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					Chapter 10 - Financial Statement Analysis


CHAPTER 10- FINANCIAL STATEMENT ANALYSIS


SELF-TEST PROBLEMS & SOLUTIONS


ST10.1      Johnson & Johnson (JNJ) and its subsidiaries have approximately 120,000 employees
            worldwide engaged in the research and development, manufacture and sale of a broad
            range of products in the health care field. Johnson & Johnson is a holding company
            with more than 250 operating companies conducting business in virtually all
            countries of the world. Johnson & Johnson’s operating companies are organized into
            three business segments: Consumer, Pharmaceutical and Medical Devices and
            Diagnostics. The Consumer segment includes a broad range of products used in the
            baby care, skin care, oral care, wound care and women’s health care fields, as well as
            nutritional and over-the-counter pharmaceutical products. Major brands include
            Band-Aid ® Brand Adhesive Bandages; Carefree ® Pantiliners; Listerine ® oral care
            products; Sudafed ® cold, flu and allergy products; and the broad family of Tylenol
            ® products. The Pharmaceutical segment includes products in the following
            therapeutic areas: anti-infective, antipsychotic, cardiovascular, contraceptive,
            dermatology, gastrointestinal, hematology, immunology, neurology, oncology, pain
            management, urology and virology. The Medical Devices and Diagnostics segment
            includes a broad range of products distributed to wholesalers, hospitals and retailers,
            used principally in the professional fields by physicians, nurses, therapists, hospitals,
            diagnostic laboratories and clinics. Based upon the brief summary of the company’s
            financial statements available at Yahoo! Finance (http://finance.yahoo.com), how
            would you characterize the company’s financial condition and performance?




                                                10-1
Chapter 10 - Financial Statement Analysis




            Balance Sheet                             Cash Flow Statement
            Total Cash (mrq)                 11.14B   Operating Cash Flow (ttm)         14.65B
            Total Cash Per Share (mrq)         3.95   Levered Free Cash Flow (ttm)       8.79B
            Total Debt (mrq)                 11.42B   Valuation Measures
            Total Debt/Equity (mrq)            0.25   Market Cap (intraday)            184.85B
            Current Ratio (mrq)                1.53   Enterprise Value (17-Jun-08)     185.82B
            Book Value Per Share (mrq)        16.19   Trailing P/E (ttm, intraday)       16.37
            Income Statement                          Forward P/E (fye 30-Dec-09)        14.01
            Revenue (ttm)                    62.25B   PEG Ratio (5 yr expected)           1.81
            Revenue Per Share (ttm)           21.71   Price/Sales (ttm)                   2.98
            Qtrly Revenue Growth (yoy)       7.70%    Price/Book (mrq)                    4.07
            Gross Profit (ttm)               43.34B   Enterprise Value/Revenue (ttm)      2.99
            EBITDA (ttm)                     18.58B   Enterprise Value/EBITDA (ttm)      10.00
            Net Income Avl to Common (ttm)   11.60B
            Diluted EPS (ttm)                  4.01
            Qtrly Earnings Growth (yoy)      39.80%
            Profitability
            Profit Margin (ttm)              18.64%
            Operating Margin (ttm)           25.32%
            Return on Assets (ttm)           12.39%
            Return on Equity (ttm)           26.81%

ST10.1 SOLUTION
         Financial analysis of JNJ’s balance sheet begins with cash and short-term
         investments, like Treasury bills. This is the minimum amount presently available to
         meet operating needs and short-term financial obligations. Total debt includes all of
         the firm’s financial obligations to creditors and is comprised of short term
         borrowings, the current portion of long term debt and capital leases, plus long term
         debt and capital lease obligations. Financial leverage is often measured by comparing
         total debt to the sum of common and preferred equity. When financial leverage is
         low, creditors can be assured that the firm has sufficient unencumbered assets to meet
         its financial obligations. To make sure borrowers are sufficiently liquid to meet
         current obligations, creditors often focus on the amount of current assets relative to
         current liabilities (current ratio). The data provided show that JNJ has modest debt
         and ample liquidity to meet operating needs and the company’s financial obligations.




                                                 10-2
Chapter 10 - Financial Statement Analysis




                   Analysis of JNJ’s income statement starts with revenue, or the amount of sales
            generated by the company's business activities. Gross profit shows how much is left
            over after the cost of goods sold is subtracted from revenue. The acronym EBITDA
            stands for "Earnings Before Interest, Tax, Depreciation, and Amortization." It is a
            useful measure of the maximum amount available to meet debt obligations and capital
            expenditure needs. Profits margins, defined as net income divided by total revenue,
            are the single best indicator of the company’s ability to set prices above production
            costs. Operating margin is used to measure operating efficiency and is the difference
            between total revenues and operating costs, all divided by total revenues, and is
            expressed as a percentage. Total Operating costs are comprised of cost of goods sold,
            selling, general & administrative expenses, R & D, depreciation & amortization, and
            other operating expenses. Return on assets, or earnings from continuing operations
            divided by total debt plus equity, is a useful measure of how well a company uses all
            of its capital resources to produce earnings. Return on equity, or earnings from
            continuing operations divided by common equity measures the efficiency with which
            financial leverage and operating leverage are employed on behalf of the firm’s
            stockholders. Operating cash flow is the amount of cash used or generated by the
            firm’s normal operating activities, and is measured by net income plus noncash
            expenses like depreciation and amortization. Operating cash flow is often closely
            related to EBITDA. Levered free cash flow excludes non-recurring items and takes
            into consideration cash inflows from financing activities such as debt or preferred
            stock issues. Taken as a whole, it is obvious that JNJ generates enormous revenue and
            generous profit margins. The company also makes wise use of fixed assets and
            financial leverage, as shown by the company’s high ROA and enviable ROE.
                   In terms of valuation measures, JNJ stock closed at 65.59 on June 17, 2008 and
            the total dollar value of all outstanding shares on that date was $184.85 billion
            computed as shares outstanding times current market price. Market cap is an
            attractive measure of corporate size. JNJ is a leading member of both the Dow Jones
            Industrial Average and the S&P 500 Index and one of the largest corporations in the
            world. Enterprise value is market cap plus debt minus cash and short minus term
            investments. It is an attractive measure of how much it would cost to acquire the
            entire company and is used by private equity buyers when they size up potential
            acquisitions. While JNJ is too big to be taken private, it is a conceivable merger
            partner. The trailing P/E ratio is a popular valuation ratio calculated by dividing the
            current market price by trailing 12-month (ttm) earnings per share (EPS). The
            forward P/E is another valuation ratio calculated by dividing the current market price
            by projected 12-month EPS and reflects expected growth. The PEG ratio is calculated
            as the P/E ratio divided by expected EPS growth over the next five years. The price to
            sales ratio, market price divided by total revenue per share, is often used to value
            rapidly growing but presently unprofitable companies. Price/book ratios, calculated as
            current market price divided by book value per share, tell how much the company is
            presently selling for as compared to the accounting value of plant and equipment. It is
            often used to indicate the relative attractiveness of assets in place.




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ST10.2      Based upon the brief summary of the company’s financial statements available at
            Yahoo! Finance (http://finance.yahoo.com), how does Johnson & Johnson’s financial
            performance stack up against industry competitors?

                                     JNJ VS. INDUSTRY LEADERS


                                                         Industry
                   Statistic                                        JNJ       JNJ Rank
                                                          Leader

                   Market Capitalization        JNJ      184.85B          -      1 / 33

                   P/E Ratio (ttm)              APPX       74.98    16.37        7 / 33

                   PEG Ratio (ttm, 5 yr expected) AZN       4.67     1.81        7 / 33

                   Revenue Growth (Qtrly YoY)   KERX     373.80%    7.70%       13 / 33

                   EPS Growth (Qtrly YoY)       LLY      108.40% 42.70%          4 / 33

                   Long-Term Growth Rate (5 yr) WX       40.19%     8.21%        8 / 33

                   Return on Equity (ttm)       GSK      53.12% 26.81%           3 / 33

                   Long-Term Debt/Equity (mrq) CHRX.OB     2.175    0.250       13 / 33

                   Dividend Yield (annual)      PFE       7.10%     2.80%        9 / 33


ST10.2 SOLUTION
         Johnson &Johnson is a standout performer when measured on an absolute basis, as
         shown in ST10.1, and on a relative basis when compared with other leading firms in
         the industry. As shown in the table above, JNJ features the largest market cap in the
         industry. This suggests that the company is recognized for having the financial
         capability to dominate important segments of the market. The company has a fairly
         modest valuation when measured by its P/E ratio, as seems reasonable given its fairly
         modest earnings growth projections. JNJ is much more profitable than the average
         competitor; the company is conservatively financed, and pays a significant dividend.
         In sum, the company should appeal to long-term investors looking for high-margin,
         dependable growth.




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Chapter 10 - Financial Statement Analysis



QUESTIONS & ANSWERS

Q10.1       Explain why financial statement analysis is the cornerstone of fundamental analysis.
            How does financial statement analysis relate to the basic difference between
            investment and speculation?

Q10.1 ANSWER
         Financial statement analysis is the cornerstone of fundamental analysis because it is
         the means by which investors ascertain the economic worth of a company. It is the
         starting point for all long-term investors, versus short-term speculators. Stock market
         investment is the process of buying and holding for dividend income and long-term
         capital appreciation the shares of companies with inherently attractive economic
         prospects. Investors seek to profit by sharing in the normal and predictable good
         fortune of such companies. Stock market speculation is the purchase or sale of
         securities on the expectation of capturing short-term trading profits from share-price
         fluctuations tied to the perhaps temporary good fortune of a given company.
         Speculators depend upon a short-term or fundamental change in the economic
         prospects facing a company.

Q10.2       Clarify how return on equity (ROE) numbers can become biased by share buy backs
            and corporate restructuring.

Q10.2 ANSWER
         ROE can sometimes be unduly influenced by share buy backs and other types of
         corporate restructuring. When Aextraordinary@ or Aunusual@ charges are significant,
         the book value of stockholders= equity is reduced, and ROE can become inflated.
         Similarly, when share repurchases are at market prices that exceed the book value per
         share, book value per share falls and ROE rises. Extraordinarily high ROE can be
         reported by companies that have recently undergone significant corporate
         restructuring.

Q10.3       What is total asset turnover, and how does it contribute to profitability?

Q10.3 ANSWER
         Total asset turnover is sales revenue divided by the book value of total assets. When
         total asset turnover is high, the firm makes its investments work hard in the sense of
         generating a large amount of sales volume. Grocery and apparel retailing are good
         examples of industries where high rates of total asset turnover can allow efficient
         firms to earn attractive rates of return on stockholders= equity despite modest profit
         margins. Among firms found in the DJIA, retail juggernauts Wal-Mart and Home
         Depot, feature above-average rates of total asset turnover.




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Chapter 10 - Financial Statement Analysis




Q10.4       What is the difference between a company’s return on assets (ROA) and its return on
            stockholders’ equity (ROE)? Why should investors be skeptical of seemingly
            extraordinary ROE?

Q10.4 ANSWER
         Both terms are relative measures of profitability. A firm’s ROA is its net income
         divided by the book value of total assets. This measure indicates how profitable a
         company in terms of the total value of assets on the balance sheet. ROA captures the
         effects of managerial operating decisions, but tends to be less affected than other
         measures by the amount of financial leverage used. In contrast, ROE is defined as net
         income divided by the book value of stockholders’ equity, which is the book value of
         total assets minus total liabilities. ROE tells how profitable a company is in terms of
         each dollar invested by shareholders. However, investors should not automatically
         assume that high reported ROE means a company is highly profitable. A limitation
         of ROE is that it can sometimes be unduly influenced by share buybacks and other
         types of corporate restructuring. When ―extraordinary‖ or ―unusual‖ charges are
         significant, the book value of stockholders’ equity is reduced, and ROE can become
         inflated. Similarly, when share repurchases are at market prices that exceed the book
         value per share, book value per share falls and ROE rises. Given the difficulty of
         interpreting ROE for companies that are highly leveraged or have undergone
         significant restructuring, some investors prefer focusing on ROA rather than ROE.

Q10.5       Why is it important for firms to earn a business profit rate, or return on equity (ROE),
            of 12% or more per year?

Q10.5 ANSWER
         The goal of all firms is to prosper and increase earnings. In order to do this, most
         firms rely on cheap sources of financing. Investors in these firms expect consistently
         strong business profit rates in exchange for cheap financing. When ROE is at or
         above 12% per year, the rate of profit is generally sufficient to compensate investors
         for the risk involved with a typical business enterprise. New debt and equity
         financing is easy to obtain, and the firm prospers. If ROE consistently falls below
         this level, financing tends to dry up and the firm withers and dies. Therefore, as a
         practical matter, firms must consistently earn a business profit rate, or ROE, of at
         least 12% per year to grow and prosper.




                                                10-6
Chapter 10 - Financial Statement Analysis




Q10.6       From an investor’s perspective, what are the advantages and disadvantages of large
            firm size?

Q10.6 ANSWER
         The advantage of investing in large companies with market capitalizations greater
         than, say, $50 billion is that they are generally considered less risky than mid-cap or
         small-cap stocks. This is because there is a large and liquid market for their shares
         and a longer history of earnings and dividend growth. Such companies have not only
         stood the test of time, they typically have a portfolio of different lines of business and
         operate in a variety of domestic and global markets. Nevertheless, it is important for
         investors to recognize that large size tends to limit opportunities for above-average
         future growth. In fact, once even an extraordinary firm reaches a certain size, it
         becomes impossible to sustain growth at a rate faster than 3-5% per year, the real rate
         of growth in GDP.

Q10.7       What are intangible assets and why are they important to investors?

Q10.7 ANSWER
         Intangible assets are valuable holdings that have no physical presence. Examples of
         intangible assets include brand names, advertising expenses, research and
         development expenses, patents, and managerial ability. Such assets do not show up
         on balance sheets or in cash flow and income statements, but undeniably add value to
         a firm. As a result, accounting balance sheet information and income and cash-flow
         statements offer only a distorted view of true economic performance for many
         companies. Investors can profit by identifying unrecognized intangible assets that
         will increase firm value in the future. An investor who buys stock in a company with
         unrecognized intangible assets has a good chance of earning above-market returns
         once other investors recognize the value of these assets.

Q10.8       What types of information are included in the firm’s Proxy Statement? When is this
            information filed? For examples, see the SEC’s website (www.sec.gov/edgar.shtml).


Q10.8 ANSWER
        The definitive proxy statement (DEF 14A) discloses important information about
        issues to be discussed at an annual meeting, lists the qualifications of management
        and board members, serves as a ballot for elections to the board of directors, lists the
        largest shareholders of a company's stock and provides detailed information about
        executive compensation. Companies have 120 days from the end of their fiscal year
        to file their definitive proxy or information statements involving the election of
        directors.




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Chapter 10 - Financial Statement Analysis




Q10.9       What types of information are included in the firm’s 10Q reports? When are they
            filed? For examples, see the SEC’s website (www.sec.gov/edgar.shtml).

Q10.9 ANSWER
        The 10Q (for quarterly) is a quarterly report of firm performance that, like the 10K, is
        filed with the SEC and made broadly available to the investing public. The 10Q must
        be filed within 35 days after the fiscal quarter end.


Q10.9       What types of information are included in the firm’s 10K reports? When are they
            filed? For examples, see the SEC’s website (www.sec.gov/edgar.shtml).



Q10.9 ANSWER
        All publicly-traded companies must file a comprehensive summary of firm
        performance on an annual basis to the Securities and Exchange Commission. This
        report is called the 10K. Typically, the 10-K contains much more detail than the
        company annual report to shareholders. It includes information such as company
        history, organizational structure, equity, holdings, earnings per share, subsidiaries,
        etc. The 10-K must be filed within 60 days (it used to be 90 days) after the end of the
        fiscal year.

Q10.10      Accounting earnings before interest, taxes, depreciation and amortization (EBITDA)
            is a popular measure of cash flow used to measure firm performance. At the same
            time, critics argue that EBITDA is a misleading indicator of firm performance
            because it does not measure free cash flow, ignores risk, pays no heed to the amount
            of invested capital, and is subject to manipulation. Discuss these criticisms of
            EBITDA and suggest alternative measures of firm performance.




                                               10-8
Chapter 10 - Financial Statement Analysis




Q10.10 ANSWER
         EBITDA can be a misleading indicator of firm value because it does not measure free
         cash flow, ignores risk, pays no heed to the amount of invested capital, and is subject
         to manipulation. EBITDA numbers are calculated by adding back depreciation
         numbers to accounting net income. This ignores the fact that depreciation is a real
         business expense. Annual depreciation expenses closely reflect the year-by-year costs
         of technological and physical obsolesce of plant and equipment for many firms. At a
         minimum, investors need to subtract from EBITDA the amount of necessary
         expenditures on property, plant and equipment to accurately judge the amount of free
         cash flow generated by the firm during a given reporting period. Because EBITDA is
         calculated from the accounting profit and loss statement, like any accounting-based
         number it is subject to potential manipulation. Moreover, EBITDA multiples
         mentioned in published transactions often report the EBITDA multiple to the seller
         only and exclude consideration of buyer circumstances. When buyers can reduce
         costs or accelerate revenues in a business combination, realized EBITDA can be far
         greater that the numbers published by the acquired firm. For all of these reasons,
         EBITDA numbers can paint a misleading picture of the firm’s ability to generate
         economic profits. Accounting net income, earnings before extraordinary items, and
         operating cash flow minus necessary capital expenditures (free cash flow) are all
         attractive alternatives to EBITDA. It is important to keep in mind that if companies
         are able to report significant net income or high rates of return on invested capital,
         few (if any) want their ongoing performance to be measured by EBITDA numbers.




                                              10-9
Chapter 10 - Financial Statement Analysis



PROBLEMS & SOLUTIONS

P10.1    Suppose a stock you have found on the OTC.BB (pink sheets) has $7.6 million in
         sales, $6.4 million in expenses, $9 million in total assets, and $5.4 million in total
         liabilities. For simplicity, assume a 25% state plus federal tax rate. Calculate net
         income, stockholders’ equity, profit margin, total asset turnover, leverage, ROA, and
         ROE for the company. Is this a highly profitable company?
10.1 SOLUTION
                       Net income = (Sales – Expenses) – Taxes
                                    = ($7.6 – $6.4) – 0.25  ($7.6 – $6.4)
                                    = $0.9 (or $900,000)
             Stockholders’ equity = Total assets – Total liabilities
                                    = $9 – $5.4
                                    = $3.6 million
                      Profit margin = Net income/Sales
                                    = $0.9/$7.6
                                    = 11.8%
              Total asset turnover = Sales/Total assets
                                    = $7.6/$9
                                    = 0.844
                          Leverage = Total assets/Stockholders’ equity
                                    = $9/$3.6
                                    = 2.50
                              ROA = Net income/Total assets
                                    = $0.9/$9
                                    = 10%
                              ROE = Profit margin  Total asset turnover  Leverage
                                    = 0.118  0.844  2.50
                                    = 25%
         Alternatively,
                              ROE = Net Income/Equity
                                    = $0.9/$3.6
                                    = 25%

            Obviously, this is a very small firm with modest economic resources and profitability.
            Nevertheless, ROE = 25% is very attractive, and if stable and predictable suggests the
            wise use of operating and financial leverage. Not many companies found on the
            OTC.BB (pink sheets) fit this profile. The company may be worth a further look.




                                              10-10
 Chapter 10 - Financial Statement Analysis




P10.2        During the best of times, the auto industry is a cyclical, low margin business. These
             are not the best of times. Auto stocks were rocked in 2008 by industry turmoil
             stemming from consumer credit deterioration and skyrocketing fuel costs. Calculate
             profit margin information for the top six auto companies found using the stock
             screener on Yahoo! Finance (http://screener.finance.yahoo.com/newscreener.html).

                                  Net Income Sales Revenue
              Company      Ticker       (mil.)        (mil.) Profit Margin
              Toyota Motor TM         $13,927      $223,640          6.23%
              GM           GM          -3,539       180,435         -1.96%
              Ford Motor   F             -100       154,866         -0.06%
              Daimler AG   DAI          3,475       150,748          2.31%
              Honda Motor HMC           5,160       106,694          4.84%
              Nissan Motor NSANY        4,275        95,278          4.49%

 10.2 SOLUTION
                                             Net Income Sales Revenue
              Company           Ticker             (mil.)        (mil.) Profit Margin
              Toyota Motor      TM               $13,927      $223,640          6.23%
              GM                GM                -3,539       180,435         -1.96%
              Ford Motor        F                   -100       154,866         -0.06%
              Daimler AG        DAI                3,475       150,748          2.31%
              Honda Motor       HMC                5,160       106,694          4.84%
              Nissan Motor      NSANY              4,275        95,278          4.49%

 P10.3       The computer software and services industry tends to be enormously profitable even
             in tough times because it offers consumer and business customers a wide range of its
             efficiency-enhancing products and services. Calculate profit margin information for
             five top computer software and service companies using data compiled using the
             stock screener on Yahoo! Finance
             (http://screener.finance.yahoo.com/newscreener.html). If industry-average net profit
             margins average 11.9%, do you detect advantages of large firm size in this industry?

                                                       Net Income Sales Revenue
                       Company               Ticker          (mil.)        (mil.)
                       Microsoft Corp.       MSFT       $16,419.0      $57,954.0
                       Oracle Corp.          ORCL          6,271.5      21,210.0
                       SAP AG                SAP           2,823.6      15,762.2
                       CA, Inc.              CA              500.0       4,277.0
                       Adobe Systems         ADBE            799.3       3,398.9




                                                      10-11
Chapter 10 - Financial Statement Analysis




10.3 SOLUTION
         As shown in the table below, computer software and service companies earn enviable
         profit margins. Even among the largest companies in the industry, advantages of large
         size are apparent. When compared with industry-average profit margins of 11.9%, the
         advantages of large size are even more apparent. (It’s good to be king.)

                                   Net Income Sales Revenue
            Company         Ticker       (mil.)        (mil.) Profit Margin
            Microsoft Corp. MSFT    $16,419.0      $57,954.0          28.3%
            Oracle Corp.    ORCL       6,271.5      21,210.0          29.6%
            SAP AG          SAP        2,823.6      15,762.2          17.9%
            CA, Inc.        CA           500.0       4,277.0          11.7%
            Adobe Systems ADBE           799.3       3,398.9          23.5%

P10.4       Tight credit markets make harder for all households, especially low-income families,
            to refinance mortgages and get installment credit on relatively good terms. Rising gas
            and food prices are also hurting many consumers, as is the weakening dollar which
            raises prices on imported products. More than ever, retailers are focusing on
            increasing sales revenue. Calculate total asset turnover ratios for a sample of top
            retailers using Value Line data below. Based on this data, what is the Costco
            advantage?

                                               Total Assets  Sales
                       Company          Ticker    (mil.)    (mil.)
                       Wal-Mart Stores WMT        $163,514 $384,442
                       Costco Wholesale COST         19,607  69,906
                       Target Corp.     TGT          44,560  63,629
                       Sears Holdings   SHLD         27,397  50,024
                       Macy's Inc.      M            29,550  26,139
                       Penney (J.C.)    JCP          12,673  19,637
                       Kohl's Corp.     KSS          10,560  16,526




                                               10-12
Chapter 10 - Financial Statement Analysis




10.4 SOLUTION
        As shown in the table below, total asset turnover ratios for a sample of top retailers
        illustrate the Costco advantage. Costco has an enviable TAT ratio reflecting the
        company’s wise use of assets.

                                                      Total Assets  Sales
                   Company                  Ticker       (mil.)    (mil.)  TAT
                   Wal-Mart Stores          WMT          $163,514 $384,442 2.35
                   Costco Wholesale         COST            19,607  69,906 3.57
                   Target Corp.             TGT             44,560  63,629 1.43
                   Sears Holdings           SHLD            27,397  50,024 1.83
                   Macy's Inc.              M               29,550  26,139 0.88
                   Penney (J.C.)            JCP             12,673  19,637 1.55
                   Kohl's Corp.             KSS             10,560  16,526 1.56

P10.5       Specialty retailers include a broad range of companies, for PC retailers, to clothing
            shops, to sporting goods chains. What they all have in common is the need to
            efficiently manage inventory and total assets. Calculate total asset turnover ratios for
            a sample of top specialty retailers using Value Line data below. Based on this data,
            what do these specialty retailers have in common?

                                                             Total Assets    Sales
                      Company                 Ticker            (mil.)      (mil.)
                      Best Buy Co.            BBY                $13,570    $40,023
                      TJX Companies           TJX                  6,600    18,903
                      Circuit City Stores     CC                   4,007    11,744
                      Pantry (The), Inc.      PTRY                 2,029     8,089
                      PC Connection           PCCC                   381     1,811
                      Aeropostale             ARO                    514     1,651
                      Wet Seal `A'            WTSLA                  224       616




                                                     10-13
Chapter 10 - Financial Statement Analysis




10.5 SOLUTION
         As shown in the table below, these disparate specialty retailer share very high total
         asset turnover ratios reflecting their wise use of assets.

                                                       Total Assets       Sales
                  Company                   Ticker        (mil.)         (mil.)  TAT
                  Best Buy Co.              BBY            $13,570       $40,023 2.95
                  TJX Companies             TJX              6,600       18,903  2.86
                  Circuit City Stores       CC               4,007       11,744  2.93
                  Pantry (The), Inc.        PTRY             2,029        8,089  3.99
                  PC Connection             PCCC               381        1,811  4.75
                  Aeropostale               ARO                514        1,651  3.21
                  Wet Seal `A'              WTSLA              224          616  2.75


P10.6       Money center banks make their money by servicing loans and providing financial
            services to consumers and business customers. They are among the most highly
            leveraged of all commercial enterprises. In the banking industry, leverage is measured
            by the ratio of shareholders equity divided by total assets (percent equity). Compute
            the percent equity and the traditional financial leverage ratio for a handful of top
            money center banks using data compiled using the excellent stock screener on Yahoo!
            Finance (http://screener.finance.yahoo.com/newscreener.html).

                                                       Shareholders'       Total Assets
                    Company          Ticker            Equity (mil.)          (mil.)
                    Bank of America   BAC                    $139,003       $1,715,746
                    JPMorgan Chase    JPM                      125,627        1,562,147
                    Wells Fargo      WFC                        47,322          575,442
                    Bank of New York   BK                       29,403          197,656

10.6 SOLUTION
         As shown in the table below, large money center banks employ huge leverage in their
         businesses.

                                                                  Total
                                            Shareholders'         Assets       Percent
        Company                      Ticker Equity (mil.)         (mil.)       Equity Leverage
        Bank of America               BAC             $139,003 $1,715,746        8.1%     12.34
        JPMorgan Chase                  JPM            125,627    1,562,147      8.0%     12.43
        Wells Fargo                   WFC                47,322    575,442       8.2%     12.16
        Bank of New York Mellon         BK               29,403    197,656      14.9%      6.72




                                                     10-14
Chapter 10 - Financial Statement Analysis




P10.7       As the mortgage lending crisis of 2007-08 unfolded, the creditworthiness of the
            small- to medium-size banks was called into question. Many were forced to raise new
            investment capital under dire circumstances. In the banking industry, leverage is
            measured by the ratio of shareholders equity divided by total assets (percent equity).
            Compute the percent equity and the traditional financial leverage ratio for a handful
            of the worst performing small- to medium-size banks during the first half of 2008
            based upon data compiled using the excellent stock screener on Yahoo! Finance
            (http://screener.finance.yahoo.com/newscreener.html). If a typical bank leverage ratio
            was 10.39 (percent equity 9.6%) during this period, were the horrible stock-market
            returns suffered by these bank shareholders caused by too much financial leverage
            (too many loans) or poor credit quality (not the right loans), or both?
                                                                         Total        Total
                                                      Shareholders'      Assets      Return
           Company                          Ticker    Equity (mil.)      (mil.)       YTD
           Synovus Financial                 SNV         $3,531         $33,018     -60.20%
           East West Bancorp                EWBC          1,104          11,852     -59.40%
           KeyCorp                           KEY          7,746          99,983     -47.20%
           Regions Financial                  RF         19,823         141,042     -41.90%

10.7 SOLUTION
         As shown in the table below, financial leverage ratios for four of the worst
         performing small- to medium-size banks during the first half of 2008 were close to
         the typical bank leverage ratio of 10.39 (percent equity 9.6%) during this period.
         KeyCorp may be an exception to this rule as it employed more than typical leverage.
         Generally speaking, however, the horrible stock-market returns suffered by
         shareholders of these banks appears to have been caused by their having made loans
         of poor credit quality (not the right loans).
                                                              Total      Total
                                      Shareholders'           Assets    Return    Percent
   Company                     Ticker Equity (mil.)           (mil.)     YTD      Equity Leverage
   Synovus Financial            SNV      $3,531              $33,018   -60.20%     10.7%     9.35
   East West Bancorp           EWBC       1,104               11,852   -59.40%       9.3%   10.74
   KeyCorp                      KEY       7,746               99,983   -47.20%       7.7%   12.91
   Regions Financial             RF      19,823              141,042   -41.90%     14.1%     7.12



P10.8       As the financial crisis of 2007-08 unfolded, the creditworthiness of the large
            investment banks was called into question. Many were forced to raise new investment
            capital under dire circumstances following the forced sale of industry heavyweight
            Bear Sterns in June 2008. Calculate financial leverage ratios for the top four
            investment banks using Value Line data below. Discuss how the need to raise new
            capital in a financial crisis can dilute current shareholders and crush stock prices.

                                                     10-15
Chapter 10 - Financial Statement Analysis




                                            Shareholders'          Total
                                               Equity              Assets     Total Return
        Company                  Ticker         (mil.)             (mil.)        YTD
        Goldman Sachs            GS           $39,529           $1,119,796      -22.2%
        Lehman Bros.             LEH           21,839             691,063         -65.1
        Merrill Lynch & Co.      MER           25,137            1,020,050        -31.5
        Morgan Stanley           MS            32,180            1,045,409        -26.9


10.8 SOLUTION
         As shown in the table below, the largest investment banks employ huge leverage in
         their businesses. All were hurt in the financial crisis of 2007-08, but shareholders for
         the most highly leveraged (Lehman and Merrill) suffered the most as the need to raise
         additional equity diluted their positions.
                                         Shareholders'    Total    Total
                                            Equity        Assets  Return
        Company                   Ticker    (mil.)        (mil.)   YTD Leverage
        Goldman Sachs               GS     $39,529     $1,119,796 -22.2% 28.33
        Lehman Bros.               LEH      21,839       691,063   -65.1 31.64
        Merrill Lynch & Co.       MER       25,137      1,020,050  -31.5 40.58
        Morgan Stanley             MS       32,180      1,045,409  -26.9 32.49


P10.9       The toy and game manufacturing industry is a risky business in which even the
            largest companies struggle to earn satisfactory rates of return. Calculate the return on
            equity during a recent year for five top toy and game manufacturing companies using
            data below from msnMoney’s excellent stock screener.

                                                   Net Profit   Asset Leverage
             Company Name               Ticker    Margin (%) Turnover    Ratio
             Mattel Inc                 MAT            9.10%      1.3      1.9
             Hasbro Inc                 HAS              8.62     1.3      2.5
             Jakks Pacific Inc          JAKK            10.03     1.0      1.3
             Mega Brands Inc            MBLKF          -16.13     0.7      3.3
             RC2 Corp                   RCRC             3.30     0.8      1.6




                                                 10-16
Chapter 10 - Financial Statement Analysis




10.9 SOLUTION
         As shown in the table below, profit rates are highly variable in this industry. Even the
         top toy and game manufacturers struggle to earn satisfactory rates of return.

                                              Net Profit   Asset Leverage ROE
         Company Name              Ticker    Margin (%) Turnover    Ratio   (%)
         Mattel Inc                MAT            9.10%      1.3      1.9 22.5%
         Hasbro Inc                HAS              8.62     1.3      2.5   28.0
         Jakks Pacific Inc         JAKK            10.03     1.0      1.3   13.0
         Mega Brands Inc           MBLKF          -16.13     0.7      3.3 -37.3
         RC2 Corp                  RCRC             3.30     0.8      1.6    4.2


P10.10      The aerospace and defense contracting industry is highly cyclical and subject to the
            hard-to-predict budgetary cycle of the U. S. government. Calculate the return on
            equity for five top aerospace and defense contractors using data below from
            msnMoney’s stock screener . Discuss differences between the ROE you have
            calculated for a recent year versus the five-year average.

                                                                                  ROE (%):
                                             Net Profit   Asset Leverage            5-Year
     Company Name                Ticker     Margin (%) Turnover    Ratio              Avg.
     Boeing                      BA              6.55%      1.2      6.7             26.0%
     Raytheon Co                 RTN               8.10     0.9      1.8                9.0
     Rolls-Royce                 RYCEY             8.07     0.7      3.2               22.0
     Elbit Systems Ltd           ESLT              4.47     0.9      5.1               12.1
     Kellstrom Industries
     Inc                         KELLQ          -21.10          0.7         5.6           4.6




                                               10-17
Chapter 10 - Financial Statement Analysis




10.10 SOLUTION
         During recent years, the Bush Administration boost in defense spending has made
         this the ―best of time‖ for firms in this industry. However, as shown in the table
         below, profit rates are highly variable in this industry. Even the top aerospace and
         defense contractors struggle to earn satisfactory rates of return on equity in the long
         run. It remains to be seen how firms in this industry will fare following the 2008
         general elections.

                                            Net Profit                                       ROE
                                              Margin          Asset   Leverage ROE         (%): 5-
     Company Name            Ticker               (%)      Turnover      Ratio   (%)     Year Avg.
     Boeing                  BA                 6.55%           1.2        6.7 52.7%        26.0%
     Raytheon Co             RTN                  8.10          0.9        1.8   13.1          9.0
     Rolls-Royce             RYCEY                8.07          0.7        3.2   18.1         22.0
     Elbit Systems Ltd       ESLT                 4.47          0.9        5.1   20.5         12.1
     Kellstrom Industries
     Inc                     KELLQ             -21.10           0.7        5.6   -82.7         4.6



P10.11      Prescription drug manufacturers are among the most consistently profitable
            companies in the world. Calculate the return on equity for five major pharmaceutical
            companies using msnMoney’s stock screener data below. Explain why many regard
            high profit margins as the most reliable sources for consistently high rates of return
            on stockholder’s equity.

                                              Net Profit   Asset Leverage ROE: 5-
     Company Name               Ticker       Margin (%) Turnover    Ratio Year Avg.
     Johnson & Johnson          JNJ             18.64%       0.8      1.9     27.7%
     Bayer                      BAYRY               7.92     0.6      3.1        4.5
     Pfizer                     PFE               16.08      0.4      1.8       12.6
     Sanofi Aventis             SNY               16.41      0.4      1.6        5.6
     Glaxosmithkline            GSK               22.40      0.8      3.4       57.5




                                                   10-18
Chapter 10 - Financial Statement Analysis




10.11 SOLUTION
         As described in the table below, prescription drug manufacturers are highly profitable
         on a consistent basis. High profit margins are the most reliable source for consistently
         high rates of return on stockholder’s equity because they reflect a company’s ability
         to set prices above the average cost of production. Many firms find themselves in
         industries where high rates of total asset turnover simply are not possible, and high
         leverage is a risky means for generating high profit rates given the unpredictable
         nature of the business cycle.

                                             Net Profit   Asset Leverage ROE ROE: 5-
    Company Name             Ticker         Margin (%) Turnover    Ratio   (%) Year Avg.
    Johnson & Johnson        JNJ               18.64%       0.8      1.9 28.3%     27.7%
    Bayer                    BAYRY                 7.92     0.6      3.1   14.7       4.5
    Pfizer                   PFE                 16.08      0.4      1.8   11.6      12.6
    Sanofi Aventis           SNY                 16.41      0.4      1.6   10.5       5.6
    Glaxosmithkline          GSK                 22.40      0.8      3.4   60.9      57.5

P10.12      Financial analysts need to be aware of the fact that data service providers sometimes
            present their information using slightly different financial statement terminology. For
            example, net worth is commonly defined as all the assets shown on the balance sheet,
            including any intangible assets (i.e., goodwill, debt discount, deferred charges) less
            current liabilities, long-term debt, and all other noncurrent liabilities. In other words,
            net worth is the sum of common plus preferred stockholders' equity and is sometimes
            referred to simply as shareholders' equity. More precisely, however, shareholders'
            equity is a balance sheet item showing net worth less the liquidating or redemption
            value of any preferred issues outstanding. Shareholders’ equity represents the sum of
            the value of common stock at par, the surplus of capital received (over par value), and
            retained earnings (i.e., earned surplus). Retained earnings are the sum of net profits
            earned in all years less dividends paid in all years. Differences between net worth and
            (common) shareholders’ equity are often modest, but can be significant in industries
            with significant preferred stock, like banking. Calculate the return on net worth and
            return on shareholders’ equity for a handful of large banks using Value Line data.
                                                            Net         Net
                                                        Income       Worth Shareholders'
           Company                          Ticker        (mil.)      (mil.)      Equity
           Bank of America                  BAC          14,982    $146,803    $139,003
           JPMorgan Chase                   JPM          15,365     123,221     125,627
           Wachovia Corp.                   WB            6,312      76,872      -17,508
           Wells Fargo                      WFC           8,057      47,628       47,322
           Bank of New York                 BK            2,039      29,403       29,403




                                                     10-19
Chapter 10 - Financial Statement Analysis



P10.12 SOLUTION

                                                                 Return  Return on
                                      Net      Net Shareholders' on Net Shareholders'
     Company               Ticker Income    Worth        Equity Worth      Equity
     Bank of America       BAC    $14,982 $146,803     $139,003 10.2%      10.8%
     JPMorgan Chase        JPM         15,365     123,221      125,627    12.5%        12.2%
     Wachovia Corp.        WB           6,312      76,872      -17,508     8.2%        -36.1%
     Wells Fargo           WFC          8,057      47,628       47,322    16.9%        17.0%
     Bank of New York      BK           2,039      29,403       29,403     6.9%         6.9%

P10.13      Return on equity is an attractive measure of management effectiveness in the use of
            operating and financial leverage. The return on total assets is a more basic profit
            measure that is unaffected by the effects of financial leverage. Therefore, differences
            between the ROE and ROA measures highlight the effects of leverage on firm
            performance. Calculate the ROE and ROA for a handful of leading beverage
            manufacturers and distributors using Value Line data. How effective is Anheuser-
            Busch in its use of financial leverage?



                                                      Net     Shareholders'       Total Assets
         Company                   Ticker         Income       Equity (mil.)             (mil.)
         Anheuser-Busch            BUD          $2,115.30         $3,148.60        $17,155.00
         Molson Coors Brewing      TAP             507.37          7,057.00         13,451.57
         Constellation Brands      STZ             403.82          3,512.70          9,438.20
         Brown-Forman              BF.B               390          1,694.60          3,551.00
         Boston Beer 'A'           SAM              27.19            119.65             195.86

P10.13 SOLUTION
         As shown in the table below, BUD’s enviable ROE is in large part due to the
         company’s very wise use of financial leverage.

                                                               Total
                                        Net Shareholders'     Assets
      Company              Ticker   Income Equity (mil.)       (mil.) ROE ROA
      Anheuser-Busch       BUD    $2,115.30     $3,148.60 $17,155.00 67.2% 12.3%
      Molson Coors Brewing TAP       507.37      7,057.00 13,451.57 7.2% 3.8%
      Constellation Brands STZ       403.82      3,512.70   9,438.20 11.5% 4.3%
      Brown-Forman         BF.B         390      1,694.60   3,551.00 23.0% 11.0%
      Boston Beer 'A'            SAM            27.19       119.65       195.86 22.7% 13.9%




                                                    10-20
Chapter 10 - Financial Statement Analysis



P10.14      Biotech firms use microorganisms or biological substances as tools to make proteins,
            similar to those found in the human body. These proteins are then used to
            manufacture drugs that treat various diseases and disorders (i.e., cancer and
            rheumatoid arthritis). Biotech company success is typically measured by the advances
            made within its R&D program and how well its drugs fare on the market, assuming
            regulatory approval is obtained. Few are presently profitable. Calculate the ratio of
            market capitalization to sales revenue (price-sales) ratio for ten large publicly-traded
            biotech companies using Value Line data. Discuss the relationship between price-
            sales ratios and firm size.

                                                       Market Cap   Sales
                      Company                Ticker         (mil.)  (mil.)
                      Amgen                  AMGN         $47,023 $14,697
                      Exelixis,Inc.          EXEL             585     113
                      Genentech Inc.         DNA           77,556 11,944
                      Gen-Probe              GPRO           2,805     425
                      Martek Biosciences     MATK           1,080     333
                      Myriad Genetics        MYGN           2,023     212
                      Regeneron Pharmac.     REGN           1,093     187
                      Techne Corp.           TECH           2,915     248
                      United Therapeutics    UTHR           2,130     233
                      Vertex Pharmac.        VRTX           4,503     172




                                               10-21
Chapter 10 - Financial Statement Analysis




10.14 SOLUTION
         As shown in the table below, there is a generally inverse relation between firm size
         and the ratio of market capitalization to sales revenue (price-sales) ratio for ten large
         publicly-traded biotech companies using Value Line data
         (http://www.valueline.com/). Market capitalization is determined by expected future
         sales, not present sales revenues for such companies. Because market prices reflect
         aggressive expectations about future growth, the potential for shareholder
         disappointment and investment loss is significant. These are very risky investments!

                                                      Market Cap Sales
               Company                      Ticker      (mil.)    (mil.) P/S Ratio
               Amgen                        AMGN         $47,023 $14,697      3.20
               Genentech Inc.               DNA           77,556 11,944       6.49
               Gen-Probe                    GPRO           2,805     425      6.61
               Martek Biosciences           MATK           1,080     333      3.24
               Techne Corp.                 TECH           2,915     248     11.76
               United Therapeutics          UTHR           2,130     233      9.15
               Myriad Genetics              MYGN           2,023     212      9.53
               Regeneron Pharmac.           REGN           1,093     187      5.84
               Vertex Pharmac.              VRTX           4,503     172     26.20
               Exelixis,Inc.                EXEL              585    113      5.17

P10.15      In the event of bankruptcy, common stockholders are the final residual claimants on
            the value of the firm after bondholders, creditors, and other residual claimants, such
            as preferred stockholders, have been paid. The debt-equity ratio is an attractive
            measure of financial leverage that should be carefully measured to account for all
            forms of financial obligations, including long-term debt, short-term debt, accounts
            payable, etc. Calculate debt-equity ratios for a sample of highly-levered cable TV
            companies as long-term debt divided by shareholders’ equity using Value Line data.
            Also measure debt-equity ratios using total financial obligations, the difference
            between total assets and stockholders’ equity, all divided by stockholders’ equity.
            Discuss any differences. How can stockholders’ equity be negative?

                                                        Total
                                   Long-Term           Assets      Shareholders'             (TA-
 Company               Ticker      Debt (mil.)          (mil.)     Equity (mil.)  LTD/SE    SE)/SE
 Cablevision Sys.      CVC          $10,785.35         $9,140.58       -$5,118.32 -210.7%   -278.6%
 Comcast Corp.         CMCSK         27,992.00        110,405.00        40,798.00   68.6%    170.6%
 DIRECTV Group         DTV            3,347.00         15,063.00         6,683.00   50.1%    125.4%
 Dish Network          DISH           4,575.25         10,086.53        -2,437.76 -187.7%   -513.8%
 Time Warner Cable     TWC           13,577.00         56,600.00        24,997.00   54.3%    126.4%




                                                     10-22
Chapter 10 - Financial Statement Analysis




P10.15 SOLUTION
         As shown in the table below, cable TV companies employ huge leverage that can be
         understated when debt-equity ratios are measured using only long-term debt. These
         companies have huge short-term obligations, as to many retailers. Measuring debt-
         equity ratios becomes tricky when shareholders’ equity is negative, as is often the
         case in the cable TV industry. Many such firms report an ongoing stream of operating
         losses that result in negative retained earnings and negative shareholders’ equity.

                                                         Total
                                   Long-Term            Assets        Shareholders'             (TA-
 Company               Ticker      Debt (mil.)           (mil.)        Equity (mil.) LTD/SE    SE)/SE
 Cablevision Sys.      CVC          $10,785.35          $9,140.58        -$5,118.32 -210.7%    -278.6%
 Comcast Corp.         CMCSK         27,992.00         110,405.00         40,798.00   68.6%     170.6%
 DIRECTV Group         DTV            3,347.00          15,063.00          6,683.00   50.1%     125.4%
 Dish Network          DISH           4,575.25          10,086.53         -2,437.76 -187.7%    -513.8%
 Time Warner Cable     TWC           13,577.00          56,600.00         24,997.00   54.3%     126.4%

P10.16      Financial liquidity is always important, but especially during a downturn. Calculate
            net working capital, current ratios, and quick ratios for a sample of downtrodden
            homebuilders using Value Line data. How would you describe the financial liquidity
            of these companies?

                                                         Total Current       Total Current
                                             Cash               Assets           Liabilities
             Company         Ticker          (mil.)              (mil.)              (mil.)
             Centex Corp.    CTX            $1,029             $11,902              $3,954
             Horton D.R.     DHI               270               9,613               1,912
             Pulte Homes     PHM             1,060               8,127               1,119
             Toll Brothers   TOL               900               6,783               2,193
             KB Home         KBH             1,325               4,978                  700




                                                      10-23
Chapter 10 - Financial Statement Analysis




P10.16 SOLUTION
         As of mid-summer 2008, top homebuilders were maintaining sufficient liquidity
         when measured by working capital numbers. However, they appear to be short of
         cash and may be having trouble collecting on their accounts receivables.


                                         Total          Total
                                        Current        Current       Working
                           Cash          Assets       Liabilities    Capital        Current    Quick
   Company          Ticker (mil.)        (mil.)         (mil.)        (mil.)         Ratio     Ratio
   Centex Corp.     CTX    $1,029        $11,902          $3,954        $7,948          3.01     0.26
   Horton D.R.      DHI       270          9,613            1,912        7,701          5.03     0.14
   Pulte Homes      PHM     1,060          8,127            1,119        7,008          7.26     0.95
   Toll Brothers    TOL       900          6,783            2,193        4,590          3.09     0.41
   KB Home          KBH     1,325          4,978               700       4,278          7.11     1.89

P 10.17     As of the first quarter of 2008, the 10Q report to the SEC for Delta Airlines, Inc.
            (DAL) showed cash of $2.7 billion, current assets of $5.3 billion, and current
            liabilities of $6.7 billion. Compute Delta’s current ratio, quick ratio and working
            capital. Comment upon Delta’s liquidity.

P10.17 SOLUTION
         With both current and quick ratios less than one, and negative working capital, Delta
         is in dire financial circumstances.

                       Current ratio =      Current assets/Current liabilities
                                     =      $5.3/$6.7
                                     =      0.79
                        Quick ratio =       Cash/Current liabilities
                                     =      $2.7/$6.7
                                     =      0.40
                     Working capital =       Current assets - Current liabilities
                                     =      $5.3 - $6.7
                                     =      -$1.4 billion

P 10.18     As of the first quarter of 2008, the 10Q report to the SEC for Google Inc.(GOOG)
            showed cash of $6.5 billion, current assets of $15.5 billion, and current liabilities of
            $2.5 billion (http://www.sec.gov/). Compute Google’s current ratio, quick ratio and
            working capital. Comment upon Google’s liquidity.




                                                   10-24
Chapter 10 - Financial Statement Analysis




P10.18 SOLUTION
         With huge current and quick ratios, and substantial working capital, Google is one of
         the most liquid of all publicly-traded corporations.

                       Current ratio =      Current assets/Current liabilities
                                     =      $15.5/$2.5
                                     =      6.20
                        Quick ratio =       Cash/Current liabilities
                                     =      $6.5/$2.5
                                     =      2.60
                     Working capital =       Current assets - Current liabilities
                                     =      $15.5 - $2.5
                                     =      $13.0 billion

P10.19      Using msnMoney’s stock screener, it is possible to find profit rates for the fifteen
            firms in the S&P 500 Index that employ the most financial leverage. Based upon the
            data displayed below, discuss how such firms find it difficult to effectively employ
            financial leverage.

                                                              ROE (%):        Debt to
                    Company Name                    Ticker   5-Year avg.   Equity (%)
                    Western Union Co                WU               0.0        456.7
                    Tenet Healthcare Corp           THC            -40.0        149.2
                    Freddie Mac                     FRE              6.7          47.4
                    SLM                             SLM             31.9          28.9
                    Qwest Communications            Q                0.0          26.9
                    Embarq Corp                     EQ               0.0          24.4
                    FORD MOTOR                      F              -22.2          23.8
                    Fannie Mae                      FNM             13.7          19.6
                    Merrill Lynch                   MER              7.1          15.7
                    General Growth Properties Inc   GGP             10.4          12.3
                    CIT Group                       CIT             10.3          11.8
                    Dean Foods Co                   DF              11.8          11.0
                    H&R Block Inc                   HRB             24.2          10.0
                    Yum! Brands Inc.                YUM             59.4           9.7
                    National Semiconductor Corp     NSM             22.3           9.5
                    Average                                          9.0          57.1




                                                    10-25
Chapter 10 - Financial Statement Analysis




10.19 SOLUTION
         Financial leverage can be an effective tool used to increase the net present value of
         the firm by investing in projects that feature an internal rate of return that exceeds the
         cost of capital. Unfortunately, as illustrated by this sample of highly leveraged firms,
         leverage cannot be used to turn an essentially bad business into a good business.
         When you leverage a bad business you create a really bad business that is susceptible
         to the always hard-to-predict business cycle. Finally, from a behavioral perspective, it
         is possible that firms—like many consumers—employ leverage with only mixed
         results because they treat borrowed funds differently than their own. If companies are
         less diligent in their spending of borrowed funds, poor returns for highly leveraged
         companies would be observed.

P10.20      Using msnMoney’s stock screener, it is possible to find the level of financial leverage
            employed by the fifteen most consistently profitable firms in the S&P 500 Index.
            Based upon the data displayed below, discuss how such firms find it difficult to
            effectively employ financial leverage effectively. Can you explain why the most
            consistently profitable firms employ so little leverage?
                                                              ROE     Debt to
                                                            (%): 5-   Equity
                           Company Name          Ticker   Year avg.      (%)
                           Moody's Corp          MCO        1,355.8       0.0
                           AutoZone Inc          AZO          144.5       4.2
                           Colgate Palmolive     CL           143.7       1.7
                           IMS Health Inc        RX           127.7       0.0
                           Avon Products Inc     AVP          105.3       2.6
                           Hercules Inc          HPC           87.8       1.6
                           Clorox Co             CLX           85.5       0.0
                           Campbell Soup Co      CPB           70.2       1.1
                           Anheuser-Busch        BUD           62.2       3.0
                           Yum! Brands Inc.      YUM           59.4       9.7
                           Dell Inc              DELL          57.8       0.6
                           Freeport McMoRan      FCX           53.8       0.4
                           MEMC Elec. Mat. Inc   WFR           50.8       0.0
                           Windstream Corp       WIN           50.2       9.0
                           Kellogg Co            K             48.8       2.6
                           Average                            166.9       2.4




                                                 10-26
Chapter 10 - Financial Statement Analysis




10.20 SOLUTION
         It is indeed striking to note the very low levels of financial leverage employed by the
         most consistently profitable firms in the S&P 500 Index. The firms most able to
         shoulder a large debt burden decline to do so. Apparently, such firms have decided to
         abstain from sophisticated financial engineering in favor of focusing on providing
         customers with high quality products and services. Clearly, they also derive important
         benefits from maintaining the financial flexibility that comes with a pristine balance
         sheet.


CFA PROBLEMS & SOLUTIONS
  CFA10.1A company's current ratio is 2.0. If the company uses cash to retire notes payable that
         are due within one year, would this transaction most likely increase or decrease the
         current ratio and asset turnover ratio, respectively?

            Current ratio                   Asset turnover ratio
            A. Increase                     Increase
            B. Increase                     Decrease
            C. Decrease                     Increase
            D. Decrease                     Decrease

            Answer: A

  CFA10.2An analyst gathered the following information about a company whose fiscal year
         end is December 31:

            • Net income for the year was $10.5 million.
            • Preferred stock dividends of $2 million were paid for the year.
            • Common stock dividends of $3.5 million were paid for the year.
            • 20 million shares of common stock were outstanding on January 1, 2001.
            • The company issued 6 million new shares of common stock on April 1, 2001.
            • The capital structure does not include any potentially dilutive convertible securities,
            options, warrants, or other contingent securities

            The company's basic earnings per share for 2001 was closest to:

            A. $0.35.
            B. $0.37.
            C. $0.43.
            D. $0.46.

            Answer: A




                                                    10-27
Chapter 10 - Financial Statement Analysis




  CFA10.3Two companies are identical except for substantially different dividend payout ratios.
         After several years, the company with the lower dividend payout ratio is most likely
         to have:

            A.   lower stock price.
            B.   higher debt/equity ratio.
            C.   less rapid growth of earnings per share.
            D.   more rapid growth of earnings per share.

            Answer: D

  CFA10.3An analyst applied the DuPont System to the following data for a company:

            •   Equity turnover                4.2
            •   Net profit margin            5.5%
            •   Total asset turnover           2.0
            •   Dividend payout ratio       31.8%

            The company’s return on equity is closest to:

            A. 1.3%.
            B. 11.0%.
            C. 23.1%.
            D. 63.6%.

            Answer: C




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Description: Debt to Equity Ratio of Honda Motor Company document sample