CHAPTER 17
FINANCIAL STATEMENT ANALYSIS
EXERCISES
Ex. 17–1
a.
HOME-MATE APPLIANCE CO.
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
2006
Amount
Percent
Sales ............................................
Cost of goods sold .....................
Gross profit.................................
Selling expenses ........................
Administrative expenses ...........
Total operating expenses ..........
Income from operations ............
Income tax expense ...................
Net income ..................................
$500,000
275,000
$225,000
$ 90,000
60,000
$150,000
$ 75,000
25,000
$ 50,000
100.0%
55.0
45.0%
18.0%
12.0
30.0%
15.0%
5.0
10.0%
2005
Amount
Percent
$450,000
234,000
$216,000
$ 94,500
63,000
$157,500
$ 58,500
22,500
$ 36,000
100.0%
52.0
48.0%
21.0%
14.0
35.0%
13.0%
5.0
8.0%
b. The vertical analysis indicates that the cost of goods sold as a percent of
sales increased by 3 percentage points (55% – 52%) between 2005 and 2006.
However, the selling expenses and administrative expenses improved by 5
percentage points. Thus, the net income as a percent of sales improved by 2
percentage points.
Ex. 17–2
a.
Speedway Motorsports, Inc.
Comparative Income Statement (in thousands of dollars)
For the Years Ended December 31, 2002 and 2001
2002
Revenues:
Admissions......................................
Event-related revenue ....................
NASCAR broadcasting revenue.....
Other operating revenue ................
$141,315
122,172
77,936
34,537
2001
37.6%
32.5
20.7
9.2
$136,362
133,289
67,488
38,111
36.3%
35.5
18.0
10.2
Total revenues ...........................
Expenses and other:
Direct expense of events ................
NASCAR purse and sanction fees .
Other direct expenses ....................
General and administrative ............
Total expenses and other .........
Income from continuing operations ...
$375,960
100.0%
$375,250
100.0%
$ 69,297
61,217
87,427
57,235
$275,176
$100,784
18.4%
16.3
23.3
15.2
73.2%
26.8%
$ 76,579
54,479
88,582
59,331
$278,971
$ 96,279
20.4%
14.5
23.6
15.8
74.3%
25.7%
b. While overall revenue did not change much between the two years, the overall mix of revenue sources did change somewhat. The event-related revenues
(such as concessions) declined as a percent of total revenues by three percentage points, while the percent of NASCAR broadcasting revenues to total
revenues increased by nearly three (2.7) percentage points. The expenses as
a percent of total revenues shifted the most between the direct event expenses and NASCAR purse and sanction fees. That is, the direct expenses as a
percent of total revenues declined nearly two percentage points, while the
NASCAR purse and sanction fees as a percent of total revenues increased by
nearly two (1.8) percentage points. Overall, the income from continuing operations increased a modest 1.1 percentage points of total revenues between
the two years, which is a favorable trend. As a further note, the income from
continuing operations as a percent of sales exceeds 25% in both years, which
is excellent. Apparently, owning and operating motor speedways is a business that produces high operating profit margins.
Note to Instructors: The high operating margin is probably necessary to compensate for the extensive investment in speedway assets. This is confirmed
by the rate of operating income return on total assets of nearly 9%.
Ex. 17–3
a.
HORIZON PUBLISHING COMPANY
Common-Size Income Statement
For the Year Ended December 31, 20—
Horizon
Publishing
Company
Amount
Percent
Sales ................................................................. $ 1,414,000
Sales returns and allowances ........................
14,000
Net sales .......................................................... $ 1,400,000
Cost of goods sold ..........................................
504,000
101.0%
1.0
100.0%
36.0
Publishing
Industry
Average
101.0%
1.0
100.0%
40.0
Gross profit......................................................
Selling expenses .............................................
Administrative expenses ................................
Total operating expenses ...............................
Operating income ............................................
Other income ...................................................
$
$
$
$
$
Other expense .................................................
Income before income tax .............................. $
Income tax expense ........................................
Net income ....................................................... $
896,000
574,000
154,000
728,000
168,000
16,800
184,800
23,800
161,000
56,000
105,000
64.0%
41.0%
11.0
52.0%
12.0%
1.2
13.2%
1.7
11.5%
4.0
7.5%
60.0%
39.0%
10.5
49.5%
10.5%
1.2
11.7%
1.7
10.0%
4.0
6.0%
b. The cost of goods sold is 4 percentage points lower than the industry average, but the selling expenses and administrative expenses are 2.5 percentage
points higher than the industry average. The combined impact is for net income as a percent of sales to be 1.5 percentage points better than the industry average. Apparently, the company is managing the cost of publishing
books better than the industry but has slightly higher selling and administrative expenses relative to the industry. The cause of the higher selling and
administrative expenses as a percent of sales, relative to the industry, can be
investigated further.
Ex. 17–4
SANTA FE TILE COMPANY
Comparative Balance Sheet
December 31, 2006 and 2005
2006
Amount
Percent
2005
Amount
Percent
Current assets ..............................
Property, plant, and equipment...
Intangible assets ..........................
Total assets ..................................
$260,000
500,000
40,000
$800,000
32.50%
62.50
5.00
100.00%
$200,000
450,000
50,000
$700,000
28.57%
64.29
7.14
100.00%
Current liabilities ..........................
Long-term liabilities .....................
Common stock .............................
Retained earnings ........................
Total liabilities and
stockholders’ equity ...............
$170,000
210,000
50,000
370,000
21.25%
26.25
6.25
46.25
$150,000
200,000
50,000
300,000
21.43%
28.57
7.14
42.86
$800,000
100.00%
$700,000
100.00%
Ex. 17–5
a.
SCRIBE PAPER COMPANY
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
Sales ............................................
Cost of goods sold .....................
Gross profit.................................
Selling expenses ........................
Administrative expenses ...........
Total operating expenses ..........
Income before income tax .........
Income tax expense ...................
Net income ..................................
2006
Amount
2005
Amount
$ 66,300
32,000
$ 34,300
$ 24,000
7,500
$ 31,500
$ 2,800
1,000
$ 1,800
$ 85,000
40,000
$ 45,000
$ 25,000
6,000
$ 31,000
$ 14,000
6,000
$ 8,000
Increase (Decrease)
Amount
Percent
$ (18,700)
(8,000)
$ (10,700)
$ (1,000)
1,500
$
500
$ (11,200)
(5,000)
$ (6,200)
– 22.00%
– 20.00%
– 23.78%
– 4.00%
25.00%
1.61%
– 80.00%
– 83.33%
– 77.50%
b. The net income for Scribe Paper Company decreased by approximately 77.5%
from 2005 to 2006. This decrease was the combined result of a decrease in
sales of 22% and higher expenses. The cost of goods sold decreased at a
slower rate than the decrease in sales, thus causing gross profit to decrease
more than the decrease in sales. In addition, selling and administrative expenses increased by 1.61% between 2005 and 2006.
Ex. 17–6
a.
(1) Working capital = Current assets – Current liabilities
2006:
$875,000 – $250,000 = $625,000
2005:
$795,000 – $265,000 = $530,000
Current assets
Current liabilities
$875,000
= 3.5
2005:
$250,000
$795,000
= 3.0
$265,000
Quick assets
Current liabilities
$480,000
= 1.92
2005:
$250,000
$424,000
= 1.6
$265,000
(2) Current ratio =
2006:
(3) Quick ratio =
2006:
b. The liquidity of Marine Equipment has improved from the preceding year to
the current year. The working capital, current ratio, and quick ratio have all
increased. Most of these changes are the result of a decrease in current liabilities, specifically accounts (notes) payable, combined with an increase in the
current assets.
Ex. 17–7
a.
(1) Current ratio =
Dec. 28, 2002:
(2) Quick ratio =
Dec. 28, 2002:
Current assets
Current liabilities
$6,413
= 1.06
$6,052
Dec. 28, 2001:
$5,853
= 1.17
$4,998
Dec. 28, 2001:
$3,791
= 0.76
$4,998
Quick assets
Current liabilities
$4,376
= 0.72
$6,052
b. The liquidity of PepsiCo has declined significantly over this time period. Both
the current and quick ratios have declined. The current ratio declined from
1.17 to 1.06, and the quick ratio declined from 0.76 to 0.72. Neither of these
declines is worrisome, however. PepsiCo is a strong company with ample resources for meeting short-term obligations.
Ex. 17–8
a. The working capital, current ratio, and quick ratio are calculated incorrectly.
The working capital and current ratio incorrectly include Goodwill as a part of
current assets. Goodwill is an intangible asset and is noncurrent. The quick
ratio has the correct numerator (quick assets) but does not include accrued
liabilities in the denominator. The denominator of the quick ratio should be
total current liabilities.
The correct calculations are as follows:
Working capital = Current assets – Current liabilities
$900,000 – $625,000 = $275,000
Current ratio =
Current assets
Current liabilities
$900,000
= 1.44
$625,000
Quick assets
Current liabilities
$275,000 + $123,000 + $172,000
= 0.912
$625,000
Quick ratio =
b. Unfortunately, the working capital, current ratio, and quick ratio are all below
the minimum threshold required by the bond indenture. This may require the
company to renegotiate the bond contract, including a possible unfavorable
change in the interest rate.
Ex. 17–9
a.
(1) Accounts receivable turnover:
Current year:
Net sales on account
Average monthly accounts receivable
$320,000
= 7.1
$45,070
Preceding year:
(2) Number of days' sales in receivables:
$300,000
= 6.5
$46,154
Accounts receivable, end of year
Average daily sales on account
$48,219
= 55.0 days
$8771
$52,603
Preceding year:
= 64.0 days
$822 2
Current year:
1
$877 = $320,000 ÷ 365 days
2
$822 = $300,000 ÷ 365 days
b. The collection of accounts receivable has improved. This can be seen in both
the increase in accounts receivable turnover and the reduction in the collection period. The credit terms require payment in 60 days. In the previous period, the collection period exceeded these terms. However, the company apparently became more aggressive in collecting accounts receivable or more
restrictive in granting credit to customers. Thus, in the current period the collection period is within the credit terms of the company.
Ex. 17–10
a.
(1) Accounts receivable turnover:
Sears:
Net sales on account
Average accounts receivable
$35,698
= 1.2
($28,155 + $30,759) / 2
Federated:
$15,434
= 5.8
($2,379 + $2,945) / 2
(2) Number of days’ sales in receivables:
Sears:
$30,759
= 314.5 days
$97.81
Accounts receivable, end of year
Average daily sales on account
$2,945
= 69.6 days
$42.3 2
1$97.8 = $35,698 ÷ 365 days
2$42.3 = $15,434 ÷ 365 days
Federated:
b. Sears’ accounts receivable turnover is much less than Federated’s (1.2 for
Sears vs. 5.8 for Federated). Likewise, the number of days’ sales in receivables is much greater for Sears than for Federated (314.4 days for Sears vs.
69.6 days for Federated). These differences must be interpreted with care.
Sears has significant MasterCard receivables with customers who have not
made purchases from Sears, which represent receivables that do no correspond to Sears’ sales. Thus, it is not surprising that Sears has a much lower
turnover than does Federated, since the accounts receivable include receivables that are outside of the Sears retail network. In addition, we do not know
how much of the Sears or Federated sales are on credit; thus, it is not possible to accurately compare the number of days’ sales in receivables with credit
terms.
Note to Instructors: The annual 10-K for Federated indicated that the sales
through its proprietary credit card was $4,128. Thus, the accounts receivable
turnover based on this number would be 1.6 ($4,128 ÷ $2,662), while the
number of days’ sales in receivables would be 260.6 days ($2,945 ÷ $11.3).
Thus, the calculations in part a. above actually overstate Federated’s accounts receivable turnover and understates Federated’s credit card days’
sales in receivables. This exercise helps the student see the importance of interpreting these ratios carefully. In the case of Sears, much of the receivables
are not related to Sears’ sales, which distorts the ratio. In the case of Federated, only $4,128 million in sales were on account, thus actually overstating
its accounts receivable turnover and understating its days’ sales in receivable, relative to the sales on account.
Ex. 17–11
a.
(1) Inventory turnover:
Cost of goods sold
Average inventory
2006:
$328,000
= 8.0
$42,000 + $40,000 /2
2005:
$430,000
= 10.0
$44,000 + $42,000 /2
(2) Number of days' sales in inventory:
2006:
$40,000
= 44.49 days
$8991
Inventory, end of year
Average daily cost of goods sold
2005:
$42,000
= 35.65 days
$1,178 2
1
$899 = $328,000 ÷ 365 days
2
$1,178 = $430,000 ÷ 365 days
b. The inventory position of the business has deteriorated. The inventory turnover has decreased, while the number of days’ sales in inventory has increased. The sales volume has declined faster than the inventory has declined, thus resulting in the deteriorating inventory position.
Ex. 17–12
a.
(1) Inventory turnover:
Cost of goods sold
Average inventory
Dell:
$29,055
= 99.5
$278 + $306 /2
HP:
$34,573
= 13.4
$5,204 + $5,797 /2
(2) Number of days' sales in inventory:
Dell:
Hewlett Packard:
Inventory, end of year
Average daily cost of goods sold
$306
= 3.8 days
$79.6 1
$5,797
= 61.2 days
$94.7 2
1
$79.6 = $29,055 ÷ 365 days
2
$94.7 = $34,573 ÷ 365 days
b. Dell has a much higher inventory turnover ratio than does HP (99.5 vs. 6.3 for
HP). Likewise, Dell has a much smaller number of days’ sales in inventory
(3.8 days vs. 61.2 days for HP). These significant differences are a result of
Dell’s make-to-order strategy. Dell has successfully developed a manufacturing process that is able to fill a customer order quickly. As a result, Dell does
not need to prebuild computers to inventory. HP, in contrast, prebuilds computers, printers, and other equipment to be sold by retail stores and other retail channels. In this industry, there is great obsolescence risk in holding
computers in inventory. New technology can make an inventory of computers
difficult to sell; therefore, inventory is costly and risky. Dell’s operating strategy is considered revolutionary and is now being adopted by many both in
and out of the computer industry. Indeed, at the time of this writing, HP and
Gateway are changing their practices to mirror those of Dell. Apple Computer
also employs similar manufacturing techniques, and thus enjoys excellent inventory efficiency.
Ex. 17–13
a. Ratio of liabilities to stockholders’ equity:
Dec. 31, 2006:
b.
$1,350,000
= 0.54
$2,500,000
Number of times bond
interest charges were earned:
Total liabilities
Total stockholders' equity
Dec. 31, 2005:
$1,540,000
= 0.70
$2,200,000
Income before tax + Interest expense
Interest expense
Dec. 31, 2006:
$528,000  $96,000 *
= 6.50
$96,000
Dec. 31, 2005:
$336,000  $112,000 **
= 4.0
$112,000
*$1,200,000 × 8% = $96,000
**$1,400,000 × 8% = $112,000
c. Both the ratio of liabilities to stockholders’ equity and the number of times
bond interest charges were earned have improved significantly from 2005 to
2006. These results are the combined result of a larger income before taxes
and lower serial bonds payable in the year 2006 compared to 2005.
Ex. 17–14
a. Ratio of liabilities to stockholders’ equity:
Hasbro Inc.:
Mattel Inc.:
Total liabilities
Total stockholders' equity
$2,016,115,000
= 1.49
$1,352,864,000
$2,802,103,000
= 1.61
$1,738,458,000
b.
Number of times
Interest before tax  Interest expense
interest charges were earned:
Interest expense
Hasbro Inc.:
Mattel Inc.:
$96,199,00 0  $103,688,0 00
= 1.93
$103,688,0 00
$430,010,0 00  $155,132,0 00
= 3.77
$155,132,0 00
c. Both companies carry a moderate proportion of debt to the stockholders’ equity, at nearly 1.5 times stockholders’ equity. Mattel has slightly more debt as
a percent of stockholders’ equity than does Hasbro (1.61 vs. 1.49). However,
Mattel has much better interest coverage than does Hasbro. The reason is
because Mattel has earned much more than Hasbro in relation to interest
charges. That is, even though Mattel uses more debt and has higher interest
charges than does Hasbro, Mattel’s earnings more than offset these differences. As a result, Hasbro has only a 1.93 coverage ratio, while Mattel has
3.77 number of time interest charges are earned. Overall, Mattel has a higher
debt than does Hasbro, but has the earnings to support the interest charges
of the debt. Hasbro’s debt is somewhat lower as a percent of stockholders’
equity, but has lower earnings, causing a weaker (although adequate) interest
coverage.
Ex. 17–15
a. Ratio of liabilities to stockholders’ equity:
H.J. Heinz:
Total liabilities
Total stockholders' equity
$2,509,169 + $4,642,968 + $1,407,607
= 4.98
$1,718,616
Hershey Foods:
$606,444 + $876,972 + $1,223,254
= 2.36
$1,147,204
b. Ratio of fixed assets to long-term liabilities:
H.J. Heinz:
Fixed assets (net)
Long-term liabilities
$2,250,074
= 0.48
$4,642,968
Hershey Foods:
$1,534,901
= 1.75
$876,972
c. H.J. Heinz uses much more debt than does Hershey Foods. This is evident in
both ratios. The total liabilities to stockholders’ equity ratio shows debt at
4.98 times the stockholders’ equity for H.J. Heinz, compared to only 2.36
times stockholders’ equity for Hershey Foods. H.J. Heinz’s ratio of total liabili-
ties to stockholders’ equity is very high, and would indicate little additional
capacity for debt. The ratio of fixed assets to long-term liabilities suggests
the same relationship. This ratio divides the property, plant, and equipment
(net) by the long-term debt. The denominator should not include the other
long-term liabilities such as pensions and deferred tax credits because these
items are not related to financing fixed assets. The ratio for H.J. Heinz is,
again, aggressive with only 48% of fixed assets covering the long-term debt.
That is, the creditors of H.J. Heinz have less than 50 cents of property, plant,
and equipment covering every dollar of long-term debt. The same ratio for
Hershey Foods shows fixed assets covering 1.75 times the long-term debt.
That is, the creditors of Hershey Foods have $1.75 of property, plant, and
equipment covering every dollar of long-term debt. This would suggest that
Hershey has stronger creditor protection and borrowing capacity than does
H.J. Heinz.
Ex. 17–16
a. Ratio of net sales to total assets:
Yellow Corp.:
$3,276,651
= 2.55
$1,285,777
Union Pacific:
$11,973,000
= 0.38
$31,551,000
C.H. Robinson Worldwide:
Net sales
Total assets
$3,090,072
= 4.52
$683,490
b. The ratio of net sales to assets measures the number of sales dollars earned
for each dollar of assets. The greater the number of sales dollars earned for
every dollar of assets, the more efficient a firm is in using assets. Thus, the
ratio is a measure of the efficiency in using assets. The three companies are
different in their efficiency in using assets, because they are different in the
nature of their operations. Union Pacific earns only 38 cents for every dollar
of assets. This is because Union Pacific is very asset intensive. That is, Union
Pacific must invest in locomotives, railcars, terminals, tracks, right-of-way,
and information systems in order to earn revenues. These investments are
significant. Yellow Corp. is able to earn $2.55 for every dollar of assets, and
thus, is able to earn more revenue for every dollar of assets than the railroad.
This is because the motor carrier invests in trucks, trailers, and terminals,
which require less investment per dollar of revenue than does the railroad.
Moreover, the motor carrier does not invest in the highway system, because
the government owns the highway system. Thus, the motor carrier has no investment in the transportation network itself unlike the railroad. The transportation arranger hires transportation services from motor carriers and rail-
roads, but does not own these assets itself. The transportation arranger has
assets in accounts receivable and information systems but does not require
transportation assets; thus, it is able to earn the highest revenue per dollar of
assets.
Ex. 17–16
Concluded
Note to Instructors: Students may wonder how asset intensive companies
overcome their asset efficiency disadvantages to competitors with better asset efficiencies, as in the case between railroads and motor carriers. Asset efficiency is part of the financial equation; the other part is the profit margin
made on each dollar of sales. Thus, companies with high asset efficiency often operate on thinner margins than do companies with lower asset efficiency. For example, the motor carrier must pay highway taxes, which lowers its
operating margins when compared to railroads that own their right-of-way,
and thus do not have the tax expense of the highway. In this exercise the railroad has the highest profit margins, the motor carrier is in the middle, while
the transportation arranger operates on very thin margins.
Ex. 17–17
a. Rate earned on total assets:
2007:
Net income plus interest
Average total assets
$150,000 + $15,000
= 12.0%
$1,375,000 *
*($1,300,000 + $1,450,000) ÷ 2
$150,000
= 13.89%
$1,080,000 *
2007:
$180,000
= 19.25%
$935,000 **
**($855,000 + $1,015,000) ÷ 2
Net income less preferred dividends
Average common stockholders' equity
$150,000  $20,000
= 14.77%
$880,000 *
*($815,000 + $945,000) ÷ 2
Net income
Average stockholders' equity
2006:
*($1,015,000 + $1,145,000) ÷ 2
Rate earned on
common stockholders' equity:
$180,000 + $15,000
= 16.25%
$1,200,000 * *
**($1,100,000 + $1,300,000) ÷ 2
Rate earned on stockholders’ equity:
2007:
2006:
2006:
$180,000  $20,000
= 21.77%
$735,000 **
**($655,000 + $815,000) ÷ 2
b. The profitability ratios indicate that Yellowstone’s profitability has deteriorated. Most of this change is from net income falling from $180,000 in 2006 to
$150,000 in 2007. The cost of debt is 8%. Since the rate of return on assets
exceeds this amount in either year, there is positive leverage from use of
debt. However, this leverage is greater in 2006 because the rate of return on
assets exceeds the cost of debt by a greater amount in 2006.
Ex. 17–18
a. Rate earned on total assets:
2002:
Net income  interest expense
Average total assets
$80,158 + $6,886
= 9.2%
($883,166 + $1,010,826 )/2
b. Rate earned on stockholders’ equity:
2002:
2001:
$29,105 + $6,869
= 4.2%
($883,166 + $848,115)/ 2
Net income
Average stockholders' equity
$80,158
= 12.1% 2001:
($883,166 + $1,010,826 )/2
$29,105
= 4.9%
($883,166 + $848,115)/ 2
c. Both the rate earned on total assets and the rate earned on stockholders’ equity have improved over the two-year period. The rate earned on total assets
improved from 4.2% to 9.2%, which is over twice the return of the prior year.
The rate earned on stockholders’ equity improved from 4.9% to 12.1%. The
rate earned on stockholders’ equity exceeds the rate earned on total assets
due to the positive use of leverage.
d. Fiscal year 2002 was a difficult time for the apparel industry. The rate earned
on total assets for Ann Taylor, however, exceeded the industry average (9.2%
vs. 6%). The rate earned on stockholders’ equity was also greater than the industry average (12.1% vs. 7.8%). These relationships suggest that Ann Taylor
has more leverage than the industry, on average.
Ex. 17–19
a. Ratio of fixed assets to long-term liabilities:
Fixed assets
Long-term liabilities
$950,000
= 1.40
$680,000
b. Ratio of liabilities to stockholders’ equity:
Total liabilities
Total stockholders' equity
$725,000
= 0.49
$1,466,000
c. Ratio of net sales to assets:
Net sales
Average total assets (excluding investments)
$3,000,000
= 1.58
$1,900,000 *
*[($2,009,000 + $2,191,000) ÷ 2] – $200,000. The end-of-period total assets are
equal to the sum of total liabilities ($725,000) and stockholders’ equity
($1,466,000).
d. Rate earned on total assets:
Net income plus interest
Average total assets
$180,000 + $51,000
= 11.00%
$2,100,000 *
*($2,009,000 + $2,191,000) ÷ 2
e. Rate earned on stockholders’ equity:
Net income
Average stockholders' equity
$180,000
= 12.78%
$1,408,000 *
*[($200,000 + $650,000 + $500,000) + $1,466,000] ÷ 2
f.
Rate earned on
Net income less preferred dividends
common stockholders' equity: Average common stockholders' equity
$180,000  $16,000
= 13.58%
$1,208,000 *
* [($650,000 + $500,000) + ($650,000 + $616,000)] ÷ 2
Ex. 17–20
a.
Income before tax + Interest expense
Number of times bond
interest charges were earned:
Interest expense
$450,000 + $180,000
= 3.5 times
$180,000
b. Number of times preferred dividends were earned:
Net income
Preferred dividends
$325,000
= 13 times
$25,000
c. Earnings per share on common stock:
Net income  Preferred dividends
Common shares outstanding
$325,000  $25,000
= $2.40
125,000 shares
d. Price-earnings ratio:
Market price per share
Earnings per share
$50
= 20.83
$2.40
e. Dividends per share of common stock:
Common dividends
Common shares outstanding
$100,000
= $0.80
125,000 shares
f.
Dividend yield:
Common dividend per share
Share price
$0.80
= 1.6%
$50.00
Ex. 17–21
a. Earnings per share:
Net income  Preferred dividends
Common shares outstanding
$444,000  $54,000
= $1.95
200,000 shares
b. Price-earnings ratio:
Market price per share
Earnings per share
$39.00
= 20
$1.95
c. Dividends per share:
Common dividends
Common shares outstanding
$156,000
= $0.78
200,000 shares
d. Dividend yield:
$0.78
= 2.0%
$39.00
Common dividend per share
Share price
Ex. 17–22
a. Earnings per share on income before extraordinary items:
Net income .....................................................................
Less gain on condemnation .........................................
Plus loss from flood damage........................................
Income before extraordinary items ..............................
$ 890,000
(256,000)
166,000
$ 800,000
Earnings before extraordinary items per share on common stock:
Income before extraordinary items  Preferred dividends
Common shares outstanding
$800,000  $320,000
= $0.96 per share
500,000 shares
b. Earnings per share on common stock:
Net income  Preferred dividends
Common shares outstanding
$890,000  $320,000
= $1.14 per share
500,000 shares
Ex. 17–23
a. Price-earnings ratio:
Bank of America:
eBay:
$68.20
= 11.54
$5.91
$73.56
= 86.54
$0.85
Coca-Cola:
$40.06
= 23.85
$1.68
Dividend yield:
Dividend per share
Market price per share
Bank of America:
eBay:
Market price per share
Earnings per share
$0
=0
$73.56
$2.56
= 3.75%
$68.20
Coca-Cola:
$0.80
= 2.0%
$40.06
b. Bank of America has the largest dividend yield, but the smallest priceearnings ratio. Stock market participants value Bank of America common
stock on the basis of its dividend. The dividend is an attractive yield at this
date. Because of this attractive yield, stock market participants do not expect
the share price to grow significantly, hence the low price-earnings valuation.
This is a typical pattern for companies that pay high dividends. eBay shows
the opposite extreme. eBay pays no dividend, and thus has no dividend yield.
However, eBay has the largest price-earnings ratio of the three companies.
Stock market participants are expecting a return on their investment from appreciation in the stock price. Some would say that the stock is priced very
aggressively at 86.54 times earnings. Coca-Cola is priced in between the other two companies. Coca-Cola has a moderate dividend producing a yield of
2%. The price-earnings ratio is near 24, which is close to the market average
at this writing. Thus, Coca-Cola is expected to produce shareholder returns
through a combination of some share price appreciation and a small dividend.
PROBLEMS
Prob. 17–1B
1.
PET CARE, INC.
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
2006
Sales .................................................
Sales returns and allowances ........
Net sales ..........................................
Cost of goods sold ..........................
Gross profit......................................
Selling expenses .............................
Administrative expenses ................
Total operating expenses ...............
Income from operations .................
Other income ...................................
Income before income tax ..............
Income tax expense ........................
Net income .......................................
$ 76,200
1,200
$ 75,000
42,000
$ 33,000
$ 13,800
9,000
$ 22,800
$ 10,200
500
$ 10,700
2,400
$ 8,300
2005
$ 61,000
1,000
$ 60,000
35,000
$ 25,000
$ 12,000
8,000
$ 20,000
$ 5,000
500
$ 5,500
1,200
$ 4,300
Increase (Decrease)
Amount Percent
$ 15,200
200
$ 15,000
7,000
$ 8,000
$ 1,800
1,000
$ 2,800
$ 5,200
0
$ 5,200
1,200
$ 4,000
24.92%
20.00%
25.00%
20.00%
32.00%
15.00%
12.50%
14.00%
104.00%
0.00%
94.55%
100.00%
93.02%
2. The profitability has significantly improved. Net sales have increased by 25%
over the 2005 base year. In addition, however, cost of goods sold, selling expenses, and administrative expenses grew at a slower rate. Increasing sales
combined with costs that increase at a slower rate results in strong earnings
growth. In this case, net income grew in excess of 93% over the base year.
Prob. 17–2B
1.
INDUSTRIAL SANITATION SYSTEMS, INC.
Comparative Income Statement
For the Years Ended December 31, 2006 and 2005
Amount
Sales ....................................................
Sales returns and allowances ...........
Net sales .............................................
Cost of goods sold .............................
Gross profit.........................................
Selling expenses ................................
Administrative expenses ...................
Total operating expenses ..................
Income from operations ....................
Other income ......................................
Income before income tax .................
Income tax expense (benefit) ............
Net income (loss) ...............................
2006
Percent
$ 144,000
4,000
$ 140,000
80,000
$ 60,000
$ 56,000
14,000
$ 70,000
$ (10,000)
2,000
$ (8,000)
(2,000)
$ (6,000)
102.86%
2.86
100.00%
57.14
42.86%
40.00%
10.00
50.00%
(7.14)%
1.43
(5.71)%
(1.43)
(4.28)%*
Amount
2005
Percent
$ 128,000
3,000
$ 125,000
72,000
$ 53,000
$ 30,000
12,000
$ 42,000
$ 11,000
1,800
$ 12,800
3,000
$ 9,800
102.40%
2.40
100.00%
57.60
42.40%
24.00%
9.60
33.60%
8.80%
1.44
10.24%
2.40
7.84%
*Rounded down
2. The net income as a percent of sales has declined. All the costs and expenses, other than selling expenses, have maintained their approximate cost as a
percent of sales relationship between 2005 and 2006. Selling expenses as a
percent of sales, however, have grown from 24% to 40% of sales. Apparently,
the new advertising campaign has not been successful. The increased expense has not produced sufficient sales to maintain relative profitability.
Thus, selling expenses as a percent of sales have increased.
Prob. 17–3B
1. a. Working capital = Current assets – Current liabilities
$594,000 – $269,000 = $325,000
b. Current ratio =
Current assets
Current liabilities
$594,000
= 2.21
$269,000
Quick assets
Current liabilities
$120,000 + $56,000 + $185,000
= 1.34
$269,000
c. Quick ratio =
2.
Working
Transaction Capital
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
$325,000
325,000
325,000
325,000
300,000
325,000
445,000
325,000
425,000
325,000
Current
Ratio
2.21
2.56
2.05
2.31
2.02
2.21
2.65
2.21
2.58
2.21
Quick
Ratio
Supporting Calculations
Current
Quick
Current
Assets
Assets
Liabilities
1.34
1.44
1.17
1.37
1.23
1.34
1.79
1.34
1.71
1.31
$594,000
534,000
634,000
574,000
594,000
594,000
714,000
594,000
694,000
594,000
$361,000
301,000
361,000
341,000
361,000
361,000
481,000
361,000
461,000
352,000
$269,000
209,000
309,000
249,000
294,000
269,000
269,000
269,000
269,000
269,000
Prob. 17–4B
1. Working capital: $945,000 – $285,000 = $660,000
Ratio
Numerator
2. Current ratio ..................
$945,000
3. Quick ratio .....................
$600,000
4. Accounts receivable
turnover .........................
$2,800,000
5. Number of days' sales
in receivables ................
$172,000
6. Inventory turnover .........
$1,250,000
7. Number of days' sales
in inventory ....................
$325,000
8. Fixed assets to longterm liabilities ................
$2,100,000
9. Liabilities to stockholders' equity ...............
$1,185,000
10. Number of times interest
charges earned .............. $501,000 + $79,000
Denominator
Calculated
Value
$285,000
$285,000
3.3
2.1
($158,000 + $172,000)/2
17.0
($2,800,000/365)
($265,000 + $325,000)/2
22.4
4.2
($1,250,000/365)
94.9
$900,000
2.3
$2,110,000
0.6
$79,000
7.3
11. Number of times
preferred dividends
earned ............................
$361,000
12. Ratio of net sales to
assets .............................
$2,800,000
13. Rate earned on total
assets ............................. $361,000 + $79,000
14. Rate earned on stockholders' equity ...............
$361,000
15. Rate earned on
common stockholders' equity ............... ($361,000 – $32,000)
16. Earnings per share
on common stock.......... ($361,000 – $32,000)
17. Price-earnings ratio.......
$64.00
18. Dividends per share
of common stock ..........
$64,000
19. Dividend yield ................
$0.80
$32,000
11.3
($3,045,000 + $2,170,000)/2
1.1
($3,295,000 + $2,370,000)/2 15.5%
($2,110,000 + $1,745,000)/2 18.7%
($1,710,000 + $1,445,000)/2 20.9%
80,000
$4.11
$4.11
15.6
80,000
$64.00
$0.80
1.25%
Prob. 17–5B
a.
0.30
Rate earned on total assets
1.
0.25
0.20
0.15
0.10
0.05
0.00
2006
2005
2004
2003
2002
Year
Industry rate earned on total assets
Crane rate earned on total assets
Rate earned on total assets =
2006:
$132,000
= 0.09
$1,550,000
2003:
$230,000
= 0.21
$1,100,000
2005:
$145,000
= 0.10
$1,425,000
2002:
$225,000
= 0.25
$900,000
2004:
$185,000
= 0.15
$1,275,000
Prob. 17–5B
Continued
b.
0.70
Rate earned on stockholders' equity
1.
Net income  Interest expense
Average total assets
0.60
0.50
0.40
0.30
0.20
0.10
0.00
2006
2005
2004
2003
2002
Year
Industry rate earned on stockholders' equity
Crane rate earned on stockholders' equity
Rate earned on stockholders’ equity =
2006:
$30,000
= 0.05
$565,000
2003:
$150,000
= 0.46
$325,000
2005:
$50,000
= 0.10
$525,000
2002:
$150,000
= 0.67
$225,000
2004:
$100,000
= 0.22
$450,000
Prob. 17–5B
Continued
c.
4.000
Number of times interest charges earned
1.
Net income
Stockholders' equity
3.500
3.000
2.500
2.000
1.500
1.000
0.500
0.000
2006
2005
2004
2003
2002
Year
Industry number of times interest charges are earned
Crane number of times interest charges are earned
Number of times
Net Income  Income tax expense  Interest expense
interest charges =
Interest expense
were earned
2006:
$141,000
= 1.38
$102,000
2003:
$275,000
= 3.44
$80,000
2005:
$160,000
= 1.68
$95,000
2002:
$270,000
= 3.60
$75,000
2004:
$215,000
= 2.53
$85,000
2004
2003
Prob. 17–5B
d.
3.500
Ratio of liabilities to stockholders' equity
1.
Continued
3.000
2.500
2.000
1.500
1.000
0.500
2006
2005
2002
Year
Industry ratio of liabilities to stockholders' equity
Crane ratio of liabilities to stockholders' equity
Ratio of liabilities to stockholders’ equity =
Total liabilitie s
Total stockholders' equity
2006:
$1,020,000
= 1.76
$580,000
2003:
$800,000
= 2.00
$400,000
2005:
$950,000
= 1.73
$550,000
2002:
$750,000
= 3.00
$250,000
2004:
$850,000
= 1.70
$500,000
Note: Total liabilities are determined by subtracting stockholders’ equity (ending balance) from the total assets (ending balance).
Prob. 17–5B
Concluded
2. Both the rate earned on total assets and the rate earned on stockholders’
equity have been moving in a negative direction in the last five years. Both
measures have moved below the industry average over the last two years.
The cause of this decline is driven by a rapid decline in earnings. The use
of debt can be seen from the ratio of liabilities to stockholders’ equity. The
ratio has declined over the time period and has declined below the industry
average. Thus, the level of debt relative to the stockholders’ equity has
gradually improved over the five years. Unfortunately, the earnings have
declined at a faster rate, causing the rate earned on stockholders’ equity to
decline. The rate earned on total assets ran below the interest cost on debt
in 2006, causing the rate earned on stockholders’ equity to drop below the
rate earned on total assets. This is an example of negative leverage. The
number of times interest charges were earned has been falling below the
industry average for several years. This is the result of low profitability
combined with high interest costs (10%). The number of times interest is
earned has fallen to a dangerously low level in 2006. The low profitability
and time interest charges are earned in 2006, as well as the five-year trend,
should be a major concern to the company’s management, stockholders,
and creditors.
HOME DEPOT, INC., PROBLEM
1. a. Working capital (in millions):
2003: $3,882 ($11,917 – $8,035)
2002: $3,860 ($10,361 – $6,501)
b. Current ratio:
2003: 1.48 ($11,917 ÷ $8,035)
2002: 1.59 ($10,361 ÷ $6,501)
c. Quick ratio:
2003: 0.41 ($3,325 ÷ $8,035)
2002: 0.53 ($3,466 ÷ $6,501)
d. Accounts receivable turnover:
2003: 58.48 {$58,247 ÷ [($920 + $1,072)/2]}
2002: 61.03 {$53,553 ÷ [($835 + $920)/2]}
e. Number of days' sales in receivables:
2003: 6.72 [$1,072 ÷ ($58,247/365)]
2002: 6.27 [$920 ÷ ($53,553/365)]
f. Inventory turnover:
2003: 5.33 {$40,139 ÷ [($8,338 + $6,725)/2]}
2002: 5.63 {$37,406 ÷ [($6,725 + $6,556)/2]}
g. Number of days' sales in inventory:
2003: 75.82 days [$8,338 ÷ ($40,139/365)]
2002: 65.62 days [$6,725 ÷ ($37,406/365)]
h. Ratio of liabilities to stockholders’ equity:
2003: 0.52 ($10,209 ÷ $19,802)
2002: 0.46 ($8,312 ÷ $18,082)
i. Ratio of net sales to average total assets:
2003: 2.07 {$58,247 ÷ [($30,011 + $26,394)/2]}
2002: 2.24 {$53,553 ÷ [($26,394 + $21,385)/2]}
j. Rate earned on average total assets:
2003: 13.12% {($3,664 + 37) ÷ [($30,011 + $26,394)/2)]}
2002: 12.86% {($3,044 + 28) ÷ [($26,394 + $21,385)/2)]}
k. Rate earned on average common stockholders’ equity:
2003: 19.34% {$3,664 ÷ [($19,802 + $18,082)/2]}
2002: 18.4% {$3,044 ÷ [($18,082 + $15,004)/2]}
Home Depot, Inc., Problem
Concluded
l. Price-earnings ratio:
2003: 13.66 ($21.31 ÷ $1.56)
2002: 38.53 ($49.70 ÷ $1.29)
m. Percentage relationship of net income to net sales:
2003: 6.29% ($3,664 ÷ $58,247)
2002: 5.68% ($3,044 ÷ $53,553)
2. Before reaching definitive conclusions, each measure should be compared
with past years, industry averages, and similar firms in the industry.
a. The working capital increased slightly.
b. and c. The working capital and the quick ratio declined modestly during
2003.
d. and e. The accounts receivable turnover and number of days’ sales in receivables indicate a slight decrease in the efficiency of collecting accounts receivable. The accounts receivable turnover decreased from
61.03 to 58.48. The number of days’ sales in receivables increased
from 6.27 to 6.72. Both measures indicate, however, that Home Depot
has significant cash sales, since the turnover is so high and the average collection period is so short. If the credit sales were known,
these ratios could be calculated with net credit sales on account in
the numerator. The resulting calculations could be compared to
Home Depot’s credit policy.
f. and g. The results of these two analyses showed a decrease in the inventory turnover and an increase in the number of days’ sales in inventory. Both trends are unfavorable. Inventory management is critical to a
retailer, so this ratio trend would warrant further analysis.
h. The margin of protection to the creditors improved slightly in 2003. Overall,
there is excellent protection to creditors.
i. These analyses indicate a decrease in the effectiveness in the use of the
assets to generate revenues.
j. The rate earned on average total assets improved slightly during 2003.
Overall, rates earned on assets that exceed 10% is usually considered
good performance.
k. The rate earned on average common stockholders’ equity in 2003 also increased. This is also evidence of the positive use of leverage, since the
rate earned on stockholders’ equity exceeds the rate earned on assets. The
rates earned on average common stockholders’ equity shown for these two
years would be considered excellent performance.
l. The price-earnings ratio dropped significantly from 2002 to 2003. This drop
accompanied an overall drop in price-earnings ratios for the whole market
during this time. In addition, market participants are revaluing Home Depot’s growth prospects downward in light of the competition from Lowe’s.
Thus, even though earnings increased, the stock price declined.
m. The percent of net income to net sales increased, from 5.68% to 6.29%, a
favorable trend.