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Key Concepts
Chapter Outline
LO 2 Horizontal Analysis
Horizontal analysis: analysis of financial results over a series of years (Exhibit 13-1, 13-2)
n Increases or decreases, compared to a base year, are in absolute dollars and as percentages of
the base year
n Publicly held companies must show, annually, the three most recent years in the income
statement and statement of cash flows, and two years for the balance sheet
• many annual reports include a multi-year analysis of selected items and ratios (Exhibit
13-3)
• trend analysis: tracking items over a series of years
• changes in the elements of the statement of cash flows are receiving increased attention
from analysts
LO 3 Vertical Analysis
Common size statements recast all items on the statement as a percentage of a selected item on the
statement.
n On the income statement, this item is net sales. (Exhibit 13-6)
• two important relationships are
♦ gross profit ratio, or the ratio of gross profit to sales, shows the relative growth of
cost of goods sold compared to growth in sales
♦ profit margin ratio, the ratio of net income to sales, measures management's ability
to control expenses
♦ often measured using income before tax because management cannot control income
tax expense
n On the balance sheet, all assets are a percent of total assets. Liability and equity accounts are
each a percent of total liabilities plus equity (Exhibit 13-5)
n Allows comparison of two companies that are very different in size
n Can also be used for one company over a number of years
Acid test ratio, also known as quick ratio, is a stricter measure of the ability to pay current debts.
n Excludes inventory and prepaid assets
• Quick assets = cash + marketable securities + accounts receivable
Cash + Marketable Securities + Short term Receivables
Acid test ratio =
Current Liabilities
n Quick ratio of below 1:1 may indicate a need to liquidate marketable securities to pay
obligations, regardless of market prices of the securities at the time
n In assessing this ratio, information such as credit terms extended to the company by its
creditors, and by the company to its customers, along with due dates of other obligations, are
important
n For many companies, an acid-test ratio below 1 is not desirable
Limitations of both ratios:
n Almost all debts require payment in cash
n Both ratios measure liquidity at one point in time
Cash flow from operations to current liabilities ratio: since cash flow from operating activities looks at
cash flow over time, it can be used to measure cash flow over the year available to cover debts.
Cash flow from operations to = Net Cash Provided by Operating Activities
current liabilities ratio Average Current Liabilities
Accounts receivable turnover ratio measures the efficiency of the collection process:
Accounts receivable Net Credit Sales
turnover ratio =
Average Accounts Receivable
n An activity ratio, over a period of time, not just one point
n Another way to measure efficiency is by measuring how long accounts remain in accounts
receivable:
number of days in period
Number of Days Sales in Receivable =
accounts receivable turnover
n Inventory turnover measures number of times inventory is purchased, sold, and replaced
during a year
Cost of Goods Sold
Inventory Turnover Ratio =
Average Inventory
n Number of days' sales in inventory tells us how long it will take to sell the average item of
inventory
days in period
Number of Days’ sales in inventory =
inventory turnover
• increase could signal obsolete inventory, problems with sales, or high prices causing
reduced demand
Cash to cash operating cycle is the time between purchase of merchandise and receipt of cash from
sale of that merchandise:
Cash to cash cycle = days' sales in inventory + days' sales in accounts receivable
LO 5 Solvency Analysis
Solvency is the ability to remain in business over the long term, and to remain financially healthy over
the period during which both long- and short-term debt will be outstanding.
Times interest earned measures the ability to meet current-year interest payments:
Net Income + Interest Expense + Income Tax Expense
Times interest earned =
Interest Expense
n Limitations are that
• it only covers interest, not principal
• it is accrual-based, and does not measure cash available to meet obligations
♦ numerator contains various noncash adjustments and denominator measures interest
expense, not cash interest payments
Debt service coverage ratio measures the adequacy of cash generated by operations in covering debt
obligations:
cash flow from operations before interest and tax payments
Debt service coverage ratio =
interest and principal payments
n Sometimes the numerator used is earnings before interest, taxes, depreciation and
amortization
n The usefulness depends on changes in current assets and liabilities during a period
n Numerator and denominator figures can be found in the statement of cash flows or footnotes
Cash flow from operations to capital expenditures ratio measures the ability of a company to finance
acquisitions of long-lived assets from operations:
Cash flow from operations to cash flow from operations − total dividends
capital expenditures ratio =
cash paid for acquisitions
Profitability Analysis LO 6
Profitability measures management's ability to use resources available to earn a return on funds
invested.
n Return is a relationship between income earned by the company and investments made by
various groups
n Return on assets is the broadest measure, calculating return on investments by all providers of
capital
• denominator is average total assets, the sum of all the investments
• numerator is some measure of income that reflects all providers of capital
♦ interest expense must be added back to net income, so that we have income before
anyone's return, creditors or stockholders, is deducted
♦ should add back interest net of tax, since net income is net of tax
Net Income + Interest Expense, Net of Tax
Return on assets =
Average Total Assets
Components of return on assets
Return on stockholders' equity measures the return to common stockholders, after the debt return is
accounted for:
Net Income − Preferred Dividends
Return on stockholders’ equity =
Average Common Stockholders' Equity
n Net income is measured after interest is deducted; common equity equals assets less liabilities
n Return on assets and return on equity are tied together in a phenomenon called leverage, the
practice of using borrowed funds and amounts received from preferred shareholders to earn a
higher overall return on common equity
n If the company can earn an overall rate that is higher than the rates they pay to preferred
shareholders and debtholders, it has been successful in its use of outside money, or can be
said to have employed favorable leverage
n If the company's net income should fall, and they pay more to these groups than they earn
overall, they will have unfavorable leverage and be at risk
Earnings per share (EPS) allows shareholders to calculate what their share of earnings is, and compare
it to what they paid for the stock:
Net Income − Preferred Dividends
Earnings per share =
Weighted Average Number of Common Shares Outstanding
Price-earnings (PE) ratio relates the price of a share of stock to earnings per share:
current maret price per share
PE ratio =
earnings per share
NOTE: Exhibit 13-8 in the textbook summarizes the most commonly used
financial ratios. Students may want to mark it for reference.
Lecture Suggestions
The Wrigley comparative statistics in Exhibit 13-3 can generate a good discussion of what can be LO 2
found by comparing more than one statistic without doing any calculations.
If students have been assigned exercises from the "Activities" section of this book involving LO 3
comparison of companies, they will have encountered situations where companies of very different
sizes had to be compared. Relating common size statements to students' ways of dealing with these
differences can launch a discussion on the use of common size statements.
The cash to cash cycle and its components, the days in inventory and the days in accounts receivable, LO 4
can be explained in conjunction with the current ratio to assess the adequacy of the company's current
ratio. Similarly, days in accounts receivable measures how "quick" accounts receivable actually is.
Students understand the concept of interest as the return on their investment in a bank account. From LO 6
there, they can make the transition to a stockholder's investment in a company, and the return the
company produces, in the form of net income. In a bank account, interest is not always withdrawn, but
is left to earn more interest than that which would be earned on the initial investment alone.
Stockholders do not withdraw as dividends all net income, but leave some invested in the company to
generate greater future income.
The Review Problem at the end of the chapter, using the Wrigley statements, contains sufficient
information to use as an in-class example for most of the ratios, including solutions for many ratios.
Since students have the statements before them in their books, it is not necessary to reproduce them.
Detailed clarification and comment as you review the ratios add to what is given in the solution to the
Problem.
LO 2 Horizontal Analysis
In-class exercise: Wrigley income statement
The income statements for 1998, 1997, and 1996 for William Wrigley Jr. Company are presented in
the review problem in your textbook. Set up a worksheet with columns similar to the Henderson
Company example (Exhibit 13-1) in your textbook to do a horizontal analysis of Wrigley’s income
statements. Round numbers to tenths of a percent to minimize rounding problems.
n Do you find any changes that you would consider significant and worthy of further
investigation? If so, what are they? Why are they important?
n Does the horizontal analysis make the comparative income statements more meaningful to
you as you try to evaluate Wrigley’s performance?
n If you wished to evaluate the influence of inflation on the Wrigley income statements, what
factors would complicate your attempts to do so?
Solution
($ million)
If you require or encourage the use of personal computers by your students, either at home or in an on-
campus lab, students can set up the table on their own as an outside assignment, using a spreadsheet,
and come into class ready to discuss their findings. This will save class time.
n Growth in expenses outpaced revenue growth. In general, 1998 was a more difficult year than
1997 for the company. The growth rate slowed. Cost of interest and plant closure were
significant items.
n This is not a “right answer” question. Students are being asked to respond subjectively to the
effect of seeing the same information in a different format. Few would have noticed, for
example, the relatively smaller growth between 1997 and 1998 compared to 1996 and 1997.
n Inflation can be measured in more than one way. One could look at the growth in costs versus
the growth in revenues. Alternatively, inflation could be measured by published “standards”
that record inflation in the economy. This is where problems arise. Since Wrigley does
business throughout the world, many inflation rates would be applied to the appropriate
figures to make this assessment, and the overall analysis would be difficult and perhaps
pointless.
Vertical Analysis LO 3
Solution
($ and shares million)
1998 1997
$ %* $ %*
Assets
Current assets:
Cash and cash equivalents 214.5 14.10 206.6 15.38
Short-term investments, at amortized cost 137.7 9.05 120.7 8.98
Accounts receivable (less allowance for doubtful
accounts: 1998–$7.5; 1997–$7.5) 194.9 12.81 175.91 13.09
Inventories—
Finished goods 64.9 4.26 63.9 4.75
Raw materials and supplies 191.1 12.56 183.4 13.65
Other current assets 25.3 1.66 30.5 2.27
Deferred income taxes—current 15.0 .98 16.4 1.22
Total current assets 843.1 55.44 797.6 59.38
Marketable securities at fair value 39.8 2.61 26.3 1.95
Deferred charges and other assets 92.1 6.05 59.5 4.43
Deferred income taxes—noncurrent 25.5 1.67 29.0 2.15
Property, plant, and equipment at cost:
Land 36.0 2.36 26.2 1.95
Buildings and building equipment 310.2 20.39 277.8 20.68
Machinery and equipment 642.5 42.24 566.7 42.19
988.7 65.01 870.8 64.83
Less accumulated depreciation 468.6 30.81 440.3 32.78
520.0 34.19 430.4 32.04
Total assets $ 1520.8 100.00 1343.1 100.00
* Each asset is expressed as a percentage of total assets; each liability or equity account is expressed as
a percentage of total liabilities plus equity.
n Balance sheet amounts are remarkable for their relative consistency. Changes in the
percentages between the two years were all immaterial.
n Foreign currencies in which Wrigley had holdings declined relative to the dollar in aggregate
in both years. The relative decline was slightly less in 1998.
n The absolute dollar statements let the reader see increases (or decreases) in individual items;
the common size statements show the relative proportions of the balance sheet items (for
example, current assets to total assets, or liabilities to total liabilities plus equity), which may
be useful in seeing whether the perceived growth is uniform, or concentrated in certain areas,
or shifting between balance sheet accounts.
Dell’s inventories are not so significant to distort the current ratio. Thus the current ratio, subject to
accounts receivable and inventory turnover, is a fair indicator of liquidity.
1
Dell Computer Corporation, 1998 Annual Report, www.dell.com
12,327
n Accounts receivable turnover =. = 10.31 times
(1, 486 + 903) / 2
n Related companies:
Apple Computer 5.5
Digital Equipment Corp. 4.1
Hewlett Packard 4.7
360
Days in accounts receivable = = 34.9 days
10.31
The company collects its accounts receivable, on the average, in 35 days. This does not appear a
particularly long collection period, especially when turnover for related companies is noted.
9,605
n Inventory turnover =
(233 + 251) / 2 = 39.6 times.
360
Days in inventory = = 9.07 days
39.69
Inventories’ behavior will differ because of Dell's business. The company buys
inventory in advance of its use in manufacturing. Inventories are not immediately
sold. In addition, inventories contain labor and overhead, not just purchased parts.
This goes beyond the scope of the course. However, in spite of these factors,
turnover is relatively short. It should be noted when evaluating accounts receivable
and inventory that the cornerstone of Dell’s business approach is universal
customization. Computers are sold directly to the customer by Dell, and tailored to
each customer’s needs. Their products are built to order.
n Cash to cash cycle = 35 + 9 = 44 days. Key factors are the extra steps involved in
manufacturing, balanced by Dell’s efforts at quick turnaround of inventories.
1,592
n Cash flow from operating activities to current liabilities = = .59 : 1.
2,697
Notwithstanding the fact that its focus is on cash, which is needed to satisfy liabilities, it is only one
indicator. None are better, but must be considered in the context of related ratios, and also in
comparison to similar companies.
n Some comparisons:
Solvency Analysis LO 5
2,975
n Debt to total capitalization ratio for 1998 = = 69.7 %
4,268
1,908
and, for 1997, = = 63.7%
2,993
Compared to other companies, with debt at 75% to 90% of total financing not uncommon, Dell does
not look overly leveraged. The ratio changed little from 1997 to 1998. It is useful to remind students
that it is good management for a business to use debt for a portion of its financing if it can earn a
higher rate of return on the funds obtained than the borrowing rate for the debt.
n Since Dell has more than adequate cash flow from operations to pay back its current debt in
full even after capital expenditures, it is in a good position to decide to either expand using
operating cash, or to borrow additional money at advantageous rates (see exercise on
leverage) with no immediate risk of not meeting principal or interest payments.
Profitability Analysis LO 6
2
Op. Cit.
n What would you, as the company officer who supervises both managers, suggest as a solution
to this problem?
Solution
n The manager is at a disadvantage because the net book value of her assets, which will include
the new building and fixtures, will be much higher than that of the older building. Thus, for
comparable net income, she will show a lower return on assets.
n The increase in performance would not be a genuine improvement, merely a form of “book
cooking.” It would be surprising if she had the freedom to unilaterally make this decision.
However, the company’s formula for calculating executive compensation is not subject to the
rules of reporting, but is an internally governed matter.
n For the company as a whole, unless they can show some justification to the contrary, like
assets should be treated in the same way. Thus, they would not use two different depreciation
methods for two managers.. Although different assets can be depreciated differently, it would
be difficult to make a distinction between two buildings.
n For internal purposes—that is for numbers that will not be published—the company does have
flexibility. They can change the definition of “total assets” to, for example, cost rather than
net book value, or even to current market value. Even in published figures, some variation is
found, leading the wise reader to conclude that it is best, if you want to be sure you are
comparing the same numbers for two companies, to calculate the ratios yourself.
n “Book cooking” notwithstanding, the manager of the newer building does have a legitimate
complaint. The two managers are not being evaluated equally. The supervisor could set
different standards for each hotel, or change the elements of the calculation to compensate for
differences between facilities. Evaluation systems frequently raise controversy, and
companies resort to detailed, complex bonus formulae to eliminate bias. The use of target
figures for return can serve as a disincentive to capital investments if new assets appear to
penalize managers.
Note to instructor:
For the sake of consistency, and to show how the ratios taken together present a
more complete picture, Dell was used for most ratio calculations in this Chapter.
However, many of the ratios were introduced earlier in the text, and exercises for
them appear in this manual using other companies.
3
Op. Cit.