt to Equity Pepsi 1.37 1.97 1.01 Debt to Equity Coke 0.96 0.98 0.99 Earnings Per Share Pepsi $ 3.49 $ 2.96 $ 3.51 Earnings Per Share Coke $ 2.65 $ 2.91 $ 2.59

502 Brooks n Financial Management: Core Concepts, 2e Solutions to Mini- Case Cranston Dispensers, Inc.: Part 2 This case requires students to prepare and interpret a Statement of Cash Flows or Sources and Uses, Common Size Statements, and Financial Ratios for a straightforward manufacturing firm which is based on a composite of firms in the dispenser and container industries. Students will use the DuPont identity to isolate areas of strength and weakness. Finally, students are asked to deduce, based on what they can observe in the statements, what internal variances may have occurred. 1. Cranston s Common Size Income Statements and Balance Sheets for 2009 and 2008 are given below. Prepare common size statements for 2010. Common size statements Income statements 2010 2009 2008 Sales 100.00% 100.00% 100.00% Cost of goods sold 67.86% 67.83% 67.25% Gross profit 32.14% 32.17% 32.75% Selling & adm. expenses 14.53% 14.93% 14.71% Depreciation 6.53% 7.18% 7.25% EBIT 11.07% 10.06% 10.80% Interest expense (net of interest income) 0.54% 0.77% 0.52% Earnings Before Taxes 10.53% 9.28% 10.28% Taxes 3.16% 2.79% 3.08% Net Income 7.37% 6.50% 7.20% Assets Balance sheets 2010 2009 2008 Assets Cash 9.80% 8.84% 9.38% Accounts receivable 20.75% 20.57% 12.72% Inventory 17.10% 16.40% 15.42% Current assets 47.64% 45.82% 37.52% Net fixed assets 52.36% 54.18% 62.48% Total assets 100.00% 100.00% 100.00%

Chapter 14 n Financial Ratios and Firm Performance 503 Liabilities and Equity Accounts payable 9.54% 9.23% 8.11% Accrued Expenses 9.86% 10.73% 7.63% Short-term Debt 14.45% 15.73% 9.66% Current liabilities 33.85% 35.69% 25.40% Long term debt 11.44% 10.38% 11.49% Other liabilities 6.87% 4.93% 5.84% Total liabilities 52.16% 51.01% 42.73% Common equity 21.98% 20.15% 21.50% Total stockholders' equity 47.84% 48.99% 57.27% Total liab. & equities 100.00% 100.00% 100.00% 2. Complete the 2010 table of financial ratios for Cranston. The 2010 financial ratios are computed as follows. Liquidity $1658 Current Ratio = = 1.41 $1178 ( $1658 $595) Quick Ratio (or Acid Ratio Test) = =.90 $1178 $341 Cash Ratio = =.29 $1178 Solvency $1815 Debt Ratio = =.52 $3480 $419 Times Interest Earned = = 20.44 $20.50 ($419 + $247) Cash Coverage Ratio = = 32.49 I$20.50 Asset Management $2568 Inventory Turnover = = 4.32 $595 365 Day' s Sale in Inventory = = 84.57 4.32

504 Brooks n Financial Management: Core Concepts, 2e $3784 Receivable s Turnover = = 5.24 $722 365 Day' s Sale in Receivables = = 69.64 5.24 $3784 Total Asset Turnover = = 1.09 $3480 Profitability $278.95 Profit Margin = = 7.37% $3784 $278.95 Return on Assets (ROA) = = 8.02% $3480 $278.95 Return on Equity (ROE) = = 16.75% $1665 Market $278.95 Earnings Per Share (EPS) = = $1.95 143 $33 Price Earnings Ratio (P/E) = = 16.92 $1.95 $3784 Earnings Growth Rate = 1= 34% $3202 16.92 PEG = 34 =.50 $1665 Book Value per Share = = $11.64 143 $33 Market to Book = = 2.83 $11.64 3. Use the common size statements and the ratio analysis you have completed above to comment on Cranston s: a. Liquidity Liquidity Cranston Industry 2010 2009 2008 2010 Current ratio 1.41 1.28 1.48 2.10 Quick ratio 0.90 0.82 0.87 1.10 Cash ratio 0.29 0.25 0.37.39

Chapter 14 n Financial Ratios and Firm Performance 505 Cranston s liquidity ratios are all below the industry average and either stable or declining. Low liquidity ratios can indicate either an aggressive pursuit of efficiency where the company attempts to achieve results with a minimum investment in current assets or it may indicated higher than average current liabilities. The asset management ratios suggest a somewhat inefficient use of current assets, so the latter explanation is more likely. b. Solvency Total Debt Ratio 0.52 0.51 0.43 0.25 Times Interest Earned 20.44 13.04 20.84 19.00 Cash Coverage 32.49 22.35 34.83 35. The total debt ratio indicates a slightly higher than average use of debt financing and the rising trend suggests increasing reliance on debt financing. On the other hand, the 2009 Times Interest Earned ratio is above average, suggesting that Cranston can easily handle its interest payments. The Cash Coverage ratio is below the industry average, but still high. It indicates that Cranston has $32.49 of EBITDA for every dollar of interest expense, so risk of financial distress is low. c. Asset management Inventory Turnover 4.32 4.24 4.78 5.20 Days' sales in inventory 84.57 86.04 76.30 70.19 Receivables turnover 5.24 4.99 8.63 6.81 Days sales in receivables 69.64 73.18 42.32 53.60 Total asset turnover 1.09 1.03 1.10 1.80 Inventory turnover and receivables turnover are both lower than the industry average, indicating that Cranston is using its current assets inefficiently. The days sales in inventory and receivables merely convert turnovers into days and are just a different way of looking at the same information. Total asset turnover is stable, but well below the industry average, most likely because of the inefficiencies noted in the use of current assets. d. Profitability Profit Margin 7.37% 6.50% 7.20% 8.60% Return on total assets 8.02% 6.67% 7.89% 15.48% Return on equity 16.75% 13.61% 13.78% 20.59% Cranston s profitability measures are stable, and even improving slightly, but remain below the industry averages. The increase in Return on Equity is largely due to an increasing Total Debt ratio. e. Market performance Earnings Per Share (EPS) $1.95 $1.46 $1.39 not meaningful

506 Brooks n Financial Management: Core Concepts, 2e Price/Earnings (P/E) 16.92 26.11 23.04 21.00 Earnings Growth Rate 34% 5% 17.5% 18% PEG 0.50 5.45 1.32 1.17 Book value $11.64 $10.69 $10.08 not meaningful Market/Book 2.83 3.55 3.18 4.26 Cranston s market performance shows that the market measures results against expectations. Even though earnings grew at a rate of 34% in 2009, investors apparently do not believe that this rate is sustainable. Averaged over the 3 years, Cranston s growth rate in earnings is just about average for the industry. The Price/Earnings, PEG, and Market to Book ratios are all below the industry averages suggesting that investors are no longer optimistic about Cranston s future. These averages also indicate, however, that Cranston stock may be attractively priced. 4. Express Cranston s Return on Equity (ROE) in terms of the DuPont identity. Which ratios are contributing to Cranston s below average ROE? By substituting ratios for raw numbers, we can express the Dupont Identity as Profit Margin Total Asset Turnover Total Assets/Total Equity = Return on Equity. For the industry average, we get 8.60% 1.80 (1/(1-.25) =20.59% and for Cranston 7.37% 1.09 x(1/(1-.52) = 16.75%. The DuPont equation clearly shows that Cranston s below average Return on Assets is caused first by an inefficient use of assets and second by below average profit margins. Cranston makes up for, or perhaps masks, these shortcomings by using more debt than the average company in its industry. 5. Based on your analyses in questions 1 through 4, why do you think Cranston s recent stock performance has been disappointing? Many firms experiencing rapid growth in sales and earnings tend to focus on marketing and expanding production while becoming careless about efficiency and financial management. When sales growth slows to more normal levels, these inefficiencies can no longer be ignored and the firm must deal with them. Cranston has allowed inventories to exceed the industry average, is slower than average in collecting its bills, and seems to have some excess capacity in fixed assets. Investors also consider a great deal of information that may not be available simply by analyzing financial statements, but the statements do reveal a company that seems to be maturing in terms of growth and must now find other ways to maintain the value of its stock. Additional Problems with Solutions 1. Constructing an Income Statement. Using the income and expense account information for Tri-Mark Products Inc. listed below, construct an income statement for the year ended 31 st December, 2011. Shares outstanding: 16,740,000

Chapter 14 n Financial Ratios and Firm Performance 507 Tax rate: 35% Interest expense: $3,540,000 Revenue: $950,500,000 Depreciation: $50,000,000 Selling, general, and administrative expense: $85,000,000 Other income: $1,350,000 Research and development: $5,200,000 Cost of goods sold: $730,000,000 ANSWER (Slides 14-30 to 14-31) Tri-mark Products Incorporated Income Statement for the year ended 31st Dec. 2011 ('000s) Revenue $ 950,500 Cost of goods sold $ 730,000 Gross Profit $ 220,500 Operating expenses Selling, general and administrative expenses $ 85,000 R&D $ 5,200 Depreciation $ 50,000 Operating Income $ 80,300 Other Income $ 1,350 EBIT $ 81,650 Interest Expense $ 3,540 Taxable Income $ 78,110 Taxes $ 27,339 Net Income $ 50,772 Shares Outstanding ( 000s) 16,740 EPS $ 3.03 2. Constructing a Balance Sheet. Construct Tri-Mark Incorporated s 2011 year-end Balance Sheet using the asset, liability, and equity accounts listed below: Retained Earnings $60,500,000 Accounts Payable $57,000,000 Accounts Receivable $43,000,000 Common Stock $189,676,000

508 Brooks n Financial Management: Core Concepts, 2e Cash $6,336,000 Short Term Debt $1,500,000 Inventory $42,000,000 Goodwill $30,000,000 Long Term Debt $74,000,000 Other Non-Current Liabilities $15,000,000 PP&E $225,000,000 Other Non-Current Assets $14,000,000 Long-Term Investments $25,340,000 Other Current Assets $12,000,000 ANSWER (Slides 14-32 to 14-33) Tri-mark Products Inc. Balance Sheet as at year ended 31st December 2011 ( 000s) Assets: Liabilities: Current Assets Current Liabilities Cash $6,336 Accounts Payable $57,000 Accts. Rec. $43,000 Short Term Debt $1,500 Inventory $42,000 TOTAL Current Liabilities. $58,500 Other Current $12,000 Long Term Debt $74,000 Total Current $103,336 Other Liabilities $15,000 L- T Inv. $25,340 Total Liabilities $147,500 PP&E $225,000 Owner s Equity Goodwill $30,000 Common Stock $189,676 Other Assets $14,000 Retained Earnings $60,500 Total Assets $397,676 Total OE $250,176 Total Liab. And OE $397,676 3. Common size statements. Re-state Tri-Mark Incorporated s 2011 financial statements as common-size statements and comment on them ANSWER (Slides 14-34 to 14-35) Trimark Product Inc s Common Size Balance Sheet as at 31 st December 2011

Chapter 14 n Financial Ratios and Firm Performance 509 Assets: Current Assets Tri-Mark s debt position seems to be moderate with less than 40% debt relative to total assets. Their total current assets are about double their total current liabilities. We would need to compare these figures with either an industry benchmark or with a competitor s ratios to get a better feel for their overall asset and liability positions. Tri-mark Products Incorporated Common Size Income Statement for the year ended 31st Dec. 2011 ('000s) Revenue $ 950,500 100.0% Cost of goods sold $ 730,000 76.8% Gross Profit $ 220,500 23.2% Operating expenses % of Total Assets Liabilities: Current Liabilities Selling, general and administrative expenses $ 85,000 8.9% R&D $ 5,200 0.5% Depreciation $ 50,000 5.3% Operating Income $ 80,300 8.4% Other Income $ 1,350 0.1% EBIT $ 81,650 8.6% % of Total Assets Cash $6,336 0.02 Accounts Payable $57,000 0.14 Accts. Rec. $43,000 0.11 Short Term Debt $1,500 0.00 Inventory $42,000 0.11 TOTAL Current Liab. $58,500 0.15 Other Current $12,000 0.03 Long Term Debt $74,000 0.19 Total Current $103,336 0.26 Other Liabilities $15,000 0.04 L- T Inv. $25,340 0.06 Total Liabilities $147,500 0.37 PP&E $225,000 0.57 Owner s Equity Goodwill $30,000 0.08 Common Stock $189,676 0.48 Other Assets $14,000 0.04 Retained Earnings $60,500 0.15 Total Assets $397,676 1.00 Total OE $250,176 0.63 Total Liab. And OE $397,676 1.00 Interest Expense $ 3,540 0.4%

510 Brooks n Financial Management: Core Concepts, 2e Taxable Income $ 78,110 8.2% Taxes $ 27,339 2.9% Net Income $ 50,772 5.3% Shares Outstanding ( 000s) 16,740 EPS $ 3.03 Trimark s cost of goods sold is 76.8% of its revenue. Its gross margin is 23.2%, while its net profit margin is 5.3%. It would be useful to compare these key cost and profit ratios over time and against a suitable benchmark so as to get a better idea of the firm s overall performance. 4. Compute and analyze financial ratios. Using the 2011 income statement and balance sheet of Trimark Products Inc., as constructed in problems 1 and 2 above, compute its financial ratios. How is the firm doing relative to its industry in the areas of liquidity, asset management, leverage, and profitability? Ratio Industry Average Current Ratio 2.200 Quick Ratio (or Acid Test Ratio) 1.500 Cash Ratio 0.135 Debt Ratio 0.430 Cash Coverage 10.600 Day s Sales in Receivables 29.000 Total Asset Turnover 2.800 Inventory Turnover 20.100 Day s Sales in Inventory 11.500 Receivables Turnover 32.000 Profit Margin 0.045 Return on Assets 0.126 Return on Equity 0.221 ANSWER (Slides 14-36 to 14-39) Trimark Industry

Chapter 14 n Financial Ratios and Firm Performance 511 Average Current Ratio 1.766 2.200 Quick Ratio (or Acid Ratio Test) 1.048 1.500 Cash Ratio 0.108 0.135 Debt Ratio 0.371 0.430 Cash Coverage 37.189 10.600 Day s Sales in Receivables 16.512 12.000 Total Asset Turnover 2.390 2.800 Inventory Turnover 28.808 30.100 Day s Sales in Inventory 12.670 11.500 Receivables Turnover 22.105 30.000 Profit Margin 0.053 0.045 Return on Assets 0.128 0.126 Return on Equity 0.203 0.221 Analysis: Liquidity: Trimark s liquidity ratios are below the industry average indicating that they might need to look into their management of current assets and liabilities. Leverage: Trimark s debt ratio is much lower than the industry average and its cash coverage is more than 3 time the average, indicating that if it needs to borrow long-term debt it should not have much of a problem. Asset management: Trimark s asset turnover ratios are all below the average. It needs to tighten up collections, and manage its inventory more efficiently. Profitability: Trimark has a good control on cost of goods sold. Its net profit margin is better than the industry and so is its ROA. The industry, however, is returning a higher rate to the shareholders on average, primarily due to the higher debt levels. 5. DuPont Analysis. Based on the ratios calculated in problem 4 above, and in conjunction with the industry averages given, conduct a DuPont analysis on Trimark s key profitability ratios. ANSWER According to the Du Pont breakdown, we have ROE = Net Profit Margin * Total Asset Turnover * Equity Multiplier (Slides 14-40 to 14-42)

512 Brooks n Financial Management: Core Concepts, 2e è ROE = NI/S * S/TA * TA/Equity Note: since we don t have the accounting information for the average, we have to figure out the industry s equity multiplier by some algebraic manipulation. Equity Multiplier = Total Assets/Equity Now, debt ratio = Total Debt/Total Assets Total Assets = Total Debt + Equity è (Total Debt/Total Assets) + Equity/Total assets = 1 è Equity/Total Assets = 1 (Total Debt/Total Assets)è TA/E = 1/(1-TD/TA) Trimark Industry Debt Ratio 0.371 0.430 Total Asset Turnover 2.390 2.800 Profit Margin 0.053 0.045 Return on Assets 0.128 0.126 Return on Equity 0.203 0.221 Equity multiplier= 1/(1-debt ratio) 1.59 1.75 Despite a lower Total Asset Turnover ratio, Trimark s ROA (12.8%) is better than that of the industry (12.6%), primarily due to its higher net profit margin. The industry, however, has a higher ROE (22.1%) due to its higher debt ratio and correspondingly higher equity multiplier.