Net plant and equipment 150,000 180,000 216,000 259,200

Total assets $300,000 $360,000 $432,000 $518,400

Accounts payable $ 30,000 $ 36,000 $ 43,200 $ 51,840

Short-term debt 45,000 87,300 141,957 214,432

Long-term debt (8% bonds maturing in 2007) 75,000 75,000 75,000 75,000

Total liabilities $150,000 $198,300 $260,157 $341,272

Shareholders™ equity (1 million shares outstanding) $150,000 $161,700 $171,843 $177,128

Other data

Market price per common share at year-end $ 93.60 $ 61.00 $ 21.00

<

2. Do a ratio decomposition analysis for the Mordett corporation of Question 1, Concept

preparing a table similar to Table 13.6.

CHECK

Turnover and Other Asset Utilization Ratios

It is often helpful in understanding a firm™s ratio of sales to assets to compute comparable

efficiency-of-utilization, or turnover, ratios for subcategories of assets. For example, fixed-

asset turnover would be

Sales

Fixed assets

This ratio measures sales per dollar of the firm™s money tied up in fixed assets.

To illustrate how you can compute this and other ratios from a firm™s financial statements,

consider Growth Industries, Inc. (GI). GI™s income statement and opening and closing balance

sheets for the years 2001, 2002, and 2003 appear in Table 13.8.

GI™s total asset turnover in 2003 was 0.303, which was below the industry average of 0.4.

To understand better why GI underperformed, we compute asset utilization ratios separately

for fixed assets, inventories, and accounts receivable.

GI™s sales in 2003 were $144 million. Its only fixed assets were plant and equipment, which

were $216 million at the beginning of the year and $259.2 million at year™s end. Average fixed

assets for the year were, therefore, $237.6 million [($216 million $259.2 million)/2]. GI™s

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462 Part FOUR Security Analysis

fixed-asset turnover for 2003 was $144 million per year/$237.6 million 0.606 per year. In

other words, for every dollar of fixed assets, there was $0.606 in sales during the year 2003.

Comparable figures for the fixed-asset turnover ratio for 2001 and 2002 and the 2003

industry average are

2001 2002 2003 2003 Industry Average

0.606 0.606 0.606 0.700

GI™s fixed-asset turnover has been stable over time and below the industry average.

Whenever a financial ratio includes one item from the income statement, which covers a

period of time, and another from the balance sheet, which is a “snapshot” at a particular time,

the practice is to take the average of the beginning and end-of-year balance sheet figures.

Thus, in computing the fixed-asset turnover ratio you divide sales (from the income statement)

by average fixed assets (from the balance sheet).

Another widely followed turnover ratio is the inventory turnover ratio, which is the ratio of

cost of goods sold per dollar of inventory. It is usually expressed as cost of goods sold (instead

of sales revenue) divided by average inventory. It measures the speed with which inventory is

turned over.

In 2001, GI™s cost of goods sold (less depreciation) was $40 million, and its average in-

ventory was $82.5 million [($75 million $90 million)/2]. Its inventory turnover was 0.485

per year ($40 million/$82.5 million). In 2002 and 2003, inventory turnover remained the same

and continued below the industry average of 0.5 per year.

Another measure of efficiency is the ratio of accounts receivable to sales. The accounts re-

ceivable ratio usually is computed as average accounts receivable/sales 365. The result is a

average number called the average collection period, or days receivables, which equals the total

collection credit extended to customers per dollar of daily sales. It is the number of days™ worth of sales

period, or days tied up in accounts receivable. You can also think of it as the average lag between the date of

receivables sale and the date payment is received.

For GI in 2003, this number was 100.4 days:

The ratio of accounts

receivable to daily ($36 million $43.2 million)/2

365 100.4 days

sales, or the total

$144 million

amount of credit

extended per dollar

The industry average was 60 days.

of daily sales.

In summary, use of these ratios lets us see that GI™s poor total asset turnover relative to the

industry is in part caused by lower than average fixed-asset turnover and inventory turnover,

and higher than average days receivables. This suggests GI may be having problems with ex-

cess plant capacity along with poor inventory and receivables management procedures.

Liquidity and Coverage Ratios

Liquidity and interest coverage ratios are of great importance in evaluating the riskiness of a

current ratio

firm™s securities. They aid in assessing the financial strength of the firm.

A ratio representing Liquidity ratios include the current ratio, quick ratio, and interest coverage ratio.

the ability of the firm

to pay off its current 1. Current ratio: current assets/current liabilities. This ratio measures the ability of the

liabilities by firm to pay off its current liabilities by liquidating its current assets (that is, turning

liquidating current

them into cash). It indicates the firm™s ability to avoid insolvency in the short run.

assets (current

GI™s current ratio in 2001, for example, was (60 30 90)/(36 87.3) 1.46.

assets/current

In other years, it was

liabilities).

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13 Financial Statement Analysis

2001 2002 2003 2003 Industry Average

1.46 1.17 0.97 2.0

This represents an unfavorable time trend and poor standing relative to the industry.

2. Quick ratio: (cash receivables)/current liabilities. This ratio is also called the acid test quick ratio, or

ratio. It has the same denominator as the current ratio, but its numerator includes only acid test ratio

cash, cash equivalents such as marketable securities, and receivables. The quick ratio is a A measure of liquidity

better measure of liquidity than the current ratio for firms whose inventory is not readily similar to the current

convertible into cash. GI™s quick ratio shows the same disturbing trends as its current ratio except for

exclusion of

ratio:

inventories (cash plus

receivables divided by

2001 2002 2003 2003 Industry Average current liabilities).

0.73 0.58 0.49 1.0

3. Interest coverage ratio: EBIT/interest expense. This ratio is often called times interest interest coverage

earned. It is closely related to the interest-burden ratio discussed in the previous section. ratio, or times

A high coverage ratio tells the firm™s shareholders and lenders that the likelihood of interest earned

bankruptcy is low because annual earnings are significantly greater than annual interest A financial leverage

obligations. It is widely used by both lenders and borrowers in determining the firm™s measure arrived at by

debt capacity and is a major determinant of the firm™s bond rating. dividing earnings

before interest and

GI™s interest coverage ratios are

taxes by interest

expense.

2001 2002 2003 2003 Industry Average

2.86 1.89 1.26 5

GI™s interest coverage ratio has fallen dramatically over this three-year period, and by

2003 it is far below the industry average. Probably its credit rating has been declining as

well, and no doubt GI is considered a relatively poor credit risk in 2003.

Market Price Ratios

There are two important market price ratios: the market-to-book-value ratio and the price“

earnings ratio.

The market-to-book-value ratio (P/B) equals the market price of a share of the firm™s market-to-

common stock divided by its book value, that is, shareholders™ equity per share. Analysts book-value ratio

sometimes consider the stock of a firm with a low market-to-book value to be a “safer” in- Market price of a

vestment, seeing the book value as a “floor” supporting the market price. share divided by book

Analysts presumably view book value as the level below which market price will not fall value per share.

because the firm always has the option to liquidate, or sell, its assets for their book values.

However, this view is questionable. In fact, some firms do sometimes sell for less than book

value. Nevertheless, a low market-to-book-value ratio is seen by some as providing a “margin

of safety,” and some analysts will screen out or reject high P/B firms in their stock selection

process.

Proponents of the P/B screen would argue that, if all other relevant attributes are the same

for two stocks, the one with the lower P/B ratio is safer. Nevertheless, book value does not

necessarily represent liquidation value, which renders the margin of safety notion unreliable.

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464 Part FOUR Security Analysis

The theory of equity valuation offers some insight into the significance of the P/B ratio. A

high P/B ratio is an indication that investors think a firm has opportunities of earning a rate of

return on their investment in excess of the market capitalization rate, k.

To illustrate this point, we can return to the numerical example in Chapter 12, Section 12.4

(see Table 12.3). That example assumes the market capitalization rate is 12% per year. Now

add the assumptions that the book value per share is $8.33 and that the coming year™s expected

EPS is $1, so that in the case for which the expected ROE on future investments also is 12%,

the stock will sell at $1/0.12 $8.33, and the P/B ratio will be 1.

Table 13.9 shows the P/B ratio for alternative assumptions about future ROE and plowback

ratio. Reading down any column, you can see how the P/B ratio changes with ROE. The num-

bers reveal that, for a given plowback ratio, the P/B ratio is higher, the higher the expected

ROE. This makes sense, because the greater the expected profitability of the firm™s future in-

vestment opportunities, the greater its market value as an ongoing enterprise compared with

the cost of acquiring its assets.

We™ve noted that the price“earnings ratio that is based on the firm™s financial statements

price“earnings

and reported in newspaper stock listings is not the same as the price“earnings multiple that

ratio

emerges from a discounted dividend model. The numerator is the same (the market price of

The ratio of a stock™s

the stock), but the denominator is different. The P/E ratio uses the most recent past account-

price to its earnings

ing earnings, while the P/E multiple predicted by valuation models uses expected future eco-

per share. Also

referred to as the nomic earnings.

P/E multiple. Many security analysts pay careful attention to the accounting P/E ratio in the belief that

among low P/E stocks they are more likely to find bargains than with high P/E stocks. The

idea is that you can acquire a claim on a dollar of earnings more cheaply if the P/E ratio is low.

For example, if the P/E ratio is 8, you pay $8 per share per $1 of current earnings, while if the

P/E ratio is 12, you must pay $12 for a claim on $1 of current earnings.

Note, however, that current earnings may differ substantially from future earnings. The

higher P/E stock still may be a bargain relative to the low P/E stock if its earnings and divi-

dends are expected to grow at a faster rate. Our point is that ownership of the stock conveys

the right to future earnings as well as to current earnings. An exclusive focus on the commonly

reported accounting P/E ratio can be shortsighted because by its nature it ignores future

growth in earnings.

An efficient markets adherent will be skeptical of the notion that a strategy of investing in

low P/E stocks will result in an expected rate of return greater than that of investing in high or

medium P/E stocks having the same risk. The empirical evidence on this question is mixed,

Plowback Ratio (b)

TA B L E 13.9

ROE 0 25% 50% 75%

Effect of ROE

and plowback

10% 1.00 0.95 0.86 0.67

ratio on P/B

12 1.00 1.00 1.00 1.00

14 1.00 1.06 1.20 2.00

Note: The assumptions and formulas underlying this table are: E1 $1;

book value per share $8.33; k 12% per year.

g b ROE

(1 b)E

P0

k g

P/B P0 /$8.33

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Fifth Edition

465

13 Financial Statement Analysis

but if the strategy has worked in the past, it surely should not work in the future because too

many investors will be following it. This is the lesson of market efficiency.

Before leaving the P/B and P/E ratios, it is worth pointing out the relationship among these

ratios and ROE.

Earnings Market price Market price

ROE

Book value Book value Earnings

P/B ratio P/E ratio

Rearranging terms, we find that a firm™s earnings yield, the ratio of earnings to price, is earnings yield

equal to its ROE divided by the market-to-book-value ratio: The ratio of earnings

to price, E/P.

E ROE

P P/B

Thus, a company with a high ROE can have a relatively low earnings yield because its P/B

ratio is high. This indicates that a high ROE does not in and of itself imply the stock is a good

buy. The price of the stock already may be bid up to reflect an attractive ROE. If so, the P/B

ratio will be above 1.0, and the earnings yield to stockholders will be below the ROE, as the

equation demonstrates. The relationship shows that a strategy of investing in the stock of high

ROE firms may produce a lower holding-period return than investing in the stock of firms

with a low ROE.

For example, Clayman (1987) found that investing in the stocks of 29 “excellent” compa-

nies, with mean reported ROE of 19.05% during the period 1976 to 1980, produced results

much inferior to investing in 39 “unexcellent” companies, those with a mean ROE of 7.09%