Module 3
Analyzing and Interpreting Financial
Statements
QUESTIONS
Q3-1. Return on investment measures profitability in relation to the amount of
investment that has been made in the business. We can always increase dollar
profit by increasing the amount of our investment (assuming it is a profitable
investment). So, dollar profits are not necessarily a meaningful way to look at
financial performance. Using return on investment in our analysis, whether as
investors or business managers, requires us to focus not only on the income
statement, but also on the balance sheet.
Q3-2. ROE is the sum of RNOA and leverage multiplied by the spread. So, increasing
leverage increases ROE as long as the spread is positive. Financial leverage is
also related to risk: the risk of potential bankruptcy and the risk of increased
variability of profits. Companies must, therefore, balance the positive effects of
financial leverage against their potential negative consequences. It is for this
reason that we do not witness companies entirely financed with debt.
Q3-3. Gross profit margins usually decline because 1. the industry has become more
competitive, and/or 2. the firm’s products have lost their competitive advantage.
Declining gross profit margins are, therefore, usually viewed negatively. On the
other hand, the sales mix might have changed from higher margin slowly turning
products to more lower margin higher turning products. This mix change might
not be viewed negatively.
Q3-4. Many costs that, arguably, produce “assets” are expensed under GAAP.
Examples include advertising expenses and R&D costs. Reducing the investment
in these categories can increase current operating profit at the expense of the
long-term competitive position of the firm.
Q3-5. Turnover relates to the amount of revenue volume compared with the investment
in an asset. Generally speaking, we want turnover to be higher rather than lower. It
is a productivity concept, as opposed to an efficiency concept. The objective is to
make our assets as productive as possible. Since turnover is one of the
components of ROE (via RNOA), increasing turnover increases shareholder value.
Turnover is, therefore, viewed as a value driver.
Q3-6. The accounts receivable turnover compares the level of receivables with sales.
Reducing receivables while maintaining sales levels increases the turnover ratio.
Companies can offer discounts for early payment or generally improve their credit
underwriting and/or collection efforts in order to improve the turnover ratio. Of
course, extension of credit is a marketing tool, and restriction of credit can
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Solutions Manual, Module 3
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adversely affect sales. Companies must continually balance the positive effects of
increasing receivables turnover rates against the potential adverse impact on
sales levels.
Q3-7. Inventory turnover rates are generally improved by 1. increasing manufacturing
efficiency (e.g., just-in-time delivery, elimination of bottlenecks to reduce work-inprocess inventories), and 2. reducing finished goods inventories by producing to
actual demand rather than forecasted demand.
Q3-8. Turnover of long-term operating assets is generally improved by increasing
throughput. Many companies are seeking to increase capacity utilization by
entering into corporate alliances with other companies to produce for their
demand as well as their own. Joint ventures of production facilities and
information technology (IT) departments have become more common in the recent
past as companies seek creative ways of increasing long-term operating asset
utilization and, therefore, long-term operating asset turnover rates.
Q3-9. The accounts payable turnover rate compares cost of goods sold with the level of
accounts payable. A reduction in the payable turnover rate implies a higher level
of accounts payable for the given volume of sales (COGS). Increasing accounts
payable increases cash flow. It is for this reason that a reduction of the payables
turnover rate can be considered favorable. Of course, firms facing cash flow
declines and potential bankruptcy may resort to extending payables in order to
survive. And, “leaning on the trade” may damage supplier relations if carried too
far. As a result, the slowing of the payables turnover rate is not always positive.
Q3-10. The cash cycle measures the time from investment of cash in inventories, to the
ultimate collection of receivables resulting from their sale. Generally speaking, we
want the cash cycle to be as short as possible. This implies that cash will be
recovered quickly and reinvested into more inventories to produce more sales
and profits.
Q3-11. There are an infinite number of possible combinations of margin and turnover that
will yield a given level of RNOA. The relative weighting of profit margin and asset
turnover results from the company’s business model. As a result, since
companies in an industry tend to adopt similar business models, industries will
generally find equilibrium points along the margin/turnover continuum.
Q3-12. Liquidity refers to cash: how much cash do we have, how much cash is coming in
the door, and how much cash can we raise quickly. Companies must generate
cash in order to pay their debts, to pay their employees and to pay their
shareholders a return on their investment. Cash is, therefore, critical to the
survival of the company.
Q3-13. Ratio analysis uses the balance sheet, income statement and statement of cash
flows. It is, therefore, dependent on the quality of those statements. Differences in
the application of GAAP across companies or within the same company across
time can affect the validity of the analysis. Limitations of GAAP itself (e.g., writeoff of R&D, non-recognition of assets that cannot be measured) and differences in
the make-up of the company (e.g., types of products or industries in which the
company competes) can also affect the usefulness of the analysis.
Q3-14.ACommon size statements express the balance sheet and the income statement in
ratio form (e.g., each asset category as a percentage of total assets and each
income statement account as a percentage of sales). The ratio form facilitates
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Financial Accounting for MBAs, 2nd Edition
comparison among firms of different sizes as well as across time for the same
firm.
©Cambridge Business Publishers, 2006
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MINI-EXERCISES
M3-15 (15 minutes)
Net operating working capital
= operating current assets – operating current liabilities
= (current assets – current financial assets) – (current liabilities – current
financial liabilities)
= ($12,928 - $0) – ($8,314 - $866)
= $5,480 million
Net long-term operating assets
= long-term operating assets – long-term operating liabilities
= ($16,969+$1,495) – ($1,796)
= $16,668 million
NOA = net operating working capital + net long-term operating assets
NOA = $5,480 + $16,688
= $22,148 million
M3-16 (15 minutes)
NOPAT = (total operating revenues – total operating expenses) * (1-tax rate)
= ($48,163 – [$31,790 + $10,696 + $838 + $1,320]) (1-[$1,119/$2,960])
= ($3,519) * (1-.378)
= $2,189
note: we treat net credit card revenues, and the related credit card expense,
as operating since Target maintains its own proprietary credit card to
support in-store sales. The accounts receivable relating to these credit
cards is also included as an operating current asset in M3-15.
NFE = NOPAT - net income = $2,189 - $1,841 = $348.
NFE can also be calculated as $559 [net interest expense]*(1-.378)=$348
M3-17 (20 minutes)
a.
RNOA = NOPAT / Average net operating assets
= $2,189 / ([$22,148 + $20,604]/2)
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Financial Accounting for MBAs, 2nd Edition
= 10.2%
b.
NOPM = NOPAT / Sales = $2,189 / $48,163 = 4.54%
NOAT = Sales / Average NOA = $48,163 / ([$22,148 + $20,604]/2)
= 2.25
RNOA = NOPM x NOAT = 4.54% x 2.25 = 10.2%
c.
NOWCT = Sales / Average net operating working capital
= $48,163 / [($5,480 + $5,387)/2] = 8.86
LTOAT = Sales / Average long-term operating assets
= $48,163 / ([$16,668 + $15,217]/2)
= 3.02
Note: L-T operating assets = NOA - NOWC
M3-18 (15 minutes)
Net operating working capital
= operating current assets – operating current liabilities
= (total current operating assets – current financial assets) – (current
operating liabilities – current financial liabilities)
= ($8,314 - $0) – ($8,669 - $2,457)
= $2,102 million
Net long-term operating assets
= long-term operating assets – long-term operating liabilities
= ($49,988-$8,314) – ($2,712+$3,745)
= $35,217 million
NOA = net operating working capital + net long-term operating assets
NOA = $2,102 + $35,217
= $37,319 million
M3-19 (15 minutes)
NOPAT = (total operating revenues – total operating expenses) * (1-tax rate) ±
other after-tax operating income (expense) items
= ($27,061 – [24,330+18-334+16]) (1-[$789/$2,254]) - 71
= ($3,031) * (1-.35) - 71
= $1,899 million
note: we treat the after-tax change in accounting principle of $71 million as
an operating activity since it relates to the accounting for operating
activities.
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NFE = NOPAT - net income = $1,899 million - $1,267 million = $632 million
M3-20 (20 minutes)
a.
RNOA = NOPAT / Average net operating assets
= $1,899 / ([$37,319 + $38,009]/2)
= 5%
b.
NOPM = NOPAT / Sales = $1,899 / $27,061 = 7%
NOAT = Sales / Average NOA = $27,061 / ([$37,319 + $38,009]/2)
= 0.72
RNOA = NOPM x NOAT = 7% x .72 = 5%
c.
NOWCT = Sales / Average net operating working capital
= $27,061 / [($2,102 + $1,693)/2] = 14.26
LTOAT = Sales / Average long-term operating assets
= $27,061 / ([$35,217 + $36,316]/2)
= .76
Note: L-T operating assets = NOA - NOWC
M3-21 (15 minutes)
a. (1) ART = $11,566/$174=66.47
(2) INVT = $7,849/$2,157=3.64
(3) LTOAT=$11,566/$4,821=2.40
b.
Toys R US is a cash-and-carry business with significant investment
in inventories and property, plant and equipment. We would, therefore,
expect its receivables to turn very quickly, and its inventories and L-T
operating assets to turn at relatively slower rates.
M3-22 (15 minutes)
a. The current ratio is computed as current assets / current liabilities (note,
liquidity measures are not concerned with the operating-nonoperating
distinction). For Toys R US, the current ratios for 2002-2004 are 1.33
($2,631/$1,974), 1.51 ($3,586/$2,378), and 1.69 ($4,684/$2,772). There is a
trend toward increasing liquidity.
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Financial Accounting for MBAs, 2nd Edition
We might want to know, however, whether the Toys R US’ current assets
are concentrated in cash or relatively illiquid inventories, as well as the
maturity schedule of its current liabilities.
b. The times interest earned ratio is earnings before interest and taxes
divided by interest. For Toys R Us, the times interest earned ratio over
the 2002-2004 period is 1.83 ($200/$109), 4.28 ($471/$110), and 2.09
($265/$127), respectively. The total liabilities-to-stockholders’ equity
ratio over the 2002-2004 period is 1.35 ($4,635/$3,441), 1.32
($5,354/$4,043), and 1.42 ($5,987/$4,231). The times interest earned ratio
has fluctuated with the level of earnings. Although not particularly high,
the times interest ratio has been greater than 1.0 over all three years,
indicating an ability to cover interest charges, albeit without an
excessive amount of cushion. The proportionate level of debt has
increased slightly in the 2003-2004 period, but is not excessively high.
c. Toys R US current ratio of 1.69 is not particularly high, especially
considering the fact that its current assets are likely comprised mostly
of inventories. Although the level of financial leverage is not excessive,
Toys R US is not particularly profitable ($265 million of earnings before
interest and taxes against total assets of over $10.2 billion). Our
concern, if any, with Toys R US’ debt is this relative lack of profitability.
©Cambridge Business Publishers, 2006
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EXERCISES
E3-23 (30 minutes)
a.
Company
($ millions)
RNOA
Target Corp ......... $2,189/([$22,148+$20,604]/2)=10.2%
Wal-Mart Stores .. $9,601/([$71,573+$66,211]/2)=13.9%
b.
Company
NOPAT margin (NOPM)
($ millions)
NOPAT/Sales
Target Corp ......... $2,189/$48,163=4.54%
Wal-Mart Stores .. $9,601/$258,681=3.71%
NOA turnover (NOAT)
Sales/Average NOA
$48,163/([$22,148+$20,604]/2)=2.25
$258,681/([$71,573+$66,211]/2)=3.75
c.
L-T Operating asset turnover
Net operating Working
(LTOAT)
Company
Capital turnover (NOWCT)
Sales/Average L-T operating
($ millions)
Sales/NOWC
assets
$48,163/([$5,480+$5,387]/2)
$48,163/([$16,668+$15,217]/2)
Target Corp .........
= 8.86
= 3.02
$258,681/([$3,370+$3,994]/2) $258,681/([$68,203+$62,217]/2)
Wal-Mart Stores ..
=70.26
= 3.97
Note: L-T operating assets=NOA-NOWC
d. Wal-Mart’s RNOA is greater than Target’s in this year. Wal-Mart’s value
pricing strategy is clearly evident in its lower NOPAT margin, but this is
more than offset by a higher turnover of net operating assets and,
hence, Wal-Mart is very successful. Wal-Mart's working capital turns
over 9 times more per year than Target’s, while its long-term operating
asset turnover rate is nearly a third higher. Wal-Mart’s low margin, high
turnover business model is clearly evident and is very successful.
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
E3-24 (30 minutes)
a.
Company
($ millions)
Abercrombie & Fitch
Gap, Inc ...............
RNOA
$203/([$861+$740]/2)=25.4%
$1,150/([$5,710+$7,314]/2)=17.7%
b.
Company
NOPAT margin (NOPM)
($ millions)
NOPAT/Sales
Abercrombie &
Fitch ..................... $203/$1,708=11.9%
Gap, Inc ............... $1,150/$15,854=7.25%
NOA turnover (NOAT)
Sales/Average NOA
$1,708/([$861+$740]/2)=2.13
$15,854/([$5,710+$7,314]/2)=2.43
c.
Company
($ millions)
Abercrombie &
Fitch ....................
Gap, Inc ..............
Net operating Working Capital
turnover (NOWCT)
Sales/NOWC
L-T Operating asset turnover
(LTOAT)
Sales/Average L-T operating
assets
$1,708/[$463+$374]/2)=4.08
$1,708/([$399+$365]/2)=4.47
$15,854/([$2,056+$3,152]/2)=6.09 $15,854/([$3,654+$4,162]/2)=4.06
Note: L-T operating assets=NOA-NOWC
d. Abercrombie & Fitch’s RNOA exceeds the GAP’s. This is primarily the
result of a significantly higher NOPAT margin as the NOA turnover rate
is slightly less than that for the GAP. Abercrombie is able to realize this
NOPAT margin as a result of the popularity of its brand and its up-scale
image. The GAP’s working capital turns more quickly than
Abercrombie’s. This is partially due to the fact that the GAP sells off all
of its accounts receivable from the GAP card to an independent bank
while Abercrombie carries some receivables on its balance sheet.
Interestingly, Abercrombie’s inventory turns are about the same as the
GAP’s (5.3 vs. 5, respectively).
©Cambridge Business Publishers, 2006
Solutions Manual, Module 3
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E3-25 (30 minutes)
a.
Company
($ millions)
Albertsons, Inc ...
Kroger Co ............
RNOA
$809/([$10,705+$10,573]/2)=7.60%
$562/([$12,375+$12,424]/2)=4.53%
b.
Company
NOPAT margin (NOPM)
($ millions)
NOPAT/Sales
Albertsons, Inc ... $809/$35,436=2.28%
Kroger Co ............ $562/$53,791=1.04%
NOA turnover (NOAT)
Sales/Average NOA
$35,436/([$10,705+$10,573]/2)=3.33
$53,791/([$12,375+$12,424]/2)=4.34
c.
L-T Operating asset turnover
Net operating Working Capital
(LTOAT)
Company
turnover (NOWCT)
Sales/Average L-T operating
($ millions)
Sales/NOWC
assets
Albertsons, Inc ... $35,436/([$1,254+$939]/2)=32.31 $35,436/([$9,451+$9,634]/2)=3.71
Kroger Co............ $53,791/([$281+$310]/2)=182.03 $53,791/([$12,094+$12,114]/2)=4.44
Note: L-T operating assets=NOA-NOWC
d. Albertsons’ RNOA is higher than Kroger’s. The extremely low NOPAT
margins of the grocery industry are evident. Albertsons’ NOPAT margin
is over twice that of Kroger, reflecting a broader assortment of
merchandise than Kroger. Kroger’s turnover rates for operating working
capital and L-T operating assets are considerably higher, reflecting a
higher concentration in the food segment of the grocery industry (less
“full service”) and less investment in plant and equipment.
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
E3-26 (30 minutes)
a.
Company
($ millions)
Coca-Cola Co ......
PepsiCo Inc .........
RNOA
$4,342/([$19,393+$17,071]/2)=23.8%
$3,649/([$12,986+$12,065]/2)=29.1%
b.
Company
NOPAT margin (NOPM)
($ millions)
NOPAT/Sales
Coca-Cola Co ...... $4,342/$21,044=20.6%
PepsiCo Inc ......... $3,649/$26,971=13.53%
NOA turnover (NOAT)
Sales/Average NOA
$21,044/([$19,393+$17,071]/2)=1.16
$26,971/([$12,986+$12,065]/2)=2.15
c.
Company
($ millions)
Coca-Cola Co .....
PepsiCo Inc ........
L-T Operating asset turnover
Net operating Working Capital
(LTOAT)
turnover (NOWCT)
Sales/Average L-T operating
Sales/NOWC
assets
$21,044/([$3,296+$2,581]/2)=7.16 $21,044/([$16,097+$14,490]/2)=1.38
$26,971/([$-75+$716]/2)=84.15
$26,971/([$13,061+$11,349]/2)=2.21
Note: L-T operating assets=NOA-NOWC
d. PepsiCo’s RNOA exceeds Coca-Cola’s. This is the result of a
considerably higher turnover of net operating assets as its NOPAT
margin is 7 percentage points less. Pepsi’s operating working capital
turnover is considerably greater than Coke’s. Coke’s working capital
and L-T operating assets continue to be affected by its bottling
operations which, while not owned, continue to require significant
investment in the form of equity method investments, loans and
infrastructure investments. Pepsi, by contrast, divested its bottling
operations and has no such investments on its balance sheet.
©Cambridge Business Publishers, 2006
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E3-27 (30 minutes)
a.
Company
($ millions)
CVS Corp .............
Walgreen Co .......
RNOA
$877/([$7,098+$6,310]/2)=13.1%
$1,150/([$7,196+$6,230]/2)=17.1%
b.
Company
NOPAT margin (NOPM)
($ millions)
NOPAT/Sales
CVS Corp............. $877/$26,588=3.3%
Walgreen Co ....... $1,150/$32,505=3.54%
NOA turnover (NOAT)
Sales/Average NOA
$26,588/([$7,098+$6,310]/2)=3.97
$32,505/([$7,196+$6,230]/2)=4.84
c.
L-T Operating asset turnover
Net operating Working Capital
(LTOAT)
Company
turnover (NOWCT)
Sales/Average L-T operating
($ millions)
Sales/NOWC
assets
CVS Corp ............ $26,588/([$3,331+$2,913]/2)=8.52 $26,588/([$3,768+$3,397]/2)=7.42
Walgreen Co ....... $32,505/([$2,938+$2,211]/2)=12.63 $32,505/([$4,258+$4,019]/2)=7.85
Note: L-T operating assets=NOA-NOWC
d. Walgreen’s RNOA is higher than CVS’. The NOPAT margins for both
companies reflect the highly competitive retail pharmaceutical industry.
Walgreen’s advantage lies in its working capital turnover rate which is
48% greater than CVS’. The L-T operating turnover rates are quite close,
reflecting similar physical layouts and quality of interior improvements.
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
E3-28 (30 minutes)
a.
Company
($ millions)
Nike Inc ................
Reebok Ltd ..........
RNOA
$962/([$5,216+$4,824]/2)=19.2%
$174/([$1,432+$1,300]/2)=12.7%
b.
Company
NOPAT margin (NOPM)
($ millions)
NOPAT/Sales
Nike Inc................ $962/$12,253=7.85%
Reebok Ltd .......... $174/$3,485=4.99%
NOA turnover (NOAT)
Sales/Average NOA
$12,253/([$5,216+$4,824]/2)=2.44
$3,485/([$1,432+$1,300]/2)=2.55
c.
Company
($ millions)
Nike Inc ...............
Reebok Ltd .........
L-T Operating asset turnover
Net operating Working Capital
(LTOAT)
turnover (NOWCT)
Sales/Average L-T operating
Sales/NOWC
assets
$12,253/([$3,255+$3,048]/2)=3.89 $12,253/([$1,961+$1,776]/2)=6.56
$3,485/([$1,169+$1,053]/2)=3.14 $3,485/([$263+$247]/2)=13.67
Note: L-T operating assets=NOA-NOWC
d. Nike’s RNOA exceeds Reebok’s. This is primarily the result of a higher
NOPAT margin as its turnover of net operating assets is less. Nike’s
NOPAT margin is most likely affected by the popularity of its brand and
the economies of scale it realizes for its considerable advertising
expenditures. Interestingly, the operating asset turnover for Reebok is
primarily driven by a significantly higher turnover of L-T operating
assets as it has proportionately much less PPE on its balance sheet
than does Nike. Both industries have utilized off-shore manufacturing
and Reebok may be utilizing this to a greater extent than does Nike.
©Cambridge Business Publishers, 2006
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E3-29 (30 minutes)
a. (1)-(3).
Receivable Turnover
Inventory
L-T operating
Company
rate
turnover rate
asset turnover
($ millions)
(ART)
(INVT)
rate (LTOAT)
Abercrombie &
Fitch
$1,708 / 8 = 213.50 $990 / $184 = 5.38 $1,708/$420=4.07
$258,681/$1,411 = $198,747/$25,506 $258,681/$67,288
Wal-Mart Stores
183.33
= 7.79
= 3.84
b. Both companies have relatively little investments in receivables as
evidenced by the high receivable turnover rates. Wal-Mart’s inventories
turn more quickly than Abercrombie, reflecting its low margin-high
turnover marketing strategy. Interestingly, despite Abercrombie’s
extensive leasehold improvements, its turnover of L-T operating assets
is higher than Wal-Mart’s. This may be due to the fact that its real estate
is represented by leases on its mall properties, all of which are
classified as operating leases and, as a result, are not reflected as
assets on its balance sheet.
E3-30 (30 minutes)
a. (1)-(3).
Company
($ millions)
Harley-Davidson
Target Corp. .....
Receivable Turnover
L-T operating
rate
Inventory turnover asset turnover rate
(ART)
rate (INVT)
(LTOAT)
$4,624/110=42.04 $2,959/$213=13.89 $4,624/$1,994=2.32
$48,163/$5,670=
$31,790/$5,052=
$48,163/$17,566=
8.49
6.29
2.74
b. Harley’s receivables turn much more quickly than Target’s. Target’s
receivables arise from its proprietary credit card and the slower turnover
rate reflects the revolving nature of these receivables. Harley’s
receivables turnover rate is a bit deceiving, however, as its long-term
finance receivables (recorded on the Harley-Davidson Financial Services
company balance sheet) are reflected as a long-term asset while
Target’s are reflected as a current asset despite the revolving nature of
the accounts.
Harley’s inventories turn more quickly than Target’s. Harley has the
luxury of a significant backlog for orders and the motorcycles are
purchased as soon as they come off the assembly line. Harley’s
inventories do not include, therefore, a significant amount of finished
goods.
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
Long-term operating asset turnover is similar for both companies. While
Harley has a significant investment in manufacturing facilities, Target
has an equally significant investment in retail locations.
E3-31 (30 minutes)
a. Disney’s current ratio over the 2001-2003 period is 1.13 ($7,029/$6,219),
1.00 ($7,849/$7,819), and 0.96 ($8,314/$8,669), respectively. Disney has
become less liquid and the current level of 0.96 is not considered to be
high.
We might want to know, however, whether Disney’s current assets are
concentrated in cash or relatively illiquid inventories, and the maturity
schedule of its current liabilities.
b. Disney’s times interest earned ratio over the 2001-2003 period is 3.12
([$1,283+$606]/$606), 3.89 ([$2,190+$759]/$759), and 4.22
([$2,254+$699]/$699), respectively. The total liabilities-to-equity ratio
over this period is 0.93 ([$43,699-$22,672]/$22,672), 1.13 ([$50,045$23,445]/$23,445), and 1.10 ([$49,988-$23,791]/$23,791). The level of debt
as measured by the total liabilities-to-Stockholders’ Equity ratio has
slightly increased from .93 to 1.1, and is not considered high. The times
interest earned ratio is increasing and at a fairly comfortable level. We
would not be overly concerned about Disney’s debt level at this point.
c. Debt becomes problematic when the company’s profitability is not
sufficient to make the required payments of principal and interest.
Although Disney’s liquidity, as measured by the current ratio, is not
great, the company’s times interest earned ratio is at a fairly comfortable
level. We would not, therefore, have serious concerns about the
company’s ability to make its required debt payments at this point in
time.
E3-32 (30 minutes)
a. Verizon’s current ratio over the 2001-2003 period is 0.61
($23,187/$38,020), 0.77 ($20,921/$27,047), and 0.69 ($18,293/$26,570),
respectively. Verizon is illiquid as measured by the current ratio and is
not exhibiting trends toward improved liquidity.
©Cambridge Business Publishers, 2006
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We might want to know, however, whether Verizon’s current assets are
concentrated in cash or relatively illiquid inventories, and the maturity
schedule of its current liabilities.
b. Verizon’s times interest earned ratio over the 2001-2003 period is 1.94
([$3,496+$3,737]/$3,737), 3.18 ([$7,472+$3,422]/$3,422), and 3.16
([$6,344+$2,941]/$2,941), respectively. The total liabilities-to-equity ratio
over this period is 4.25 ([$170,795-$32,539]/$32,539), 4.13 ([$167,468$32,616]/$32,616), and 3.96 ([$165,968-$33,466]/$33,466). The level of
debt as measured by the total liabilities-to-Stockholders’ Equity ratio
has slightly decreased over the 2001-2003 period, but is still at a very
high absolute level. The times interest earned ratio is also at a fairly high
level. Although Verizon is highly leveraged, it appears to have the
operating profitability to cover its interest payments with a reasonable
cushion.
c. We might become concerned if Verizon’s industry continues to face
increasing levels of competition and capital expenditures (and, thus,
indebtedness) are projected to increase significantly.
E3-33 (30 minutes)
a. Viacom’s current ratio over the 2001-2003 period is 0.95 ($7,206/$7,562),
0.98 ($7,167/$7,341), and 1.02 ($7,736/$7,585), respectively. Viacom is
only just liquid as measured by the current ratio and is exhibiting a
slight trend toward improved liquidity.
We might want to know, however, whether Viacom’s current assets are
concentrated in cash or relatively illiquid inventories, and the maturity
schedule of its current liabilities.
b. Viacom’s times interest earned ratio over the 2001-2003 period is 1.68
([$656+$963]/$963), 5.36 ([$3,695+$848]/$848), and 4.69
([$2,861+$776]/$776), respectively. The total liabilities-to-equity ratio
over this period is 0.45 ([$90,810-$62,717]/$62,717), 0.44 ([$89,754$62,488]/$62,488), and 0.42 ([$89,849-$63,205]/$63,205). The level of debt
as measured by the total liabilities-to-Stockholders’ Equity ratio has
slightly decreased over the 2001-2003 period, and is not at a very high
absolute level. The times interest earned ratio is at a fairly high level.
Viacom is not highly leveraged, and it appears to have the operating
profitability to cover its interest payments with a reasonable cushion.
©Cambridge Business Publishers, 2006
16
Financial Accounting for MBAs, 2nd Edition
c. We would not have serious concerns about Viacom’s debt level despite
its relatively low current ratio. The company is not highly leveraged as
measured by the total liabilities-to-stockholders’ equity ratio and it has a
relatively high times interest earned ratio.
E3-34 (30 minutes)
a. Wal-Mart’s current ratio over the 2001-2003 period is 1.04
($28,246/$27,282), 0.93 ($30,483/$32,617), and 0.92 ($34,421/$37,418),
respectively. Wal-Mart is illiquid as measured by the current ratio and is
exhibiting a slight trend toward poorer illiquidity.
b. Wal-Mart’s times interest earned ratio over the 2001-2003 period is 8.38
([$10,751+$1,456]/$1,456), 11.72 ([$12,719+$1,187]/$1,187), and 13.45
([$14,193+$1,140]/$1,140), respectively. The total liabilities-to-equity ratio
over this period is 1.38 ([$83,451-$35,102]/$35,102), 1.41 ([$94,685$39,337]/$39,337), and 1.40 ([$104,912-$43,623]/$43,623). The level of
debt as measured by the total liabilities-to-Stockholders’ Equity ratio
has remained fairly constant over the 2001-2003 period, and is not at a
very high absolute level. The times interest earned ratio is at a
substantially high level. Wal-Mart is not highly leveraged, and it appears
to have the operating profitability to cover its interest payments with a
reasonable cushion.
c. Despite the relatively modest current ratio, we have no concerns about
Wal-Mart’s ability to manage its debt payments. Financial leverage is not
high and the company’s earnings are very strong compared with its
required interest payments.
©Cambridge Business Publishers, 2006
Solutions Manual, Module 3
17
PROBLEMS
P3-35 (30 minutes)
a.
2003
2002
49.0%
47.8%
Gross profit margin ..............................
($21,236 /
($19,249 /
$43,377)
$40,238)
30.9%
31.2%
Operating expense
($13,383 /
($12,571 /
margin ...................................................
$43,377)
$40,238)
12.5%
11.3%
Net operating profit
($7,853*.689)
($6,678*.682)
margin1 ..................................................
/ $43,377)
/ $40,238
2001
43.7%
($17,142 /
$39,244)
31.6%
($12,406 /
$39,244)
7.6%
($4,736*.633)
/ $39,244
2000
46.1%
($18,437 /
$39,951)
31.2%
($12,483 /
$39,951)
9.5%
($5,954*.64) /
$39,951
1-$2,344/$7,530 1-$2,031/$6,383
After-tax % ..................................................
= .689)
= .682
1-$1,694/$4,616
= .633
1-$1,994/$5,536
= .64
Procter & Gamble
1
b. 1. The improvement in net operating profit margin is due to an increase
in the gross profit margin and a reduction in operating expenses as a
percent of sales. The improvement in gross profit margin is unusual
as many companies find it difficult to increase gross profit margins in
a highly competitive market and must usually concentrate on
expense control in order to achieve gains in the net operating profit
margin.
2. In highly competitive markets, companies can only increase their
selling prices if they have a product that is relatively immune from
competition, say because of patent protection or technological
innovation. Lowering product costs may allow companies to increase
their gross profit margins as selling prices will be set by the
companies in the industry and will be based on “normal”
manufacturing costs. Product cost reductions can be achieved via
technological innovation that leads to more efficient production
processes, by substituting lower cost materials, and by outsourcing
production to lower labor cost environments.
c. Operating expenses for P&G are not broken out specifically in its 10-K,
as is common practice. We can only guess at the composition of this
account. It is likely that operating expenses for P&G include wage costs
for non-production personnel (production wages are included in COGS),
advertising expense, occupancy costs for property other than
production facilities, and the like. Companies can manage any or all of
these areas in order to achieve cost reduction. Some cost reductions,
©Cambridge Business Publishers, 2006
18
Financial Accounting for MBAs, 2nd Edition
such as in advertising, offer short-term gains at an, arguably, longerterm cost. Reducing wage costs by employee terminations and wage
freezes, may also produce short-term gains at a longer-term cost of loss
of morale, inefficiencies, and possible loss of customer service and
related goodwill.
P3-36 (30 minutes)
a.
Accounts receivable
($43,377 / [($3,038 +
turnover ...........................................................
$3,090) / 2]
2002
13.37
2001
13.44
($40,238 / [($3,090 +
$2,931) / 2]
($39,244 / [($2,931 +
$2,910) / 2]
25.56
Average collection
($3,038 / [$43,377 /
period...............................................................
365])
28.03
27.26
($3,090 / [$40,238 /
365])
($2,931 / [$39,244 /
365])
Procter & Gamble
2003
14.16
6.14
6.43
($22,141 / [$3,640 +
turnover ..........................................
$3,456] / 2)
6.24
($20,989 / [$3,456 +
$3,384] / 2)
($22,102 / [$3,384 +
$3,490] / 2)
60.01
Average inventory
($3,640 / [$22,141 /
days outstanding ............................................
365])
($3,456 / [$20,989 /
365])
1.73
Long-term operating
($43,377/([$24799 +
1
asset turnover ...............................................
$25,445] / 2)
1.74
1.87
$40,238 / ([$25,445 +
$20,759] / 2)
$39,244 / ([$20,759 +
$21,2942] / 2)
$40,776 - $12,166 $1,077 - $2,088 =
$25,445
$34,387 - $10,889 $894 - $1,845 =
$20,759
Inventory
1
Net long-term operating
assets
2
$43,706 - $15,220 $1,396 - $2,291 =
$24,799
60.10
55.88
($3,384 /[$22,102 / 365])
Net long-term operating assets for 2000 = $34,366 - $10,146 - $625 - $2,301 = $21,294
b. Improving the receivable turnover ratio is a delicate process. The
extension of credit is an important marketing tool. Restricting credit can
lead to a loss of sales and the resulting gross profit. Extending credit
too freely, while increasing sales, can lead to significant credit losses. In
order to improve the receivables turnover ratio, then, companies must
find ways of reducing the level of receivables relative to sales while not
offending their customer base. One way in which this can be done is to
improve the underwriting and collection process in order to eliminate
the segment of the customer base that usually leads to collection
problems. Another method is to offer cash incentives for early payment.
This can be profitable for the company if the return on the cash received
is greater than the discount offered.
c. The inventory turnover ratio measures the time for costs to flow from
raw materials to sales. This can be accomplished by reducing costs, so
that they can be absorbed more quickly with the current volume of
sales, or by reducing the cycle time for the manufacturing process
(eliminating bottlenecks, improving flow, etc.). Inventories for
©Cambridge Business Publishers, 2006
Solutions Manual, Module 3
19
manufacturing companies consist of raw materials, work-in-process,
and finished goods. Raw materials costs can be reduced by just-in-time
deliveries or holding the raw materials on consignment until possession
is taken at the start of the production process. Work-in-process
inventories are reduced by elimination of bottlenecks in the production
process. And finished goods inventories can be reduced by producing
to orders rather than producing to estimated demand (e.g., demand-pull
manufacturing).
d. The long-term operating asset turnover rate is difficult to affect because
it involves assets that are difficult to get rid of. Since companies cannot
easily divest of part of a manufacturing plant, improvement in the ratio
can usually be realized by increasing throughput (e.g., increased sales)
by using excess capacity to produce for other companies. This concept
has been used successfully by many companies forming corporate
alliances to spread manufacturing capacity over multiple users. This
concept has also been used to more efficiently utilize the investment in
information technology (IT). Gains in the long-term operating asset ratio
are difficult to realize and require creative thinking, but can lead to
significant improvements in total asset turnover and, consequently, in
RNOA and ROE.
P3-37 (30 minutes)
a.
Procter and Gamble
2003
1-($2,344/$7,530
= .689)
After-tax % ..........................................................
Net operating profit after-tax
$7,853 * .689 = $5,411
(NOPAT) ..............................................................
$43,706 - $300 ($12,358 - $2,172) Net operating assets (NOA) ............................
$1,396 - $2,291 =
$29,533
$2,172 + $11,475 - $300 =
Net financial obligations (NFO).........................
$13,347
$16,186
Stockholders’ Equity .........................................
1
1
2002
2001
1-$2,031/$6,383 = .682
1-$1,694/$4,616 = .633
$6,678 * .682 = $4,554
$4,736 * .633 = $2,998
$40,776 - $196 ($12,704 - $3,731) $1,077 - $2,088 =
$28,442
$3,731 + $11,201 - $196
= $14,736
$13,706
$34,387 - 212 ($9,846 - $2,233) $894 - $1,845 =
$23,823
$2,233 + $9,792 - $212
= $11,813
$12,010
Net long-term operating assets for 2000 = $34,366 - 185 - ($10,141 - $3,241) - $625 - $2,301 = $24,355
Procter and Gamble
2003
2002
1. Net operating profit margin
12.474%
11.318%
(NOPM) ..........................................................................................
($5411 / $43,377)
($4,554 / $40,238)
18.667%
17.427%
2. Return on net operating
assets
($5,411 / ([$29,533 +
($4,554 / ([$28,442 +
(RNOA) ..............................................................................
$28,442] / 2)
$23,823] / 2)
93.948%
103.239%
3. Financial leverage (FLEV) .......................................................
([$13,347 + $14,736 ] / 2) /
([$14,736 + $11,813] / 2) /
2001
7.639%
($2,998 / $39,244)
12.446%
($2,998 / ([$23,823 +
$24,355] / 2)
98.288%
([$13,706 + $12,010] / 2)
([$11,813 + $12,068] / 2) /
([$12,010 + $12,287] / 2)
1.585%
1.52%
4. Net financial rate (NFR) ...........................................................
($561 - $238) * .689 /
($603 - $308) * .682 /
($794 - $674) * .633 /
([$16,186 + $13,706] / 2))
0.638%
©Cambridge Business Publishers, 2006
20
Financial Accounting for MBAs, 2nd Edition
([$13,347 + $14,736] / 2)
([$14,736 + $11,813] / 2)
17.082%
15.907%
5. Spread .......................................................................................
(18.666% - 1.585%)
(17.427% - 1.52%)
34.698%
33.85%
6. Return on equity (ROE) ...........................................................
($5,186 /
($4,352 /
7. Formula computation of
ROE
([$11,813 + $12,068] / 2)
11.808%
(12.446% - 0.638%)
24.052%
([$16,186 + $13,706 / 2)
[$13,706 + $12,010] / 2)
($2,922 /
([$12,010 + $12,287 / 2)
18.667% + (93.948% x
17.082%) = 34.698%
17.427% + (103.239% x
15.907%) = 33.85%
12.446% + (98.288% x
11.808%) = 24.052%
b. P&G is utilizing both operating returns and financial leverage in order to
drive its ROE improvement. RNOA comprises 53.8% of ROE as of 2003.
Leverage has slightly decreased during the 2001-2003 period, and is
below the level of 2001, but is over twice the median of 0.40 for publicly
traded companies. RNOA has increased significantly from 12.446% in
2001 to 18.667% in 2003. This is a positive development as we would
generally prefer ROE to result more from RNOA than from financial
leverage.
P3-38 (30 minutes)
a.
Procter and Gamble
Current ratio (current
assets / current liabilities)
Quick ratio (quick assets /
current liabilities)
2003
2002
2001
2000
1.23
0.96
1.11
1.00
0.75
0.53
0.55
0.44
The current and quick ratios have been increasing over the 2000-2003
period, and are, nevertheless, at a reasonable level so as not to indicate a
liquidity problem.
b.
Procter and Gamble
2003
2002
Total liabilities-to-Equity .....................................
1.7
2.0
Times interest earned ..........................................
14.42
11.59
2001
1.9
6.81
2000
1.8
8.67
P&G’s financial leverage as measured by the total liabilities-to-equity ratio
has remained constant over the past 4 years. Its times interest earned ratio
is quite high, and indicates no concern for its debt-payment ability.
c. The Altman Z-Score for P&G as of 2003 is:
Z= 0.717 X1 + 0.847 X2 + 3.107 X3 + 0.420 X4 + 0.998 X5 = 2.12
where,
X1 = Working capital/ Total assets
X2 = Retained earnings/Total assets
X3 = Earnings before interest and taxes /Total assets
0.717x0.065=0.047
0.847x0.313=0.265
3.107x0.185=0.575
©Cambridge Business Publishers, 2006
Solutions Manual, Module 3
21
X4 = Equity/ Total liabilities
X5 = Sales/ Total assets
0.420x0.588=0.247
0.998x0.992=0.990
Z-Score= 2.124 .
P&G’s Z-score is in the gray area—the prediction is inconclusive.
P3-39 (30 minutes)
a.
Merck & Co.
2003
2002
1. Gross profit
80.8%
margin .................................................................
($22,485.9-$4,315.3) / $22,485.9
43.0%
2. OEM .................................................................
($6,394.9+$3,178.1+
$101.8) / $22,485.9
3. Tax expense /
pretax profit…
2001
81.8%
($21,445.8-$3,907.1) /
$21,445.8
82.9%
($21,199-$3,624.8) / $21,199
38.8%
38.5%
($5,652.2+$2,677.2) /
$21,445.8
($5,700.6+$2,456.4) /
$21,199
27.2%
29.6%
29.1%
$2,462/$9,051.6
$2,856.9/$9,651.7
$2,894.9/$9,948.1
29.0%
($22,485.9-$4,315.3-$6,394.94. Net operating
$3,178.1-101.8+474.2)*
profit margin .......................................................
[1-($2,462/$9,051.6)])
/ $22,485.9
32.3%
33.8%
($21,445.8-$3,907.1-$5,652.2$2,677.2+644.7) * [1($2,856.9/$9,651.7)]) /
$21,445.8
($21,199-$3,624.8-$5,700.6$2,456.4+$685.9) *
[1-($2,894.9/$9,948.1)]) /
$21,199
b. 1. The decline in net operating profit margin is primarily due to a
decrease in the gross profit margin and other income as a percentage
of sales, and an increase in operating expenses as a percent of sales.
MRK benefited by a reduction of the effective tax rate in 2003 from
29% of pre-tax income to 27.2%.
2. In highly competitive markets, companies can only increase their
selling prices if they have a product that is relatively immune from
competition, say because of patent protection or technological
innovation. For MRK, the loss of patent protection is a significant
issue. Lowering product costs may allow companies to increase their
gross profit margins. Product cost reductions can be achieved via
technological innovation that leads to more efficient production
processes, by substituting lower cost materials, and by outsourcing
production to lower labor cost environments.
c.
R&D is clearly important for companies like MRK. Even though an
increase in R&D adversely affects operating profit margins in the
short-run, they are critical to MRK’s long-term performance. Our
concern is not necessarily with the level of R&D, but with its
effectiveness. That is, what significant new products is the R&D
generating as opposed to incremental changes in existing products?
©Cambridge Business Publishers, 2006
22
Financial Accounting for MBAs, 2nd Edition
P3-40 (30 minutes)
a.
2003
Merck & Co.
2002
4.76
4.03
([$4,023.6+$5,423.4] /2)
$21,445.8 /
([$5,423.4+$5,215.4 / 2)
1. Accounts receivable turnover.................................... $22,485.9 /
65.31
92.3
$4,023.6/($22,485.9/365)
$5,423.4/($21,445.8/365)
Average collection period ..............................................
1.56
1.19
$4,315.3 /
([$2,554.7+$2,964.3]/2)
$3,907.1 /
([$2,964.3+$3,579.3]/2)
2. Inventory turnover ......................................................
216.08
276.92
$2,554.7/($4,315.3/365)
$2,964.3/($3,907.1/365)
1.35
3. Long-term operating asset
$22,485.9 /
turnover ............................................................................
) a
$21,445.8 /
([$18,741.5+$17,285.3]/2) a
Average inventory days outstanding ............................
1.19
([$14,688.8 + $18,741.5] / 2
Merck & Co.
2003
2002
2001
$14,169 + $1,085.4 +
$14,195.6 + $4,127 +
Long-term net
$864 + $5,000.7 $3,114 + $4,483.1 operating assets ..............................................................
$6,430.3 = $14,688.8
$7,178.2 = $18,741.5
$13,103.4 + $4,127 +
$3,364 + $3,481.7 $6,790.8 = $17,285.3
b. Improving the receivable turnover ratio is a delicate process. The
extension of credit is an important marketing tool. Restricting credit can
lead to a loss of sales and the resulting gross profit. Extending credit
too freely, while increasing sales, can lead to significant credit losses. In
order to improve the receivables turnover ratio, then, companies must
find ways of reducing the level of receivables relative to sales while not
offending their customer base. One way in which this can be done is to
improve the underwriting and collection process in order to eliminate
the segment of the customer base that usually leads to collection
problems. Another method is to offer cash incentives for early payment.
This can be profitable for the company if the return on the cash received
is greater than the discount offered.
c. The inventory turnover ratio measures the time for costs to flow from
raw materials to sales. This can be accomplished by reducing costs, so
that they can be absorbed more quickly with the current volume of
sales, or by reducing the cycle time for the manufacturing process
(eliminating bottlenecks, improving flow, etc.). Inventories for
manufacturing companies consist of raw materials, work-in-process,
and finished goods. Raw materials costs can be reduced by just-in-time
deliveries or holding the raw materials on consignment until possession
is taken at the start of the production process. Work-in-process
inventories are reduced by elimination of bottlenecks in the production
©Cambridge Business Publishers, 2006
Solutions Manual, Module 3
23
process. And finished goods inventories can be reduced by producing
to orders rather than producing to estimated demand (e.g., demand-pull
manufacturing).
d. The long-term operating asset turnover rate is difficult to affect because
it involves assets that are difficult to get rid of. Since companies cannot
easily divest of part of a manufacturing plant, improvement in the ratio
can usually be realized by increasing throughput (e.g., increased sales).
Many companies have addressed this issue by forming corporate
alliances with other companies to spread manufacturing capacity over
multiple users. Gains in the long-term operating asset ratio are difficult
to realize and require creative thinking, but can lead to significant
improvements in total asset turnover and, consequently, in RNOA and
ROE.
©Cambridge Business Publishers, 2006
24
Financial Accounting for MBAs, 2nd Edition
P3-41 (30 minutes)
a.
Merck & Co.
2003
2002
29.04%
($22,485.9-$4,315.3-$6,394.9-$3,178.11. Net operating profit
101.8+474.2)*
margin (NOPM) .............................................................................
[1-($2,462/$9,051.6)])
/ $22,485.9
2. Turnover of net
operating assets (NOAT)
32.35%
($21,445.8-$3,907.1-$5,652.2$2,677.2+644.7) * [1- ($2,856.9/$9,651.7)]) /
$21,445.8
1.162
0.955
$22.485.9/([$40,587.5 - $2,972 - $7,941.2 ($9,569.6 -$1,700 -$822.7) $6,430.3]+[$47,561.2 - $2,728.2 - $7,255.1 ($12,375.2 -$3,669.8 - $808.4) - $7,178.2] / 2)
$21,448.8 /( [$47,561.2 - $2,728.2 - $7,255.1 ($12,375.2 - $3,669.8 - $808.4) - $7,178.2] +
[$44,021.2 - $1,142.6 - $6,983.5 - ($11,544.2 $4,066.7 - $795.8) -$6,790.8] / 2)
33.748%
30.883%
[($22,485.9-$4,315.3-$6,394.9-$3,178.1101.8+474.2)*
[1-($2,462/$9,051.6)])] / [($40,587.5 - $2,972
3. Return on net operating
- $7,941.2 - ($9,569.6 -$1,700 -$822.7) $6,430.3)+($47,561.2 - $2,728.2 - $7,255.1 assets (RNOA) ..............................................................................
($12,375.2 -$3,669.8 - $808.4) - $7,178.2) / 2]
($21,445.8-$3,907.1-$5,652.2$2,677.2+644.7) * [1- ($2,856.9/$9,651.7)])/
([($47,561.2 - $2,728.2 - $7,255.1 - ($12,375.2
- $3,669.8 - $808.4) - $7,178.2) + ($44,021.2 $1,142.6 - $6,983.5 - ($11,544.2 - $4,066.7 $795.8) -$6,790.8)] / 2)
4. RNOA = NOPM x NOAT
33.748%=29.04% x 1.162
30.883%=32.35% x 0.955
-12.546%
-1.524%
(($1,700 + $5,096 - $2,972 - $7,941.2) +
5. Financial leverage
($3,669.8 + $4,879 - $2,728.2 - $7,255.1) / 2)
(FLEV) ............................................................................................
/ (($15,576.4+$3,915.2+$822.7) +
[($3,669.8 + $4,879 - $2,728.2 - $7,255.1) +
($4,066.7 + $4,798.6 - $1,142.6 - $6,983.5) / 2]
/ [($18,200.5 + $4,928.3 + $808.4) +
($16,050.1 + $4,837.5 + $795.8) / 2]
$18,200.5+$4,928.3+$808.4) / 2)
10.834
6. Net Financial Return
[(-$81.6 x (1-($2,462 / $9,051.6)) - $241.3] /
(($1,700 + $5,096 - $2,972 - $7,941.2) +
(NFR) ..............................................................................................
($3,669.8 + $4,879 - $2,728.2 - $7,255.1) / 2)
22.914%
7. Spread .......................................................................................
33.748%-10.834%
30.87%
8. Return on equity (ROE) ...........................................................
$6,830.9 / [($15,576.4 + $3,915.2 + $822.7)
9. ROE =
RNOA+FLEV*Spread
61.063%
[($202.3 x (1-($2,856.9 / $9,651.7)) - $354.7] /
[($3,669.8 + $4,879 - $2,728.2 - $7,255.1) +
($4,066.7 + $4,798.6 - $1,142.6 - $6,983.5) / 2]
-30.18%
30.883%-61.063%
31.343%
+ ($18,200.5 + $4,928.3 + 808.4)]/2
$7,149.5 / [($18,200.5 + $4,928.3 + 808.4) +
($16,050.1 + $4,837.5 + $795.8)]/2
30.87% =
33.748% + (-12.546% x 22.914%)
31.343% =
30.883% + (-1.524% x -30.18%)
b. MRK’s return on equity is less than its RNOA as a result of the negative
financial leverage (FLEV). Negative financial leverage arises when
financial assets exceed financial liabilities. In essence, MRK’s high cost
equity capital is financing lower earning financial assets rather than
higher earning operating assets.
©Cambridge Business Publishers, 2006
Solutions Manual, Module 3
25
P3-42 (30 minutes)
a.
Merck & Co.
Current ratio
Quick ratio
2003
2002
2001
1.20
1.16
1.12
$11,527.2 / $9,569.6
$14,386.4 / $12,375.2
$12,961.6 / $11,544.2
0.86
0.84
0.74
($1,201 + $2,972 + $4,023.6) /
$9569.6
($2,243 + $2,728.2 + $5,423.4 /
$12,375.2
($2,144 + $1,142.6 + $5,215.4 /
$11,544.2
The current and quick ratios have been increasing over the 2001-2003
period. This is indicative of an increasing level of financial liquidity.
b.
Merck & Co.
2003
2002
2001
1.12
1.06
Total liabilities($9,569.6 + $5,906 + $6,430.3 ($12,375.2 + $4,879 + $7,178.2)
to-Equity .....................................................................
/ ($15,576.4 + $3,915.2)
/ ($18,200.5 + $4,928.3)
($11,544.2 + $4,798.6 + $6,790.8)
/ ($16,050.1 + $4,837.5)
1.11
Times interest
48.71
earned ...................................................................
N/A
($9,651.7 + $202.3) / $202.3
($9,948.1+$155) / $155
65.18
MRK’s financial leverage has remained constant over the past 3 years, and
is not at an excessive level. Its times interest earned ratio is quite high, and
indicates no concern for its debt-payment ability. In 2003, MRK reported net
interest income and, therefore, the times interest earned ratio is not
meaningful.
©Cambridge Business Publishers, 2006
26
Financial Accounting for MBAs, 2nd Edition
P3-43 (30 minutes)
a.
1
2
3
4
5
6
1
Colgate-Palmolive
2003
1
NOPAT ....................................................................................$1,507.7
Net operating profit margin2 .................................................. 15.2%
2
NOA3 ........................................................................................$3,990.0
Average NOA...........................................................................$3,972.1
Return on net operating assets (RNOA)............................... 38.0%
3
Average NFO4..........................................................................$3,353.4
Average equity ........................................................................ $618.7
Financial leverage (FLEV) ......................................................
5.42
4
Net financial expense (NFE)5 .................................................
Net financial return (NFR)6 .....................................................
$86.4
2.6%
5
Spread (RNOA-NBC) ..............................................................
35.4%
6
Return on equity (ROE=NI/AveSE) ........................................ 229.7%
7
Return on equity (ROE=RNOA+[FLEV×Spread]) ................. 229.9%
2003 NOPAT = $2,166.0 [1 – ($620.6/$2,041.9)] = $1,507.7
2003 NOPAT margin = $1,507.7 / $9,903.4 = $15.2%
NOA(2003) = Total Assets less non-operating assets – Total Liabilities less nonoperating liabs
($7,478.8 - $0) - ($6,591.7 - $103.6 - $314.4 - $2,684.9) = $3,990.0
NOA(2002) = ($7,087.2 - $0) - ($6,736.9 - $94.6 - $298.5 - $3,210.8) = $3,954.2
NFO(2003) = Non-operating liabilities – Non-operating assets
($103.6 + $314.4 + $2,684.9) - ($0) = $3,102.9
NFO(2002) = ($94.6 + $298.5 + $3,210.8) - ($0) = $3,603.9
NFE(2003) = NOPAT – NI = $1,507.7 - $1,421.3 = $86.4
Or, alternatively, NFE can be estimated as follows:
NFE(2003) = Interest Expense (1-tax rate) = $124.1 x [1- [620.6/2041.9]) = $86.4
NFR(2003) = NFE / AveNFO = $86.4 / $3,353.4 = 2.6%
b. Colgate is utilizing both operating returns and financial leverage to drive
its ROE. RNOA comprises 17% of ROE in 2003 (38%/229.7%) and
leverage drives the remaining 83%. Leverage is considerable for
Colgate—that is, each dollar from owners is matched by $5.42 from
nonowners. This is markedly higher than the median of about 0.40 for
publicly traded companies. We generally prefer ROE to result more from
RNOA than from leverage. Colgate may have difficulty sustaining its
current level of leverage and the return on that leverage.
©Cambridge Business Publishers, 2006
Solutions Manual, Module 3
27
c.
1
2
3
1
Colgate-Palmolive
2003
Gross profit margin .............................................................. 55.0%
SGAM .................................................................................... 33.3%
NOPAT 1 ................................................................................. $1,507.7
Net operating profit margin ................................................. 15.2%
2003 NOPAT = $2,166.0 [1 – ($620.6/$2,041.9)] = $1,507.7
d. In highly competitive markets, companies can only increase their selling
prices if they have a product that is relatively immune from competition,
say, because of patent protection or technological innovation.
Lowering product costs may allow companies to increase their gross
profit margins as selling prices are set by companies in the industry (via
equilibrium mechanisms) and are based on ‘normal’ manufacturing
costs. Product cost reductions can be achieved via technological
innovation that leads to more efficient production processes, by
substituting lower cost materials, and by outsourcing production to
lower labor cost environments.
e. It is likely that SG&A expenses include wage costs for non-production
personnel (production wages are included in COGS), advertising
expense, occupancy costs for property other than production facilities,
and the like. Companies can manage any or all of these areas to achieve
cost reductions.
Some cost reductions, like advertising and research & development,
offer short-term gains at an, arguably, longer-term cost. Reducing wage
costs by employee terminations and wage freezes, may also produce
short-term gains at a longer-term cost of loss of morale, inefficiencies,
and possible loss of customer service and related goodwill.
f.
1
2
3
4
Colgate-Palmolive
2003
Accounts receivable turnover ...............................................
8.37
Average collection period ......................................................45.1 days
Inventory turnover ..................................................................
6.41
Average inventory days outstanding ...................................58.8 days
Notes: Average receivables = $1,183.9
Average daily sales = 27.13
Average inventory = $695.0
Average daily cost of sales = 12.21
©Cambridge Business Publishers, 2006
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Financial Accounting for MBAs, 2nd Edition
g. Improving the receivable turnover ratio is a delicate process. The
extension of credit is an important marketing tool. Restricting credit can
lead to a loss of sales and the resulting gross profit. Extending credit
too freely, while increasing sales, can lead to substantial credit losses.
To improve the receivables turnover ratio, companies must find ways of
reducing the level of receivables relative to sales while not offending
their customer base. One way in which this can be done is to improve
the underwriting and collection process to eliminate the segment of the
customer base that usually leads to collection problems. Another
method is to offer cash incentives for early payment. This can be
profitable for the company if the return on the cash received is greater
than the discount offered.
h. Inventory turnover measures the time for costs to flow from raw
materials to sales. This can be accomplished by reducing costs, so that
they can be absorbed more quickly with the current volume of sales, or
by reducing the cycle time for the manufacturing process (eliminating
bottle necks, improving flow, etc.). Inventories for manufacturing
companies consist of raw materials, work-in-process, and finished
goods. Raw materials costs can be reduced by just-in-time deliveries or
holding the raw materials on consignment until possession is taken at
the start of the production process. Work-in-process inventories are
reduced by elimination of bottlenecks in the production process.
Finished goods inventories can be reduced by producing to orders
rather than producing to estimated demand (e.g., demand-pull
manufacturing).
i. Altman Z-Score of Colgate for 2003 is computed below using this model:
Z= 0.717 X1 + 0.847 X2 + 3.107 X3 + 0.420 X4 + 0.998 X5
where,
X1 = Working capital/ Total assets
X2 = Retained earnings/Total assets
X3 = Earnings before interest & tax/
Total assets
X4 = Equity/ Total liabilities
X5 = Sales/ Total assets
=0.0068
=0.9939
× 0.717 = 0.0049
× 0.847 = 0.8418
=0.2896
=0.1346
=1.3242
× 3.107 = 0.8998
× 0.420 = 0.0565
× 0.998 = 1.3215
Z-Score = 3.1245
Colgate’s Z-score of 3.1245 is in the ‘low probability of bankruptcy’
region.
©Cambridge Business Publishers, 2006
Solutions Manual, Module 3
29
P3-44 (30 minutes)
a.
NOPAT margin vs. NOA turnover
NOPAT margin
14.00%
12.00%
10.00%
8.00%
6.00%
4.00%
2.00%
0.00%
0.00
1.00
2.00
3.00
4.00
Net operating asset tunrover rate
The graph generally reveals the margin/turnover tradeoff.
b. High performing companies are those that exhibit a higher profit margin
holding asset turnover constant, and have a higher turnover holding
profit margin constant. Increasing RNOA requires managers to manage
both the income statement and the balance sheet.
©Cambridge Business Publishers, 2006
30
Financial Accounting for MBAs, 2nd Edition