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CHAPTER 13 FINANCIAL STATEMENT ANALYSIS Changes from Eleventh Edition Updated from Eleventh Edition Approach Although it is not possible to do this precisely, the financial statement analysis discussion is more coherent, we believe, if it is built around Illustration 13-1. The theme is that the financial statement proxy for shareholder value is return on investment, and the ratios help explain why a given return was not satisfactory (if it was not), or at least identify the areas that need investigation. As with Chapter 8, the amount of attention given to this chapter depends on whether or not the students are taking or will take a course in finance. In such a course, they will, of course, deal considerably more with financial statement analysis than is contained in this introductory treatment. When a finance course is given, we do not assign the chapter, but suggest only that students skim through it. Students should not get the impression that there is one “best” list of ratios to be memorized. Although the 24 given in Illustration 13-3 could be expanded still further, in practice the analyst will select the ratios most appropriate for a given industry setting. Cases Genmo Corporation is a “backwards” case in which students deduce the financial statements of General Motors Corporation from the ratios. Amerbran Company (B) is a case involving straightforward calculation of ratios. Identify the Industries--1996 is a case showing companies in the different industries can have quite disparate values of their ratios. Supplement to Identify the Industries is a case showing companies in the different industries can have quite disparate values of their ratios. Springfield National Bank is a case in financial analysis as the basis for a lending decision. It involves both the calculation of ratios and the exercise of judgment. Quality Furniture Company is a case involving a credit decision. Sears, Roebuck and Co. vs Wal-Mart Stores, Inc examines two companies with a similar return on equity but very different business strategies. Portor Lumber Company, Inc. involves preparation of proforma financial statements using financial ratios. This case has been moved from Chapter 14 to Chapter 13 for the Twelfth Edition.

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Problems Problem 13-1 a. Profit Margins M  Net income 54   .05 (5 percent) M  Sales 1,080 N  Net income 122   .10 (10 percent) N  Sales 1,215

N has the higher profit margin. b. Investment Turnover M  Sales 1,080   6x M  Investment 180 N  Sales 1,215   3x N  Investment 405

M has the higher investment turnover. c. Return on Investment

M  Net income M-Sales   .05 x 6  .30 (30 percent) M  Sales M-Investment N  Net income N  Sales



N  Sales N  Investment

 .10 x 3  .30 (30 percent)

Both firms have similar returns on investments. Based on this investment criterion, the investments are equally attractive.

Problem 13-2 Since the division has no control over the financing of its assets employed in its operation, the most appropriate measure of return on investment to use to judge its performance is Net income excluding interest expense Average total assets



$54,000  ($4,200 x .7) ($400,000  $525,000)/2



$56,940 $462,500

= .123 (12.3 percent).

Problem 13-3

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Current Year Days' cash  

$5,479,296 ($83,138,408 / 365)

$5,479,296 $227,776

= 24 days Preceeding Year Days' cash  

$6,123,704 ($99,748,943 / 365)

$6,123,704 $273,285

= 22.4 days The new controller holds more cash relative to the company’s cash expenses than did the old controller. The higher level may be safer (i.e. less chance of not meeting payments when due), but what is its cost? If the cash balance is excessive, the excess is a low-return use of cash compared to investing it in higher return assets.

Problem 13-4 Current Year Accounts receivable days  

$1,392,790 ($13,035,085 / 365)

$1,392,790 $35,713

= 39 days Previous Year Accounts receivable days  

$1,207,393 ($11,597,327 / 365)

$1,207,3930 $31,774

= 38 days The new policy has not changed the payment practices of customers in any material way.

Problem 13-5

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Average inventory 

Anthony/Hawkins/Merchant

($58,160  $62,880) 2

= $60,520 $60,520 ($300,000 / 365)

Days' inventory 



$60,520 $822

= 74 days Inventory turnover 

$300,000 $60,520

= 5 times Ms. Whitney’s utilization of her investment in inventory is lower than for similar companies.

Problem 13-6 Price/earnings ratio 



$82 ($20,000,000/2,000,000 shares)

$82 $10

= 8.2 times Dividend yield 

$5.74 82

= .07 (7 percent) Dividend payout  

($5.74 x 2,000,000 shares) $20,000,000

$11,480,000 $20,000,000

= 57.4 percent

Problem 13-7

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$1,750,000,000 $250,000,000

Working capital turnover 

= 7 times Capital intensity 

$1,750,000,000 $525,000,000

= 3.33 times Equity turnover 

$1,750,000,000 $1,500,000,000

= 1.17 times

Cases Case 13-1 Genmo Corporation

*

Note: Unchanged from the Eleventh Edition. Approach This case increases an understanding of ratios and of financial statement relationships by requiring the student to work backwards from the straightforward description of ratios given in the text. It requires a clear understanding and considerable deductive reasoning. The numbers are those of General Motors Corporation for 1986 and 1987, divided by 10,000; that is, in 1986 General Motors had revenues of $97.8 billion. (GMAC is not consolidated; consolidation was required beginning in 1988 (FASB 94), which made the ratios illustrated here less interpretable.) The case therefore gives the student a picture of relationships in this huge corporation and is more interesting than a mechanical calculation. In particular, reasons for a relatively low current ratio and high inventory turnover (virtually no inventory of completed cars) can be discussed. Discussion In several instances, alternative ways of calculating a ratio were possible. In each, the correct alternative can be found by checking the way the ratios actually were computed in 1986 (2001 in the case). Financial statements and the method of calculating each item are given in Ex. A. The 1987 (2002 in the case) return on shareholders’ equity was 9.60 percent. The 1986 and 1987 ROE performance trend was obviously unsatisfactory from a longer-term perspective, and 9.60 percent was unsatisfactory given AAA bond returns in 1987.

Exhibit A *

This teaching note was prepared by Robert N. Anthony. Copyright © Robert N. Anthony.

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9. 10. 11. 12. 13.

GENMO CORPORATION Balance Sheet as of December 31, 2002 Assets Cash and marketable securities.......................................................................................................................................... $ 416 Accounts receivable........................................................................................................................................................... 1,117 Subtotal: quick assets...................................................................................................................................................... 1,533 Inventories......................................................................................................................................................................... 872 Prepaid expenses................................................................................................................................................................ 273 Total current assets.......................................................................................................................................................... 2,678 Noncurrent assets............................................................................................................................................................... 4,524 Total assets................................................................................................................................................................... $7,202 Liabilities and Equity Current liabilities............................................................................................................................................................... $2,285 Noncurrent liabilities.......................................................................................................................................................... $1,885 Shareholders’ equity........................................................................................................................................................... 3,032 Total invested capital.......................................................................................................................................................... 4,917 Total liabilities and shareholders’ equity...................................................................................................................... $7,202

14. 15. 16. 17. 18.

Income Statement, 2002 Revenues............................................................................................................................................................................ $10,281 Cost of sales....................................................................................................................................................................... 8,727 Gross margin...................................................................................................................................................................... 1,554 Other expense.................................................................................................................................................................... 1,263 Net Income......................................................................................................................................................................... $ 291

Line 1. 2. 3. 4. 5. 6. 7. 8.

Notes Line 1. 2. 3. 4. 5. 6. 7. 8. 9. 10.

Line 3 - line 2 Revenue (10,281) * days’ receivables (39.66) / 365 Current liabilities (2,285) * quick ratio (0.671) Cost of sales (line 15)  inventory turnover (10.005) Line 6 - (line 3 + line 4) Current liabilities (2,285) * current ratio (1.172) Line 8 - line 6 Same as line 13 Given Let debt = X; then X  (4,917 - X) = 0.6215 (debt/equity). Solving, X = 1,885. (The 4,917 comes from line 12.) 11. Line 12 - line 10 12. Revenues (10,281) / invested capital turnover (2.091) 13. Line 9 + line 12 14. Given 15. Line 14 - line 16 16. Revenues (10,281) * gross margin percentage (0.1512) 17. Line 16- line 18 18. Revenue (10,281)* profit margin percentage (0.02831) Case 13-2: Amerbran (B)* *

This teaching note was prepared by James S. Reece. Copyright © James S. Reece.

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Note: This case is unchanged from the Eleventh Edition. Approach This is a straightforward exercise in calculating various ratios for two years’ of an actual company’s (American Brands) financial statements. Although the numbers have been revised, the magnitudes and relationships have been preserved. (Most of the data appear in Exhibit 1 of Amerbran Company (A).) I discuss question 1 after the gross margin percentage has been calculated, and question 2 after all of the ratios have been presented. It is worthwhile to have students give the definition of each ratio and a brief statement as to what it indicates before presenting their numbers for the ratio for space each year. The required calculations are shown in the table below. The only tricky one is days’ cash. For 20x0, no information is available in either the (A) or (B) case to estimate cash expenses. For 20xl, two approaches are available. One is to use the “quick and dirty” estimate of total expenses less depreciation (given in item 1 of the (A) case), which results in an estimate of $7,177,930; this is the approach taken for 20xl in the table below. Of course, a better option would be to use a variation on the approach from preparing the cash flow statement for the (A) case: Cash generated by operations was $574,128. Collections would have been sales less the increase in accounts receivable: $7,622,677 - $68,827 = $7,553,850. Thus cash expenses would have been $7,553,850 - $574,128 = 6,979,722. With this number the 20xl days’ cash result would have been 1.51 days. For 20x0, the approach taken here was to take 20xl depreciation, $115,974 and multiply it by the ratio of 20x0 to 20xl property, plant, and equipment (at cost), giving an estimate of $101,198. Other approaches are also possible, but aren’t likely to change the result very much since depreciation is such a small percentage of total expenses (1.6 percent in 20xl). Question 1 Some years ago in looking at some oil company annual reports, I discovered (to my surprise) that there was not uniform treatment of excise taxes on gasoline. Some companies included excise taxes in revenues and then subtracted them below the gross margin line as a period cost (nonincome tax expense). Other companies ignored excise taxes altogether in their statements, reflecting the view that the company was in effect an involuntary tax collector and that the taxes collected were neither revenues nor expenses to the firm. (I personally support this view.) The pretax income reported by the two approaches is identical, but the absolute amount of revenues is inflated by the first approach, thus affecting the gross margin percentage (and any other ratio that involves revenues in its calculation). Amerbran Company collects excise taxes on tobacco products and uses the approach of including the excise taxes in revenues and subtracting them as an expense but with the twist of treating the taxes as a product cost (pregross margin) rather than as a period cost. This approach results in the same absolute amount of gross margin as if the taxes were ignored altogether. However, it makes the company’s sales look greater by a significant amount: in 20x0, revenues excluding the taxes would have been $4,223,130, or 36 percent lower than the amount reported. On the other hand, treating the taxes as a product cost reduces the gross margin percentage. For example, with the taxes included in revenues but subtracted below the gross margin line, in 20x0 the percentage would have been $4,004,130 / $6,577,480 = 60.9%; and with the taxes ignored altogether the percentage would have been $1,649,780 / $4,223,130 = 39.1%. As treated by Amerbran, the 20x0 gross margin percentage was 25.1%. Thus, one must speculate that the company sees some advantage in trying to downplay (i.e., understate) its actual margin while at the same time overstating its size (revenues). Question 2 This question is intended to get students to think about the ratios, not just mindlessly calculate them. It also suggests that ratio analysis raises questions, but it seldom automatically answers them, and that some

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important questions are only indirectly related to the ratios. The overriding question is why net income was down 13 percent from 20x0 to 20xl while revenues (including excise taxes) were up 16 percent: this is directly reflected in the decreased net income percentage (return on sales) ratio. (I stress that though this ratio is down only 1.45 percentage points, this is a decrease in the ratio of 25 percent.) This profit margin question also at least indirectly relates to the downward trend in interest coverage, ROA, and ROE. In fact, improved asset turnover (as well as equity turnover, which students weren’t asked to calculate) helped offset part of the effect on ROA (and ROE) of the lower profit margin. Since the gross margin percentage actually increased slightly in 20xl, the explanation of the narrowed profit margin must lie in SG&A expenses, which were 14.8 percent of sales in 20x0 but 17.4 percent in 20xl. The decline in the current and acid-test ratios may not be a concern, but rather may simply reflect better credit and inventory management (notice that collection period days’ receivables is down and inventory turnover is up). Financial leverage as measured by the debt/capitalization ratio has declined a bit, but even in 20x0 was at a relatively safe level for a firm of this basic stability.

1 .

2 .

3 .

4 .

Definition 20x0 20xl Return [Net Income + [$378,782 + [$328,773 on Assets.......................................................................................................................................................................................................... Interest $105,165 $102,791 *(1-Tax Rate)] *(1-.4394)] = 0.0987 *(1-.455l)] = 00797 = 9.87% = 7.97% Total Assets $4,433,448 $4,826,512

Return Net Income $378,782 $328,773 on Equity......................................................................................................................................................................................................... = .1735 = 0.1417 = = Shareholders’ $2,182,869 $2,320,620 17.35 14.17 Equity % % Gross Gross Margin $1,649,780 $1,931,438 Margin = 0.2508 = 0.2534 Percentage....................................................................................................................................................................................................... = = Net Sales Revenue $6,577,480 $7,622,677 25.08 25.34 % % Return Net Income $378,782 $328,773 on Sales........................................................................................................................................................................................................... = 0.0576 = 0.0431 = 5.76% = 4.31% Net Sales Revenue $6,577,480 $7,622,677

5 .

Asset Sales Revenue $6,577,480 $7,622,677 Turnover.......................................................................................................................................................................................................... = 1.48 = 1.58 Times Times Total Assets $4,433,448 $4,826,512

6 .

Days’ Cash $23,952 $28,912 Cash................................................................................................................................................................................................................. = 1.43 = 1.47 Days Days Cash Expenses / ($6,198,698 ($7,293,904 365 $101,198)/365 $115,974/365

7 .

Days’ Accounts $687,325 $756,152 Receivables..................................................................................................................................................................................................... Receivable = 38.1 = 36.2 Days Days Sales / 365 $6,577,480/365 $7,622,677/365

8 .

Days’ Inventory $1,225,402 $1,244,912 Inventories....................................................................................................................................................................................................... = 173.8 = 162.1 Days Days Cost of sales / 365 $2,573,350/365 $2,803,623/365

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9 .

Inventory Cost of Sales $2,573,350 $2,803,623 Turnover............................................................................................................................................................................................ = 2.10 = 2.25 Times Times Inventory $1,225,402 $1,244,912

1 0 .

Current Current Assets $2,013,846 $2,106,116 Ratio.................................................................................................................................................................................................. = 1.53 = 1.30 Current Liabilities

1 1 .

$1,317,751

$1,625,218

Acid-Test Monetary Current $711,277 $785,064 Ratio.................................................................................................................................................................................................. Assets = 0.54 = 0.48 Current Liabilities

$1,317,751

$1,625,218

1 2 .

Debt/ Noncurrent $932,828 $880,674 Capitalizatio Liabilities = 0.2994 = 0.2751 n = = Ratio.................................................................................................................................................................................................. 29.94 27.51 (Noncurrent $932,828 + $880,674 + % % Liabilities $2,182,869 $2,320,620 + Shareholder’s Equity)

1 3 .

Times Pretax Operating Interest Profit $675,659 + $105,165 $603,331 + Earned............................................................................................................................................................................................... + Interest = 7.42 $102,791 = 6.87 times Times Interest $105,165 $102,791

Case 13-5: Springfield Bank* Note: Unchanged from the Eleventh Edition. Approach This case was used by Professor Ray G. Stephens in a study of the use of accounting information by bank lending officers. For a full account of the study, see Ray G. Stephens, The Uses of Financial Information in Structuring and Improving Decision Processes for Bank Lending Officers (an unpublished thesis, Harvard Business School). The data for Dawson Stores, Inc., are the consolidated 1974 - 77 financial statements for Dayton-Hudson Corporation, multiplied by 13 and / 1,000. Excerpts from interviews with three loan officers are given below to indicate the diversity of approaches to the problem. (The loan officers reviewed the data before the multiplier effect used in this case.) In addition, students can act as loan officers, presenting various arguments supported by ratio analysis. Loan Officer B Loan Officer B read the first two pages of the empirical study problem and turned to the financial statements. In examining the financial statement, he noted: (1) accounts receivable were up, (2) company *

This teaching note was prepared by Ray G. Stephens. Copyright © Ray G. Stephens.

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had deferred taxes on installment sales which he inferred meant that they were selling fixed assets off. (3) questioned the accounts receivable as he would think that the company would be primarily a cash business, (4) wondered what the bad debt write-offs were, (5) wondered whether the company would be better off factoring accounts receivable, (6) was curious about the purpose of the requested line of credit because of the nonutilization of bank credit in the past, but felt that it would be a desirable account from the deposit balances, and (7) wondered to whom the long-term debt was owed. At this point Loan Officer B felt that he could not make a decision about the extension of credit without further clarification on four issues: (1) What were the credit terms of Dawson stores, Inc.? (2) Had the company changed stores recently? (3) Who was the lender on the long-term debt? and (4) What did the company feel was the purpose of the request for funds and when would the funds be used and repaid? Loan Officer D Loan Officer D started with a comment about Mr. Dawson leaving the statements without an opportunity for the lending officer to discuss his need for funds. In actual practice, he would expect more complete statements of this type. Loan Officer D then focused upon the current assets section of the statement of financial position as communicating most about the companies’ need for the loan: The need for cash or working capital (a better word) has to come from his current position, wherein the inventory or the receivables reach such a point they’re not turning fast enough to support the cash outlay; they’re not turning fast enough or there’s some sort of . . . they’re out of kilter [There is something out of kilter between the relationship of ] the three: receivables, inventory, and cash, so he has to have satisfied me that the reason for this increase in receivables or inventory is legitimate. After having satisfied himself as to the legitimacy of the increase, Loan Officer D then proceeded to compute the following ratios: current, acid, debt/equity, sales/receivables, sales/merchandise (inventory), profits/equity, and payables/purchases. He started out to compute only the first five and computed the others also. The first five were felt to be basic to all companies while the latter were felt to be relevant for this specific firm (from some later comments, we infer due probably to the retail nature of the company). Loan Officer D was more interested in the trend of a specific ratio than in the absolute value of the financial ratio. Loan Officer D’s processing up to this point indicated that the company was a strong candidate as a loan recipient. The only uncertainty was the amount of the loan, which would be granted. The detailed cash flow statements previously requested would be utilized to determine the amount that the Loan Officer would make a commitment of the bank to loan. Loan Officer D was not concerned with the 19-day slowdown in accounts receivable collection, which the sales/merchandise ratio (computed in days) indicated. Loan Officer D would, however, request the endorsement of the two Dawson brothers as principals, even though they did not have controlling ownership of the company, due to his bank’s standard policies. Loan Officer E Loan Officer E computed the following ratios: cost of sales/inventory, cost of sales/payables, cost of revenues, operating expenses/revenues, earnings before income taxes/revenues, and net earnings/revenues. While reviewing the cash flow statements, he placed a large question mark by “Mortgages assumed by purchasers of office properties and prepayment on long-term debt.” Loan Officer E then computed what the accounts payable would have been if they had remained at the same level as the first year which was contained in the empirical study problem. His computation was undertaken in the belief that the increase in accounts payable from $1,153,000 (33 days) to $2,272,000 (49 days) indicated the amount of undercapitalization of the firm. This indicated that the firm was undercapitalized by

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approximately $900,000 ($2,272,000 - $1,400,000). If the company had its payables at the end of ‘03 down to approximately the 30-day level which they were at three years ago, although I don’t know it was probably satisfactory, their payables would have been down to whatever the satisfactory level is, which we assume [is] maybe 30 days, and the bank would have found itself with a $900,000 unsecured loan at the time of the year when a retailer should be most liquid and out of debt. Clearly, he’s telling me that this year he needs $1,000,000 more than he needed last year, or one could say that last year he needed $900,000, so maybe he needs a little bit more money than he needed last year. Loan Officer E was also concerned about Dawson Stores, Inc., paying out so much in dividends. Over the last four years, dividends amounted to approximately $600,000, which represented a large portion of the amount that Loan Officer E felt that the company was undercapitalized. Combined with the lack of breakdown in operating expenses, Loan Officer E was unable to tell how much money the officers were taking out of the firm. Further, Loan Officer E was concerned about the real estate operation of the firm. He felt that managing real estate was not their business. Combining this with the information about the sale of office properties, he further confirmed his antipathy toward granting a seasonal $1,000,000 loan commitment. Summarizing, Loan Officer E said: Well, there’s sufficient information here to indicate that the company is undercapitalized and that basically [through] the analysis I did with accounts payable, most of it has come to light. The company is undercapitalized. I don’t want to capitalize it with unsecured debt; . . . if this was something [a loan request] coming in from the outside, I would probably just reject it without asking for additional information. Given that it is a long-term customer of the bank, I would seek out additional information to see if it would [become a loan situation]. Loan Officer E would express apprehensions to the loan requester in several areas: dividends, carrying retail accounts receivable, real estate operations, and owning their own real estate. Loan Officer E felt that his comments would be applicable to companies 10 times or 100 times as large.

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