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					12                     Financial Statement Analysis

Discussion Questions

NOTE TO INSTRUCTOR: Many of the Discussion Questions in this
   chapter refer to the Family Dollar annual report which was
   included in the textbook.

12-1. If the company=s management becomes too focused on the
      presentation of short-term results to external parties, they will
      have a tendency to make operating decisions based how those
      decisions affect the financial statements, rather than for the
      long-term good of the company. This is known as managing
      the financial statements rather than managing the business.

12-2. Management is constrained by the fact that it is expected to act
      ethically and responsibly in the overall presentation of financial
      information. Since management does have options available
      when choosing the methods used to present financial
      information, management is responsible for presenting the
      information to interested users in accordance with prevailing
      GAAP. By doing so, management acts in an ethical manner
      with respect to users of the financial data.

12-3. NOTE TO INSTRUCTOR: The examples we chose to use to
      model an answer to Discussion Question 12-3 are two of an
      almost unlimited number. Your students will derive many others
      (maybe better ones). Personal computers, cable TV, video
      games, video cassette recorders, and ipods are examples of
      products that did not exist 30 years ago. Changes in society
      have also led to dramatic changes in industries dealing with
      such things as home and automobile security systems, health
      care, and many others.
Chapter 12 – Financial Statement Analysis                     F12-1
        As is so often the case with the Discussion Questions, the
        answers your students provide is not nearly as important as the
        thought process they go through to arrive at those answers.
        Possible answers include:

        1)   The change in family structure over the past thirty years
             has led to eating out more often, so there are fewer sit-
             down family meals than there were in the 1970s. Two
             industries that have been greatly influenced by this
             change are the fast-food industry and the grocery
             industry.
                   The number of fast-food restaurants in the United
             States has exploded in the past thirty years. Additionally,
             the food offered by these establishments has changed.
             Many of them now serve breakfast and have salad bars,
             where thirty years ago they were really nothing more than
             hamburger and taco stands.
                   The composition of products sold in the grocery
             industry has been greatly influenced by changes in eating
             patterns, as well. Not only have grocery stores
             dramatically increased the number of nonfood items they
             sell (many now even sell clothes and hardware items,
             etc.), but the food products they carry have also changed.
             The freezer sections of most grocery stores are loaded
             with products that need only be heated and served. This
             is the grocery industry=s version of fast food.
.
        2)   People drive smaller, more fuel efficient cars now than
             they did thirty years ago. Just two of the industries greatly
             influenced by this change are automobile manufacturing
             and retail gas stations.
                   The auto industry has been forced to produce the
             smaller, more fuel efficient cars demanded by consumers.
             Even what we now call large, luxury cars are smaller and
             get better gas mileage than the huge gas guzzling
F12-2                                  Chapter 12 – Financial Statement Analysis
                monsters of the 1960s.
                      The impact of the desire for more fuel efficient cars
                has had a particularly marked impact on retail gas
                stations, which bear little resemblance to the full-service
                establishments of thirty years ago. To compensate for
                lower sales of gas, almost all gas stations are now self-
                serve (fewer employees needed) and many of them are
                now a combination of gas station and convenience
                market. It is not uncommon for these establishments to
                earn more from the sale of cigarettes, beer, and soda
                than they do from the sale of gas and oil.

        NOTE TO INSTRUCTOR: Discussion Questions 12-4, 12-5,
        and 12-6 will be more beneficial to your students if you will give
        them some guidance as to the two industries they choose in
        formulating their answers. Suggest that they choose industries
        with striking differences such as a highly labor-intensive
        industry and one based more on technology than manpower.
        In the solutions below, we have chosen one industry that is
        relatively young and subject to rapid technological change and
        another that is more mature, and not so susceptible to changes
        in technology.

12-4. The two industries we have chosen in constructing our
      suggested solution to this question (and the next two) are
      manufacturing computers (young) and manufacturing
      refrigerators (mature).
      Similarities:
      a. Both deal in tangible, physical product.
      b. Both are manufacturers, so both have factories.
      c. Both can be affected by general economic conditions and
            political events.
      d. Both must respond to changes in consumer demands



 Chapter 12 – Financial Statement Analysis                       F12-3
         Differences:
         a. While there are certainly technological changes in the
               manufacture of refrigerators, technology is changing
               much more rapidly in the computer industry.
         b. From a consumer=s point of view, it appears that the
               competition among computer producers is much fiercer
               than the competition among refrigerator manufacturers.
         c. Refrigerator manufacturers are more labor intensive than
               are computer manufacturers.
         d. Future demand for the products is certainly harder to
               predict for the computer manufacturer than for the
               refrigerator producer.

12-5. Those students who tend to avoid taking risks and desire a
      stable environment in which the risks of failure are lower will
      probably choose the refrigerator manufacturer. Those students
      who are risk takers and desire a fast-paced, ever-changing
      environment in which excitement runs high will probably select
      the computer manufacturer. This type of company may offer
      more challenges.

12-6. The rewards of investment in these two industries are very
      likely reflective of the amount of risk involved in each. The
      potential of a high return on money invested in a refrigerator
      manufacturer is probably lower than the potential return on an
      investment in a computer manufacturer.
            Students often choose very differently when they assume
      the role of potential investor than they do when they select an
      industry in which they would seek a position of employment.
      Even students who wanted the stability of refrigerator
      manufacturing for employment may select the computer
      manufacturer as an investment because of the potential of a
      high return on their invested dollars. Likewise, some may want
      to face the challenges of change in the computer industry as a
      manager, but they may want their investment to be safer in a
      more stable industry.
 F12-4                               Chapter 12 – Financial Statement Analysis
12-7. The situations your students come up with in answer to this
      question will probably be examples of either cost reduction or
      cost increase type decisions.
      Cost reduction decisions. Decisions of this type are greatly
      influenced by whether management has a short-term or long-
      term perspective. A good example is whether or not to reduce
      a company=s labor force. Most businesses find it necessary to
      lay off employees periodically. The cost of labor is extremely
      high and a company simply cannot afford to keep employees
      on the payroll if the volume of business is not high enough to
      support the cost. The decision to let employees go, however,
      must be made carefully because there are long-term as well as
      short-term considerations.
      Short-term perspective. There is probably no better way to
      quickly improve profits than laying off employees, which
      reduces wages expense. Companies whose management is
      focused on the short run can actually use layoffs as a way to
      manipulate profits.
      Long-term perspective. Letting employees go will save a
      company money in the short run, but may actually be more
      costly in the long fun, for a number of reasons:
      1. It usually costs an enormous amount of money to train
            employees. If a company reduces its labor force to save
            money, but then must replace those employees later on, it
            will incur the cost of training the new employees.
      2. Employee layoffs usually cause morale problems and
            there is often an adverse impact on the productivity of
            remaining employees.
      If management has the long-term well-being of the company in
      mind, it will carefully consider the possible future adverse
      effects of cost reduction decisions. If, on the other hand,
      management is preoccupied with short-term profits, it will
      ignore potential future problems and will make the decision that
      will have the most immediate impact on profits.


 Chapter 12 – Financial Statement Analysis                  F12-5
         Cost increase decisions. This type of decision is also greatly
         influenced by whether management has a short-term or long-
         term perspective. About the best example of this situation we
         can think of is whether or not a company should spend money
         on research and development (R&D). R&D is usually very
         costly. Furthermore, the benefits derived from the money spent
         on R&D are often not realized for many years (if at all).
         Short-term perspective. Current accounting standards (GAAP)
         require that all monies spent on R&D be expensed in the
         period incurred. This means that every dollar spent reduces net
         income by a dollar. Therefore, management can improve the
         short-term profits of a company by deciding not to involve itself
         in R&D activities or reducing its R&D expenditures.
         Long-term perspective. In many industries, companies must
         spend money on R&D if they are to remain technologically
         competitive. Indeed, many companies will simply not survive at
         all if they do not invest in R&D. If management has an eye on
         the long-run success (or survival) of the company, it is willing to
         sacrifice profits in the short run to achieve success in the
         future.

12-8. NOTE TO INSTRUCTOR: An important concept you should
      convey in your coverage of Discussion Question 12-8 is that
      there is not a universally Agood@ profit margin before income
      tax ratio, because values of this ratio are very industry-specific.
       Some industries, such as retail jewelry stores, tend to have
      very high profit margin before income tax figures. It is not
      uncommon for a jewelry store to have a profit margin before
      income tax of 20% whereas for grocery stores, this ratio might
      be as low as 2%.
            The two situations that might cause a low profit margin
      before income tax are:
      !     Low sales may be a function of low prices or low volume.
      !     High expenses may be due to high fixed expenses or high
            variable expenses such as cost of goods sold or
            manufactured.
 F12-6                                   Chapter 12 – Financial Statement Analysis
         This is logical if you remember two things. First, the formula for
         this ratio is net income before taxes divided by sales. Second,
         net income before income tax is calculated as all revenue (of
         which sales is the largest component) minus expenses. If
         sales are low or expenses are high, the result will be a lower
         profit margin before income tax. Both can be influenced by the
         maturity of the industry and/or the level of competition within
         the industry.

 12-9. In order to make its total asset turnover higher, a company
       must either:
       !    produce more sales with the assets it currently possesses
            (increase the numerator).
       or
       !    use fewer assets to produce its present level of sales
            (decrease the denominator).

12-10. In general, management experts agree that the profit margin
       before income tax ratio is easier to improve than the total asset
       turnover ratio. To understand why, we must determine what
       must be done to improve each ratio.

         Profit margin before income tax: This ratio can be improved
         by increasing sales or decreasing expenses (or a combination
         of the two). Increasing sales is very difficult and sometimes not
         even possible, depending on market pressures. Reducing
         expenses is difficult as well, but not as difficult as increasing
         sales. In an earlier Discussion Question (12-7) we mentioned
         that laying-off employees will improve short-term profits
         immediately. A company could also reduce its advertising
         expenditures, curtail research and development, or take any
         number of other steps that would reduce expenses. These
         actions may be detrimental to the long-term well-being of the
         company, but in the short run will reduce expenses and result
         in a higher profit margin before income tax ratio.

  Chapter 12 – Financial Statement Analysis                      F12-7
          Total asset turnover: This ratio can be improved by
          increasing sales or decreasing the company=s investment in
          assets (or a combination of the two). As mentioned previously,
          increasing sales is very difficult and sometimes not even
          possible, depending on market pressures. Reducing
          investment in assets is also extremely difficult, and may not
          even be possible (in the short run, anyway).
               Because expenses are easier to reduce than assets, profit
          margin before income tax is easier to improve than total asset
          turnover.

12-11. Normally listed as an income statement item, interest expense
       is always available in the annual report. The cash paid for
       interest is required to be included in the direct method
       operating section of the cash flow statement or in a
       supplemental schedule to the indirect method cash flow
       statement. This should approximate the interest expense. If we
       do not find interest expense on the income statement, it is
       normally included in the long-term liability section of the notes
       to the financial statements.

12-12. Interest expense is found in the income statement, the
       footnotes to the financial statements or in the statement of
       cash flow or its supplemental schedule.

12-13. NOTE TO INSTRUCTOR: Discussion Question 12-13 is
       important because there is a tendency to think of all these
       different ratios as independent of one another. If you conduct
       the discussion of this question seriously, your student will
       better understand that things affecting one ratio often have an
       effect on other ratios, as well.
             Interest on borrowed money is not one of the Family
       Dollar=s expenses. Any added interest would affect any of the
       ratios that include expenses in their calculation. This would
       include any ratio that has the words Anet income@ in either the
       numerator or the denominator. For each of the five ratios asked
  F12-8                                Chapter 12 – Financial Statement Analysis
         about in this question, the effect is:
         a. Profit margin before income tax. The formula for this
             ratio is net income before taxes divided by sales. Any
             interest expense would have no effect on the
             denominator, but it would reduce the numerator.
             Therefore, this ratio would be lower.
         b. Profit margin after income tax. The formula for this ratio
             is net income after taxes divided by sales. Any interest
             expense would have no effect on the denominator, but it
             would reduce the numerator. Therefore, this ratio would
             be lower.
         c. Return on assets. The formula for this ratio is net income
             before taxes divided by total assets. Any interest expense
             would have no effect on the denominator, but it would
             reduce the numerator. Therefore, this ratio would be
             lower.
         d. Return on equity. The formula for this ratio is net income
             after taxes divided by equity. Any interest expense would
             reduce the numerator. It would also reduce the
             denominator (because net income for the period is added
             to equity). Since the numerator and the denominator
             would both be reduced by exactly the same amount, this
             ratio would be lower.
         e. Total asset turnover. The formula for this ratio is sales
             divided by total assets. Any interest expense would have
             no effect on either the numerator or the denominator.
             Therefore, this ratio would remain the same.

12-14. Any company asset that it reasonably expects to become cash
       within the next year is classified as a current asset. The most
       common item classified as a current asset, but excluded in the
       calculation of the quick ratio, is merchandise inventory.
       Additionally, prepaid expenses (rent and insurance) are
       classified as current assets, not because they are expected to
       become cash within one year, but because the benefit derived
       from them is expected within the next year.
  Chapter 12 – Financial Statement Analysis                   F12-9
12-15. NOTE TO INSTRUCTOR: In answering Discussion Question
       12-15, your students will have a tendency to think only about
       the effect of excess inventory on assets. If they do this, they
       will think only ratios that have either inventory or assets in the
       numerator or denominator will be affected by holding excessive
       amounts of inventory.
              If they are to understand the full impact of inventory on the
       ratios, your students must think about inventory as tangible,
       physical product rather than just a dollar amount on the
       balance sheet. Because it is tangible, inventory must be stored
       somewhere. There are expenses associated with that storage.
       Those expenses include the cost of the warehouse, the cost of
       employees, insurance, property taxes, etc. All these expenses
       serve to reduce profits (net income). Therefore, any ratio that
       has the words Anet income@ in either the numerator or the
       denominator is affected.
       a. Profit margin before income tax. The formula for this
              ratio is net income before taxes divided by sales. Neither
              the expenses caused by holding excessive amounts of
              inventory nor the inventory itself would have any effect on
              the denominator, but the increased expense would reduce
              the numerator. Therefore, this ratio would be lower.
       b. Profit margin after income tax. The formula for this ratio
              is net income after taxes divided by sales. Neither the
              expenses caused by holding excessive amounts of
              inventory nor the inventory itself would have any effect on
              the denominator, but the increased expense would reduce
              the numerator. Therefore, this ratio would be lower.
       c. Return on assets. The formula for this ratio is net income
              before taxes divided by total assets. The excessive
              inventory would increase the denominator and the
              expenses caused by holding the excess inventory would
              reduce the numerator. In other words, holding excessive
              inventory reduces the numerator and increases the
              denominator (a double whammy). Therefore, this ratio
              would be lower.
  F12-10                                Chapter 12 – Financial Statement Analysis
         d.      Return on equity. The formula for this ratio is net income
                 after taxes divided by equity. Expenses caused by holding
                 excessive amounts of inventory would reduce the
                 numerator. These expenses would also reduce the
                 denominator because net income is the current period=s
                 addition to equity. If the numerator and denominator are
                 both reduced by the same amount, this ratio would be
                 lower.
         e.      Current ratio. The formula for this ratio is current assets
                 divided by current liabilities. Since inventory is a part of
                 current assets, holding excessive inventory would
                 increase the numerator and would therefore make this
                 ratio higher. If there are liabilities associated with the
                 excessive inventory (accounts payable, wages payable,
                 etc.) this will cause the denominator to increase and will
                 make this ratio lower. The net affect cannot be
                 determined from the information provided.
         f.      Quick ratio. The formula for this ratio is quick assets
                 (cash + accounts receivable + notes receivable) divided
                 by current liabilities. Inventory is specifically excluded
                 from the calculation of the quick ratio, so holding
                 excessive amounts of inventory will not affect the
                 numerator of this ratio. If there are liabilities associated
                 with the excessive inventory (accounts payable, wages
                 payable, etc.) this will cause the denominator to increase
                 and will make this ratio lower.
         g.      Total asset turnover. The formula for this ratio is sales
                 divided by total assets. Neither the numerator nor the
                 denominator of this ratio would be affected by the
                 expenses associated with holding excessive amounts of
                 inventory, but the excessive inventory itself causes the
                 denominator to increase. Therefore, this ratio is lower.

12-16. To determine the total liabilities for Family Dollar, we must add
       the current liabilities to the long-term liabilities from the balance
       sheet.
  Chapter 12 – Financial Statement Analysis                       F12-11
12-17. NOTE TO INSTRUCTOR: There is obviously no Acorrect@
       answer to Discussion Question 12-17. Because of the way the
       ratios are presented in the chapter, students may feel that all
       four of their choices should be profitability ratios. Or, they may
       want to choose one from each of two categories and two from
       the other (as we did). Whatever their selections, try and get
       your students to think seriously about what kind of information
       they would want, and select the ratios they think will provide
       that information.
             The four ratios we have selected are not necessarily the
       ones you or your students would choose. As is so often the
       case with these questions, the particular ratios chosen are not
       as important as the reasoning behind the choices.
             In looking at financial ratios, potential equity investors
       attempt to determine if the company will be able to distribute
       dividends in the future and if its stock will rise in value. Both of
       these activities are directly related to the company=s ability to
       produce profits. Therefore, we would want to look at all the
       profitability ratios. However, since the question only allows us
       to look at four ratios in total and we want to consider liquidity
       and solvency as well, we have selected return on assets and
       return on equity from the profitability ratios.
       B     Return on Assets. This ratio gives an indication of how
             efficiently a company is using its assets to produce profits.
             The more profits it produces with a given level of
             investment in assets, the more profits are available to be
             distributed in the form of dividends. Additionally, efficient
             use of assets in producing profits has a positive influence
             on the company=s stock price.
       B     Return on Equity. This ratio measures the amount of
             after-tax income generated from the investment made by
             the stockholders. Profits are great, but we want to know
             how efficiently the company is utilizing the investment
             made by the owners.
       If one of the two companies we are considering has an
       appreciably higher return on assets ratio and return on equity
  F12-12                                Chapter 12 – Financial Statement Analysis
       ratio than the other, we may conclude that our investment in
       that company may yield a higher return on our investment.
             While potential stockholders are most interested in
       profitability, they understand that if a company cannot meet its
       short-term obligations, it may not be around long enough to be
       profitable in the future. Therefore, we are also interested in
       liquidity. Since we also want to analyze at least one solvency
       ratio and we looked at two profitability ratios, we are limited to
       only one liquidity ratio. Our choice is the quick ratio.
       B     Quick Ratio. This ratio compares only highly liquid
             current assets to current liabilities. By excluding certain of
             the company=s less liquid current assets, this ratio
             provides a very stringent measure of a company=s ability
             to meet its short-term obligations.
       By analyzing the quick ratios of the two companies we are
       considering, we can get an idea of the companies= relative
       ability to meet their short-term obligations.
             Another thing potential stockholders are interested in is
       the way companies service their long-term debt. Information
       about this is found in the solvency ratios. We can only look at
       one because we have already selected three ratios from the
       other two categories. Our selection is the total liabilities to net
       worth ratio.
       B     Total Liabilities to Net Worth Ratio. This ratio measures
             the shared risk between creditors and stockholders in
             financing assets. It discloses the relative proportion of a
             company=s assets financed by debt and equity.
             If one of the two companies we are considering has a very
       high total of liabilities to net worth ratio, it may indicate that the
       company may not be able to service its debt in the future. On
       the other hand, if one of the companies has a very low ratio, it
       may indicate that the company is not availing itself of the
       opportunity to utilize debt financing. Further, it may indicate to
       us that the stockholders of this company are bearing an undue
       share of the risk associated with financing the business.

Chapter 12 – Financial Statement Analysis                         F12-13
12-18. NOTE TO INSTRUCTOR: Discussion Question 12-18 is a
       capstone question on the thirteen ratios presented in this
       chapter and also serves as a good set-up for the discussion at
       the end of the chapter on the limitations of ratio analysis. It
       relates a Chapter 8 concept (the effect of straight-line vs.
       accelerated depreciation on periodic net income) to the ratios
       presented in this chapter. If your students really understood the
       Chapter 8 presentation, you should be able to guide them to
       the conclusion that there is no real difference between the
       results of Martino and Patco, but their ratios will make the
       results appear different. This is a very powerful concept and is
       one your students need to grasp if they are to understand what
       ratios can and cannot do for economic decision makers.
             NOTE: Our model answer assumes that income tax
       expense was exactly the same for Patco and Martino, which is
       simplistic and probably somewhat unrealistic. Making this
       assumption, however, allows you and your students to focus on
       the ratios themselves, rather than drifting off into discussions of
       deferred taxes, differences between tax law and accounting
       rules, etc., etc., etc.
             The answer to the first part of this Discussion Question is
       that some of the ratios will be:
       B     exactly the same for the two companies.
       B     higher for Patco.
       B     higher to Martino.
             To answer the second part of this question we must first
       determine how the different depreciation methods affect each
       element of the income statement and balance sheet for the two
       companies:

           Income Statement:
           Sales: No difference between the two companies.
           Expenses: Higher for Patco due to more depreciation
           expense.
           Operating income: Lower for Patco due to higher
           expenses.
  F12-14                               Chapter 12 – Financial Statement Analysis
       Interest expense: No difference between the two
       companies.
       Net income before income tax: Lower for Patco due to
       higher expenses.
       Income taxes: No difference between the two companies
       Net income after income tax: Lower for Patco due to lower
       net income before tax.

       Balance Sheet:
       Current assets: No difference between the two companies.
       Property, plant and equipment: Lower for Patco due to
       higher accumulated depreciation.
       Total assets: Lower for Patco due to lower net property,
       plant and equipment
       Current liabilities: No difference between the two
       companies.
       Long-term liabilities: No difference between the two
       companies.
       Equity: Lower for Patco due to lower net income.
       Total liabilities and equity: Lower for Patco due to lower
       equity.
             Now we simply fit the information from above into the
       components of each of the thirteen ratios and determine the
       differences between the ratios for the two companies.
       1. Return on Assets. The formula for this ratio is net
             income before taxes divided by total assets. Patco=s net
             income before taxes (numerator) is lower than Martino=s
             by exactly the amount of the difference between the two
             companies= depreciation expense. Patco=s total assets
             (denominator) is lower by exactly the difference between
             the two companies= accumulated depreciation. Since
             both the numerator and denominator for Patco=s
             calculation of return on assets are lower by exactly the
             same amount, Patco=s ratio is lower.
       2. Profit Marin Before Income Tax. The formula for this
Chapter 12 – Financial Statement Analysis                  F12-15
              ratio is net income before taxes divided by sales. The
              denominator will be the same for both companies, but
              since Patco had a lower net income before taxes than
              Martino, the numerator will be smaller for Patco.
              Therefore, Patco=s ratio is lower.
         3.   Total Asset Turnover. The formula for this ratio is sales
              divided by total assets. The numerator will be the same
              for both companies, but since Patco has lower total
              assets than Martino, the denominator will be smaller for
              Patco. Therefore, Patco=s ratio is higher.
         4.   Profit Margin After Income Tax. The formula for this
              ratio is net income after taxes divided by sales. The
              denominator will be the same for both companies, but
              since Patco had a lower net income after taxes than
              Martino, the numerator will be smaller for Patco.
              Therefore, Patco=s ratio is lower.
         5.   Return on Equity. The formula for this ratio is net income
              after taxes divided by equity. Patco=s net income after
              taxes (numerator) is lower than Martino=s by exactly the
              amount of the difference between the two companies=
              depreciation expense. Patco=s equity (denominator) is
              lower by exactly the difference between the two
              companies= net income for the period because this is the
              end of the first year of operations. Since both the
              numerator and denominator for Patco=s calculation are
              lower by the same amount, Patco=s ratio is lower.
         6.   Return Before Taxes on Equity. The formula for this
              ratio is (net income before taxes) divided by equity.
              Patco=s net income before taxes plus interest
              (numerator) is lower than Martino=s by exactly the
              amount of the difference between the two companies=
              depreciation expense. Patco=s equity (denominator) is
              lower by exactly the difference between the two
              companies net income for the period. Since both the
              numerator and denominator for Patco=s calculation of
F12-16                                 Chapter 12 – Financial Statement Analysis
               return before interest and taxes on equity are lower by
               exactly the same amount, Patco=s ratio is lower.
       7.      Current Ratio. The formula for this ratio is current assets
               divided by current liabilities. The way the two companies
               depreciate their assets has no impact whatever on current
               assets or current liabilities, so the numerator and
               denominator are the same for both companies.
               Therefore, this ratio for both companies is the same.
       8.      Quick Ratio. The formula for this ratio is quick assets
               (cash + accounts receivable + notes receivable) divided
               by current liabilities. The way the two companies
               depreciate their assets has no impact whatever on current
               assets (and therefore quick assets, which is the
               numerator) or current liabilities, so the numerator and
               denominator are the same for both companies.
               Therefore, this ratio for both companies is the same.
       9.      Receivables Turnover. The formula for this ratio is sales
               divided by accounts receivable. The way the two
               companies depreciate their assets has no effect on sales
               (numerator) or accounts receivable (denominator).
               Therefore, this ratio for both companies is the same.
     10.       Inventory Turnover. The formula for this ratio is cost of
               sales divided by inventory. The way the two companies
               depreciate their assets has no effect on cost of sales
               (numerator) or inventory (denominator). Therefore, this
               ratio for the two companies is the same.
     11.       Debt Ratio. The formula for this ratio is total liabilities
               divided by total assets. The numerator will be the same
               for both companies, but since Patco has lower total
               assets than Martino, the denominator will be smaller for
               Patco. Therefore, Patco=s ratio is higher.
     12.       Total Liabilities to Net Worth. The formula for this ratio
               is total liabilities divided by net worth. The numerator will
               be the same for both companies, but since Patco has
               lower equity (net worth) than Martino, the denominator will

Chapter 12 – Financial Statement Analysis                        F12-17
              be smaller for Patco. Therefore, Patco=s ratio is higher.


     13.      Coverage Ratio. The formula for this ratio is earnings
              before interest expense and income taxes divided by
              interest expense. The denominator will be the same for
              both companies, but since Patco had a lower earnings
              before interest expense and income taxes than Martino,
              the numerator will be smaller for Patco. Therefore,
              Patco=s ratio is lower.

Review the Facts

A.       The purpose of financial statement analysis is to gather
         information beyond the face of the financial statements to aid
         interested users in making economic decisions.

B.       Creditors analyze financial statements to assure themselves
         that money lent to the company regardless of the terms will be
         paid back in a timely manner. Equity investors both present
         and potential analyze financial statements to determine if the
         entity will be able to distribute dividends in the future and
         whether its stock will rise in value. Management analyzes the
         financial statements for two major reasons. One is to put the
         company’s statements in the best possible light before
         presenting them to external parties. The second reason for
         analysis is to monitor the overall performance of the company
         to help them make decisions.

C.       External factors that must be considered include general
         economic conditions and expectations, political events and
         political climate, and the industry outlook. The FASB warns that
         analyzing financial statements without considering the impact
         of each of these external factors does not provide a complete
         picture of the company being analyzed. One must remember
F12-18                                 Chapter 12 – Financial Statement Analysis
       that these factors are only a piece of the puzzle and the impact
       of each must be weighed carefully in drawing conclusions
       about the performance of a company.

D.     The ratios are drawn from the information presented in the
       balance sheet and the income statement.

E.     Profitability is the ease with which a company generates
       income. The profitability ratios include the following:
       1. Return on Assets Ratio = NI before Taxes/Total Assets
       2. Profit Margin before Income Tax = NI before Taxes/Sales
       3. Total Asset Turnover = Sales/ Total Assets
       4. Profit Margin after Inc. Tax Ratio = NI after Taxes/Sales
       5. Return on Equity = NI after Taxes/Equity
       6. Return before Taxes on Equity = NI before Taxes/Equity

       The profitability ratios represent a set of ratios that measure the
       firm’s past performance and help predict its future profitability
       level.

F.     Profitability is the ease with which a company generates
       income.

G.     The two component ratios of the return on assets are the profit
       margin before taxes and the total asset turnover.

H.     Liquidity is the ease with which a company can convert assets
       to cash. Liquidity refers to the ability of the company to
       generate cash to meet its short term obligations.

I.     The liquidity ratios include:
       1. Current Ratio = Current Assets/Current Liabilities
       2. Quick Ratio = Cash + Receivables +Marketable Securities
            divided by Current Liabilities
       3. Receivables Turnover = Sales/Accounts Receivable
       4. Inventory Turnover = Cost of Sales/Inventory
Chapter 12 – Financial Statement Analysis                      F12-19
         Each of these ratios provides a measure of the ease with
         which the current assets may be turned to cash to meet
         short term obligations.

J.       The difference between the current ratio and the quick ration is
         the exclusion of inventory in the computation of the quick ratio.
         Inventory is excluded from the computation of the quick ratio
         because the quick ratio is a more stringent measure of liquidity
         and the inventory may take more time to convert to cash.

K.       Solvency is a company’s ability to meet the obligations created
         by its long term debt.

L.       The solvency ratios are as follows:
         1. Debt Ratio = Total Liabilities/Total Assets
         2. Debt to Equity = Total Liabilities/Net Worth
         3. Coverage Ratio = Income before Interest and Taxes/Interest
         Expense
         The debt ratio indicates the proportion of a company’s assets is
         financed by debt. The debt to equity ratio indicates the
         relationship between creditors’ claims to assets and the
         owners’ claims to assets. The coverage ratio is a measure of
         the company’s ability to make its periodic interest payments.

M.       Both the debt ratio and the debt to equity ratio utilize total
         liabilities in the numerator.

N.       The coverage ratio or times interest earned ratio provides an
         indication of a company’s ability to make its periodic interest
         payments.

O.       NAICS stands for the North American Industry Classification
         System. This system provides a six digit code used to group
         companies by industry.


F12-20                                  Chapter 12 – Financial Statement Analysis
P.     When comparing ratios of similar companies one is able to
       make judgments about how one company compares with
       another and if industry averages are available how each of the
       companies compares with industry averages.

Q.     When comparing a company’s ratios with its own historical
       ratios, management can readily see if the company trend is
       progressing, holding steady, or going backward. This is
       extremely valuable information for all interested users of the
       financial information.

R.     The six limitations of ratio analysis are:
       1. Attempting to predict the future using past results depends
       on the predictive value of the information we use.
       2. The financial statements used to prepare the ratios are
       based on historical cost.
       3. Figures used to calculate ratios that come from the balance
       sheet are year end numbers when the use of averages might
       be better.
       4. Industry peculiarities create difficulty in comparing ratios of
       a company in one industry with those of a company in another
       industry.
       5. Lack of uniformity in the formulas makes comparison to
       published industry averages very difficult.
       6. Tendency on the part of users to place too much reliance on
       the ratios.




Chapter 12 – Financial Statement Analysis                     F12-21
Apply What You Have Learned

12-19.
      The three major categories of financial statement users include
creditors, equity investors, and management. Each of these groups
may have different objectives in their analysis of financial
statements.
      Short-term creditors may include trade creditors who sell
goods and services to companies in the normal course of business.
Trade creditors do not usually charge interest. Since the credit they
extend is essentially an interest free loan, their primary purpose in
analyzing financial statements is to determine whether the company
pays its bills on time and will be able to do so promptly in the future.
      The other type of short-term creditor is the lending institution
offering commercial loans to support the day-to-day operations of
the business. Unlike trade creditors, banks charge interest and have
the customer sign a short-term note. The objectives of this group are
very similar to those of trade creditors in that their major concern is
the ability of the company to make prompt payments.
      Long-term creditors are also interested in receiving prompt
payments, but their perspective is somewhat different. Long-term
creditors (banks and corporate bondholders) lend money to
companies for relatively long periods of time. In analyzing the
financial statements of a company, the principal objectives of long-
term creditors are to determine whether the company will be able to
make its periodic interest payments and to repay the loan when
required.
      Equity investors are those who purchase an ownership
interest in a company. As owners of a company, their primary
objectives differ greatly from those of creditors. Equity investors
analyze financial statements to determine if the company will be able
to pay dividends in the future and if the stock will rise in value.
F12-22                               Chapter 12 – Financial Statement Analysis
12-19. (Continued)
      Management is responsible for the company=s day-to-day
operations. Because managers are internal decision makers,
compared to external decision makers such as creditors and equity
investors, their objectives in performing financial statement analysis
are somewhat different. Management has two major objectives in
analyzing the company=s financial statements. The first objective is
to put financial statements in the best possible light before
presenting them to the external users. The second objective of
management is to monitor the overall performance of the business.
Management must take care that they manage the business and not
the financial statements, which is a naturally occurring problem.

12- 20.
      To place the financial statement information in the proper
context, it is important to gather sufficient background information. It
is important also to gather background information about the
company=s internal and external environment, because a company
does not operate in a vacuum. The FASB denotes three other areas
of information they consider important when analyzing a company=s
financial statements, including general conditions, political events
and political climate, and industry outlook.
      The general economic environment in which a company
operates affects its business activity and, therefore, its financial
results. The health of the American economy is a topic that receives
widespread news coverage. Business periodicals, such as Business
Week and Fortune, are sources of information. The Economic
Indicators Handbook and the Survey of Current Business also
provide a wealth of information to prospective financial statement
analysts.
      Political events and the political climate should also be
analyzed to determine their impact on business. The attitude of

Chapter 12 B Financial Statement Analysis                        F12-23
government toward business is a definite indicator of how a
business may perform. Events such as the collapse of the Soviet
Union and the unification of Europe have major implications for
12- 20. (continued)
business in the United States. Questions of corporate social
responsibility have become a crucial issue in the tobacco industry. It
is important for financial analysts to review the political climate to
see how it may affect the company being analyzed.
      The third factor to consider when analyzing a company is the
overall industry outlook. We must consider such things as regulation
or deregulation of an industry, and its potential impact on
profitability. Technological innovation and other innovations unique
to a particular industry are very important. Review of Standard and
Poor=s Industry Surveys, U.S. Industrial Outlook and Inside U.S.
Business: A Concise Encyclopedia of Leading Industries may all
provide important information on the industry.
      Creditors analyze financial statements to assure themselves
that money lent to the company regardless of the terms will be
repaid in a timely manner. Equity investors, both present and
potential, analyze financial statements to determine if the entity will
be able to distribute dividends in the future and whether its stock will
rise in value. Management analyzes the financial statements for two
major reasons. One is to put the company’s statements in the best
possible light before presenting them to external parties. The second
reason for analysis is to monitor the overall performance of the
company to help them make decisions.




F12-24                                  Chapter 12 B Financial Statement Analysis
12-21.

 1.     j      Designed to measure a firm=s ability to generate
               sufficient cash to meet its short-term obligations.
 2.     b      A method for analyzing the relationship between two
               items from a company=s financial statements for a
               given period.
 3.     h      Designed to measure the ease with which a company
               generates income.
 4.     l      Focus on interest payments and the overall debt load a
               company carries.
 5.     m      A system of six-digit codes to indicate a company=s
               industry.
 6.     a      Looking beyond the face of the financial statements to
               gather additional information.
 7.     e      Those who own an equity interest in a corporation.
 8.     i      The ease with which an item, such as an asset, can be
               converted into cash.
 9.     c      Trade creditors and lending institutions such as banks.
10.     k      A company=s ability to meet the obligations created by
               its long-term debt.
11.     d      Bondholders and lending institutions such as banks.
12.     g      The ease with which companies generate income.
13.     f      Responsible for a company=s day-to-day operations.




Chapter 12 B Financial Statement Analysis                       F12-25
12-22.

 1.      e   Most common ratio used to measure a company=s
             ability to meet short-term obligations.
 2.      h   Measures a company=s ability to make periodic interest
             payments.
 3.      a   Measures the return earned on investment in assets.
 4.      f   A more stringent test of short-term liquidity than the
             current ratio.
 5.      b   Measures the pretax earnings produced from a given
             level of revenues.
 6.      c   Measures the amount of after-tax net income generated
             by a dollar of sales.
 7.      g   Indicates the proportion of assets financed by debt.
 8.      d   Measures a company=s ability to generate revenues
             from a given level of assets.
9.       m   Compares the amount of debt financing with the
             amount of equity financing.
10.      i   Measures how much after-tax income was generated
             for a given level of equity investment,
11.      l   Indicates how long a company holds its inventory.
12.      j   Measures the return on equity before taxes
13.      k   Measures how quickly a company collects amounts
             owed to it by its customers.




F12-26                                 Chapter 12 B Financial Statement Analysis
12-23.

 1.     P      Return on assets
 2.     S      Debt ratio
 3.     P      Profit margin before income tax
 4.     L      Quick ratio
 5.     P      Total asset turnover
 6.     L      Current ratio
 7.     S      Coverage ratio
 8.     P      Return on equity
 9.     L      Receivables turnover
10.     P      Return before taxes on equity
11.     L      Inventory turnover
12.     S      Debt to equity
13.     P      Profit margin after income tax.




Chapter 12 B Financial Statement Analysis        F12-27
12-24.
a.                                           2008                 2007
     Current ratio = Current assets =      $6,635                $6,368
                    Current liabilities    $5,421                $5,040
                                        = 1.22 to 1             1.26 to 1
b.
                                          2008                    2007
     Quick ratio = Cash + A/R = $3,400 + $1,825               $2,920 + $2,212
                  Current liabilities    $5,421                  $5,040
                                      = .96 to 1                1.02 to 1

c.       All financial statement users are interested in these two ratios.
         Short-term creditors, however, tend to be most interested in the
         current ratio and the quick ratio. Because they are expecting to
         be paid in the short-term (less than one year), these creditors
         have a vested interest in whether Mikey Company has
         sufficient liquidity to meet its short-term obligations.

d.       Based on the comparison between Mikey Company and the
         industry averages, Mikey is less liquid than the average
         company in its industry. That is, the company holds
         proportionately smaller amounts of current assets relative to its
         level of current liabilities than the industry average. This does
         not mean, however, that Mikey is a bad credit risk. The
         company=s lower level of current assets may be a result of
         careful cash and inventory management. Company policy may
         be to invest as little capital as possible in current assets. The
         current ratio and quick ratio are only indicators of a company=s
         ability to meet its current obligations. More importantly, they are
         only two of many that might deserve consideration.




F12-28                                       Chapter 12 B Financial Statement Analysis
12-25.
a.                                                 2007         2006
Current ratio = Current assets =                   $4,221       $4,597
                Current liabilities                $3,154       $3,080

                                             =    1.34 to 1    1.49 to 1
b.
                                  2007                             2006
Quick ratio = Cash + A/R = $2,110 + $1,254                    $2,650 + $977
             Current liabilities $3,154                           $3,080

                                            = 1.07 to 1         1.18 to 1
c.     All financial statement users are interested in these two ratios.
       Short-term creditors, however, are most interested in the
       current ratio and the quick ratio. Because they expect to be
       paid in the short-term (less than one year), these creditors
       have a vested interest in whether Harold Company has
       sufficient liquidity to meet its short-term obligations.
d.     Harold=s current ratio is considerably lower than the industry
       average, and from 2006 to 2007 it declined. This does not
       mean, however, that Harold=s will have trouble meeting its
       short-term obligations or that creditors should automatically
       consider the company a bad credit risk.
              The information provided shows that Harold has a quick
       ratio that is slightly higher than the industry average, indicating
       the company holds a higher proportion of highly liquid current
       assets than do other companies in the industry. Even though
       the company=s quick ratio is slightly higher than the average, it
       too, has declined from 2006 to 2007. Overall, Harold=s would
       probably be considered less liquid than the average company
       in its industry.
e.     Both the current ratio and the quick ratio comparison between
Chapter 12 B Financial Statement Analysis                                   F12-29
         2006 and 2007 indicate that Harold is less liquid in 2007 than it
         was in 2006.


12-26.
a.       This analysis provides mixed signals about Sagal=s liquidity over
         the five years. The current ratio has grown steadily from 2003 to
         2007. In 2003, the company had only $1.24 of current assets for
         every dollar of current liabilities. In 2007, there were $4.13 of
         current assets for every dollar of current liabilities. If the assets that
         created the rise in the current ratio (inventory, for example) are
         reasonably liquid and can generate the cash needed to meet the
         company=s current liabilities, then Sagal=s liquidity rose over the
         five-year period.
               However, the quick ratio behaved exactly the opposite. When
         considering only highly liquid current assets in the ratio, a more
         stringent measure of liquidity, Sagal appears much less liquid in
         2007 than in 2003. Even though the company=s current ratio rose,
         it appears based on this information that the company=s liquidity
         position declined over the five years.
b.       The composition of Sagal=s current assets shifted from highly
         liquid items (cash and accounts receivable) to less liquid assets
         (inventory and prepaid expenses). This may indicate serious future
         liquidity problems.

12-27.
a.       This analysis indicates that Carnegie=s management became
         more effective in its liquidity management over the five years. The
         current ratio declined steadily from 2003 to 2007, which is a good
         signal because it fell from a level considered to be unproductive, to
         a near normal 2:1 ratio.
               The trend of the quick ratio has been exactly the opposite.
         When considering only highly liquid current assets in the
         calculation, Carnegie appears much more liquid in 2007 than in
         2003. If the 2007 current ratio is considered sufficient for a basic
         level of liquidity, the rising trend in the quick ratio can be
         interpreted as an indicator of the company=s move to a safer

F12-30                                          Chapter 12 B Financial Statement Analysis
       liquidity position over the five years.
b.     The composition of Carnegie=s current assets has been shifted to
       highly liquid items (cash and accounts receivable) from less liquid
       assets (inventory and prepaid expenses).

12-28.
a. Moron=s ability to generate profits from sales increased during
    the five years, both before and after taxes. However, the
    information provided, in and of itself, cannot tell us with
    certainty that the company=s performance over the five-year
    period improved. For instance, we cannot determine what
    caused the improvement (increased sales, decreased
    expenses, or some combination of both).
          Because the profit margins are only proportions of sales,
    we cannot determine the actual level of sales in each period.
    In 2005, 6.88% of each sales dollar resulted in net income
    before taxes. In 2006, the percentage rose to 7.96%. But what
    if sales fell from $6 million to $2 million? The increase in
    Moron=s profit margin would be little consolation. From the rise
    in profit margins, we can conclude only that the company
    became more efficient in generating a higher net income from
    each sales dollar. Understanding this, we can conclude that the
    trend of the profit margins is positive.
          By comparing the two ratios over time, we can draw a
    conclusion about the relative impact of taxes. For example, the
    profit margin figures tell us that in 2003, net income before
    taxes was 3.68% of sales. In that same year, net income after
    taxes was 2.2% of sales. The difference in the two profit margin
    figures (3.68 B 2.22) indicates the income tax expense for the
    period as a percentage of sales for the period. For 2003,
    income tax expense was 1.46% of sales. By computing the
    difference between the two profit margin figures for each year,
    we can determine what percentage of each sales dollar went to
    income tax expense. The figures for each year are as follows:

               2003             2004        2005   2006   2007
Chapter 12 B Financial Statement Analysis                          F12-31
           1.46       1.66        2.47        2.69            2.78

    Over the five-year period, income tax expense increased as a
    percentage of sales. Is that bad? Not necessarily. This may be
12-28. (Continued)
    a common experience in Moron=s industry. Also, we have no
    information about the sales level during the period. No
    company wants to incur more income tax expense than
    necessary, but Moron may not be concerned about the
    increase in its tax expense as a proportion of sales B especially
    if it is the result of rapidly rising sales figures. Because the after
    tax profit margins increased, even if income tax expense is
    claiming more of each sales dollar in 2007 than it was in 2003,
    the company still increased its pretax profit margin from 3.68%
    in 2003 to 9.87% in 2007.
b. (1) Trade creditors tend to be more concerned with liquidity
            than with profitability. They do not ignore profitability, but
            they understand that to pay its bills, a company must be
            profitable. Trade creditors would probably interpret
            Moron=s change in profitability as a positive indicator of
            its ability to meet its short-term obligations.
    (2) Long-term creditors are concerned with a company=s
            ability to meet its periodic interest payments and retire
            long-term debt according to schedule. Long-term creditors
            understand that a company must be profitable to service
            its debt. Long-term creditors would probably interpret this
            analysis as a positive indicator of Moron=s ability to meet
            its periodic interest payments and retire its long-term debt.
    (3) Moron=s stockholders would likely be ecstatic over this
            analysis. Stockholders earn their return on investment
            through periodic dividends and the appreciation of the
            market price of the stock shares they own. Moron=s
            increased profit margin over the five years would improve
            its ability to pay dividends. More importantly to the
            stockholders, profitability is considered to be the most

F12-32                                    Chapter 12 B Financial Statement Analysis
               significant influence on the market value of a company=s
               stock. Moron=s stockholders would see this as a positive
               indicator of increased stock value.

12-29.
a. From both a pretax and after tax perspective, Manley=s ability to
       generate profits from sales steadily declined over the five-year
       period. However, the information provided, in and of itself, cannot
       tell us with certainty that the company=s performance over the five-
       year period deteriorated. From the information provided, we cannot
       determine what caused the decline (lower sales, higher expenses,
       or some combination of both).
              Because the profit margins are only a proportion of sales, we
       cannot determine the actual level of sales in each period. In 2005,
       8.48% of each sales dollar resulted in net income before taxes. In
       2006, the percentage fell to 7.01%. But what if sales for 2006 were
       double what they were for 2005? The decline in the profit margin
       would be of some concern, and Manley=s management would
       investigate the cause. However, the company would accept a lower
       profit margin if it were accompanied by skyrocketing sales.
              By comparing the two ratios over time, we can determine the
       income tax expense for the period as a percentage of each sales
       dollar. For example, the profit margin figures tell us that in 2003,
       net income before taxes was 11.28% of sales. In that same year,
       net income after taxes was 9.33% of sales. The difference in the
       two profit margin figures (11.28 B 9.33) indicates the income tax
       expense for the period as a percentage of sales for the period. By
       computing the difference between the two profit margin figures for
       each year, we can determine what percentage of each sales dollar
       went to income tax expense. The figures for each year are as
       follows:

               2003            2004         2005   2006   2007
               1.95            .57          2.34   1.29   1.89

       Over the five-year period, income tax expense as a percentage of
       sales fluctuated considerably. Is that bad? Not necessarily. Other

Chapter 12 B Financial Statement Analysis                          F12-33
         companies in Manley=s industry may have experienced similar
         changes over time. Also, we have no information about the level of
         sales during the period. The proportion of income tax expense to
         sales may be affected by the actual level of sales. Some external

12-29. (Continued)
     financial statement users may want to investigate the big change
     from 2004 to 2005, but most decision makers would draw no
     specific conclusions from the income tax expense figures.
b.   (1) Trade creditors tend to be more concerned with liquidity than
          with profitability. They do not ignore profitability, but they
          understand that a company must be profitable to pay its bills.
           Without sales information over the five-year period, it is
          difficult to say if the declining profit margins would alarm
          trade creditors. If sales have declined over the five years,
          trade creditors would probably see this trend as an indication
          of Manley=s declining ability to meet its short-term
          obligations.
     (2) Long-term creditors focus on a company=s ability to meet its
          periodic interest payments and retire long-term debt
          according to schedule. Long-term creditors know that a
          company must be profitable to service its debt. If these
          declining profit margins are coupled with declining or level
          sales figures for the five years, Manley=s long-term creditors
          would probably see this trend as a negative indicator of its
          ability to meet its periodic interest payments and retire its
          long-term debt.
     (3) Manley=s stockholders would likely be alarmed by this
          analysis. Stockholders earn their return on investment
          through periodic dividends and the appreciation of the market
          price of their stock shares. The company=s decreased profit
          margins over the five years would inhibit its ability to pay
          dividends, or it may cause it to pay a level dividend to avoid
          alarming stockholders. Because profitability is the most
          significant influence on the market value of a company=s
          stock, Manley=s stockholders would surely interpret this
          analysis as a potential decline in their investment value.

F12-34                                      Chapter 12 B Financial Statement Analysis
12-30.
a. The total liabilities to net worth ratio and the debt ratio both
    measure the proportion of assets financed by debt as opposed
    to that financed by equity (its capital structure). Over the five -
    year period, Smythe steadily decreased the percentage of its
    assets financed by borrowing. In 2003, more than 73% of its
    assets were financed by debt. This means that less than 27%
    of its assets were financed by equity. By 2007, it was a 50/50
    split.
           These ratios indicate the proportion of debt financing, but
    not what caused the change over time. A decrease in the
    proportion of debt financing could have resulted from retiring
    long-term debt each year, or by increasing the level of equity
    financing (issuing stock).
b. (1) Smythe=s trade creditors probably have less interest in
           the company=s capital structure than Smythe=s ability to
           pay the amounts owed to them. However, if moving from
           a higher proportion of debt financing in 2003 to a situation
           of evenly shared risk between creditors and stockholders
           is viewed as a sign of overall health, trade creditors would
           probably interpret this as a favorable trend.
    (2) Long-term creditors do not like to see a company over-
           extend itself in debt. They are very interested in both of
           these ratios and would examine this analysis carefully.
           Certainly, long-term creditors would be interested in the
           actions which caused the shift in capital structure, and
           their reaction to the trend would be different if the change
           were a result of constant debt retirement than if it had
           been caused by the issuance of more equity. However, in
           general, Smythe=s trend toward a greater proportion of

Chapter 12 B Financial Statement Analysis                       F12-35
          equity financing would likely be viewed favorably by long-
          term creditors because it indicates a more evenly shared
          risk between creditors and shareholders.



12-30. (Continued)
    (3) As was the case with long-term creditors, Smythe=s
          stockholders would be very interested in this analysis. It
          may seem strange, but equity investors tend to get
          uncomfortable when the proportion of assets financed by
          equity becomes very high in relation to assets financed by
          debt. Clearly, the proportion of equity financing has
          increased over time (from 26.67% in 2003 to 50% in
          2007). Since we cannot tell what level of equity financing
          is considered acceptable or Anormal@ for companies of
          this type, we have no way to judge how the stockholders
          would interpret this analysis. Also, since we cannot be
          sure what has caused this change over time (e.g., retiring
          debt or issuing stock), stockholders= reaction cannot be
          anticipated.

12-31.
a. The total liabilities to net worth ratio and the debt ratio both
    measure the proportion of assets financed by debt as opposed
    to that financed by equity. This five-year analysis indicates an
    erratic trend in the percentage of assets Bausch financed by
    borrowing versus the amount financed by equity. The
    percentage of debt dropped from 2003 to 2004, went up in
    2005 and then dropped in 2006 and 2007.
          These changes in the total liabilities to net worth ratio and
    the debt ratio may indicate that Bausch expanded in 2005 by
    borrowing money and then began paying off the debt in 2006
    and 2007. Another possibility is that Bausch may have reduced
    its equity by purchasing treasury stock in 2005, and the

F12-36                                  Chapter 12 B Financial Statement Analysis
       declines in 2006 and 2007 could be the result of normal debt
       retirement. Without seeing Bausch=s financial statements or
       other ratios, it is impossible to determine exactly what caused
       the two ratios in this analysis to change as they did.


12-31. (Continued)
b. (1) Bausch=s trade creditors probably have less interest in
          the company=s capital structure than whether or not they
          will be paid amounts owed to them. However, if the trade
          creditors have any additional information which would
          help them interpret these ratios as indicators of the
          company=s overall financial health, they may find the
          analysis interesting.
    (2) Long-term creditors do not like to see a company over-
          extend itself in debt. They are very interested in both of
          these ratios and would examine this analysis carefully.
          Their interpretation of the information for the five-year
          period would depend on the cause of the 2005 increase in
          the proportion of debt financing. However, the 2006 and
          2007 figures suggesting Bausch=s trend toward a greater
          proportion of equity financing would likely be viewed
          favorably by long-term creditors, because it indicates a
          move toward shared risk between creditors and
          stockholders.
    (3) Bausch=s stockholders would be very interested in this
          analysis. However, without more details about the cause
          of the rise in the proportion of debt financing in 2005, the
          stockholders= interpretation of and reaction to these
          ratios cannot be anticipated. Certainly, equity investors
          tend to get uncomfortable when the debt ratio falls. The
          highest proportion of equity financing was at the end of
          2004. If the company is performing well, and all other
          indicators suggest that Bausch is financially healthy, most
          likely the shareholders prefer the lower proportion of

Chapter 12 B Financial Statement Analysis                      F12-37
             equity financing indicated in 2005, 2006, and 2007.




12-32.
(1) Return on assets:

         Net income before taxes =     $ 540 = 5.12%
              Total assets             $10,551

(2)      Profit margin before income tax:

         Net income before taxes    = $ 540 = 4.81%
              Sales                   $11,228

(3)      Total asset turnover:

                Sales               = $11,228 = 1.06 times
             Total assets             $10,551

(4)      Profit margin after income tax:

         Net Income after taxes     = $ 426 = 3.79%
                Sales              $11,228

(5)      Return on equity:

         Net Income after taxes    =   $ 426 = 7.99%
              Equity                   $ 5,333

(6)      Return before interest on equity:

         Net Income after taxes    =   $540 = 10.13%

F12-38                                  Chapter 12 B Financial Statement Analysis
               Equity                                  $5,333

(7)    Current ratio:

      Current assets                            = $4,801        = 1.77 to 1
    Current liabilities                           $2,718
12-32. (Continued)

(8)    Quick ratio:

       Cash + Accounts receivable                 = $1,618 + $1,925 = 1.30
            Current liabilities                         $2,718

(9) Receivables turnover:

             Sales         = $11,228 = 5.83 times
       Accounts Receivable   $ 1,925

(10) Inventory turnover:

       Cost of Sales                        = $7,751     = 7.24 times
        Inventory                             $1,070

(11) Debt ratio:

       Total liabilities =             $ 5,218 = 49.46%
        Total assets                        $10,551

(12) Debt to Equity:

       Total liabilities =             $5,218 = 98%
        Net Worth                           $5,333

(13) Coverage ratio:


Chapter 12 B Financial Statement Analysis                                     F12-39
Net income before taxes + interest expense = $708 = 4.21 times
         Interest expense                $168




12-33.
a. (1)          Return on assets:
                     2007:                             2006:
                $ 632 / $7,868 = 8.03%            $1,081/ $6,494 = 16.63%


         (2)    Profit margin before income tax:
                    2007:                                   2006:
                $ 632 / $9,228 = 6.85%         $1,081 / $8,765 = 12.33%


         (3)    Total asset turnover:
                     2007:                             2006:
               $9,228 / $7,868 = 1.17 times   $8,765 / $6,494 = 1.35 times


         (4)    Profit margin after income tax:
                    2007:                             2006:
                $ 442 / $9,228 = 4.79%            $ 724 / $8,765 = 8.26%


         (5)    Return on equity:
                      2007:                       2006:
                $ 442 / $5,433 = 8.14%            $ 724 / $4,741 = 15.27%


         (6)    Return before interest on equity:
                   2007:                       2006:
         $442 + $98 / $5,433 = 9.94% $724 + $89 / $4,741 = 17.15%



F12-40                                        Chapter 12 B Financial Statement Analysis
       (7)     Current ratio:
                    2007:                            2006:
              $3,418 / $1,598 = 2.14 to 1    $3,107 / $1,286 = 2.42 to 1


12-33. (Continued)

       (8)     Quick ratio:
               2007:                            2006:
$1,292+$1,068 / $1,598 = 1.48 to 1 $980+ $1,112 / $1,286 =1.63 to 1

       (9)     Receivables turnover:
                  2007:                              2006:
       $9,228 / $1,068 = 8.64 times          $8,765 / $1,112 = 7.88 times

       (10)            Inventory turnover:
                  2007:                             2006:
          $6,751/ $ 970 = 6.96 times         $6,097 / $ 906 = 6.73 times

       (11) Debt ratio:
                    2007:                           2006:
               $2,435 / $7,868 = 30.95%        $1,753 / $6,494 = 26.99

       (12)         Total liabilities to net worth:
                    2007:                           2006:
               $2,435 / $5,433 = 45%          $1,753 / $4,741 = 37%

       (13) Coverage ratio:
                    2007:                           2006:
             $730 / $ 98 = 7.45 times          $1,170 / $89 = 13.1 times




Chapter 12 B Financial Statement Analysis                          F12-41
12-33. (Continued)
b.                                             Assets Between
                                         Total   $5 Million &
                                   ____Industry $10 Million   Earlywine
Current ratio                            1.46          1.95                    2.14
Quick ratio                               .93          1.11                    1.48
Coverage ratio                           5.63          5.16                    7.45
Total asset turnover                     1.76          1.42                    1.17
Inventory turnover                       5.73          5.47                    6.96
Receivables turnover                     7.83          6.54                    8.64
Total liabilities to net worth           1.94          1.93                     .45
Debt ratio                               65.99        65.87                   30.95
Return on assets                         9.30          10.40                   8.03
Return on equity                         6.12          5.85                    8.14
Return before interest on equity         8.92          9.73                    9.94
Profit margin before tax                 6.27          5.88                    6.85
Profit margin after tax                  4.99          4.61                    4.79

c.       Ratios selected for further analysis tend to be very subjective.
         The choice is also influenced by the type of economic decision
         maker analyzing the ratios. Creditors (short-term and long-
         term) may be interested in different ratios than either investors
         (present or potential) or the management of the company.

Note to Instructor: Because of the reasons cited above, our
choices of which ratios warrant further investigation and which do
not may not be the ones you would have selected. In any event, our
choices and our reasons are outlined in (1) and (2) below.


F12-42                                     Chapter 12 B Financial Statement Analysis
(1) Ratios Not Needing Further Investigation:
    Current ratio. Earlywine=s ratio is higher than the industry
    average, indicating the company has even more current assets
    in relation to the level of its current liabilities than the average.
    Since these comparisons suggest Earlywine has sufficient
    liquidity, no further analysis is warranted.
12-33. (Continued)
    Quick ratio. Earlywine=s quick ratio is higher than both the
    industry average and the average for companies of comparable
    asset size, indicating a high level of liquidity. Since Earlywine=s
    ratio is not excessively higher, no further analysis is warranted.

       Coverage ratio. Many experts feel a coverage ratio of 4:1
       should be maintained. Given this standard, the coverage ratios
       for both the entire industry and for companies of comparable
       asset size are quite good. Earlywine=s coverage ratio is
       significantly higher than either of the averages, suggesting that
       the company can adequately service its debts.
       Total asset turnover. While Earlywine=s total asset turnover
       ratio is somewhat lower than both the industry average and the
       average for companies of comparable asset size, the
       difference may be due to the high amount of cash it holds.
       Therefore, no further analysis is warranted.
       Inventory turnover. Earlywine=s inventory turnover ratio is
       higher than both the industry average and the average for
       companies of comparable asset size. The higher inventory
       turnover figure suggests that Earlywine holds its inventory
       fewer days, which is generally considered to be better.
       Receivables turnover. Earlywine=s receivables turnover
       ratio is higher than both the industry average and the average
       for companies of comparable asset size, suggesting that
       Earlywine collects its receivables even faster than average.
       Earlywine=s ratio is higher, so no further analysis is warranted.
       Return on equity. Earlywine=s return on equity ratio is higher
       than both the industry average and the average for companies
Chapter 12 B Financial Statement Analysis                         F12-43
         of comparable assets size. Since Earlywine appears to be able
         to generate higher than average income for a given level of
         equity, no further analysis is warranted.
         Return before taxes on equity. Since Earlywine=s return on
         equity is higher than the averages, it is not surprising that its
         return before taxes on equity ratio is higher than both the

12-33. (Continued)
    industry average and the average for companies of comparable
    asset size.
    Note: The difference between the return on equity and the
    return before taxes on equity indicates the impact of interest
    costs on profitability. The difference between these two ratios
    for Earlywine is noticeably lower than for the averages because
    it has less debt than the average of the industry, as indicated
    by the solvency ratios.
    Profit margin before tax. Earlywine=s profit margin before tax
    is higher than both the industry average and the average for
    companies of comparable asset size. Since Earlywine=s profit
    margin before tax is higher, no further analysis is warranted.
    Profit margin after tax. Earlywine=s profit margin after tax is
    slightly lower than the industry average and slightly higher
    than the average for companies of comparable asset size.
    Since Earlywine=s profit margin after tax is comparable, no
    further analysis is warranted.

(2) Ratios Needing Further Analysis:
    Total liabilities to net worth. Earlywine=s total liabilities to net
    worth ratio is significantly different than both the industry
    average and the average for companies of comparable asset
    size. Earlywine has only 45 cents of debt for every dollar of
    equity. The average for its entire industry is $1.94 of debt for
    every dollar of equity and companies of comparable size have
    (on average) $1.93 of debt for every dollar of equity.
Care must be taken when interpreting this ratio. A generalization that

F12-44                                     Chapter 12 B Financial Statement Analysis
Alower is better@ is not appropriate. Long-term creditors are likely to
feel that Earlywine=s level of debt financing offers its creditors a
relatively low-risk situation. As a group long-term creditors are
financing less than a third of the company=s assets. On the other
hand, stockholders may feel that this ratio comparison indicates
Earlywine is not utilizing enough debt financing. Investors tend to
12-33. (Continued)
      be unhappy if they feel that they are bearing an inordinate
      burden in financing assets.
      Note: Earlywine=s relatively low level of long-term debt
      resulted in a very healthy coverage ratio, and very small drop
      from the company=s return before interest on equity to its
      return on equity. After this analysis, we should analyze the
      company=s ratio over several years to determine the trend of
      its blend of financing over time. This would help to determine if
      the ratio for 2002 is representative.
      Debt ratio. The debt ratio reveals the same information as the
      total liabilities to net worth ratio but presents it in a different
      form. Earlywine=s debt ratio is less than half of both the
      industry average and the average for companies of comparable
      asset size. Roughly 31% of Earlywine=s assets have been
      financed by the company=s creditors (debt), which means
      about 69% of its assets have been financed by the investors
      (equity). Roughly 66% of the assets for both the entire industry
      and companies of comparable asset size have been financed
      through debt and about 34% have been financed through
      equity.
      Note: The conclusions drawn and information gathered from
      the analysis of the debt ratio are the same as described above
      for the total liabilities to net worth ratio.
      Return on assets. Earlywine=s return on assets is lower than
      both the industry average and the average for companies of
      similar asset size. This ratio is intended to measure how
      efficiently a company is using its assets to produce income.
      The comparison indicates Earlywine is not as efficient at

Chapter 12 B Financial Statement Analysis                         F12-45
         producing income with its investment in assets. However,
         further investigation may bring us to a different conclusion.

         Return on assets = Total asset turnover x Profit margin before tax


12-33. (Continued)
    The return on assets ratio is, indeed, the result of multiplying
    two other ratios in our analysis. For Earlywine=s figures, this
    relationship can be verified:

                    8.03 = 1.17 x 6.85 (rounded)
         A closer look at the two components of the return on assets
         reveals that Earlywine=s total asset turnover is a bit lower than
         the averages. Certainly, the company=s profit margin is not a
         problem B it was higher than the averages. If our investigation
         of the return on assets brings us to any conclusion, it may be
         that the company=s total asset turnover deserves a second
         look. That ratio would suggest that Earlywine does not
         generate as high a level of sales for its asset base as
         compared to the averages. This may be due in part to the high
         level of cash the company maintains. Cash is not a productive
         asset.
         Note: Because of the mathematical properties of averages, the
         average total asset turnover x the average profit margin before
         tax does NOT equal the average return on assets. The
         relationship among the three ratios can only be verified with
         data from a single company.

12-34.
Ratios selected for further analysis tend to be very subjective. The
choice is also influenced by the type of economic decision maker
analyzing the ratios. Creditors (short-term and long-term) may be
interested in different ratios than either investors (present or
potential) or the management of the company.

F12-46                                      Chapter 12 B Financial Statement Analysis
Note to Instructor: Because of the reasons cited above, our
choices of which ratios warrant further investigation and which do
not may not be the ones you would have selected. In any event, our
choices and our reasons are outlined in a. and b. below.

12-34. (Continued)
a. Ratios Not Needing Further Investigation:
    All ratios in the five-year analysis warrant further investigation.
    While some of the ratios may be acceptable when compared to
    industry averages (we do not have that information), all of the
    ratios presented have developed trends over the five-year
    period that warrant investigation.
b. Ratios Needing Further Analysis:
    Current ratio. Harry=s current ratio has increased significantly
    over the past five years. This means that the company has
    more current assets in relation to current liabilities in 2007 than
    it did in 2003. Whether this is good or bad depends largely on
    the composition of the current assets. In this case, the quick
    ratio reveals that the increase in the current ratio is due to the
    accumulation of relatively less liquid current assets (such as
    inventories). Therefore, it should not necessarily be viewed as
    an improvement.
    Quick ratio. Harry=s quick ratio has decreased significantly
    over the past five years. This means that the company has a
    smaller proportion of highly liquid current assets in relation to
    current liabilities in 2007 than it did in 2003. Coupled with the
    current ratio, the quick ratio reveals that the composition of
    Harry=s current assets has become less liquid over the five
    years of the analysis, indicating that Harry=s current ratio and
    quick ratio have worsened during the period of analysis.
    Coverage ratio. This ratio worsened over the five-year period.
     Many experts feel a coverage ratio of 4:1 should be
    maintained. The fact that Harry=s coverage ratio is below that
    standard in 2007 is not as disturbing as the significant decline

Chapter 12 B Financial Statement Analysis                       F12-47
         over the period. If this trend continues, the company may have
         difficulty making its future periodic interest payments.
         Total asset turnover. This ratio has steadily declined over the
         five-year period. Regardless of whether the decline was
         caused by lower sales or increased investment in assets, the

12-34. (Continued)
    results of the analysis show an unhealthy trend in total asset
    turnover.
    Inventory turnover. This ratio has steadily gotten worse over
    the five-year period. In 2003, Harry=s average holding period
    for its inventory was just over 41 days (365/8.88). By 2007, the
    holding period had increased to just over 82 days (365/4.45).
    Given the very high cost of holding inventory, this is a dramatic
    and disturbing trend.
    Receivables turnover. This ratio has steadily gotten worse
    over the five-year period. In 2003, Harry=s average collection
    period for its receivables was just under 41 days (365/8.93).
    By 2007, the collection period increased to more than 68 days
    (365/5.34). As was the case with inventory turnover, this is a
    dramatic and disturbing trend.
    Debt to equity. Harry=s total liabilities to net worth ratio is
    significantly different in 2007 than it was in 2003. In 2003,
    Harry had only 96 cents of debt for every dollar of equity. By
    2007, the company had $2.54 of debt for every dollar of equity.
    Clearly, the company has moved toward more debt in financing
    its assets, but care must be taken in interpreting this ratio. This
    may or may not be a negative trend. As the analysis of the
    coverage ratio showed, however, Harry=s ability to service the
    debt it has accumulated has deteriorated over the time of this
    analysis.
    Debt ratio. The debt ratio reveals the same information as the
    total liabilities to net worth ratio but presents it in a different
    form. Harry=s debt ratio is significantly different in 2007 than it
    was in 2003. In 2003, roughly 49% of Harry=s assets were

F12-48                                    Chapter 12 B Financial Statement Analysis
    financed by the company=s creditors (debt), which means
    about 51% of its assets were financed by the investors (equity).
    By 2007, roughly 72% of the company=s assets were financed
    through debt and about 28% were financed through equity.
    Clearly, the company has moved toward more debt in financing
    its assets, but care must be taken in interpreting this ratio.
12-34. (Continued)
    This may or may not be a negative trend. As the analysis of the
    coverage ratio showed, however, Harry=s ability to service the
    debt it has accumulated has deteriorated over the time of this
    analysis.
    Return on assets. Note: The return on asset figures for
    Harry=s company are incorrect. However, this error has no
    effect on the conclusion drawn from the analysis of this ratio.
    Since we know the return on assets is related to two other
    ratios, the correct figures are:

                2003            2004        2005   2006   2007
               14.60           13.23        9.68   8.40   4.08

       Whether you consider the figures above or the ones originally
       presented, this ratio deteriorated over the five-year period. The
       whole purpose of obtaining assets is to produce income. The
       significant decline of this ratio over the period indicates that
       Harry is not producing as much income relative to investment
       in assets in 2007 as it was in 2003. Remember that the return
       on assets ratio is actually composed of the total asset turnover
       ratio and the profit margin before income tax ratio. This
       analysis shows that both of those component ratios have
       deteriorated over the five-year period.
       Return on equity. This ratio declined over the five-year period.
       Those who invest in a company must earn a reasonable return
       on their investment or it makes no sense to leave their
       investment dollars in that company. What constitutes a
       reasonable return is dependent on the industry involved and

Chapter 12 B Financial Statement Analysis                        F12-49
         the amount of risk associated with the company. We do not
         know what a reasonable return is for the industry in which
         Harry operates. The significant decline over the five years
         indicates that the company is not earning as much for the
         stockholders in 2007 as it was in 2003.

12-34. (Continued)
    Return before taxes on equity. This ratio worsened over the
    five-year period. Such a decline can be caused by decreased
    revenues, increased operating expenses or a combination of
    the two. In any event, the decrease in this ratio over the five-
    year period is not favorable, and the downward trend is more
    disturbing than the actual figures.
    Profit margin before tax. This ratio fell by more than half
    during the five-year period. Unless that is the trend of the whole
    industry, this is troublesome.
    Profit margin after tax. This ratio worsened over the five-year
    period. Harry=s profit margin after tax has declined steadily
    and significantly since 2003. This ratio measures a company=s
    ability to generate net income from sales dollars. The
    downward trend of this ratio suggests that the company has
    become less profitable. Since none of the other ratios suggest
    a significant increase in sales levels, a decline in the proportion
    of each sales dollar resulting in net income is disturbing.
c. Most, if not all, of Harry=s ratios are significantly worse in 2007
    than in 2003. More importantly, its performance has declined
    dramatically over the past five years and unless some
    turnaround occurs, this company will not likely survive.

12-35.
(1)      Return on assets:
                    2008:                     2007:
         $ 617 / $10,725 = 5.75%   $1,013 / $9,032 = 11.22%

(2)      Profit margin before income tax:

F12-50                                  Chapter 12 B Financial Statement Analysis
                  2008:                                2007:
       $ 617 / $14,745 = 4.18%              $1,013 / $12,908 = 7.85%

(3)    Total asset turnover:
              2008:                                 2007:
       $14,745 / $10,725 = 1.37 times           $12,908 / $9,032 = 1.43 times
12-35. (Continued)
(4)    Profit margin after income tax:
            2008:                     2007:
       $ 494 / $14,745 = 3.35%        $ 658 / $12,908 = 5.10%

(5)    Return on equity:
            2008:                                   2007:
       $ 658 / $4,389 = 11.26%                 $ 494 / $3,432 = 19.17%

(6) Return before Taxes on equity:
         2008:                        2007:
$494 + $123 / $4,389 = 14.06%    $658 + $355 / $3,432 = 29.52%

(7)    Current ratio:
            2008:                                   2007:
       $5,279 / $4,336 = 1.28 to 1             $5,556 / $4,000 = 1.32 to 1

(8)    Quick ratio:
            2008:                                   2007:
       $2,240 + $2,340 = 1.06 to 1             $1,936 + $2,490 = 1.11 to 1
           $4,336                                   $4,000

(9)    Receivables turnover:
            2008:                                  2007:
       $14,745 / $2,340 = 6.30 times           $12,908 / $2,490 = 5.18 times

(10) Inventory turnover:
          2008:                                     2007:
     $10,213 / $776 = 13.16 times              $ 8,761 / $693 = 12.64 times

(11) Debt ratio:
          2008:                                     2007:
Chapter 12 B Financial Statement Analysis                               F12-51
         $5,600/ $10,725 = 59.08%         $6,336 / $9,032 = 62.00%

(12) Total liabilities to net worth:
          2008:                               2007:
     $5,600 / $4,389 = 144%              $6,336 / $3,432 = 160%

12-36. (Continued)
(13) Coverage ratio:
          2008:                               2007:
     $789 /$172 = 4.59 times             $1,150 / $137 = 8.39 times

12-36.
a.                                        Assets Between
                                  Total   $10 Million and
                                 Industry   $25 Million             Atkinson
Current ratio                       2.24      1.95                     1.28
Quick ratio                         1.33      1.31                     1.06
Coverage ratio                      5.43      3.16                     4.59
Total asset turnover                1.76      1.42                     1.37
Inventory turnover                  5.78      5.77                    13.16
Receivables turnover                7.83      6.54                     6.30
Total liabilities to net worth      2.28      1.94                     1.44
Debt ratio                         69.51     65.99                    59.08
Return on assets                   9.30      10.40                     5.75
Return on equity                   11.11     11.73                    11.26
Return before interest on equity   16.12     15.85                    15.17
Profit margin before tax            6.67      3.88                     4.18
Profit margin after tax             4.49      2.61                     3.35

b.       Ratios selected for further analysis tend to be very subjective.
         The choice is also influenced by the type of economic decision
         maker analyzing the ratios. Creditors (short-term and long-
         term) may be interested in different ratios than either investors
         (present or potential) or the management of the company.

Note to Instructor: Because of the reasons cited above, our
choices of which ratios warrant further investigation and which do

F12-52                                     Chapter 12 B Financial Statement Analysis
not may not be the ones you would have selected. In any event, our
choices and our reasons are outlined in (1) and (2) below.




12-36. (Continued)
(1) Ratios Not Needing Further Investigation:
    Coverage ratio. Atkinson=s coverage ratio falls between the
    industry average and the average for companies of comparable
    asset size. Based on this comparison, Atkinson=s coverage
    ratio appears to be reasonable and warrants no further
    investigation.
    Total asset turnover. While Atkinson=s total asset turnover
    ratio is somewhat lower than both the industry average and the
    average for companies of comparable asset size, the
    difference does not cause concern.
    Receivables turnover. Atkinson=s receivables turnover ratio
    is only slightly lower than the average for companies of
    comparable asset size. The biggest difference is between
    Atkinson=s figure (6.30) and the total industry average (7.83).
    However, when these figures are converted into average
    collection periods, the difference seems insignificant. The
    industry average is 47 days, and Atkinson=s average collection
    period is 58 days.
    Total liabilities to net worth. Atkinson=s total liabilities to net
    worth ratio is lower than both the industry average and the
    average for companies of comparable asset size, indicating
    that Atkinson has a more conservative capital structure than its
    competitors. We need to analyze the debt ratio to determine if
    the difference might be troublesome to equity investors.
    Debt ratio. The debt ratio reveals the same information as the
    total liabilities to net worth ratio but presents it in a different
    form. Atkinson=s debt ratio is lower than both the industry
    average and the average for companies of comparable asset
Chapter 12 B Financial Statement Analysis                       F12-53
         size. Roughly 59% of Atkinson=s assets have been financed
         by the company=s creditors (debt), which means that about
         41% of its assets have been financed by the investors (equity).
         Neither creditors nor investors should be troubled by
         Atkinson=s capital structure.

12-36. (Continued)
    Return on equity. Atkinson=s return on equity falls between
    the industry average and the average for companies of
    comparable asset size. Based on this comparison, Atkinson=s
    return on equity requires no further investigation.
    Return before interest on equity. Atkinson=s return before
    interest on equity ratio is only slightly lower than both the
    industry average and the average for companies of comparable
    asset size. The difference is due to the fact that Atkinson has
    less debt than its competitors.
    Profit margin before tax. Atkinson=s profit margin before tax
    is lower than the industry average but higher than the average
    for companies of comparable asset size. Since
    Atkinson=s profit margin before tax seems reasonable in the
    context of these comparisons, no further analysis is warranted.
    Profit margin after tax. Atkinson=s profit margin after tax is
    lower than the industry average and higher than the average
    for companies of comparable asset size. Since Atkinson=s
    profit margin after tax falls between the two standards of
    comparison, no further analysis is warranted.

(2) Ratios Needing Further Analysis:
     Current ratio. Atkinson=s current ratio is lower than both the
     industry average and the average for companies of comparable
     asset size. The current ratio is an indicator of the company=s
     ability to meet its short-term obligations. On the surface it
     appears that Atkinson=s ratio may be too low. However, care
     must be exercised in interpreting the current ratio because it
     depends on the composition of the current assets and current
F12-54                                    Chapter 12 B Financial Statement Analysis
       liabilities included in the calculation. Before concluding that the
       company will have trouble meeting its short-term obligations,
       we should look at the quick ratio. Atkinson=s management may
       be planning to refinance some of the current liabilities with
       long-term debt, or it may be planning to sell some of the
       company=s long-term assets.

12-36. (Continued)
    Quick ratio. Atkinson=s quick ratio is lower than both the
    industry average and the average for companies of comparable
    asset size, but above the rule of thumb of 1.00 to 1. If this
    information raises concerns about Atkinson=s ability to meet its
    short-term obligations, additional information should be
    gathered to make a better decision.
    Inventory turnover. Atkinson=s inventory turnover ratio is
    much higher than both the industry average for companies of
    comparable asset size. This means Atkinson has a much
    shorter holding period for its inventory, which is generally
    viewed positively. When the inventory turnover figures are
    converted to holding periods, we find both averages in our
    analysis are 63 days, while Atkinson=s is only 28 days.
    Because shorter holding periods are better, it would seem that
    no further analysis is warranted. However, the difference
    between Atkinson=s figures and those of its industry is so great
    that most analysts would be suspicious. It is possible the
    company has an inventory system that allows it to maintain
    unusually low levels of inventory without risking the loss of
    sales due to stock-outs. But in any case, the situation should
    be investigated to see just what is causing Atkinson=s
    inventory turnover to be so different from industry averages.
    Return on assets. Atkinson=s return on assets is significantly
    lower than both the industry average and the average for
    companies of comparable asset size. These figures suggest
    that Atkinson is producing fewer dollars of profit relative to its
    investment in assets than other companies in the industry.

Chapter 12 B Financial Statement Analysis                          F12-55
         This situation may be a cause for concern in the future
         because Atkinson may not be as efficient in utilizing its assets
         as other companies in its industry. As part of the investigation
         of Atkinson=s return on assets, we should reexamine the two
         component ratios.

12-36. (Continued)
         Return on assets = Total asset turnover x Profit margin before tax
               5.75 = 1.37 x 4.18         (rounded)

         A closer look at the two components of the return on assets
         reveals that Atkinson=s total asset turnover is a bit lower than
         the averages. The company=s profit margin was comparable,
         falling in between the two averages. If our investigation of the
         return on assets brings us to any conclusion, it may be that the
         company=s total asset turnover deserves a second look. That
         ratio would suggest that Atkinson does not generate as high a
         level of sales for its asset base as compared to the averages.
         Part of this is due to the high amount of cash the company
         maintains. Cash is the least productive asset. However, without
         additional information, we cannot be sure that a recent major
         investment in long-term assets would not explain this result.
         Note: Because of the mathematical properties of averages,
         the average total asset turnover x the average profit margin
         before tax does NOT equal the average return on assets.
         The relationship among the three ratios can only be verified
         with data from a single company.
(3)      Overall, Atkinson compares very favorably with both its entire
         industry and with companies in that industry of comparable
         size. Most of the company=s ratios are either better or
         comparable to the industry averages. Even the ones we chose
         to investigate further are not alarmingly different. Atkinson
         appears to be a solid, healthy company.



F12-56                                      Chapter 12 B Financial Statement Analysis
12-37.
a. Note to Instructor: The solutions offered for this question
are based on the following information only:
                                            2004      2005    2006     2007   2008
Current ratio                                2.07     2.62    1.79     1.32    1.28
Quick ratio                                  1.00     1.09    1.01     1.11    1.06
Coverage ratio                                6.31    5.44    4.48     8.39    4.59
Total asset turnover                          1.11    1.86    1.34     1.43    1.37
Inventory turnover                          10.88    11.37   11.81    12.64   13.16
Receivables turnover                          4.80    4.99     5.10    5.18    6.30
Total liabilities to net worth                1.22    1.65    1.61     1.63    1.44
Debt ratio                                  54.95    62.26   61.69    62.00   59.08
Return on assets                              5.20    7.66    5.94    11.22    5.75
Return on equity                            10.98    11.62   11.05    19.17   11.26
Return before taxes on equity               14.48    13.77   15.43    23.16   15.17
Profit margin before tax                      4.68    4.12    4.44     7.85    4.18
Profit margin after tax                       3.06    3.16    3.31     5.10    3.35

b.  Ratios selected for further analysis tend to be very subjective.
    The choice is also influenced by the type of economic decision
    maker analyzing the ratios. Creditors (short-term and long-
    term) may be interested in different ratios than either investors
    (present or potential) or the management of the company.
    Note to Instructor: Because of the reasons cited above, our
    choices of which ratios warrant further investigation and which
    do not may not be the ones you would have selected. In any
    event, our choices and our reasons are outlined in (1) and (2)
    below.
Note: Before beginning the analysis of each ratio, something can
    be learned by scanning the company=s overall picture for
    the five-year period. Based on the behavior of the coverage
Chapter 12 B Financial Statement Analysis                                         F12-57
    ratio and the last five ratios in the list, it appears that 2008
    was an unusual year for Atkinson, and it would be important
    to investigate the cause of these unusual results. Since
    2007 does not appear to be representative of Atkinson=s
    normal operating performance, figures from that year should
    be ignored when trying to identify trends over time.
12-37. (Continued)
(1) Ratios Not Needing Further Investigation:
    Quick ratio. Atkinson=s quick ratio has remained relatively
    constant over the five years. The company generally holds a
    level of highly liquid current assets about equal to its current
    liabilities. Without any additional information suggesting a
    reason for concern, this level of highly liquid current assets
    appears to be reasonable.
    Total asset turnover. Over the five years examined, this ratio
    has remained relatively constant. Based solely on the data
    provided, no further investigation is warranted.
    Inventory turnover. In 2004, Atkinson=s average holding
    period for its inventory was about 34 days (365/10.88). By
    2008, the holding period had decreased to just under 28 days
    (365/13.16). Given the high cost of holding inventory, any
    decrease in the inventory holding period can have a dramatic
    impact on a company=s profits. This appears to be a positive
    trend for Atkinson.
    Receivables turnover. In 2004, Atkinson=s average collection
    period for its receivables was 76 days (365/4.80). By 2008, the
    collection period had decreased to 58 days (365/6.30). This is
    a dramatic and encouraging trend.
    Total liabilities to net worth. There has been little change in
    Atkinson=s total liabilities to net worth ratio over the last five
    years. Unless we discover that its capital structure is a
    problem, the ratio needs no further investigation.
    Debt ratio. The debt ratio reveals the same information as the
    total liabilities to net worth ratio in that Atkinson=s debt ratio in
    2008 is not significantly different than in 2004. In 2004, about

F12-58                                   Chapter 12 B Financial Statement Analysis
       55% of the company=s assets were financed by the
       company=s creditors (debt), and 45% were financed by the
       investors (equity). In 2008, roughly 59% of its assets were
       financed through debt and about 41% were financed through
       equity. The company=s capital structure is reasonably
       conservative.

12-37. (Continued)
     Return on assets. Note: The figures for Atkinson=s return on
     assets in 2004, 2005, and 2006 as originally presented were
     incorrect. Figures shown in the table in requirement a. properly
     reflect the relationship between the return on assets ratio and
     its two component ratios. Regardless of which figures are
     considered, the same conclusion is drawn from the analysis.
     Except for 2007, when the return on assets was very high, this
     ratio has remained relatively constant over the five-year period.
     Return before taxes on equity. Atkinson=s return on equity
     has remained relatively constant over the five-year period
     (except 2007, which appears to be unrepresentative).
     Profit margin before tax. This ratio has remained relatively
     stable over the five-year period (except 2007, which appears to
     be unrepresentative).
     Profit margin after tax. This ratio has remained relatively
     stable over the five-year period (except 2007, which appears to
     be unrepresentative).
 (2) Ratios Needing Further Analysis:
     Current ratio. Atkinson=s current ratio has decreased
     significantly over the past five years, indicating that the
     company has a lower amount of current assets in relation to
     current liabilities in 2008 than it did in 2004. Atkinson
     maintained a stable quick ratio to insure its liquidity.
     Considering the dramatic decline in accounts receivable and
     inventory, as evidenced in its higher receivable turnover and
     inventory turnover, the company may have reached a high
     level of efficiency in managing its working capital, which can be

Chapter 12 B Financial Statement Analysis                      F12-59
         viewed as a positive indicator.
         Coverage ratio. The ratio declined over the five-year period
         (ignoring 2007). Many experts feel a coverage ratio of 4:1
         should be maintained. Although Atkinson=s coverage ratio is
         above the standard in all five years, its decline over the period
         is troublesome. If the trend continues, the company may have
         difficulty making future periodic interest payments.

12-37. (Continued)
 (3) Most of Atkinson=s ratios improved or remained relatively
     constant over the five years of the analysis. Atkinson appears
     to be a solid, healthy company that has performed well over the
     past five years.

12-38.
a.                     Ross Atkinson and Company
                        Statement of Cash Flows
                 For the Year Ended December 31, 2008
                                (in Thousands)

Cash Flows from Operating Activities:
 Net Income                                           $ 494
 Adjustments to reconcile net income to net
  cash provided by operating activities:
     Depreciation Expense                   $ 184
     Decrease in Accounts Receivable            150
     Increase in Merchandise Inventory          ( 83)
     Increase in Prepaid Expense                ( 40)
     Increase in Accounts Payable                536      747
Net Cash Provided By Operating Activities             $1,241
Cash Flows from Investing Activities:
     Purchase of Building                   $(1,300)
     Purchase of Equipment                     (300)
Net Cash Used By Investing Activities                  (1,600)
Cash Flows from Financing Activities:

F12-60                                      Chapter 12 B Financial Statement Analysis
     Proceeds from Long-Term Loan                        $    400
     Proceeds from Sale of Common Stock                       600
     Payment of Short-Term Loan                              (200)
     Payment of Cash Dividends                               (137)
Net Cash Provided by Financing Activities                                663
Net Increase in Cash During 2002                                      $ 304
Beginning Cash Balance, January 1, 2008                                1,936
Ending Cash Balance, December 31, 2008                                $2,240
12-38. (Continued)

b.     Operating activities: $1,241,000.
c.     In the long-run, all cash must be provided by operating
       activities. In this year, at least, Atkinson=s operating activities
       appropriately provided the majority of its cash.
d.     Investing activities: $1,600,000.
e.     Investing activities normally will result in a net outflow of cash if
       a company is growing and healthy. In this year, at least,
       Atkinson had a net outflow of cash in investing activities. If the
       purchase of buildings and equipment are the result of
       expansion, the investments of cash indicate Atkinson is a
       growing, healthy company.

12-39.
a.
                          Ross Atkinson and Company
                      Statement of Stockholders= Equity
                    For the Year Ended December 31, 2008
                                (in Thousands)
                                                     Total
                                Common Retained Stockholders=
                                Stock     Earnings  Equity

Balance, January 1                     $2,400   $1,032       $3,432
Add: Sale of Stock                        600                   600
Add: Net Income                                   494           494

Chapter 12 B Financial Statement Analysis                                F12-61
Less: Dividends                           137               137
Balance, December 31         $3,000    $1,389            $4,389

b.       The statement of stockholders= equity demonstrates
         articulation among the financial statements by providing a
         bridge between the information presented on the income
         statement and the information presented on the balance
         sheet. In Atkinson=s case, the net income for 2008 as
         reported on the company=s income statement ($494) is
         added to the beginning retained earnings balance on the
         statement of stockholders= equity. The ending retained
         earnings balance on the statement of stockholders= equity
         ($1,389) is the same as the balance shown on the balance
         sheet at December 31, 2008. In addition, the final balance in
         Common Stock ($3,000) and Total Stockholders= Equity
         ($4,389) can also be followed from the statement of
         stockholders= equity to the 2008 balance sheet.

12-40.
(1) Past results can be unreliable predictors of the future unless
    the analysts takes into account such things as changes in
    the general economy, changes in the economy of the
    particular industry being studied, and changes in a firm=s
    management.
(2) Assets are recorded at historical cost. As time passes, in
    many cases, changes in asset value are not recognized. For
    instance, land acquired 20 years ago is still reported on the
    balance sheet at the original cost, even though the market
    value of the land may have tripled. Buildings are
    depreciated, so over time their book value decreases, but
    their market value may remain constant or increase. Ratios
    such as return on assets, which uses total assets in its
    denominator, may be distorted by the use of historical cost.
(3) In almost all instances, the numbers used in the calculation
    of the ratios are year-end numbers which tend to be lower for

F12-62                                   Chapter 12 B Financial Statement Analysis
       working capital accounts than the rest of the year because
       many businesses have their fiscal year-end when business
       is slow. The impact of this limitation is most apparent when
       these amounts fluctuate during the year.
(4)    Comparing the ratios of a company in one industry with
       those of a company in another industry is difficult, because
       industry peculiarities will cause the ratios to differ. Some
       industries are very labor-intensive; others require significant
       investment in plant assets. Differences such as these cause
       wide variations from industry to industry in the Anormal@
       level of some ratios.
(5)    There are no hard and fast rules as to what numbers are
       used to calculate the ratios. The lack of uniformity in what is
       or is not included in the calculation of ratios makes
       comparison extremely difficult.
(6)    Ratios cannot and should not be viewed as some sort of
       magical checklist in the evaluation process. They represent
       only a small part of what decision makers should consider
       when making credit, investment, and similar types of
       decisions. Certainly no overall conclusions about a
       company=s health should be drawn from numbers alone.
       Decision makers need to ask why the numbers are what they
       are before drawing a final conclusion.

12-41 – 12-43.
NOTE TO INSTRUCTOR:

For questions 12-41 through 12-43 acquaint students with
Edgarscan. Have students go through the following steps to
provide graph results for the various corporations referred to in
each problem. This will provide the student with a powerful tool to
use in their research.

       Step 1 Go to www.edgarscan.pwcglobal.com.
       Step 2 Click on Edgarscan

Chapter 12 B Financial Statement Analysis                      F12-63
         Step 3 Enter Company name: e.g. Darden Restaurants and
         click on search
         Step 4 Click on Benchmarking assistant box toward bottom
         of page below
         Step 5 Type in Darden and click search
         Step 6 Type in e.g. Sonic Corp. and click search
         Step 7 Click on Sonic Corp Name to move to right hand
         column
         Step 8 Click on “graphs” and then determine results

12-41.
a.
           Ratios               Darden                    Sonic Industries
Current ratio
Quick ratio
Receivables turnover
Inventory turnover
Total asset turnover
Total liabilities to net
worth
Debt ratio
Coverage ratio
Return on assets
Return on equity
Return before taxes on
equity
Profit margin before tax
Profit margin after tax

 b. and c. Responses will vary depending on the dates and
the selections.




F12-64                                   Chapter 12 B Financial Statement Analysis
12-42.
a
            Ratios                          Ford Motor Co.   General Motors
Current ratio
Quick ratio
Receivables turnover
Inventory turnover
Total asset turnover
Total liabilities to net
worth
Debt ratio
Coverage ratio
Return on assets
Return on equity
Return before taxes on
equity
Profit margin before tax
Profit margin after tax

b. and c. Responses will vary depending on the dates and
the selections.




Chapter 12 B Financial Statement Analysis                               F12-65
12-43.
a.
         Ratios            Dollar General Stores          Family Dollar Stores
Current ratio
Quick ratio
Receivables turnover
Inventory turnover
Total asset turnover
Total liabilities to net
worth
Debt ratio
Coverage ratio
Return on assets
Return on equity
Return before taxes on
equity
Profit margin before tax
Profit margin after tax

 b. and c. Responses will vary depending on the dates and
the selections.




F12-66                                     Chapter 12 B Financial Statement Analysis
Chapter 12 B Financial Statement Analysis   F12-67

				
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