Chapter 14 - Financial Statement Analysis

CHAPTER 14
FINANCIAL STATEMENT ANALYSIS

1.
a. Inventory turnover ratio in 2015
Cost of Goods Sold $2,850
= = = 5.876
Average Inventories ($490 + $480)/2

b. Debt to equity ratio in 2015

Debt $3,340
= = = 3.479
Equity $960

c. Cash flow from operating activities in 2015

Net income $ 410,000
Adjustments to Net Income
+ Depreciation 280,000
Change in AR 30,000
Change in inventory (10,000)
Change in AP (110,000)
CF from Operations $ 600,000

d. Average collection period

Average Accounts Receivables ($660 + $690)/2
=  365 =  365 = 44.795
Annual Sales $5,500

e. Asset turnover ratio

Sales $5,500
= = = 1.324
Average Total Assets ($4,300 + $4,010)/2

f. Interest coverage ratio

EBIT $870
= = = 6.692
Interest Expense $130

g. Operating profit margin

EBIT $870
= = = .158 =15.8%
Sales $5,500

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Chapter 14 - Financial Statement Analysis

h. Return on equity
Net Income $410
= = = .463 = 46.3%
Average Shareholder's Equity ($960 + $810)/2

i. P/E ratio
Unable to calculate as market price is not provided.

j. Compound leverage ratio

Pretax Profit Average Assets $740 ($4,300 + $4,010)/2
=  =  = 3.993
EBIT Average Equity $870 ($960 + $810)/2

k. Net cash provided by operating activities. See answer to part c.

2.
a.
Purchase of Bus $ (33,000)
Sale of old equipment 72,000
Cash from Investments $ 39,000

b.
Cash dividend $ (80,000)
Repurchase of stock (55,000)
Cash from financing $ (135,000)

c.
Cash dividend $ (80,000)
Purchase of bus (33,000)
Interest paid on debt (25,000)
Sales of old equipment 72,000
Repurchase of stock (55,000)
Cash payments to suppliers (95,000)
Cash collections from customers 300,000
Total cash flow $ 84,000

3. ROA = (EBIT/Sales)  (Sales/Average Total Assets) = Return on Sales  ATO

The only way that Crusty Pie can have a return on sales higher than the industry
average and an ROA equal to the industry average is for its ATO to be lower than the
industry average.

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Chapter 14 - Financial Statement Analysis

4. ABC’s asset turnover must be above the industry average.

5. This transaction would increase the current ratio. The transaction reduces both current
assets and current liabilities by the same amount, but the reduction has a larger
proportionate impact on current liabilities than on current assets. Therefore, the current
ratio would increase.

This transaction would increase the asset turnover ratio. Sales should remain
unaffected, but assets are reduced.

6. c. Inventory increases due to a new (internally developed) product line.

7. c. Interest paid to bondholders.

8.
a. Lower bad debt expense will result in higher operating income.

b. Lower bad debt expense will have no effect on operating cash flow until Galaxy
actually collects receivables.

9. a. Certain GAAP rules can be exploited by companies in order to achieve specific

goals, while still remaining within the letter of the law. Aggressive assumptions, such
as lengthening the depreciable life of an asset (which are utilized to boost earnings),
result in a lower quality of earnings.

10. a. Off balance-sheet financing through the use of operating leases is acceptable when
used appropriately. However, companies can use them too aggressively in order to
reduce their perceived leverage. A comparison among industry peers and their
practices may indicate improper use of accounting methods.

11. a. A warning sign of accounting manipulation is abnormal inventory growth as

compared to sales growth. By overstating inventory, the cost of goods sold is lower,
leading to higher profitability.

12. ROE = Net Profit Margin  Total Asset Turnover  Leverage Ratio
Net Profit Sales Average Assets
=   = .055  2.0  2.2 = .242 = 24.2%
Sales Average Assets Average Equity

13. Use Equation 14.1 to solve for operating ROA:

Debt
ROE = (1 – Tax rate) [ROA + (ROA – Interest rate) ]
Equity
.03 = (1 – .35)  [ROA + (ROA – .06)  .5]  ROA = .05 = 5%

14. ROE = Tax Burden  Interest Burden  Margin  Turnover  Leverage

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Chapter 14 - Financial Statement Analysis

= .75  .6  .1  2.4  1.25 = .135 = 13.5%

15.
Value of Common Stock 20,000  $20 = $ 400,000
Retained Earnings 5,000,000
Addition to Retained Earnings 70,000
Book Value $5,470,000
Book value per share = $5,470,000/20,000 = $273.50
16.
a. Economic Value Added = (ROC – Cost of Capital)  Total Assets
Acme: (.17 – .09)  ($100 + $50) = $12 million
Apex: (.15 – .10)  ($450 + $150) = $30 million

Apex has higher economic value added.

b. Economic value added per dollar of invested capital:

Acme: ( .17 – .09)  $1 = $ .08
Apex: ( .15 – .10)  $1 = $ .05

Acme has higher economic value added per dollar of invested capital.

CFA 1
Answer:
Since ROE is a function of net profit and equity, it is possible to maintain a stable ROE
while net profits decline, so long as equity also declines proportionally.

CFA 2
Answer:
c. Old plant and equipment is likely to have a low net book value, making the ratio of
“net sales to average net fixed assets” higher.

CFA 3
Answer:
SmileWhite has the higher quality of earnings for several reasons:
i. SmileWhite amortizes its goodwill over a shorter period than does QuickBrush.
SmileWhite therefore presents more conservative earnings because it has greater
goodwill amortization expense.

ii. SmileWhite depreciates its property, plant and equipment using an accelerated
method. This results in earlier recognition of depreciation expense, so that
income is more conservatively stated.

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Chapter 14 - Financial Statement Analysis

iii. SmileWhite’s bad debt allowance, as a percent of receivables, is greater.

SmileWhite therefore recognizes higher bad-debt expense than does
QuickBrush. If the actual collection experience for the two firms is comparable,
then SmileWhite has the more conservative recognition policy.

CFA 4
Answer:
Cash + receivables $325 + $3,599
a. Quick Ratio = Current liabilities = = .99
$3,945

EBIT Net income before tax + interest expense

b. ROA   Average assets
Assets
$2,259  $78
  .364  36.4%
($8,058  $4,792) / 2

c. Preferred Dividends = 0.1  $25  18,000 = $45,000

Common Equity in 2013 = $829 + $575 + $1,949 = $3,353 thousand
Common Equity in 2012 = $550 + $450 + $1,368 = $2,368 thousand

Net income － Preferred dividends $1,265 － $45

ROE = = = .426 = 42.6%
Average common equity ($3,353 + $2,368)/2

$1,265  $45
d. Earnings Per Share   $1.77
(829  550) / 2

EBIT $2,259  $78

e. Profit Margin    .194  19.4%
Sales $12,065

EBIT $2,259  $78

f. Times Interest Earned =   30.0
Interest expense $78

Cost of goods sold $8,048

g. Inventory Turnover = = = 4.2
Average inventory ($1,415  $2,423) / 2

Average Assets ($4,792  $8,058) / 2

h. Leverage ratio = = = 1.9
Average Equity ($2,868  $3,803) / 2

CFA 5
Answer:

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Chapter 14 - Financial Statement Analysis

a. QuickBrush has had higher sales and earnings growth (per share) than
SmileWhite. Margins are also higher. But this does not necessarily mean that
QuickBrush is a better investment. SmileWhite has a higher ROE, which has been
stable, while QuickBrush’s ROE has been declining. We can use DuPont analysis
to identify the source of the difference in ROE:
Component Definition QuickBrush SmileWhite
Tax burden Net profit/Pretax profit 67.44% 65.99%
Interest burden Pretax profit/EBIT 1.00 0.9545
Profit margin EBIT/Sales 8.51% 6.46%
Asset turnover Sales/Average Assets 1.8259 3.6286
Leverage Average Assets/Average Equity 1.5071 1.5386
ROE Net profit/Average Equity 15.8% 22.7%
While tax burden, interest burden, and leverage are similar, profit margin and
asset turnover differ. Although SmileWhite has a lower profit margin, it has far
higher asset turnover.
Sustainable Growth = ROE  Plowback Ratio
Plowback Sustainable Ludlow’s
ROE
ratio growth rate estimate
QuickBrush 15.8% 1.00 15.8% 30.0%
SmileWhite 22.7% .344 7.8% 10.0%
Ludlow has overestimated the sustainable growth rate for each company.
QuickBrush has little ability to increase its sustainable growth because plowback
already equals 100%. SmileWhite could increase its sustainable growth by
increasing its plowback ratio.

b. QuickBrush’s recent EPS growth has been achieved by increasing book value
per share, not by achieving greater profits per dollar of equity. Since EPS is
equal to (Book value per share  ROE), a firm can increase EPS even if ROE is
declining; this is the case for QuickBrush. QuickBrush’s book value per share
has more than doubled in the last two years.

Book value per share can increase either by retaining earnings or by issuing new
stock at a market price greater than book value. QuickBrush has been retaining
all earnings, but the increase in the number of outstanding shares indicates that it
has also issued a substantial amount of stock.

CFA 6
Answer:
Net profit Net profit Pretax profit EBIT Sales Assets
a. ROE      
Equity Pretax profit EBIT Sales Assets Equity
= Tax burden  Interest burden  Profit margin  Asset turnover  Leverage

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Chapter 14 - Financial Statement Analysis

Net profit $510

Tax burden    .6335
Pretax Profit $805
Pretax profit $805
Interest burden    .9699
EBIT $830
EBIT $830
Profit margin = = = .1615
Sales $5,140
Sales $5,140
Asset turnover = = = 1.6992
Average Total Assets ($3,100 + $2,950)/2

Average Total Assets ($3,100 + $2,950)/2

Leverage = = = 1.4070
Average Total Equity ($2,200 + $2,100)/2

b. ROE = .6335  .9699  .1615  1.6992  1.4070 = .2372 = 23.72%

$1.96 － $ .60
c. g = ROE  plowback = .2372  = .1646 = 16.46%
$1.96

CFA 8
Answer:

2013 2016

Operating income － Depreciation $38 － $3 $76 － $9

Operating margin = = 6.45% = 6.84%
Sales $542 $979
Sales $542 $979
Asset turnover = = 2.2122 = 3.3643
Total Assets $245 $291

Pretax income $32 $67

Interest Burden = = 0.9143 = 1.00
Operating income  Depreciation $38 － $3 $76 － $9

Total Assets $245 $291

Financial Leverage = = 1.5409 = 1.3227
Shareholde rs' Equity $159 $220

Income taxes $13 $37

Income tax rate = = 40.63% = 55.22%
Pr etax income $32 $67

* As ROE can be defined as either (Net Income/Average Equity) or (Net Income/Year-

end Equity), here we use the latter definition for this problem.

a. Using the DuPont formula:

ROE (2013) = (1 – .4063)  .9143  .0645  2.2122  1.5409 = .119 = 11.9%

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Chapter 14 - Financial Statement Analysis

ROE (2016) = (1 – .5522)  1.0  .0684  3.3643  1.3227 = .136 = 13.6%

i. Asset turnover measures the ability of a company to minimize the level of

assets (current or fixed) to support its level of sales. The asset turnover
increased substantially over the period, thus contributing to an increase in the
ROE.

ii. Financial leverage measures the amount of financing, not including equity,
but including short and long-term debt, that the firm uses. Financial leverage
declined over the period, thus adversely affecting the ROE. Since asset
turnover increased substantially more than financial leverage declined, the
net effect was an increase in ROE.

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