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Inventories 75,000 90,000 108,000 129,600
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.
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
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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Fifth Edition

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.
In other years, it was
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Essentials of Investments, Analysis Companies, 2003
Fifth Edition

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
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
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
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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Fifth Edition

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
and reported in newspaper stock listings is not the same as the price“earnings multiple that
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
k g
P/B P0 /$8.33
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition

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
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.
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%


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