Garrisonch Chapter 14

BONUS Chapter



Chapter 1   Managerial Accounting and the Business Environment

14

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Chapter 4   Systems Design: Process Costing

Learning Objectives After studying Chapter 14, you should be able to:

1.

Explain the need for and limitations of financial statement analysis.



2.

Prepare a trend and common-size balance sheet and income statement.

3.

Compute and interpret the financial ratios used by the common shareholder.

4.

Explain what is meant by the term financial leverage and show how financial leverage is measured.

5.

Compute and interpret the financial ratios used by the short-term creditor.

6.

Compute and interpret the financial ratios used by the long-term creditor.

Tim Hortons Inc., 2006 Annual Report: Excerpts Tim Hortons became a separate public company again on September 29, 2006, when Wendy’s spun off controlling interest by distributing the shares it owned to its shareholders. Thus Tim’s provided its own annual report for the full year ended December 31, 2006. Tim Hortons’ reported revenues of $1.7 billion for 2006, an increase of approximately 12% over 2005. They reported this increase was made up of an increase in same store revenues, price increases and revenues of new restaurants. Operating income before tax and interest expense amounted to $379.2 million, a 30.7% increase over 2005. An analysis of the reasons is provided in their management discussion and analysis contained in the annual report. Net income increased 35.8% in 2006 and amounted to $259.6 million. They state that the increase in net income was less than the increase in operating income because of increases in interest expense and higher income taxes. The management discussion provides estimates of growth levels for 2007 and some of the risk factors expected in attempting to achieve this growth. Two such factors are increased construction costs and labour shortages. Many more facts and analyses can be found in the full annual report. The quarterly financial reports provide more timely information than the annual report but they are not as detailed and they are not audited. For example, a quarterly report for March 31, 2007, is available providing a timely update on 2006. The question addressed in the upcoming chapter is how investors and creditors make sense of the many pages in the annual and quarterly reports. For management, the questions are: Have we satisfied the reporting regulations? How will we be viewed by our investors? How do we compare to our competitors? Source: Tim Hortons, 2006 Annual Report.

Business focus



“HOW WELL AM I DOING?” FINANCIAL STATEMENT ANALYSIS

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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

A

ll financial statements are essentially historical

documents. They tell what has happened during a particular period of time. However, most users of financial statements are concerned about what will happen in the future. For example, shareholders are concerned with future earnings and dividends. Creditors are concerned with the company’s future ability to repay its debts. Managers are concerned with the company’s ability to finance future expansion and how statement users will view their performance. Despite the fact that financial statements are historical documents, they can still provide valuable information bearing on all of these concerns. Financial statement analysis involves careful selection of data from financial statements for the primary purpose of forecasting the financial health of the company. This is accomplished by examining trends in key financial data, comparing financial data across companies, and analyzing key financial ratios. In this chapter, we consider some of the more important ratios and other analytical tools that analysts use in attempting to predict the future course of events in business organizations. Managers are also vitally concerned with the financial ratios discussed in this chapter. First, the ratios provide indicators of how well the company and its business units are performing. Some of these ratios would ordinarily be used in a balanced scorecard approach as discussed in Chapter 11 in the textbook. The specific ratios selected depend on the company’s strategy. For example, a company that wants to emphasize responsiveness to customers may closely monitor the inventory turnover ratio discussed later in this chapter. Second, since managers must report to shareholders and may wish to raise funds from external sources, they must pay attention to the financial ratios used by external investors to evaluate the company’s investment potential and credit­worthiness.

Need for and Limitations of Financial Statement Analysis Learning Objective 1

Explain the need for and limitations of financial statement analysis.

The Internal Use of Ratios From the perspective of top management, ratio analysis can serve as a useful tool for performance evaluation; analysis of threats, constraints, and opportunities; and strategic planning. As was discussed in Chapter 11 in the textbook, ratios such as ROI combined with other measures can aid in evaluating the performance of individual unit managers. Further, ratios such as the current ratio and debt ratio can be calculated to determine whether managers are operating in accordance with contractual agreements regarding restrictions such as minimum working capital requirements and borrowing limitations. Ratios are helpful in formulating policy and in developing an ongoing organizational plan. A deeper awareness of the total business environment is essential for long‑term growth and survival. Key business ratios of competitors, customers, and suppliers can be calculated to provide input data for marketing strategy. Indeed, regular monitoring of competitors may help to predict competitors’ reactions to pricing and production decisions. Key ratios for customers can prove to be valuable in assessing their ability to honour their purchase commitments. Ratios for suppliers can provide signals about their ability to meet deadlines and other contractual provisions. In summary, ratios of competitors, customers, and suppliers are of great potential value in the competitive struggle for business survival and growth.

Benchmarking Financial statements are not only historical documents but also are essentially static documents. They speak only of the events of a single period of time. However, statement users are concerned about more than just the present; they are also concerned about the www.mcgrawhill.ca/olc/garrison



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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

trend of events over time. For this reason, financial statement analysis directed toward a single period is of limited usefulness. The results of financial statement analysis for a ­particular period are of greater value only when viewed in comparison with the results of other periods (intrafirm analysis) and, in some cases, with the results of other firms (interfirm analysis). It is only through comparison that one can gain insight into trends and make intelligent judgements as to their significance. Ratios of other firms in the same industry can serve as standards by which to make comparisons. Industry ratios are available from a number of sources such as Statistics Canada (CANSIM), which provides statistics for 14 key ratios. (See Exhibit 14–10 at the end of this chapter for a list of sources.) Rather than industry averages, the ratios of the most successful firms may be chosen as standards of comparison. This is known as benchmarking, a process of continuously measuring a firm against the best firms in the industry. In today’s increasingly competitive inter­national environment, successful firms set benchmarks based on the highest industry standards. The most successful companies emphasize the highest standards in terms of cost efficiency, quality products and services, and customer focus. Once industry benchmarks are chosen, a manager can make individual comparisons. Depending on the direction and extent of any deviation from a ratio’s benchmark, a judgement is made as to whether a particular ratio is good, bad, or satisfactory. Plans should then be put in place by management to address any weak spots while maintaining strengths. This requires looking beyond ratios and seeking out detailed information on what best practices successful firms use. It is not always easy to obtain sensitive information from competitors but much can be learned by visiting both competing and non-competing firms and by keeping up to date with recent industry and trade publications and talking with knowledgeable industry experts, discriminating customers, and discerning suppliers. Industry benchmarks should be interpreted with caution. For example, structural or technological change in an industry can cause a benchmark to become outdated and limit its usefulness. Used properly, benchmarks should lead both production and service firms to continuous quality improvements. The aim is to be the best in all value‑added activities in terms of lower costs, better quality, and greater customer satisfaction. This may necessitate major changes to value chain activities and the elimination of non‑value‑added activities. Such major changes are referred to as re-engineering or restructuring. Ratios should be interpreted in the context of management’s chosen competitive strategy. If the chosen strategy is high turnover/low profit margin, benchmarks should reflect the performance of companies with a similar strategic focus and may not be comparable to firms that employ a lower turnover/high profit margin strategy. For example, a successful company with a low turnover/high profit margin strategy would react with less concern to ratios reflecting lower cost control, because it can recover its cost through the relatively higher prices it charges for its goods or services. Customers are willing to pay more because of real or perceived differences in the firm’s product or services. On the other hand, a company with a high turnover/low profit margin strategy would be unable to pass these costs on to customers. Such companies are no‑frill operations that attempt to keep costs as low as possible. Successful companies using this strategy are profitable as a consequence of their high sales volume. Even a small change in unit cost will make a relatively large impact on total cost because many units are affected. High cost for a firm following this strategy translates into lower profits and may severely threaten a firm’s ability to compete. Although financial statement analysis is a highly useful tool, it has two limitations that we must mention before proceeding any further. These two limitations involve the comparability of financial data between companies and the need to look beyond ratios.

Comparison of Financial Data Comparisons of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare the companies’ financial data. For www.mcgrawhill.ca/olc/garrison

Benchmarking

The process of measuring a firm against the most ­successful firms in the industry.

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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

example, if one firm values its inventories by the FIFO method and another firm by the average cost method, then direct comparisons of financial data such as inventory valuations and cost of goods sold between the two firms may be misleading. Sometimes enough data is presented in footnotes to the financial statements to restate data on a comparable basis. Otherwise, the analyst should keep in mind the lack of comparability of the data before drawing any definite conclusions. Nevertheless, even with this limitation in mind, comparisons of key ratios with other companies and with industry averages often suggest avenues for further investigation.

The Need to Look Beyond Ratios An inexperienced analyst may assume that ratios are sufficient in themselves as a basis for judgements about the future. Nothing could be further from the truth. Conclusions based on ratio analysis must be regarded as tentative in nature. Ratios should not be viewed as an end, but rather they should be viewed as a starting point, as indicators of what to pursue in greater depth. They raise many questions, but they rarely answer any questions by themselves. In addition to ratios, other sources of data should be analyzed in order to make judgements about the future of an organization. The analyst should look, for example, at industry trends, technological changes, changes in consumer tastes, changes in broad economic factors, and changes within the firm itself. A recent change in a key management position, for example, might provide a basis for optimism about the future, even though the past performance of the firm (as shown by its ratios) may have been mediocre.

Statements in Comparative and Common-Size Form Statements in Comparative and Common-Size Form Learning Objective 2

Prepare a trend and commonsize balance sheet and income statement.

Few figures appearing on financial statements have much significance standing by themselves. It is the relationship of one figure to another and the amount and direction of change over time that are important in financial statement analysis. How does the analyst key in on significant relationships? How does the analyst dig out the important trends and changes in a company? Three analytical techniques are widely used: 1. Dollar and percentage changes on statements. 2. Common-size statements. 3. Ratios. The first and second techniques are discussed in this section; the third technique is discussed in the next section. To illustrate these analytical techniques, we analyze the financial statements of Example Company, a supplier of computer and cellphone components. While Example Company is artificial and may differ from specific real companies, it provides an opportunity to view the complete range of analysis. Thus after studying Example Company, modifications of the illustrated analysis can be made to accommodate the specifics of a real company.

Dollar and Percentage Changes on Statements A good place to begin in financial statement analysis is to put statements in comparative form. This consists of little more than putting two or more years’ data side by side. Statements cast in comparative form underscore movements and trends and may give the analyst valuable clues as to what to expect. Examples of financial statements placed in comparative form are given in Exhibits 14–1 and 14–2. These statements of Example Company reveal the firm has been experiencing substantial growth. The data on these statements are used as a basis for discussion throughout the remainder of the chapter.

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changes in dollar form helps the analyst focus on key factors that have affected profitability or financial position. For example, observe in Exhibit 14–2 that sales for 2008 were up $4 million over 2007, but that this increase in sales was more than negated by a $4.5 million increase in cost of goods sold.

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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

EXHIBIT 14–1 14–1   Comparative Comparative Exhibit

EXAMPLE COMPANY Comparative Balance Sheet December 31, 2008 and 2007 (dollars in thousands)

Balance Sheet Sheet Balance

Increase (Decrease) 2008

2007

Amount

Percent

$ 2,350 4,000 10,000 120

$(1,150) 2,000 (2,000) 180

(48.9)%* 50.0% (20.0)% 150.0%

(970)

Assets Current assets: Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,200 Accounts receivable, net . . . . . . . . . . . . 6,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Prepaid expenses . . . . . . . . . . . . . . . . . 300 Total current assets . . . . . . . . . . . . . .

15,500

16,470

Property and equipment: Land . . . . . . . . . . . . . . . . . . . . . . . . . . . Buildings and equipment, net . . . . . . . .

4,000 12,000

4,000 8,500

Total property and equipment . . . . . .

16,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . $31,500

(5.9)%

–0– 3,500

–0–% 41.2%

12,500

3,500

28.0%

$28,970

$ 2,530

8.7%

Liabilities and Shareholders Equity Current liabilities: Accounts payable . . . . . . . . . . . . . . . . . $ 5,800 Accrued payables . . . . . . . . . . . . . . . . . 900 Notes payable, short term . . . . . . . . . . . 300

$ 4,000 400 600

$ 1,800 500 (300)

45.0% 125.0% (50.0)%

2,000

40.0%

Total current liabilities . . . . . . . . . . . .

7,000

5,000

Long-term liabilities: Bonds payable, 8% . . . . . . . . . . . . . . . .

7,500

8,000

Total liabilities . . . . . . . . . . . . . . . . .

14,500

13,000

Shareholders equity: Preferred shares, $6 no par, $100 liquidation value . . . . . . . . . . . . Common shares, 500 no par . . . . . . . . .

2,000 7,000

2,000 7,000

–0– –0–

–0–% –0–%

Total paid-in capital . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . .

9,000 8,000

9,000 6,970

–0– 1,030

–0–% 14.8%

Total shareholders equity . . . . . . .

17,000

15,970

1,030

6.4%

Total liabilities and shareholders equity . . . . . . . . . . . . . . . $31,500

$28,970

$ 2,530

8.7%

(500) 1,500

(6.3)% 11.5%

*Since we are measuring the amount of change between 2007 and 2008, the dollar amounts for 2007 become the base figures for expressing these changes in percentage form. For example, Cash decreased by $1,150 between 2007 and 2008. This decrease expressed in percentage form is computed as follows: $1,150 � $2,350 � 48.9%. Other percentage figures in this exhibit and Exhibit 14–2 are computed in the same way.

Horizontal Analysis

Comparison of two or more years’ financial data is known as horizontal analysis or trend analysis. Horizontal analysis is facilitated by showing changes between years in both dollar and percentage form, as has been done in Exhibits 14–1 and 14–2. Showing changes in dollar form helps the analyst focus on key factors that have affected profitability or financial position. For example, observe in Exhibit 14–2 that sales for 2008 were up $4 million over 2007, but that this increase in sales was more than negated by a $4.5 million increase in cost of goods sold. www.mcgrawhill.ca/olc/garrison

Horizontal or trend analysis

A side-by-side comparison of two or more years’ financial statements.

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Exhibit Comparative EXHIBIT 14–2 14–2    Comparative

EXAMPLE COMPANY Comparative Income Statement and Reconciliation of Retained Earnings For the Years Ended December 31, 2008 and 2007 (dollars in thousands)

Income Income and Retained Earnings Earnings Statement Statement

Increase (Decrease) 2008 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52,000 Cost of goods sold . . . . . . . . . . . . . . . . . . 36,000

2007

Amount

$48,000 31,500

$4,000 4,500

Percent 8.3% 14.3%

Gross margin . . . . . . . . . . . . . . . . . . . . . .

16,000

16,500

(500)

(3.0)%

Operating expenses: Selling expenses . . . . . . . . . . . . . . . . . . Administrative expenses . . . . . . . . . . . .

7,000 5,860

6,500 6,100

500 (240)

7.7% (3.9)%

Total operating expenses . . . . . . . . . .

12,860

12,600

260

2.1%

Operating income . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . .

3,140 640

3,900 700

(760) (60)

(19.5)% (8.6)%

Net income before taxes . . . . . . . . . . . . . . Less income taxes (30%) . . . . . . . . . . . . .

2,500 750

3,200 960

(700) (210)

(21.9)% (21.9)%

Net income . . . . . . . . . . . . . . . . . . . . . . . .

1,750

2,240

$ (490)

(21.9)%

Dividends to preferred shareholders, $6 per share (see Exhibit 14–1) . . . . . .

120

120

1,630

2,120

600

600

1,030

1,520

6,970

5,450

Retained earnings, end of year . . . . . . . . . $ 8,000

$ 6,970

Net income remaining for common shareholders . . . . . . . . . . . . . . . . . . . . . Dividends to common shareholders, $1.20 per share . . . . . . . . . . . . . . . . . . . Net income added to retained earnings . . . . . . . . . . . . . . . . . Retained earnings, beginning of year . . . . . . . . . . . . . . . . . . . . . . . . . .

Showing changes between years in percentage form helps the analyst to gain Showing changes between years in percentage form helps the analyst to gain perperspective and to gain a feel for the significance of the changes that are taking place. A spective and to gain a feel for the significance of the changes that are taking place. A $1 million increase in sales is much more significant if the prior year’s sales were $2 $1 million increase in sales is much more significant if the prior year’s sales were $2 milmillion than if the prior year’s sales were $20 million. In the first situation, the increase lion than if the prior year’s sales were $20 million. In the first situation, the increase would be 50%—undoubtedly a significant increase for any firm. In the second situation, would be 50%—undoubtedly a significant increase for any firm. In the second situation, the increase would be only 5%—perhaps just a reflection of normal growth. the increase would be only 5%—perhaps just a reflection of normal growth.

S

Trend percentages

The expression of several years’ financial data in percentage form in terms of a base year.

Trend percentages

The expression of several years’ financial data in percentage form in terms of a base year.

Trend Percentages Horizontal Horizontal analysis of financial statements can also be carried out Trend Percentages analysis of financial statements can also be carried out by computing trend percentages. Trend percentages state several years’ financial data by computing trend percentages. Trend percentages state several years’ financial data in in terms of a base year. The base year equals 100%, with all other years stated as some terms of a base year. The base year equals 100%, with all other years stated as some perpercentage of this base. To illustrate, consider Tim Hortons which vies with other fast centage of this base. To illustrate, consider TELUS, which vies with BCE and Rogers for food suppliers for a position the fast food field. Tim Hortons enjoyed tremendous growth position in the communications field. TELUS enjoyed tremendous growth in the last in the last number of years, as evidenced by the following data: number of years, as evidenced by the following data: Tim Hortons Inc.

TELUS Consolidated

Income Statement (millions) Income Statement (millions)

2003

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating revenues . . . . . . . . $7,146.0 Operating income . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . 331.5 Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2006

2002

2001

2005

2000

1999

2004

1998

$1,659.5 $1,482.0 $1,338.3 $7,006.7 $7,202.6 $6,106.4 $5,588.9 $5,560.1 379.2 290.0 319.3 (229.0) 461.0 67.01 259.6 453.5 191.1 349.8 205.1

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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

By simply looking at these data, one can see that sales increased in nearly every year since 2004. But how rapidly have sales been increasing and have the increases in net income kept pace with the increases in sales? By looking at the raw data alone, it is difficult to answer these questions. The increases in sales and the increases in net income can be put into better perspective by stating them in terms of trend percentages, with 2004 as the base year. These percentages (all rounded) are given below: Tim Hortons Inc. Income Statement (millions)

2006

2005*

2004

Revenues . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating income . . . . . . . . . . . . . . . . . . . . . . . . . Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

124.0 118.8 126.6

110.7 90.8 93.2

100 100 100

*For 2005: $1,482.0/$1,338.3 = 1.107; 290.0/319.3 = .908; 191.1/205.1 = .932

The trend analysis is particularly striking when the data are plotted as shown in Exhibit 14–3. Tim Hortons’ sales growth has been impressive since 2004, but the growth in net income has been more sporadic.

Common-Size Statements Key changes and trends can also be highlighted by the use of common-size statements. A common-size statement is one that shows the items appearing on it in percentage form as well as in dollar form. Each item is stated as a percentage of some total of which that item is a part. The preparation of common-size statements is known as vertical analysis. Common-size statements are particularly useful when comparing data from dif­ferent companies. For example, in a recent year Tim Hortons’ revenue was $1,659.5 million. Since there are few Canadian comparatives, you might look at Starbucks Corporation for their 52 weeks ended October 1, 2006. Starbucks’ revenue was $7,786.9 million U.S. This comparison is somewhat misleading because of the dramatically different size but a perspective may be gained by using operating income as a percentage of revenues: Tim Hortons 22.9% (379.2/1659.5); Starbucks 11.5% (893.9/7786.9). The common size comparison now favours Tim Hortons. The questions for further analyis is why the difference.

Common-size statement

A statement that shows the items appearing on it in percentage form as well as in dollar form. On the income statement, the percentages are based on total sales revenue; on the balance sheet, the percentages are based on total assets.

Vertical analysis

The presentation of a company’s financial statements in commonsize form.

The Balance Sheet One application of the vertical analysis idea is to state the separate

assets of a company as percentages of total assets. A common-size statement of this type is shown in Exhibit 14–4 for Example Company. Notice from Exhibit 14–4 that placing all assets in common-size form clearly shows the relative importance of the current assets as compared to the non-current assets. It also shows that significant changes have taken place in the composition of the current assets over the last year. Notice, for example, that the receivables have  increased in relative importance and that both cash and inventory have declined in relative importance. Judging from the sharp increase in receivables, the  deterioration in the cash position may be a result of an inability to collect from c­ ustomers.

Exhibit 14–3    Tim Hortons

Tim Hortons Trends

Trend Analysis of Sales and Net Income

Percentage Change

150 100

Sales Net Income

50 0

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1

2 Years

3

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EXHIBIT CommonSize Exhibit 14–4    Common Size Balance Balance SheetSheet

Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

EXAMPLE COMPANY Common-Size Comparative Balance Sheet December 31, 2008 and 2007 (dollars in thousands) Common-Size Percentages 2008

2007

2008

2007

$ 2,350 4,000 10,000 120

3.8%* 19.0% 25.4% 1.0%

8.1% 13.8% 34.5% 0.4%

Assets Current assets: Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,200 Accounts receivable, net . . . . . . . . . . . . . . . 6,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,000 Prepaid expenses . . . . . . . . . . . . . . . . . . . . 300 Total current assets . . . . . . . . . . . . . . . . .

15,500

16,470

49.2%

56.9%

Property and equipment: Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Buildings and equipment, net . . . . . . . . . . .

4,000 12,000

4,000 8,500

12.7% 38.1%

13.8% 29.3%

Total property and equipment . . . . . . . . .

16,000

12,500

50.8%

43.1%

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . $31,500

$28,970

100.0%

100.0%

$ 4,000 400 600

18.4% 2.8% 1.0%

13.8% 1.4% 2.1%

Liabilities and Shareholders Equity Current liabilities: Accounts payable . . . . . . . . . . . . . . . . . . . . $ 5,800 Accrued payables . . . . . . . . . . . . . . . . . . . . 900 Notes payable, short term . . . . . . . . . . . . . . 300 Total current liabilities . . . . . . . . . . . . . . .

7,000

5,000

22.2%

17.3%

Long-term liabilities: Bonds payable, 8% . . . . . . . . . . . . . . . . . . .

7,500

8,000

23.8%

27.6%

Total liabilities . . . . . . . . . . . . . . . . . . . .

14,500

13,000

46.0%

44.9%

Shareholders equity: Preferred shares, $6 no par, $100 liquidation value . . . . . . . . . . . . . . . Common shares, 500 no par . . . . . . . . . . . .

2,000 7,000

2,000 7,000

6.4% 22.2%

6.9% 24.2%

Total paid-in capital . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . .

9,000 8,000

9,000 6,970

28.6% 25.4%

31.1% 24.0%

Total shareholders equity . . . . . . . . . . .

17,000

15,970

54.0%

55.1%

Total liabilities and shareholders equity . . . . . . . . . . . . . . . . . . $31,500

$28,970

100.0%

100.0%

*Each asset account on a common-size statement is expressed in terms of total assets, and each liability and equity account is expressed in terms of total liabilities and shareholders equity. For example, the percentage figure above for Cash in 2008 is computed as follows: $1,200  $31,500  3.8%.

The Balance Income Sheet Statement Another application of the vertical ideatheis separate to place One application of the vertical analysis ideaanalysis is to state

all items the income statement inofpercentage in terms of sales. A common-size assets of aoncompany as percentages total assets.form A common-size statement of this type statement of this type is shown in Exhibit 14–5. is shown in Exhibit 14–4 for Example Company. Notice By placing items 14–4 on thethat income statement inin common size inform termsclearly of sales, it is fromall Exhibit placing all assets common-size shows possible to see at a glance how each dollar of sales is distributed among the various costs, the relative importance of the current assets as compared to the non-current assets. It also expenses, profits. changes By placing successive years’ statements side of by the side, it is easy to shows thatand significant have taken place in the composition current assets over the last year. Notice, for example, that the receivables have increased in relative www.mcgrawhill.ca/olc/garrison www.mcgrawhill.ca/college/garrison

Gross ma

A broad g

excludes fixed costs. When fixed costs are included in the cost of goods sold figure, the gross margin percentage tends to increase and decrease with sales volume changes. With

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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

EXHIBIT 14–5 14–5    Common CommonSize Size Exhibit

EXAMPLE COMPANY Common-Size Comparative Income Statement For the Years Ended December 31, 2008 and 2007 (dollars in thousands)

Income Statement Income

Common-Size Percentages 2008 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 36,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . .

16,000

2007

2008

2007

$48,000 31,500

100.0% 69.2%

100.0% 65.6%

16,500

30.8%

34.4%

Operating expenses: Selling expenses . . . . . . . . . . . . . . . . . . . . . . 7,000 6,500 13.5% 13.5% Chapter 15 “How Well Am I Doing?” Financial Statement Analysis Administrative expenses . . . . . . . . . . . . . . . . 5,860 6,100 11.3% 12.7% Total operating expenses . . . . . . . . . . . . .

12,860

12,600

24.7%

26.2%

Income taxes (30%) . . . . . . . . . . . . . . . . . . . . .

750

960

1.4%

2.0%

BC15-9

importance and that both declined in3,900 relative importance. JudgOperating income . . . . cash . . . . .and . . . .inventory . . . . . . . . .have . 3,140 6.0% 8.1% ing from the sharp increase in receivables, the deterioration in the cash position may be a Interest expense . . . . . . . . . . . . . . . . . . . . . . . . 640 700 1.2% 1.5% resultNet of income an inability to collect from customers. before taxes . . . . . . . . . . . . . . . . . 2,500 3,200 4.8% 6.7% the vertical analysis3.4% idea is to4.7% place The Net Income incomeStatement . . . . . . . . . . . .Another . . . . . . . .application . . . . . . . . $of1,750 $ 2,240

all items on the income statement in percentage form in terms of sales. A common-size *Note that the percentage figures each year are expressed in terms of total sales for the year. statement of this type is shown infor Exhibit 14–5. For example, the percentage figure for cost of goods in 2008 issize computed as follows: By placing all items on the income statement sold in common in terms of sales, it is $36,000 � $52,000 � 69.2% possible to see at a glance how each dollar of sales is distributed among the various costs, expenses, and profits. And by placing successive years’ statements side by side, it is easy to spot interesting trends. For example, as shown in Exhibit 14–5, the cost of goods sold as a percentage of sales increased from 65.6% in 2007 to 69.2% in 2008. Or looking at this from a different viewpoint, the gross margin percentage declined from 34.4% in 2007 tospot 30.8% in 2008.trends. Managers investment analysts often pay close to the sold grossas interesting For and example, as shown in Exhibit 14–5, theattention cost of goods margin percentage because it is considered a broad gauge of profitability. The gross mara percentage of sales increased from 65.6% in 2007 to 69.2% in 2008. Or looking at this gin percentage computed as from a differentis viewpoint, thefollows: gross margin percentage declined from 34.4% in 2007

to 30.8% in 2008. Managers and investment analysts often pay close attention to the gross margin percentage because it is considered a broad gauge of profitability. The gross margin percentage is computed as follows: auge of profitability, calculated by dividing sales into the gross margin.

gin percentage

Gross margin percentage

A broad gauge of profitability, calculated by dividing sales into the gross margin.

Gross margin Sales The Thegross grossmargin marginpercentage percentagetends tendstotobebemore morestable stablefor forretailing retailingcompanies companiesthan thanfor for otherservice servicecompanies companiesand andfor formanufacturers manufacturerssince sincethe thecost costofofgoods goodssold soldininretailing retailing other excludesfixed fixedcosts. costs.When Whenfixed fixedcosts costsare areincluded includedininthe thecost costofofgoods goodssold soldfigure, figure,the the excludes grossmargin marginpercentage percentagetends tendstotoincrease increaseand anddecrease decreasewith withsales salesvolume volumechanges. changes.With With gross increases in sales volume, the fixed costs are spread across more units and the gross margin percentage improves. While a higher gross margin percentage is generally considered to be better than a lower gross margin percentage, there are exceptions. Some companies purposely choose EXHIBIT 14–5 Common Size EXAMPLE COMPANY a strategy emphasizing low prices (and hence low gross margins). An increasing gross Income Statement Common-Size Income Statement strategy is not being margin in such a company might Comparative be a sign that the company’s For the Years Ended December 31, 2008 and 2007 effectively implemented. (dollars thousands) Common-size statements are also in very helpful in pointing out efficiencies and inefficiencies that might otherwise go unnoticed. To illustrate, in 2008, Example Company’ Common-Size selling expenses increased by $500,000 over 2007. A glance at the common-size income Percentages statement shows, however, that on a relative basis, selling expenses were no higher in 2008 2007 2007 2008 than in 2007. In each year, they represented 13.5% of sales. 2008 Gross margin percentage �

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $52,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 36,000

www.mcgrawhill.ca/olc/garrison Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . Operating expenses:

16,000

$48,000 31,500

100.0% 69.2%

100.0% 65.6%

16,500

30.8%

34.4%

Earnings per Share An investor buys a share in the hope of realizing a return in the form of either dividends or future 14   increases theAm value of theFinancial share. Since earnings form the basis for dividend Chapter “How in Well I Doing?” Statement Analysis payments, as well as the basis for future increases in the value of shares, investors are always interested in a company’s reported earnings per share. Probably no single statistic is more widelyShareholder quoted relied on by investors than earnings per share, although it has Ratioor Analysis—The Common Shareholder Ratio Analysis—The Common some inherent limitations, as discussed below. Earnings per share is computed dividing net income available for common A number of financial ratios are used toby assess how well the company is doing from the Learning Objective 3 shareholders average number common shares outstanding duringdividends, the year. “Net standpoint ofby thethe shareholders. Theseofratios naturally focus on net income, and Compute and interpret the income available for common shareholders” is net income less dividends paid to the ownshareholders’ equities. financial ratios used by the ers of the company’s preferred shares.1

BC14–10

common shareholder.

Earnings per Share 1. complication can arise when a company has issued securities as executive stockdividends options or AnAnother investor buys a share in the hope of realizing a return in such the form of either warrants that can be converted into common shares. If these conversions were to take place, the same earnor ings future increases in the value of the share. Since earnings form the basis for dividend would have to be distributed among a greater number of common shares. Therefore, a supplemental payments, asshare wellfigure, as the basis for earnings future increases in the of shares, investors are earnings per called diluted per share, may havevalue to be computed.

always interested in a company’s reported earnings per share. Probably no single statistic is more widely quoted or relied on by investors than earnings per share, although it has Earnings per share some inherent limitations, as discussed below. Earnings per share is computed by dividing net income available for common Earnings share available for Netper income Net income available for common common shareholders dividedshareholders by the average number of common shares outstanding during the year. “Net shareholders the of common by the divided averageby number shares outstanding during the year. income available for common shareholders” is net income less dividends paid to the average number of common owners of the company’s preferred shares.1 shares outstanding during the year.

Net income � Preferred dividends Chapter Earnings per share � 15 “How Well Am I Doing?” Financial Statement Analysis Average number of common shares outstanding Using the data in Exhibits 14–1 and 14–2, we see that the earnings per share for Example Company for 2008 would be computed as follows: $1,750,000 � $120,000 � $3.26 (500,000 shares � 500,000 shares)/2

(1)

Note that the denominator in the earnings per share formula uses the weightedaverage is average number of of common common shares sharesoutstanding outstandingfor forthe theyear. year.Using Usinga weighted a weighted average appropriate is appropriatebecause becauseit itrecognizes recognizesthat thatcommon commonshareholders shareholders may may contribute contribute varying amounts of capital for varying amounts of time. A weighted-average number of shares reflects earnings per andand is not a measure of entitlement to earnreflects pershare shareduring duringthetheperiod period is not a measure of entitlement to ings at period-end. Assume that athat company beganbegan operations on January 2, 2003, by issuearnings at period‑end. Assume a company operations on January 2, 2007, by ing 10,000 common shares, andand onon October issuing 10,000 common shares, October1,1,2003, 2007,ananadditional additional10,000 10,000 shares were year-end. However, the issued. The company obviously has 20,000 shares outstanding at year‑end. weighted-average number of shares outstanding for the year is calculated as follows:



� 9 months 5 � 90,000 share months 10,000 shares 3 20,000 shares � 3 3 months � 5 60,000 share months 12 150,000 share months 12

before any any new The 10,000 shares issued on January 2 were outstanding for nine months before shares were issued. On October 1, another 10,000 shares were issued, bringing the total months of of thethe year. TheThe weighted average can now outstanding to to 20,000 20,000for forthe thelast lastthree three months year. weighted average can be determined by dividing the the number of of share now be determined by dividing number sharemonths months(150,000) (150,000)by bythe the number number of months in a year (12) to give a weighted average of 12,500 shares. complicationscan canarise arise in connection the computation of earnings per Two complications in connection withwith the computation of earnings per share. share. The firstwhenever arises whenever an extraordinary gain or loss appears part ofThe net The first arises an extraordinary gain or loss appears as part of netasincome. income.arises The second arises wheneverhas a company hassecurities convertible its balance second whenever a company convertible on securities its balanceonsheet. These sheet. These complications discussed in the following paragraphs. complications are discussedare in the following paragraphs.

Extraordinary Items and Earnings per Share 1. Another complication can arise when a company has issued securities such as executive stock options Extraordinary items are items resulting from transactions or events that have all of the folor warrants that can be converted into common shares. If these conversions were to take place, the same lowing characteristics: earnings would have to be distributed among a greater number of common shares. Therefore, a supplementalare earnings per share figure, calledfrequently diluted earnings share, years. may have to be computed. 1. They not expected to occur overper several

2. They do not typify the normal business activities of the entity. www.mcgrawhill.ca/olc/garrison 3. They do not depend primarily on the decisions of management or determinations by management or owners.



Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

Extraordinary Items and Earnings per Share Extraordinary items are items resulting from transactions or events that have all of the following characteristics: 1. They are not expected to occur frequently over several years. 2. They do not typify the normal business activities of the entity. 3. They do not depend primarily on the decisions of management or determinations by management or owners. If a company has extraordinary gains or losses appearing as part of net income, two earnings per share figures must be computed—one showing the earnings per share resulting from normal operations and one showing the earnings per share impact of the extraordinary items. This approach to computing earnings per share accomplishes three things. First, it helps statement users to recognize extraordinary items for what they are—unusual events that probably will not recur. Second, it eliminates the distorting influence of the extraordinary items from the basic earnings per share figure. Third, it helps statement users to assess properly the trend of normal earnings per share over time. Since one would not expect the extraordinary or unusual items to be repeated year after year, they should be given less weight in judging earnings performance than is given to profits resulting from normal operations. In addition to reporting extraordinary items separately, the accountant also reports them net of their tax effect. This means that whatever impact the extraordinary item has on income taxes is deducted from the extraordinary item on the income statement. Only the net, after‑tax gain or loss is used in earnings per share computations. To illustrate these ideas, let us assume that Amata Company has suffered a fire loss of $6,000 and that management is wondering how the loss should be reported on the company’s income statement. The correct and incorrect approaches to reporting the loss are shown in Exhibit 14–6. As shown under the correct approach in the exhibit, the $6,000 loss is reduced to only $4,200 after tax effects are taken into consideration. The reasoning behind this computation is as follows: The fire loss is fully deductible for tax purposes. Therefore, this deduction will reduce the firm’s taxable income by $6,000. If taxable income is $6,000 lower, then income taxes will be $1,800 (30% 3 $6,000) less than they otherwise would have been. In other words, the fire loss of $6,000 saves the company $1,800 in taxes that otherwise would have been paid. The $1,800 savings in taxes is deducted from the loss that caused it, leaving a net loss of only $4,200. This same $4,200 figure could have been obtained by multiplying the original loss by the formula (1 2 Tax rate): [$6,000 3 (1 2 0.30) 5 $4,200]. This same procedure is used in reporting extraordinary gains. The only difference is that extraordinary gains increase taxes; thus, any tax resulting from such a gain must be deducted from it, with only the net gain reported on the income statement. To continue our illustration, assume that the company in Exhibit 14–6 has 2,000 common shares outstanding. Earnings per share would be reported as follows: Earnings per share on common stock:    On net income before extraordinary item ($7,000 4 2,000 shares) . . . . . . . . .    On extraordinary item, net of tax ($4,200 4 2,000 shares) . . . . . . . . . . . . . . . .

$ 3.50 (2.10)

Net earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 1.40

In summary, clearly segregating extraordinary items as we have done above is necessary to avoid misunderstanding a company’s normal income‑producing ability. Reporting only the flat $1.40 per share figure would be misleading and perhaps cause investors to regard the company less favourably than they should.

Fully Diluted Earnings per Share A problem sometimes arises in trying to determine the number of common shares to use in computing earnings per share. Until recent years, the distinctions between common www.mcgrawhill.ca/olc/garrison

BC14–11

BC14–12

Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

EXHIBIT 14–6    Reporting Reporting Exhibit Extraordinary Items Net of Their Tax Effects

Incorrect Approach Sales . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . .

Conversio



$100,000 60,000

Gross margin . . . . . . . . . . . . . . . Operating expenses: Selling expenses . . . . . . . . . . . $18,000 Administrative expenses . . . . . 12,000 Fire loss . . . . . . . . . . . . . . . . . . 6,000

40,000

36,000

Net income before taxes . . . . . . . Income taxes (30%) . . . . . . . . . .

4,000 1,200

Net income . . . . . . . . . . . . . . . . .

$

2,800

Correct Approach Sales . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . .

$100,000 60,000



Extraordinary gains and losses should not be included with normal items of revenue and expense. This distorts a firm s normal income-producing ability.

Reporting the extraordinary Gross margin . . . . . . . . . . . . . . . 40,000 item separately and net of its Operating expenses: tax effect leaves the normal Selling expenses . . . . . . . . . . . $18,000 items of revenue and expense Chapter “How Well Am I Doing?” Financial Statement Analysis Administrative expenses . . . . . 1512,000 30,000 unaffected. Operating income . . . . . . . . . . . . 10,000 Income taxes (30%) . . . . . . . . . . ed stock or bond feature that allows the purchaser to convert preferred3,000 shares or bonds into common shares at

re time.



Net income before extraordinary item .securities . . . . . . . . .are present in the 7,000 Original loss of . . .a. firm, . . . . $6,000 When convertible financial structure the quesExtraordinary item: Less reduction in taxes tion arises as to whether these securities should be retained in their unconverted form or Fire net of shares tax . . .in . . computing .... a 30% rate . . .accepted . . . 1,800 treated asloss, common earnings4,200 per share.atThe generally posi-

A preferre some futu

Fully dilu per share

An earnin

. . . . . . . . securities . . . . . . . . . should be treated $ 2,800both in Loss, netpresent of tax . and . . . . prospective . $4,200 tionNet is income that convertible their forms. This requires the presentation of two earnings per share figures, one showing earnings per share assuming no conversion into common shares and the other showing full conversion into common shares. The latter figure is known as the fully diluted earnings shares, preferred shares, and debt were quite clear. However, these distinctions have per share. become murkier due to a growing tendency to issue convertible securities of various types. Rather than simply issuing common shares, firms today often issue preferred shares or Conversion feature bonds that carry a conversion feature allowing the purchaser to convert the preferred A preferred shares or bond shares or bonds into common shares at some future time. feature that allows the purchaser When convertible securities are present in the financial structure of a firm, the question utedshares earnings to convert preferred or arises as to whether these securities should be retained in their unconverted form or treated bonds into common shares at as common shares in computing earnings per share. The generally accepted position is some future time. that convertible securities should be treated both in their present and prospective forms. er the correct approach in the exhibit, the $6,000This lossrequires is reduced only $4,200ofafter effectsper areshare takenfigures, into consideration. reasoning thetopresentation twotax earnings one showingThe earnings per perisshare showing full conversion into common shares. utation is as follows: The firegsloss fullyfigure deductible for tax purposes. Therefore, this deduction will reduce the firm’s taxable income by share assuming no conversion into common shares and the other showing full conversion ncome is $6,000 lower, then income taxes will be $1,800 (30%  $6,000) less than they otherwise would have been. In other words, the fire Fully diluted earnings into common shares. The latter figure is known as the fully diluted earnings per share. Tohave illustrate the computation computation of aa company’s company’s fully dilutedfrom earnings perthat share, let us us es the company $1,800 in taxes that otherwise would been paid. The $1,800 savings in taxes isfully deducted the loss caused it, per share To illustrate the of diluted earnings per share, let assume that the preferred shares of Example Company in Exhibit 14–1 are convertible of only $4,200. This same $4,200 figure could have been obtained by multiplying the original loss by the formula (1  Tax rate): [$6,000  An earnings per share figure assume that the preferred shares of Example Company in Exhibit 14–1 are convertible into into common shares the basis five shares of common forshare each of share of preferred. 00]. showing full conversion into common shares on theonbasis of fiveofshares of common for each preferred. Since Since 20,000 preferred shares are outstanding, conversion would require issuing an addicommon shares.extraordinary gains. 20,000 cedure is used in reporting The only difference is that extraordinary gains increase taxes; thus, any tax resulting from preferred shares are outstanding, conversion would require issuing an additional tional 100,000 common shares. Earnings per share on a fully diluted basis would be combe deducted from it, with only the net gain reported on the income statement. 100,000 common shares. Earnings per share on a fully diluted basis would be computed puted as follows: ur illustration, assume that the company in Exhibit 14–6 has 2,000 common shares outstanding. Earnings per share would be reported as as follows:

Net income

re on common stock: (Weighted-average number of common shares outstanding before extraordinary item ($7,000  2,000 shares) . . . . . . . . . $ 3.50 � Potential shares issued on convertible securities) ry item, net of tax ($4,200  2,000 shares) . . . . . . . . . . . . . . . . (2.10)

�

Fully diluted earnings per share

$1,750,000 Net income � � $2.92 (2) 600,000 shares (500,000 shares outstanding clearly segregating extraordinary items as we have done above is converted necessaryshares) to avoid misunderstanding a company’s normal � 100,000 common g ability. Reporting only the flat $1.40 per share figure would be misleading and perhaps cause investors to regard the company less In comparing equation (2) with equation (1), we can note that the earnings per share ey should. figure has dropped by 34 cents. Although the impact of full dilution is relatively small in this case, it can be very significant in situations where large amounts of convertible secuwww.mcgrawhill.ca/olc/garrison www.mcgrawhill.ca/college/garrison Earnings per Share rities are present. In summary, diluted earnings per share permitUntil the user to see thethe impact on mes arises in trying to determine the number of common shares tofully use in computing earnings per share. recent years, distincshare . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1.40

Price-earnings ra



BC14–13

Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

figure has dropped by 34 cents. Although the impact of full dilution is relatively small in this case, it can be very significant in situations where large amounts of convertible securities are present. In summary, fully diluted earnings per share permit the user to see the impact on earnings per share of share issues that would dilute the earnings attributable to each common share if they were to happen. For example, the issue of 100,000 common shares in addition to the 500,000 weighted-average number of shares existing for the basic earnings per share would require at least 100,000 3 $3.26 or $326,000 of new earnings to avoid diluting the earnings to common shareholders. In our example, earnings to common shareholders increased only $120,000 [($1,750,000 – $120,000) – $1,750,000] for the 100,000 new shares. The $1.20 for the new shares is below the $3.26 needed to avoid dilution. To illustrate, if earnings increased by $206,000 ($326,000 – $120,000), then no dilution would have occurred: ($1,750,000 + $206,000)/600,000 = $3.26

Earnings per Share and Profitability

Chapter 15 “How Well Am I Doing?” Financial Statement Analysis

Earnings per share can be a misleading measure of profitability. To illustrate, assume that Simyar Company has 100,000 shares outstanding over a three‑year period. Simyar Company has total assets for year 2006 of $1 million and it is company policy to pay out of its after-tax income as dividends. Note from the following data that earnings per share 50% of its after‑tax income as dividends. Note from the following data that earnings per increased each period. This increase may be misinterpreted as improved operating pershare increased each period. This increase may be misinterpreted as improved operating formance when in fact it is totally attributable to Simyar Company reinvesting 50% of its performance when in fact it is totally attributable to Simyar Company reinvesting 50% of earnings. Return on investment has actually remained at 10%. For this illustration, it is its earnings. Return on investment has actually remained at 10%. For this illustration, it is assumed that ROI is calculated on total assets at the beginning of the year. assumed that ROI is calculated on total assets at the beginning of the year. Year Assets Year Assets 2006 . . . . . . . . . . . . . . 2006 . . . . . . . . . . . . . . 2007 . . . . . . . . . . . . . . 2007 . . . . . . . . . . . . . . 2008 . . . . . . . . . . . . . . 2008 . . . . . . . . . . . . . .

$1,000,000 $1,000,000 1,050,000 1,050,000 1,102,500 1,102,500

Earnings Available Return on Earnings Earnings Available Return on Earnings for Common Shareholders Investment per Share for Common Shareholders Investment per Share $100,000 $100,000 105,000 105,000 110,250 110,250

10% 10% 10% 10% 10% 10%

$1.0000 $1.0000 1.0500 1.0500 1.1025 1.1025

Price-Earnings Price-EarningsRatio Ratio relationship between betweenthe themarket marketprice priceofof a share share’s current earnings The relationship a share andand the the share’s current earnings per per share is often quoted in terms a price-earningsratio. ratio.IfIfwe weassume assume that that the the current current share is often quoted in terms of aofprice-earnings Example Company’ Company’ shares is $40 $40 each, each, the the company’s company’s price-earnings price-earnings market price for Example ratio would be computed as follows: Market price per share Price-earnings ratio � Earnings per share $40 � 12.3 $3.26 The price-earnings ratio is 12.3; that is, the shares are selling for about 12.3 times times current earnings. The price-earnings ratio is widely used by investors as a general guideline in gauging that investors areare willing to pay premium share values. A Ahigh highprice-earnings price-earningsratio ratiomeans means that investors willing to apay a prefor thefor company’s shares—presumably because the company is expected to havetohigher mium the company’s shares—presumably because the company is expected have than average future earnings growth.growth. Conversely, if investors believebelieve a company’s future higher than average future earnings Conversely, if investors a company’s earnings growth prospects are limited, thethe company’s future earnings growth prospects are limited, company’sprice-earnings price-earningsratio ratio would would be relatively low.

DividendPayout Payoutand andYield Yield Ratios Dividend Ratios Investors hold hold shares shares in in aa company company because because they they anticipate anticipate an an attractive attractive return. return. The The return return Investors sought is not always dividends. Many investors prefer not to receive dividends. Instead, sought is not always dividends. Many investors prefer not to receive dividends. Instead, they prefer to have the company retain all earnings and reinvest them internally in order www.mcgrawhill.ca/olc/garrison to support growth. The shares of companies that adopt this approach, loosely termed growth shares, often enjoy rapid upward movement in market price. Other investors pre-

Dividend

Shows the

BC14–14

Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

they prefer to have the company retain all earnings and reinvest them internally in order to support growth. The shares of companies that adopt this approach, loosely termed growth shares, often enjoy rapid upward movement in market price. Other investors prefer to have a dependable, current source of income through regular dividend payments. Such investors seek out shares with consistent dividend records and payout ratios. Dividend payout ratio

An index showing whether a company pays out most of its earnings in dividends or reinvests the earnings internally.

The Dividend Payout Ratio The dividend payout ratio gauges the portion of cur-

rent earnings being paid out in dividends. Investors who seek growth in market price would like this ratio to be small, whereas investors who seek dividends prefer it to be large. This ratio is computed by relating dividends per share to earnings per share for common stock: Dividends per share Dividend payout ratio � Dividends per share Dividend payout ratio Earnings per share Earnings per share

Fortend Example Company, theratios, dividend payoutpayout ratio for 2008 is computed assets ­findustries ollows: to have low payout whereas ratios tend to be high as in follows: For Example Company, the dividend payout ratio for 2008 is computed as follows: with limited reinvestment opportunities. $1.20 (see Exhibit 14–2) $1.20 (see Exhibit 14–2) � 36.8% 36.8% assets tend to have low payout ratios,$3.26 whereas payout ratios tend to be high in industries $3.26 dividend obtained by dividing the curDividend Yieldthing Ratio with limited opportunities. TheThere isreinvestment no such as a The “right” payoutyield ratio,ratio evenisthough it should be noted that There is noper such thing a current “right” payout ratio,aper even thoughindustry. it shouldIndustries be noted with that rentratio dividends share byas the market price share: the tends be similar for companies within particular There is notosuch thing as a “right” payout ratio, even though it should be noted that the ratio tends to be for similar for at companies a particular Industries with ample opportunities growth high rateswithin of return on assetsindustry. tend to have low payout the ratio tends to be similar for companies within a particular industry. Industries with ample opportunities for growth at high rates of return on assets tend to have low payout The dividend yield ratio is obtained by dividing the curThe Dividend Yield Ratio ratios, opportunities whereas payout ratios tend to be high in industries with ample for growth at high rates of return on assets tendlimited to havereinvestment low payout ratios, whereasperpayout ratios to be highprice in industries limited reinvestment yield ratio rent dividends share by the tend current per share: with opportunities. ratios, whereas payout ratios tend to market be high in industries with limited reinvestment opportunities. e return in terms of cash dividends being provided by a share. opportunities. Dividends per share yield ratio Dividend ratio � Dividend yield ratio The Dividend Yield Ratioyield The dividend yield ratio is obtained by dividing the Market priceisper share by dividing the curThe Dividend Yield Ratio The dividend yieldprice obtained return dividends being provided by a share. Shows the returnein termsinofterms cashof cash current dividends per share by the current market peris share: The Dividend Yield Ratio The dividend yield ratio ratio obtained by dividing the current dividends per share by the current market price per share: dividends being provided by a rent dividends share the current marketDividends price per share: per share The marketper price forbyExample share. Dividend yieldCompany’ ratio � shares is $40 each, so the dividend yield is computed as follows: Market price per share $1.20 yield ratio � 3.0% yield ratio e return in terms of cash being provided by a share. $40 shares The price for Company’ dividends The market market price for Example Example Company’ shares isis $40 $40 each, each, so so the the dividend dividend yield yield isis e return in terms of cash dividends being provided by a share. computed as follows: computed as follows: Dividends $1.20 The dividend yield ratio measures the rate of returnper (inshare the form of cash dividends Dividends per share Dividend yield ratio �� 3.0% Dividend yield ratio Market price per share only) that would be earned by an investor buys the common $40 who Market price per share shares at the current market price. A low dividend yield ratio is neither bad nor good by itself. As discussed above, Theadividend dividend yield ratio measures theinrate rate of return return (ineach, the form ofdividend cash dividends market price forpay Example shares is $40 so the yield is The yield ratio measures the of (in the of cash dividends company may out veryCompany’ little dividends it form has ample opportunities The market price for Example Company’ shares isbecause $40 each, so the dividend yield is only) that would be earned by an investor who buys the common shares at the current computed as follows: only) that would be earned by an investor who buys the common shares at the current for reinvesting funds within the company at high rates of return. computed as follows: $1.20 market price. price. A A low low dividend dividend yield yield ratio ratio is neither bad nor good by itself. As discussed market is neither bad nor good by itself. As discussed $1.20 � 3.0% 3.0% because $40in above, aa company company may may pay pay out out very very little little dividends because itit has has ample ample opportunities opportunities above, $40in dividends Return on Total Assetsthe for reinvesting funds within within the company company at at high high rates rates of of return. return. for reinvesting funds The dividend yield ratio measures the rate of return (in the form of cash dividends Managers have both financing and operating Financing The dividend yield ratio measures the rateresponsibilities. of return (in the form of responsibilities cash dividends only) that would be earned by an investor who buys the common shares at the current relate to how one obtains the funds needed to provide for the assets in an organization. only) that would be earned by an investor who buys the common shares the current Return onTotal Assetsyield ratio is neither bad nor good by itself. atAs Return on Assets market price. ATotal low dividend discussed Operating responsibilities relate to how uses thebad assets obtained. market price. A low dividend yield ratioone is neither noronce goodthey by have itself.been As discussed above, a company may pay out very little in dividends because it has ample opportunities Managers havetoboth both financing and operating responsibilities. Financing responsibilities Managers have financing operating responsibilities. Financing Both are vital a well-managed firm. However, care must be taken toresponsibilities confuse or mix above, a company may pay outand very little in dividends because it hasnot ample opportunities for reinvesting funds within the company at high rates of return. relate to when how one one obtains the funds needed tomanager. provide for the assets in an an organization. relate to how obtains the funds needed provide for the in organization. the reinvesting two assessing the performance of ahigh That is,assets whether funds have been for funds within the company at to rates of return. Operating responsibilities relate toshareholders how one one uses usesshould the assets assets once they have have been obtained. obtained. Operating responsibilities relate how the they been obtained from creditors or fromto not once be allowed to influence one’s Both are vital to a well-managed firm. However, care must be taken not to confuse orfirm. mix Both are vital to a well-managed firm. However, care must be taken not to confuse mix assessment ofTotal how well the assets have been employed since being received by theor Return on Assets Return on Total Assets the two two when assessing the performance of a manager. That is, whether funds have been the when assessing the performance of a manager. That is, whether funds have been The return on total assets is a measure of operating performance that shows how Managers havecreditors both financing and operating responsibilities. Financing responsibilities obtained from or from from shareholders should not be be allowed allowed to influence influence one’s obtained from or shareholders should not to one’s well assets havecreditors beenfinancing employed. It is defined as follows: Managers have both and operating responsibilities. Financing responsibilities relate to how one obtains the funds needed to provide for the assets in an organization. assessment of how well the assets have been employed since being received by the firm. assessment of how well the assets have been employed since being received by the firm. relate to how one obtains the funds needed to provide for the assets in an organization. Operating responsibilities relate to one uses the assets once they havethat been obtained. Return on total assets The The return return on total total assets assets is ahow a measure measure of operating operating performance shows how on of performance shows how n total assets Operating responsibilities relate is to how one uses the assets once they havethat been obtained. Both are vital to a well-managed firm. However, care must be taken not to confuse or mix Measure of how well assets well assets have been employed. It is defined as follows: of how wellhave assets have been employed by management. well assets have been employed. It is defined as follows: Both are vital to a well-managed firm. However, care must be taken not to confuse or mix the two when assessing the performance of a manager. That is, whether funds have been been employed by ­management. the two when assessing the performance of � a manager. That is, whether funds have been Net income [Interest expense � (1 �toTax rate)]* obtained fromoncreditors or from should not be allowed influence one’s n total assets Return total assets � shareholders obtained from creditors or from shareholders should not be allowed to influence one’s Average total assets assessment of how well the assets have been employed since being received by the firm. of how well assets have been employed management. assessment of howby well the assets have been employed since being received by the firm. The return on istotal assetscalled is anopat. measure of operating performance that shows how *This numerator commonly The return on total assets is income a measure of operating performance thatrate)]* shows how Net � [Interest expense � (1 � Tax well assets have been employed. It is defined as follows: Returnhave on total assets � well Adding assets been employed. It is defined as follows: interest expense back to net income results total in anassets adjusted earnings figure that Average www.mcgrawhill.ca/olc/garrison Net been income � [Interest expense � (1 � Tax rate)]* shows what earnings would have if the assets had been acquired solely by selling Net income [Interest expense (1 Tax rate)]* Return on total assets � called nopat. *This numerator is commonly Return on total assets total assets for companies with shares. With this adjustment, the return on total Average assets can be compared Average total assets

Return on comm Return on comm shareholders’ equ shareholders’ equ

When compared t When compared total assets, meas total assets, meas to which financial to which financial working for or aga working for or aga shareholders. shareholders.



BC14–15

Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

Adding interest expense back to net income results in an adjusted earnings figure that shows what earnings would have been if the assets had been acquired solely by selling shares. With this adjustment, the return on total assets can be compared for companies with differing amounts of debt or over time for a single company that has changed its mix of debt and equity. Thus, the measurement of how well the assets have been employed is not influenced by how the assets were financed. Notice that the interest expense is placed on an after-tax basis by multiplying it by the factor (1 2 Tax rate). The return on total assets for Example Company for 2008 would be computed as follows (from Exhibits 14–1 and 14–2): Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,750,000 Assets, end of year . . . . $640,000 . . . . . . . .3 . . (1 . .2 . . 0.30) . . . . . . . . . . . . . . . . . . . . . .    . 31,500,000 Add back interest expense: 448,000 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$. 2,198,000 $60,470,000 Total (nopat) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (a) Average total assets: � 2 . . . . . . . . . . . . . . . . $28,970,000 . $30,235,000 (b) Assets, beginning of year$60,470,000 . . . . . . . . . . . . . . . . . . . . . . . . . . . . Return on total assets, (a) (b) . . . . . . . . . . . . . . . . . . . . . . . 7.3% � Assets, end of year . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   31,500,000 Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,470,000 Example Company has earned a return of 7.3% on average assets employed over

the

last year.

Average total assets: $60,470,000 4 2 . . . . . . . . . . . . . . . . . . $30,235,000 (b) Return on total assets, (a) 4 (b) . . . . . . . . . . . . . . . . . . . . . . . . 7.3%

Return on Common Shareholders’ Equity

Example Company has earned a return of 7.3% on average assets employed over the One of the primary reasons for operating a corporation is to generate income for the benlast year. efit of the common shareholders. One measure of a company’s success in this regard is the return on common shareholders’ equity, which divides the net income remaining for Return Common Equity commonon shareholders by Shareholders’ the average common shareholders’ equity for the year. The formula is as follows: One of the primary reasons for operating a corporation is to generate income for the

benefit of the common shareholders. One measure of a company’s success in this regard n on common shareholders’ equity is the return on common shareholders’ equity, which divides the net income remaining compared to the return on total assets, measures the extent to which financial leverage is working for or against for common shareholders by the average common shareholders’ equity for the year. The on shareholders. formula is as follows: Net income � Preferred dividends Return on common � shareholders’ equity Average common shareholders equity ’ where

{

Average common Average total shareholders’ equity shareholders’ equity � � Average preferred shares

}

ForFor Example common shareholders’ shareholders’equity equityis is 11.3% ExampleCompany, Company,the thereturn return on on common 11.3% forfor 2008 2008 as shown below: as shown below: income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .$. 1,750,000 $ 1,750,000 NetNet income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Deduct preferred dividends . . . . . . . . . . . . . . . . . . . . . . . . . .    .   120,000 120,000 Deduct preferred dividends . . . . . . . . . . . . . . . . . . . . . . . . . . . income remaining common shareholders . . . . . . . . . $. 1,630,000 $ 1,630,000 NetNet income remaining forfor common shareholders . . . . . . . . . . (a) (a) Average shareholders equity . . . . . . . . . . . . . . . . . . . . . . . . $16,485,000* . $16,485,000* Average shareholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . † † Deduct average preferred shares . . . . . . . . . . . . . . . . . . . . .    . 2,000,000 2,000,000 Deduct average preferred shares . . . . . . . . . . . . . . . . . . . . . . Average common shareholders equity . . . . . . . . . . . . . . . . . $14,485,000 . $14,485,000 Average common shareholders’ equity . . . . . . . . . . . . . . . . . . (b) (b) Return common shareholders equity, (b) . . . . . . . . . 11.3% 11.3% Return on on common shareholders’ equity, (a)(a) 4� (b) . . . . . . . . . *$15,970,000 � $17,000,000 � $32,970,000; $32,970,000 � $16,485,000. *$15,970,000 1 $17,000,000 5 $32,970,000; $32,970,000 4 2�52$16,485,000. † † $2,000,000 � $2,000,000 � $4,000,000; $4,000,000 � $2,000,000. $2,000,000 1 $2,000,000 5 $4,000,000; $4,000,000 4 2�52$2,000,000.

Compare the return on common shareholders’ equity in the preceding (11.3%) with the Compare thetotal return on common shareholders’ the preceding (11.3%) with return on assets computed previously equity (7.3%).inWhy is the return on common theshareholders’ return on total assets computed previously (7.3%). Why is the return on common equity so much higher? The answer lies in the principle of financial levershareholders’ equity so much higher? The lies in the principle of financial leverage. age. Financial leverage is discussed in answer the following paragraphs. Financial leverage is discussed in the following paragraphs.

Financial Leverage

www.mcgrawhill.ca/olc/garrison

LEARNING OBJECTIVE 4

Explain what is meant by the term financial leverage and show how financial leverage

Return on common shareholders’ equity

Measures the income as a percentage of average common shareholders’ investment in the company.

BC14–16

Financial Leverage

Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

Financial Leverage

A situation in which the fixed return to a company’s creditors and preferred shareholders is less than the return on total assets. In this situation, the return on common shareholders’ equity will be greater than the return on total assets.

Financial leverage (often called leverage for short) involves acquiring assets with funds that have been obtained from creditors or from preferred shareholders at a fixed rate of return. If the assets in which the funds are invested are able to earn a rate of return greater than the fixed rate of return required by the funds’ suppliers, then we have positive financial leverage and the common shareholders benefit. For example, suppose that CTV is able to earn an after-tax return of 12% on its broadcasting assets. If the company can borrow from creditors at a 10% interest rate in order to expand its assets, then the common shareholders can benefit from positive leverage. The borrowed funds invested in the business will earn an after-tax return of 12%, but the after-tax interest cost of the borrowed funds will be only 7% [10% interest rate 3 (1 2 0.30) 5 7%]. The difference will go to the common shareholders. We can see this concept in operation in the case of Example Company. Notice from Exhibit 14–1 that the company’s bonds payable bear a fixed interest rate of 8%. The after-tax interest cost of these bonds is only 5.6% [8% interest rate 3 (1 2 0.30) 5 5.6%]. The company’s assets are generating an after-tax return of 7.3%, as we computed earlier. Since this return on assets is greater than the after-tax interest cost of the bonds, leverage is positive, and the difference accrues to the benefit of the common shareholders. This explains in part why the return on common shareholders’ equity (11.3%) is greater than the return on total assets (7.3%). Unfortunately, leverage is a two-edged sword. If assets are unable to earn a high enough rate to cover the interest costs of debt, or to cover the preferred dividend due to the preferred shareholders, then the common shareholder suffers. Under these circumstances, we have negative financial leverage.

Negative financial leverage

The Impact of Income Taxes Debt and preferred shares are not equally efficient in

Learning Objective 4

Explain what is meant by the term financial leverage and show how financial leverage is measured.

Financial leverage

Acquiring assets with funds that have been obtained from creditors or from preferred shareholders at a fixed rate of return.

Positive financial leverage

A situation in which the fixed return to a company’s creditors and preferred shareholders is greater than the return on total assets. In this situation, the return on common shareholders’ equity will be less than the return on total assets.

generating positive leverage. The reason is that interest on debt is tax-deductible, whereas preferred dividends are not. This usually makes debt a much more effective source of positive leverage than preferred shares. To illustrate this point, suppose that Hotel Corporation is considering three ways of financing a $100-million expansion of its chain of hotels: 1. $100 million from an issue of common shares. 2. $50 million from an issue of common shares, and $50 million from an issue of preferred shares bearing a dividend rate of 8%. 3. $50 million from an issue of common shares, and $50 million from an issue of bonds bearing an interest rate of 8%. Assuming that Hotel Corporation can earn an additional $15 million each year before interest and taxes as a result of the expansion, the operating results under each of the three alternatives are shown in Exhibit 14–7. If the entire $100 million is raised from an issue of common shares, then the return to the common shareholders will be only 10.5%, as shown under alternative 1 in the exhibit. If half of the funds are raised from an issue of preferred shares, then the return to the common shareholders increases to 13%, due to the positive effects of leverage. However, if half of the funds are raised from an issue of bonds, then the return to the common shareholders jumps to 15.4%, as shown under alternative 3. Thus, long-term debt is much more efficient in generating positive leverage than are preferred shares. The reason is that the interest expense on long-term debt is tax-deductible, whereas the dividends on preferred shares are not.

The Desirability of Leverage Because of leverage, having some debt in the capital

structure can substantially benefit the common shareholder. For this reason, most companies today try to maintain a level of debt that is considered to be normal within the industry. Many companies, such as commercial banks and other financial institutions, rely heavily on leverage to provide an attractive return on their common shares. www.mcgrawhill.ca/olc/garrison



$50,000,000 $50,000,000 Alternative 1: Common Alternative 1: Common Shares; Shares; $100,000,000 $50,000,000 $100,000,000 $50,000,000 Common Shares Preferred Shares Chapter 14   “How Well Am I Doing?” Financial Analysis Common SharesStatement Preferred Shares

Chapter 15 “How Well Am I Doing?” Financial Statement Analysis

Earnings $ 15,000,000 15,000,000 Earnings before before interest interest and and taxes taxes .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. $ Exhibit 14–7     Leverage from Preferred Shares and Long-Term Debt  $50,000,000) . . . . . . . . . — Deduct interest expense (8% — Deduct interest expense (8% � $50,000,000) . . . . . . . . .

EXHIBIT 14–7 Leverage from Preferred Shares and Long-Term Debt

$15,000,000 $15,000,000 — —

$50,000,000 $50,000,000 Common Common Shares; Shares; $50,000,000 $50,000,000 Bonds BC14–17 Bonds

BC15-17

$15,000,000 $15,000,000 4,000,000 4,000,000

Net Net income income before before taxes taxes .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. Deduct income taxes Deduct income taxes (30%) (30%) .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. ..

15,000,000 15,000,000 11,000,000 15,000,000 15,000,000 11,000,000 Alternatives: $100,000,000 Issue of Securities 4,500,000 4,500,000 3,300,000 4,500,000 4,500,000 3,300,000

Net Net income income .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. Deduct Deduct preferred preferred dividends dividends (8% (8%  � $50,000,000) $50,000,000) .. .. .. .. .. .. ..

10,500,000 10,500,000 — —

10,500,000 Alternative 2: 10,500,000 4,000,000 $50,000,000 4,000,000 Alternative 1: Common Shares; Net $ $ Net income income remaining remaining for for common common (a) (a) .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. $ 10,500,000 10,500,000 $ 6,500,000 6,500,000 $100,000,000 $50,000,000 Common $100,000,000 $50,000,000 Common shareholders shareholders equity equity (b) (b) .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. $100,000,000 $50,000,000 Common Shares Preferred Shares Return on common shareholders equity (a)  (b) . . . . . . 10.5% 13.0% Return on common shareholders equity (a) � (b) . . . . . . 10.5% 13.0% The Desirability of Leverage having some capital Earnings before interest and taxes . .Because . . . . . . . .of . . leverage, ...... $ 15,000,000 $15,000,000 The Desirability of Leverage Because of leverage, having some debt debt in in the the capital structure can substantially benefit the common shareholder. For this reason, most compa. . . shareholder. ...... — Deduct interest expense (8% � $50,000,000) structure can substantially benefit the common For—this reason, most compa-

nies today try to a level of debt that is considered considered to to be be normal indusnies trybefore to maintain maintain normal within within the the indusNettoday income taxes . .a. level . . . . .of . . debt . . . . .that . . . is ........ 15,000,000 15,000,000 try. Many companies, such as commercial banks and other financial institutions, rely try. Many companies, such as commercial banks and other financial institutions, rely Deduct income taxes (30%) . . . . . . . . . . . . . . . . . . . . . . . 4,500,000 4,500,000 heavily on leverage to provide an attractive return on their common shares. heavily on leverage to provide an attractive return on their common shares. Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,500,000 10,500,000 Deduct preferred dividends (8% � $50,000,000) . . . . . . .

Book Value per Net income remaining for common (a) Book Value per Share Share

...............

— $ 10,500,000

7,700,000 Alternative 3: 7,700,000 — $50,000,000 — Common Shares; $ $ 7,700,000 7,700,000 $50,000,000 $50,000,000 $50,000,000 Bonds 15.4% 15.4% $15,000,000 4,000,000 11,000,000 3,300,000

4,000,000

7,700,000 —

$ 6,500,000

$ 7,700,000

Another frequently the common Commonstatistic shareholders equityused (b) . .in . . . . . . . . . . to . . .assess .. $100,000,000 $50,000,000 Another statistic frequently used in. . attempting attempting to assess the well-being well-being of of the the$50,000,000 common shareholder is book value per share. The book value per share measures the amount that shareholder is book shareholders value per share. The share measures the amount that � (b) value Return on common equity (a)book . . . . . per . 10.5% 13.0% 15.4% would would be be distributed distributed to to holders holders of of each each common common share share if if all all assets assets were were sold sold at at their their balbalance ance sheet sheet carrying carrying amounts amounts (i.e., (i.e., book book values) values) and and if if all all creditors creditors were were paid paid off. off. Thus, Thus, book value per share is based entirely on historical costs. The formula for computing book value per share is based entirely on historical costs. The formula for computing it it is is as follows: Book Value per Share as follows: Another statistic frequently used in attempting to assess the well-being of the common ue ue per per share share shareholder is book value per share. The book value per share measures the amount that Book value per share Measures the amount that woulddistributed be distributedholders to holderscommon of each common share if allwere assets were sold at their balance the the amount amount that that would would be be distributed to to holders of of common shares shares ifif all all assets assets were sold sold at at their their balance balance sheet sheet would be distributed to holders sheet carrying amounts (i.e., book values) and if all creditors were paid off. Thus, book value amounts amounts and and ifif all all creditors creditors were were paid paid off. off. of common shares if all assets per share is based entirely on historical costs. The formula for computing it is as follows: were sold at their balance sheet Common shareholders’ equity (Total Common shareholders’ equity (Total n in which the fixed return to a company’s creditors and preferred shareholders is greater than the return on total carrying amounts and if all shareholders’  shares) shareholders’ equity � Preferred Preferred shares) this situation, the return on common shareholders’ equity will be less thanequity the return on total assets. creditors were paid off. Book value per share  Book value per share � Number of common shares outstanding Number of common shares outstanding The Impact Total of Income Taxes Debt and preferred are not equally efficient in ..shares .. .. .. $17,000,000 Total shareholders equity (see Exhibit 14–1) $17,000,000 Total shareholders shareholders’equity equity(see (seeExhibit Exhibit14–1) 14–1) . . . $17,000,000 generating positive leverage. The reason isExhibit that interest on debt is tax-deductible, whereas Deduct preferred shares (see 14–1) . . . . Deduct preferred . . . .    2,000,000 2,000,000 Deduct preferred shares shares (see (see Exhibit 14–1) . . . . 2,000,000 preferred dividends are not. This usually makes debt a much more effective source of posCommon shareholders equity .. .. .. .. .. .. .. .. .. .. .. .. .. .. .. $15,000,000 Common shareholders $15,000,000 Common shareholders’ equity . . . . . . . . . . . . . . $15,000,000 itive leverage than preferred shares. equity To illustrateper thisshare point, suppose that Hotel Corporation is considering three follows: ways of The book of Example Company’ common shares computed The book avalue value per share share of of Example ExampleofCompany’ Company’ common sharesisis iscomputed computedasas as­follows: follows: common financing $100-million expansion its chain of hotels:shares $15,000,000 $15,000,000  $30 1. $100 million from an issue of500,000 commonshares shares.� $30 500,000 shares 2. $50 million from an issue of common and $50 million from an issue of If If this this book book value value is is compared compared with with the the $40 $40shares, market value of Example Company shares, market value of Example Company shares, If this book value is compared with the $40 market value of Example Company shares, preferred shares bearing a dividend rate of 8%. then the theshares sharesappear appeartoto be somewhat overpriced. However, asdiscussed we discussed earlier, then be overpriced. However, as earlier, marthen the million shares reflect appear toissue be somewhat somewhat overpriced. However, as we we discussed earlier, mar3. $50 from an of common shares, and $50 million from an issue of bonds market prices expectations about future earnings and dividends, whereas book ket prices reflect expectations about future earnings and dividends, whereas book value ket prices reflect expectations about future earnings and dividends, whereas book value bearing an interest rate of 8%. value largely reflects the results of that events that occurred in the past. Ordinarily, the market largely reflects the results occurred in Ordinarily, the value of largely reflects theexceeds results of ofitsevents events that occurred in the the past. past. Ordinarily, the market market value of value of a share book value. For example, in a recent year, Canadian Tire aa share exceeds its book value. Assuming that Hotelvalue. Corporation can earn an additional $15 million each year before share exceeds its book Corporation Limited traded on the stock market at 2.2 times its book value per share and interest and taxes as a result of the expansion, the operating results under each of the three 15.90 times its earnings per share. alternatives are shown in Exhibit 14–7. If the entire $100 million is raised from an issue of common shares, then the return to the common shareholders will be only 10.5%, as shown under alternative 1 in the exhibit. If half of the funds are raised from an issue of preferred shares, then the return to the comRatio Analysis—TheRatio Short-Term Creditor mon shareholders increases to 13%, due to the positive effectsAnalysis—The of leverage. However, ifShort-Term Creditor half of the funds are raised from an issue of bonds, then the return to the common shareShort-term creditors, such as suppliers, want to be repaid on time. Therefore, they focus holders jumps to 15.4%, as shown under alternative 3. Thus, long-term debt is much more on the company’s cash flows and on its working capital since these are the company’s efficient in generating positive leverage than are preferred shares. The reason is that the primary sources of cash in the short run. interest expense on long-term debt is tax-deductible, whereas the dividends on preferred shares are not. www.mcgrawhill.ca/olc/garrison

The excess of current assets over current liabilities is known as working capital. The working working capital capital for for Example Example Company Company is is computed computed below: below: Working Working capital capital

BC14–18 Chapter 14   “How Well Am I Doing?” Financial Statement Analysis Measures the company’s ability to repay current liabilities using only current assets. Measures the company’s ability to repay current liabilities using only current assets. Learning Objective 5

Compute and interpret the financial ratios used by the short-term creditor.

Working Working Capital Working capital capital �  Current Current assets assets �  Current Current liabilities liabilities 2008 is known 2007 The excess of current assets over current liabilities as working capital. The 2008 2007 working capital for Example Company is computed below: Current assets . . . . . . . . . . $15,500,000 $16,470,000 Current assets . . . . . . . . . . $15,500,000 $16,470,000 Current liabilities . . . . . . . . 7,000,000 5,000,000 Current liabilities . . Current ..... 7,000,000 5,000,000 Working capital.5 assets 2 Current liabilities Working capital . . . . . . . . . $ 8,500,000 $11,470,000 Working capital . . . . . . . . . $ 8,500,000 $11,470,000 2008 2007

Working capital

Measures the company’s ability to repay current liabilities using only current assets.

The working capital to considerable Current assets . . . . . . . . . . $15,500,000 The amount amount of of working capital available available to aa firm firm is is of of$16,470,000 considerable interest interest to to shortshortterm creditors, because it represents assets financed from long-term capital sources Current itliabilities . . . . assets . . . .  financed   7,000,000 5,000,000 capital sources that term creditors, because represents from  long-term that do repayment. Therefore, the greater the working capital, the Working capital . . . . . . . . . $ 8,500,000 $11,470,000 do not not require require near-term near-term repayment. Therefore, the greater the working capital, the greater is the cushion of protection available to short-term creditors and the greater is greater is the cushion of protection available to short-term creditors and the greater is the the assurance that short-term debts will be paid when due. assurance that short-term debts will be paid when due. The amount of working capital available to a firm is of considerable interest to shortalways comforting short-term creditors see working capital Although is always it comforting to assets short-term creditors to long-term see aa large large capital workingsources capital termAlthough creditors,itit is because representsto financed fromto balance, a large balance by itself is no assurance that debts will be paid when due. Rather balance, a large balance by itself is no assurance that debts will be paid when due. Rather that do not require near-term repayment. Therefore, the greater the working capital, the than being aa sign of aa large working capital balance may mean that than being sign of strength, strength, largeavailable working to capital balance may simply simply mean that obsoobsogreater is the cushion of protection short-term creditors and the greater is the lete inventory is being accumulated. Therefore, to put the working capital figure into lete inventory is being accumulated. Therefore, to put the working capital figure into assurance that short-term debts will be paid when due. proper perspective, it must be supplemented with other analytical work. The following four proper perspective, it must be supplemented with other analytical work. The following four Although it is always comforting to short-term creditors to see a large working capital ratios (the ratio, ratio, the receivable and the invenratios (thea current current ratio, the the acid-test ratio, the accounts accounts receivable turnover, anddue. the Rather invenbalance, large balance by acid-test itself is no assurance that debts will beturnover, paid when tory turnover) should all be used in connection with an analysis of working capital. tory turnover) should all be used in connection with an analysis of working capital. than being a sign of strength, a large working capital balance may simply mean that obsolete inventory is being accumulated. Therefore, to put the working capital figure into

proper perspective, Current Ratio Current Ratio it must be supplemented with other analytical work. The following four ratios (the current ratio, the acid-test ratio, the accounts receivable turnover, and the

The elements involved in of capital are expressed in The elements involved in the the computation of working workingwith capital are frequently frequently expressed in inventory turnover) should allcomputation be used in connection an analysis of working capital. ratio form. A company’s current assets divided by its current liabilities is known as the ratio form. A company’s current assets divided by its current liabilities is known as the current current ratio: ratio: Current Current ratio ratio

Current Ratio

The elements involved in the computation of working capital are frequently expressed in

Test of short-term debt-paying ability. Test of short-term debt-payingratio ability. form. A company’s current assets divided by its current liabilities is known as the

Current ratio

Test of short-term debt-paying ability.

current ratio:

Current Current assets assets Current Current ratio ratio �  Current liabilities Current liabilities

For For Example Example Company, Company, the the current current ratios ratios for for 2007 2007 and and 2008 2008 would would be be computed computed as as follows: follows: 2008 2007 2008 2007 $15,500,000 $16,470,000 $15,500,000 � 2.21 to 1 $16,470,000 � 3.29 to 1  2.21 to 1  3.29 to 1 $7,000,000 $5,000,000 $7,000,000 $5,000,000 Although Although widely widely regarded regarded as as aaa measure measure of short-term debt-paying ability, the current ­ccurrent urrent Although widely regarded as measure of of short-term short-term debt-paying debt-paying ability, ability, the the ratio must be interpreted with great care. A declining ratio, as above, might be a sign ratio must be interpreted with great care. A declining ratio, as above, might be a sign of aaa ratio must be interpreted with great care. A declining ratio, as above, might be a sign of of deteriorating financial condition. On the other hand, it might be the result of eliminating deteriorating financial condition. On the other hand, it might be the result of eliminating deteriorating financial condition. On the other hand, it might be the result of eliminating obsolete current assets. An ratio might be result obsolete inventories inventoriesor otherstagnant stagnant current assets. An improving the obsolete inventories ororother other stagnant current assets. An improving improving ratio ratio mightmight be the thebe result of an unwise stockpiling of inventory, or it might indicate an improving financial situation. result of an unwise stockpiling of inventory, or it might indicate an improving financial of an unwise stockpiling of inventory, or it might indicate an improving financial situation. In short, ratio is tricky avoid analyst situation. In current short, the current ratiobut is useful, butinterpret. tricky toTo To avoidthe a blunder, In short, the the current ratio is useful, useful, but tricky to to interpret. Tointerpret. avoid aa blunder, blunder, the analyst must take a hard look at the individual assets and liabilities involved. the analyst must take a hard look at the individual assets and liabilities involved. must take a hard look at the individual assets and liabilities involved. for aa current ratio of to This rule subject to The The general generalrule ruleof thumbcalls calls a current ratio 1. This is subject to The general rule ofofthumb thumb calls forfor current ratio of 22of to21. 1.to This rule is isrule subject to many many exceptions, depending on the industry and the firm involved. Some industries can operate many exceptions, depending on the industry and the firm involved. Some industries can exceptions, depending on the industry and the firm involved. Some industries can operate quite successfully on of over 11 to 1. The of aa current operate quite successfully on ratio aratio current ratio of slightly 1adequacy to 1. The of a quite successfully on aa current current of slightly slightly over towww.mcgrawhill.ca/college/garrison 1.over The adequacy of adequacy current ratio ratio www.mcgrawhill.ca/college/garrison depends heavily on the composition of the assets involved. For example, as we see in current ratio depends heavily on the composition of the assets involved. For example, as depends heavily on the composition of the assets involved. For example, as we see in the the table below, both Worthington Corporation and Greystone, Inc. have current ratios of 2 to we see in the table below, both Worthington Corporation and Greystone, Inc. have current table below, both Worthington Corporation and Greystone, Inc. have current ratios of 2 to 11ratios H ii they arebl ii ll di G ii lik hh dif condition. H of 2 tohh1. However, blnotfi fiin comparable di ii financial G lik ll Greystone difis likely to have difficulty meeting its current financial obligations, since almost all of its current assets consist of inventory rather than more liquid assets such as cash and accounts receivable. www.mcgrawhill.ca/olc/garrison

quick) ratio

Worthington Corporation



Greystone, Inc.

BC14–19

Chapter 14   “How Well Am I Doing?” Financial Statement Analysis Current assets: Cash . . . . . . . . . . . . . . . . . . . . $ 25,000 $ 2,000 Worthington Greystone, Accounts receivable, net . . . . . 60,000 8,000 Corporation Inc. Inventory . . . . . . . . . . . . . . . . . 85,000 160,000 Prepaid expenses . . . . . . . . . . 5,000 5,000 Current assets: Total current assets . . . . . . . $175,000 $175,000 (a) Cash . . . . . . . . . . . . . . . . . . . . $ 25,000 $ 2,000 Accounts receivable, net . . . . 60,000 8,000(b) Current liabilities . . . . . . . . . . . . . $ 87,500 $ 87,500 Inventory . . . . . . . . . . . . . . . . . 85,000 160,000 Current ratio,expenses . . . . . . . . . . (a) � (b) . . . . . . . . 2 to5,000 1 2 to5,000 1 Prepaid         Total current assets . . . . . . $175,000

$175,000 (a)

liabilities . . . . . . . . . . . . . $ 87,500 Acid-Test Current (Quick) Ratio

$ 87,500 (b)

ratio, (a) 4 (b) . . . . . . . . 2 to 1 2 to 1 The acid-testCurrent (quick) ratio is a much more rigorous test of a company’s ability to meet its short-term debts. Inventories and prepaid expenses are excluded from total current assets, leaving only the more liquid (or “quick”) assets to be divided by current liabilities.

Acid-Test (Quick) Ratio

The acid-test (quick) ratio is a much more rigorous test of a company’s ability to meet its short-term debts. Inventories and prepaid expenses are excluded from total current assets, leaving only the more liquid (or “quick”) assets to be divided by current ­liabilities.

rt-term debt-paying ability without having to rely on inventory.

Acid-test ratio �

Cash � Temporary Investments � Current receivables* Current liabilities

Acid-test (quick) ratio

Test of short-term debt-paying ability without having to rely on ­inventory.

*Current receivables include both accounts receivable and any short-term notes receivable.

The Theacid-test acid-testratio ratio is is designed can meet its its obligations designed to tomeasure measurehow howwell wella company a company can meet obligawithout having to liquidate or depend too heavily on its inventory. Since inventory may tions without having to liquidate or depend too heavily on its inventory. Since inventory be difficult to sell in times of economic stress, it is generally felt that to be properly may be difficult to sell in times of economic stress, it is generally felt that to be properly protected,each eachdollar dollarofofliabilities liabilitiesshould shouldbebebacked backedby byatatleast least$1 $1ofofquick quickassets. assets.Thus Thus, protected, , an acid-test ratio of 1 to 1 is broadly viewed as being adequate in many firms. an acid-test ratio of 1 to 1 is broadly viewed as being adequate in many firms. The Theacid-test acid-testratios ratiosfor forExample ExampleCompany Companyfor for2007 2007and and2008 2008are arecomputed computedbelow: below:

2008 2008

2007 2007

Cash(see (seeExhibit Exhibit14–1) 14–1) . . . . . . . . . . . . . . . . . $1,200,000 $2,350,000 $2,350,000 Cash . . . . . . . . . . . . . . . . $1,200,000 Accounts receivable (see Exhibit 14–1) . . . . .   6,000,000   4,000,000 Accounts receivable (see Exhibit 14–1) . . . . 6,000,000 4,000,000 Total quick assets . . . . . . . . . . . . . . . . . . . . . $7,200,000 $6,350,000 (a) Total quick assets . . . . . . . . . . . . . . . . . . . . . $7,200,000 $6,350,000 (a) Currentliabilities liabilities(see (seeExhibit Exhibit14–1) 14–1) .. .. .. .. .. .. .. $7,000,000 $7,000,000 $5,000,000 $5,000,000 (b) Current (b) Acid-testratio, ratio,(a) (a)�4(b) (b) . . . . . . . . . . . . . . . . . 1.03toto11 Acid-test . . . . . . . . . . . . . . . . 1.03

1.27toto11 1.27

Although AlthoughExample ExampleCompany Company an acid-test for that 2008 that is the within the hashas an acid-test ratio ratio for 2008 is within acceptacceptable range, an analyst might be concerned about several disquieting trends revealed able range, an analyst might be concerned about several disquieting trends revealed in the in the company’s sheet.inNotice Exhibit that short-term debts while are rising, company’s balance balance sheet. Notice Exhibitin14–1 that14–1 short-term debts are rising, the while the cash position seems to be deteriorating. Perhaps the weakened cash cash position seems to be deteriorating. Perhaps the weakened cash position is a resultposition of the is a result of thevolume greatly of expanded of accounts receivable. One wonders why the greatly expanded accountsvolume receivable. One wonders why the accounts receivable accounts receivable have been allowed to increase so rapidly in so brief a time. have been allowed to increase so rapidly in so brief a time. InInshort, short,asaswith withthe thecurrent currentratio, ratio,the theacid-test acid-testratio ratioshould shouldbe beinterpreted interpretedwith withone one eye on its basic components. eye on its basic components.

AccountsReceivable Receivable Turnover Accounts Turnover Theaccounts accountsreceivable receivable turnover turnover isis aarough roughmeasure measureofofhow howmany manytimes timesa acompany’s company’s The accounts receivable have been turned into cash during the year. It is frequently usedinin accounts receivable have been turned into cash during the year. It is frequently used conjunction with an analysis of working capital, since a smooth flow from accounts receivable conjunction with an analysis of working capital, since a smooth flow from accounts www.mcgrawhill.ca/college/garrison into cash isinto an cash important the “quality” a company’s capital and is receivable is an indicator importantofindicator of theof“quality” of aworking company’s working critical to its ability to operate. The accounts receivable turnover is computed by dividing sales on account (i.e., credit sales) by the average accounts receivable balance for the year. www.mcgrawhill.ca/olc/garrison

Accounts receivable turnover

A rough measure of how many times a company’s accounts receivable have been turned into cash during the year.

BC15-20

BC15-20 BC14–20 BC15-20

Average collection period

Chapter 15 “How Well Am I Doing?” Financial Statement Analysis

Assuming that all sales for the year were on account, the accounts receivable turnover for Example Company for 2008 would be computed as follows: Sales on account Sales account $52,000,000 Accounts receivable turnover �  Chapter I IDoing?” Financial Statement Analysis Chapter 14   “How Well Amon Doing?” Statement Analysis Chapter 15 15 “How “HowWell WellAm Financial Analysis   times Average receivable � accounts � 10.4balance Average accounts receivable balance $5,000,000* Assuming that all sales for the year were on account, the accounts receivable turnover *$4,000,000   2 $5,000,000 average. Sales account � $6,000,000  � $10,000,000; $10,000,000 �on � Sales on account for Example Company for 2008 would be computed as follows: Accounts receivable turnover � Accounts receivable turnover �Average accounts receivable balance Average receivable balance The turnover figure can then be divided into 365accounts to determine the average number of Sales on account $52,000,000 days being taken to collect an account (known as the average collection period). Assuming Assuming that all sales for the year were on account, the accounts receivable turnover � � 10.4 times   that the the Assuming thatall allsales salesfor for theyear yearwere wereon onaccount, account, theaccounts accountsreceivable receivableturnover turnover Average accounts receivable balance $5,000,000* for Example Company for 2008 would be computed as follows: for forExample ExampleCompany Companyfor for2008 2008would wouldbe becomputed computedasasfollows: follows: *$4,000,000 �  $6,000,000 �  $10,000,000; $10,000,000 � 2�  $5,000,000 average.

Sales $52,000,000 $52,000,000 Saleson onaccount account Average accounts receivable balance $5,000,000* days being taken to collect an account (known as the average collection period). 365 days *$4,000,000 ��$6,000,000 $10,000,000; Average collection period  *$4,000,000 $6,000,000�� $10,000,000; $10,000,000��2 2��$5,000,000 $5,000,000average. average. � $10,000,000 Accounts receivable turnover The The turnover figure can then be divided into 365 totodetermine determine the average number of Theturnover turnoverfigure figurecan canthen thenbe bedivided dividedinto into365 365to determinethe theaverage averagenumber numberof of Average collection period days The average collection period for Example Company for 2008collection is computed as follows: being taken to collect an account (known as the average period). AverageMeasure collection period days being taken to collect an account (known as the average collection period). days being taken to collect an account (known as the average collection period). of the average number of days taken to collect an account receivable. Measure of the average number 365  of days taken to collect an � 35 days 365 days times Average collection 10.4 period �  account receivable. Average collection period Average collection period Accounts receivable turnover Measure ofofdays totocollect account This simply means that onan average it receivable. takes 35 days to collect on a credit sale. Whether the Measureofofthe theaverage averagenumber number daystaken taken collect an account receivable. The average average collection period for Example Example Company for 2008depends is computed computed ascredit follows: The period for Company is follows: average of 35collection days taken to collect an account is goodfor or 2008 bad on theas terms 365 days 365 days Average collection period � Example Company is offering its customers. If the credit terms are 30 days, then a 35-day Average collection period � 365 Accounts receivable turnover 35 days  Accounts average collection period would 10.4 usually be � viewed asreceivable very good.turnover Most customers will times The average collection period for Example Company for 2008 is computed tend to withhold payment for as long as the credit terms will allow and mayas even go over The average collection period for Example Company for 2008 is computed asfollows: follows: This that average takes 35 days to collect on aaacredit sale. Whether the simply means that on onadded average takes 35 days to collect on credit sale. Whether the aThis fewsimply days. means This factor, to ititever-present problems with few slow-paying cus365 365 �is35good average of days taken to an or bad depends on the credit terms days average can of 35 35 daysthe taken to collect collect an account account is good or bad depends on the credit terms tomers, cause average collection period to exceed normal credit terms by a week � 35 days 10.4 10.4times timesIf Example offering its customers. Example Company iscause offering itsalarm. customers. If the the credit credit terms terms are are 30 30 days, days, then then aa 35-day 35-day or so andCompany should notis great average collection period would usually be viewed as very good. Most customers will average collection period would usually be viewed as very good. Most customers This simply means that on average it takes 35 days to collect on a credit sale. Whether the On the other hand, if the company’s credit terms are 10 days, then a 35-day average This simply means that on average it takes 35 days to collect on a credit sale. Whetherwill the tend to withhold payment for as long long as thecredit credit terms will allow and may even goover over tend to withhold payment for as as the terms will allow and may even go average of 35 days taken to collect an account is good or bad depends on the credit terms collection period is worrisome. The long collection period may result from many olda average of 35 days taken to collect an account is good or bad depends on the credit terms aunpaid fewdays. days. This added to ever-present problems with aslow-paying fewdays, slow-paying cusfew This factor, added toits ever-present a few customers, Example Company is customers. IfIf credit are 30 then aa35-day accounts offactor, doubtful collectability, orproblems itthe may bewith aterms result of poor day-to-day credit Example Company isoffering offering its customers. the credit terms are 30 days, then 35-day tomers, can cause the average collection period tonormal exceed normal credit terms byoraso week can cause the average collection period to exceed credit terms by a week and average collection period would usually be viewed as very good. Most customers management. The firm may be making sales with inadequate credit checks on customers, average collection period would usually be viewed as very good. Most customerswill will or so and should not cause great alarm. should not cause great alarm. tend to withhold payment for as long as the credit terms will allow and may even go over or perhaps no follow-ups are being made on slow accounts. tend to withhold payment for as long as the credit terms will allow and may even go over On the hand, ififadded the company’s credit are days, then aa 35-day Ondays. the other other the company’s credit terms terms are 10 10 days, then 35-day average average a afew This factor, totoever-present problems with aafew cusfew days. Thishand, factor, added ever-present problems with fewslow-paying slow-paying cuscollection period is worrisome. The long collection period may result from many old collection period is worrisome. The long collection period may result from many old tomers, can cause the average collection period to exceed normal credit terms by a week tomers, can cause the average collection period to exceed normal credit terms by a week Inventory Turnover unpaid accounts of doubtful collectability, or itit may be aa result of poor day-to-day credit unpaid accounts of doubtful collectability, or may be result of poor day-to-day credit or so and should not cause great alarm. or so and should not cause great alarm. management. The firm be making with inadequate credit checks on management. The firm may may be making sales sales with inadequate credit checks on customers, customers, On hand, ififratio the company’s credit terms are days, aa35-day average The inventory turnover measures how many times a10 company’s inventory has been Onthe theother other hand, the company’s credit terms are10 days,then then 35-day average or perhaps no follow-ups are being made on slow accounts. or perhaps no follow-ups are being made on slow accounts. collection period is worrisome. The long collection period may result from many sold and replaced during the year. It is computed by dividing the cost of goods sold by the collection period is worrisome. The long collection period may result from manyold old unpaid accounts of doubtful collectability, or it may be a result of poor day-to-day credit average level of inventory on hand: unpaid accounts of doubtful collectability, or it may be a result of poor day-to-day credit management. The management.Turnover Thefirm firmmay maybe bemaking makingsales saleswith withinadequate inadequatecredit creditchecks checkson oncustomers, customers, Inventory Inventory Turnover Inventory turnover ratio ororperhaps no follow-ups are being made on slow accounts. perhaps no follow-ups are being made on slow accounts. The The inventory inventory turnover turnover ratio ratio measures measures how how many many times times aa company’s company’s inventory inventory has has been been Inventory turnover ratio and during is by Measure of howtimes manya times asold company’s inventory has the been soldIt the year. Measure of how many sold and replaced replaced during the year. year. Itduring is computed computed by dividing dividing the the cost cost of of goods goods sold sold by by the the Inventory Turnover Inventory Turnover average level inventory company’s inventory has been average level of of inventory on on hand: hand: sold during the year. The aacompany’s inventory Cost times of goods sold Theinventory inventoryturnover turnoverratio ratiomeasures measureshow howmany many times company’s inventoryhas hasbeen been Inventory turnover ratio Inventory turnover  � sold and replaced during the year. It is computed by dividing the cost of goods sold by the sold and replaced during the year. It is computed by dividing the cost of goods sold by the Average inventory balance average level of inventory on hand: average level of inventory on hand: Measure of how many times a company’s inventory has been soldisduring the year. inventory figure of of thethe beginning andand ending inventory fig The average average inventory figure isthe theaverage average beginning ending inventory ures. Since Example Company has a beginning inventory of $10,000,000 and an ending Inventory turnover ratio figures. Since Example Company has a beginning inventory of $10,000,000 and an Inventory turnover ratio inventory of $8,000,000, its average for theofyear be would $9,000,000. The comCost goods ending inventory of $8,000,000, its inventory average inventory forwould thesold year be $9,000,000. Inventory turnover �  the Measure company’s inventory has sold year. inventory turnover for 2008 would be computed as follows: The company’s inventory turnover for 2008 would be computed as follows: Measureofofhow howmany manytimes timesaapany’s company’s inventory hasbeen been soldduring during the year.inventory Average balance Cost of goods soldaverage of$36,000,000 The average inventory figure is the the beginningand ending inventory fig � � 4 times Cost ofofgoods sold Cost goods sold ures. Since Example Company has a beginning inventory of $10,000,000 and an ending Average inventory balance $9,000,000 ale period Inventory Inventoryturnover turnover��Average inventory balance inventory of $8,000,000, its average inventory for theinventory year would be $9,000,000. The comAverage balance ofThe The number ofselldays being taken to sell the entire one time (calledfigthe pany’s inventory turnover 2008 would be computed as inventory follows: of the average number days taken to the for inventory oneaverage time. inventory figure is ofofthe beginning and inventory Theaverage average inventory figure isthe the by average the beginning andending ending inventory figaverage sale period) can be computed dividing 365 by the inventory turnover ­ fi gure: Average sale period Chapterhas 15aabeginning “How Well inventory Am I Doing?” Financial Statement Analysis ures. Since Example Company ofof$10,000,000 and an ending ures. Since Example Company has beginning inventory $10,000,000 and an ending Cost of goods sold $36,000,000 Measure of the average number � 4betimes  be inventory itsitsaverage for year would $9,000,000. inventoryofof$8,000,000, $8,000,000, averageinventory inventory� forthe the365 year would $9,000,000.The Thecomcomdays Average inventory balance $9,000,000 of days taken to sell the inventory Average sale period � pany’s inventory turnover for 2008 would be computed as follows: pany’s inventory turnover for 2008 would be computed follows: Inventoryasturnover one time. 10.4 times �$5,000,000* 10.4 timesnumber of turnover can be divided into� 365 to determine�� the average Measure of the average number ofThe days taken tofigure collect an then account receivable. Average accounts receivable balance

Cost $36,000,000 365 Costofofgoods goodssold sold $36,000,000 � 4 times ��� 911⁄4 days � 4 times Average inventory balance $9,000,000 4 times Average inventory balance $9,000,000 The average sale period varies from industry to industry. Grocery stores tend to turn www.mcgrawhill.ca/olc/garrison over their inventory very quickly, perhaps as often as every 12 to 15 days. On the other hand, jewellery stores tend to turn over their inventory very slowly, perhaps only a couple

Average Averagesas

Measure Measureo

Average sale period �

365 days Inventory turnover

Chapter 14  365 “How � Well I Doing?” Financial Statement Analysis 1 ⁄4 days 91Am

4 times

The average sale period varies from industry to industry. Grocery stores tend to turn over their inventory very quickly, perhaps as often as every 12 to 15 days. On the other other hand, jewellery stores tend to turn over their inventory very slowly, perhaps only a couple of times each year. If a firm firm has a turnover that is much slower than the average for its industry, then then it it may have have obsolete obsolete goods on hand, hand, or or its its inventory inventory may may be be needlessly needlessly high. high. Excessive Excessive inventories tie up funds that could be used elsewhere in operations. Managers sometimes argue that they must buy in very very large large quantities quantities to take take advantage advantage of the the best best discounts discounts being offered. But these discounts must be carefully weighed against the added costs of insurance, taxes, financing, and risks of obsolescence obsolescence and deterioration deterioration that result from from carrying added inventories. Inventory turnover has been increasing in recent years as as companies companies have have adopted adopted just-in-time (JIT) methods. Under JIT, inventories are purposely kept low, and just-in-time (JIT) methods. Under JIT, inventories are purposely kept low, and thus athus com-a company utilizing JIT methods may have a very high inventory turnover when compared pany utilizing JIT methods may have a very high inventory turnover when compared to to other companies. Indeed, of the goals of JIT to increase inventory turnover by other companies. Indeed, oneone of the goals of JIT is toisincrease inventory turnover by syssystematically reducing the amount of inventory on hand. tematically reducing the amount of inventory on hand.

Cash Flow FlowRatios Ratios Cash In analyzing analyzing the thefirm’s firm’sshort-term short‑termliquidity liquidityrisk, risk,the themanager managermay may find it useful to refer find it useful to refer to to the statement of cash flows in conjunction with a firm’s balance sheet and the statement of cash flows in conjunction with a firm’s balance sheet and incomeincome statestatement to compute various Theofratio cashfrom flowoperations from operations (CFO) to ment to compute various ratios.ratios. The ratio cashofflow (CFO) to current current liabilities can provide valuable clues to management on how best to finance liabilities can provide valuable clues to management on how best to finance business business operations. is anof indicator of the cash firm has derived operations. This ratioThis is anratio indicator the amount of amount cash theof firm hasthe derived from operfrom operations after meeting current debt and working capital obligations. In calculating ations after meeting current debt and working capital obligations. In calculating this ratio, ratio,toituse is cash best to usefrom cashcontinuing flow fromoperations continuingsooperations as notby tounusual be misled itthis is best flow as not to besomisled or by unusual or non-recurring items. A ratio of .40 or more is considered good forora non-recurring items. A ratio of .40 or more is considered good for a manufacturing manufacturing retailing firm. or retailing firm. In addition additiontotoshort-term short‑termratio ratio analysis, a manager it useful do a analysis, a manager maymay alsoalso find find it useful to do to a trend trend analysis comparing net income over several periods with cash flow from operations. analysis comparing net income over several periods with cash flow from operations. To To reduce effect non-cash items, suchasasdepreciation depreciationand andaccruals accrualsof of revenue revenue and reduce the the effect of of non-cash items, such expenses, one could use the following ratio: CFO before interest and taxes Operating income before interest, taxes, and depreciation Any evidence of the CFO and operating income not moving in parallel could signal Any evidence of the CFO and operating income not moving in parallel could signal trouble and the cause should be investigated in time to take corrective action. trouble and the cause should be investigated in time to take corrective action. Other cash flow ratios may also be of interest. In assessing the quality of earnings, Other cash flow ratios may also be of interest. In assessing the quality of earnings, for for example, insight can be gained by dividing cash flow from operations by sales. A high example, insight can be gained by dividing cash flow from operations by sales. A high ratio signals high‑quality earnings. Cash flow from operations is used in lieu of operating ratio signals high-quality earnings. Cash flow from operations is used in lieu of operating income because the latter is subject to more judgement regarding cost allocation and income because the latter is subject to more judgement regarding cost allocation and revrevenue recognition. Another indicator of quality of earnings is cash flow from operations enue recognition. Another indicator of quality of earnings is cash flow from operations divided by operating income. Because of non-cash expenses such as depreciation and divided income. Because of non-cash expenses such as depreciation and Chapter by 15 operating “How Well I Doing?” Financial Statement Analysis non-cash revenues suchAm as credit sales or the recognition of previously deferred revenue, non-cash revenues such as credit sales or the recognition of previously deferred revenue, a substantial difference may exist between CFO and operating income. a substantial difference may exist between CFO and operating income. In addition to assessing quality com­pute pute  quality of earnings, earnings, CFO CFO can also be used to com In addition to assessing quality of earnings, CFO can also be used to compute other ratios of interest to management. A manager may be interested, for exam exam­pple, le,  in other ratios of interest to management. A manager may be interested, for example, in ­ddetermining etermining the firm’s ability to make capital expenditures from internally generated determining the firm’s ability to make capital expenditures from internally generated funds. A helpful ratio is CFO divided by capital asset acquisitions. Dividends are usually funds. A helpful ratio is CFO divided by capital asset acquisitions. Dividends are usually deducted from CFO under the assumption that current dividends will not be cut. deducted from CFO under the assumption that current dividends will not be cut. CFO � Dividends CFO � Dividends Cash paid for capital assets Cash paid for capital assets www.mcgrawhill.ca/college/garrison Although it is likely that firm will will seek seek long-run long‑run sources sources of of financing financing for major Although it is likely that aa firm for major AlthoughCFO it is has likely that a firm will seek long-run sources of as financing for major acquisitions, information content. CFO can be interpreted an indicator acquisitions, CFO has information content. CFO can be interpreted as an indicator of the of the i iti CFO h i f ti t t CFO b i t t d i di t f th firm’s ability to service debt. However, this ratio does have limitations, as do cash flow www.mcgrawhill.ca/olc/garrison ratios generally. Because managers often have considerable discretion regarding capital asset decisions, the CFO to capital expenditures ratio can easily be manipulated. One

BC14–21

BC14–22

Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

firm’s ability to service debt. However, this ratio does have limitations, as do cash flow ratios generally. Because managers often have considerable discretion regarding capital asset decisions, the CFO to capital expenditures ratio can easily be manipulated. One should look for trends and seek explanations for changes in these trends. Caution should be exercised in the use and interpretation of all cash flow ratios. Cash flow ratios, for example, should not be interpreted as a measure of the firm’s ability to distribute cash. This is because cash flow ratios do not include some critical information that has future cash flow effects. Cash flow ratios, for example, do not include provision for asset replacement or for contingencies. When used in conjunction with other ratios, however, cash flow ratios may provide useful insights for managerial decisions.

Cash Burn Rate Cash burn rate

The monthly rate of cash use.

A cash flow ratio developed to look at Internet companies is called the cash burn rate. The cash burn rate is computed from the cash flow statement as follows: Cash burn rate = (Cash flow from operations + Cash used for capital assets acquisitions + Cash used to purchase going-concern businesses) ÷ Number of months presented in the statement (that is 3, 6, 9, 12, depending on the specific set of statements)

Months to burn out

The time needed to use up cash and liquid assets.

A variation to assist interpretation is the months to burn out. This amount is computed as follows: Months to burn out = (Cash and cash equivalents + Temporary investments) ÷ Cash burn rate Application of the above ratios assumes that the numerator of the cash burn rate is negative (a cash outflow). However, the use of the burn rate is positive because the cash and its equivalents amounts are positive; otherwise, insolvency is likely. To illustrate the sign issue, the following is taken from Exhibit 14–8 (page BC14–26). Here, the cash flow from operations was $5,520 inflow, while $5,000 was paid for investments. Thus, the net inflow was $520 ($5,520 – $5,000). The statement was for 12 months, so the inflow per month was $43.33, the opposite of a burn. Thus, with $1,470 of cash and equivalents on hand, this balance should grow instead of being consumed as implied if the cash from operations was negative. If the $43.33 amount was negative (an outflow), then the $1,470 would be burned out in 33.9 months.

Ratio Analysis—The Long-Term Creditor Ratio Analysis—The Long-Term Creditor Learning Objective 6

Compute and interpret the financial ratios used by the long-term creditor.

The position of long-term creditors differs from that of short-term creditors in that they are concerned with both the near-term and the long-term ability of a firm to meet its commitments. They are concerned with the near term since the interest they are entitled to is normally paid on a current basis. They are concerned with the long term since they want to be fully repaid on schedule. Since the long-term creditor is usually faced with greater risks than the short-term creditor, firms are often required to agree to various restrictive covenants, or rules, for the long-term creditor’s protection. Examples of such restrictive covenants include the ­maintenance of minimum working capital levels and restrictions on payment of dividends to common shareholders. Although these restrictive covenants are in widespread use, they must be viewed as a poor second to adequate future earnings from the point of view of assessing protection and safety. Creditors do not want to go to court to collect their claims; they would much prefer staking the safety of their claims for interest and eventual repayment of principal on an orderly and consistent flow of funds from operations. www.mcgrawhill.ca/olc/garrison

repayment of principal on an orderly and consistent flow of funds from operations. the long-term creditor ison theantimes interest earned ratio. computed by dividing earnrepayment of principal orderly and consistent flow Itofisfunds from operations. ings before interest expense and income taxes (i.e., operating income) by the yearly interest charges that must be met: Ratio Times Interest Earned

Times

Interest Earned Ratio Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

BC14–23

The most common measure of the ability of a firm’s operations to provide protection to terest earned ratio The most common measure of theinterest ability of a firm’s operations to provide protection to the to long-term creditor is the times earned ratio. It is computed by dividing earnof the company’s ability make interest payments. the long-term creditor is the times interest earned ratio. It is computed by dividing earnTimes Interest Earned ings before interest expense andRatio income taxes (i.e., operating income) by the yearly interbefore(i.e., interest expense and income ings before interest expense andEarnings income taxes operating income) by the taxes yearly interest charges that must be met: Times interest earned � of the ability of a firm’s operations to provide protection The most common est charges that mustmeasure be met: Interest expense to the long-term creditor is the times interest earned ratio. It is computed by dividing Times interest earned ratio terest earned ratio For Example Company, the times interesttaxes earned ratio for 2008 would by be the computed earnings before interest expense and income (i.e., operating income) yearly Measure of the company’s ability terest ratioability of the earned company’s to make interest payments. as follows: to make interest payments. interest charges thatpayments. must be met: of the company’s ability to make interest Earnings before interest expense and income taxes Times interest earned � Earnings $3,140,000 before interest expense and income taxes Interest � 4.9 timesexpense Times interest earned � $640,000 Interest expense For Example Company, the times interest earned ratio for 2008 would be computed Earnings before income taxes mustinterest be usedearned in the computation, interest expense as follows: For Example Company, the times ratio for 2008since would be computed deductions come before income taxes are computed. Creditors have first claim on earnas follows: $3,140,000 ings. Only those earnings remaining after all interest charges have been provided for are $3,140,000 � 4.9 times � 4.9 times $640,000 subject to income taxes. $640,000 Generally,before earnings are viewed as adequate to the protect long-termsince creditors if the times Earnings income taxes must be used in computation, interest expense Earnings before before income income taxes taxes must must be be used used in inthe thecomputation, computation, since sinceinterest interest expense expense interest Earnings earned ratio is 2 or more. Before making a final judgement, however, it would be deductions come before income taxes are computed. Creditors have claim on deductionscome comebefore beforeincome incometaxes taxes are computed. Creditors have first claim on earnearndeductions are computed. Creditors have firstfirst claim on earnings. necessary to look at a firm’s long-run trend of earnings and evaluate how vulnerable the ings. Only remaining after all have been for ings. those Only those those earnings earnings remaining after all interest interest charges have been provided provided for are are Only earnings remaining after all interest chargescharges have been provided for are subject firm is to cyclical changes in the economy. subject to income taxes. subject to taxes. income taxes. to income Generally, earnings are viewed as adequate to protect long-term creditors ifif the the times Generally, earnings earnings are are viewed viewed as as adequate adequate to to protect protect long-term long-term creditors creditors if the times times Generally, interest earned ratio is 2 or more. Before making a final judgement, however, it would be Debt-to-Equity Ratio interest earned earned ratio ratio is is 22 or or more. more. Before Before making making aa final final judgement, judgement, however, however, itit would would be be interest necessary to look at a firm’s long-run trend of earnings and evaluate how vulnerable the necessary to to look look at at aa firm’s firm’s long-run long-run trend trend of of earnings earnings and and evaluate evaluate how how vulnerable vulnerable the the necessary Long-term creditors are also concerned with keeping a reasonable balance between the firm is to cyclical changes in the economy. firm is is to to cyclical cyclical changes changes in in the the economy. economy. firm portion of assets provided by creditors and the portion of assets provided by the shareholders of a firm. This balance is measured by the debt-to-equity ratio:

Debt-to-Equity Debt-to-Equity Ratio Ratio Debt-to-Equity Ratio

Long-term aa reasonable balance between the Long-term creditors are also concerned with keeping reasonable balance between the Long-term creditors are are also alsoconcerned concernedwith withkeeping keeping a reasonable balance between portion of assets provided by creditors and the portion of assets provided by the shareportion of assets provided by creditors and the portion of assets provided by the sharethe portion of assets provided by creditors and the portion of assets provided by the of the amount of assets being provided by creditors for each dollar of assets being provided by the holders This is by ratio: holders of of aa firm. firm. This balance balance is measured measured by the the debt-to-equity ratio:ratio: Debt-to-equity ratio shareholders of a firm. This balance is measured bydebt-to-equity the debt-to-equity ders.

equity ratio

equity equity ratio ratio

Debt-to-equity ratio �

Total liabilities Shareholders’ equity

of of the the amount amount of of assets assets being being provided provided by by creditors creditors for for each each dollar dollar of of assets assets being being provided provided by by the the 2008 2007 ders. 2008 2007 ders.

Measure of the amount of assets being provided by creditors for each dollar of assets being provided by the shareholders.

Total liabilities . . . . . . . . . . . . . . . . . . . . . . $13,000,000 (a) Total liabilities . . . . . . . . . . . . . . . . . . . . . . $14,500,000 $14,500,000 (a) Total Total liabilities liabilities$13,000,000 Debt-to-equity Shareholders’ 15,970,000 (b) Debt-to-equity ratio Shareholders equity . . . . . . . . . . . . . . . . . equity . . . . . . . . .ratio ....� .� . . Shareholders’ . 17,000,000 17,000,000 equity 15,970,000 (b) Debt-to-equity ratio, (a) (a) � 4 (b) (b) . . . . . . . . . . 0.85 0.81 Debt-to-equity ratio, . . . . . . . . . .Shareholders’ 0.85 to to 1 1 equity 0.81 to to 11

2008 2007 The assets by 2008 2007 The debt-to-equity debt-to-equity ratio ratio indicates indicates the the amount amount of of assets being being provided provided by creditors creditors for of assets being provided by the owners of aa company. In 2007, creditors of Total liabilities . . . . . . . . . . . . . . . . . . . . . . $14,500,000 $13,000,000 (a) for each each dollar dollar of assets being provided by the owners of company. In 2007, creditors of Total liabilities . . . . . . . . . . . . . . . . . . . . . . $14,500,000 $13,000,000 (a) Example Company were providing 81 cents of assets for each $1 of assets being provided equity . . . . . . . . . . . . . . . . . 17,000,000 15,970,000 (b) ExampleShareholders Company were providing 81 cents of assets for each $1 of assets being provided Shareholders equity . . . . . . . . . . . . . . . . . 17,000,000 15,970,000 (b) by the increased to by 2008. Debt-to-equity ratio, � .. .. .. .. slightly .slightly to 11 to by shareholders; shareholders; the figure figure increased only to 85 85 cents by0.81 2008. � (b) Debt-to-equity ratio, (a) (a) (b) .. ..only . .. .. .. 0.85 0.85 tocents 0.81 to 11 www.mcgrawhill.ca/college/garrison Creditors would like the debt-to-equity ratio to be relatively low. The the Creditors would like the debt-to-equity ratio to be relatively low. The lower lower the ratio, ratio, The ratio indicates the amount of assets being by The debt-to-equity debt-to-equity ratio indicates the amountby of the assets beingofprovided provided by creditors creditors the greater the amount of assets being provided owners aa company and the the greater the amount of assets being provided by the owners of company and the for of being by of In 2007, of for each eachisdollar dollar of assets assets being provided provided by the the owners owners of aa company. company. In 2007, creditors creditors of greater the buffer of protection to creditors. By contrast, common shareholders would greater is the buffer of protection to creditors By contrast common shareholders would Example Company were providing 81 cents of assets for each $1 of assets being provided Example Company were providing 81 cents of assets for each $1 of assets being provided like the ratio to be relatively high, because through leverage, common shareholders can by the increased only slightly by shareholders; shareholders; the figure figure slightly to to 85 85 cents cents by by 2008. 2008. benefit from the assets beingincreased providedonly by creditors. www.mcgrawhill.ca/college/garrison Creditors would like the debt-to-equity ratio to be relatively low. The lower ratio, Creditors would like the debt-to-equity ratio to be relatively low. lower the the ratio, www.mcgrawhill.ca/college/garrison In most industries, norms have developed over the years that serveThe as guides to firms the greater the amount of assets being provided by the owners of a company and the the greater the amount of assets being provided by the owners of a company and the in their decisions as to the “right” amount of debt to include in the capital structure. greater is the buffer of protection to creditors. By contrast, common shareholders would greater is the buffer of protection to creditors By contrast common shareholders would Different industries face different risks. For this reason, the level of debt that is appropriate like the ratio to be relatively high because through leverage common shareholders can for firms in one industry is not necessarily a guide to the level of debt that is appropriate for firms in a different industry.

Monitoring Productivity Monitoring Productivity The importance of productivity has increased among Canadian business firms. In the manufacturing sector, Canadian firms have not kept pace with other ­competitors. To help www.mcgrawhill.ca/olc/garrison

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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

MONITORING PRODUCTIVITY

The importance productivitymust has increased Canadiantechniques business firms. In the reverse this trend,ofmanagement be alert to among new production that result in manufacturing sector, Canadian have not kept pace with other competitors. To long‑term productivity gains and firms must make use of measurement methods that help the help reverseitsthis trend,position. management must be alert to new production that firm assess relative Long‑term productivity gains can resulttechniques from the early result in long-term productivity gains and must make of measurement methods that adoption of more efficient production techniques. Theuse development and application of help the firm assess its relative productivity Improved gains canproductivity result from knowledge and new ideas are theposition. primary Long-term drivers of productivity. the adoption efficient production techniques. The development and applimayearly manifest itselfofinmore savings in materials, labour, capital, and energy costs. Productivity cation knowledge and new ideas are the or primary drivers faster of productivity. benefitsofcould also include improved quality more variety, cycle time, Improved faster and productivity manifest itself savings in materials, more efficientmay production runs, andinbetter customer service. labour, capital, and energy costs. benefits could productivity also include can improved or more faster ToProductivity management, improving mean quality obtaining highervariety, profitability cycle time, faster and more efficient runs,competitive and better customer service. and greater assurance of survival in production an ever more business environment. management, improving productivity can meanrole obtaining profitability and The To management accountant can play an important in the higher assessment of a firm’s greater assurance of survival in an ever more competitive business environment. The manproductivity. agement accountant play an important roleofinsome the assessment a firm’s productivity. Productivity cancan be determined as a ratio measure ofof output to some measure Productivity ratio of some of output tocorresponding some measure of of input. Outputscan canbebedetermined expressedas inaphysical units measure or by dollar values to input. Outputs can be Inputs expressed in physical units labour, or by dollar valuesand corresponding to the the firm’s objectives. consist of materials, overhead, capital. Corporate firm’s Inputs consist of materials, andmeasuring capital. Corporate annual annualobjectives. reports typically provide physicallabour, data overhead, useful for a company’s reports typically provide physical data useful for measuring a company’s productivity. productivity. methodscan canbe beused usedtoto measure productivity. They range sophisti Numerous methods measure productivity. They range fromfrom sophisticated cated computer models that perform sensitivity analysis on productivity (profitability) as computer models that perform sensitivity analysis on productivity (profitability) as any any allthe of elements the elements of the input changed, to the simple utilization of finanor allorof of the input mixmix are are changed, to the simple utilization of financial cial readily available the firm’s existing accounting system. performance datadata readily available fromfrom the firm’s existing accounting system. BothBoth performance and and productivity of invested capital canmeasured be measured by calculating financial that productivity of invested capital can be by calculating financial ratiosratios that help help to relate production inputs to production outputs. to relate production inputs to production outputs. One measurement ratio useful in assessing productivity is the return on investment investment formula calculated in Chapter 11 as follows: ROI �

Operating income Sales Operating income � � Sales Average operating assets Average operating assets

may helphelp assess productivity include such ratios manu Other financial financialratios ratiosthat that may assess productivity include such as ratios as cost to cost sales,toand administrative cost to sales. More detailed facturing cost tocost sales, manufacturing to selling sales, selling sales, and administrative cost to sales. More productivity analysis can be extended, example, analyze the detailed productivity analysis can be for extended, fortoexample, to individual analyze thecomponents individual of manufacturing cost. Separate ratios can beratios computed raw materials, and components of manufacturing cost. Separate can beforcomputed for rawlabour, materials, manufacturing overhead as percentages the market value production labour, and manufacturing overhead asofpercentages of theofmarket value(manufacturing of production cost times the ratio salesthe to cost (manufacturing costoftimes ratioof ofsales). sales to cost of sales). Other partial measures of productivity can be computed by expressing components of the balance sheet sheet as aspercentages percentagesofofsales. sales.The Thelower lowerthe theinvestment investment a given level forfor a given level of of sales, more productive is the business in the utilization resources. examsales, thethe more productive is the business in the utilization of of its its resources. ForFor example, ple, taking the ratio of capital to the sales, the higher thethat sales can be generated taking the ratio of capital assetsassets to sales, higher the sales canthat be generated for each for each dollarininvested in capital assets, is thethe greater is the productivity of theassets. firm’s dollar invested capital assets, the greater productivity of the firm’s fixed fixed assets. The management accountant should be cautious, however, in interpreting productivity TheThe management accountant shouldthe be various cautious,measures however,of in interpreting ratios. interrelationships among productivity productivand their ity ratios.effect The on interrelationships among must the various measures of productivity andlabour their ultimate the firm’s profitability be clearly understood. For example, ultimate effect on theasfirm’s profitability must be clearly understood. labour may be decreasing a percentage of manufacturing cost as a resultFor of example, the purchase of higher‑quality raw materials. Careful analysis may reveal that increased productivity may be decreasing as a percentage of manufacturing cost as a result of the purchase of labour was more offset Careful by the increased cost reveal of thethat rawincreased materials.productivity Nevertheless, higher-quality rawthan materials. analysis may of partial productivity ratios can provide information on how output is affected by a given input factor, and changes in these ratios can serve as a signal for investigation that might www.mcgrawhill.ca/college/garrison otherwise go unnoticed. Productivity analysis is as important to service industries as it is to manufacturing firms. Measures such as the number of customers served per day or the number of transactions completed per week for a given staff complement are examples of productivity measures for service industries. In spite of the fact that productivity can be measured for any input factor, labour‑hours have been the most commonly used input in measuring productivity. Productivity measures derived from labour no doubt can be useful to management in assessing learning curve effects and the motivational level of employees. However, as firms face stiffer competition both nationally www.mcgrawhill.ca/olc/garrison

stiffer competition both nationally and internationally, it seems prudent for management to assess the interrelationships among several productivity measures. This is especially true in the new manufacturing environment where costs are mostly fixed. Even the direct labour as fixed theAm sense that employee are essen that remains can be interpreted Chapter 14   “Howin Well I Doing?” Financialskills Statement Analysis tial to a firm’s success. The amount invested in training and development may be a critical performance measure in this environment in assessing current position and as an and internationally, it seems prudent for management to assess the interrelationships among indicator of future productivity. Since workers need multiple skills in the high-tech enviseveral productivity measures. This is especially true in the new manufacturing environment ronment, a measure such as percent cross-trained could be a revealing statistic in moniwhere costs are mostly fixed. Even the direct labour that remains in this modern environment toring productivity. Other useful measures could include number of defects, percentage can be interpreted as fixed in the sense that employee skills are essential to a firm’s success. passing first inspection, work in process turnover, scrap as a percentage of output, and The amount invested in training and development may be a critical performance measure percentage of on-time shipments. in this environment in assessing current position and as an indicator of future productivity. What is measured and reported should be determined by the measure’s relationship Since workers need multiple skills in the high‑tech environment, a measure such as percent to the firm’s operating and strategic goals. For example, if a major objective of a company cross‑trained could be a revealing statistic in monitoring productivity. Other useful measures is to increase market share, measures of delivery and quality improvements may provide could include number of defects, percentage passing first inspection, work in process turnover, useful strategic information. By using productivity ratios and new performance indicascrap as a percentage of output, and percentage of on‑time shipments. tors to help understand key interrelationships, management may be able to more quickly What is measured and reported should be determined by the measure’s relationship adopt cost-reducing innovations that lead to improvements in total productivity and to to the firm’s operating and strategic goals. For example, if a major objective of a company increased long-term profitability. is to increase market share, measures of delivery and quality improvements may provide useful strategic information. By using productivity ratios and new performance indicators ratios to help understand key interrelationships, management may be able to more quickly adopt cost‑reducing innovations thatsuch leadas todirect improvements in total productivity and to increased easure output in relation to some measure of input, labour charges. long‑term profitability.

BC14–25

Productivity ratios

Ratios that measure output in relation to some measure of input, such as direct labour charges.

RATIOS AND PROFIT PLANNING Ratios and Profit Planning Profit planning projection of budgeted financial statements discussed Profit planning and and the the projection of budgeted financial statements werewere discussed in in Chapter 9 in the textbook. Ratios can be linked to the budgeting process to help project Chapter 9 in the textbook. Ratios can be linked to the budgeting process to help project financial statement account balances asaswell as toinassist in estimating cash financial statement account balances as well to assist estimating cash flows. In flows. addi- In addition, using ratios in the forecasting process allows a complete articulation of the tion, using ratios in the forecasting process allows a complete articulation of the balance balance sheet, income statement, and statement of cash flows. For example consider the sheet, income statement, and statement of cash flows. following two ratios. \ Sales on account Accounts receivable turnover � Accounts receivable Accounts receivable �

Sales on account Accounts receivable turnover

accounts receivable can,can, therefore, be estimated by dividing projected salessales Budgeted Budgeted accounts receivable therefore, be estimated by dividing projected on account by the receivable turnover. For For example, if projected salessales for 2008 on account by accounts the accounts receivable turnover. example, if projected for 2008 for Example Company, fromfrom Exhibit 14–2, is $52,000 and and if the accounts receivable for Example Company, Exhibit 14–2, is $52,000 if the accounts receivable turnover is forecasted to beto8.67, thenthen estimated accounts receivable for 2008 is $6,000 turnover is forecasted be 8.67, estimated accounts receivable for 2008 is $6,000 ($52,000/8.67 rounded). ($52,000/8.67 rounded). 15inventory “How Well Doing?” Financial Statement Analysis Similarly, for Am 2008 can can be projected by manipulating the inventory turnover Chapter Similarly, inventory for I2008 be projected by manipulating the inventory turnover www.mcgrawhill.ca/college/garrison formula. Recall that:that: formula. Recall Cost Cost of of goods goods sold sold Inventory Inventory turnover turnover � � Inventory Inventory Then: Chapter 15 “How Well Am I Doing?” Financial Statement Analysis Then: Cost Cost of of goods goods sold sold Inventory Inventory � � Inventory turnover Inventory turnover If the cost estimated turnover is If If the the cost cost of of goods goods sold sold is is estimated estimated at at 69% 69% of of sales sales and and the the inventory inventory turnover turnover is is expected to be 4.5, then inventory is projected to be 7,973 [($52,000 � 0.69)/4.5]. expected to be 4.5, then inventory is projected to be 7,973 [($52,000 3 0.69)/4.5]. expected to be 4.5, then inventory is projected to be 7,973 [($52,000 � 0.69)/4.5]. Accounts payable can be projected by linking budgeted purchases to new ratio Accounts Accounts payable payable can can be be projected projected by by linking linking budgeted budgeted purchases purchases to to aaa new new ratio ratio called the accounts payable turnover. called the accounts payable turnover. called the accounts payable turnover. Purchases Purchases on on account account Accounts Accounts payable payable turnover turnover � � Accounts payable Accounts payable Therefore: Therefore: Purchases Purchases on on account account Accounts Accounts payable payable � � Accounts payable turnover Accounts payable turnover However, However, because because purchases purchases on on account account is is not not disclosed, disclosed, it it too too must must be be estimated. estimated. A A www.mcgrawhill.ca/olc/garrison convenient way to project purchases is through the algebraic manipulation of convenient way to project purchases is through the algebraic manipulation of the the cost cost of of goods goods sold sold (CGS) (CGS) formula. formula.

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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

However, because purchases on account is not disclosed, it too must be estimated. A convenient way to project purchases is through the algebraic manipulation of the cost of goods sold (CGS) formula. Beginning inventory 1 Purchases 2 Ending inventory 5 CGS Therefore: BC15-26

5 CGS 2 Beginning Ending inventory Chapter 15 Purchases “How Well Am I Doing?” Financial inventory Statement1 Analysis

5 $35,880 2 $10,000 1 $7,973 5 $33,853

If 5.8 times is the accounts payable turnover, then accounts payable is projected to equal $5,837 ($33,853/5.8). A full integration of the sales forecast for 2008 is presented in Exhibit 14–8, which incorporates the following additional assumptions. Prepaid expenses are projected to be $300 at December 31, 2008. The Land account balance is expected not to change, and buildings and equipment are forecasted at $12,000 net of depreciation. The expected ­balance of accrued payables is $900; $500 will be used to retire bonds and $300 to pay short-term notes. Where amounts in Exhibit 14–8 differ with corresponding items in Exhibits 14–1 and 14–2, it is a result of rounding.

Exhibit 14–8   Estimated Financial Statements

Estimated Income Statement* Sales revenue (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$52,000 35,880

Gross margin on sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Operating expenses: Selling expenses (13.5%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Administrative expenses (11.2%) . . . . . . . . . . . . . . . . . . . . . . . . . . . .

16,120

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

12,860

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense (1.2%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,260 640

Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2,620 786

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 1,834

Estimated Statement of Cash Flows Operating activities: Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in accounts receivable (52,000/8.67 � 4,000) . . . . . . . . . . . Decrease in inventory (35,880/4.5 � 10,000) . . . . . . . . . . . . . . . . . . . Increase in prepaid expenses (given) . . . . . . . . . . . . . . . . . . . . . . . . . Depreciation expense (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increase in accounts payable (33,853/5.8 � 4,000) . . . . . . . . . . . . . . Increase in accrued payable (900 given � 400) . . . . . . . . . . . . . . . . .

$ 1,834 (1,998) 2,027 (180) 1,500 1,837 500

7,000 5,860

Cash flow from operations . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Financing activities: Retired bonds (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retired short-term notes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Paid dividends (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investing activities: Purchased equipment (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(5,000)

Net change in cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . Cash balance 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

(880) 2,350

Balance of cash and cash equivalents 2008 . . . . . . . . . . . . . . . . . . . . . .

5,520 (500) (300) (600)

$ 1,470

*Assumes depreciation of $1,500 is included in selling and administrative expenses.

www.mcgrawhill.ca/olc/garrison



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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

Exhibit EXHIBIT 14–8   Estimated Estimated

Estimated Balance Sheet, December 31, 2008

Financial Financial Statements Statements (concluded) (concluded)

Assets Current Assets: Cash and cash equivalents . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable (52,000  8.67) . . . . . . . . . . . . . . . . . . . . . . . . . Inventory (35,880  4.5) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$ 1,470 5,998 7,973 300

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital assets: Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Buildings and equipment, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

15,741 4,000 12,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$31,741

Liabilities Current liabilities: Accounts payable (33,853  5.8) . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accrued payables (given) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Notes payable, short-term . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$5,837 900 300

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Long-term liabilities: Bonds payable, 8% (8,000  500) . . . . . . . . . . . . . . . . . . . . . . . . . . .

7,037 7,500

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

14,537

Shareholders Equity Preferred shares, $100 liquidation value $6 no par . . . . . . . . . . . . . . . . . Common shares 500 no par . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

2,000 7,000

Total contributed capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings (6,970  1,834  600 given) . . . . . . . . . . . . . . . . . .

9,000 8,204

Total shareholders equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

17,204

Total liabilities and shareholders equity . . . . . . . . . . . . . . . . . . . . . . . . .

$31,741

Proforma Earnings Proforma Earnings Management will discuss the company’s earnings performance in the annual report to shareholders and in press releases to the news media. Obviously, it is to the company’s advantage to present results in a manner that creates the most favourable image. If the results are bad relative to expectations, then a “big bath” may be called for­—the presentation of results even more unfavourably than warranted by the actual circumstances. The reason for this is to enable the future to be better by placing costs that belong to the future in the current period, the period of the “bath.” Alternatively, management may present results according to the practice of proforma reporting, presenting “proforma earnings” in an “if then” context: “If we did not have these non-cash charges, then our earnings would have been $xxx.” “If we did not have these non-cash accounting expenses from amortization, then our earnings would have been $yyy.” “If we did not have debt charges, then our income would have been $zzz.” Common proforma income results would be EBIT (earnings before interest and taxes) or EBITDA (earnings before interest, taxes, depreciation and amortization). Because these proforma income/earnings do not include all legitimate costs, expenses, and losses, and because they are not GAAP, the users of such results can be misled. What management must be concerned about with this type of reporting is the reputation they generate for themselves or their firm by the use of such numbers. For example, Telus reported in its 2006 annual report that they had a 9% increase in EBITDA, excluding restructuring, over 2005. EBITDA excludes $1,575.6 million of depreciation, $504.7 million for www.mcgrawhill.ca/olc/garrison

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interest, and $351.0 million for income taxes. These three matters account for 28% of revenue for 2006. Will the statement user be misled by the comments about the EBITDA increase or will they believe the 9% represents the increase in core business operations? Management believes that the 9% increase is a key reflection of their operations.

Summary of Ratios and Sources of Comparative Ratio Data Exhibit 14–9 contains a summary of the ratios discussed in this chapter. The formula for each ratio and a summary comment on each ratio’s significance are included in the exhibit. Exhibit 14–10 contains a listing of some sources that provide comparative ratio data organized by industry. These sources are used extensively by managers, investors, and analysts in doing comparative analyses and in attempting to assess the well-being of companies. The Internet also contains a wealth of financial and other data. A search engine such as Google can be used to track down information on individual companies. Many companies have their own web sites on which they post their latest financial reports and news of interest to  potential investors. the Sedar and EDGAR databases listed in Exhibit 14–10 are par­ticularly rich sources of data. They contain copies of all reports filed by com­panies with the agencies since about 1995—including U.S. annual reports filed as form 10-K.

Exhibit 14–9    Summary of Ratios

Ratio

Formula

Significance

Profitability Gross margin percentage Gross margin 4 Sales A broad measure of profitability Earnings per share (of common (Net income 2 Preferred dividends) Tends to have an effect on the    shares)    4 Average number of common shares    market price per share, as reflected    outstanding    in the price-earnings ratio Price-earnings ratio Market price per share 4 Earnings An index of whether a share is    per share   cheap or relatively expensive in relation to current earnings Dividend payout ratio Dividends per share 4 Earnings An index showing whether a    per share   company pays out most of its earnings in dividends or reinvests the earnings internally Dividend yield ratio Dividends per share 4 Market price Shows the return in terms of cash    per share    dividends being provided by a share Return on total assets {Net income 1 [Interest expense 3 Measure of how well assets have    (1 2 Tax rate)]} 4 Average total    been employed by management    assets Return on common shareholders’ (Net income 2 Preferred dividends) When compared to the return on    equity    4 Average common shareholders’    total assets, measures the extent    equity (Average total shareholders’    to which financial leverage is    equity 2 Average preferred shares)    working for or against common       shareholders Book value per share Common shareholders’ equity (Total Measures the amount that would    shareholders’ equity 2 Preferred    be distributed to holders of    shares) 4 Number of common    common shares if all assets were    shares outstanding   sold at their balance sheet carrying amounts and if all creditors were paid off Liquidity Working capital Current assets 2 Current liabilities Measures the company’s ability to   repay current liabilities using only current assets. Current ratio Current assets 4 Current liabilities Test of short-term debt-paying ability Acid-test (quick) ratio (Cash 1 Temporary Investments 1 Current Test of short-term debt-paying ability    receivables) 4 Current liabilities    without having to rely on inventory (continued)

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Exhibit 14–9    Summary of Ratios (concluded)

Ratio

Formula

Significance

Accounts receivable turnover Sales on account 4 Average accounts A rough measure of how many times    receivable balance   a company’s accounts receivable have been turned into cash during the year Average collection period 365 days 4 Accounts receivable turnover Measure of the average number of    (age of receivables)   days taken to collect an account receivable Inventory turnover Cost of goods sold 4 Average inventory Measure of how many times a company’s    balance   inventory has been sold during the year Average sale period (turnover in days) 365 days 4 Inventory turnover Measure of the average number of   days taken to sell the inventory one time Solvency Times interest earned Earnings before interest expense and Measure of the company’s ability    income taxes 4 Interest expense    to make interest payments Debt-to-equity ratio Total liabilities 4 Shareholders’ equity Measure of the amount of assets   being provided by creditors for each dollar of assets being provided by the shareholders Cash burn rate (Cash flow from operations + Capital asset Determines the rate of cash use for    acquisitions + Cash used to purchase    operating decisions    going concerns) ÷ Number of months in    statements Months to burn out Cash and cash equivalents + Short-term Assesses the ability to sustain    marketable securities ÷ Burn rate    the current burn rate

Exhibit 14–10    Sources of Financial Information

Source

Content

Internet Resources http://www.hemscott.com This is a British service where financial reports and other news are available. http://www.hoovers.com/ This is an extensive site for reviews and summary financial information, including for international ­companies. http://www.ic.gc.ca/ Industry Canada publishes studies of various industry groups. They also provide a benchmarking service. http://www.rmahq.org/ This site was formerly maintained by Robert Morris Associates. It is now the Risk Management Association site and contains extensive financial studies of industries; these studies must be purchased. http://www.sec.gov/ or These sites provide a source of financial information that companies must file with the Securities http://www.freeedgar.com/ and Exchange Commission in the United States. The commonly used SEC forms for annual and quarterly financial filings are the 10-K and 10-Q forms, r­ espectively. http://www.sedar.com/ This database provides the annual and quarterly accounting reports for Canadian public companies. This site is similar to the SEC site except that filings are not in a specified form. http://www.statscan.ca/ Various series contain survey information about industry groups in terms of prospects and ratios. Library Internet Resources Public libraries and university libraries often have access to some or all of the following services where financial or background information can be found: ABIGlobal A reference source for topical and company literature. CBCA A Canadian business reference source. EBSCO Provides an extensive database of references and journal articles. (continued)

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Exhibit 14–10    Sources of Financial Information (concluded)

Source

Content

Financial Post Corporate Reports A wide-ranging resource for Canadian financial and market information, including graphical capabilities. Mergent online Moody’s Mergent is a source of financial information on companies and their industries. LexisNexis

An extensive database of legal, regulatory, and financial information is provided by this source.

Compustat

An analyis database of a large number of North American and worldwide companies.

DevelopmentsDevelopments in Generally Accepted Accounting Principles in Generally Accepted Accounting Principles Generally accepted accounting principles (GAAP) in Canada are specified in the Handbook published by the Accounting Standards Board (AcSB) of the Canadian Institute of Chartered Accountants. Membership of the AcSB consists of members of the three accounting professions in Canada and is overseen by the Accounting Standards Oversight Council (AcSOC) from the year 2000. AcSOC is a creature of CICA but it has a representative membership from the financial community in Canada. Authority for the Handbook of AcSB comes from the Securities Acts of the Canadian provinces and territories, and the various companies’ Acts that authorized limited companies. Canadian GAAP is in a process of change whereby it is being harmonized with the International Financial Reporting Standards (IFRS) published by the International Accounting Standards Board (IASB). The harmonization of GAAP for public companies in Canada has a deadline of 2011 for its completion. This harmonization process is helped by the 2002 agreement of the Financial Accounting Standards Board to move toward harmonizing with the IFRS’s, an important factor given the extensive financing of Canadian companies in the United States. During the next few years, changes will be frequent and numerous. Certainly an analyst or accountant interested in financial reporting should obtain a copy of the CICA Handbook and follow the developments on various web sites.2 Without such study, numerous errors are possible because differences exist currently in a wide variety of areas. Some examples of the areas of difference include inventories, revenue, shareholders’ equity, and depreciation.

In BUSINESS XBRL: The Next Generation of Financial Reporting The Securities and Exchange Commission (SEC) in the United States and securities commissions in Canada encourage companies to submit financial reports using a computer code known as Extensible Business Reporting Language, or XBRL for short. XBRL is a “financial reporting derivation of Extensible Markup Language, or XML—a framework that establishes individual ‘tags’ for elements in structured documents, allowing specific elements to be immediately accessed and aggregated.” XBRL dramatically improves the financial reporting process in two ways. First, data are tagged in accordance with a generally accepted framework. This simplifies the process of making apples-to-­apples comparisons of financial results across companies. For example,

2.

Sources for details about harmonization changes can be found at the following: www.cica.ca; www.iasb.org; www.iasplus.com (published by Deloitte); www.pwc.com/ifrs (published by PricewaterhouseCooper). A recent summary article is Michel Blanchette, IFRS in Canada: Evolution or Revolution, “CMA Management, May 2007, pp. 22–26.

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“many of the components of a ‘property, plant, and equipment’ listing on a balance sheet . . . may be described differently by different companies, but when tagged in XBRL, a straight comparison becomes much simpler.” Second, XBRL simplifies the exchange of financial data. Without XBRL, a company’s financial data are typically stored in a format that is unique to that company’s specific financial software application and that cannot be easily read by other financial software. This problem is overcome with XBRL because the tagged data become “independent of the originating application and can readily be shared with any application that recognizes XBRL. This feature of XBRL makes the markup language very ­attractive for government regulators and financial analysts.” Sources: Glenn Cheney, “U.S. gets its XBRL in gear: SEC, FDIC OK tagged data,” Accounting Today, March 14–April 3, 2005, pp. 26–27; Neal Hannon, “XBRL Fundamentals,” Strategic Finance, April 2005, pp. 57–58; Ghostwriter, “From Tags to Riches,” CFO-IT, Spring 2005, pp. 13–14; www.xbrl.ca; www.sedar.com.

Summary

Summary

The data contained in financial statements represent a quantitative summary of a firm’s operations and activities. Someone who is skilful at analyzing these statements can learn much about a company’s strengths, weaknesses, emerging problems, operating efficiency, profitability, and so forth. Many techniques are available to analyze financial statements and to assess the direction and importance of trends and changes. In this chapter, we have discussed three such analytical techniques—dollar and percentage changes in statements, common-size statements, and ratio analysis. Refer to Exhibit 14–9 for a detailed listing of the ratios. This listing also contains a brief statement as to the significance of each ratio. Extensive supplementary reporting is being distributed by companies to demonstrate aspects such as governance and sustainability that extend the information typically contained in financial statements.

Glossary Visit the Online Learning Centre at http://www.mcgrawhill.ca/olc/garrison/ for a review of key terms and definitions.

Questions 14–1 What three basic analytical techniques are used in financial statement analysis? 14–2 Distinguish between horizontal and vertical analysis of financial statement data. 14–3 What is the basic purpose for examining trends in a company’s financial ratios and other data? What other kinds of comparisons might an analyst make? 14–4 Why does the financial analyst compute financial ratios rather than simply studying raw financial data? What dangers are there in the use of ratios? 14–5 Assume that two companies in the same industry have equal earnings. Why might these companies have different price-earnings ratios? If a company has a price-earnings ratio of 20 and reports earnings per share for the current year of $4, at what price would you expect to find the share selling on the market? 14–6 Armcor, Inc. is in a rapidly growing technological industry. Would you expect the company to have a high or low dividend payout ratio? 14–7 Distinguish between a manager’s financing and operating responsibilities. Which of these responsibilities is the return on total assets ratio designed to measure? 14–8 What is meant by the dividend yield on a common share investment? www.mcgrawhill.ca/olc/garrison

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14–9 What is meant by the term financial leverage? 14–10 The president of a medium-sized plastics company was recently quoted in a business journal as stating, “We haven’t had a dollar of interest-paying debt in over 10 years. Not many companies can say that.” As a shareholder in this firm, how would you feel about its policy of not taking on interest-paying debt? 14–11 Why is it more difficult to obtain positive financial leverage from preferred shares than from long-term debt? 14–12 If a share’s market value exceeds its book value, then the share is overpriced. Do you agree? Explain. 14–13 Weaver Company experiences a great deal of seasonal variation in its business activities. The company’s high point in business activity is in June; its low point is in January. During which month would you expect the current ratio to be highest? 14–14 A company seeking a line of credit at a bank was turned down. Among other things, the bank stated that the company’s 2 to 1 current ratio was not adequate. Give reasons why a 2 to 1 current ratio might not be adequate. 14–15 If you were a long-term creditor of a firm, would you be more interested in the firm’s longterm or short-term debt-paying ability? Why? 14–16 A young university student once complained to one of the authors, “ The reason that corporations are such big spenders is that the federal income tax department always picks up part of the tab.” What did he mean by this statement? 14–17 What pitfalls are involved in computing earnings per share? How can these pitfalls be avoided? 14–18 What is meant by reporting an extraordinary item on the income statement net of its tax effect? Give an example of both an extraordinary gain and an extraordinary loss net of its tax effect. Assume a tax rate of 30%. 14–19 “Earnings per share this year is higher than last year. Profitability is definitely improving.” Comment. 14–20 How can cash flow ratios be used to access earnings quality? Explain.

Exercises

S

EXERCISE 14–1 Common-Size Income Statement [LO2] A comparative income statement is given below for Ryder Company: Ryder Company Comparative Income Statement This Year

Last Year

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,000,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . 3,160,000

$4,000,000 2,400,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

1,840,000

1,600,000

Selling and administrative expenses:   Selling expenses . . . . . . . . . . . . . . . . . . . . . . . .   Administrative expenses . . . . . . . . . . . . . . . . . .

900,000 680,000

700,000 584,000

Total selling and administrative expenses . . . . . .

1,580,000

1,284,000

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . .

260,000 70,000

316,000 40,000

Net income before taxes . . . . . . . . . . . . . . . . . . . $ 190,000

$ 276,000

The president is concerned that net income is down even though sales have increased during the year. The president is also concerned that administrative expenses have increased because the company made a concerted effort to cut “fat” out of the organization. Required: 1. Express each year’s income statement in common-size percentages. Carry computations to one decimal place. 2. Comment briefly on the changes between the two years. www.mcgrawhill.ca/olc/garrison



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EXERCISE 14–2 Financial Ratios for Common Shareholders [LO3] Comparative financial statements for Heritage Antiquing Services for the fiscal year ending December 31 appear below and on the next page. The company did not issue any new common or preferred shares during the year. A total of 600,000 common shares were outstanding. The interest rate on the bond payable was 14%, the income tax rate was 40%, and the dividend per common share was $0.75. The market value of the company’s common shares at the end of the year was $26. All of the company’s sales are on account. Heritage Antiquing Services Comparative Balance Sheet (dollars in thousands) This Year Last Year Assets Current assets:   Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   Accounts receivable, net . . . . . . . . . . . . . . . . .   Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   Prepaid expenses . . . . . . . . . . . . . . . . . . . . . .

$ 1,080 9,000 12,000 600

$ 1,210 6,500 10,600 500

Total current assets . . . . . . . . . . . . . . . . . . . . . . .

22,680

18,810

Property and equipment:   Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   Buildings and equipment, net . . . . . . . . . . . . .

9,000 36,800

9,000 38,000

Total property and equipment . . . . . . . . . . . . . . .

45,800

47,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $68,480

$65,810

Liabilities and Shareholders’ Equity Current liabilities:   Accounts payable . . . . . . . . . . . . . . . . . . . . . . . $18,500   Accrued payables . . . . . . . . . . . . . . . . . . . . . . 900   Notes payable, short term . . . . . . . . . . . . . . . . —

$17,400 700 100

Total current liabilities . . . . . . . . . . . . . . . . . . . . . Long-term liabilities:   Bonds payable . . . . . . . . . . . . . . . . . . . . . . . . .

19,400

18,200

8,000

8,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . .

27,400

26,200

Shareholders’ equity:   Preferred shares . . . . . . . . . . . . . . . . . . . . . . . .   Common shares . . . . . . . . . . . . . . . . . . . . . . . .

1,000 6,000

1,000 6,000

  Total paid-in capital . . . . . . . . . . . . . . . . . . . . .   Retained earnings . . . . . . . . . . . . . . . . . . . . . .

7,000 34,080

7,000 32,610

Total shareholders’ equity . . . . . . . . . . . . . . . . . .

41,080

39,610

Total liabilities and shareholders’ equity . . . . . . . $68,480

$65,810

Required: Compute the following financial ratios for common shareholders for this year: 1. Gross margin percentage. 2. Earnings per common share. 3. Price-earnings ratio. 4. Dividend payout ratio. 5. Dividend yield ratio. 6. Return on total assets. 7. Return on common shareholders’ equity. 8. Book value per common share.

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Heritage Antiquing Services Comparative Income Statement and Reconciliation (dollars in thousands) This Year Last Year

S

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$66,000 43,000

$64,000 42,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

23,000

22,000

Selling and administrative expenses:   Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . .

11,500 7,400

11,000 7,000

Total selling and administrative expenses . . . . . . . . . . . . . .

18,900

18,000

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

4,100 800

4,000 800

Net income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

3,300 1,320

3,200 1,280

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends to preferred shareholders . . . . . . . . . . . . . . . . . .

1,980 60

1,920 400

Net income remaining for common shareholders . . . . . . . . . Dividends to common shareholders . . . . . . . . . . . . . . . . . . .

1,920 450

1,520 450

Net income added to retained earnings . . . . . . . . . . . . . . . . Retained earnings, beginning of year . . . . . . . . . . . . . . . . .

1,470 32,610

1,070 31,540

Retained earnings, end of year . . . . . . . . . . . . . . . . . . . . . . .

$34,080

$32,610

EXERCISE 14–3 Financial Ratios for Short-Term Creditors [LO5] Refer to the data in Exercise 14–2 for Heritage Antiquing Services. Required: Compute the following financial data for short-term creditors for this year: 1. Working capital. 2. Current ratio. 3. Acid-test ratio. 4. Accounts receivable turnover. (Assume that all sales are on account.) 5. Average collection period. 6. Inventory turnover. 7. Average sale period.

S

EXERCISE 14–4 Financial Ratios for Long-Term Creditors [LO6] Refer to the data in Exercise 14–2 for Heritage Antiquing Services. Required: Compute the following financial ratios for long-term creditors for this year: 1. Times interest earned ratio. 2. Debt-to-equity ratio.

S

EXERCISE 14–5 Trend Percentages [LO2] Starkey Company’s sales, current assets, and current liabilities (all in thousands of dollars) have been reported on the next page over the last five years (Year 5 is the most recent year): Required: 1. Express all of the asset, liability, and sales data in trend percentages. (Show percentages for each item.) Use Year 1 as the base year, and carry computations to one decimal place. 2. Comment on the results of your analysis.

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Year 5

Year 4

Year 3

Year 2

Year 1

Sales . . . . . . . . . . . . . . . . . . . $5,625 $5,400 $4,950 $4,725 $4,500 Current assets:   Cash . . . . . . . . . . . . . . . . . . $ 64 $ 72 $ 84 $ 88 $ 80   Accounts receivable . . . . . 560 496 432 416 400   Inventory . . . . . . . . . . . . . . 896 880 816 864 800 Total current assets . . . . . . . . $1,520 $1,448 $1,332 $1,368 $1,280 Current liabilities . . . . . . . . . . $ 390 $ 318 $ 324 $ 330 $ 300

S

EXERCISE 14–6 Selected Financial Ratios for Common Shareholders [LO3, LO4] Selected financial data from the September 30 year-end statements of Kosanka Company are given below: Total assets . . . . . . . . . . . . . . . . . . . . . . . $5,000,000 Long-term debt (12% interest rate) . . . . $750,000 Preferred shares, 8,000, $7 no par . . . . . $800,000 Total shareholders’ equity . . . . . . . . . . . . $3,100,000 Interest paid on long-term debt . . . . . . . . $90,000 Net income . . . . . . . . . . . . . . . . . . . . . . . $470,000

Total assets at the beginning of the year were $4,800,000; total shareholders’ equity was $2,900,000. There has been no change in preferred shares during the year. The company’s tax rate is 30%. Required: 1. Compute the return on total assets. 2. Compute the return on common shareholders’ equity. 3. Is the company’s financial leverage positive or negative? Explain. EXERCISE 14–7 Selected Financial Measures for Short-Term Creditors [LO5] Rightway Products had a current ratio of 2.5 on June 30 of the current year. On that date, the company’s assets were as follows: Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000 Accounts receivable, net . . . . . . . . . . . . . . . 460,000 Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . 750,000 Prepaid expenses . . . . . . . . . . . . . . . . . . . . 10,000 Plant and equipment, net . . . . . . . . . . . . . . 1,900,000

S

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . $3,200,000

Required: 1. What was the company’s working capital on June 30? 2. What was the company’s acid-test ratio on June 30? 3. The company paid an account payable of $100,000 immediately after June 30. a. What effect did this transaction have on working capital? Show computations. b. What effect did this transaction have on the current ratio? Show computations. EXERCISE 14–8 Selected Financial Ratios [LO5, LO6] Recent financial statements for Madison Company are given on the next page. Account balances at the beginning of the company’s fiscal year were: accounts receivable, $140,000; and inventory, $260,000. All sales were on account. Required: Compute financial ratios as follows: 1. Gross margin percentage. 2. Current ratio. 3. Acid-test ratio. www.mcgrawhill.ca/olc/garrison

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Madison Company Balance Sheet June 30 Assets Current assets:   Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   Accounts receivable, net . . . . . . . . . . . . . . . .   Merchandise inventory . . . . . . . . . . . . . . . . . .   Prepaid expenses . . . . . . . . . . . . . . . . . . . . .

$

21,000 160,000 300,000 9,000

Total current assets . . . . . . . . . . . . . . . . . . . . . . Property and equipment, net . . . . . . . . . . . . . . .

490,000 810,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$1,300,000

Liabilities and Shareholders’ Equity Liabilities:   Current liabilities . . . . . . . . . . . . . . . . . . . . . .   Bonds payable, 10% . . . . . . . . . . . . . . . . . . .

$ 200,000 300,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . Shareholders’ equity:   Common shares, 20,000 no par . . . . . . . . . . $100,000   Retained earnings . . . . . . . . . . . . . . . . . . . . . 700,000

500,000

Total shareholders’ equity . . . . . . . . . . . . . . . . .

800,000

Total liabilities and shareholders’ equity . . . . . .

$1,300,000

Madison Company Income Statement For the Year Ended June 30 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,100,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . 1,260,000 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . .

840,000 660,000

Operating income . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . .

180,000 30,000

Net income before taxes . . . . . . . . . . . . . . . Income taxes . . . . . . . . . . . . . . . . . . . . . . . . .

150,000 45,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . $ 105,000

4. 5. 6. 7. 8.

S

Average collection period. Average sale period. Debt-to-equity ratio. Times interest earned. Book value per share.

EXERCISE 14–9 Selected Financial Ratios for Common Shareholders [LO3] Refer to the financial statements for Madison Company in Exercise 14–8. In addition to the data in these statements, assume that Madison Company paid dividends of $3.15 per share during the year. Also assume that the company’s common shares had a market price of $63 per share on June 30 and there was no change in the number of outstanding common shares during the fiscal year. Required: Compute the following: 1. Earnings per share. 2. Dividend payout ratio. 3. Dividend yield ratio. 4. Price-earnings ratio. www.mcgrawhill.ca/olc/garrison



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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

S

EXERCISE 14–10 Selected Financial Ratios for Common Shareholders [LO3, LO4] Refer to the financial statements for Madison Company in Exercise 14–8. Assets at the beginning of the year totalled $1,100,000, and the shareholders’ equity totalled $725,000. Required: Compute the following: 1. Return on total assets. 2. Return on common shareholders’ equity. 3. Was financial leverage positive or negative for the year? Explain.

Problems PROBLEM 14–11 Common-Size Statements and Financial Ratios for Creditors [LO2, LO5, LO6] Modern Building Supply sells various building materials to retail outlets. The company has just approached Linden Bank requesting a $300,000 loan to strengthen the Cash account and to pay certain pressing short-term obligations. The company’s financial statements for the most recent two years are shown below and on the next page. During the past year, the company has expanded the number of lines that it carries in order to stimulate sales and increase profits. It has also moved aggressively to acquire new customers. Sales terms are 2/10, n/30. All sales are on account. Modern Building Supply Comparative Balance Sheet This Year

Last Year

Assets Current assets:   Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 90,000   Temporary investments . . . . . . . . . . . . . . . . . 0   Accounts receivable, net . . . . . . . . . . . . . . . . 650,000   Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000   Prepaid expenses . . . . . . . . . . . . . . . . . . . . . 20,000

$ 200,000 50,000 400,000 800,000 20,000

Total current assets . . . . . . . . . . . . . . . . . . . . . . Plant and equipment, net . . . . . . . . . . . . . . . . .

2,060,000 1,940,000

1,470,000 1,830,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,000,000

$3,300,000

Liabilities and Shareholders’ Equity Liabilities:   Current liabilities . . . . . . . . . . . . . . . . . . . . . . $1,100,000   Bonds payable, 12% . . . . . . . . . . . . . . . . . . . 750,000

$ 600,000 750,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . .

1,850,000

1,350,000

Shareholders’ equity:   Preferred shares, 4,000, $4 no par . . . . . . . .   Common shares, 50,000, no par . . . . . . . . . .   Retained earnings . . . . . . . . . . . . . . . . . . . . .

200,000 500,000 1,450,000

200,000 500,000 1,250,000

Total shareholders’ equity . . . . . . . . . . . . . . . . .

2,150,000

1,950,000

Total liabilities and shareholders’ equity . . . . . . $4,000,000

$3,300,000

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Problems

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Modern Building Supply Comparative Income Statement and Reconciliation This Year Last Year Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $7,000,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 5,400,000



$6,000,000 4,800,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . . . . .

1,600,000 970,000

1,200,000 710,000

Operating income . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . .

630,000 90,000

490,000 90,000

Net income before taxes . . . . . . . . . . . . . . . . . Income taxes (40%) . . . . . . . . . . . . . . . . . . . . . .

540,000 216,000

400,000 160,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . .

324,000

240,000

Dividends paid:   Preferred dividends . . . . . . . . . . . . . . . . . . . .   Common dividends . . . . . . . . . . . . . . . . . . . .

16,000 108,000

16,000 60,000

Total dividends paid . . . . . . . . . . . . . . . . . . . . .

124,000

76,000

Net income retained . . . . . . . . . . . . . . . . . . . . . Retained earnings, beginning of year . . . . . . . .

200,000 1,250,000

164,000 1,086,000

Retained earnings, end of year . . . . . . . . . . . . . $1,450,000

$1,250,000

Assume that the following ratios are typical of companies in the building supply industry: Current ratio . . . . . . . . . . . . . . . Acid-test ratio . . . . . . . . . . . . . . Average collection period . . . . . Average sale period . . . . . . . . . Debt-to-equity ratio . . . . . . . . . Times interest earned . . . . . . . . Return on total assets . . . . . . . . Price-earnings ratio . . . . . . . . . . Net income margin . . . . . . . . . . .

2.5 1.2 18 days 50 days 0.75 6.0 10% 9 4%

Required: 1. Linden Bank is uncertain whether the loan should be made. To assist it in making a decision, you have been asked to compute the following amounts and ratios for both this year and last year: a. Working capital. b. Current ratio. c. Acid-test ratio. d. Average collection period. (The accounts receivable at the beginning of last year totalled $350,000.) e. Average sale period. (The inventory at the beginning of last year totalled $720,000.) f. Debt-to-equity ratio. g. Times interest earned. 2. For both this year and last year (carry computations to one decimal place): a. Present the balance sheet in common-size form. b. Present the income statement in common-size form down through net income. 3. From your analysis in (1) and (2) above, what problems or strengths do you see for Modern Building Supply? Make a recommendation as to whether the loan should be approved.

S

PROBLEM 14–12 Financial Ratios for Common Shareholders [LO3, LO4] Refer to the financial statements and other data in Problem 14–11. Assume that you have just inherited several hundred shares of Modern Building Supply. Not being acquainted with the company, you decide to do some analytical work before making a decision about whether to retain or sell the shares you have inherited. www.mcgrawhill.ca/olc/garrison



Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

Required: 1. You decide first to assess the well-being of the common shareholders. For both this year and last year, compute the following: a. The earnings per share. b. The dividend yield ratio for common shares. The company’s common shares are currently selling for $45 per share; last year they sold for $36 per share. c. The dividend payout ratio for common shares. d. The price-earnings ratio. How do investors regard Modern Building Supply as compared to other companies in the industry? Explain. e. The book value per common share. Does the difference between market value and book value suggest that the shares at their current price are too high? Explain. 2. You decide next to assess the company’s rate of return. Compute the following for both this year and last year: a. The return on total assets. (Total assets at the beginning of last year were $2,700,000.) b. The return on common shareholders’ equity. (Shareholders’ equity at the beginning of last year was $1,786,000.) c. Is the company’s financial leverage positive or negative? Explain. 3. Based on your analytical work (and assuming that you have no immediate need for cash), would you retain or sell the shares you have inherited? Explain. PROBLEM 14–13 Effects of Transactions on Various Ratios [LO5] Selected amounts from Reingold Company’s balance sheet from the beginning of the year follow:

Cash Temporary investments Accounts receivable, net Inventory Prepaid expenses Plant and equipment, net Accounts payable Accrued liabilities Notes due within one year Bonds payable in five years

$70,000 $12,000 $350,000 $460,000 $8,000 $950,000 $200,000 $60,000 $100,000 $140,000

During the year, the company completed the following transactions: x. Purchased inventory on account, $50,000. a. Declared a cash dividend, $30,000. b. Paid accounts payable, $100,000. c. Collected cash on accounts receivable, $80,000. d. Purchased equipment for cash, $75,000. e. Paid a cash dividend previously declared, $30,000. f. Borrowed cash on a short-term note with the bank, $60,000. g. Sold inventory costing $70,000 for $100,000, on account. h. Wrote off uncollectible accounts in the amount of $10,000 reducing the accounts receivable balance accordingly. i. Sold temporary investments costing $12,000 for cash, $9,000. j. Issued additional common shares for cash, $200,000. k. Paid off all short-term notes due, $160,000.

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Required: 1. Compute the following amounts and ratios as of the beginning of the year: a. Working capital. b. Current ratio. c. Acid-test ratio. 2. Indicate the effect of each of the transactions given above on working capital, the current ratio, and the acid-test ratio. Give the effect in terms of increase, decrease, or none. Item (x) is given as an example of the format to use:

The Effect on

Working Transaction Capital

(x) Purchased inventory on account . . . . .

x

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None

Current Ratio

Acid-Test Ratio

Decrease Decrease

PROBLEM 14–14 Comprehensive Ratio Analysis [LO3, LO4, LO5, LO6] You have just been hired as a loan officer at Fairfield Bank. Your supervisor has given you a file containing a request from Hedrick Company, a manufacturer of auto components, for a $1,000,000 five-year loan. Financial statement data on the company for the last two years are given on the following page. Marva Rossen, who just two years ago was appointed president of Hedrick Company, admits that the company has been “inconsistent” in its performance over the past several years. But Rossen argues that the company has its costs under control and is now experiencing strong sales growth, as evidenced by the more than 25% increase in sales over the last year. Rossen also argues that investors have recognized the improving situation at Hedrick Company, as shown by the jump in the price of its common shares from $20 per share last year to $36 per share this year. Rossen believes that with strong leadership and with the modernized equipment that the $1,000,000 loan will permit the company to buy, profits will be even stronger in the future. Anxious to impress your supervisor, you decide to generate all the information you can about the company. You determine that the following ratios are typical of companies in Hedrick’s industry: Current ratio . . . . . . . . . . . . . . . Acid-test ratio . . . . . . . . . . . . . . Average collection period . . . . . Average sale period . . . . . . . . . Return on assets . . . . . . . . . . . . Debt-to-equity ratio . . . . . . . . . . Times interest earned . . . . . . . . Price-earnings ratio . . . . . . . . . .

2.3 1.2 31 days 60 days 9.5% 0.65 5.7 10

Required: 1. You decide first to assess the rate of return that the company is generating. Compute the following for both this year and last year: a. The return on total assets. (Total assets at the beginning of last year were $4,320,000.) b. The return on common shareholders’ equity. (Shareholders’ equity at the beginning of last year totalled $3,016,000. There has been no change in preferred or common shares over the last two years.) c. Is the company’s financial leverage positive or negative? Explain. 2. You decide next to assess the well-being of the common shareholders. For both this year and last year, compute: a. The earnings per share. b. The dividend yield ratio for common shares. c. The dividend payout ratio for common shares. d. The price-earnings ratio. How do investors regard Hedrick Company as compared to other companies in the industry? Explain. e. The book value per common share. Does the difference between market value per share and book value per share suggest that the shares at their current price are a bargain? Explain. f. The gross margin percentage. www.mcgrawhill.ca/olc/garrison



Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

Hedrick Company Comparative Balance Sheet This Year

Last Year

Assets Current assets:   Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 320,000   Temporary investments . . . . . . . . . . . . . . . . . 0   Accounts receivable, net . . . . . . . . . . . . . . . . 900,000   Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,300,000   Prepaid expenses . . . . . . . . . . . . . . . . . . . . . 80,000

$ 420,000 100,000 600,000 800,000 60,000

Total current assets . . . . . . . . . . . . . . . . . . . . . . Plant and equipment, net . . . . . . . . . . . . . . . . .

2,600,000 3,100,000

1,980,000 2,980,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,700,000

$4,960,000

Liabilities and Shareholders’ Equity Liabilities:   Current liabilities . . . . . . . . . . . . . . . . . . . . . . $1,300,000   Bonds payable, 10% . . . . . . . . . . . . . . . . . . . 1,200,000

$ 920,000 1,000,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . .

2,500,000

1,920,000

Shareholders’ equity:   Preferred shares, 20,000, $2.40 no par value   Common shares, 50,000, no par . . . . . . . . . .   Retained earnings . . . . . . . . . . . . . . . . . . . . .

600,000 2,000,000 600,000

600,000 2,000,000 440,000

Total shareholders’ equity . . . . . . . . . . . . . . . . .

3,200,000

3,040,000

Total liabilities and shareholders’ equity . . . . . . $5,700,000

$4,960,000

Hedrick Company Comparative Income Statement and Reconciliation This Year Last Year Sales (all on account) . . . . . . . . . . . . . . . . . . . . $5,250,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 4,200,000

$4,160,000 3,300,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . . . .

1,050,000 530,000

860,000 520,000

Operating income . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . .

520,000 120,000

340,000 100,000

Net income before taxes . . . . . . . . . . . . . . . . . Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . .

400,000 120,000

240,000 72,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . .

280,000

168,000

Dividends paid:   Preferred shares . . . . . . . . . . . . . . . . . . . . . .   Common shares . . . . . . . . . . . . . . . . . . . . . .

48,000 72,000

48,000 36,000

Total dividends paid . . . . . . . . . . . . . . . . . . . . .

120,000

84,000

Net income retained . . . . . . . . . . . . . . . . . . . . . Retained earnings, beginning of year . . . . . . . .

160,000 440,000

84,000 356,000

Retained earnings, end of year . . . . . . . . . . . . . $ 600,000

$ 440,000

3. You decide, finally, to assess creditor ratios to determine both short-term and long-term debt paying ability. For both this year and last year, compute: a. Working capital. b. The current ratio. c. The acid-test ratio. www.mcgrawhill.ca/olc/garrison

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d. The average collection period. (The accounts receivable at the beginning of last year totalled $520,000.) e. The average sale period. (The inventory at the beginning of last year totalled $640,000.) f. The debt-to-equity ratio. g. The times interest earned. 4. Make a recommendation to your supervisor as to whether the loan should be approved. PROBLEM 14–15 Common-Size Financial Statements [LO2] Refer to the financial statement data for Hedrick Company given in Problem 14–14. Required: For both this year and last year: 1. Present the balance sheet in common-size format. 2. Present the income statement in common-size format down through net income. 3. Comment on the results of your analysis. PROBLEM 14–16 Effects of Transactions on Various Financial Ratios [LO3, LO5, LO6] In the right-hand column below, certain financial ratios are listed. To the left of each ratio is a business transaction or event relating to the operating activities of Graham Company.   1. Inventory was sold for cash at a profit. Debt-to-equity ratio   2. Land was purchased for cash. Earnings per share   3. Inventory was sold on account at cost. Acid-test ratio   4. Some accounts payable were paid off. Working capital   5. A customer paid an overdue bill. Average collection period   6. A cash dividend was declared, but not yet paid. Current ratio   7. A previously declared cash dividend was paid. Current ratio   8. The company’s common share price increased. Book value per share   9. The company’s common share price increased. Dividend yield ratio Earnings per share remained unchanged. 10. Property was sold for a profit. Return on total assets 11. Obsolete inventory was written off as a loss. Inventory turnover ratio 12. Bonds were sold with an interest rate Return on common shareholders’ equity less than the company’s return on assets. 13. The company’s common share price decreased. Dividend payout ratio The dividend paid per share remained the same. 14. The company’s net income decreased, but Times interest earned long-term debt remained unchanged. 15. An uncollectible account was written off Current ratio against the Allowance for Bad Debts. 16. Inventory was purchased on credit. Acid-test ratio 17. The company’s common share price increased. Price-earnings ratio Earnings per share remained unchanged. 18. The company paid off some accounts payable. Debt-to-equity ratio Required: Indicate the effect that each transaction or event would have on the ratio listed opposite to it. State the effect in terms of increase, decrease, or no effect on the ratio involved, and give the reason for your choice. In all cases, assume that the current assets exceed current liabilities both before and after the event or transaction. Use the following format for your answers:

Effect on Ratio Reason for Increase, Decrease, or No Effect

1. 2. Etc.

S

PROBLEM 14–17 Interpretation of Financial Ratios [LO3, LO4, LO5] Being a prudent investor, Sally Perkins always investigates a company thoroughly before purchasing its shares for investment. Ms. Perkins is interested in the common shares of Plunge Enterprises. The following data are available for the company:

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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

Year 3 Year 2 Year 1

Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable turnover . . . . . . . . . . . . . Inventory turnover . . . . . . . . . . . . . . . . . . . . . . Sales trend . . . . . . . . . . . . . . . . . . . . . . . . . . . Dividends paid per share* . . . . . . . . . . . . . . . . Dividend yield ratio . . . . . . . . . . . . . . . . . . . . . Dividend payout ratio . . . . . . . . . . . . . . . . . . . Return on total assets . . . . . . . . . . . . . . . . . . . Return on common shareholders’ equity . . . .



2.8 0.7 8.6 5.0 130.0 $2.50 5% 40% 13.0% 16.2%

2.5 0.9 9.5 5.7 118.0 $2.50 4% 50% 11.8% 14.5%

2.0 1.2 10.4 6.8 100.0 $2.50 3% 60% 10.4% 9.0%

*There were no changes in common shares outstanding over the three-year period.

Ms. Perkins would like answers to a number of questions about the trend of events over the last three years in Plunge Enterprises. Her questions are as follows: a. Is the market price of the company’s shares going up or down? b. Is the earnings per share increasing or decreasing? c. Is the price-earnings ratio going up or down? d. Is the company employing financial leverage to the advantage of the common shareholders? e. Is it becoming easier for the company to pay its bills as they come due? f. Are customers paying their bills at least as fast now as they did in Year 1? g. Is the total of the accounts receivable increasing, decreasing, or remaining constant? h. Is the level of inventory increasing, decreasing, or remaining constant? Required: Answer each of Ms. Perkins’ questions and explain how you arrived at your answer. PROBLEM 14–18 Ethics and the Manager [LO5] Mountain Aerosport was founded by Jurgen Prinz to produce a ski he had designed for doing aerial tricks. Up to this point, Jurgen has financed the company with his own savings and with cash generated by his business. However, Jurgen now faces a cash crisis. In the year just ended, an acute shortage of a vital tungsten steel alloy developed just as the company was beginning production for the Christmas season. Jurgen had been assured by his suppliers that the steel would be delivered in time to make Christmas shipments, but the suppliers had been unable to fully deliver on this promise. As a consequence, Mountain Aerosport had a large inventory of unfinished skis at the end of the year and had been unable to fill all of the orders that had come in from retailers for the Christmas season. Consequently, sales were below expectations for the year, and Jurgen does not have enough cash to pay his creditors. Well before the accounts payable were due, Jurgen visited a local bank and inquired about obtaining a loan. The loan officer at the bank assured Jurgen that there should not be any problem getting a loan to pay off his accounts payable—providing that on his most recent financial statements the current ratio was above 2.0, the acid-test ratio was above 1.0, and operating income was at least four times the interest on the proposed loan. Jurgen promised to return later with a copy of his financial statements. Jurgen would like to apply for a $120 thousand six-month loan bearing an interest rate of 10% per year. The unaudited financial reports of the company appear on the next page. Required: 1. Based on the above unaudited financial statements and the statement made by the loan officer, would the company qualify for the loan? 2. Last year Jurgen purchased and installed new, more efficient equipment to replace an older heat-treating furnace. Jurgen had originally planned to sell the old equipment but found that it is still needed whenever the heat-treating process is a bottleneck. When Jurgen discussed his cash flow problems with his brother-in-law, he suggested to Jurgen that the old equipment be sold or at least reclassified as inventory on the balance sheet since it could be readily sold. At present, the equipment is carried in the Property and Equipment account and could be sold for its net book value of $68 thousand. The bank does not require audited financial statements. What advice would you give to Jurgen concerning the machine?

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Mountain Aerosport Comparative Balance Sheet As of December 31, This Year and Last Year (in thousands of dollars) This Year Last Year

Assets Current assets:   Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   Accounts receivable, net . . . . . . . . . . . . . .   Inventory . . . . . . . . . . . . . . . . . . . . . . . . . .   Prepaid expenses . . . . . . . . . . . . . . . . . . .



$105 75 240 15

$225 60 150 18

Total current assets . . . . . . . . . . . . . . . . . . . . Property and equipment . . . . . . . . . . . . . . . .

435 405

453 270

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . .

$840

$723

Liabilities and Shareholders’ Equity Current liabilities:   Accounts payable . . . . . . . . . . . . . . . . . . .   Accrued payables . . . . . . . . . . . . . . . . . . .

$231 15

$135 15

Total current liabilities . . . . . . . . . . . . . . . . . . Long-term liabilities . . . . . . . . . . . . . . . . . . .

246 0

150 0

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . .

246

150

Shareholders’ equity:   Common shares . . . . . . . . . . . . . . . . . . . . .   Retained earnings . . . . . . . . . . . . . . . . . . .

150 444

150 423

Total shareholders’ equity . . . . . . . . . . . . . . .

594

573

Total liabilities and shareholders’ equity . . . .

$840

$723

Mountain Aerosport Income Statement For the Year Ended December 31, This Year (in thousands of dollars)

Sales (all on account) . . . . . . . . . . . . . . . . . . . . $630 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . 435 Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . .

195

Selling and administrative expenses:   Selling expenses . . . . . . . . . . . . . . . . . . . . . .   Administrative expenses . . . . . . . . . . . . . . . .

63 102

Total selling and administrative expenses . . . .

165

Operating income . . . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . . . .

30 0

Net income before taxes . . . . . . . . . . . . . . . . . Income taxes (30%) . . . . . . . . . . . . . . . . . . . . . .

30 9

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 21

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PROBLEM 14–19 Incomplete Statements; Analysis of Ratios [LO1, LO3, LO5, LO6] Incomplete financial statements for Tanner Company are given on the next page. The following additional information is available about the company: a. Selected financial ratios computed from the statements given.

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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

Current ratio . . . . . . . . . . . . . . . . . . Acid-test ratio . . . . . . . . . . . . . . . . . Accounts receivable turnover . . . . Inventory turnover . . . . . . . . . . . . . . Debt-to-equity ratio . . . . . . . . . . . . Times interest earned . . . . . . . . . . . Earnings per share . . . . . . . . . . . . . Return on total assets . . . . . . . . . . .

2.40 1.12 15.0 6.0 0.875 7.0 $4.05 14%

Tanner Company Income Statement For the Year Ended December 31 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,700,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . ? Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . Selling and administrative expenses . . . . . .

? ?

Operating income . . . . . . . . . . . . . . . . . . . . . Interest expense . . . . . . . . . . . . . . . . . . . . . .

? 45,000

Net income before taxes . . . . . . . . . . . . . . . Income taxes (40%) . . . . . . . . . . . . . . . . . . .

? ?

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . $

?

Tanner Company Balance Sheet December 31 Current assets:   Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .   Accounts receivable, net . . . . . . . . . . . . . . . .   Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$

Total current assets . . . . . . . . . . . . . . . . . . . . . . Plant and equipment, net . . . . . . . . . . . . . . . . .

? ? ? ? ?

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$

Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . Bonds payable, 10% . . . . . . . . . . . . . . . . . . . . .

$250,000 ?

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . .

?

Shareholders’ equity:   Common shares, 40,000 no par . . . . . . . . . . .   Retained earnings . . . . . . . . . . . . . . . . . . . . .

100,000 ?

Total shareholders’ equity . . . . . . . . . . . . . . . . .

?

Total liabilities and shareholders’ equity . . . . . .

$

?

?

b. All sales during the year were on account. c. The interest expense on the income statement relates to the bonds payable; the amount of bonds outstanding did not change throughout the year. d. There were no changes in the number of common shares outstanding during the year. e. Selected balances at the beginning of the current year (January 1) were as follows: Accounts receivable . . . . . . $160,000 Inventory . . . . . . . . . . . . . . . $280,000 Total assets . . . . . . . . . . . . . $1,200,000

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BC14–45

BC14–46

Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

Required: Compute the missing amounts on the company’s financial statements. (Hint: You may find it helpful to think about the difference between the current ratio and the acid-test ratio.)

x

e cel

PROBLEM 14–20  Forecast Financial Statements: Computer Spreadsheet [LO1, LO3, LO5, LO6]   AC Company has just prepared the annual financial statements for 2007 given below: AC COMPANY Income Statement For the Years Ended December 31, 2008 and 2007

2008

2007

Sales revenue (one half on credit for 2007) . . . . . . . . . . . $98,000 Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$95,000   46,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Expenses (including $3,000 interest expense each year)

49,000   33,000

Pretax income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax on operations (19%) . . . . . . . . . . . . . . . . . . .

16,000    3,040

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$12,960

AC COMPANY Balance Sheet At December 31, 2008 and 2007

2008

2007

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Capital assets (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$  20,000 30,000 40,000   100,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

$190,000

Liabilities Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Income tax payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Note payable, long‑term . . . . . . . . . . . . . . . . . . . . . . . . . .

$50,000 1,000 25,000

Shareholders’ Equity Capital stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

80,000    34,000

Total liabilities and shareholders’ equity . . . . . . . . . . . . .

$190,000

Additional information: Depreciation expense was $20,000 in 2007; depreciation rate for 2008 based on the beginning account balance, .20; long-term note payments expected at the end of 2008, $2,000; unpaid taxes expected at the end of 2008, $1,200; dividends expected to be paid in 2008, $7,000; additions to capital assets in 2008, $10,000; credit sales as a percentage of total sales for 2008, .60; $10,000 was in inventory, January 1, 2007. Required: Using a computer spreadsheet, prepare forecasts of the 2008 income statement, statement of cash flows, and December 31, 2008 balance sheet. (Hint: Use 2007 turnovers as estimates for 2008.)

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Chapter 14   “How Well Am I Doing?” Financial Statement Analysis

Research R 14–21  Harmonization [LO3, LO5, LO6]   Using the CICA web site, www.cica.ca, and the International Accounting Standards Board site, www.iasb.org, describe the changes that may be made to the disclosure of income statement matters. Consider if these proposed changes would simplify or make more complicated the interpretation of income performance. R 14–22  Governance [LO1, LO3]   Governance refers to the overall management of the organization. Shareholders, directors, and senior managers are involved in governance activities. a. Examine the shareholder relations tab of the web site for Tim Hortons or Canadian Tire for their discussion of ethics and governance. b. Explain the elements they consider as part of their governance practices. R 14–23  XBRL [LO1, LO3, LO5, LO6]   Using the web, sites www.xbrl.ca, or www.xbrl.org describe the potential benefits of XBRL use for the analysis of financial statements.

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BC14–47

Research