CH-13-14 Business Organization and Financial Data – Introduction to Finance: Markets, Investments, and Financial Management : Book Guide

This Document Contains Chapters 13 to 14 Chapter 13 Business Organization and Financial Data CHAPTER PREVIEW Our discussion of business finance begins with an overview of the forms of business organization (proprietorship, partnership, and corporate) along with the financial implications of each type of organization. Special cases of these organizations (e.g., limited partnership, subchapter S corporation, LLC) also are reviewed. The goal of any firm is to maximize the wealth of its owners; in the case of a corporation, this means to maximize the wealth of the common shareholders. Managers within the firm as well as the firm’s lenders (e.g., banks, bondholders) and owners keep track of the firm’s performance by reviewing its financial statements—income statement, balance sheet, and statement of cash flows. These financial statements show the trends facing the firm; the result of management’s decisions; and how well future market opportunities, debt obligations, and shareholder needs can be met. Thus, financial institutions, markets, and investors, as well as the firm’s managers, are interested in reviewing and interpreting a firm’s financials. LEARNING OBJECTIVES Describe the three major forms of business organization. Provide a brief description of the income statement. Provide a brief description of the balance sheet. Provide a brief description of the statement of cash flows. Identify the goal and functions of financial management. Describe the agency relationships in a business organization and their implications for financial management. Learning Extension: Federal Income Taxation CHAPTER OUTLINE I. STARTING A BUSINESS Strategic Plan with a Vision or Mission Business and Financial Goals II. FORMS OF BUSINESS ORGANIZATION IN THE UNITED STATES Proprietorship Partnership Corporation THE ANNUAL REPORT ACCOUNTING PRINCIPLES INCOME STATEMENT VI. THE BALANCE SHEET Assets Liabilities Owner’s Equity VII. STATEMENT OF CASH FLOWS FINANCIAL STATEMENTS OF DIFFERENT COMPANIES IX. GOAL OF A FIRM Measuring Shareholder Wealth Linking Strategy and Financial Plans Criterion for Nonpublic Firms What About Ethics? X. CORPORATE GOVERNANCE A. Principal-Agent Problem B. Reducing Agency Problems FINANCE IN THE ORGANIZATION CHART SUMMARY LEARNING EXTENSION 13: FEDERAL INCOME TAXATION Federal Income Taxation Depreciation Basics LECTURE notes I. STARTING A BUSINESS To attract capital, whether for an entrepreneur’s start-up or a large corporation, there must be the expectation of future return. The ability to generate cash for investors arises from the firm’s ability to make a product or service that others are willing to buy. Most firms have a vision or mission statement that spells out their reason for being. This statement directs the firm’s activities and should help to keep it focused on its core competencies. You may wish to supplement the mission statements given in the text by mission statements from recent annual reports. The financial market allows firms to obtain capital. The market allocates funds in line with the risk/expected return trade-off discussed earlier in the text. Risky ventures need to show potential for high expected returns. (Use Discussion Questions 1 and 2 here.) II. FORMS OF BUSINESS ORGANIZATION IN THE UNITED STATES In this section, a discussion of the legal forms of business focuses on the financial implications of each form. It may be helpful to give your students a copy of Table 13.1 which summarizes, for each organizational form, its capital-raising ability; liquidity of ownership/ability to transfer ownership; limited/unlimited liability; tax status; ease of start-up; and life span. Forms of organization designed to better meet the needs of some owners include limited partnerships, LLCs, and subchapter S corporations. (Use Discussion Questions 3 through 5 here.) III. THE ANNUAL REPORT The annual report is a main source of information to shareholders. It contains financial statements and management’s discussion of the past year. Shareholders read what management has to say; to see what future plans are; and if management understands the competitive environment in which the firm operates. (Use Discussion Question 6 here.) IV. ACCOUNTING PRINCIPLES Standard principles limit accountants’ actions to some extent, but they still have some flexibility as to which accounting principles they can choose. Here are some examples of different principles that firms can use. Details as to which Generally Accepted Accounting Principles (GAAP) are used can be found in the footnotes to a firm’s financial statements. Students will find it interesting that the U.S. government does not follow GAAP to account for its revenues, expenses, assets, and liabilities. Table 13.3 will help show students the difference that can exist when different countries’ accounting standards are applied to the same set of accounting transactions. EXAMPLE OF GAAP—GENERALLY ACCEPTED ACCOUNTING PRINCIPLES Revenue recognition— Recognized 1. At time goods are sold (accrual) 2. As cash is collected (installment or cost-recovery-first) 3. As production progresses (percentage of completion method) Uncollectible accounts— Recognized 1. When revenue is recognized (allowance method) 2. When accounts are found to be uncollectible (direct write off) Inventories— Cash flow assumption 1. LIFO 2. FIFO 3. Weighted average Cost assumption 1. Acquisition cost 2. Lower of acquisition cost or market 3. Standard cost 4. Net realizable value Investments in securities— 1. Lower of cost or market 2. Equity method 3. Consolidation method Depreciation— 1. Straight-line 2. Double declining balance 3. Sum of the years’ digits 4. Units of production 5. ACRS (accelerated cost recovery system) Table 13.2 provides some comparison between accounting and financial perspectives when examining accounting principles. (Use Discussion Question 7 here.) V. INCOME STATEMENT Here we review the component parts of a basic income statement. It is useful to refer back to the above discussion to show that the accounting revenues and expenses on an income statement may not measure cash entering or leaving the firm. A firm’s net income will only by serendipity equal the increase in the firm’s cash account! (Use Discussion Question 8 here.) VI. THE BALANCE SHEET The basic components of a balance sheet are reviewed. The accounting identity, Assets = Liabilities + Equity, is a useful tool for financial planning. Students sometimes must be reminded that the balance sheet must balance. For every dollar owned by the firm (i.e., assets) the firm will have some combination of debt or equity financing for it. Assets and liabilities are listed in order of liquidity. But students should be cautioned that liquidity is not the same as cash. (Use Discussion Questions 9 and 10 here.) VII. STATEMENT OF CASH FLOWS The statement of cash flows is a good tool to use to determine a firm’s ability to generate cash flows. A quick estimate of operating cash flows is to add net income and depreciation. A more appropriate means is to use the format of the operating cash flow section of the statement of cash flows: net income + depreciation + changes in net working capital. This, once again, shows that net income is not the same as cash. Whether a change in an account is a source or a use can be determined by playing a mind game—does the transaction lead to an increase or decrease in cash? For example, an increase in an asset is a use of cash because of the accounting identity. An increase in an asset account leads to an increase in financing needs; funds are used to finance the increase in the asset account. An increase in a liability or equity account is a source of cash as it causes funds or cash to come into the firm (e.g., as when bonds are sold or when accounts payable are used to finance a rise in inventories). (Use Discussion Question 11 here.) VIII. Financial Statements of different companies Examination of financial statements can shed light on how a company generates profits and whether it is capital-intensive or debt-heavy. Firms in different industries will have different operating characteristics. This chapter introduces an easy way to compare different-sized firms by using common-size financial statements. The text uses an example of oil, retail drug store, and software firms to look at differences in operating and financing structure (balance sheet) and profit generation (income statement). (Use Discussion Questions 12 and 13 here.) IX. GOAL OF A FIRM Whatever a firm’s mission statement says, it must seek to satisfy the needs to the financial markets, otherwise capital will not be available to the firm in the future. Goals of market share growth, quality, customer satisfaction, attention to stakeholders are all well and good. But a measurable goal that all participants, especially those in the financial markets, can evaluate is that of shareholder-wealth maximization. Offering a good quality product at a fair price, offering good customer service, treating workers well—all are means to an end of enhancing shareholder wealth and the firm’s ability to meet its future competitive needs. Managers, financial institutions, and investors pay attention to movements in a firm’s stock price, especially relative to the market as a whole and its close competitors. Changes in stock price above and below market changes signal investor satisfaction or dissatisfaction with management’s decisions. The popular measures of MVA (Market Value Added) and EVA (Economic Value Added) are based on this principle of adding to shareholder wealth. Nonpublic firms still will be run with the goal of maximizing the wealth of their owners. But in the case of private firms, “wealth” includes more than just dollars. It includes nonpecuniary income such as leisure time, keeping the firm in the family, and meeting personal satisfaction goals. (Use Discussion Questions 14 through 17 here.) X. CORPORATE GOVERNANCE Here we delve more deeply into the issues surrounding the separation of ownership and control. The discussion can start by talking generally about owner/manager or principal/ agent situations: real estate brokers; sports star salary negotiations; the voting public and elected officials; and the consequences if the agents do not act in the best interests of the principals. This can then lead into a discussion of what happens if corporate managers do not act in the best interests of shareholders. It is interesting to note that U.S.-style corporate governance issues are arising oversees as shareholders in other countries begin to focus on shareholder wealth issues. This material forms the basis for good discussions of ethical behavior in finance. There are a number of ways to reduce agency problems in the corporate setting. One is to make managers think like owners by tying their compensation into stock price performance through stock options or restricted stock. The other is to make managers more accountable to outside board members or to the financial community by better disseminating information about firm performance. This is a goal of the Sarbanes-Oxley Act of 2002. (Use Discussion Questions 18 through 22 here.) XI. FINANCE IN THE ORGANIZATION CHART Chapter 13 concludes with a discussion of the place of the finance function within a large firm. The controller function is accounting and tax oriented; many positions advertising for controllers seek individuals with strong accounting backgrounds, including a CPA. The treasurer handles many of the traditional finance functions, including the overseeing of capital budgeting, capital structure, and net working capital decisions. (Use Discussion Questions 23 and 24 here.) DISCUSSION QUESTIONS AND ANSWERS 1. It has often been said that a business should begin with a vision or mission statement. Explain what that means. The vision or mission statement should indicate what product or service the firm wants to produce, distribute, and sell. Typically, comments on customer service and quality are made as well. The statement provides the firm’s reason for being and how it will attempt to compete and maximize shareholder wealth. 2. How do the financial markets accommodate the needs of both risky firms and very safe firms? Financial markets adjust the prices of securities so return expectations are in line with risk perceptions. Higher risk securities should offer higher expected returns. 3. Identify and briefly describe the three major forms of business ownership used in the United States. Proprietorships are owned by a single individual who personally receives all profits and is liable for all losses. Partnerships are created when two or more people combine finances and skills to start a business. They share in the profits; each partner is jointly and severally liable for the losses of the partnership. Corporations are persons in the eyes of the law. They are chartered in a state and are owned by shareholders who have limited liability. 4. What are the differences in owner liability in proprietorships and partnerships versus corporations? Proprietors and partners are liable for all the debts of their business; their personal assets can be attached if needed to satisfy the business’ obligations. Corporate owners, the shareholders, have limited liability; the most they can lose is the funds they have invested in the firm. 5. Briefly describe the differences between a subchapter S corporation and a limited liability company. A subchapter S firm has fewer than 35 shareholders, none of whom comprise another corporation. Its income is taxed once, as personal income of the shareholders. An LLC is similar to a subchapter S corporation except it can have an unlimited number of shareholders. This type of corporation must, however, satisfy certain regulations; for example, if one owner leaves, all must agree to continue the firm. 6. What types of information are included in an annual report? Annual reports usually contain financial highlights, a letter to stockholders by the Board Chairman and Chief Executive Officer, financial statements, and management’s discussion of the past year. Sometimes the firm’s new products are featured, descriptions of current business areas are provided, and future opportunities are discussed. 7. General accounting practice is based upon the accrual concept. Explain what this means and briefly describe how this compares with the financial manager’s focus on cash. Under accrual accounting, revenues and their associated expenses are recognized when a sale occurs, regardless of when cash revenues or expenses really occur. This is the matching principle. From the financial manager’s perspective, cash is what matters most. The cash flows, or the cash expenses and cash revenues associated with a sale, may occur over the space of many months and even years. Yet, under accrual accounting’s matching principal, the accounting revenues and expenses appear to have all occurred this year, even on a single day, the day of the sale. 8. What is the purpose of the income statement? Also, briefly identify and describe the major types of expenses that are shown on the typical income statement. The income statement reports the revenues generated and the expenses incurred by the firm over an accounting period. Some major expenses include cost of goods sold (labor and materials used to produce a good or service); selling, marketing, general and administrative expense (costs associated with selling and advertising, record keeping etc.); depreciation (estimate of the reduction in economic value of fixed assets); interest expense (on bonds, bank, and other loans); and taxes (paid to state and federal governments). 9. What is the purpose of the balance sheet? Briefly identify and describe the major types of assets and the claims of creditors and owners shown on the typical balance sheet. The balance sheet is a snapshot of a firm’s assets, liabilities, and equity as of a specific date. a. Current assets are assets that are normally converted to cash over the operating cycle. Inventory is sold on credit, creating an accounts receivable, which is later paid as cash is received. b. Fixed assets, the firm’s plant, property, and equipment, are listed both gross and net of accumulated depreciation. c. Current liabilities are those that will be paid within the operating cycle; accounts payable represent suppliers’ claims on the firm; notes payable represent short-term loans. d. Accrued liabilities represent upcoming payments to workers (salaries) or the government (taxes). e. Long-term liabilities typically are bonds; the owner’s equity section represents the funds invested by the firm’s owners. 10. Describe the three different accounts that comprise the owners’ equity section on a typical corporate balance sheet. The common stock account reflects the number of outstanding shares of common stock carried at a stated or par value. Par value is an arbitrary value and thus is not related to a firm’s stock price or market value. The paid-in capital account (or surplus account) represents the amount over and above the par value that was paid by shareholders purchasing stock when it was originally sold. The third account is called the retained earnings account, and it shows the accumulated undistributed earnings (i.e., earnings not paid out as dividends) within the corporation over time. 11. What is a statement of cash flows? What are the three standard sections contained in a statement of cash flows? The statement of cash flows provides a summary of the cash inflows and outflows during a specified period. The three standard sections include operating cash flows, investing cash flows, and financing cash flows. 12. How can common-size financial statements be used? Common-size financial statements can be used to more easily compare the operating and financing (balance sheet), and profit generation (income statement) characteristics of two firms of different sizes (assets or sales). Second, they can be used to gain insight into the differences between various industries, including the status of competition in the industries and the firm’s methods of serving their markets. 13. How are industry-operating differences reflected in a firm’s financial statements? Firms in capital-intensive industries will likely have lower (higher) ratios of current (fixed) assets to total assets. Firms in retail industries may have higher ratios of inventory to assets, accounts payable to assets, and current liabilities to assets. Firms with intangible assets may have lower (higher) ratios of debt (equity) to assets. Firms in less-competitive industries will have higher operating profits relative to sales. 14. Describe the financial goal espoused by business firms. The financial goal of a firm should be to maximize owners’ or shareholders’ wealth. 15. Briefly explain how shareholder wealth is measured. Shareholder wealth equals the common stock price multiplied by the number of shares outstanding. 16. What does it mean when a firm’s MVA is negative? A negative measure for MVA (market value-added) means the market value of a firm’s bonds and stock is less than the sum of retained earnings plus the value of the firm’s bonds and stocks when they were first issued. 17. How are financial strategy and financial plans linked together? The movements in a firm’s stock price provide information to managers concerning the market’s perceptions of the firm. Stock returns that are poor relative to the market as a whole or to a firm’s competitors should cause management to review its actions and plans and develop strategies to enhance shareholder wealth. 18. What is meant by the principal-agent problem in the context of corporate governance? Principals (the owners or shareholders) hire agents (managers) to run the day-to-day operations of the firm for the benefit of the principals. Problems can arise should the agents make decisions that favor their position instead of making decisions that are in the best interest of the owners. 19. Discuss some ways agents can make self-serving decisions. Agents, or corporate managers, can make self-serving decisions in a number of ways which either harm shareholders or indicate they do not have the shareholders’ best interests at heart. These include increasing expenses of the firm for managers’ benefit (corporate jets, high salaries, lavish offices); accounting manipulations to improve profits; place relatives, friends on the corporate board; award themselves lifetime benefits (office, car, access to jet, long-term care insurance); resist takeovers when shareholders are offered an attractive premium for their shares. 20. What are the two main solutions for reducing the adverse effects of agency problems? One solution is to align the interests of managers with those of shareholders. Popular means of doing this include stock options and restricted stock so management’s wealth is tied to shareholder wealth. The second solution is to legislate and mandate reforms to ensure board independence and proper oversight of the firm’s accountants and managers. 21. What is restricted stock? How does it improve managerial incentives compared to the use of stock options? Restricted stock is shares of stock awarded to managers which vest, or become saleable, after a stated number of years. Managers collect dividends on the shares but cannot sell them until three to five years pass. Large gains on the sale of restricted stock are less likely, unlike what can occur with stock options, but whereas options can expire worthless the shares of stock should still retain some value. Restricted stock is usually issued for a longer period of time than stock options. The short-run incentives to manipulate earnings are not as great with restricted stock. 22. Describe four provisions of the Sarbanes-Oxley Act. a. The creation of the Public Company Accounting Oversight Board (PCAOB) with five members which reports to the SEC. PCOAB registers firms which conduct corporate accounting audits and establishes auditing, quality control, ethical and independence standards for auditors. b. Accounting firms cannot perform other functions (bookkeeping, financial system consulting, etc.) in firms for which they perform audits to minimize conflicts of interest. To try to maintain independence, the lead auditor must be changed at least every five years. Other standards regarding auditors include the following: auditors must present their report to the board of directors’ audit committee; the audit committee must contain at least one “financial expert”; only independent directors can sit on the audit committee. c. The CEO and CFO of the firm must certify that the firm’s financial reports conform to SOX requirements and good accounting practice. To avoid board/manager conflicts of interest, mangers may no longer receive low-or-no cost loans for their firms. A code of ethics must be created for the firm’s top managers. d. Attempts to minimize conflicts of interest between the analysts’ firm and possible investment banking clients. Analysts must be kept separate from investment banking operation. Research reports written by the analysts cannot be reviewed or approved by the firm’s investment-banking arm and analysts cannot be paid based upon the investment banking fees generated by favorable research reports written about the firm’s clients. Analysts’ reports must disclose if the analyst owns any of the securities issued by the firm about which he is making a recommendation. 23. What are the responsibilities of a firm’s controller? The controller manages accounting, cost analysis, and tax planning. 24. Briefly describe the financial responsibilities undertaken by a firm’s treasurer. The treasurer oversees the traditional finance functions: capital budgeting, short-term and long-term financing decisions, and current asset management. PROBLEMS and answers 1. Use the “balance sheet equation” to determine owners’ equity if liabilities are $5 million and assets are $10 million. Assets = Liabilities + Owners’ Equity $10 million = $5 million + Owners’ Equity Owners’ Equity = $10 million - $5 million = $5 million 2. Use your knowledge of balance sheets to fill in the amounts missing in the text. Cash $ l0,000 Accounts payable $ 12,000 Accounts receivable 100,000 Notes payable 50,000 Inventory 110,000 Total current liabilities $ 62,000 Total current assets $220,000 Long-term debt 128,000 Gross P&E 500,000 Total Liabilities $190,000 Less accumulated Common stock 100,000 depreciation 125,000 Paid-in capital 155,000 Net P&E $375,000 Retained earnings 150,000 Total assets $ 595,000 Total stockholders’ equity $ 405,000 Total liabilities and equity $ 595,000 3. Use your knowledge of balance sheets to fill in the amounts missing in the text. Cash $ 50,000 Accounts payable $ 12,000 Accounts receivable 80,000 Notes payable 50,000 Inventory 100,000 Total current liabilities $ 62,000 Total current assets $ 230,000 Long-term debt 218,000 Gross P&E 730,000 Total liabilities $ 280,000 Less accumulated Common stock 100,000 depreciation 130,000 Paid-in capital 250,000 Net P&E $600,000 Retained earnings 200,000 Total assets $ 830,000 Total stockholders’ equity $ 550,000 Total liabilities and equity $ 830,000 4. Use your knowledge of balance sheets and common-size statements to fill in the missing dollar amounts. Assets Cash $25,000 3.4% Accounts receivable $125,000 17.0% Inventory $200,000 27.1% Total current assets $350,000 47.5% Gross plant and equipment $700,000 95.0% Less: accumulated depreciation $313,000 42.5% Net plant and equipment $387,000 52.5% Total assets $737,000 100.0% Liabilities Accounts payable $116,000 15.7% Notes payable $29,000 3.9% Total current liabilities $145,000 19.7% Long-term debt $248,000 33.6% Total liabilities $393,000 53.3% Common stock ($.01 par, 450,000 shares) $4,500 0.6% Paid-in capital $220,500 29.9% Retained earnings $119,000 16.1% Total stockholders’ equity $344,000 46.7% Total liabilities and equity $737,000 100.0% 5. Use your knowledge of income statements to fill in the missing items. Sales $ 2,175,000 = Gross profit + COGS COGS 575,000 Gross profit $1,600,000 G&A expense 200,000 Sales & Mkting expense 250,000 can be determined after operating income is found Depreciation 50,000 Operating income $1,100,000 = EBT + Interest Interest 100,000 Income before taxes $1,000,000 EBT(1 – .30) = $700,000; EBT = $1,000,000 Income taxes (30%) 300,000 Net income $ 700,000 6. Use the following information to construct an income statement. Interest = $25,000; Sales = $950,000; Income tax rate = 25%; Selling and marketing expenses = $160,000; General and administrative expenses = $200,000; Gross profit = $550,000; Depreciation = $30,000; and Cost of goods sold = $400,000. Sales $950,000 COGS 400,000 Gross profit $550,000 G&A expense 200,000 S&M expense 160,000 Depreciation 30,000 Operating income $160,000 Interest 25,000 Income before taxes $135,000 Income taxes (25%) 33,750 Net income $101,250 7. Use the following information to construct an income statement. Cost of goods sold = $684,000; Gross profit = $546,000; General and administrative expense = $159,000; Selling and marketing expense = $134,000; Operating income = $228,000; Income before taxes = $87,000, and Income tax rate = 27%. Sales $1,230,000 Cost of goods sold $684,000 Gross profit $546,000 General and administrative expense $159,000 Selling and marketing expense $134,000 Depreciation $25,000 Operating income $228,000 Interest $141,000 Income before taxes $87,000 Income taxes (27%) $23,490 Net income $63,510 8. Use your knowledge of income statements and common-size statements to fill in the missing dollar amounts. Sales $2,876,200 100.0% Cost of goods sold $2,147,200 74.7% Gross profit $729,000 25.3% General and administrative expense $250,000 8.7% Selling and marketing expense $140,000 4.9% Depreciation $110,000 3.8% Operating income $229,000 8.0% Interest $132,000 4.6% Income before taxes $97,000 3.4% Income taxes (25%) $24,250 0.8% Net income $72,750 2.5% 9. Challenge Problem. Use a spreadsheet to construct a common-size balance sheet from the data in problem 2 and a common-size income statement from the data in problem 5. Balance sheet from problem 2 Cash $ 10,000 Accounts payable $ 12,000 Accounts receivable 100,000 Notes payable 50,000 Inventory 110,000 Total current liabilities $ 62,000 Total current assets 220,000 Long-term debt 128,000 Gross P&E 500,000 Total Liabilities 190,000 Less accumulated Common stock 100,000 Depreciation 125,000 Paid-in capital 155,000 Net P&E 375,000 Retained earnings 150,000 Total assets $ 595,000 Total stockholders’ equity $ 405,000 Total liabilities and equity $ 595,000 Common-size balance sheet Cash Accounts payable 2.0% Accounts receivable 16.8% Notes payable 8.4% Inventory 18.5% Total current liabilities 10.4% Total current assets 37.0% Long-term debt 21.5% Gross P&E 84.0% Total Liabilities 31.9% Less accumulated 0.0% Common stock 16.8% Depreciation 21.0% Paid-in capital 26.1% Net P&E 63.0% Retained earnings 25.2% Total assets 100.0%.0 Total stockholders’ equity 68.1% Total liabilities and equity 100.0% Income statement from problem 5 Dollar amounts Common-size Sales $2,175,000 100.0% COGS $575,000 26.4% Gross profit $1,600,000 73.6% G&A expense $200,000 9.2% Sales & Mkting expense $250,000 11.5% Depreciation $50,000 2.3% Operating income $1,100,000 50.6% Interest $100,000 4.6% Income before taxes $1,000,000 46.0% Income taxes (30%) $300,000 13.8% Net income $700,000 32.2% 10. Use the following income statement and balance sheet information to put together a statement of cash flows. 2010 Assets 2010 2009 Sales $1,230,000 Cash $25,000 $21,990 Cost of goods sold $684,000 Accounts receivable $125,000 $115,000 Gross profit $546,000 Inventory $200,000 $215,000 Gen’l & admin expense $159,000 Total current assets $350,000 $351,990 Selling & mkt expense $134,000 Gross plant and equipment $700,000 $475,000 Depreciation $25,000 Less: accum. depreciation $313,000 $288,000 Operating income $228,000 Net plant and equipment $387,000 $187,000 Interest $141,000 Total assets $737,000 $538,990 Income before taxes $87,000 Liabilities Income taxes (27%) $23,490 Accounts payable $116,000 $103,000 Net income $63,510 Notes payable $29,000 $29,000 Total current liabilities $145,000 $132,000 Dividends paid $25,000 Long-term debt $248,000 $152,000 Total liabilities $393,000 $284,000 Common stock ($.01 par) $4,500 $4,000 Paid-in capital $220,500 $170,500 Retained earnings $119,000 $80,490 Total stockholders’ equity $344,000 $254,990 Total liabilities and equity $737,000 $538,990 Using this data, we obtain the following statement of cash flows. Statement of Cash Flows 2010 Operating Activities Net Income $63,510 Depreciation $25,000 Increase in Accounts Receivable -$10,000 Decrease in Inventories $15,000 Increase in Accounts Payable $13,000 CASH FROM OPERATIONS $106,510 Investing Activities Purchase of Fixed Assets $225,000 CASH FROM INVESTMENTS -$225,000 Financing Activities Dividends Paid -$25,000 Issuance of Common Stock $50,500 Issuance of Long-term debt $96,000 CASH FROM FINANCING $121,500 NET CHANGE IN CASH $3,010 11. Challenge Problem. Using the financial statements below for the Global Manufacturing corporation, a. Compute common-size financial statements. Balance sheet 2010 2009 2010 2009 ASSETS Cash 25,000 20,000 5.0% 5.0% Account receivable 100,000 80,000 20.0% 20.0% Inventories 125,000 100,000 25.0% 25.0% Total current assets 250,000 200,000 50.0% 50.0% Gross plant and equipment 300,000 225,000 60.0% 56.3% Less accumulated depreciation -100,000 -75,000 -20.0% -18.8% Net plant and equipment 200,000 150,000 40.0% 37.5% Land 50,000 50,000 10.0% 12.5% Total fixed assets 250,000 200,000 50.0% 50.0% Total assets 500,000 400,000 100.0% 100.0% LIABILITIES AND EQUITY Accounts payable 78,000 65,000 15.6% 16.3% Note payable 34,000 10,000 6.8% 2.5% Accrued liabilities 30,000 25,000 6.0% 6.3% Total current liabilities 142,000 100,000 28.4% 25.0% Long-term debt 140,000 100,000 28.0% 25.0% Total Liabilities 282,000 200,000 56.4% 50.0% Common Stock ($1 par, 50,000 shares) 50,000 50,000 10.0% 12.5% Paid-in capital 100,000 100,000 20.0% 25.0% Retained earnings 68,000 50,000 13.6% 12.5% Total stockholder's equity 218,000 200,000 43.6% 50.0% Total liabilities and equity 500,000 400,000 100.0% 100.0% Put together a statement of cash flows of the firm. Where did the firm invest funds during the year? How did it finance these purchases? Statement of Cash Flows for Global Manufacturing, Inc. Cash Flows from Operating Activities Net income $36,000 Depreciation 25,000 Increase in Accounts Payable 13,000 Increase in Accrued Liabilities 5,000 Increase in Accounts Receivable (20,000) Increase in Inventories (25,000) Net cash provided by operating activities $34,000 Cash Flows from Investing Activities Increase in Plant and Equipment $75,000) Net cash used in investing activities ($75,000) Cash Flows from Financing Activities Increase in Notes Payable $24,000 Increase in Long-term Debt 40,000 Dividend payment (18,000) Net cash provided by financing activities $46,000 Net increase in Cash and Marketable Securities $ 5,000 The firm primarily invested funds in plant and equipment and current assets such as accounts receivable and inventories. These investments were financed by the firm’s profits, increases in short-term financing (accounts payable, notes payable) and increases in long-term debt. 12. Compare and contrast the two common-size balance sheets below. Which one do you think may belong to an auto manufacturer? To a computer manufacturer? Common Size Balance Sheets Assets Firm A Firm B Cash 26.7% 10.6% Accounts receivable 18.8% 0.9% Inventory 1.7% 2.9% Other current assets 7.9% 5.0% Total current assets 55.1% 19.4% Net plant and equipment 7.9% 13.3% Other long-term assets 37.1% 67.3% Total assets 100.0% 100.0% Liabilities Accounts payable 37.9% 6.5% Notes payable 0.0% 0.6% Other current liabilities 18.5% 19.0% Total current liabilities 56.4% 26.0% Long-term debt 2.6% 56.3% Other liabilities 8.4% 13.9% Total liabilities 67.5% 96.3% Common equity 0.8% 1.0% Retained earnings 31.7% 2.7% Total stockholders’ equity 32.5% 3.7% Total liabilities and equity 100.0% 100.0% Common Size Balance Sheets Dell Ford Assets Firm A Firm B Cash 26.7% 10.6% Accounts receivable 18.8% 0.9% Inventory 1.7% 2.9% Other current assets 7.9% 5.0% Total current assets 55.1% 19.4% Firm A has large CA due to cash/AR position Net plant and equipment 7.9% 13.3% Firm B has larger stock of plant and other LT assets Other long-term assets 37.1% 67.3% Total assets 100.0% 100.0% Liabilities Accounts payable 37.9% 6.5% Firm A has large relative AP balance, always buying from suppliers Notes payable 0.0% 0.6% Other current liabilities 18.5% 19.0% Total current liabilities 56.4% 26.0% Long-term debt 2.6% 56.3% Other liabilities 8.4% 13.9% Total liabilities 67.5% 96.3% Firm B has larger debt load, much of it long term Common equity 0.8% 1.0% Retained earnings 31.7% 2.7% Total stockholders’ equity 32.5% 3.7% Firm A uses relatively more equity financing Total liabilities and equity 100.0% 100.0% Firm B is the car manufacturer; clues include its larger stock of long-term assets and heavy debt load which is characteristic of a firm with much fixed assets. This problem uses actual data from a computer manufacturer (Dell, Firm A) and an auto manufacturer (Ford, Firm B). 13. Compare and contrast the two common-size balance sheets below. Which one do you think may belong to a supermarket? To a jeweler? Common Size Balance Sheets Assets Firm A Firm B Cash 5.3% 2.7% Accounts receivable 4.1% 0.0% Inventory 37.5% 61.7% Other current assets 5.9% 4.1% Total current assets 52.8% 68.5% Net plant and equipment 35.1% 20.6% Other long-term assets 12.4% 11.0% Total assets 100.0% 100.0% Liabilities Accounts payable 19.6% 23.8% Notes payable 0.1% 0.0% Other current liabilities 16.8% 3.6% Total current liabilities 36.5% 27.4% Long-term debt 11.9% 14.2% Other liabilities 14.7% 8.0% Total liabilities 63.1% 49.6% Common equity 4.9% 4.9% Retained earnings 32.0% 45.5% Total stockholders’ equity 36.9% 50.4% Total liabilities and equity 100.0% 100.0% Common Size Balance Sheets Assets Firm A Firm B Cash 5.3% 2.7% Accounts receivable 4.1% 0.0% Firm B has no receivables (all are sold to factors, see chapter 16) Inventory 37.5% 61.7% Firm B has larger inventory Other current assets 5.9% 4.1% Total current assets 52.8% 68.5% Net plant and equipment 35.1% 20.6% Firm A has more fixed assets--owns its stores Other long-term assets 12.4% 11.0% Total assets 100.0% 100.0% Liabilities Accounts payable 19.6% 23.8% Notes payable 0.1% 0.0% Other current liabilities 16.8% 3.6% Total current liabilities 36.5% 27.4% Firm A has more current liabilities--frequent restocking of shelves Long-term debt 11.9% 14.2% Other liabilities 14.7% 8.0% Total liabilities 63.1% 49.6% Firm A's steady cash flow allows it to support more debt Common equity 4.9% 4.9% Retained earnings 32.0% 45.5% Total stockholders’ equity 36.9% 50.4% Total liabilities and equity 100.0% 100.0% Firm A is the supermarket; clues include its liability structure (more current liabilities and more debt). Firm B is the jeweler; clues include its large inventory of expensive jewelry. As jewelry can fluctuate in value, relatively more equity financing is needed. This problem uses actual data from a supermarket (Winn-Dixie, Firm A) and a jeweler (Zales, Firm B). 14. Challenge Problem. Using the financial statements in the text: a. Compute common-size financial statements. Balance Sheet 2010 2009 2008 2007 2006 Cash & Cash Equivalents 0.2% 0.2% 2.4% 2.9% 1.7% Accounts Receivable 9.0% 8.7% 8.2% 7.6% 8.9% Inventories 39.4% 39.8% 41.7% 41.4% 41.2% Other Current Assets 1.1% 1.3% 2.2% 1.6% 3.4% Net Fixed Assets 49.2% 48.3% 43.9% 43.7% 41.7% Other Long Term Assets 1.1% 1.8% 1.5% 2.8% 3.0% TOTAL ASSETS 100.0% 100.0% 100.0% 100.0% 100.0% Accounts Payable 17.5% 19.2% 19.1% 18.5% 19.3% Short Term Debt 5.0% 0.0% 0.0% 0.0% 0.0% Other Current Liabilities 11.6% 13.2% 13.4% 13.7% 14.9% Long Term Debt 0.0% 0.0% 0.0% 0.0% 0.0% Other Liabilities 7.0% 8.0% 8.4% 9.6% 9.4% TOTAL LIABILITIES 41.1% 40.4% 41.0% 41.9% 43.6% Preferred Equity 0.0% 0.0% 0.0% 0.0% 0.0% Common Equity 7.7% 6.3% 5.7% 4.0% 2.5% Retained Earnings 51.3% 53.3% 53.3% 54.1% 53.9% STOCKHOLDERS' EQUITY 58.9% 59.6% 59.0% 58.1% 56.4% TOTAL LIAB. & EQUITY 100.0% 100.0% 100.0% 100.0% 100.0% Income Statement 2010 2009 2008 2007 2006 Revenue 100.0% 100.0% 100.0% 100.0% 100.0% Cost of Goods Sold 72.2% 71.8% 71.6% 71.5% 71.2% Selling, Gen'l & Admin. 21.0% 21.3% 21.6% 21.8% 22.2% Depreciation & Amort. 1.1% 1.1% 1.2% 1.2% 1.2% R&D 0.0% 0.0% 0.0% 0.0% 0.0% OPERATING INCOME 5.7% 5.8% 5.7% 5.5% 5.3% Interest Expense 0.0% 0.0% 0.0% 0.0% 0.0% Other Expenses (Income) -0.1% -0.2% -0.1% -0.3% 0.0% INCOME BEFORE TAXES 5.8% 6.0% 5.8% 5.7% 5.3% Income Taxes 2.2% 2.3% 2.3% 2.2% 2.1% INCOME AFTER TAXES 3.6% 3.7% 3.5% 3.5% 3.3% b. Compute year-to-year percentage changes in the various accounts. Balance Sheet 2010 2009 2008 2007 Cash & Cash Equivalents 32.0% -91.0% -1.5% 97.3% Accounts Receivable 29.9% 26.3% 30.4% -0.8% Inventories 23.0% 15.0% 21.5% 17.0% Other Current Assets 4.7% -29.7% 65.6% -45.1% Net Fixed Assets 26.8% 32.2% 21.0% 22.2% Other Long Term Assets -24.6% 37.7% -32.5% 6.3% TOTAL ASSETS 24.4% 20.3% 20.5% 16.5% Accounts Payable 13.4% 20.7% 24.6% 11.6% Short Term Debt undefined 0.0% 0.0% 0.0% Other Current Liabilities 9.0% 18.4% 17.9% 7.5% Long Term Debt 0.0% 0.0% 0.0% 0.0% Other Liabilities 8.7% 13.5% 5.4% 19.7% TOTAL LIABILITIES 26.4% 18.5% 18.0% 11.9% Preferred Equity 0.0% 0.0% 0.0% 0.0% Common Equity 51.6% 32.3% 72.1% 83.2% Retained Earnings 19.6% 20.4% 18.6% 17.1% STOCKHOLDERS' EQUITY 23.0% 21.5% 22.3% 20.1% TOTAL LIAB. & EQUITY 24.4% 20.3% 20.5% 16.5% Income Statement 2006 2009 2008 2007 Revenue 16.1% 18.9% 16.5% 14.5% Cost of Goods Sold 16.7% 19.3% 16.6% 15.1% Selling, Gen'l & Admin. 14.6% 17.5% 15.4% 12.1% Depreciation & Amort. 17.0% 9.5% 11.2% 15.2% R&D 0.0% 0.0% 0.0% 0.0% OPERATING INCOME 14.2% 20.6% 21.6% 17.9% Interest Expense 675.0% 0.0% -60.0% -50.0% Other Expenses (Income) -30.6% 222.0% -71.4% 616.7% INCOME BEFORE TAXES 12.6% 23.0% 17.1% 23.2% Income Taxes 10.4% 20.6% 18.6% 23.2% INCOME AFTER TAXES 14.0% 24.5% 16.2% 23.2% EPS (as reported) 13.2% 22.6% 14.8% 22.7% c. What insights about the firm can you obtain from this analysis? In examining the common-size financials, look for items with trends or for years with percentages that are higher or lower than usual. For example, the cash balance is trending downward, comprising a lesser percentage of total assets than in past years. Accounts receivable is fairly steady over time as in inventory. Net Fixed Assets rose markedly in 2009. As far as liabilities and equity are concerned, they show fairly consistent results. Although short-term debt did rise in 2010, that rise is balanced by reductions in accounts payable and other current liabilities. The firm has enjoyed some growth in the common equity account, too. The income statement also shows year-to-year consistency. In examining the year-to-year growth rates, focus on areas that differ from sales growth. Net-fixed assets has grown faster than sales, perhaps because of continued growth in opening new stores. Accounts receivable and inventory have risen faster than sales. Accounts payable has risen faster than sales, as has the firm’s equity. Cost of goods sold is rising along with sales and increases in SGA expense have been balanced with reductions in depreciation expenses. SUGGESTED QUIZ 1. The goal of a firm should be to maximize shareholder wealth. How should decisions be made in a nonprofit or private firm? 2. Define or discuss briefly: a. Limited partnership b. Subchapter S corporation c. Limited liability company d. Agents 3. What is the accounting identity? Why is depreciation expense important from a cash perspective? Learning Extension 13 Federal Income Taxation I. FEDERAL INCOME TAXATION The tax tables show our tax system is progressive. Knowing average tax rates is useful for quick calculations of the impact of expected increases in pretax income on net income. Financial decisions, however, should be made using marginal tax rates. (Use Learning Extension Discussion Questions 1 and 2 here.) II. DEPRECIATION BASICS Most firms choose the fastest depreciation method allowed by law; thus, many will use the Modified Accelerated Cost Recovery System (MACRS). The desire to depreciate as quickly as possible is because of the depreciation tax shield. As the example in the text shows, depreciation, as a noncash expense, reduces cash outflows by reducing taxes. A larger depreciation expense will lead to lower earnings but, all else constant, higher cash flow. This is good, since it is cash that pays bills, not earnings. (Use Learning Extension Discussion Question 3 here.) QUESTIONS AND PROBLEMS 1. Why is it said that the personal-income-tax rate in the United States is progressive? The higher the income, the larger the percentage of income that must be paid in taxes. 2. Corporate tax rates vary with the amount of taxable income. What currently is the range (lowest and highest) of corporate tax rates in the United States? The marginal tax rate is 15% for corporations earning between $1 and $50,000; it is 39% for corporations earning between $100,001 and $335,000. 3. What is meant by the statement that depreciation provides a tax shield? Explain how this works. Depreciation is deducted from taxable income as an expense; yet, no cash outflow arises from depreciation. The depreciation deduction reduces taxable income with no cash outflow, so it is called a tax shield. 4. Determine the marginal and average tax rates under the tax law for corporations with the following amounts of taxable income: a. $60,000 Income = $60,000 Marginal tax rate = 25% Total tax = .15($50,000) + .25($10,000) = $10,000 Average tax rate = $10,000/$60,000 = 16.7% b. $150,000 Income = $150,00 Marginal tax rate = 39% Total tax = .15($50,000) + .25($25,000) + .34($25,000) + .39($50,000) = $41,750 Average tax rate = $41,750/$150,000 = 27.8% c. $500,000 Income = $500,000 Marginal tax rate = 34% Total tax = .15 ($50,000) + .25($25,000) + .34($25,000) + .39($235,000) + .34($165,000) = $170,000 Average tax rate = $170,000/$500,000 = .34 5. What would the tax obligation be for a corporation with pretax earnings as shown below. What would be the personal tax obligation of a person filing her taxes under the “single” filing status if she had the above pretax income levels? (Note: Answers below use the 2010 tax schedules presented in the text.) a. $60,000 Income = $60,000 Corporate tax = .15($50,000) + .25($10,000) = $7,500 + $2,500 = $10,000 Single person tax = .10($8,375) + .15($34,000 - $8,375) + .25($60,000 - $34,000) = $837.50 + $3,843.75 + $6500.00 = $11,181.25 b. $150,000 Income = $150,000 Corporate tax = .15($50,000) + .25($25,000) + .34($25,000) + .39($50,000) = $41,750 Single person tax = .10($8,375) + .15($34,000 – $8,375) + .25($82,400-$34,000) + .28($150,000-$82,400) = $837.50 + $3,843.75 + $12,100.00 + $18,928.00 = $35,709.25 c. $500,000 Income = $500,000 Corporate tax = .15($50,000) + .25($25,000) + .34($25,000) + .39($235,000) + .34($165,000) = $170,000 Single person tax = 10($8,375) + .15($34,000 – $8,375) + .25($82,400- $34,000) + .28($171,850 - $82,400) + .33($373,650 – $171,850) + .35($500,000 – $373,650) = $837.50 + $3,843.75 + $12,100.00 + $25,046.00 + $66,594.00 + 44,222.50 = $152,643.75 6. Find the annual depreciation expenses for the following items: a. Original cost is $35,000 for an asset in the three-year class. Year 1 .3333 × $35,000 = $ 11,665.50 Year 2 .4445 × $35,000 = 15,557.50 Year 3 .1481 × $35,000 = 5,183.50 Year 4 .0741 × $35,000 = 2,593.50 Total depreciation expense = $ 35,000.00 b. Original cost is $70,000 for an asset in the five-year class. Year 1 .20 × $70,000 = $ 14,000 Year 2 .32 × $70,000 = 22,400 Year 3 .192 × $70,000 = 13,440 Year 4 .1152 × $70,000 = 8,064 Year 5 .1152 × $70,000 = 8,064 Year 6 .0576 × $70,000 = 4,032 Total depreciation expense = $ 70,000 7. Assume a corporation earns $75,000 in pretax income. Determine the firm’s income tax liability. Corporate taxes to be paid = .15($50,000) + .25($25,000) = $13,750 Calculate the firm’s average income tax rate. Average tax rate = tax paid/income = $13,750/$75,000 = 18.33% Assume that a corporation purchases a new piece of equipment for $90,000. The equipment qualifies for a three-year class life for depreciation purposes. What is the dollar amount of depreciation that can be taken in the first year? $90,000 x .3333 = $29,997 Determine the depreciation for the remaining years. Year 2: $90,000 x .4445 = $40,005 Year 3: $90,000 x .1481 = $13,329 Year 4: $90,000 x .0741 = $6,669 Total depr. expense = $90,000 Chapter 14 Financial Analysis and Long-Term Financial Planning CHAPTER PREVIEW Chapter 13 introduced and reviewed the basic financial statements of the firm. Here, in Chapter 14, we see how to analyze them. The techniques discussed here will be used both by the firm’s own analysts (as they study their own firm and its competitors) as well as by outside evaluators, such as stock and bond investors, competitors, bond rating agencies, and lenders such as banks. Financial ratio analysis examines historical data to pinpoint a firm’s strengths and weaknesses. Financial planning uses historical and expected financial ratios and financial statement relationships to estimate a firm’s future asset and financing needs as well as future earnings levels. LEARNING OBJECTIVES Describe what is meant by financial statement analysis. Describe the five basic types of financial ratios. Indicate what is meant by Du Pont analysis and indicate its major components. Explain the importance of the quality of financial statements. Describe the link between asset investment requirements and sales growth. Describe how internally generated financing occurs. Describe how additional external financing requirements are determined. Describe the cost-volume-profit analysis concept. CHAPTER OUTLINE FINANCIAL STATEMENT ANALYSIS RATIO ANALYSIS OF BALANCE SHEET AND INCOME STATEMENT TYPES OF FINANCIAL RATIOS Liquidity Ratios and Analysis Asset Management Ratios and Analysis Financial Leverage Ratios and Analysis D. Profitability Ratios and Analysis E. Market Value Ratios and Analysis F. Summary of Ratio Analysis for Walgreens DU PONT METHOD OF RATIO ANALYSIS LONG-TERM FINANCIAL PLANNING PERCENTAGE OF SALES TECHNIQUE Asset Investment Requirements Internally Generated Financing External Financing Requirements B. Cost-Volume-Profit Analysis C. Degree of Operating Leverage VI. SUMMARY LECTURE NOTES I. FINANCIAL STATEMENT ANALYSIS Financial statement analysis can be used to identify a firm’s strengths and weaknesses. It is also used to help forecast future period’s financial statements and financing needs. Not only do the firm’s managers analyze financial statements, so do potential and current creditor and equity holders. (Use Discussion Question 1 here.) II. RATIO ANALYSIS OF BALANCE SHEET AND INCOME STATEMENT Ratios can be analyzed using: 1. Trend or time-series analysis 2. Cross-sectional analysis 3. Industry comparative analysis Financial statement analysis is assisted by information contained in the firm’s annual report and SEC filings (10-K and 10-Q reports). Industry average data are available from a number of sources. Because of firms’ multiple lines of business and different accounting standards, comparing a firm’s ratios with those of another firm or an industry average may be difficult. Which ratios are most important depends upon the perspective of the analysts; for example, short-term creditors will be most interested in a firm’s liquidity ratios. Bondholders will be interested in the firm’s cash flows and long-term debt ratios. Stockholders will be interested in profitability ratios. (Use Discussion Question 2 here.) III. TYPES OF FINANCIAL RATIOS We examine the following five groups of financial ratios: 1. Liquidity ratios. Liquidity ratios indicate the ability of a firm to meet its short-term obligations as they come due. Ratios: current ratio, quick ratio, average payment period 2. Asset management ratios. Asset management ratios show the efficiency of operations by indicating the dollars of sales supported by different types of assets. Ratios: total assets turnover, fixed assets turnover, average collection period, inventory turnover 3. Financial leverage ratios. Financial leverage ratios are used to show the level of debt used to finance assets and the ability of the firm to service its debt obligations. Ratios: total debt to total assets, total debt to equity, equity multiplier, interest coverage ratio, fixed charge coverage ratio 4. Profitability ratios. Profitability ratios indicate the ability of the firm to earn returns on its sales, assets, and equity. Ratios: operating profit margin, net profit margin, operating return on assets, return on total assets, return on equity 5. Market value ratios. Market value ratios show the value of a firm in the market place relative to financial statement values. Ratios: price/earnings ratio, price-to-book-value ratio The “quality” of a firm’s balance sheet and income statement is an important consideration to a financial analyst. All else being the same, a firm with higher quality financial statements will have higher market value ratios. SUMMARY OF RATIO ANALYSIS FOR WALGREENS This section reviews the ratio analysis for Walgreens. The graphs presented in the text are a useful tool for visualizing trends and making easy comparisons between a firm’s ratios and a benchmark, be it another firm or industry average. (Use Discussion Questions 3 through 9 here.) IV. DU PONT METHOD OF RATIO ANALYSIS Return on assets is decomposed into the product of the profit margin and total asset turnover. Return on equity can be broken down into the product of the profit margin, total assets turnover, and the equity multiplier. Du Pont analysis assists analysts in discovering why ROA and ROE vary over time or among firms or firms and industry averages. The components of ROA and ROE in Du Pont analysis can themselves be disaggregated into their basic balance sheet and income statement components, as shown in Figure 12.6 in the text. (Use Discussion Questions 10 and 11 here.) V. LONG-TERM FINANCIAL PLANNING This section discusses how ratios and financial statement relationships can be used to forecast earnings and future levels of assets and financing needs. The percentage of sales technique uses a sales forecast and relationships between sales and balance sheet accounts to estimate asset growth, additions to retained earnings, and outside financing needs. Cost-volume-profit analysis or its variation, break-even analysis, relates quantity sales forecasts to profit expectations. The degree of operating leverage relates changes in sales to changes in operating income. (Use Discussion Questions 12 through 19 here.) DISCUSSION QUESTIONS AND ANSWERS 1. List some reasons why financial statement analysis is conducted. Identify some of the participants that analyze firms’ financial statements. Financial statements are analyzed to determine a firm’s future earnings and its risks. Suppliers, banks, bondholders, equity holders, and potential investors examine ratios. 2. What is ratio analysis? Also briefly describe the three basic categories or ways that ratio analysis is used. Ratio analysis involves dividing various financial statement numbers into one another. Ratios can be used in trend analysis, in which values of a ratio are examined over time; cross-sectional analysis, in which different firms are compared to each other; and industry comparative analysis, in which a firm’s ratios are compared to industry averages. 3. Identify the types of ratios that are used to analyze a firm’s financial performance based on its income statements and balance sheets. We examined the following ratio categories: liquidity, asset management, financial leverage, profitability, and market value. 4. Which type or category of ratios relates stock market information to financial statement items? The market value ratios relate stock market information to financial statement items. 5. What do liquidity ratios indicate? Identify some basic liquidity ratios. Liquidity ratios indicate the ability of a firm to meet its short-term obligations as they come due. Ratios include current ratio, quick ratio, and the average payment period. 6. What do asset management ratios indicate? Identify some basic asset management ratios. Asset management ratios show the efficiency of operations by indicating the dollars of sales supported by different types of assets. Ratios include total assets turnover, fixed assets turnover, average collection period, and inventory turnover. 7. What do financial leverage ratios indicate? Identify some measures of financial leverage. Financial leverage ratios are used to show the level of debt used to finance assets and the ability of the firm to service its debt obligations. Ratios include total debt to total assets, total debt to equity, equity multiplier, interest coverage ratio, fixed charge coverage ratio. 8. What do profitability ratios indicate? Identify some measures of profitability. Profitability ratios indicate the ability of the firm to earn returns on its sales, assets, and equity. Ratios include operating profit margin, net profit margin, operating return on assets, return on total assets, and return on equity. 9. What do market value ratios indicate? Identify some market value ratios. Market value ratios show the value of a firm in the market place relative to financial statement values. Ratios include price/earnings ratio and price-to-book-value ratio. 10. Describe the Du Pont method or system of ratio analysis. What are the two major components of the system? The Du Pont method breaks ROA into the product of two components: profit margin and total assets turnover. (ROE can also be broken into ROA and the equity multiplier). It shows how a firm can generate profits: via profitability or turnover (or, in the case of ROE, by increasing financial leverage). 11. How is the Du Pont system related to both the balance sheet and the income statement? Du Pont analysis relates to both the balance sheet and income statement, as ROA and ROE are ratios using components from both. 12. How is the process of financial planning used to estimate asset investment requirements? A sales forecast, combined with the total asset turnover ratio, is used to estimate future total assets. The difference between the present level of total assets and the estimated future level is the amount of assets to be acquired and financed. 13. Explain how internally generated funds are used to reduce the need for external financing to fund asset investments. Internally-generated funds are the additions to retained earnings, that is, the year’s net income that remains after dividends are distributed. These funds help finance the change in assets; as such they reduce the need for outside financing. 14. Explain how financial planning is used to determine a firm’s external financing requirements. A sales forecast is used to estimate next year’s assets using the total asset turnover ratio. The difference between the present level of assets and the forecast is the expected amount of assets to be acquired and financed. To determine external financing needs, the amount of the expected increase in retained earnings (forecasted net income less dividends) is subtracted from the expected change in assets. Next, the spontaneous increase in current liabilities is deducted (this is determined based upon their expected percentage relationship to sales). The remaining difference is the forecasted external financing need. 15. What is cost-volume-profit analysis? How can it be used by a firm? Cost-volume-profit analysis is used by managers to estimate operating income at different levels of unit sales. Operating income, or earnings before interest and taxes, is estimated as sales revenue (price times quantity sold) less variable costs (variable cost per unit times quantity sold) less fixed costs. 16. What is the purpose of knowing the break-even point? It tells management how many units of product must be sold so a loss does not occur. 17. What will happen to the break-even point if the contribution margin rises (falls)? The contribution margin is the portion of each unit sold that goes toward paying fixed costs. As the contribution margin rises, less product must be sold to cover fixed costs, so the break-even point falls. As the contribution margin falls, more products must be sold to cover fixed costs, so the break-even point rises. Thus, there is an inverse relationship between the break-even point and the contribution margin. 18. What does a firm’s degree of operating leverage (DOL) indicate? DOL measures the sensitivity of operating income (EBIT) to changes in unit sales. 19. Describe what would happen to the DOL if all costs are fixed? Variable? If all costs are fixed, any increase in sales above the break-even point immediately increases EBIT by a similar amount. If a firm’s costs are all variable, the firm’s DOL will equal one and there will be no leverage effect of a change in sales on operating profit. The greater (lower) the firm’s fixed costs relative to its variable costs, the greater (lower) will be the DOL. PROBLEMS AND ANSWERS The Robinson Company has current assets and current liabilities for the two years listed in the text. a. Compare the current ratios between the two years. 2011: $700,000/$350,000 = 2.0 2012: $900,000/$600,000 = 1.5 Liquidity as measured by the current ratio, fell in 2012. b. Compare the acid-test ratios between 2011 and 2012. Comment on your findings. 2011: ($700,000 – $350,000)/$350,000 = 1.0 2012: ($900,000 – $500,000)/$600,000 = .67 Liquidity, as measured by the acid-test ratio, fell in 2012. The Robinson Company had a cost of goods sold of $1,000,000 in 2011 and $1,200,000 in 2012. a. Calculate the inventory turnover for each year. Comment on your findings. 2011: $1,000,000/$350,000 = 2.86 2012: $1,200,000/$500,000 = 2.40 Inventory grew faster than cost of goods sold between 2011 and 2012. What would have been the amount of inventories in 2012 if the 2011 turnover ratio had been maintained? Inventory turnover = COGS/Inventory = 2.86 = $1,200,000/Inventory Inventory = $1,200,000/2.86 = $419,580 3. The Dayco Manufacturing Company had the following financial statement results for last year. Net sales were $1.2 million with net income of $90,000. Total assets at year end amounted to $900,000. a. Calculate Dayco’s asset turnover ratio and its profit margin. Total asset turnover = Sales/TA = 1,200,000/$900,000 = 1.333 Profit margin = Net income/Sales = $90,000/$1,200,000 = 0.075 or 7.5% b. Show how the two ratios in Part a can be used to determine Dayco’s rate of return on assets. ROA = Profit margin × Total asset turnover = 7.5% × 1.333 = 10.00% ROA = Net income/Total assets = $90,000/$900,000 = 0.10 or 10% c. Dayco operates in an industry whose industry ratios are these: Return on assets: 9%; Asset turnover: 2.5 times; Net profit margin: 3.6%. Compare Dayco’s performance against the industry averages. Dayco had a higher profit margin, but a lower asset turnover. The net result on ROA was that Dayco’s return on assets was slightly above that of the industry. 4. Next year, Allgreens expects its sales to reach $33,000 with an investment in total assets of $10,750. Net income of $1,225 is anticipated. This year, sales were $30,000, total assets were $9,900, and net income was $1,000. Last year, these figures were $28,000, $9,000, and $750 respectively. a. Use the Du Pont system to compare Allgreens’ anticipated performance against its prior year results. Comment on your findings. Using the data presented we can compute the net profit margin, total asset turnover, and multiply them together to determine ROA: Last Year This Year Next Year Sales $28,000 $30,000 $33,000 Total Assets 9,000 9,900 10,750 Net Income 750 1,000 1,225 The resulting ratios are: Last Year This Year Next Year Net Profit Margin $750/$28,000 = 2.68% $1.000/$30,000= 3.33% $1,225/$33,000=3.71% Total Asset Turnover 28,000/9,000 = 3.11 30,000/9,900 = 3.03 33,000/10,750 = 3.07 ROA 8.33% 10.09% 11.39% b. How would Allgreens compare with the industry if it operates in the same industry as Dayco (see Problem 3) and if the industry average ratios remain the same over time? Expectations of Allgreens’ above-industry-average asset efficiency next year, along with a slightly higher-than-industry-average net profit margin will result in an above-average ROA. 5. Selected financial data in thousands of dollars for the Hunter Corporation are listed in the text. a. Calculate Hunter’s rate of return on total assets in 2012 and in 2011. Did the ratio improve or worsen? 2011: $100/$1,000 = 0.10 or 10% 2012: $110/$1,200 = 9.17% ROA fell in 2012. b. Diagram the expanded Du Pont system for Hunter for 2012. Insert the appropriate dollar amounts wherever possible. c. Use the Du Pont system to calculate the return on assets for the two years, and determine why they changed. Profit margin × Asset turnover = ROA 2011: 8.33% × 1.20 = 10.0% 2012: 7.33% × 1.25 = 9.17% Asset efficiency rose in 2012, but ROA fell because of a lower profit margin. The profit margin fell as expenses rose over 26% while sales rose 25%. The asset turnover rose as sales rose 25% and assets rose only 20%. 6. Financial statements for the Genatron Manufacturing Corporation for 2012 and 2011 are shown in the text. a. Apply Du Pont analysis to both the 2012 and 2011 financial statements’ data. Net income × Sales × Total assets = ROE Sales Total assets Equity $93,000 × $1,300,000 × $1,000,000 = ROE 2011 $1,300,000 $1,000,000 $430,000 7.15% × 1.30 × 2.33 = 21.66% $114,000 × $1,500,000 × $1,200,000 = ROE 2012 $1,500,000 $1,200,000 $470,000 7.60% × 1.25 × 2.55 = 24.23% b. Explain how financial performance differed between 2012 and 2011. 2012’s ROE rose because of a rising profit margin and a greater use of debt. 7. This problem uses the financial statements for the Genatron Manufacturing Corporation for the years 2012 and 2011 from Problem 6. a. Calculate Genatron’s dollar amount of net working capital in each year. Net working capital = Current assets – Current liabilities 2012: $800,000 – $330,000 = $470,000 2011: $700,000 – $270,000 = $430,000 b. Calculate the current ratio and the acid-test ratio in each year. Current ratio = Assets/Current liabilities 2012: $800,000/$330,000 = 2.42 2011: $700,000/$270,000 = 2.59 Acid-test ratio = (CA – Inventory)/CL 2012: ($800,000 – $500,000)/$330,000 = 0.91 2011: ($700,000 – $450,000)/$270,000 = 0.93 c. Calculate the average collection period and the inventory-turnover ratio in each year. Average collection period = AR/(Sales/365) 2012: $260,000/($1,500,000/365) = 63.3 days 2011: $200,000/($1,300,000/365) = 56.2 days Inventory turnover = COGS/Inventory 2012: $900,000/$500,000 = 1.80 2011: $780,000/$450,000 = 1.73 d. What changes in the management of Genatron’s current assets seem to have occurred between the two years? Although the dollar amount of net working capital rose in 2012, both the current ratio and acid-test ratios fell, indicating that current liabilities rose faster than current assets. Genatron’s apparently healthy current ratios are greatly reduced once inventories are removed (acid-test ratio). Accounts receivable rose, in part because of higher 2012 sales and in part because of customers’ slower payments. On the bright side, inventory management apparently improved as inventory turnover rose in 2012. 8. Genatron Manufacturing expects its sales to increase by 10 percent in 2013. Estimate the firm’s external financing needs by using the percent-of-sales method for the 2012 data. Assume that no excess capacity exists and that one-half of the 2012 net income will be retained in the business. 2013 forecasted sales: $1,500,000(1.10) = $1,650,000 Change in sales: $1,650,000 – $1,500,000 = $150,000 EFN = (TA/NS)( NS) – [(AP + AC)/NS) – (NS07)(NPM)(RR) where: TA = total assets NS = net sales NS = change in net sales AP = accounts payable AC = accruals NS13 = next year’s 2013 forecasted sales NPM = net profit margin (net income/net sales) RR = percent of net income retained in firm EFN = ($1,200,000/$1,500,000)($150,000) – [($170,000 + $70,000)/$1,500,000]($150,000) – ($1,650,000)($114,000/$1,500,000)(.50) = .80($150,000) – .16($150,000) – $1,650,000(.076)(.50) = $120,000 – $24,000 – $62,700 = $33,300 9. Rework Problem 8 assuming that Genatron Manufacturing expects its sales to increase by 20 percent in 2013. What is the amount of external financing needed? 2013 forecasted sales: $1,500,000(1.20) = $1,800,000 Change in sales: $1,800,000 – $1,500,000 = $300,000 EFN = (TA/NS)( NS) – [(AP + AC)/NS) – (NS07)(NPM)(RR) where:TA = total assets NS = net sales NS = change in net sales AP = accounts payable AC = accruals NS13 = next year’s 2013 forecasted sales NPM = net profit margin (net income/net sales) RR = percent of net income retained in firm EFN = ($1,200,000/$1,500,000)($300,000) – [($170,000 + $70,000)/$1,500,000]($300,000) – ($1,800,000)($114,000/$1,500,000)(.50) = .80($300,000) – .16($300,000) – $1,800,000(.076)(.50) = $240,000 – $48,000 – $68,400 = $123,600 10. Genatron wants to estimate what will happen to its income before interest and taxes if its net sales change from the 2012 level of $1,500,000. Refer to Genatron’s 2012 income statement, shown in Problem 6, where the income before interest and taxes is $247,000 (EBT of $190,000 plus Interest of $57,000). Assume that the costs of goods sold are variable expenses and that the other operating expenses are fixed. a. Calculate the expected amount of income before interest and taxes for both a 10 percent decrease and a 10 percent increase in net sales for next year. Percent Change Current – 10% + 10% Net sales $ 1,500,000 $ 1,350,000 $ 1,650,000 Cost of goods sold (Var. exp., $900,000/$1,500,000 = 60%) – 900,000 – 810,000 – 990,000 Gross profit $ 600,000 $ 540,000 $ 660,000 General & administrative – 150,000 – 150,000 – 150,000 Marketing – 150,000 – 150,000 – 150,000 Depreciation – 53,000 – 53,000 – 53,000 Income before interest & taxes $ 247,000 $ 187,000 $ 307,000 b. Determine the percentage change in income before interest and taxes given your calculations in Part a, and determine the degree of operating leverage. Percent change in operating income = (247,000 – 187,000)/247,000 = 24.3% Degree of operating leverage: 24.3%/10% = 2.43 11. Challenge Problem. Using the information in Tables 14.1 and 14.2, compute the financial ratios we discussed in this chapter for Walgreens using the 2007 and 2006 data. 2006 2007 Current ratio 1.69 1.41 Quick Ratio 0.59 0.37 Average Payment Period 43.79 36.01 Total Asset Turnover 2.77 2.78 Fixed Asset Turnover 6.82 6.56 Average Collection Period 15.88 15.18 Inventory Turnover 5.56 5.57 Total Debt to Total Assets 0.41 0.43 Equity Multiplier 1.69 1.74 Interest Coverage not defined not defined Operating Profit Margin 0.06 0.06 Net Profit Margin 0.04 0.04 Operating Return on Assets 0.16 0.16 Return on Assets 0.10 0.11 Return on Equity 0.17 0.18 12. Challenge Problem. Below are financial statements for Global Manufacturing. After computing the ratios we discussed in this chapter, discuss strong and weak points of Global’s performance. Ratio 2012 2011 2010 Current ratio 1.8 2.0 1.63 Quick ratio 0.9 1.0 0.77 Average payment period 63.3 63.3 62.6 Total asset turnover 1.4 1.5 1.5 Fixed asset turnover 2.8 3.0 2.7 Average collection period 52.1 48.7 37.9 Inventory turnover 3.6 3.75 4.2 Total Debt to Total Assets 56.4% 50.0% 46.6% Total Debt to Equity 1.3 1.0 0.87 Equity Multiplier 2.3 2.0 1.87 Interest Coverage 5.3 6.0 6.4 Operating Profit Margin 10.6% 10.0% 8.7% Net Profit Margin 5.1% 5.0% 4.4% Operating Return on Assets 14.8% 15.0% 13.4% Return on Assets 7.2% 7.5% 6.8% Return on Equity 16.5% 15.0% 12.8 The liquidity ratios show recent declines in liquidity although they have improved since 2010. Its asset efficiency ratios show a decline and a marked increase in Global’s collection period. Global’s debt ratios are increasing and may be high, although a comparison versus the industry averages will be needed. Its profitability ratios have generally improved over the three years. 13. Following are the consolidated financial statements for Global Manufacturing’s industry. Use Du Pont analysis on the industry financial statements to determine why industry return on equity changed from year to year. Net income × Sales × Total assets = ROE Sales Total assets Equity $66,000 × $1,100,000 × $440,000 = ROE 2012 $1,100,000 $440,000 $300,000 6% × 2.50 × 1.47 = 22.05% $48,000 × $1,000,000 × $400,000 = ROE 2011 $1,000,0000 $400,000 $280,000 4.80% × 2.50 × 1.43 = 17.16% $30,000 × $900,000 × $360,000 = ROE 2010 $900,000 $360,000 $250,000 3.33% × 2.50 × 1.44 = 12.00% 2011’s rise in ROE was due mainly to higher profitability. 2012’s increase in ROE was again mainly due to increased profitability accompanied by a slight increase in leverage. 14. Compare the reasons for the changes in return on equity for Global Manufacturing and its industry. The industry ROE increase occurred primarily because of increased profitability. Changes in Global’s ROE were primarily due to increased leverage and secondarily due to higher profitability. Unlike the industry, which had constant total asset turnover, Global suffered from a slight decline in asset efficiency during this time. The ratios for Global follow (equality may not hold because of rounding): Year Net profit margin x asset turnover x equity multiplier = ROE 2012 5.1% 1.4 2.3 16.5 2011 5.0 1.5 2.0 15.0 2010 4.4 1.5 1.87 12.8 15. Challenge Problem. Compute the financial ratios for Global Manufacturing’s industry. Using Global’s ratios from problem 12, graph the firm’s and industry ratios as we’ve done in this chapter. Analyze Global’s performance in comparison to its industry. Ratio 2012 2011 2010 Current ratio 2.22 1.95 1.68 Quick ratio 1.30 1.15 0.84 Average payment period 30.2 28.1 27.4 Total asset turnover 2.5 2.5 2.5 Fixed asset turnover 5.5 4.88 4.5 Average collection period 36.5 32.9 24.3 Inventory turnover 7.00 8.13 7.50 Total Debt to Total Assets 31.8% 30.0% 30.6% Total Debt to Equity 0.47 0.43 0.44 Equity Multiplier 1.47 1.43 1.44 Interest Coverage 8.33 6.33 4.57 Operating Profit Margin 11.36% 9.50% 7.11% Net Profit Margin 6.00% 4.80% 3.33% Operating Return on Assets 28.4% 23.8% 17.8% Return on Assets 15.0% 12.0% 8.3% Return on Equity 22.0% 17.1% 12.0% The liquidity ratios show recent declines in liquidity while industry liquidity is rising (current ratio, quick ratio) and a very slow payment period when compared to the industry. Global may face a severe cash shortage if its suppliers demand quicker payments. Should Global need to raise money quickly, it may not be able to issue debt, as Global’s debt ratios are higher than the industry averages (debt to assets, equity multiplier) and its interest coverage is declining while the industry’s is rising. Part of Global’s difficulties can be traced to poor cost control (lower than average operating profit margin and operating return on assets) and poor asset management (the asset turnover ratios are below the industry average). The receivables collection period is much longer than average as well. The combination of poor cost control and inefficient asset management has led to poor profitability compared to industry average trends (net profit margin, return on total assets, return on equity). 16. Challenge Problem. Evaluate the performance of Johnson and Johnson in comparison to its industry. Liquidity ratios: on a par with the industry, although quick ratio is lower than the industry average, a sign that J&J’s has a higher relative level of inventory. Asset Management ratios: in general, J&J has more efficient asset management. Only fixed asset turnover is below industry average levels. J&J collects its accounts more quickly than the industry, manages inventory more efficiently, and supports its sales with a lower level of assets relative to the industry. Debt ratios: close to those of the industry average Profitability ratios: its profit margin is below the industry average but its superior asset management helps to place its ROA and ROE above that of the industry. Market value: the market places a lower earnings multiple on J&J but a higher P/B ratio compared to the industry. 17. Associated Containers Company is planning to manufacture and sell plastic pencil holders. Direct labor and raw materials will be $2.28 per unit. Fixed costs are $15,300 and the expected selling price is $3.49 per unit. a. Determine the break-even point (where operating profit is zero) in units and dollars. QBE = FC/(P – VC) = $15,300/($3.49 – $2.28) = 12,645 units b. How much profit or loss before interest and taxes will there be if 10,825 units are sold? EBIT = $3.49(10,825) – $2.28(10,825) – $15,300 = $ –2,201.75 c. What will the selling price per unit have to be if 13,650 units are sold in order to break even? QBE = FC/(P – VC) = 13,650 = $15,300/(P – $2.28)  price = $3.40 d. How much will variable costs per unit have to be in order to break even if only 9,500 units are expected to be sold and the selling price is $3.49? QBE = FC/(P – VC) = 9,500 = $15,300/($3.49 – VC) = $1.87 18. Challenge Problem. Graph the revenue and cost lines to estimate the break-even point for the following data. Compute the break-even point mathematically. a. price = $12.95; variable cost/unit = $6.89; fixed costs = $10,000 b. price = $23, 995; variable cost/unit = $16,545; fixed costs = $40 million c. price = $249; variable cost/unit = $50; fixed costs = $800,000 As the tables below show, the breakeven point for a) is approximately 1650 units; for b) it is 5,369 units; and for c) it is about 4020 units. This data can be easily graphed using a spreadsheet package. A b c Price 12.95 23,995 249 variable cost per unit 6.89 16,545 50 fixed costs 10,000 40,000,000 800,000 a. Quantity 500 1,000 1,500 1,650 2,000 Revenue 6,475 12,950 19,425 21,367.5 25,900 Total cost 13,445 16,890 20,335 21,368.5 23,780 Profit -6,970 -3,940 -910 -1 2,120 b. Quantity 4,000 5,000 5,369 6,000 7,000 Revenue 95,980,000 119,975,000 128,829,155 143,970,000 167,965,000 Total cost 106,180,000 122,725,000 128,830,105 139,270,000 155,815,000 Profit -10,200,000 -2,750,000 -950 4,700,000 12,150,000 c. Quantity 2,000 3,000 4,000 4,020 5,000 Revenue 498,000 747,000 996,000 1,000,980 1,245,000 Total cost 900,000 950,000 1,000,000 1,001,000 1,050,000 Profit -402,000 -203,000 -4,000 -20 195,000 19. This problem uses the two years of financial statements data provided in Problem 6 for the Genatron Manufacturing Corporation. a. Calculate and compare each current assets account as a percentage of total assets for that year. 2012: Cash: $40,000/$1,200,000 = 3.33% AR: $260,000/$1,200,000 = 21.67% Inventory: $500,000/$1,200,000 = 41.67% 2011: Cash: $50,000/$1,000,000 = 5.00% AR: $200,000/$1,000,000 = 20.00% Inventory: $450,000/$1,000,000 = 45.00% In 2012, cash and inventory fell relative to total assets; AR rose. b. Calculate and compare each current liabilities account as a percentage of total liabilities and equities for that year. 2012: AP: $170,000/$1,200,000 = 14.17% Bank loan: $90,000/$1,200,000 = 7.50% Accruals: $70,000/$1,200,000 = 5.83% 2011: AP: $130,000/$1,000,000 = 13.00% Bank loan: $90,000/$1,000,000 = 9.00% Accruals: $50,000/$1,000,000 = 5.00% In 2012, AP and accruals rose relative to assets; loans fell. c. Calculate the current ratio and the acid-test ratio for each year. Describe the changes in liquidity, if any, that occurred between the two years. Current ratio Acid-test ratio 2012: $800,000/$330,000 = 2.42 $300,000/$330,000 = 0.91 2011: $700,000/$270,000 = 2.59 $250,000/$270,000 = 0.93 Between 2011 and 2012, AR rose relative to assets, as did payables. Bank loans remained constant in dollar terms while accruals rose. Relative to assets, cash and inventory fell. Total current liabilities rose faster than total current assets, as seen in the declining current ratio and acid-test ratio. 20. The Jackman Company had sales of $1,000,000 and net income of $50,000 last year. Sales are expected to increase by 20 percent next year. Selected year-end balance sheet items were: Current assets = $400,000; Fixed assets = $500,000; Total assets = $900,000; Current liabilities = $200,000; Long-term debt = $200,000; Owners’ equity = $500,000; and Total liabilities and equity = $900,000. a. Express each balance sheet item as a percent of this year’s sales. Current assets 40% Current liabilities 20% Fixed assets 50% Long-term debt 20% Total assets 90% Owners’ equity 50% Total liability and equity 90% b. Estimate the new asset investment requirement for next year, assuming no excess production capacity. With no excess capacity, a 20% sales increase will result in a 20% increase in assets. Assets will rise from $900,000 to $1,080,000, an increase of $180,000. c. Estimate the amount of internally generated funds for next year, assuming all profits will be retained in the firm. NI = Profit margin × Sales forecast = ($50,000/$1,000,000) × $1,080,000 = $54,000 = addition to retained earnings d. If all current liabilities are expected to change spontaneously with sales, what will be their dollar increase next year? Estimated CL = $200,000(1.20) = $240,000 Current liabilities are expected to rise by $40,000. e. Estimate Jackman’s external financing requirements for next year. EFN = Change in assets ($180,000) – Additions to retained earnings ($54,000) Increase in current liabilities ($40,000) = $86,000 21. Using the data in the chapter, estimate Walgreen’s external financing needs if a 20-percent growth rate is expected. 1. Forecast the dollar amount of expected sales increase. A 20-percent increase on sales volume of $63,335 is $12,667. Sales are forecast to equal $76,002. 2. Determine the dollar amount of new asset investments necessary to support the sales increase. Anticipated new asset investment of about $4,741.17. ($12,667 x 37.43%). 3. Subtract the expected amount of retained profits from the planned asset investments. The average profit margin during 2006-2009 for Walgreens was about 3.6%. If net sales are expected to rise by 20 percent next year to $76,002 and the profit margin is expected to hold, then profits would be projected at about $2,736.07 ($76,002 x 3.6%). The text states that, according to Walgreens’ annual report, the firm pays about 20 percent of earnings to shareholders as dividends. After paying dividends, we expect Walgreens to have $2,188.86 (80 percent of $2,736.07) in internally generated funds to finance the expected $4,741.17 expansion in assets. The remainder to be financed totals $2,552.31. 4. Subtract the amount of spontaneous increases expected in accounts payable and accrued liabilities from the planned asset investments. Accounts payable plus other current liabilities have averaged 11.7 percent of sales for Walgreens. Based on a 20 percent expected increase in sales, accounts payable and other current liabilities would be expected to rise and provide about $1,476.54 ($12,667 x 11.7%) in spontaneous short-term funds. 5. The remaining dollar amount of asset investments determines the external financing needs (EFN). After deducting spontaneous financing, this leaves an external financing need for Walgreens of about $1,075.77 ($2,552.31 minus $1,476.54) in order to cover the asset investment requirements. 6. Note, if fixed assets are not expected to change with the sales increase, the only assets that changes with sales are the current assets. In this case, current assets will be expected to rise $2,370.61 and the firm’s the external financing needs (EFN) will be $(1,294.79); that is, they will have a surplus of funds. To summarize, based upon spreadsheet output (thus some of the above numbers may suffer from rounding): Forecasted sales $76,002.00 20% growth rate Increase in sales $12,667.00 Increase in total assets $4,741.17 change in sales * avg TA/S Increase in current assets $2,370.61 change in sales * avg CA/S Forecasted profit $2,736.07 forecasted sales*avg net profit margin Internally generated funds $2,188.86 20% dividend payout Spontaneous financing $1,476.54 Change in sales*CL/S External financing needed $1,075.77 Assuming total assets increase along with sales EFN (fixed assets assumed constant) $(1,294.79) If fixed assets do not change, only current assets change as sales rise 22. Using Global Manufacturing’s financial statements in problem 12, estimate their external financing needs if 10-percent growth in sales is expected and the firm pays out half of its earnings as dividends. The percentage-of-sales balance sheet appears next: 2012 2011 2010 2012 2011 2010 Average ASSETS Cash and marketable securities $25,000 $20,000 $16,000 3.6% 3.3% 3.0% 3.3% Accounts receivable 100,000 80,000 56,000 14.3% 13.3% 10.4% 12.7% Inventories 125,000 100,000 80,000 17.9% 16.7% 14.8% 16.4% Total current assets 250,000 200,000 152,000 35.7% 33.3% 28.1% 32.4% Gross plant and equipment 300,000 225,000 200,000 42.9% 37.5% 37.0% 39.1% Less: accumulated depreciation -100000 -75,000 -50,000 -14.3% -12.5% -9.3% -12.0% Net plant and equipment 200,000 150,000 150,000 28.6% 25.0% 27.8% 27.1% Land 50,000 50,000 50,000 7.1% 8.3% 9.3% 8.2% Total fixed assets 250,000 200,000 200,000 35.7% 33.3% 37.0% 35.4% Total assets $500,000 $400,000 $352,000 71.4% 66.7% 65.2% 67.8% LIABILITIES AND EQUITY Accounts payable $78,000 $65,000 $58,000 11.1% 10.8% 10.7% 10.9% Notes payable 34,000 10,000 10,000 4.9% 1.7% 1.9% 2.8% Accrued liabilities 30,000 25,000 25,000 4.3% 4.2% 4.6% 4.4% Total current liabilities 142,000 100,000 93,000 20.3% 16.7% 17.2% 18.1% Long-term debt 140,000 100,000 71,000 20.0% 16.7% 13.1% 16.6% Total liabilities $282,000 $200,000 $164,000 40.3% 33.3% 30.4% 34.7% Common stock ($1 par, 50,000 shares) $50,000 $50,000 $50,000 7.1% 8.3% 9.3% 8.2% Paid-in capital 100,000 100,000 100,000 14.3% 16.7% 18.5% 16.5% Retained earnings 68,000 50,000 38,000 9.7% 8.3% 7.0% 8.4% Total stockholders’ equity 218,000 200,000 188,000 31.1% 33.3% 34.8% 33.1% Total liabilities and equity $500,000 $400,000 $352,000 71.4% 66.7% 65.2% 67.8% 1. Forecast the dollar amount of expected sales increase. A 10-percent increase on sales volume of $700,000 is $70,000. Sales are forecast to equal $770,000. 2. Determine the dollar amount of new asset investments necessary to support the sales increase. Anticipated new asset investment of about $47,460 ($70,000 x 67.8%). 3. Subtract the expected amount of retained profits from the planned asset investments. From problem 12, we see the average profit margin during 2010-2012 for Global was about 4.83%. If net sales are expected to rise by 10 percent next year to $770,000 and the profit margin is expected to hold, then profits would be projected at about $37,191 ($770,000 x 4.83%). Since 50 percent of earnings are paid as dividends, Global will have $18,595.50 (50 percent of $37,191) in internally generated funds to finance the expected $47,460 expansion in assets. The remainder to be financed totals $28,864.50. 4. Subtract the amount of spontaneous increases expected in accounts payable and accrued liabilities from the planned asset investments. Accounts payable plus other current liabilities have averaged 15.3 percent of sales for Global. Based on a 10 percent expected increase in sales, accounts payable and other current liabilities would be expected to rise and provide about $10,710 ($70,000 x 15.3%) in spontaneous short-term funds. 5. The remaining dollar amount of asset investments determines the external financing needs (EFN). After deducting spontaneous financing, this leaves an external financing need for Global of about $18,154.50 ($28,864.50 minus $10,710) in order to cover the asset investment requirements. 23. Using the financial statements presented in problem 12, determine Global Manufacturing’s degree of operating leverage in each of the years presented. Assume the costs of goods sold are variable costs and all other costs are fixed. Year 2012 2011 2010 Sales 700,000 600,000 540,000 Cost of goods sold (variable cost) 450,000 375,000 338,000 General and administrative 95,000 95,000 95,000 Selling and marketing 56,000 50,000 45,000 Depreciation 25,000 20,000 15,000 Total Fixed Cost 176,000 165,000 155,000 Degree of operating leverage = (S - TVC)/(S - TVC - FC) 3.38 3.75 4.30 24. Using your estimate for the degree of operating leverage for Global in 2012, estimate the level of operating income if the following year’s sales a) rise by 5 percent; b) fall by 12 percent. Degree of operating leverage 3.38 Change in sales a) 5% b) -12% Change in EBIT = change in sales x DOL 16.89% -40.54% 25. Using the financial statements presented in problem 6, determine Genatron’s degree of operating leverage in each of the years presented. Assume the cost of goods sold and marketing expenses are variable costs and all other costs are fixed. Year 2012 2011 Sales 1,500,000 1,300,000 Cost of goods sold (variable) 900,000 780,000 Marketing expense (variable) 150,000 150,000 Total variable cost 1,050,000 930,000 General and administrative (fixed) 150,000 150,000 Depreciation (fixed) 53,000 40,000 Total Fixed cost 203,000 190,000 Degree of operating leverage = (S - TVC)/(S - TVC - FC) 1.82 2.06 26. Using your estimate for the degree of operating leverage for Genatron in 2012, estimate the level of operating income if the following year’s sales a) rise by 5 percent; b) fall by 12 percent. Degree of operating leverage 1.82 Change in sales a) 5% b) -12% Change in EBIT = change in sales x DOL 9.11% -21.86% SUGGESTED QUIZ 1. Where can information on a firm’s financial condition and industry average ratios be obtained? 2. What are the five basic categories of financial ratios? What information does each category provide? 3. Following is information from Harris Enterprises. Compute: a. Current ratio b. Debt-to-assets ratio c. Inventory turnover ratio d. Return on equity, using the Du Pont relationship Harris Enterprises Balance Sheet, 2012 (millions of dollars) Cash $ 2 Accounts payable $ 5 Receivables 6 Notes payable 4 Inventory 3 Long-term bonds 8 Fixed assets 10 Stockholders’ equity 4 Total assets $21 Total liabilities and equity $21 Harris Enterprises Income Statement, 2012 (millions of dollars) Sales $50 Cost of goods sold 25 Depreciation 10 Earnings before interest and taxes $15 Taxes 5 Net income $10 Solution a. The current ratio is $11/$9, or 1.22. b. The debt-to-assets ratio is $17/$21 = .8095 or 80.95%. c. Inventory turnover equals $25/$3 = 8.33. d. The Du Pont relationship states that ROE equals: ROE = profit margin × total asset turnover × equity multiplier = ($10/$50) × ($50/$21) × ($21/$4) = .20 × 2.381 × 5.25 = 2.50 or 250% 4. Define or discuss briefly: a. Budgets b. Break-even point c. Contribution margin d. Degree of operating leverage Solution Manual for Introduction to Finance: Markets, Investments, and Financial Management Ronald W. Melicher, Edgar A. Norton 9780470561072, 9781119560579, 9781119398288