The excel homework assignment below has five tabs that cover five different topics: Net Present Value Analysis, Capital Budgeting and Cost of Capital, Working Capital, Management, Financial Ratio Analysis, Projected Final Statements and Financing. When you complete the worksheets, please put in the proper formulas in each excel cell to show the work or formula on how you obtained the answer, and not just the answers. This will show me how answers were obtained, and I can use it learning aid for this class. Thanks!

Topic 5 (20 points) The CEO of Midwest Manufacturing Company has asked for your analysis of and recommendation related to the proposed acquisition of an additional stamping machine for its principal manufacturing plant. Demand for the company's products has risen to a level that exceeds its present productive capacity. An additional stamping machine will make it possible for the company to increase its production and sales by 15 percent, resulting in projected incremental relevant cash flows (after income taxes and the tax benefits of the \"depreciation tax shield\") in each of the next five years, as indicated in the Table 1 shown below: The equipment will cost $100,000 to purchase and install. Management estimates that its economic life will be five years, after which it will have no residual value. The company's required rate of return on new investments (cost of capital) is 11.0 percent (or, 0.11). Complete the NPV analysis of the stamping machine proposal, below. Regard all incremental relevant cash flows as \"risky\" and assume they occur at the end of years indicated, as listed above. State your recommendation to the CEO, including the basis for it. Limit the length of your response to 50 words Table 1 Projected incremental cash flows $10,000 30,000 Additional Given Information from above: 40,000 Initial Cost = $100,000 30,000 Cost of Capital = 11% 20,000 $130,000 Year 1 2 3 4 5 Total a. Complete the NPV analysis of the stamping machine proposal: Year (n) \"Time zero\" 1 2 3 4 5 NPV Relevant cash flow Discount factor Discounted cash flows b. State your recommendation to the CEO, including the basis for it. Limit the length of your response to 50 words. Replace this text with your response Topic 6 (20 points) The VP-Operations of Midwest Manufacturing Company has asked for your review of her capital budgeting analysis, comparing two alternative machines the company is considering acquiring for one of its plants. Using the information provided in the table below, complete her analysis by computing the company's cost of equity capital, rE, weighted average cost of capital, rWACC, and the equivalent annual cost (EAC) for each machine under consideration. State your recommendation to the VP with regard to selecting one of these machines. Given From Above rE = ? rWACC = ? B = 1.8 rD = 9.50% t = 40% rM = 12.50% rF = 4% D= 50% E = 50% Complete Parts A, B, C, and D On The Next Page a. Compute the company's cost of equity capital, rE. Show computations in good form and label properly all amounts presented. Formula: rE = b. Compute the company's weighted average cost of capital, rWACC. Show computations in good form and label properly all amounts presented. c. Compute the equivalent annual cost (EAC) for each machine under consideration, ignoring \"cost recovery\" income tax deductions, the tax deductibility of ownership costs, and capital gains taxes upon the machine's disposal). Show computations in good form and label properly all amounts presented. Machine X Machine Y d. State your recommendation to the VP- Operations, including the basis for it, in the box below. Limit the length of your response to 50 words. Topic 7 (20 points) The VP-Sales and Marketing of Midwest Manufacturing Company has asked for your analysis of her proposal to modify the company's current terms of sale, \"2/10, net/30.\" She has proposed more generous terms - \"3/10, net/30\" - in order to promote increased sales and market share. She has acknowledged that more generous terms may also lead to increased bad debts. The business' operating budget for the forthcoming fiscal year includes the following relevant information: Budgeted unit sales, Q18,000,000 units Budgeted unit selling, SP $15 per unit Budgeted bad debts, BD1, as percent of sales 0.01 (or, 1.0 percent) Budgeted unit variable cost, VC (excluding BD1) $8 per unit Combined effective income tax rate, t 0.40 (or, 40.0 percent) Current interest rate on business' debt, rD 0.12 (or, 12.0 percent) In addition, based on the existing terms of sales: Discount percentage, CD1 0.02 (or, 2.0 percent) Discount period, DP1 10days Under the proposed terms of sales: Discount percentage, CD2 0.03 (or, 3.0 percent) Discount period, DP2 10 days Estimated bad debts, BD2, as percent of sales 0.015 (or, 1.5 percent) Given from above Q1 = 8,000 SP = $15 BD1 = 1% VC = $8 t= 40% rD = 12% CD1 = 2% DP1 = 10 CD2 = 3% DP2 = 10 BD2 = 1.50% Complete Parts A & B days days On The Next Page a. Compute the NPV of the company's existing terms of sales based on its operating budget and other information provided, above. Show computations in good form and label properly all amounts presented. b. Compute the required sales volume, Q2, under the proposed terms of sale necessary to achieve the NPV of the existing credit policy - i.e., the \"break even\" unit sales volume. Show computations in good form and label properly all amounts presented. Topic 8 (20 points) Demonstrate your ability to apply financial ratio analysis to common-sized financial statements. Analyze the common-sized balance sheet and income statement of FirstRate Company, included in the Topic 8 background paper, Financial Ratio Analysis. Identify the most significant: Trends in the 20X0 - 20X4 common-sized financial information, and Differences between the common-sized financial information of the company and its industry's norms Your analysis should indicate the basis on which you indentified trends or differences as significant, including the potential implications for FirstRate's business or financial condition. Limit your response to a maximum of 200 words. Spell-check and-grammar-and-stylecheck your completed response using MS Word's tool for this purpose, being sure to correct any matters identified by these checking tools. Please provide your word count here Your response here (please do not modify the formatting, fonts, colors, and so forth in this document template) Topic 9 (20 points) The CEO of Southwest Manufacturing Company has asked you to (a) complete the projected income statement and projected balance sheet for the coming fiscal year (FY) of the company using the information set forth below. She has also asked you to (b) determine the amount of any additional external financing the company will require during the coming fiscal year and (c) assess the reasonableness of the projections in relation to the company's estimated cost of equity capital, r E, and its sustainable sales growth rate. Use the average gross margin during the preceding two-year period to project the amount of gross profit. Use the average ratio of "all other S&A-to-sales revenue" during the preceding two-year period to project the amount of all other S&A expense. Use the average amount of R&D expense during the two preceding FYs to project the amount of this expense. The estimated combined effective income tax rate during the projected FY is 0.40 (40.0 percent). Project the balances of cash and cash equivalents, total current assets, and total liabilities as \"residual amounts\" using the general methodology examined in Topic 9 of the course. Project total assets using the projected balance of total liabilities and shareholders' equity. Project the balance of total liabilities and stockholders' equity based on projected total stockholders' equity and a targeted total debt ratio (ratio of total liabilities-to-total stockholders' equity) of 0.70 (70 percent). Project the balance of accounts receivable (AR) using a projected average AR collection period ratio of 45 days. Project the balance of inventory using a projected average days to sell inventory ratio of 90 days. Project the balance of other assets using the average balance of this item during the two preceding FYs. Project the balance of accounts payable (AP) using projected "cash costs" and a projected average AP payment period of 45 days. "Cash costs" include projected COGS and operating expenses, excluding depreciation. Project the balance of dividends payable as the dividends that the company expects to declare during the final week of the projected FY (based on net income for that year) and pay early in the next FY. The company's payout ratio (dividend policy) is 0.40 (40 percent). The company plans no issuances (or repurchases) of common stock during the projected FY. Project retained earnings (RE) using projected net income and projected dividends to be declared near the end of the projected FY. The company's estimated cost of equity capital, rE, is 0.185 (18.5 percent), computed using CAPM as: rF + x (rM - rF) = 0.04 + 1.7 x (0.125 - 0.04) Complete Parts A, B, and C On The Following Pages a. Projected income statement Compu Projected tationa l Notes (Formu las or 20X1 20X2 equati ons used) 55,550,000 ### Given Actual (historical) 20X0 (A) (B) (C) (D) (E) (F) (G) (H) (I) (J) (K) (L) (M) (N) (O) Sales ### revenue Cost of goods sold (COGS): Deprec. of 7,500,000 manufa 7,200,000 cturing PP&E All other ### 29,720,000 COGS Total ### 37,220,000 COGS Gross ### 18,330,000 profit Gross 31.00% 33.00% margin Operating expenses: Selling c. and admin. (S&A) exp.: of non $274,000 391,000 mf er g S& 6,348,000 6,666,000 A Researc exp h and devel. 1,500,000 1,700,000 (R&D) Other exp. operatin 178,000 173,000 8,300,000 ng expens es Operatin 8,100,000 g income Interest -620,000 on debt Income from 20,000 investm Gain ents on (loss) PP&E disposal s 8,930,000 g expense Total s operati ### Given ### Given 240,000 Given 9,400,000 -760,000 -846,666 Given 20,000 20,000 Given -160,000 - Given (P) (Q) (R) Income 7,500,000 before taxes Provision for income 3,000,000 taxes Net ### income 8,500,000 3,400,000 5,100,000 b. Determine the amount of any additional external financing the company will require during the coming FY. Show computations in good form and label properly all amounts presented. c. Assess the reasonableness of the projected financial statements in relation to the company's estimated cost of equity capital, rE, and its sustainable sales growth rate. Return on average common equity (ROCE) ratio Net income (available to common stockholders) Total stockholders' equity, beginning of FY Actual (historical) 20X0 20X1 21.00% 21.00% ### 5,100,000 $ ### ### $ Projected 20X2 % Total stockholders' equity, end of FY Average total stockholders' equity ### ### $ ### ### $ Sustainable rate of sales growth % Net income (available to common stockholders) $ Beginning-of-year shareholders' equity Payout ratio $ % Assessment of projected ROCE and sustainable growth rate in sales ratios (limit your response below to a maximum of 100 words): Present value interest factor of $1 per period at i% for n periods, PVIF(i,n). Period 1% 2% 3% 4% 5% 6% 7% 8% 9% 1 0.990 0.980 0.971 0.962 0.952 0.943 0.935 0.926 0.917 2 0.980 0.961 0.943 0.925 0.907 0.890 0.873 0.857 0.842 3 0.971 0.942 0.915 0.889 0.864 0.840 0.816 0.794 0.772 4 0.961 0.924 0.888 0.855 0.823 0.792 0.763 0.735 0.708 5 0.951 0.906 0.863 0.822 0.784 0.747 0.713 0.681 0.650 6 0.942 0.888 0.837 0.790 0.746 0.705 0.666 0.630 0.596 7 0.933 0.871 0.813 0.760 0.711 0.665 0.623 0.583 0.547 8 0.923 0.853 0.789 0.731 0.677 0.627 0.582 0.540 0.502 9 0.914 0.837 0.766 0.703 0.645 0.592 0.544 0.500 0.460 10 0.905 0.820 0.744 0.676 0.614 0.558 0.508 0.463 0.422 11 0.896 0.804 0.722 0.650 0.585 0.527 0.475 0.429 0.388 12 0.887 0.788 0.701 0.625 0.557 0.497 0.444 0.397 0.356 13 0.879 0.773 0.681 0.601 0.530 0.469 0.415 0.368 0.326 14 0.870 0.758 0.661 0.577 0.505 0.442 0.388 0.340 0.299 15 0.861 0.743 0.642 0.555 0.481 0.417 0.362 0.315 0.275 16 0.853 0.728 0.623 0.534 0.458 0.394 0.339 0.292 0.252 17 0.844 0.714 0.605 0.513 0.436 0.371 0.317 0.270 0.231 18 0.836 0.700 0.587 0.494 0.416 0.350 0.296 0.250 0.212 19 0.828 0.686 0.570 0.475 0.396 0.331 0.277 0.232 0.194 20 0.820 0.673 0.554 0.456 0.377 0.312 0.258 0.215 0.178 25 0.780 0.610 0.478 0.375 0.295 0.233 0.184 0.146 0.116 30 0.742 0.552 0.412 0.308 0.231 0.174 0.131 0.099 0.075 35 0.706 0.500 0.355 0.253 0.181 0.130 0.094 0.068 0.049 40 0.672 0.453 0.307 0.208 0.142 0.097 0.067 0.046 0.032 50 0.608 0.372 0.228 0.141 0.087 0.054 0.034 0.021 0.013 ds, PVIF(i,n). 10% 11% 12% 13% 14% 15% 16% 17% 18% 19% 0.909 0.901 0.893 0.885 0.877 0.870 0.862 0.855 0.847 0.840 0.826 0.812 0.797 0.783 0.769 0.756 0.743 0.731 0.718 0.706 0.751 0.731 0.712 0.693 0.675 0.658 0.641 0.624 0.609 0.593 0.683 0.659 0.636 0.613 0.592 0.572 0.552 0.534 0.516 0.499 0.621 0.593 0.567 0.543 0.519 0.497 0.476 0.456 0.437 0.419 0.564 0.535 0.507 0.480 0.456 0.432 0.410 0.390 0.370 0.352 0.513 0.482 0.452 0.425 0.400 0.376 0.354 0.333 0.314 0.296 0.467 0.434 0.404 0.376 0.351 0.327 0.305 0.285 0.266 0.249 0.424 0.391 0.361 0.333 0.308 0.284 0.263 0.243 0.225 0.209 0.386 0.352 0.322 0.295 0.270 0.247 0.227 0.208 0.191 0.176 0.350 0.317 0.287 0.261 0.237 0.215 0.195 0.178 0.162 0.148 0.319 0.286 0.257 0.231 0.208 0.187 0.168 0.152 0.137 0.124 0.290 0.258 0.229 0.204 0.182 0.163 0.145 0.130 0.116 0.104 0.263 0.232 0.205 0.181 0.160 0.141 0.125 0.111 0.099 0.088 0.239 0.209 0.183 0.160 0.140 0.123 0.108 0.095 0.084 0.074 0.218 0.188 0.163 0.141 0.123 0.107 0.093 0.081 0.071 0.062 0.198 0.170 0.146 0.125 0.108 0.093 0.080 0.069 0.060 0.052 0.180 0.153 0.130 0.111 0.095 0.081 0.069 0.059 0.051 0.044 0.164 0.138 0.116 0.098 0.083 0.070 0.060 0.051 0.043 0.037 0.149 0.124 0.104 0.087 0.073 0.061 0.051 0.043 0.037 0.031 0.092 0.074 0.059 0.047 0.038 0.030 0.024 0.020 0.016 0.013 0.057 0.044 0.033 0.026 0.020 0.015 0.012 0.009 0.007 0.005 0.036 0.026 0.019 0.014 0.010 0.008 0.006 0.004 0.003 0.002 0.022 0.015 0.011 0.008 0.005 0.004 0.003 0.002 0.001 0.001 0.009 0.005 0.003 0.002 0.001 0.001 0.001 0.000 0.000 0.000 20% 0.833 0.694 0.579 0.482 0.402 0.335 0.279 0.233 0.194 0.162 0.135 0.112 0.093 0.078 0.065 0.054 0.045 0.038 0.031 0.026 0.010 0.004 0.002 0.001 0.000 Background Paper: Financial Ratio Analysis College of Business and Economics Master of Business Administration MBA C604 Accounting and Finance Concepts for Managers Contents Introduction and Purpose Categories of Financial Ratios Liquidity Capital Structure and Solvency Return on Investment Operating Performance Asset Utilization Stock Performance Definitions of Financial Ratios Current (working capital) ratio Acid-test (quick) ratio Average collection period (of customer accounts receivable) Average days to sell inventory Total debt-to-equity (total debt) ratio Times interest earned (interest coverage) ratio Return on assets ratio Return on total common stockholders' equity ratio Gross margin ratio Operating expenses-to-sales ratio Pre-tax margin ratio Net margin ratio Accounts receivable turnover ratio Inventory turnover ratio Price-earnings (P-E) ratio Price-book ratio Common-sized Financial Analysis Limitations and Proper Use of Financial Ratios Interpreting Financial Ratios Effect of Limitations on Usefulness of Financial Statements Forming Preliminary Expectations before Computing Financial Ratios Financial Ratio Volatility versus Trends Using Limited Financial Statement Information to Compute Average Values Interpreting Interim Period Financial Ratios of Seasonal Businesses 1 Topic 8 Introduction and Purpose Topic 3-4 background paper examines financial reporting literacy. This background paper extends the examination of financial reporting literacy to include financial ratio analysis. Financial ratio analysis is a tool for controlling a business' activities and evaluating its financial condition and performance. The Topic 9 background paper examines the use of financial ratios for forecasting or projecting a business' future financial performance. A primary purpose of financial ratio analysis is to help managers identify and prioritize issues requiring their investigation and further action. This analysis may also provide insights into the underlying causes for these issues. Financial ratios describe the relationships between financial statement amounts (such as, between sales and accounts receivable) or between financial statement amounts and nonfinancial statement information (such as, earnings per share [EPS] and company's stock price). Managers examine these relationships and changes in them over time as part of their evaluation of the financial condition and performance of a business. Managers can perform evaluations that are more robust by comparing such ratios for their business with those of its competitors and its industry as a whole (industry norms), in connection with \"benchmarking\" analysis, as noted in the Topic 1-2 background paper. 2 Learning Objective 1 Categories of Financial Ratios There are many ratios available for managers' use in controlling and evaluating a business' financial condition and performance, as well as for budgeting and strategic business planning, securities and credit analysis, and financial statement and operational auditing. This background paper considers many of the most widely used financial ratios (the A602, F602, A605, and F606 courses examine additional financial ratios). Analysts have organized financial ratios under the following categories: Liquidity. The Topic 3-4 background paper defines liquidity as the nearness of a business' assets to cash and explains that liquidity is essential to a business' daily operations. The clich remains essentially correct: Cash is the lifeblood of a business. For example, businesses require cash on an ongoing basis sufficient to pay amounts they owe to vendors, employees, tax collection agencies, and lenders under short-term lines of credit, as the Topic 7 background paper indicates. Capital structure and solvency. The Topic 3-4 background paper explains that solvency describes the extent of a business' ability to pay its debts as they mature. A business' operating performance and capital structure largely determine its solvency. In turn, the nature, maturity (or permanence), and other terms of a business' debt and equity financing characterize its capital structure. A key aspect of a business' capital structure is the extent of its financial leverage, as discussed in the Topic 6 background paper and further below. While liquidity ratios focus on a business' near-term operations, solvency ratios reflect a mediumto-long-term outlook. Return on investment. Return-on-investment ratios permit managers and investors to compare a business' overall financial performance to previously projected performance for the business, or the overall performance of other firms. These comparisons also permit investors, creditors, and managers to evaluate their earlier investment and credit decisions by comparing the business' return on investment ratios to required rates of return (discussed in the Topic 6 background paper), as set forth in previously approved investment policies or plans. Operating performance. Operating performance ratios describe the sources and sustainability of a business' profitability given its level and trend of sales revenue. For example, an examination of these ratios may reveal deteriorating per-unit product selling prices and profitability, in spite of growing total sales volume. These ratios may also reveal excessive operating leverage (inflexible or fixed operating costs) that a business is unable to reduce sufficiently in response to deteriorating per-unit profitability or declining unit sales volume, as examined in the Topic 1-2 background paper. Asset utilization. Asset utilization ratios describe the recoverability (realizability or quality) of a business' operating assets in the normal course of business, including working capital assets and long-lived tangible and intangible assets such as PP&E and intellectual property. These ratios measure the recoverability of long-lived assets in terms of the efficiency with which a business uses them. For example, if a business can increase its levels of production and sales (while avoiding material changes in its selling prices or perunit production costs), without making proportional additions to its productive capacity (PP&E), it will operate more efficiently and thereby increase its return on investment. Stock performance. Stock performance ratios measure the relationship between the price of a company's common stock and accounting-based measurements - EPS (discussed in the Topic 3-4 background paper) and book value per share (generally, common stockholders' equity as reported in a company's balance sheet divided by the number of shares of common stock outstanding at the balance sheet date). These ratios are of particular interest to current and potential investors in a company's common stock because they facilitate comparisons of the investment merits of alternative companies. 3 This background paper examines the following financial ratios1 organized under the categories described above: Liquidity Current (working capital) ratio Acid-test (quick) ratio Average collection period (of customer accounts receivable) Average days to sell inventory Capital structure and solvency Total debt-to-equity (total debt) ratio Times interest earned (interest coverage) ratio Return on investment Return on assets ratio Return on total common stockholders' equity ratio Operating performance Gross margin ratio Operating expenses-to-sales ratios Operating margin ratio Pre-tax margin ratio Net margin ratio Asset utilization Accounts receivable turnover ratio Inventory turnover ratio Stock performance Price-earnings (P-E) ratio Price-book ratio (The Topic 3-4 background paper examines the OCF-to-net income ratio, used in assessing a business' earnings quality.) _____ 1 In the context of financial analysis, managers and analysts use the term \"ratio\" a bit more loosely than your K-12 teachers used the term. As a youngster, you learned that \"ratio\" expressed relationships in the form A:B (for example, the exchange ratio of apples for bananas is 1:2 - that is, 1 apple for 2 bananas. In the financial analysis context, ratios are typically expressed in percentage form (for example, a business' gross profit margin ratio is 22 percent) or in decimal form (for example, a business' total debt ratio is 0.47. Financial ratios also capture a variety relationships measured in: Number of days (for example, average days to sell inventory), Number of \"multiples\" (for example, times interest earned (or, interest coverage) ratio, annual turnover of accounts receivable, or price-book ratio), and Currency amounts per share of common stock (EPS, book value per share) 4 Learning Objective 1 Definitions of Financial Ratios As you study these financial ratios, consider how you would interpret increasing and decreasing trends over several years in each ratio for a particular business. Also, keep in mind that experienced managers and other users of financial ratios are careful to interpret any particular ratio (or trend in any particular ratio) within the larger context of the level and trend of other ratios. To illustrate, A manager may interpret a positive trend in a business' net profit margin ratio differently if its gross margin ratio has stagnated or deteriorated, rather than improved, during the same period. A manager may interpret a positive trend in a business's return on common equity (ROCE) ratio cautiously if this improvement is primarily attributable to increases in the total debt ratio (financial leverage) that appears to have climbed to an excessively risky level, while its operating performance ratios have stagnated or deteriorated during the same period. 5 RATIO DEFINITION USE AND INTERPRETATION Current (working capital) ratio Total current assets Total current liabilities Acid-test (quick) ratio [Cash and cash equivalents + Investment securities (at market value) + Accounts receivable, net of allowance] Total current liabilities Average collection period (days) (see also accounts receivable turnover ratio, below) Average accounts receivable (AR), net Average daily sales The current ratio measures the extent to which a business could liquidate its near-term obligations (current liabilities) with its existing cash and cash equivalents, plus cash from the eventual realization of short-term investments, accounts receivable, inventory, and other working capital assets. The acidtest ratio is more stringent than the current ratio because its numerator includes only working capital assets nearest to realization - accounts receivable and short-term investments - as well as cash and cash equivalents. Generalizing broadly, businesses desire a current ratio of 1.0 or greater and an acid-test ratio of \"slightly less than\" 1.0. However, \"greater is better\" is not a proper interpretation of the current ratio. As discussed in the Topic 7 background paper, businesses should maintain working capital sufficient to ensure their ongoing liquidity. However, excessive working capital is undesirable because the real rate of return on working capital is generally close to zero. Several factors may limit the usefulness of the current ratio and acid-test ratios. The primary limitation relates to the quality of working capital assets. For example, if a business' working capital assets are low in quality, these ratios overstate the extent of the business' liquidity. The quality (or realizability) of accounts receivable is low if customers are slow or unwilling to pay their account balances, if the business permits customers extended payment terms, or if the business applies lax collection policies and procedures. The quality (or realizability) of inventory is low if its salability is impaired by declining customer demand, damage or other physical deterioration, or technological obsolescence. These factors may prompt the business to discount heavily expected selling prices or discard inventory. In either case, these ratios reflect overstated realizable values or understated selling periods. Managers' examination of the average collection period and average days to sell inventory ratios (including trends in these ratios) help them evaluate the quality (realizability) of accounts receivable and inventory, respectively. An additional limitation of the current and acid-test ratios is that they do not consider unrecognized nearterm commitments, discussed in the Topic 3-4 background paper, which may lead to overstatement of these ratios. On the other hand, these ratios also do not consider unrecognized potential sources of liquidity, such as committed credit facilities obtained from banks (discussed in the Topic 7 background paper) or planned sales of non-working capital assets for cash. LIQUIDITY where Average daily sales = Sales revenue, net of returns and allowances Number of days in period (assume 360-day year) and Average accounts receivable (AR), net = (AR, net at beg. of period + AR, net at end of period) 2 Average days to sell inventory (see also inventory turnover ratio, below) Average inventory, at lower-of-cost-or-market Average daily cost of goods sold (COGS) where Average daily COGS = Total cost of goods sold (COGS) Number of days in period (assume 360-day year) and Average inventory, at LOCOM = (Inventory, beg. of period + Inventory, end of period) 2 The Topic 7 background paper explains that: Gross operating cycle = (Average collection period (days) + Average days to sell inventory) This is the average length of time between the point at which a business obtains materials for use in production (in a manufacturing business) and the point at which the business collects cash from customers as a result of the sale of goods produced by the business. 6 RATIO DEFINITION USE AND INTERPRETATION CAPITAL STRUCTURE AND SOLVENCY Total debt-toequity (total debt) ratio Times interest earned (interest coverage) ratio Total (current AND noncurrent) liabilities Total stockholders' equity Income before income taxes and interest exp. (EBIT) Interest expense (net of any interest income) where EBIT = [Income before income taxes + Interest expense (net of any interest income)] Note: Leverage (and other) financial ratios are often the subject of financial covenants specified in a company's bond indentures and loan agreements. These covenants are contractual requirements, as negotiated between a business and its creditors (bondholders, banks, and so forth). For example, a loan agreement may prohibit a borrower from exceeding a total debt ratio of 0.75 (75 percent) at any time while the loan is outstanding, or require the borrower to achieve a minimum TIE ratio of 3.0 in each of its fiscal years while the loan remains outstanding. The purpose of financial covenants is to protect a lender from credit risks resulting from a borrower's decisions or conditions arising after the date of the debt agreement A company's violation of financial or other covenants included in its debt agreements represents \"an event of technical default.\" Depending on the contract's provision for \"remedies,\" upon default, creditors may Obtain additional rights affecting the control or operation of the company, Impose additional interest and penalties on the company, or Demand immediate and full repayment of the debt. Any of these remedies may lead to potentially serious financial difficulty for the company. The total debt-to-equity ratio measures the extent of a business' financial leverage. In general, a business' increased financial leverage presents it with both: The opportunity to increase the return on total common stockholders' equity (ROCE) (discussed below) provided the business' earnings are stable and sufficient to service its debt (i.e., make interest and principal payments as they become due), and The risk of bankruptcy if the business' earnings and operating cash flows are insufficient to service its debt, resulting in defaults on the business' credit obligations and legal insolvency Increased financial leverage may enhance a profitable business' ROCE because the business may use increased debt to finance additional investments in income-generating PP&E and other assets, without increasing proportionally its common equity by, for example, selling additional shares of common stock. However, if a business experiences operating losses, financial leverage magnifies its negative ROCE ratio. (The A602 and F602 courses examine risk-versusreturn related to financial leverage in detail). The desired or optimal level of financial leverage for a particular business may depend on several factors. For example, if a business operates in a stable or noncyclical industry, a higher total debt-to-equity ratio may not present the business, its creditors, and its stockholders with significant additional risk. A business having sufficiently high and sustainable operating income and cash flows is better able to service its debt. The times interest earned (interest coverage) ratio is useful for making this evaluation. The desired or optimal TIE ratio, like the total debt ratio, depends on the current conditions and prospects for a business' industry, the industry's structure (e.g., consumer staples versus cyclical commodities) against the backdrop of the overall economic outlook, and the business' competitive position within its industry. 7 RATIO DEFINITION USE AND INTERPRETATION [Net income + Interest expense (net of any interest income) x (1 - Effective income tax rate)] Average total assets (TA) Return-on-investment ratios permit managers and investors to compare a business' overall financial performance to previously projected performance for the business, or the overall performance of other firms. that may be larger or smaller than the business. To illustrate, while Company B reported net income in 20X1 five times larger than that of Company A, the companies' return on investment ratios are the same: RETURN ON INVESTMENT Return on assets (ROA) ratio where Effective income tax rate = Income tax provision Income before income taxes and Average total assets (TA) = (TA, beg. of period + TA, end of period) / 2 Note: The ROA ratio excludes the (after-tax) effect of interest expense so that managers may better compare this ratio for competing firms that may be similar in most important respects, but have different capital structures. For example, two otherwise similar firms may have debt-to-equity ratios of 0.60 and 0.50, respectively. Their ROA ratios should not include distortion caused by their different choices of capital structure. (Net income - Dividends on any preferred stock) Average total COMMON stockholders' equity Return on total common stockholders' equity (ROCE) ratio where Average total COMMON stockholders' equity (CE) = (CE, beg. of period + CE, end of period) / 2 Note: The ROCE ratio computes net income available to COMMON stockholders by subtracting from net income dividends on any preferred stock because the governing instrument (such as, articles of incorporation) stipulates that a company must distribute dividends to any preferred stockholders before it may declare dividends on its COMMON stock. In the case of \"cumulative\" preferred stock, this dividend preference is effective even if the company does not declare a dividend to preferred stockholders in a particular year. 1 About 3/4 of the improvement in these companies' ROCE ratios is attributable to the increase in financial leverage - i.e., \"recapitalization\" of some of its equity as additional debt. However, about 1/4 of the increase in their ROCE ratios is due to the tax deductibility of the additional interest on the increased debt, as the Topic 6 background paper discusses. U.S. dollars in millions Company A Interest expense, net Income before taxes Income taxes Net income Average total liabilities Average CE Average TA ROA ratio ROCE ratio Total debt ratio $4,000 $15,000 5,000 $10,000 $80,000 120,000 $200,000 6.3% 8.3% 66.7% Company B $20,000 $75,000 25,000 $50,000 $400,000 600,000 $1,000,000 6.3% 8.3% 66.7% ROA measures the financial performance of a business from an \"insider's\" (manager's) perspective. In contrast, ROCE measures financial performance from an \"outsider's\" (investor's) point of view. Both managers and investors are interested in both ratios because financial leverage, discussed above, is the link between them. That is, for a given (positive) ROA, a business may increase its ROCE by increasing its financial leverage. To illustrate, by increasing its total debt ratio from 66.7% to 80% (by replacing some of its CE with additional debt 1), either company may increase its ROCE from 8.3% to 8.7%, even though its ROA remains at about 6.3%: U.S. dollars in millions Company A Interest expense, net Income before taxes Income taxes Net income Average total liabilities Average CE Average TA ROA ratio ROCE ratio Total debt ratio $4,400 $14,600 4,900 $9,700 $88,900 111,100 $200,000 6.3% 8.7% 80.0% Company B $22,200 $72,800 24,300 $48,500 $444,500 555,500 $1,000,000 6.3% 8.7% 80.0% 8 RATIO DEFINITION USE AND INTERPRETATION OPERATING PERFORMANCE Gross margin ratio Gross profit Sales revenue, net of returns and allowances where Gross profit = [Sales revenue, net of returns and allowances - Total cost of goods sold (COGS)] Operating expenses-tosales ratios Operating margin ratio Selling and administrative expense (or ANY category of operating expenses) Sales revenue, net of returns and allowances Operating income (i.e., BEFORE non-operating items) Sales revenue, net of returns and allowances Operating performance ratios describe the sources and sustainability of a business' profitability given its level and trend of sales revenue. To illustrate, consider the 20X2 income statement of Company C, accompanied by the corresponding operating performance ratios: U.S. dollars in millions Sales, net $100.0 100% COGS 80.0 Gross profit, Gross margin ratio 20.0 20% Selling and admin. expense 6.0 6% R&D expense 3.0 3% Other operating expense 1.0 1% 10.0 10% Operating expense, Operating expense-to-sales ratios: Operating income, Operating margin Non-operating items: Pre-tax margin ratio Income before income taxes Sales revenue, net of returns and allowances Interest expense 1.5 Gain on sale of PP&E (0.5) Income before taxes, Pre-tax margin 9.0 Provision for income taxes 3.0 Net income, Net margin Net margin ratio Net income Sales revenue, net of returns and allowances $6.0 9% 6% By examining the trends in a business' operating performance ratios over several years and performing related follow-up investigation, managers may be able to identify causes for improvement or deterioration in the business' net margin during the period, or opportunities for further improvements in the business' operating performance. Examples of such opportunities include eliminating redundant or unnecessary activities, renegotiating suppliers' pricing, or outsourcing non-essential services to more efficient specialist firms. Managers may also be able to identify opportunities for improved financial performance by comparing the operating performance ratios of their business with those of competitors or industry norms (median or weighted-average ratios). 9 RATIO DEFINITION USE AND INTERPRETATION ASSET UTILIZATION Accounts receivable turnover ratio (see also Average collection period, above) Inventory turnover ratio (see also Average days to sell inventory, above) Sales revenue, net of returns and allowances Average accounts receivable (AR), net where Average accounts receivable (AR), net = (AR, net at beg. of period + AR, net at end of period) 2 Total cost of goods sold (COGS) Average inventory, at lower-of-cost-or market where Average inventory at LOCOM = (Inventory, beg. of period + Inventory, end of period) 2 As stated above, asset utilization ratios describe the recoverability (realizability or quality) of a business' operating assets in the normal course of business. Managers may examine turnover ratios for: Cash and cash equivalents Accounts receivable Inventory Working capital assets, net of working capital liabilities (net sales / average net working capital) PP&E (net sales / average PP&E) Total assets (net sales / average TA) Typically, the most \"revealing\" turnover ratios are those for accounts receivable and inventory because they largely explain year-to-year changes in the working capital and total asset turnover ratios. As discussed above, the PP&E (and, to some extent, the total asset) turnover ratio measures the recoverability of long-lived assets in terms of the efficiency with which a business uses them. The AR and inventory turnover ratios are essentially inversions of the average collection period and average days to sell inventory (liquidity) ratios. Therefore, these turnover ratios describe the quality of working capital assets, as discussed above. Managers' also examine the turnover and average days ratios for AR and inventory to identify opportunities to reduce a business' necessary investment in these assets. This is because, as discussed in the Topic 7 background paper, the real rate of return on working capital assets is about zero, even though a business must finance its investment in these assets at a cost (implicit or explicit interest expense). 10 RATIO DEFINITION USE AND INTERPRETATION STOCK PERFORMANCE Price-earnings (P-E) ratio Market price per share of COMMON stock Earnings per share of COMMON stock (EPS) where, for companies with simple capital structures, generally EPS = Net income available to COMMON stockholders Average number shares of COMMON stock outstanding during period and Net income available to COMMON stockholders = (Net income - Dividends on any preferred stock) Note: Companies compute net income available to COMMON stockholders by subtracting from net income dividends on any preferred stock because the governing instrument (such as, articles of incorporation) stipulates that a company must distribute dividends to any preferred stockholders before it may declare dividends on its COMMON stock. In the case of \"cumulative\" preferred stock, this dividend preference is effective even if the company does not declare a dividend to preferred stockholders in a particular year. Price-book (P-B) ratio Market price per share of COMMON stock Book value per share of COMMON stock where, for companies with simple capital structures, Book value per share of COMMON stock = Total COMMON stockholders' equity Number of shares of COMMON stock outstanding at end of period Note: In computing book value per share of COMMON stock, a company reduces COMMON stockholders equity by undeclared cumulative dividends on any cumulative preferred stock because it must distribute such dividends before declaring dividends on its COMMON stock. Note: Managers may locate the market price of a company's common stock as of a specified date from many sources. Online sources include financial search engines, such as Yahoo! Finance. Traditional sources include most newspapers. As stated above, stock performance ratios measure the relationship between the price of a company's common stock and accounting-based measurements: EPS (discussed in the Topic 3-4 background paper) and Book value per share These ratios are of particular interest to current and potential investors in a company's common stock because they facilitate comparisons of the investment merits of alternative companies. Read literally, the P-E ratio indicates how much investors are willing to pay for each dollar of a company's net income. The typical use of the P-E ratio is to evaluate the timing of investments or compare alternative stocks by comparing a company's current P-E ratio with: Average P-E ratios of the company's industry group The P-E ratio of a group of companies comprising an index, such as the Standard & Poors 500 The P-E ratio of specified competitor companies Historical P-E ratios for a group of companies comprising an industry or an index The price-book ratio measures the relationship between: The market value of a company, as indicated by quoted prices for the company's stock and The company's reported net assets (or \"book value\"), equal to reported balances of recognized assets in excess of the reported balances of its liabilities, as set forth in the company's balance sheet, prepared according to U.S. GAAP Investors use the price-book (P-B) ratio as a screening device to identify potentially undervalued stocks (P-B ratio is less than 1.0) or potentially overvalued stocks (P-B ratio greatly exceeds 1.0). Investors pursuing a \"value stock\" strategy often begin by identifying companies whose P-B ratios are less than 1.0 and which operate in cyclical or mature industries experiencing stable but modest sales and earnings growth. In contrast, investors pursuing a \"growth stock\" strategy begin by identifying companies whose P-B ratios exceed 1.0 and for which new or developing technology or \"intellectual assets\" are critical to their prospective growth and profitability. However, if a company's P-B ratio greatly exceeds 1.0, the market may have overvalued the stock (in which case investors may sell, \"short,\" or avoid the stock). 11 As suggested above, financial ratio analysis is most useful if managers compute and compare financial ratios over five or more years. Such horizontal analysis reveals trends and captures the effects of a full business cycle (economic recession and expansion), including any intervening anomalies in a business' operations. Managers may also perform vertical analysis by comparing the financial ratios of their business to: Similar ratios computed using the business' approved financial budget for the period (that is, comparison of actual to expected, or forecasted, values) Industry norms (that is, industry average or median ratios), and Ratios of the business' key competitors These comparisons may facilitate \"benchmarking\" analysis and prompt managers' investigation and other follow-up action. Learning Objective 1 Common-sized Financial Analysis The exhibit below illustrates common-sized financial statements. Common-sized analysis is useful for describing the structure and changes in that structure over time of a business' Investments and sources of financing for those investments, and Sources of profitability and revenue-cost relationships Common-sized balance sheets and income statements facilitate this structural analysis by recasting the reported amounts in percentage terms: Common-sized balance sheets - presented in comparative form for several periods - state the amount of total assets (and total liabilities and stockholders' equity) as 100 percent and the amounts of each other balance sheet item as a percentage of total assets. Common-sized income statements - presented in comparative form for several periods - state the amount of total sales revenue as 100 percent and the amounts each other income statement item as a percentage of total sales revenue. To be most useful, managers should perform common-sized analysis over five or more years. This horizontal analysis reveals structural changes occurring over time and captures the effects of a full business cycle, including any intervening anomalies in a business's operations. Managers may also perform vertical analysis by comparing common-sized financial statements of their business to common-sized financial statements of key competitors. These comparisons may facilitate \"benchmarking\" analysis by revealing important structural differences between the business and its competitors. Awareness of such differences may also prompt managers' investigation and other follow-up action. (Businesses do not generally prepare common-sized cash flow statements.) 12 FirstRate Company and subsidiaries Common-sized Balance Sheets, FYE Dec. 31, 20X0 20X1 20X2 20X3 20X4 Industry Norm 20X4 Assets: Current assets: Cash and cash equivalents 5% 4% 4% 2% 1% 3% Investment securities available for sale, at market 8% 7% 6% 6% 5% 2% Accounts receivable, net of allowance 16% 16% 16% 18% 19% 15% Inventory, at lower of cost or market 33% 33% 34% 34% 35% 31% Total current assets 62% 59% 60% 60% 59% 51% Property, plant, and equipment, at cost 78% 75% 74% 74% 73% NA Less: Accumulated depreciation 40% 34% 34% 33% 33% NA Property, plant, and equipment, net 38% 41% 40% 40% 41% 49% 100% 100% 100% 100% 100% 100% Total assets Liabilities: Current liabilities: Accounts payable 16% 16% 18% 19% 21% NA Accrued income taxes payable 1% 1% 1% 1% 1% NA Dividends payable on common stock 5% 4% 4% 5% 5% NA 21% 22% 23% 23% 23% NA 0% 0% 0% 1% 1% NA 44% 44% 46% 48% 49% 39% 7% 7% 6% 9% 13% 10% 51% 51% 52% 57% 62% 49% Bank note payable - current portion Accrued interest payable Total current liabilities Bank note payable - noncurrent portion Total liabilities Total shareholders' equity Total liabilities and shareholders' equity 49% 49% 48% 43% 38% 51% 100% 100% 100% 100% 100% 100% 13 FirstRate Company and subsidiaries Industry Norm Common-sized Income Statements, FYE Dec. 31, 20X0 20X1 20X2 20X3 20X4 100.0% 100.0% 100.0% 100.0% 100.0% 100% Cost of goods (or services) sold (COGS) 70.0% 70.0% 71.1% 71.9% 72.7% 70% Gross profit 30.0% 30.0% 28.9% 28.1% 27.3% 30% 15.0% 15.0% 15.8% 16.2% 16.6% 15% 5.0% 5.0% 4.2% 3.9% 3.6% 4% Sales revenue (net of returns and allowances) 20X4 Operating expenses: Selling and administrative expenses Research and development (R&D) expenses Other operating expenses 1.0% 1.0% 1.1% 1.3% 1.5% 1% 21.0% 21.0% 21.1% 21.4% 21.7% 20% 9.0% 9.0% 7.8% 6.7% 5.6% 10% 0.0% 0.0% 0.0% 0.0% 0.0% - Loss on disposal of equipment 0.0% 0.2% 0.0% 0.0% 0.0% - Interest on bank note 1.0% 1.0% 1.1% 1.3% 1.5% - Income from continuing operations before income taxes 8.0% 7.8% 6.7% 5.4% 4.1% 10% Taxes on income from continuing operations 2.7% 2.6% 2.2% 1.8% 1.4% 3% Income from continuing operations 5.3% 5.2% 4.4% 3.6% 2.7% 7% Income (loss) from discont. oper., net income taxes 0.0% -0.4% 0.0% 0.0% 0.0% - Income before extraordinary items 5.3% 4.8% 4.4% 3.6% 2.7% 7% Extraordinary gain (loss), net of related income taxes 0.0% -0.2% 0.0% 0.0% 0.0% - Net income 5.3% 4.6% 4.4% 3.6% 2.7% 7% Total operating expenses Operating income Non-operating items: Non-operating revenues and gains Gain on disposal of equipment Non-operating expense and losses: 14 Limitations and Proper Use of Financial Ratios Learning Objectives 2, 3 Financial ratio analysis is a widely used, but poorly understood and overrated, management tool. Inexperienced managers and financial analysts often compute these ratios without understanding that they are a beginning, rather than the end, of an evaluation of a business' financial condition and performance. As stated above, a primary purpose of financial ratio analysis is to help managers identify and prioritize issues requiring their investigation and further action. This analysis may also provide insights into the underlying causes for these issues. A more pervasive weakness of financial ratios is that they do not permit managers and others to assess the long-run sustainability of a business' operations within a society. For example, these ratios do not measure the impact of a business' operations or products on: The communities in which it is located, or the customers that use them, The natural environment, or The health and safety of its employees Interpreting Financial Ratios. The proper interpretation of financial ratios is often complex and requires care. To illustrate, a company's R&D expense-to-sales ratio may be declining over several fiscal years or quarters. This may be a favorable trend because, by itself, decreasing expenses leads to increasing net income and return on investment ratios. However, such decreases may reflect real earnings management (examined in the Topic 3-4 background paper). In that case, reduced R&D (advertising, plant maintenance, or employee training) expenses may affect adversely future sales, net income, operating performance ratios, and return on investment ratios because the activities related to these expenditures are important drivers of sales and net income growth. Effect of Limitations on Usefulness of Financial Statements. Because managers compute financial ratios using financial statement information, the ratios are subject to the same limitations that may impair the usefulness (relevance and representational faithfulness) of the financial statements, themselves. The Topic 3-4 background paper examines several factors that limit the usefulness of financial statements, including: Trade-offs of predictive value or completeness of financial statements for freedom from error and verifiability, resulting from conservative accounting standards and articulation Problems in applying the definitions of financial statement elements and measurement uncertainty Political influences that result in the failure of accounting principles to reflect economic reality Management judgment: accounting policy choices, accounting estimates, and earnings management To illustrate the impact of such limitations, consider the price-book (P-B) ratio: 15 As discussed above, the price-book (P-B) ratio measures the relationship between (i) the market value of a company, as indicated by quoted prices for the company's stock and (ii) the company's reported net assets, or \"book value.\" Book value is equal to the reported balances of a business' recognized assets in excess of the reported balances of its liabilities, as set forth in the business' balance sheet, prepared according to U.S. GAAP. As discussed in the Topic 3-4 background paper, limitations of general-purpose financial statements include, among others: Balance sheets do not recognize \"R&D assets\" and internally generated intangible assets, such as goodwill and brand value, as well as most commitments under executory contracts and contingent liabilities that managers cannot measure with reasonable reliability. Balance sheets report most assets at their historical costs or other valuation bases, rather than their fair values (including market values). These limitations can distort a company's \"book value\" and thereby impair the usefulness of the P-B ratio. As a result, managers must interpret this ratio carefully. To the extent possible, analysts respond to these limitations by adjusting a business' financial statements before computing financial ratios. The A602 course examines this process in detail. Proficient users of financial ratios appreciate the following important aspects of such analysis: Forming Preliminary Expectations before Computing Financial Ratios. Financial ratio analysis is more effective if managers form preliminary expectations for the values of the ratios before computing them from actual financial statement information. To be useful, managers need not quantify precisely these preliminary expectations. To illustrate, a manager may expect to compute a gross margin ratio for the fourth quarter of the recently completed fiscal year that is \"slightly lower\" than the ratio for previous quarters of the same year, or for the fourth quarter of the previous fiscal year. The manager may base this expectation on her knowledge that the business engaged in promotional discounting late in the fiscal year that was more aggressive than usual for the business. By forming preliminary expectations for financial ratios before computing them, managers are better prepared to properly interpret the computed ratios and perform the appropriate follow-up investigation or other action. As the illustration above suggests, before she can develop these preliminary expectations, a manager must first obtain information about recent changes in the business and its operating environment and then consider the likely effects of these changes on the business' financial condition and performance. Managers should obtain an understanding of changes in the following factors: Business' strategy and accompanying business risks Industry competition and economic conditions (business cycle stage: recession or expansion) Industry regulation and income tax laws Life cycle stage of the business (start-up, growing, mature, or declining) Effectiveness of controls in place to mitigate business risks R&D activities, investments in product technology, productive capacity or efficiency Business' products, markets, or distribution channels or methods Supplier arrangements and manufacturing processes and methods Acquisitions, mergers, or disposals of business units Nature and sources of business' financing (capital structure) Condition of the economy, including labor and capital markets Employment agreements, incentive arrangements, and union contracts 16 Effectively managed businesses initially include these preliminary expectations in a financial budget (or forecast), prepared before the start of the fiscal year for which the manager is to analyze financial ratios. Therefore, managers should compare financial ratios computed from financial statements for a completed period with similar ratios computed using previously approved financial budgets (or forecasts) for the same period. Financial Ratio Volatility versus Trends. The observation that a particular financial ratio is highly variable (volatile) over time may be at least as important as any discernable underlying trend in that ratio. To illustrate, Company A and Company B are competitors in the same industry. Over the five-year period ending in 20X5, the firms have experienced similar overall trends (improvement) in their respective gross margin ratios. However, Company A's gross margin ratio has experienced significantly more volatility during this period than has Company B's gross margin ratio: Gross Margin Ratios of Company A and Company B 36% 35% 34% 33% Company B gross margin ratio Company A gross margin ratio 32% 31% 30% Fiscal year 20X1 20X2 20X3 20X4 20X5 To further illustrate this point, in the table below, the significant increase in the business' ratio of bad debt provision to sales in 20X4 may contain more important information than the fact that the ratio remained stable at 7.0 percent since then, or the 4.0 percent average for this ratio for the five-year period presented. (Recall that, under accrual accounting, the provision for bad debts does not represent actual write-off of identified customer accounts, but rather represents managers' estimate of expected eventual write-offs of yet-to-be identified customer accounts.) Company X (U.S. dollars in millions) 20X1 20X2 20X3 Sales revenue, net of returns and allowances $105.1 $114.5 $122.1 20X4 20X5 $133.5 $141.1 Average $123.2 Percent growth in net sales 7.5% 8.9% 6.7% 9.3% 5.7% 6.1% Provision for bad debts (uncollectible accounts receivable) $2.1 $2.3 $2.4 $9.3 $9.9 $5.2 Ratio of bad debt provision to sales 2.0% 2.0% 2.0% 7.0% 7.0% 4.0% 17 Using Limited Financial Statement Information to Compute Average Values. Financial ratios that use computed average values for balance sheet items (such as, inventory turnover and return on assets) might experience distortion when only beginning-of-year (BOY) and end-of-year (EOY) values are available for computing these period averages. This is because the interim values of these balance sheet elements may not \"lie on a straight line\" between the BOY and EOY values used to compute the average. To illustrate, in the table below, average inventory computed using the BOY balance ($5.0 million) and EOY balance ($9.0 million) is $7.0 million. However, a value that better represents the actual average balance of inventory during 20X2 is $8.7 million, computed using the interim quarter end, as well as the BOY and EOY, balances of inventory. The $1.7 million (20 percent) understatement of the average inventory balance resulting from the use of only BOY and EOY balances may distort certain ratios, including inventory turnover, average days to sell inventory, and return on assets. Company Y (U.S. dollars in millions) Total inventory reported in balance sheets Following its long-standing production strategy, during the first half of each fiscal year (FY), Company Y produces more inventory than needed to meet sales during the first half of the FY in order to build up inventory in anticipation of seasonally high sales during the second half of its FY, which exceeds its productive capacity. $10.0 8.0 6.0 4.0 2.0 0.0 Fiscal quarter end date 4QX1 1QX2 2QX2 3QX2 4QX2 Interpreting Interim Period Financial Ratios of Seasonal Businesses. The seasonality of a business' activities may affect the appropriateness of comparing ratios computed for successive quarterly (interim) periods. To illustrate, a business may traditionally experience seasonally low sales and net income during the first half of its fiscal year and high sales and net income during the second half of its fiscal year. As a result, comparison of a business' return on investment ratios for successive quarterly (interim) periods may not reveal sustainable trends, but only the seasonality of the business. In the table below, note the impact of seasonal changes in sales and net income on the quarter-to-quarter (annualized) return on stockholder equity ratio, in spite of the stable quarter-to-quarter net margins. Company Z (U.S. dollars in millions) 1QX0 2QX0 3QX0 4QX0 20X0 Sales revenue, net of returns and allowances $18.0 $22.0 $28.0 $32.0 $100.0 Percent of total sales for fiscal year 20X0 18% 22% 28% 32% 100% Net income $1.2 $1.4 $1.8 $2.1 $6.5 Net margin 6.5% 6.5% 6.5% 6.5% 6.5% Average total stockholders' equity $50.0 $51.3 $52.9 $54.9 $52.3 Return on stockholders' equity (annualized for the quarterly periods) 9.4% 11.2% 13.8% 15.2% 12.4% Consequently, in the case of highly seasonal businesses, it may be more meaningful to compare financial ratios for an interim period with those of same interim period in previous years. 18 ***** Course developer's note on content of and sources used in preparing course background papers: In selecting the content and determining the organization of material for this course, the developer considered a number of factors, including the university's MBA program outcomes, material examined in the program's accounting and finance foundation courses, and material examined in subsequent MBA accounting and finance courses, in particular MBA A602 (Interpreting Accounting Information) and MBA F602 (Financial Decision-making), which, in turn, are prerequisites for other MBA accounting and finance courses. The course developer reviewed several accounting and finance texts, listed below, to ensure that the examination of models, concepts, methods, and terminology in the background papers is generally consistent with a variety of such texts over time. The course developer noticed that, on the one hand, there is substantial similarity among texts in the material (models, concepts, methods, and terminology) examined. The developer also noticed that, on the other hand, in spite of this similarity, none of these texts appears to include references to other texts (just original research articles, authoritative accounting literature, and the occasional federal statute, internal revenue code section, or IRS regulation). In addition, much of the material examined in the texts and the background papers is the subject of articles on several unrestricted Websites, such as Wikipedia.com. As such, the material contained in the background papers represents both essential and common knowledge for business managers. Atkinson, A. A., Banker, R. D., Kaplan, R. S. & Young, S. M. (1995). Management accounting. Englewood Cliffs, New Jersey: Simon & Schuster Co./Prentice-Hall. Horngren, Charles T. (1977). Cost accounting: A managerial emphasis. (4th ed.). Englewood Cliffs, NJ: Prentice-Hall. Kieso, D. E., Weygandt, J. J., & Warfield, T. D. (2004). Intermediate accounting. (11th ed.). New York: Wiley & Sons. Ross, S. A., Westerfield, R. W. & Jaffe, J. E. (1993). Corporate finance. (3rd ed.). Burr Ridge, IL: Richard D. Irwin. Wild, J. J., Subramanyam, K. R. & Halsey, R. F. (2004). Financial statement analysis. (10th ed.). New York: McGraw-Hill/Irwin. Wolk, H. I., Dodd, J. L. & Tearney, M. G. (2004). Accounting theory: Conceptual issues in a political and economic environment. (6th ed.). Mason, OH: Thomson Learning/South-Western. 19