income to total assets. Return on common equity is found by
dividing net income into common equity.
e. Market value ratios relate the firm’s stock price to its earnings
and book value per share. The price/earnings ratio is calculated by
dividing price per share by earnings per share--this shows how much
investors are willing to pay per dollar of reported profits. The
price/cash flow is calculated by dividing price per share by cash
flow per share. This shows how much investors are willing to pay
per dollar of cash flow. Market-to-book ratio is simply the market
price per share divided by the book value per share. Book value per
share is common equity divided by the number of shares outstanding.
f. Trend analysis is an analysis of a firm’s financial ratios over
time. It is used to estimate the likelihood of improvement or
deterioration in its financial situation. Comparative ratio
analysis is when a firm compares its ratios to other leading
companies in the same industry. This technique is also known as
g. The Du Pont chart is a chart designed to show the relationships
among return on investment, asset turnover, the profit margin, and
leverage. The Du Pont equation is a formula which shows that the
rate of return on assets can be found as the product of the profit
margin times the total assets turnover.
h. Window dressing is a technique employed by firms to make their
financial statements look better than they really are. Seasonal
factors can distort ratio analysis. At certain times of the year a
firm may have excessive inventories in preparation of a “season” of
high demand. Therefore an inventory turnover ratio taken at this
time as opposed to after the season will be radically distorted.
3-2 The emphasis of the various types of analysts is by no means uniform
nor should it be. Management is interested in all types of ratios for
two reasons. First, the ratios point out weaknesses that should be
strengthened; second, management recognizes that the other parties are
interested in all the ratios and that financial appearances must be
kept up if the firm is to be regarded highly by creditors and equity
investors. Equity investors are interested primarily in profitability,
but they examine the other ratios to get information on the riskiness
of equity commitments. Long-term creditors are more interested in the
debt ratio, TIE, and fixed-charge coverage ratios, as well as the
profitability ratios. Short-term creditors emphasize liquidity and
look most carefully at the liquidity ratios.
3-3 The inventory turnover ratio is important to a grocery store because of
the much larger inventory required and because some of that inventory
is perishable. An insurance company would have no inventory to speak
of since its line of business is selling insurance policies or other
similar financial products--contracts written on paper and entered into
between the company and the insured. This question demonstrates the
Learning Objectives: 3 - 2 The Dryden Press
b. Common equity is determined at a point in time, say December 31,
2001. Profits are earned over time, say during 2001. If a firm is
growing rapidly, year-end equity will be much larger than beginning-
of-year equity, so the calculated rate of return on equity will be
different depending on whether end-of-year, beginning-of-year, or
average common equity is used as the denominator. Average common
equity is conceptually the best figure to use. In public utility
rate cases, people are reported to have deliberately used end-of-
year or beginning-of-year equity to make returns on equity appear
excessive or inadequate. Similar problems can arise when a firm is
3-9 Firms within the same industry may employ different accounting
techniques which make it difficult to compare financial ratios. More
fundamentally, comparisons may be misleading if firms in the same
industry differ in their other investments. For example, comparing
Pepsico and Coca-Cola may be misleading because apart from their soft
drink business, Pepsi also owns other businesses such as Frito-Lay,
Pizza Hut, Taco Bell, and KFC.
3-10 Total Effect
Current Current on Net
Assets Ratio Income
a. Cash is acquired through issuance of
additional common stock. + + 0
b. Merchandise is sold for cash. + + +
c. Federal income tax due for the previous
year is paid. - + 0
d. A fixed asset is sold for less than
book value. + + -
e. A fixed asset is sold for more than
book value. + + +
f. Merchandise is sold on credit. + + +
g. Payment is made to trade creditors for
previous purchases. - + 0
h. A cash dividend is declared and paid. - - 0
i. Cash is obtained through short-term bank
loans. + - 0
j. Short-term notes receivable are sold at
a discount. - - -
k. Marketable securities are sold below cost. - - -
Learning Objectives: 3 - 4 The Dryden Press
b. The financial statements and ratios for the scenario in which the
cost of goods sold decreases by an additional $125,000 are shown
below. As you can see, the profit ratios are quite high and the
stock price has risen to $66.24.
INPUT DATA: KEY OUTPUT:
2002 Firm Industry
Cash $ 159,527 Quick 1.4 1.0
A/R 395,000 Current 3.2 2.7
Inventories 700,000 Inv. turn. 6.1 7.0
Land and bldg. 238,000 DSO 33 32
Machinery 132,000 F.A.turn. 8.3 13.0
Other F.A. 150,000 T.A.turn. 2.4 2.6
ROA 14.3% 9.1%
Accts. & notes pay. $ 275,000 ROE 26.0% 18.2%
Accruals 120,000 TD/TA 45.0% 50.0%
Long-term debt 404,290 PM 5.9% 3.5%
Common stock 575,000 EPS $11.04 n.a.
Retained earnings 400,237 Stock Price $66.24 n.a.
P/E ratio 6.0 6.0
Total assets $1,774,527 M/B 1.56 n.a.
Total claims $1,774,527
Cost of G.S. 3,325,000
Adm. & sales exp. 248,775
Net income $ 253,935
P/E ratio 6
No. of shares 23,000
Cash dividend $ 0.95
c. The financial statements and ratios for the scenario in which the
cost of goods sold increases by $125,000 over the revised estimate
are shown below. As you can see, profits would decline sharply.
The ROE would drop to 12.6%, EPS would fall to $4.52, the stock
price would drop to $27.11, and the M/B ratio would be only 0.76.
Percent Change Income
2000 2001 2002E
Sales 0.0% 70.0% 105.0%
COGS 0.0% 100.0% 113.0%
Other exp. 0.0% 100.0% -8.0%
Depr. 0.0% 518.8% 534.9%
EBIT 0.0% -430.3% 140.4%
Int. Exp. 0.0% 181.6% 28.0%
EBT 0.0% -691.1% 188.3%
Taxes 0.0% -691.1% 188.3%
NI 0.0% -691.1% 188.3%
WE SEE THAT 2002 SALES GROW 105% FROM 2000, AND THAT NI GROWS
188% FROM 2000. SO COMPUTRON HAS BECOME MORE PROFITABLE. WE SEE
THAT TOTAL ASSETS GROW AT A RATE OF 138%, WHILE SALES GROW AT A RATE
OF ONLY 105%. SO ASSET UTILIZATION REMAINS A PROBLEM.
H. USE THE EXTENDED DU PONT EQUATION TO PROVIDE A SUMMARY AND OVERVIEW
OF COMPUTRON’S FINANCIAL CONDITION AS PROJECTED FOR 2002. WHAT ARE
THE FIRM’S MAJOR STRENGTHS AND WEAKNESSES?
PROFIT TOTAL ASSETS EQUITY
ANSWER: DU PONT EQUATION = MARGIN × TURNOVER × MULTIPLIER
= 3.6% × 2.01 × 1/(1 - 0.5561) = 16.3%.
STRENGTHS: THE FIRM’S FIXED ASSETS TURNOVER WAS ABOVE THE INDUSTRY
AVERAGE. HOWEVER, IF THE FIRM’S ASSETS WERE OLDER THAN OTHER FIRMS
IN ITS INDUSTRY THIS COULD POSSIBLY ACCOUNT FOR THE HIGHER RATIO.
(COMPUTRON’S FIXED ASSETS WOULD HAVE A LOWER HISTORICAL COST AND
WOULD HAVE BEEN DEPRECIATED FOR LONGER PERIODS OF TIME.) THE FIRM’S
PROFIT MARGIN IS SLIGHTLY ABOVE THE INDUSTRY AVERAGE, DESPITE ITS
HIGHER DEBT RATIO. THIS WOULD INDICATE THAT THE FIRM HAS KEPT COSTS
DOWN, BUT, AGAIN, THIS COULD BE RELATED TO LOWER DEPRECIATION COSTS.
WEAKNESSES: THE FIRM’S LIQUIDITY RATIOS ARE LOW; MOST OF ITS ASSET
MANAGEMENT RATIOS ARE POOR (EXCEPT FIXED ASSETS TURNOVER); ITS DEBT
MANAGEMENT RATIOS ARE POOR, MOST OF ITS PROFITABILITY RATIOS ARE LOW
(EXCEPT PROFIT MARGIN); AND ITS MARKET VALUE RATIOS ARE LOW.
I. USE THE FOLLOWING SIMPLIFIED 2002 BALANCE SHEET TO SHOW, IN GENERAL
TERMS, HOW AN IMPROVEMENT IN THE DSO WOULD TEND TO AFFECT THE STOCK
PRICE. FOR EXAMPLE, IF THE COMPANY COULD IMPROVE ITS COLLECTION
PROCEDURES AND THEREBY LOWER ITS DSO FROM 44.9 DAYS TO THE 32-DAY
INDUSTRY AVERAGE WITHOUT AFFECTING SALES, HOW WOULD THAT CHANGE
“RIPPLE THROUGH” THE FINANCIAL STATEMENTS (SHOWN IN THOUSANDS
BELOW) AND INFLUENCE THE STOCK PRICE?
ACCOUNTS RECEIVABLE $ 878 DEBT $1,945
OTHER CURRENT ASSETS 1,802
NET FIXED ASSETS 817 EQUITY 1,552
TOTAL ASSETS $3,497 PLUS EQUITY $3,497
ANSWER: SALES PER DAY = $7,035,600/360 = $19,543.
ACCOUNTS RECEIVABLE UNDER NEW POLICY = $19,543 × 32 DAYS
FREED CASH = OLD A/R - NEW A/R = $878,000 - $625,376 = $252,624.
J. DOES IT APPEAR THAT INVENTORIES COULD BE REDUCED, AND, IF SO, HOW
SHOULD THAT ADJUSTMENT AFFECT COMPUTRON’S PROFITABILITY AND STOCK
ANSWER: THE INVENTORY TURNOVER RATIO IS LOW. IT APPEARS THAT THE FIRM
EITHER HAS EXCESSIVE INVENTORY OR SOME OF THE INVENTORY IS OBSOLETE.
IF INVENTORY WERE REDUCED, THIS WOULD IMPROVE THE LIQUIDITY RATIOS,
THE INVENTORY AND TOTAL ASSETS TURNOVER, AND THE DEBT RATIO, WHICH
SHOULD IMPROVE THE FIRM’S STOCK PRICE AND PROFITABILITY.
K. IN 2001, THE COMPANY PAID ITS SUPPLIERS MUCH LATER THAN THE DUE
DATES, AND IT WAS NOT MAINTAINING FINANCIAL RATIOS AT LEVELS CALLED
FOR IN ITS BANK LOAN AGREEMENTS. THEREFORE, SUPPLIERS COULD CUT
THE COMPANY OFF, AND ITS BANK COULD REFUSE TO RENEW THE LOAN WHEN
IT COMES DUE IN 90 DAYS. ON THE BASIS OF DATA PROVIDED, WOULD YOU,
AS A CREDIT MANAGER, CONTINUE TO SELL TO COMPUTRON ON CREDIT? (YOU
COULD DEMAND CASH ON DELIVERY, THAT IS, SELL ON TERMS OF COD, BUT
THAT MIGHT CAUSE COMPUTRON TO STOP BUYING FROM YOUR COMPANY.)
SIMILARLY, IF YOU WERE THE BANK LOAN OFFICER, WOULD YOU RECOMMEND
RENEWING THE LOAN OR DEMAND ITS REPAYMENT? WOULD YOUR ACTIONS BE
INFLUENCED IF, IN EARLY 2002, COMPUTRON SHOWED YOU ITS 2002
PROJECTIONS PLUS PROOF THAT IT WAS GOING TO RAISE OVER $1.2 MILLION
OF NEW EQUITY CAPITAL?
ANSWER: WHILE THE FIRM’S RATIOS BASED ON THE PROJECTED DATA APPEAR TO BE
IMPROVING, THE FIRM’S LIQUIDITY RATIOS ARE LOW. AS A CREDIT
MANAGER, I WOULD NOT CONTINUE TO EXTEND CREDIT TO THE FIRM UNDER ITS
CURRENT ARRANGEMENT, PARTICULARLY IF I DIDN’T HAVE ANY EXCESS
CAPACITY. TERMS OF COD MIGHT BE A LITTLE HARSH AND MIGHT PUSH THE
FIRM INTO BANKRUPTCY. LIKEWISE, IF THE BANK DEMANDED REPAYMENT THIS
COULD ALSO FORCE THE FIRM INTO BANKRUPTCY.
CREDITORS’ ACTIONS WOULD DEFINITELY BE INFLUENCED BY AN INFUSION
OF EQUITY CAPITAL IN THE FIRM. THIS WOULD LOWER THE FIRM’S DEBT
RATIO AND CREDITORS’ RISK EXPOSURE.
L. IN HINDSIGHT, WHAT SHOULD COMPUTRON HAVE DONE BACK IN 2000?
ANSWER: BEFORE THE COMPANY TOOK ON ITS EXPANSION PLANS, IT SHOULD HAVE DONE
AN EXTENSIVE RATIO ANALYSIS TO DETERMINE THE EFFECTS OF ITS PROPOSED
EXPANSION ON THE FIRM’S OPERATIONS. HAD THE RATIO ANALYSIS BEEN
CONDUCTED, THE COMPANY WOULD HAVE “GOTTEN ITS HOUSE IN ORDER” BEFORE
UNDERGOING THE EXPANSION.
M. WHAT ARE SOME POTENTIAL PROBLEMS AND LIMITATIONS OF FINANCIAL RATIO
ANSWER: SOME POTENTIAL PROBLEMS ARE LISTED BELOW:
1. COMPARISON WITH INDUSTRY AVERAGES IS DIFFICULT IF THE FIRM
OPERATES MANY DIFFERENT DIVISIONS.
2. DIFFERENT OPERATING AND ACCOUNTING PRACTICES DISTORT COMPARISONS.
3. SOMETIMES HARD TO TELL IF A RATIO IS “GOOD” OR “BAD.”
4. DIFFICULT TO TELL WHETHER COMPANY IS, ON BALANCE, IN A STRONG OR
5. “AVERAGE” PERFORMANCE IS NOT NECESSARILY GOOD.
6. SEASONAL FACTORS CAN DISTORT RATIOS.
7. “WINDOW DRESSING” TECHNIQUES CAN MAKE STATEMENTS AND RATIOS LOOK
N. WHAT ARE SOME QUALITATIVE FACTORS ANALYSTS SHOULD CONSIDER WHEN
EVALUATING A COMPANY’S LIKELY FUTURE FINANCIAL PERFORMANCE?
ANSWER: TOP ANALYSTS RECOGNIZE THAT CERTAIN QUALITATIVE FACTORS MUST BE
CONSIDERED WHEN EVALUATING A COMPANY. THESE FACTORS, AS SUMMARIZED
BY THE AMERICAN ASSOCIATION OF INDIVIDUAL INVESTORS (AAII), ARE AS
1. ARE THE COMPANY’S REVENUES TIED TO ONE KEY CUSTOMER?
2. TO WHAT EXTENT ARE THE COMPANY’S REVENUES TIED TO ONE KEY PRODUCT?
3. TO WHAT EXTENT DOES THE COMPANY RELY ON A SINGLE SUPPLIER?
4. WHAT PERCENTAGE OF THE COMPANY’S BUSINESS IS GENERATED OVERSEAS?
6. FUTURE PROSPECTS
7. LEGAL AND REGULATORY ENVIRONMENT