Managerial Accounting - 6th Edition by James Jiambalvo

Chapter 14 - Problems 13, 14, and 15 (see attachment)

Problem 14-13. Common-Size Financial Statements (p.564)

Problem 14-14. Horizontal Analysis (p.565)

Problem 14-15. Comprehensive Ratio Analysis (p.565)

14 Analyzing Financial Statements: A Managerial Perspective Home and Garden Warehouse (HGW) is a large home improvement retailer, much like Home Depot or Lowe's. A number of its managers are interested in the company's financial situation. For example, Barbara Wilson, president of HGW, wants to know whether the company has been able to obtain planned discounts from suppliers and reduce selling and operating expenses. Bob Watson, a manager at PG Lighting which is one of HGW's suppliers, is also interested in HGW's financial situation. PG Lighting is considering linking its information system to the electronic checkout systems at the more than 200 HGW locations so it can track sales and efficiently schedule production of products it markets exclusively to HGW. Before making this investment, Bob wants to be confident that HGW is profitable and financially stable. Unless HGW is going to be around for the foreseeable future, PG Lighting's investment won't be worthwhile. Finally, Thomas Nandier, the CEO of HGW, is preparing for a meeting with shareholders and financial analysts, and he wants to be ready for questions they may ask about the company's performance. Thus, he too is interested in HGW's financial situation. In each of these situations, the managers will analyze the financial statements of HGW to address their concerns. This chapter discusses how to p erform this analysis. Exactostock/SuperStock Learning Objectives 1 Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement. 2 Discuss earnings management and the importance of comparing net income to cash flow from operations. Also, understand how MD&A, credit reports, and news articles can be used to gain insight into a company's current and future financial performance. 3 Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios. 531 532 chapte r 1 4 A n a l y z i n g F i n a n c i a l S t a t e m e n t s : A M a n a g e r i a l P e r s p e c t i v e LEARNING O BJECTIVE 1 Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement. WHY MANAGERS ANALYZE FINANCIAL STATEMENTS Managers analyze financial statements for a variety of reasons including: (1) to control operations; (2) to assess the financial stability of vendors, customers, and other business partners; and (3) to assess how their companies appear to investors and creditors. In this section, we discuss each of these motivations for analyzing financial statements. Control of Operations Managers frequently set goals and develop financial plans related to various aspects of their businesses. To gain insight into whether their goals have been achieved or the plans have been implemented successfully, managers analyze financial statements. In part, this is how they control operations. Managers expect that successful implementation of their plans will be reflected in subsequent financial information. If the financial information is inconsistent with successful implementation, managers launch an investigation to determine why this is the case. If the information is consistent with successful implementation, then managers assume that their plans are working and direct their attention to other pressing issues. For example, consider the case of City Appliances. During 2016, the company had cost of goods sold of $80,000,000 and inventory at the end of 2016 of $20,000,000. Thus, inventory turnover (the ratio of cost of goods sold to ending inventory) was 4. Senior management of City Appliances knows that the industry average is closer to 6 and concludes that the company has too much invested in inventory given its sales levels. In light of this, the company develops plans to better monitor inventory and sales data and gets commitments from suppliers to provide merchandise on a timely basis. This should allow City Appliances to reduce the amount of inventory it keeps on hand. Has the plan been successful? At the end of 2017 (or quarterly), the company can monitor inventory turnover. Suppose that during 2017 cost of goods sold was $90,000,000 and that inventory at the end of 2017 is $15,700,000. In this case, inventory turnover is 5.73 ($90,000,000 $15,700,000), which is much closer to the industry average of 6. Given this result, senior management can reasonably conclude that its plans for controlling the amount invested in inventory are achieving considerable success. Assessment of Vendors, Customers, and Other Business Partners Another important reason for analyzing financial statements is to assess the financial stability of vendors (i.e., suppliers), customers, and other business partners. Increasingly, companies are establishing strong relationships with a relatively small number of vendors who are willing to commit to high quality levels and short lead times. In part, the short lead times are facilitated by sharing sales and other key data with vendors. Before committing substantial funds to integrate the vendor's information system with the company's system (which facilitates data sharing and reduces lead times), managers want to be confident that the vendor will be stable and continue in existence over the foreseeable future. In short, managers want to avoid developing systems to coordinate with a vendor only to have the vendor go out of business. Companies analyze the financial statements of customers to assess whether they will be able to pay the amounts they owe on a timely basis. Companies are also concerned about the long-term viability of customers, especially if they need to make substantial investments in equipment to produce goods for them. Many companies are also developing partnerships with other firms to produce and sell products and services. Obviously, they do not want to enter such a partnership with a firm that is in financial difficulty. How can a manager assess the financial stability of H o r i z o n t a l a n d V e r t i c a l A n a l y s e s 533 potential vendors, customers, and other business partners? Analysis of financial statements can be very helpful. We will go into more detail in following sections, but for now we'll consider one financial ratio, times interest earned, which is the ratio of operating income to interest expense. If this ratio is less than 1, it suggests that the company will not be able to make required debt payments, which may lead to bankruptcy. Thus, this ratio and others that we will be discussing should be calculated for companies that are potential vendors, customers, or business partners. Assessment of Appearance to Investors and Creditors Investors and creditors carefully analyze a company's financial statements, and managers should anticipate how their financial information will appear to these important stakeholders. If, for example, managers know that the financial statements will show a marked difference between cash flow from operations and net income and that such a difference is likely to cause investor concern, then they can communicate with investors via notes in their financial statements, press releases, or other news articles to explain the difference and, it is hoped, alleviate concern. Alternatively, they can avoid transactions leading to such differences. In general, managers should analyze financial statements from the perspective of their investors and creditors so they can anticipate, and fully answer, questions from these stakeholders. T est y ou r K N O W L E D G E Managers analyze financial statements: a. To control operations. b. To assess vendors, customers and other business partners. c. To assess appearance to investors and creditors. d. All of these answer choices are correct. Correct answer is d. HORIZONTAL AND VERTICAL ANALYSES We will use the financial statements of HGW to demonstrate how to analyze financial statements. Let's begin by performing two types of analyses: horizontal analysis and vertical analysis. Horizontal analysis consists of analyzing the dollar value and percentage changes in financial statement amounts across time. Vertical analysis (also called common size analysis) consists of analyzing financial statement amounts in comparison to a base amount (total assets when analyzing the balance sheet and net sales when analyzing the income statement). The calculations for either horizontal or vertical analysis are easy to do using a spreadsheet program. Analysis of the Balance Sheet The results of performing a horizontal analysis of the balance sheet for HGW are presented in Illustration 14-1. What are the major changes in HGW between 2016 and 2017? Somewhat arbitrarily, we'll define a major change to be a change exceeding $10 million (obviously a very large amount, but keep in mind that total assets are over $2 billion). For assets, these changes relate to receivables, merchandise inventory, land, buildings, and furniture and fixtures (all of which have increased). For liabilities and stockholders' equity, major changes relate to accounts payable, long-term debt, and retained earnings. 534 chapte r 1 4 A n a l y z i n g F i n a n c i a l S t a t e m e n t s : A M a n a g e r i a l P e r s p e c t i v e Illustration 14-1 Horizontal analysis of the balance sheet for HGW Home and Garden Warehouse Balance Sheets (in thousands) December 31, 2017 December 31, 2016 Change Percent Change* Assets Current assets: Cash and cash equivalents Receivables, net Merchandise inventories Other current assets Total current assets Property and equipment: Land Buildings, net Furniture, fixtures, and equipment, net Net property and equipment Total assets Liabilities and Stockholders' Equity Current liabilities: Accounts payable Accrued salaries and related expenses Other accrued expenses Income taxes payable Current portion of long-term debt Total current liabilities Long-term debt Total liabilities Stockholders' equity: Common stock Additional paid-in capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 17,201 70,150 641,280 15,003 743,634 $ 16,968 59,287 554,389 14,544 645,188 $ 233 1.4% 10,863 18.3% 86,891 15.7% 459\t3.2% 98,446 15.3% 427,230 622,867 290,577 1,340,674 $2,084,308 328,048 488,234 230,179 1,046,461 $1,691,649 99,182 134,633 60,398 294,213 $392,659 $ 244,905 62,725 29,886 6,807 3,258 347,581 254,525 602,106 $ 199,420 54,123 26,943 6,158 2,968 289,612 75,628 365,240 $ 45,485 8,602 2,943 649 290 57,969 178,897 236,866 22.8% 15.9% 10.9% 10.5% 9.8% 20.0% 236.5% 64.9% 440,538 16,413 1,025,251 1,482,202 $2,084,308 440,538 16,413 869,458 1,326,409 $1,691,649 155,793 155,793 $392,659 0.0% 0.0% 17.9% 11.7% 23.2% 30.2% 27.6% 26.2% 28.1% 23.2% * Percent change equals change divided by 2016 balance. What can we conclude? It appears that HGW is expanding (hence the increases in land, buildings, and furniture, fixtures, and equipment) and building up receivables and inventories. The expansion is funded partly by increased long-term debt and partly by internally generated funds (hence the increase in retained earnings). A vertical analysis of the balance sheets of HGW is presented in Illustration 14-2. Note that the base in this analysis is total assets. The analysis indicates that the primary asset accounts are merchandise inventory, land, and buildings (all greater than 20 percent of total assets). In terms of liabilities and shareholders' equity balances, only common stock and retained earnings exceed 20 percent of total assets (or, alternatively, 20 percent of liabilities and stockholders' equity, which equals total assets). Note that except for long-term debt, which has increased from 4.5 percent to 12.2 percent of total assets, balances as a percent of total assets are quite consistent between 2016 and 2017. H o r i z o n t a l a n d V e r t i c a l A n a l y s e s 535 Illustration 14-2 Vertical analysis of the balance sheet for HGW Home and Garden Warehouse Balance Sheets (in thousands) December 31, 2017 Assets Current assets: Cash and cash equivalents Receivables, net Merchandise inventories Other current assets Total current assets Property and equipment: Land Buildings, net Furniture, fixtures, and equipment, net Net property and equipment Total assets Liabilities and Stockholders' Equity Current liabilities: Accounts payable Accrued salaries and related expenses Other accrued expenses Income taxes payable Current portion of long-term debt Total current liabilities Long-term debt Total liabilities Stockholders' equity: Common stock Additional paid-in capital Retained earnings Total stockholders' equity Total liabilities and stockholders' equity $ 17,201 70,150 641,280 15,003 743,634 427,230 622,867 290,577 1,340,674 $2,084,308 0.8% 3.4% 30.8% 0.7% 35.7% 20.5% 29.9% 13.9% 64.3% 100.0% December 31, 2016 $ 16,968 1.0% 59,287 3.5% 554,389 32.8% 14,544\t0.9% 645,188 38.1% 328,048 488,234 230,179 1,046,461 $1,691,649 19.4% 28.9% 13.6% 61.9% 100.0% $ 244,905 62,725 29,886 6,807 3,258 347,581 254,525 602,106 11.7% 3.0% 1.4% 0.3% 0.2% 16.7% 12.2% 28.9% $ 199,420 54,123 26,943 6,158 2,968 289,612 75,628 365,240 11.8% 3.2% 1.6% 0.4% 0.2% 17.1% 4.5% 21.6% 440,538 16,413 1,025,251 1,482,202 $2,084,308 21.1% 0.8% 49.2% 71.1% 100.0% 440,538 16,413 869,458 1,326,409 $1,691,649 26.0% 1.0% 51.4% 78.4% 100.0% Analyzing the Income Statement Similar to our analyses related to the balance sheet, let's perform horizontal and vertical analyses of the income statement. The horizontal analysis is presented in Illustration 14-3. The most obvious change between 2016 and fiscal 2017 is the $825,508 increase in net sales. This represents a 42.5 percent increase over fiscal 2016. Cost of merchandise sold increased by $577,992, and this was a 42.4 percent increase. The result of these two changes is an increase in gross profit of 43 percent. Recall from our analysis of the balance sheet that HGW appeared to be expanding operations (e.g., the cost of buildings increased by 28 percent). Thus, it appears that HGW is opening new stores, which, at least in part, accounts for the very substantial increase in sales. It may also be that the economy improved in 2017, which would increase sales of the types of products sold by HGW. 536 chapte r 1 4 A n a l y z i n g F i n a n c i a l S t a t e m e n t s : A M a n a g e r i a l P e r s p e c t i v e Illustration 14-3 Horizontal analysis of the income statement for HGW Home and Garden Warehouse Statements of Earnings (in thousands) Net sales Cost of merchandise sold Gross profit Operating expenses: Selling and store operating expenses General and administrative expenses Total operating expenses Operating income Interest expense Earnings before income taxes Income taxes Net earnings For the Year Ended December 31, 2017 For the Year Ended December 31, Percent 2016 Change Change* $2,766,425 1,942,654 823,771 $1,940,917 1,364,662 576,255 $825,508\t42.5% 577,992 42.4% 247,516 43.0% 518,742 50,601 569,343 254,428 14,747 239,681 83,888 $ 155,793 344,360 33,886 378,246 198,009 3,737 194,272 67,995 $ 126,277 174,382 16,715 191,097 56,419 11,010 45,409 15,893 $ 29,516 50.6% 49.3% 50.5% 28.5% 294.6% 23.4% 23.4% 23.4% * Percent change equals change divided by 2016 balance. The other major change in 2017 is the $191,097 increase in operating expenses. This increase is 50.5 percent, exceeding the percentage increase in sales. Overall, we can see that HGW had a substantial increase in sales that was partially offset by increases in expenses. Net earnings for fiscal 2017 increased by $29,516, a 23.4 percent increase over fiscal 2016. A vertical (common size) analysis of the income statement is presented in Illustration 14-4. Note that in this analysis, the base is net sales (in the analysis of the balance sheet, the base was total assets). As indicated, net income has declined from Illustration 14-4 Vertical analysis of the statement of earnings (also called income statement) for HGW Home and Garden Warehouse Statements of Earnings For the Year Ended (in thousands) December 31, 2017 For the Year Ended December 31, 2016 Net sales Cost of merchandise sold Gross profit Operating expenses: Selling and store operating expenses General and administrative expenses Total operating expenses Operating income Interest expense Earnings before income taxes Income taxes Net earnings 344,360 17.7% 33,886 1.7% 378,246 19.5% 198,009 10.2% 3,737\t0.2% 194,272 10.0% 67,995\t3.5% 126,277 6.5% $2,766,425\t100.0% $1,940,917\t100.0% 1,942,654 70.2% 1,364,662\t70.3% 823,771\t29.8% 576,255\t29.7% 518,742 18.8% 50,601 1.8% 569,343 20.6% 254,428 9.2% 14,747\t0.5% 239,681 8.7% 83,888\t3.0% $ 155,793 5.6% $ E a r n i n g s M a n a g e m e n t a n d t h e N e e d t o C o m p a r e E a r n i n g s a n d C a s h - F l o w I n f o r m a t i o n 537 6.5 percent of sales to 5.6 percent. What's the culprit for this decline? The most obvious cause of the decline is the relative increase in selling and store operating expenses. This was only 17.7 percent in fiscal 2016 but it increased to 18.8 percent in fiscal 2017. While this may appear to be only a minor increase, remember that these values are percentages of sales and sales are quite large (over $2.7 billion in fiscal 2017). LEARNING O BJECTIVE 2 Discuss earnings man agement and the impor tance of comparing net income to cash flow from operations. Also understand how MD&A, credit reports, and news articles can be used to gain insight into a company's current and future financial performance. EARNINGS MANAGEMENT AND THE NEED TO COMPARE EARNINGS AND CASH-FLOW INFORMATION It is well known that accounting earnings can be manipulated to make financial performance appear stronger than it actually is, and allegations of financial improprieties have been leveled against such firms as Cendant, Computer Associates, Enron, Kroger, Lucent, Sunbeam, and Waste Management. Why do some managers manipulate earnings? As you well know, \"You get what you measure,\" and managers often are evaluated and rewarded based on the level of firm earnings. Thus, for example, if earnings are below the level specified for achieving a bonus, managers have strong incentives to manipulate earnings upward. Another reason to manage earnings upward might be to inflate stock prices so managers can profit from exercising their stock options. A red flag suggesting that accounting irregularities may be a problem is a substantial difference between reported net income and operating cash flows. Why is this comparison informative? Suppose a firm records fictitious sales. Income will increase, but operating cash flows will not be affected (since companies don't collect cash from fictitious sales!) and, thus, there will be a difference between income and operating cash flows. Likewise, if a company understates expenses (which increases income) but still makes payments related to the actual expenses, there also will be a difference between income and operating cash flows. In the case of HGW, net earnings for fiscal 2017 were $155,793,000 (see Illustration 14-3) while net cash provided by operations was only $144,562,000 (see Illustration 14-5). The more than $10 million difference (recall values are in thousands) does indeed suggest that earnings may have been managed upward at HGW. This, of course, is not definitive proof that earnings have been manipulated, but, as already stated, it's a red flag sending the signal \"Beware!\" Link to Practice Watching Cash Flow versus Earnings When Jamie Olis, former vice president of finance at Dynegy (an energy trading firm), went on trial, jurors heard about cash flow versus earnings. According to the prosecutor, Assistant U.S. Attorney Belinda Beek, Olis was worried that \"professional watchers\" such as stock analysts and credit-rating agencies would notice the company's gap between cash flow and earnings, which raises a red flag concerning earnings management. To increase cash flow, the company entered a deal called Project Alpha. The company characterized the deal as increasing operating cash flows, but the government argued that the cash really came from a loan. Interestingly, back in 2001, Chuck Watson, Dynegy's CEO, was critical of Enron's financial shenanigans and stated in a Forbes Magazine cover story: \"I just hope [Enron] doesn't think all this spinning, which got them into trouble to begin with, is going to get them out of it.\" Watson resigned in 2002, and the company's stock price jumped 5 percent on the day his resignation was announced. Source: Laura Goldberg, \"Trial Opens in Dynegy's Alpha Deal; Prosecutor Tells Jury Case is about Lying,\" Houston Chronicle, November 4, 2003. 538 chapte r 1 4 A n a l y z i n g F i n a n c i a l S t a t e m e n t s : A M a n a g e r i a l P e r s p e c t i v e Illustration 14-5 The statement of cash flows for HGW Home and Garden Warehouse Consolidated Statement of Cash Flows (in thousands) Cash Provided from Operations Net earnings Reconciliation of net earnings to cash provided by operations: Depreciation and amortization Increase in receivables Increase in merchandise inventories Increase in other current assets Increase in accounts payable Increase in accrued salaries and related expenses Increase in other accrued expenses Increase in income taxes payable Increase in current portion of long-term debt Net cash provided by operations For the Year Ended December 31, 2017 $ 155,793 29,013 (10,863) (86,891) (459) 45,485 8,602 2,943 649 290 144,562 Cash Flow from Investing Activities Additions to property and equipment (323,226) Cash Flow from Financing Activities Issuance of long-term debt Increase in cash and cash equivalents Cash and cash equivalents at beginning of year Cash and cash equivalents at end of year 178,897 233 16,968 $ 17,201 OTHER SOURCES OF INFORMATION ON FINANCIAL PERFORMANCE In addition to analyzing the basic financial statements, a number of other information sources can be used to gain insight into a company's current and future financial performance. Here we will discuss three such sources: management discussion and analysis, credit reports, and news articles. Management Discussion and Analysis The annual report of public companies contains a section called management discussion and analysis (abbreviated as MD&A). In this section, management provides stockholders and other financial statement users with explanations for financial results that are not obvious simply from reading the basic financial statements. Illustration 14-6 provides Illustration 14-6 Excerpt from the MD&A section of HGW's annual report Fiscal Year ended December 31, 2017, compared to December 31, 2016 Net sales for fiscal 2017 increased 42.5% to $2.8 billion from $1.9 billion in fiscal 2016. This increase is attributable to, among other things, full-year sales from the 35 new stores opened during fiscal 2016, and 15 new store openings in 2016 as well as an 8 percent comparable storefor-store sales increase. Gross profit as a percent of sales was 29.8 percent for fiscal 2017 compared to 29.7 percent for fiscal 2016. The increase was primarily attributable to a lower cost of merchandise resulting from product-line reviews and benefits from our global sourcing programs. O t h e r S o u r c e s o f I n f o r m a t i o n o n F i n a n c i a l P e r f o r m a n c e 539 Illustration 14-7 Dun & Bradstreet's web page offering credit reports Source: Smallbusiness. dnb.com. Reprinted by permission of Dun & Bradstreet. an excerpt from the MD&A of HGW in the annual report for fiscal 2017. Note that the information is consistent with our brief analysis of the financial statements that indicated that HGW is engaged in substantial expansion. Credit Reports A number of firms (e.g., Dun & Bradstreet) sell credit reports that provide information on a company's credit history. A picture of the web page of Dun & Bradstreet's small-business solutions service, which offers credit ratings, is provided in Illustration 14-7. The ratings help managers evaluate the likelihood that a company they do business with will pay its bills on time. News Articles News articles are another very valuable source of information with financial implications. For example, a recent article indicated that William Nelson, chief operating officer of HGW, resigned. Such a departure could be a signal of serious internal problems. However, the article also noted that HGW is deep in talent related to merchandising and the company's stock price actually increased the day of the announcement. This suggests that the stock market did not view the departure as a major negative event. Lexis-Nexis is a company that, for a fee, provides access to articles from major newspapers, magazines, and newswire services. A free service, and one that is targeted at financial performance, is provided by Yahoo! Finance (http://finance.yahoo.com). On this website you can search for news articles for publicly traded companies by entering their stock ticker symbols. 540 chapte r 1 4 A n a l y z i n g F i n a n c i a l S t a t e m e n t s : A M a n a g e r i a l P e r s p e c t i v e LEARNING O BJECTIVE 3 Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios. RATIO ANALYSIS To control operations, to assess the stability of vendors, customers, and other business partners, and to assess how their companies appear to investors and creditors, managers frequently perform financial analyses using various ratios. We will examine a number of ratios in common use and group them into three categories: those dealing with the profitability of a company, those dealing with asset turnover, and those dealing with a company's debt-paying ability. Profitability Ratios Let's begin by examining the profitability ratios presented in Illustration 14-8 using the data for HGW (see Illustrations 14-2 and 14-3). The first ratio we will examine is earnings per share (EPS) calculated as net income less preferred dividends divided by the number of shares of common stock that are outstanding. For fiscal 2017, HGW had net earnings of $155,793,000 and it had 465,000,000 shares of common stock outstanding at the end of 2017. Thus, its earnings per share is $0.335. The second profitability ratio is the price-earnings ratio calculated as the market price per share divided by earnings per share. For HGW, the market price per share at the end of 2017 was $5.02, and thus its price-earnings ratio is 14.99. This ratio has increased slightly from the prior year. While a variety of factors affect the price-earnings ratio, including interest rates and other factors that relate to general economic conditions, a major factor is investors' expectations of future profitability. The gross margin percentage is simply the gross margin divided by net sales, which provides a rough estimate of the incremental profit generated by each dollar of sales. This ratio (0.298) has stayed relatively constant between fiscal 2016 and fiscal 2017. Return on total assets is equal to net income (adjusted for interest expense net of taxes) divided by total assets. The adjustment for interest is made so that the assessment of profitability is independent of how the firm is financed. (Debt financing reduces Illustration 14-8 Profitability ratios for HGW Earnings per share = (Net income Preferred dividends) Number of common shares outstanding 2017\t($155,793,000 0) 465,000,000 = $0.335 2016\t($126,277,000 0) 465,000,000 = $0.272 Price-earnings ratio = Market price per share Earnings per share 2017\t$5.02 $0.335 = $14.99 2016\t$4.05 $0.272 = $14.89 Gross margin percentage = Gross margin Net sales 2017\t$823,771 $2,766,425 = 0.298 2016\t$576,255 $1,940,917 = 0.297 Return on total assets = {Net income + [Interest expense (1 Tax rate)]} Total assets 2017\t{$155,793 + [$14,747 (1 0.35)]} $2,084,308 = 0.079 2016\t{$126,277 + [$3,737 (1 0.35)]} $1,691,649 = 0.076 Return on common stockholders' equity = (Net income Preferred dividends) Common stockholders' equity 2017\t($155,793 0) $1,482,202 = 0.105 2016\t($126,277 0) $1,326,409 = 0.095 R a t i o A n a l y s i s 541 income [due to interest expense], but equity financing does not reduce reported income.) The tax rate is determined by dividing income taxes ($83,888 in fiscal 2017) by earnings before income taxes ($239,681 in fiscal 2017) yielding a tax rate of 35 percent. Return on total assets was 0.079 in fiscal 2017 and 0.076 in fiscal 2016. This indicates only a slight increase in profitability. The final profitability ratio that we will examine is return on common stockholders' equity, which is equal to net income less preferred dividends divided by common stockholders' equity. Consistent with the increase in the return on total assets, the return on common stockholders' equity has increased from 0.095 in fiscal 2016 to 0.105 in fiscal 2017. Financial Leverage. Note that the return on common equity is higher than the return on assets (0.105 versus 0.079 for fiscal 2017). This indicates that the company is making good use of financial leverage, which relates to the use of debt financing to acquire assets. Whenever the cost of debt is less than the return that the company can earn on its assets, financing with debt will increase the percentage return to shareholders. Summary of the Profitability Ratios. Let's summarize what we've learned from the profitability ratios. It appears that the profitability of HGW has increased but not dramatically. Earnings per share is up and so is the price-earnings ratio. The gross margin percentage, return on total assets, and return on stockholders' equity are also up, but only slightly. Turnover Ratios Turnover ratios reveal the efficiency with which a company uses its assets. The turnover ratios we will use in examining HGW are presented in Illustration 14-9. The first turnover ratio that we will discuss is asset turnover defined as net sales divided by total assets.1 Note that this ratio has increased from 1.147 to 1.327, suggesting an improvement in the efficient use of assets. Now let's take a look at two particular assets: accounts receivable and inventory. The accounts receivable turnover ratio is defined as net credit sales divided by accounts receivable. Generally, financial statements do not indicate the breakdown of credit and cash sales so most analysts assume that all sales are credit sales. This assumption would not be reasonable for HGW since, for this company, cash sales predominate. Recall from Illustration 14-2 that receivables are relatively unimportant for HGW; they make up only 3.4 percent of total assets. Thus, the fact that we cannot obtain credit sales information that facilitates calculation of the accounts receivable turnover ratio is not unduly troubling. Here we make the simplifying assumption that total sales are roughly equivalent to credit sales so we can illustrate the calculation of the accounts receivable turnover ratio. Making the assumption, we can see that the turnover in receivables has increased from 32.738 in fiscal 2016 to 39.436 in fiscal 2017. Additional insight into receivables can be achieved by converting the accounts receivable turnover ratio into a measure of how many days' sales are in receivables. This is done by dividing the turnover ratio into 365 days. As indicated in Illustration 14-9, the days' sales in receivables was 11.149 days for fiscal 1 Using ending total assets in the denominator of this ratio is consistent with the approach used in a number of finance textbooks (e.g., Robert Higgins, Analysis for Financial Management, McGraw-Hill, Irwin, 2004). However, it is also common to calculate the ratio using the average of beginning and ending total assets in the denominator. Similarly, some books use ending inventory in the inventory turnover ratio and ending accounts receivable in the accounts receivable turnover ratio, while others use average values in the denominator. There are pros and cons to both approaches. Most important, however, is that you use the same approach in each year when comparing performance from one year to another. 542 chapte r 1 4 A n a l y z i n g F i n a n c i a l S t a t e m e n t s : A M a n a g e r i a l P e r s p e c t i v e Illustration 14-9 Turnover ratios for HGW Asset turnover = Net sales Total assets 2017\t$2,766,425 $2,084,308 = 1.327 2016\t$1,940,917 $1,691,649 = 1.147 Accounts receivable turnover = Net credit sales Accounts receivable 2017\t$2,766,425 $70,150 = 39.436 2016\t$1,940,917 $59,287 = 32.738 Days' sales in receivables =\t365 Accounts receivable turnover 2017\t365 39.436 = 9.256 2016\t365 32.738 = 11.149 Inventory turnover = Cost of goods sold Inventory 2017\t$1,942,654 $641,280 = 3.029 2016\t$1,364,662 $554,389 = 2.462 Days' sales in inventory =\t365 Inventory turnover 2017\t365 3.029 = 120.502 2016\t365 2.462 = 148.253 2016 and 9.256 days for fiscal 2017. These values are quite low and reflect the fact that most sales are actually cash sales. For a company that had credit sales with payment due in 30 days, we would expect to see values in the 30- to 50-day range. A measure of the efficient use of inventory is provided by the inventory turnover ratio defined as cost of goods sold divided by inventory. This ratio increased from 2.462 to 3.029. We can also convert this ratio into a days' sales in inventory measure by dividing 365 days by the inventory turnover ratio. This reveals that HGW has 120.502 days of sales in inventory for fiscal 2017 compared to 148.253 days for fiscal 2016. While there has been some improvement in days' sales in inventory, the number of days is quite high given the nature of HGW's business. In comparison, the number of days' sales in inventory for Home Depot is less than 70 days. Any Q u es tions ? Q: After we calculate a ratio, how do we know whether it's too high or too low? Is this one of those \"it's more art than science\" things? A : In short, yes! No ratio has an unequivocally \"correct\" value. Consider the inventory turnover ratio. We can, for example, compare a company's inventory turnover ratio to those of its major competitors. But the average value of the ratio for competitors isn't necessarily the optimal value for a particular company. What if a company's ratio is lower than the industry average? That could mean that the company has excess inventory, or it could mean that the company has a great selection of items that is leading to high sales. Or, suppose a company's inventory turnover ratio is higher than the average ratio value of competitors. This could mean that the company is doing a great job of controlling inventory, or it could mean that there's a problem and the company is frequently missing sales because inventory is back-ordered. It's best to think of ratios as clues to a company's financial condition. You need to organize the clues and compare them to other pieces of information (such as credit reports, news articles, knowledge of economic conditions, etc.). With some experience, you'll find that the clues are providing you with important insights and helping you solve the \"mystery\" of a company's financial condition. R a t i o A n a l y s i s 543 Illustration 14-10 Debt-related ratios for HGW Current ratio = Current assets Current liabilities 2017\t$743,634 $347,581 = 2.139 2016\t$645,188 $289,612 = 2.228 Acid test (quick ratio) =\t(Cash + Marketable securities + Short-term receivables) Current liabilities 2017\t($17,201 + $70,150) $347,581 = 0.251 2016\t($16,698 + $59,287) $289,612 = 0.262 Debt-to-equity ratio = Total liabilities Stockholders' equity 2017\t$602,106 $1,482,202 = 0.406 2016\t$365,240 $1,326,409 = 0.275 Times interest earned = Operating income Interest expense 2017\t$254,428 $14,747 = 17.253 2016\t$198,009 3,737 = 52.986 Summary of Turnover Ratios.From the turnover ratios, we can see that HGW appears to have been more efficient in its use of assets in fiscal 2017 compared to fiscal 2016. Asset turnover has increased, which is due in part to an increase in the turnover of inventory. Given the high dollar value of inventory, it is appropriate to note especially that while days' sales in inventory has improved, it is quite high in comparison to the ratio of HGW's major competitors such as Home Depot. Debt-Related Ratios The last set of ratios we will examine relate to the amount of debt a company has and its ability to repay its obligations. The debt-related ratios we will use to examine HGW are presented in Illustration 14-10. The current ratio is computed as current assets divided by current liabilities, and it provides an indication of a company's ability to meet its short-term obligations. For HGW, the current ratio declined slightly from 2.228 to 2.139. However, given that the ratio is substantially greater than 1, it appears that there is little doubt that HGW will be able to pay its current liabilities. A more stringent test of short-term debt paying ability is provided by the acid-test ratio (also known as the quick ratio). This ratio compares cash, marketable securities, and short-term receivables to current liabilities. Note that the numerator of this ratio only includes a company's most liquid assets. For HGW, this ratio also decreased slightly from 0.262 to 0.251. For many companies, an acid-test ratio less than 1 is troubling, and this is the case for HGW. Recall that the company is not able to quickly convert its inventory into sales and then to cash to satisfy current liabilitiesit has 120.502 days' sales in inventory, which implies that the company requires about four months to convert its inventory into sales that generate cash that can be used to satisfy current liabilities. The debt-to-equity ratio is calculated as the ratio of total liabilities to stockholders' equity, and it provides an assessment of a company's debt position. The higher the ratio, the more debt the company has and the more risky the company becomes because it must continue to make principal and interest payments on its debt even if sales decline. Further, potential creditors hesitate to grant additional financing to a company with a high debt-to-equity ratio since repayment is at least somewhat doubtful. For HGW, the ratio increased from 0.275 to 0.406, consistent with the increase in debt that we noted in the horizontal analysis of HGW's balance sheet. In conjunction with the debt-to-equity ratio, it is useful to examine the ratio referred to as \"times interest earned.\" This ratio is computed as operating income divided by 544 chapte r 1 4 A n a l y z i n g F i n a n c i a l S t a t e m e n t s : A M a n a g e r i a l P e r s p e c t i v e interest expense. For HGW, the ratio is quite high, 17.253, although it has decreased from 52.986. Since the level of operating income is so high compared to the amount of interest expense, it seems highly likely that the company will be able to make its debt payments in spite of the fact that debt financing has increased. Summary of Debt-Related Ratios. From the debt-related ratios, we can see that HGW has current assets in excess of current liabilities, indicating that the company should be able to cover its short-term obligations. And while debt financing has increased, the company has operating income many times higher than the amount of interest it must pay on its debt. Thus, it appears that the company will be quite able to satisfy its long-term obligations as well as its short-term obligations. A concern, however, relates to the acid-test ratio, which is only 0.251. This is particularly troubling, given our earlier finding that the company has 120.502 days' sales in inventory. Link to Practice Tribune Company Took on Too Much Debt In December 2008, the Tribune Company, owner of the famed newspaper the Chicago Tribune, filed for bankruptcy. In April 2007, investor Sam Zell had taken the company private in a transaction light on equity and heavy on debt. Zell invested only $315 million in equity while the company was saddled with $13 billion in debt. To say that the company had an extremely high debt-to-equity ratio is a major understatement. In filing for bankruptcy, Zell is quoted as saying, \"This filing is all about relieving the pressure on the company from too much debt.\" The company's bondholders will likely receive only a small fraction of what they lent the company. Source: Michael O'Neil and Phil Rosenthal, \"Tribune Co. Files for Bankruptcy Protection,\" chicagotribune.com, December 9, 2008. A MANAGERIAL PERSPECTIVE ON THE ANALYSIS OF HGW'S FINANCIAL STATEMENTS At the start of the chapter, we noted that managers analyze financial statements for three reasons: (1) to control operations; (2) to assess the stability of vendors, customers, and other business partners; and (3) to assess how their companies appear to investors and creditors. Now let's see how these objectives would be addressed in terms of the analyses we've performed for HGW. Control of Operations Recall that at the start of fiscal 2017, HGW decided to press for discounts from suppliers and to work to reduce selling and store operating expenses. Has the company been successful in achieving these goals? Our analysis suggests that its plans have not been effective. The gross margin percentage has remained at approximately 0.30, which implies that cost of merchandise sold is approximately the same percent of sales in fiscal 2017 as in fiscal 2016. Further, selling and store operating expenses actually have increased as a percentage of sales. Thus, financial analysis would suggest that the management of HGW should reexamine its plans and their implementation. Decision Making/ Incremental Analysis Financial Ratios and Decision Making. We've just seen that HGW has not had the increase in its gross margin percentage that it hoped to achieve by receiving discounts from suppliers. What should the company do about this? Should it put more pressure on existing suppliers and threaten to take its business elsewhere? Should it seek out new low-cost suppliers? Or should it consider changes in its product mix and marketing in an effort to get customers to purchase products with a higher margin? Each of these potential actions is a decision alternative, and you certainly know how to analyze d ecisions: A Managerial Perspective on the A n a l y s i s o f H gw ' s F i n a n c i a l S t a t e m e n t s 545 incremental analysis! The alternative that has the highest incremental profit (and that might be doing nothing) is the action that should be pursued. You get what you M e a s u r e Financial Ratios in a Balanced Scorecard: You Get What You Measure!In general, it is advisable to include at least one or two financial ratios in the financial performance section of a balanced scorecard (see Chapter 12). Comparing actual performance to targets helps a company evaluate how successful it has been in executing its strategy for success. If part of the strategy is to get suppliers to provide discounts leading to a higher gross margin percentage, then the gross margin percentage should be included in the balanced scorecard. As we've noted throughout the book, \"You get what you measure!\" And since financial ratios are useful in controlling operations, we want managers to focus on them. If they are part of a business unit's balanced scorecard, and if top management supports the use of the scorecard, you can be confident that the financial ratios will gain the attention of managers. Stability of Vendors, Customers, and Other Business Partners PG Lighting is interested in developing a strategic partnership with HGW. In this partnership, PG Lighting will link its information system to the electronic checkout systems at the more than 200 HGW locations so it can track sales and efficiently schedule its production. LINK TO PRACTICE Comparative Ratio Data In this chapter, we've gained insight into HGW by comparing its ratios in fiscal 2017 to its ratios in fiscal 2016. It's also useful to compare a company's ratios to those of its primary competitor or to industry averages. Here's how to find competitors. The process may seem involved, but it will take less than five minutes! 1. Go to Yahoo! Finance (http://finance.yahoo.com). 2.\tInsert the ticker symbol of the company you are analyzing. 3.\tUnder Company, click Competitors. This will lead you to a list of competitors and industry data. Once you have determined the competitor of interest, go to that company's website to obtain its annual report, or go to the SEC (Securities and Exchange Commission) website, where you can download the company's form 10K (the annual filing with the SEC that contains the company's financial statements and a great deal of additional information that would be useful in analysis). The SEC website (known as EDGAR) is found at www.sec.gov/cgi-bin/srch-edgar. Industry ratios can be found in the Annual Statement Studies published by RMA (Risk Management Association, formerly known as Robert Morris Associates). This publication is available in many libraries or by subscribing online. Should PG Lighting be concerned about the financial stability of HGW? Our analysis suggested that HGW needs to do a better job controlling its inventory levels. However, the financial viability of HGW is not in question since the company is still reasonably profitable and in no danger of failing to meet its financial obligations. Thus, PG Lighting should not be concerned that an alliance with HGW will be jeopardized by financial problems. Appearance to Investors and Creditors Suppose you were the CEO at HGW, and you were going to meet with shareholders and financial analysts. Given the analyses we've performed, what questions would you anticipate? Quite possibly, questions would focus on days' sales in inventory, which is more than 120 days. By performing financial analysis, the CEO can anticipate questions from investors and be prepared with solid answers. The same point would hold in regard to a meeting with creditors. 546 chapte r 1 4 A n a l y z i n g F i n a n c i a l S t a t e m e n t s : A M a n a g e r i a l P e r s p e c t i v e SUMMARY OF ANALYSES Let's briefly summarize the types of analyses we've performed in this chapter. We began by performing horizontal and vertical analyses of the balance sheets and income statements. We also performed ratio analysis. The ratios we examined were grouped into three categories: profitability ratios (which provide insight into the overall profitability of a company), turnover ratios (which provide insight into the efficient use of assets), and debt-related ratios (which provide insight into a company's ability to satisfy its short-term and long-term obligations). The specific formulas for the ratios we've covered are summarized in Illustration 14-11. The meaning of the ratios is summarized in Illustration 14-12. When conducting financial analysis, it is important to get beyond the numbers. As we discussed, it is often useful to read the MD&A section of the annual report to learn management's explanation for financial results. Also, news articles and credit reports can provide insight into a firm's current and future performance. Illustration 14-11 Summary of ratio formulas Profitability Ratios Earnings per share (Net income Preferred dividends) Number of common shares outstanding Price-earnings ratio Market price per share Earnings per share Gross margin percentage Gross margin Net sales Return on total assets {Net income + [Interest expense (1 Tax rate)]} Total assets Return on common (Net income Preferred dividends) stockholders' equity Common stockholders' equity Turnover Ratios Asset turnover Net sales Total assets Accounts receivable turnover Net credit sales Accounts receivable Days' sales in receivables\t365 Accounts receivable turnover Inventory turnover Cost of goods sold Inventory Days' sales in inventory\t365 Inventory turnover Debt-Related Ratios Current ratio Current assets Current liabilities Acid-test ratio (quick ratio)\t(Cash + Marketable securities + Short-term receivables) Current liabilities Debt-to-equity ratio Total liabilities Stockholders' equity Times interest earned Operating income Interest expense Illustration 14-12 Meanings of ratios Profitability Ratios Earnings per share Amount of earnings generated per share of common stock. The more earnings per share a company can generate, the higher its stock price. Price-earnings ratio Indicates how much investors are willing to pay per dollar of e arnings. Generally, a high price-earnings ratio indicates that investors believe a company will have relatively high earnings growth. Gross margin percentage Indicates how much a company earns per dollar of sales, taking into account the cost of the items it sells. Companies that have a relatively high markup on the products they sell (e.g., jewelry stores) have relatively high gross margin percentages. S u m m a r y o f L e a r n i n g O b j e c t i v e s 547 Illustration 14-12 (continued) Return on total assets Indicates how profitable a company is in relation to its assets. It also shows how efficiently management is using its assets irrespective of how the company is financed. Return on common stockholders' equity The return a company is able to earn on funds invested by shareholders. A ratio higher than the return on total assets suggests that the company is making good use of leverage (debt financing). Turnover Ratios Asset turnover Shows how efficiently assets are used to generate sales. Generally, firms with high gross margins (e.g., firms selling luxury goods such as high-end watches) have lower asset turnover compared to firms with lower gross margins (e.g., grocery stores selling canned goods). Accounts receivable turnover Indicates how many times receivables turn over. The more times they turn over, the sooner receivables are collected. Days' sales in receivables A measure of how long it will take to collect receivables. Inventory turnover Indicates how many times inventory turns over. Generally, the higher the ratio, the more efficient the management of inventory levels. Days' sales in inventory A measure of how long it will take to sell inventory. Debt-Related Ratios Current ratio A measure of a company's ability to pay short-term obligations. Acid-test ratio (quick ratio) Compared to the current ratio, a more stringent test of a company's ability to pay short-term obligations. Debt-to-equity ratio A measure of the relative amount of debt versus equity in a firm's capital structure. Firms with relatively high values may have too much debt; if they face a sales downturn, they still will have to make debt payments, and that may result in financial distress. Times interest earned A measure of a company's ability to make interest payments on its debt. Decision Making Insight Many companies are trying to drive down the costs of their supply chain by integrating their information system with the information systems of their major suppliers who are referred to as \"strategic partners.\" Critical to the success of such efforts is the choice of strategic partners. Financial analysis can help ensure that a company will not partner with a firm that isn't profitable and may go out of business in the near future. Systems integration is very costly and not appropriate if a partner's ability to continue doing business is doubtful. Summary of Learning Objectives Explain why managers analyze financial statements and perform horizontal and vertical analyses of the balance sheet and the income statement. LEARNING OBJECTIVE 1 Managers analyze financial statements for three reasons: (1) to control operations; (2) to assess the stability of vendors, customers, and other business partners; and (3) to assess how their companies appear to investors and creditors. Horizontal analysis involves comparing the dollar value of balances and percentage changes between years; vertical a nalysis involves comparing individual balances to total assets (when analyzing balance sheet accounts) or sales (when analyzing income statement balances). LEARNING OBJECTIVE 2 Discuss earnings anagement and the importance of comparing net m income to cash flow from operations. Also, understand how MD&A, credit reports, and news articles can be used to gain insight into a company's current and future financial performance. 548 chapte r 1 4 A n a l y z i n g F i n a n c i a l S t a t e m e n t s : A M a n a g e r i a l P e r s p e c t i v e In analyzing financial information, it is important to recognize that earnings can be managed in an effort to make a company appear more profitable. Thus, it is useful to compare net income to cash flow from operations since cash flow is more difficult to manage. Income much higher than cash flow suggests (but, certainly, does not definitively indicate) that the earnings information is not reliable. In addition to the insights from analyzing the basic financial statements, useful information can be obtained from the section of the annual report titled management discussion and analysis (MD&A), from credit reports, and from news articles. A good source of news articles is the website Yahoo! Finance. 3 Calculate and interpret profitability ratios, turnover ratios, and debt-related ratios. LEARNING OBJECTIVE The profitability ratios are earnings per share, the price- earnings ratio, the gross margin percentage, return on total assets, and return on common stockholders' equity. These ratios can be used to assess the overall profitability of a firm. The turnover ratios are asset turnover, accounts receivable turnover (and the related ratio, days' sales in receivables), and inventory turnover (and the related ratio, days' sales in inventory). These ratios can be used to assess whether a company uses its assets to generate sales in an efficient manner. The debt-related ratios are the current ratio, the acid-test ratio (also known as the quick ratio), the debt-to-equity ratio, and times interest earned. These ratios can be used to assess a company's ability to meet its obligations to short-term and long-term creditors. Review Problem 1 Answer each of the following questions related to analyzing financial statements: a. The Jones Company has inventory turnover of 5.0. What is the company's days' sales in inventory? b. The Jones Company has changed its policy for collecting receivables. Its previous terms required payment within 30 days. In an effort to stimulate sales, it now allows customers to pay within 60 days. How will this affect the accounts receivable turnover ratio? c. The debt-to-equity ratio of the Jones Company is 5. The debt-to equity ratio of the Smith Company, its major competitor, is 2. All else being equal, which company is more risky? d. Why is the acid-test ratio (also called the quick ratio) a more stringent test of a firm's ability to pay its short-term obligations compared to the current ratio? e. The Jones Company has a price-earnings ratio of 7 while the Smith Company, its major competitor, has a price-earnings ratio of 15. Most likely, stockholders of _______ Company expect future growth in earnings to be higher compared to _______ Company. An s w ers a. (365 5) = 73 days. b. The accounts receivable turnover ratio will decrease. c. Jones Company. If sales decline, it will still have to make very substantial payments on its debt. d. The acid-test ratio only includes a company's most liquid assets in the numerator of the ratio. Thus, it excludes current assets, such as inventory, from the numerator. e. Smith, Jones. Review Problem 2 Blast Tennis Racquets has asked Norton Industries to produce its new line of carbon fiber racquets. The initial order is for 20,000 racquets at $75 each (a $1,500,000 order). Blast will make a $200,000 deposit, and the remaining $1,300,000 will be paid within 90 days of shipment. This is an especially large order for Norton, and the company wants to make sure that Blast will be able to pay its bill when it comes due. To gain confidence, Norton will analyze Blast's financial statements. R e v i e w P r o b l e m 2 549 Blast Tennis Racquets Balance Sheets (in thousands) Assets Current assets: Cash and cash equivalents Accounts receivable Inventory Prepaid expenses Total current assets Plant and equipment, net Total assets December 31, 2017 December 31, 2016 $ 302 2,433 16,104 42 18,881 1,302 $20,183 $ 405 2,658 15,685 23 18,771 1,256 $20,027 Liabilities and Stockholders' Equity Current liabilities: Accounts payable $2,808 Bank loan payable 5,987 Other accrued payables 881 Total current liabilities 9,676 Long-term debt 1,585 Total liabilities 11,261 Stockholders' equity: Common stock 3,500 Retained earnings 5,422 Total stockholders' equity 8,922 Total Liabilities and Stockholders' Equity\t$20,183 Blast Tennis Racquets Consolidated Statement of Earnings (in thousands) Net sales Cost of goods sold Gross margin Operating expenses: Selling expenses General and administrative expenses Total operating expenses Operating income Interest expense Income before taxes Income taxes Net income $2,738 6,259 760 9,757 1,677 11,434 3,500 5,093 8,593 $20,027 Year Ended December 31, 2017 Year Ended December 31, 2016 $19,288 12,151 7,137 $25,057 15,034 10,023 3,086 2,377 5,463 1,674 1,168 506 177 $ 329 3,007 2,255 5,262 4,761 1,254 3,507 1,227 $2,280 Req u ir ed a. Calculate the following ratios for Blast for 2017 and 2016: return on total assets, inventory turnover, days' sales in inventory, current ratio, acid test (quick ratio), the debt-to-equity ratio, and times interest earned. b. Based on your analysis in part a, do you recommend that Norton take on the order for Blast? 550 chapte r 1 4 A n a l y z i n g F i n a n c i a l S t a t e m e n t s : A M a n a g e r i a l P e r s p e c t i v e An s w er a. Return on total assets = {Net income + [Interest expense (1 - Tax rate)]} Total assets 2017 {$329 + [$1,168 (1 - .35)]} $20,183 = 0.054 2016 {$2,280 + [$1,254 (1 - .35)]} $20,027 = 0.155 Inventory turnover = Cost of goods sold Inventory 2017 $12,151 $16,104 = 0.755 2016 $15,034 $15,685 = 0.958 Days' sales in inventory =\t365 Inventory turnover 2017 365 0.755 = 483.443 2016 365 0.958 = 381.002 Current ratio = Current assets Current liabilities 2017 $18,881 $9,676 = 1.951 2016 $18,771 $9,757 = 1.924 Acid test (quick ratio) =\t\u0007(Cash + Marketable securites + Short-term receivables) Current liabilities 2017 ($302 + $2,433) $9,676 = 0.282 2016 ($405 + $2,658) $9,757 = 0.314 Debt-to-equity ratio = Total liabilities Stockholders' equity 2017 $11,261 $8,922 = 1.262 2016 $11,434 $8,593 = 1.331 Times interest earned = Operating income Interest expense 2017 $1,674 $1,168 = 1.433 2016 $4,761 $1,254 = 3.797 b.\tNorton should be very cautious about entering into a large transaction with Blast Tennis Racquets. Blast's profitability is down substantially, as indicated by the decline in return on assets. Most important, the company is holding 483 days of inventorymore than the amount needed for an entire year. This suggests that the inventory may be obsolete and the cost on the balance sheet may be higher than the market value of the inventory. Also, note that the acid-test ratio (which excludes inventory) is only 0.28, suggesting that if the inventory cannot be sold, the company will have a great deal of difficulty satisfying its current liabilities. In addition, times interest earned has declined, indicating that the company may have difficulty meeting required interest payments in the future. In light of this information, Norton should not enter into the transaction unless Blast is able to pay for all or most of the order in advance of production. Key Terms Financial leverage (541) Horizontal analysis (533) Self-Assessment Management discussion and analysis (MD&A) (538) Vertical analysis (533) (Answers Below) 1. Why do managers analyze financial statements? a. To evaluate and control operations. b.\tTo evaluate vendors and customers. c. To anticipate questions from shareholders and creditors. d. All of these answer choices are correct. 2. Horizontal analysis analyzes: a.\tComparable companies. b. Changes in expenses as a percent of sales. c. Changes in expenses as a percent of total assets. d.\tChanges in balances from one period to another. 3. Net income substantially higher than cash flow from operations may indicate: a. Exceptional profitability. b. Manipulation of income. c.\tExceptional control of expenses. d. That a company has a lot of depreciation expense. Q u e s t i o n s 551 4. In connection with a company's annual report, MD&A stands for: a. Management discussion and analysis. b. More depreciation and amortization. c. Monthly depreciation and amortization. d. Monthly discounts and advertising. 5. The fact that the return on common stockholders' e quity is higher than the return on total assets suggests that a company: a.\tHas made good use of financial leverage. b.\tHas funded asset acquisition primarily with debt. c.\tHas excessive debt financing. d.\tHas good control of operations. 6. A primary difference between the current ratio and the acid-test ratio (quick ratio) is: a.\tThe current ratio takes into account depreciation expense. b.\tThe acid-test ratio is computed using monthly data. c.\tThe acid-test ratio excludes inventory from the numerator. d.\tAll of the above. 7. Days' sales in inventory is equal to: a.\t365 Inventory turnover. b.\tSales Inventory turnover. c.\t365 Inventory/Sales. d.\t365 Sales/Inventory. QUESTIONS 8. The times interest earned ratio can be used to evaluate: a.\tThe amount of debt versus equity financing. b.\tThe extent to which interest income exceeds interest expense. c.\tThe extent to which interest expense exceeds interest income. d.\tThe likelihood that a company will be able to make required interest payments. 9. The efficient use of assets is indicated by: a.\tTurnover ratios. b.\tDebt-related ratios. c.\tThe ratio of debt to equity. d.\tThe ratio of current assets to current liabilities. 10. Which of the following items is not included in the calculation of income from operations? a.\tGains on the sale of short-term investments. b.\tInterest income. c.\tInterest expense. d.\tNone of these answer choices is included in the calculation of income from operations. Answers to Self-Assessment 1. d 2. d 3. b 4. a 5. a 6. c 7. a 8. d 9. a 10. d 1.\tList three types of decisions managers can make by analyzing financial statements. 2.\tExplain what is meant by horizontal and vertical analyses of the balance sheet and the income statement. 3.\tSuppose net income is much higher than cash flow from operations. Why is this potentially indicative of earnings manipulation? 4.\tIn addition to the three basic financial statements, what other information sources can be used to gain insight into a company's current and future financial performance? 5.\tList three profitability ratios, and discuss how these ratios are used to assess a company's performance. 6.\tList three turnover ratios, and discuss how these ratios are used to assess a company's performance. 7.\tList three debt-related ratios, and discuss how these ratios are used to assess a company's performance. 8.\tDavis Company operates in an industry that experiences seasonal fluctuations in its sales. The high point is during October and the low point is in April. During which month would you expect the current ratio to be highest? Why? 552 chapte r 1 4 A n a l y z i n g F i n a n c i a l S t a t e m e n t s : A M a n a g e r i a l P e r s p e c t i v e 9.\tA company is applying for a line of credit at a bank. The company's current ratio is 2 to 1. Although the bank felt that the company should be able to meet its short-term obligations, it stated that the current ratio was a concern. Discuss why a current ratio of 2 to 1 might indicate problems for the company. 10.\tSouki Corporation had a gross margin percentage of 45 percent in the prior year. The gross margin ratio has now dropped to 32 percent. Discuss what this ratio measures and what a change like this could indicate for the company. Exercises EXERCISE 14-1. [LO 1] Explain why companies are concerned about the financial viability of suppliers and customers. EXERCISE 14-2. [LO 2] Write a paragraph explaining why net income that is substantially higher than cash flow from operations may indicate manipulation of earnings. EXERCISE 14-3. [LO 3] Go to the website of Yahoo! Finance (http://finance.yahoo.com). Enter the ticker symbols for Home Depot (HD) and Lowe's (LOW). For each firm, click on Key Statistics and note the ratio for profit margin (the ratio we called gross margin percentage). How do the two companies stack up in terms of this ratio? EXERCISE 14-4. Financial News and Analysis [LO 2] For a company recommended by your instructor, read current financial news articles (available on Yahoo! Finance) and summarize how