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479
13 Financial Statement Analysis


• It is often helpful to the analyst to decompose a firm™s ROE ratio into the product of
several accounting ratios and to analyze their separate behavior over time and across
companies within an industry. A useful breakdown is
Net profits Pretax profits EBIT Sales Assets
ROE
Pretax profits EBIT Sales Assets Equity
• Other accounting ratios that have a bearing on a firm™s profitability and/or risk are fixed-
asset turnover, inventory turnover, days receivable, and the current, quick, and interest
coverage ratios.
• Two ratios that make use of the market price of the firm™s common stock in addition to its
financial statements are the ratios of market to book value and price to earnings. Analysts
sometimes take low values for these ratios as a margin of safety or a sign that the stock
is a bargain.
• A major problem in the use of data obtained from a firm™s financial statements is
comparability. Firms have a great deal of latitude in how they choose to compute various
items of revenue and expense. It is, therefore, necessary for the security analyst to adjust
accounting earnings and financial ratios to a uniform standard before attempting to
compare financial results across firms.
• Comparability problems can be acute in a period of inflation. Inflation can create
distortions in accounting for inventories, depreciation, and interest expense.

KEY
accounting earnings, 456 economic value profit margin, 459
TERMS
acid test ratio, 463 added, 467 quality of earnings, 472
asset turnover, 459 FIFO, 470 quick ratio, 463
average collection income statement, 452 residual income, 467
period, 462 interest coverage return on assets, 457
balance sheet, 452 ratio, 463 return on equity, 456
current ratio, 462 leverage ratio, 460 return on sales, 459
days receivables, 462 LIFO, 470 statement of cash
earnings yield, 465 market-to-book-value flows, 454
economic ratio, 463 times interest earned, 463
earnings, 456 price“earnings ratio, 464

PROBLEM
1. The Crusty Pie Co., which specializes in apple turnovers, has a return on sales higher
SETS
than the industry average, yet its ROA is the same as the industry average. How can you
explain this?
2. The ABC Corporation has a profit margin on sales below the industry average, yet its
ROA is above the industry average. What does this imply about its asset turnover?
3. Firm A and firm B have the same ROA, yet firm A™s ROE is higher. How can you
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explain this?
4. Which of the following best explains a ratio of “net sales to average net fixed assets” that
exceeds the industry average?
a. The firm added to its plant and equipment in the past few years.
b. The firm makes less efficient use of its assets than other firms.
c. The firm has a lot of old plant and equipment.
d. The firm uses straight-line depreciation.
5. A company™s current ratio is 2.0. If the company uses cash to retire notes payable due
within one year, would this transaction increase or decrease the current ratio and asset
turnover ratio?
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition




480 Part FOUR Security Analysis


6. The information in the following table comes from the 1997 financial statements of
QuickBrush Company and SmileWhite Corporation:
NOTES TO THE 1997 FINANCIAL STATEMENTS
QuickBrush SmileWhite
Goodwill The company amortizes The company amortizes
goodwill over 20 years. goodwill over 5 years.
Property, plant, The company uses a straight-line The company uses an accelerated
and equipment depreciation method over the depreciation method over the
economic lives of the assets, economic lives of the assets, which
which range from 5 to 20 years range from 5 to 20 years for
for buildings. buildings.
Accounts The company uses a bad debt The company uses a bad debt
receivable allowance of 2% of accounts allowance of 5% of accounts
receivable. receivable.


Determine which company has the higher quality of earnings by discussing each of the
three notes.
7. An analyst applies the DuPont system of financial analysis to the following data for a
company:
• Leverage ratio 2.2
• Total asset turnover 2.0
• Net profit margin 5.5%
• Dividend payout ratio 31.8%
What is the company™s return on equity?
8. An analyst gathers the following information about Meyer, Inc.:
• Meyer has 1,000 shares of 8% cumulative preferred stock outstanding, with a par value
of $100, and liquidation value of $110.
• Meyer has 20,000 shares of common stock outstanding, with a par value of $20.
• Meyer had retained earnings at the beginning of the year of $5,000,000.
• Net income for the year was $70,000.
• This year, for the first time in its history, Meyer paid no dividends on preferred or
common stock.
What is the book value per share of Meyer™s common stock?
9. The cash flow data of Palomba Pizza Stores for the year ended December 31, 2001, are
as follows:

Cash payment of dividends $ 35,000
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Purchase of land 14,000
Cash payments for interest 10,000
Cash payments for salaries 45,000
Sale of equipment 38,000
Retirement of common stock 25,000
Purchase of equipment 30,000
Cash payments to suppliers 85,000
Cash collections from customers 250,000
Cash at beginning of year 50,000


a. Prepare a statement of cash flows for Palomba in accordance with FAS 95 showing:
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition




481
13 Financial Statement Analysis


• Net cash provided by operating activities.
• Net cash provided by or used in investing activities.
• Net cash provided by or used in financing activities.
b. Discuss, from an analyst™s viewpoint, the purpose of classifying cash flows into the
three categories listed above.
10. The financial statements for Chicago Refrigerator Inc. (see Tables 13.14 and 13.15) are
to be used to compute the ratios a through h for 1999.
a. Quick ratio.
b. Return on assets.
c. Return on common shareholders™ equity.
d. Earnings per share of common stock.
e. Profit margin.

1998 1999
TA B L E 13.14
Assets
Chicago Refrigerator
Current assets
Inc. balance sheet,
as of December 31 Cash $ 683 $ 325
($ thousands) Accounts receivable 1,490 3,599
Inventories 1,415 2,423
Prepaid expenses 15 13
Total current assets $3,603 $6,360
Property, plant, equipment, net 1,066 1,541
Other 123 157
Total assets $4,792 $8,058
Liabilities
Current liabilities
Notes payable to bank $ ” $ 875
Current portion of long-term debt 38 115
Accounts payable 485 933
Estimated income tax 588 472
Accrued expenses 576 586
Customer advance payment 34 963
Total current liabilities $1,721 $3,945
Long-term debt 122 179
Other liabilities 81 131
Total liabilities $1,924 $4,255
Shareholders™ equity
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Common stock, $1 par value 1,000,000 shares
authorized; 550,000 and 829,000 outstanding,
respectively $ 550 $ 829
Preferred stock, Series A 10%; $25.00 par value; 25,000
authorized; 20,000 and 18,000 outstanding, respectively 500 450
Additional paid-in capital 450 575
Retained earnings 1,368 1,949
Total shareholders™ equity $2,868 $3,803
Total liabilities and shareholders™ equity $4,792 $8,058
\
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition




482 Part FOUR Security Analysis


1998 1999
TA B L E 13.15
Net sales $7,570 $12,065
Chicago
Other income, net 261 345
Refrigerator Inc.
income statement,
Total revenues $7,831 $12,410
years ending
December 31 Cost of goods sold $4,850 $ 8,048
($ thousands) General administrative and marketing expenses 1,531 2,025
Interest expense 22 78
Total costs and expenses $6,403 $10,151
Net income before tax $1,428 $ 2,259
Income tax 628 994
Net income $ 800 $ 1,265



f. Times interest earned.
g. Inventory turnover.
h. Leverage ratio.
11. In an inflationary period, the use of FIFO will make which one of the following more
realistic than the use of LIFO?
a. Balance sheet
b. Income statement
c. Cash flow statement
d. None of the above
12. A company acquires a machine with an estimated 10-year service life. If the company
uses the Accelerated Cost Recovery System depreciation method instead of the straight-
line method:
a. Income will be higher in the 10th year.
b. Total depreciation expense for the 10 years will be lower.
c. Depreciation expense will be lower in the first year.
d. Scrapping the machine after eight years will result in a larger loss.
13. Why might a firm™s ratio of long-term debt to long-term capital be lower than the
industry average, but its ratio of income-before-interest-and-taxes to debt-interest
charges be lower than the industry average?
a. The firm has higher profitability than average.
b. The firm has more short-term debt than average.
c. The firm has a high ratio of current assets to current liabilities.
d. The firm has a high ratio of total cash flow to total long-term debt.
14. During a period of falling price levels, the financial statements of a company using
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FIFO instead of LIFO for inventory accounting would show:
a. Lower total assets and lower net income.
b. Lower total assets and higher net income.
c. Higher total assets and lower net income.
d. Higher total assets and higher net income.
15. Scott Kelly is reviewing MasterToy™s financial statements in order to estimate its
sustainable growth rate. Using the information presented in Table 13.16
a. Identify and calculate the components of the DuPont formula.
b. Calculate the ROE for 1999 using the components of the DuPont formula.
c. Calculate the sustainable growth rate for 1999 from the firm™s ROE and
plowback ratios.
Bodie’Kane’Marcus: IV. Security Analysis 13. Financial Statement © The McGraw’Hill
Essentials of Investments, Analysis Companies, 2003
Fifth Edition




483
13 Financial Statement Analysis

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