04 Chapter model

Chapter 4. Analysis of Financial Statements

This model is STRICTLY OPTIONAL. Neither students nor instructors need to go through it. However, if someone wants to practice with Excel, then the model can be useful. Also, on the tabs
we show solutions for the within-chapter self-test questions.

This spreadsheet model sets up common size balance sheets and income statements for Allied (2010 and 2011 statements) and conducts a full ratio analysis of Allied's financial statements.

Common Size Analysis is not illustrated in the text, but we show it because it is so easy to do with Excel. The common size balance sheet shows each asset and liability item as a percentage of
total assets, and the common size income statement shows the other items as a percentage of sales. Common size statements are useful for getting an idea of how the various statement items
match up, and they are especially good for comparing companies that differ in size.

INPUT DATA SECTION: Historical Data Used in the Analysis

2011 2010
Year-end stock price $23.60 $26.00
Shares outstanding (in millions) 50 50
Tax rate 40% 40%

COMMON SIZE BALANCE SHEETS - Allied Food Products - December 31

(in millions of dollars)
COMMON SIZE
2011 2010 2011 2010
Assets
Cash and equivalents $10 $80 0.50% 4.76%
Accounts receivable 375 315 18.75% 18.75%
Inventories 615 415 30.75% 24.70%
Total current assets $1,000 $810 50.00% 48.21%
Net plant and equipment 1,000 870 50.00% 51.79%
Other LT assets - - 0.00% 0.00%
Total assets $2,000 $1,680 100.00% 100.00%

Liabilities and equity

Accounts payable $60 $30 3.00% 1.79%
Notes payable 110 60 5.50% 3.57%
Accruals 140 130 7.00% 7.74%
Total current liabilities $310 $220 15.50% 13.10%
Long-term bonds 750 580 37.50% 34.52%
Total debt $1,060 $800 53.00% 47.62%
Common stock (50M shares) 130 130 6.50% 7.74%
Retained earnings 810 750 40.50% 44.64%
Total common equity $940 $880 47.00% 52.38%
Total liabilities and equity $2,000 $1,680 100.00% 100.00%

INCOME STATEMENTS - Allied Food Products - Years Ending December 31

(in millions of dollars)
COMMON SIZE
2011 2010 2011 2010
Net sales $3,000.0 $2,850.0 100.00% 100.00%
Oper costs except depr'n & amort. 2,616.2 2,497.0 87.21% 87.61%
Depreciation and amortization 100.0 90.0 3.33% 3.16%
Operating income (EBIT) $283.8 $263.0 9.46% 9.23%
Less interest 88.0 60.0 2.93% 2.11%
Earnings before taxes (EBT) $195.8 $203.0 6.53% 7.12%
Taxes 78.3 81.2 2.61% 2.85%
Net income $117.5 $121.8 3.92% 4.27%

Common dividends $57.5 $53.0 1.92% 1.86%

Addition to retained earnings $60.0 $68.8 2.00% 2.41%

PER-SHARE DATA
2011 2010
Earnings per share (EPS) $2.35 $2.44
Dividends per share (DPS) $1.15 $1.60
Book value per share (BVPS) $18.80 $17.60

2011 FREE CASH FLOW (FCF)

FCF = EBIT(1 – T) + Depr'n – [Cap Ex + ΔNOWC ]
FCF = $170.3 + $100.0 – [$230.0 + $150 ]
FCF = $270.3 – $380.0
FCF = ($109.7)

SECTIONS 4-1 TO 4-6, RATIO ANALYSIS

Here we calculate Allied's ratios for 2010 and 2011. These results are compared across time and to the industry averages.

Liquidity ratios 2011 2010 Ind Avg

Current Ratio 3.23 3.68 4.20
Quick Ratio 1.24 1.80 2.20
Asset Management ratios
Inventory Turnover 4.88 6.87 10.90
Days Sales Outstanding 45.62 40.34 36.00
Fixed Assets Turnover 3.00 3.28 2.80
Total Assets Turnover 1.50 1.70 1.80
Debt Management ratios
Debt Ratio 53.00% 47.62% 40.00%
Times Interest Earned 3.23 4.38 6.00
Profitability ratios
Operating Margin 9.46% 9.23% 10.00%
Profit Margin 3.92% 4.27% 5.00%
Return on Assets 5.87% 7.25% 9.00%
Basic Earning Power 14.19% 15.65% 18.00%
Return on Equity 12.50% 13.84% 15.00%
Market Value ratios
Price-to-Earnings Ratio 9.81 10.67 11.30
Market-to-Book Ratio 1.23 1.48 1.70

SECTION 4-7. TYING THE RATIOS TOGETHER: THE DuPONT EQUATION

The DuPont equation shows that a firm's ROE depends on three essential components: (1) the profit margin, (2) the total assets turnover, and (3) the equity multiplier.

ROE = Profit Margin x TA Turnover x Equity Multiplier

Net income /
x Sales / Total x
Sales
ROE = assets Total assets / Equity
ROE = 3.9% x 1.5 x 2.13 = 12.5%

Industry = 5.0% x 1.8 x 1.67 = 15.0%

Industry Equity Multiplier = 1 / (1 – Debt ratio) = = 1/(1-F82)

SECTION 4-9c, TREND ANALYSIS

Trend analysis allows you to see how a firm's results are changing over time. For example, Allied's ROE has been declining for the past 3 years, and it is now below the industry average. Not a
good sign.

Allied Ind Avg

2007 14.0% 13.2%
2008 16.1% 15.0%
2009 14.8% 16.0%
2010 13.8% 16.2%
2011 12.5% 15.0%
Trend Analysis: Allied's ROE
ROE
18.0%
17.0%
16.0% Industry
15.0%
14.0%
13.0% Allied
12.0%
11.0%
10.0%
2007 2008 2009 2010 2011
Year
Table 4.1. Effects of Financial Leverage on Stockholder Returns

Interest rate on debt 10%

Tax rate 40%

FIRM U (UNLEVERAGED, i.e., NO DEBT))

Current Assets $50 Debt $-
Fixed Assets 50 Common Equity 100
Total Assets $100 Total Liab & Equity $100

Business Conditions
Good Expected Bad
Sales revenues $150.0 $100.0 $75.0
Oper. costs Fixed 45.0 45.0 45.0
Variable 0.4 60.0 40.0 30.0
Total operating costs 105.0 85.0 75.0
Operating income (EBIT) $45.0 $15.0 $0.0
Interest 0.0 0.0 0.0
Earnings before taxes (EBT) $45.0 $15.0 $0.0
Taxes 18.0 6.0 0.0
Net income (NI) $27.0 $9.0 $0.0
27.0% 9.0% 0.0%
ROEU

FIRM L (LEVERAGED, i.e., SOME DEBT))

Current Assets $50 Debt $50
Fixed Assets 50 Common Equity 50
Total Assets $100 Total Liab & Equity $100

Business Conditions
Good Expected Bad
Sales revenues $150.0 $100.0 $75.0
Oper. costs Fixed 45.0 45.0 45.0
Variable 0.4 60.0 40.0 30.0
Total operating costs 105.0 85.0 75.0
Operating income (EBIT) $45.0 $15.0 $0.0
Interest 5.0 5.0 5.0
Earnings before taxes (EBT) $40.0 $10.0 $-5.0
Taxes 16.0 4.0 0.0
Net income (NI) $24.0 $6.0 $-5.0
ROEL 48.0% 12.0% -10.0%

ROE
Firm U Firm L
Good $150.00 27.0% 48.0%
Expected $100.00 9.0% 12.0%
Bad $75.00 0.0% -10.0%

Average $108.33 12.0% 16.7%

Effect of Leverage
ROE

30.0% Leveraged
Unleveraged

$50 $100 SALES $150

-20.0%
SECTION 4-2
SOLUTIONS TO SELF-TEST QUESTIONS

4a. A company has current liabilities of $500 million, and its current ratio is 2.0. What is its level of current assets?

Current liabilities ($M) $500

Current ratio 2.0 = CA / CL

Current assets ($M) = CL × CR = CL × 2 = $1,000

4b. A company has current liabilities of $500 million, and its current ratio is 2.0. If this firm’s quick ratio is 1.6, how much inventory does it
have?

Current liabilities ($M) $500

Current ratio 2.0
Quick ratio = (CA – Inventories) / CL 1.6
CA – Inventories = CL × 1.6 = $800.00

Current assets as found in previous question $1,000

Inventory = $1,000 - $800 = $200

SECTION 4-3
SOLUTIONS TO SELF-TEST QUESTIONS

5a. A firm has annual sales of $100 million, $20 million of inventory, and $30 million of accounts receivable. What is its inventory turnover ratio?

Annual Sales ($M) $100

Inventory ($M) $20
Accounts receivable ($M) $30 Not relevant to this question.

Inventory turnover = Sales / Inventory = 5.0

5b. A firm has annual sales of $100 million, $20 million of inventory, and $30 million of accounts receivable. What is its DSO?

Annual Sales ($M) $100

Inventory ($M) $20
Accounts receivable ($M) $30

Days sales outstanding = Receivables / (Sales/365) = 109.5 days

SECTION 4-5
SOLUTIONS TO SELF-TEST QUESTIONS

4a. A company has $20 billion of sales and $1 billion of net income. Its total assets are $10 billion, financed half by debt and half by common equity. What is its profit margin?

Sales ($B) $20

Net income ($B) $1
Total assets ($B) $10
Debt ratio 50%

Profit margin = Net Income / Sales = 5.00%

4b. A company has $20 billion of sales and $1 billion of net income. Its total assets are $10 billion, financed half by debt and half by common equity. What is its ROA?

Sales ($B) $20

Net income ($B) $1
Total assets ($B) $10
Debt ratio 50%

ROA = Net income / Total assets = 10.00%

4c. A company has $20 billion of sales and $1 billion of net income. Its total assets are $10 billion, financed half by debt and half by common equity. What is its ROE?

Sales ($B) $20

Net income ($B) $1
Total assets ($B) $10
Debt ratio 50%

Equity = (1 – Debt ratio) × Assets = $5.0

ROE = Net income / Equity 20.00%

4d. Would this firm's ROA increase if it used less leverage?

Answer: Yes, because with less debt, interest would be lower, hence net icome would
be higher. That would raise the ROA.

4e. Would its ROE increase if the firm used less leverage?

Answer: In general, the answer would be "maybe and maybe not."

With less debt, interest would be lower, but the firm would have more
equity. So, in the ROE equation both the numerator and the denominator
would change. Therefore, the ROE could end up either higher or lower.
However, in this case, with the ROE > ROA, the interest rate on the
debt must be less than the ROE, which causes leverage to raise the ROE. So,
in this case, lowering the debt ratio would lower the ROE.
 Chapter 4. Solution to End-of-Chapter Comprehensive/Spreadsheet Problem
Problem 4-24

Corrigan Corporation's December 31 Balance Sheets

Assets 2011 2010

Cash $72,000 $65,000
Accounts receivable 439,000 328,000
Inventories 894,000 813,000
Total current assets $1,405,000 $1,206,000
Land and building 238,000 271,000
Machinery 132,000 133,000
Other fixed assets 61,000 57,000
Total assets $1,836,000 $1,667,000

Liabilities and equity

Accounts and notes payable $432,000 $409,500
Accrued liabilities 170,000 162,000
Total current liabilities $602,000 $571,500
Long-term debt 404,290 258,898
Common stock 575,000 575,000
Retained earnings 254,710 261,602
Total liabilities and equity $1,836,000 $1,667,000

Corrigan Corporation's December 31 Income Statements

2011 2010
Sales $4,240,000 $3,635,000
Cost of goods sold 3,680,000 2,980,000
Gross operating profit $560,000 $655,000
General admin. and selling epenses 236,320 213,550
Depreciation 159,000 154,500
Miscellaneous 134,000 127,000
EBT $30,680 $159,950
Taxes (40%) 12,272 63,980
Net income $18,408 $95,970

Per-Share Data 2011 2010

EPS $0.80 $4.17
Cash dividends $1.10 $0.95
Market price (average) $12.34 $23.57
P/E ratio 15.42 5.65
Number of shares outstanding 23,000 23,000

Once we have this information set, we can calculate the necessary ratios for this analysis.

Ratio Analysis 2011 2010 Industry Avga

Liquidity
Current ratio 2.33 2.11 2.7
Asset Management
Inventory turnoverb 4.74 4.47 7.0
Days sales outstandingc 37.79 32.94 32
Fixed assets turnoverb 9.84 7.89 13.0
Total assets turnoverb 2.31 2.18 2.6
Profitability
Return on assets 1.00% 5.76% 9.1%
Return on equity 2.22% 11.47% 18.2%
Profit margin 0.43% 2.64% 3.5%
Debt Management
Debt-to-assets ratio 54.81% 49.81% 50.0%
Market Value
P/E ratio 15.42 5.65 6.0
Price/cash flow ratio 1.60 2.16 3.5

a Industry average ratios have been constant for the past 4 years.
b Based on year-end balance sheet figures.
c Calculation is based on a 365-day year.

a. Assess Corrigan's liquidity position and determine how it compares with peers and how the liquidity
position has changed over time.
Corrigan's liquidity position has improved from 2010 to 2011; however, its current ratio is still
below the industry average of 2.7.

b. Assess Corrigan's asset management position and determine how it compares with peers and
how its asset management efficiency has changed over time.
Corrigan's inventory turnover, fixed assets turnover, and total assets turnover have improved from
2010 to 2011; however, they are still below industry averages. The firm's days sales outstanding ratio
has increased from 2010 to 2011--which is bad. In 2010, its DSO was close to the industry average.
In 2011, its DSO is somewhat higher. If the firm's credit policy has not changed, it needs to
look at its receivables and determine whether it has any uncollectibles. If it does have uncollectible
receivables, this will make its current ratio look worse than what was calculated above.

c. Assess Corrigan's debt management position and determine how it compares with peers and how its
debt management has changed over time.
Corrigan's debt ratio has increased from 2010 to 2011, which is bad. In 2010, its debt ratio was right
at the industry average, but in 2011 it is higher than the industry average. Given its weak current and
asset management ratios, the firm should strengthen its balance sheet by paying down liabilities.

d. Assess Corrigan's profitability ratios and determine how they compare with peers and how its
profitability position has changed over time.
Corrigan's profitability ratios have declined substantially from 2010 to 2011, and they are substantially
below the industry averages. Corrigan needs to reduce its costs, increase sales, or both.

e. Assess Corrigan's market value ratios and determine how its valuation compares with peers
and how it has changed over time.
Corrigan's P/E ratio has increased from 2010 to 2011, but only because its net income has declined
significantly from the prior year. Its P/CF ratio has declined from the prior year and is well below
the industry average. These ratios reflect the same information as Corrigan's profitability ratios.
Corrigan needs to reduce costs to increase profit, lower its debt ratio, increase sales, and improve
its asset management.

f. Calculate Corrigan's ROE as well as the industry average ROE using the DuPont equation.
From this analysis, how does Corrigan's financial position compare with the industry
average numbers?
ROE = PM x TA Turnover x Equity Multiplier
2011 2.22% 0.43% 2.31 2.21
2010 11.47% 2.64% 2.18 1.99
Industry Avg. 18.20% 3.50% 2.60 2.00

Looking at the DuPont equation, Corrigan's profit margin is significantly lower than the industry
average and it has declined substantially from 2010 to 2011. The firm's total assets turnover has
improved slightly from 2010 to 2011, but it's still below the industry average. The firm's equity
multiplier has increased from 2010 to 2011 and is higher than the industry average. This
indicates that the firm's debt ratio is increasing and it is higher than the industry average.

Corrigan should increase its net income by reducing costs, lower its debt ratio, and improve its asset
management by either using less assets for the same amount of sales or increase sales.

g. What do you think would happen to its ratios if the company initiated cost-cutting measures that
allowed it to hold lower levels of inventory and substantially decreased the cost of goods sold? No
calculations are necessary. Think about which ratios would be affected by changes in these
two accounts.
If Corrigan initiated cost-cutting measures, this would increase its net income. This would improve its
profitability ratios and market value ratios. If Corrigan also reduced its levels of inventory, this would
improve its current ratio--as this would reduce liabilities as well. This would also improve its inventory
turnover and total assets turnover ratios. Reducing costs and lowering inventory would also improve
its debt ratio.
Table 4A.1 Allied: Common Size Income Statements
2011
Industry
Income Statement: Composite 2011 2010 Industry 2011 2010
Net sales 100.0% 100.0% 100.0% 407,333 3,000 2,850
Operating costs excl. deprec. & amort. 88.0% 87.2% 87.6% 358,283 2,616 2,497
Depreciation & amortization 2.0% 3.3% 3.2% 8,317 100 90
Total operating costs 90.0% 90.5% 90.8% 366,600 2,716 2,587
Operating income (EBIT) 10.0% 9.5% 9.2% 40,733 284 263
Interest 1.7% 2.9% 2.1% 6,789 88 60
EBT 8.3% 6.5% 7.1% 33,944 196 203
Taxes 3.3% 2.6% 2.8% 13,578 78 81
Net income 5.0% 3.9% 4.3% 20,367 117 122

Table 4A.2 Allied: Common Size Balance Sheets

2011
Industry
Balance Sheet: Composite 2011 2010 Industry 2011 2010
Cash & equivalents 1.4% 0.5% 4.8% 3,275 10 80
Accounts receivable 17.8% 18.8% 18.8% 40,175 375 315
Inventories 16.5% 30.8% 24.7% 37,370 615 415
Total current assets 35.7% 50.0% 48.2% 80,820 1,000 810
Net fixed assets 64.3% 50.0% 51.8% 145,476 1,000 870
Other assets 0.0% 0.0% 0.0% 0 0 0
Total assets 100.0% 100.0% 100.0% 226,296 2,000 1,680

Accounts payable 2.3% 3.0% 1.8% 5,098 60 30

Accruals 3.4% 7.0% 7.7% 7,697 140 130
Notes payable 2.8% 5.5% 3.6% 6,448 110 60
Total current liabilities 8.5% 15.5% 13.1% 19,243 310 220
Long-term bonds 31.5% 37.5% 34.5% 71,276 750 580
Total debt 40.0% 53.0% 47.6% 90,519 1,060 800
Total common equity 60.0% 47.0% 52.4% 135,778 940 880
Total liabilities & equity 100.0% 100.0% 100.0% 226,296 2,000 1,680

Table 4A.3 Allied: Income Statement Percentage Change Analysis

Income Statement:
Percent
Change in
Base year = 2010 2011
Net sales 5.3%
Operating costs excl. deprec. & amort. 4.8%
Depreciation & amortization 11.1%
Total operating costs 5.0%
Operating income (EBIT) 7.9%
Interest 46.7%
EBT -3.5%
Taxes -3.5%
Net income -3.5%

Allied: Balance Sheet Percentage Change Analysis

Balance Sheet:
Percent
Change in
Base year = 2010 2011
Cash & equivalents -87.5%
Accounts receivable 19.0%
Inventories 48.2%
Total current assets 23.5%
Net fixed assets 14.9%
Other assets
Total assets 19.0%

Accounts payable 100.0%

Accruals 7.7%
Notes payable 83.3%
Total current liabilities 40.9%
Long-term bonds 29.3%
Total debt 32.5%
Total common equity 6.8%
Total liabilities & equity 19.0%