Part One Introduction What determines return on assets and equity? (LO4-4) ∙ The Du Pont system links financial ratios together to explain the return on assets and equity. ∙ Return on assets is the product of asset turnover and operating profit margin. ∙ Return on equity is the product of the leverage ratio, asset turnover, operating profit margin, and debt burden. What are some potential pitfalls in financial statement analysis? (LO4-5) ∙ Accounting entries do not always reflect current market values, and in rare cases, accounting is not transparent because unscrupulous managers make up good news and hide bad news in financial statements. ∙ You need a benchmark to assess a company’s financial condition. Analysts usually compare financial ratios with the company’s ratios in earlier years and with ratios of other firms in the same industry. ∙ Financial ratios must be interpreted in the context of a firm’s industry norms as well as its business strategy. Financial statement analysis will rarely be useful if done mechanically. Financial ratios do not provide final answers, although they should prompt the right questions. LISTING OF EQUATIONS 4.1 after-tax operating income Return on assets = ____________________ assets after-tax operating income sales ______________________ = _____ assets × sales ↑ ↑ asset turnover operating profit margin 4.2 after-tax operating income __________ net income assets sales net income __________ ______ _____ _____ ROE = = × × × equity equity assets sales after-tax operating income ↑ ↑ ↑ ↑ leverage asset operating ratio turnover profit margin “debt burden” QUESTIONS AND PROBLEMS ® 1. Market Value Added. Here is a simplified balance sheet for Locust Farming: Current assets Long-term assets $ , , Total $ , Current liabilities Long-term debt Other liabilities Equity Total $ $ , , , , , Locust has 657 million shares outstanding with a market price of $83 a share. (LO4-1) a. Calculate the company’s market value added. b. Calculate the market-to-book ratio. c. How much value has the company created for its shareholders as a percent of shareholders’ equity, that is, as a percent of the net capital contributed by shareholders)? 2. Market Value Added. Suppose Target’s stock price falls by 10% in a given year. (LO4-1) a. Will the firm’s market value added increase or decrease? b. How will this change affect your assessment of the performance of the firm’s management? c. Now suppose that in the same year, the broad stock market fell by 20%, a lot more than the decline in Target’s stock. Would this cause you to rethink your assessment of the firm’s management? d. Can you think of an improvement to the way in which we relate market value added to our evaluation of firm management? Chapter 3. Measuring Corporate Performance Measuring Performance. Here are simplified financial statements for Watervan Corporation: INCOME STATEMENT (Figures in $ millions) Net sales Cost of goods sold Depreciation Earnings before interest and taxes (EBIT) Interest expense Income before tax Taxes Net income $ BALANCE SHEET (Figures in $ millions) End of Year Assets Current assets Long-term assets Total assets Liabilities and shareholders’ equity Current liabilities Long-term debt Shareholders’ equity Total liabilities and shareholders’ equity Start of Year $ $ $ $ $ $ $ $ The company’s cost of capital is 8.5%. (LO4-2) a. Calculate Watervan’s economic value added (EVA). b. What is the company’s return on capital? (Use start-of-year rather than average capital.) c. What is its return on equity? (Use start-of-year rather than average equity.) d. Is the company creating value for its shareholders? 4. Measuring Performance. Recalculate Target’s economic value added as we did in Section 4.3, but assuming its cost of capital is 10%. (LO4-2) 5. Economic Value Added. EVA will be positive whenever ROC is positive and greater than the cost of capital. Explain why this is so. (LO4-2) 6. Return on Capital. Microlimp does not raise any new finance during the year, but it generates a lot of earnings, which are immediately reinvested. If you were calculating the company’s return on capital, would it make more sense to use capital at the start of the year or an average of the starting and ending capital? Would your answer change if Microlimp made a large issue of debt early in the year? Illustrate your answer with simple examples. (LO4-2) 7. Financial Ratios. Here are simplified financial statements for Phone Corporation in 2020: INCOME STATEMENT (Figures in $ millions) Net sales Cost of goods sold Other expenses Depreciation Earnings before interest and taxes (EBIT) Interest expense Income before tax Taxes (at %) Net income Dividends $ $ , , , , , $ , $ , , Part One Introduction BALANCE SHEET (Figures in $ millions) End of Year Assets Cash and marketable securities Receivables Inventories Other current assets Total current assets Net property, plant, and equipment Other long-term assets Total assets Liabilities and shareholders’ equity Payables Short-term debt Other current liabilities Total current liabilities Long-term debt and leases Other long-term liabilities Shareholders’ equity Total liabilities and shareholders’ equity $ $ $ Start of Year $ , , , , , $ $ , , , , , $ , , $ , , $ , , , , , $ , , , , , $ $ Calculate the following financial ratios for Phone Corporation using the methodologies listed for each part: (LO4-3) a. Return on equity (use average balance sheet figures) b. Return on assets (use average balance sheet figures) c. Return on capital (use average balance sheet figures) d. Days in inventory (use start-of-year balance sheet figures) e. Inventory turnover (use start-of-year balance sheet figures) f. Average collection period (use start-of-year balance sheet figures) g. Operating profit margin h. Long-term debt ratio (use end-of-year balance sheet figures) i. Total debt ratio (use end-of-year balance sheet figures) j. Times interest earned k. Cash coverage ratio l. Current ratio (use end-of-year balance sheet figures) m. Quick ratio (use end-of-year balance sheet figures) 8. Financial Ratios. Consider this simplified balance sheet for Geomorph Trading: (LO4-3) Current assets Long-term assets $ $ a. b. c. d. 9. Current liabilities Long-term debt Other liabilities Equity $ $ What is the company’s debt-equity ratio? What is the ratio of total long-term debt to total long-term capital? What is its net working capital? What is its current ratio? Receivables. Chik’s Chickens has accounts receivable of $6,333. Sales for the year were $9,800. What is its average collection period? (LO4-3) 10. Inventory. Salad Daze maintains an inventory of produce worth $400. Its total bill for produce over the course of the year was $73,000. How old on average is the lettuce it serves its customers? (LO4-3) 11. Times Interest Earned. In the past year, TVG had revenues of $3 million, cost of goods sold of $2.5 million, and depreciation expense of $200,000. The firm has a single issue of debt outstanding with book value of $1 million on which it pays an interest rate of 8%. What is the firm’s times interest earned ratio? (LO4-3) Chapter Measuring Corporate Performance 12. Leverage Ratios. Lever Age pays an 8% rate of interest on $10 million of outstanding debt with face value $10 million. The firm’s EBIT was $1 million. (LO4-3) a. What is its times interest earned? b. If depreciation is $200,000, what is its cash coverage ratio? 13. Financial Ratios. There are no universally accepted definitions of financial ratios, but some of the following ratios make no sense at all. If the definition is incorrect, substitute a correct one. (LO4-3) a. Debt‒equity ratio = long-term debt/(long-term debt + equity) b. Return on equity = net income/average equity c. Operating profit margin = after-tax operating income/sales d. Inventory turnover = total sales/average inventory e. Current ratio = current liabilities/current assets f. Average collection period = sales/(average receivables/365) g. Quick ratio = (cash + marketable securities + receivables)/current liabilities 14. Asset Turnover. In each case, choose the firm that you expect to have the higher asset turnover ratio. (Hint: Think about the likely nature of each firm’s business model. For example, would the firm require a lot or a little capital? Would it strive for high sales or high profit margins?) (LO4-3) a. Economics Consulting Group or Target b. Catalog Shopping Network or Gucci c. Electric Utility Co. or Standard Supermarkets 15. Inventory Turnover. (LO4-3) a. If a firm’s inventory level of $10,000 represents 30 days’ sales, what is the annual cost of goods sold? b. What is the inventory turnover ratio? 16. Leverage. A firm has a long-term debt–equity ratio of .4. Shareholders’ equity is $1 million. Current assets are $200,000, and the current ratio is 2. The only current liabilities are notes payable. What is the total debt ratio? (LO4-3) 17. Leverage Ratios. A firm has a debt-to-equity ratio of .5 and a market-to-book ratio of 2. What is the ratio of the book value of debt to the market value of equity? (LO4-3) 18. Liquidity Ratios. A firm uses $1 million in cash to purchase inventories. (LO4-3) a. Will its current ratio rise or fall? b. Will its quick ratio rise or fall? 19. Current Ratio. Would the following events increase or decrease a firm’s current ratio? (LO4-3) a. Inventory is sold. b. The firm takes out a bank loan to pay its suppliers. c. The firm arranges a line of credit with a bank that allows it to borrow at any time to pay its suppliers. d. A customer pays its overdue bills. e. The firm uses cash to buy additional inventory. 20. Financial Ratios. True or false? (LO4-3) a. A company’s debt‒equity ratio is always less than 1. b. The quick ratio is always less than the current ratio. c. For a profitable company, the return on equity is always less than the return on assets. 21. Interpreting Financial Ratios. In each of the following cases, state which of the two companies is likely to be characterized by the higher ratio. (Hint: Think about the likely nature of each firm’s business model. For example, would the firm require a lot or a little capital? Would it strive for high sales or high profit margins? Does it sell goods for cash or on credit?) (LO4-3) a. Debt‒equity ratio: a shipping company or a computer software company b. Ratio of sales to assets: an integrated pulp and paper manufacturer or a paper mill c. Average collection period: Regional Electric Power Company or Z-Mart Discount Outlets 22. Financial Ratios. As you can see, someone has spilled ink over some of the entries in the balance sheet and income statement of Transylvania Railroad. Use the information from the tables to work out the following missing entries, and then calculate the company’s return on equity. Note: Inventory turnover, average collection period, and return on equity are calculated using start-of-year, not average, values. (LO4-3) Part One Introduction Long-term debt ratio Times interest earned Current ratio Quick ratio Cash ratio Inventory turnover Average collection period . . . . . . days INCOME STATEMENT (Figures in $ millions) Net sales Cost of goods sold Selling, general, and administrative expenses Depreciation Earnings before interest and taxes (EBIT) Interest expense Income before tax Tax ( % of income before tax) Net income BALANCE SHEET (Figures in $ millions) This Year Assets Cash and marketable securities Accounts receivable Inventories Total current assets Net property, plant, and equipment Total assets Liabilities and shareholders’ equity Accounts payable Notes payable Total current liabilities Long-term debt Shareholders’ equity Total liabilities and shareholders’ equity a. b. c. d. e. f. g. h. i. j. k. l. m. n. o. p. Total assets Total current liabilities Total current assets Cash and marketable securities Accounts receivable Inventory Fixed assets Long-term debt Shareholders’ equity Net sales Cost of goods sold EBIT Interest expense Income before tax Tax Net income Last Year Chapter Measuring Corporate Performance 23. Interpreting Financial Ratios. Many ratios provide slightly different perspectives on similar questions. Turn back to Table 4.8. For the sample of industries in that table, plot a scatter diagram of the current ratio versus quick ratio. Do these two measures of liquidity tend to move together? Would you conclude that once you know one of these ratios, there is little to be gained by calculating the other? (There is room for disagreement here. What is your conclusion?) (LO4-3) 24. Du Pont Analysis. Last year Electric Autos had sales of $100 million and assets at the start of the year of $150 million. If its return on start-of-year assets was 15%, what was its operating profit margin? (LO4-4) 25. Du Pont Analysis. Torrid Romance Publishers has total receivables of $3,000, which represents 20 days’ sales. Total assets are $75,000. The firm’s operating profit margin is 5%. Find: (a) the firm’s ROA and (b) its asset turnover ratio. (LO4-4) 26. Du Pont Analysis. Keller Cosmetics maintains an operating profit margin of 5% and asset turnover ratio of 3. (LO4-4) a. What is its ROA? b. If its debt-equity ratio is 1, its interest payments and taxes are each $8,000, and EBIT is $20,000, what is its ROE? 27. Interpreting Financial Ratios. CFA Corp. has a debt-equity ratio that is lower than the industry average, but its cash coverage ratio is also lower than the industry average. What might explain this seeming contradiction? (LO4-4) 28. Using Financial Ratios. For each category of financial ratios discussed in this chapter, give some examples of who would be likely to examine these ratios and why. (LO4-5) WEB EXERCISE 1. Log on to finance.yahoo.com to find the latest simplified financial statements for Target. Recalculate Target’s financial ratios. What have been the main changes from the financial statements shown in this chapter? If you owned some of Target’s debt, would these changes make you feel more or less happy? SOLUTIONS TO SELF TEST QUESTIONS 4.1 Market capitalization is $75 × 14.5 million = $1,087.5 million. Market value added is $1,087.5 − $610 = $477.5 million. Market-to-book is 1,087.5/610 = 1.78. You can also calculate book value per share at $610/14.5 = $42.07, and use price per share to calculate market to book: $75/$42.07 = 1.78. 4.2 The cost of capital in dollars is .115 × $188 million = $21.62 million. EVA is $30 − $21.62 = $8.38 million. 4.3 After-tax operating income is calculated before interest expense. Net income is calculated after interest expense. Financial managers usually start with net income, so they add back after-tax interest to get after-tax operating income. After-tax operating income measures the profitability of the firm’s investment and operations. If properly calculated, it is not affected by financing. 4.4 ROE measures return to equity as net income divided by the book value of equity. ROC and ROA measure the return to all investors, including interest paid as well as net income to shareholders. ROC measures return versus long-term debt and equity. ROA measures return versus total assets. 4.5 Average daily expenses are $54,864/365 = $150.1 million. Accounts payable at the start of the year are $9,761 million. The average payment delay is therefore 9,761/150.1 = 65.0 days. 4.6 In industries with rapid asset turnover, competition forces prices down, reducing profit margins.
