Chapter 13 Financial Analysis, Math Problem Example

Practice Question 1

Vertical analysis, also called common-size analysis, is a technique for evaluating financial statement data that expresses each item in a financial statement as a percent of a base amount.

• On a balance sheet we might say that current assets are 22% of total assets (total assets being the base amount.)
• On an income statement we might say that selling expenses are 16% of net sales (net sales being the base amount.)

Practice Question 2

Ratios Used in Analyzing a Company’s Liquidity, Solvency, and Profitability (page 668)

For analysis of the primary financial statements, ratios can be classified into three types:

• Liquidity ratios
• Solvency ratios
• Profitability ratios
• Ratios can provide clues to underlying conditions that may not be apparent from an inspection of the individual components.
• A single ratio by itself is not very meaningful.

Liquidity ratios measure the short-term ability of the enterprise to pay its maturing obligations and to meet unexpected needs for cash.

• Short-term creditors such as bankers and suppliers are particularly interested in assessing liquidity.
• The following ratios can be used to determine the enterprise’s short-term debt-paying ability:

1. Working capital shows how much current assets exceed current liabilities and is used to assess liquidity. A higher working capital is better.  Reported in dollars ($).

Working Capital = current assets – current liabilities

2. The current ratio expresses the relationship of current assets to current liabilities. A safe ratio is 2:1 ($2 of current assets for every $1 of current liabilities).  The current ratio is widely used for evaluating a company’s liquidity and short-term debt-paying ability.  A higher current ratio is better.  Reported as a ratio of x.xx:1.

  Current liabilities

3. Current cash debt coverage ratio measures a company’s ability to generate cash to cover their debt. This ratio uses cash provided by operating activities rather than a balance at one point in time as used in the current ratio and therefore may provide a better representation of liquidity.  A higher ratio is better. Reported as a percentage (%).

Cash provided by operating activities

Average current liabilities

4. The receivables turnover ratio measures the number of times on average; receivable are collected during the period and indicates how quickly accounts receivable are being converted to cash. A higher ratio is better.  Reported as x.xx times.

Net credit sales (net sales less cash sales)

Average gross receivables during the year

5. The average collection period converts receivables turnover ratio to the number of days on average it takes customers to pay off their receivables. The lower the number of day the better but the general rule is that the collection period should not greatly exceed the credit term period. Reported in days.

Receivables turnover ratio  

5. The inventory turnover ratio measures the number of times on average the inventory is sold during the period and the larger the ratio the more quickly inventory is being sold. Reported as x.xx times.

Average inventory during the period

6. Days in inventory converts the inventory turnover ratio to the number of days on average it takes to sell the inventory. The smaller the number of days the better as less days means inventory is being sold more quickly.  Reported in days.

Inventory turnover ratio     

Solvency ratios – measure the ability of the enterprise to survive over a long period of time.

• Long-term creditors and stockholders are interested in a company’s long-run solvency, particularly its ability to pay interest as it comes due and to repay the face value of debt at maturity.
• In addition free cash flow provides information about the company’s solvency and its ability to pay additional dividends or invest in new projects.

1. The debt to total asset ratio measures the percentage of total assets provided by creditors. This ratio indicates the degree of financial leveraging and provides some indication of the company’s ability to withstand losses without impairing the interests of its creditors.  The higher the percentage of debt to total assets, the greater the risk that the company may be unable to meet its liabilities. The lower the ratio, the more equity “buffer” is available to creditors if the company becomes insolvent.  100% – debt to total asset ratio=the percentage of assets financed by equity. Reported as a percentage (%).

Total liabilities (both current and long-term)

Total assets

2. The times interest earned ratio, also called interest coverage, indicates the company’s ability to meet interest payments as they come due. A higher ratio is better as it indicates that there is income available for interest expense. Reported as xx.xx times.

Income before interest expense and income taxes

Interest expense

3. The cash debt coverage ratio is a cash-basis measure of solvency and indicates a company’s ability to repay its liabilities from cash generated from operating activities without having to liquidate the assets used in its operations. The higher the ratio, the better as it indicates that cash is being provided from operations to cover liabilities.  Reported as a percentage (%).

Cash provided by operating activities

Average total liabilities

4. Free cash flow is an indication of a company’s solvency and its ability to pay dividends or expand operations. The more free cash flow a company can generate the better.  Reported in dollars ($).

Cash provided by operating activities – capital expenditures – cash dividends

Profitability ratios – measure the income or operating success of an enterprise for a given period of time.

• Profitability ratios are important because a company’s income or lack of it, affects its ability to obtain debt and equity financing, its liquidity position, and its ability to grow.
• Profitability is frequently used as the ultimate test of management’s operating effectiveness.

1. The gross profit rate indicates a company’s ability to maintain an adequate selling price above its cost of goods sold. The profit margin is one of two factors that strongly influence the profit margin ratio.  A higher ratio is better.  Reported as a percentage (%).

Gross profit (net sales less cost of goods sold)

Net sales

2. The profit margin ratio, or rate of return on sales, is a measure of the percentage of each dollar of sales that results in net income. The return on assets ratio is affected by two factors, the first of which is the profit margin ratio.  A higher ratio is better.  Reported as a percentage (%).

Net income

Net sales

3. Return on common stockholders’ equity ratio shows how many dollars of net income were earned for each dollar invested by the owners and is a widely used measure of profitability from the common stockholder’s viewpoint. The higher the ratio, the better as stockholders’ want a good return on their investment.  Reported as a percentage (%).

Net income minus any preferred stock dividends

Average common stockholders’ equity

4. The return on assets ratio measures the overall profitability of assets in terms of the income earned on each dollar invested in assets. The return on common stockholders’ equity ratio is affected by two factors:  the return on assets ratio and the degree of leverage.  A higher ratio is better.  Reported as a percentage (%).

Average total assets

5. The asset turnover ratio measures how efficiently a company uses its assets to generate sales and shows the sales dollars produced by each dollar invested in assets. An asset turnover of 1.5 times, means that $1.50 of sales is produced by each $1 of assets.  The asset turnover ratio is the other factor that affects the return on assets ratio.  A higher ratio is better.  Reported as x.xx times.

Average total assets

6. Earnings per share (EPS) is a measure of the net income earned on each share of common stock and provides a useful perspective for determining profitability. A higher ratio is better.  Reported as dollars ($) to two decimal places.

Average number of common shares outstanding during the year

7. The price-earnings (P-E) ratio measures the ratio of the market price of each share of common stock to the earnings per share and is a reflection of investors’ assessments of a company’s future earnings. This is the most widely used ratio in valuing stocks.  A higher ratio is better.  Reported as x.xx times.

Market price per share of the stock

Earnings per share

8. The payout ratio measures the percentage of earnings distributed in the form of cash dividends. Companies that have high growth rates are characterized by low payout ratios because they reinvest most of their net income in the business.  A higher ratio is better for the stockholders’ but not necessarily for creditors.  Reported as a percentage (%).

Cash dividends declared on common stock

Net income

Quality of Earnings

• A company that has a high quality of earnings provides full and transparent information that will not confuse or mislead users of financial statements.
• The issue of quality of earnings has taken on increasing importance because recent accounting scandals suggest that some companies are spending too much time managing their income and not enough time managing their business.
• Some of the factors affecting quality of earnings include the following:

1. Alternative accounting methods – Variations among companies in the application of generally accepted accounting principles may hamper comparability and reduce quality of earnings.

• For example, one company may use the FIFO method of inventory costing, while another company in the same industry may use LIFO.
• If inventory is a significant asset to both companies, it is unlikely that their current ratios are comparable.
• Differences also exist in reporting such items as depreciation, depletion, and amortization.

2. Pro Forma Income – Companies whose stock is publicly traded are required to present their income statement following generally accepted accounting principles (GAAP).

• In recent years, many companies have been also reporting a second measure of income, in addition to their GAAP, called pro forma income.
• Pro forma income is a measure that usually excludes items that the company thinks are unusual or nonrecurring.
• There are no rules as to how to prepare pro forma earnings. Companies have a free rein to exclude any items they deem inappropriate for measuring their performance.
• Many analysts are critical of the practice of using pro forma income because these numbers often make companies look better then they really are.
• Pro forma numbers might be called EBS, which stands for “earnings before bad stuff.”
• Companies, on the other hand, argue that pro forma numbers more clearly indicate sustainable income because unusual and nonrecurring expenses are excluded.
• Recently, regulators stated that they will crack down on companies that use creative accounting to artificially inflate poor earnings results.

3. Improper recognition – Because some managers have felt the pressure to continually increase earnings, they have manipulated the earnings numbers to meet these expectations.

• The most common abuse is the improper recognition of revenue.
• One practice that companies are using is called channel stuffing. Offering deep discounts on their products to customers, companies encourage their customers to buy early (stuff the channel) rather than later.
• This lets the company report good earnings in the current period, but it often leads to a disaster in subsequent periods because customers have no need for additional goods.
• Another practice is the improper capitalization of operating expenses. The classic case is WorldCom, which capitalized over $7 billion of operating expenses to ensure that it would report positive net income.

Practice Question 3 – complete the following tables and answer the questions using the information for Columbia and Timberland provided on page 10.

Which company is more liquid?  Explain.

Columbia would be more liquid in this case due to the fact that they have more capital and the cash debt coverage is lower. The number tell us that this company has less liabilities and more current assets. Columbia would be able to continue business on credit without having any major problems.        

Which company is more profitable?  Explain.

Timberland is more profitable due to the fact that its gross profit and net income are higher than that of Columbia. Timberland’s Return on Common Stockholder’s Equity is also higher than that of Columbia’s which makes them a more profitable company!                                                                         

Which company is more solvent?  Explain.

Columbia would be more solvent between the two as the company has lower total liabilities with higher total assets. Their debt to total assets is lower; therefore, it is easier to pay bills that arise.