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( 100 .)


Dividends paid 410 410
Cash and marketable securities 800 300
a Taxes are paid in their entirety in the year that the tax
obligation is incurred.
b Netfixed assets are fixed assets net of accumulated
depreciation since the asset was installed.

21. Balance Sheet. Construct a balance sheet for Fincorp for 1999 and 2000. What is share-
holders™ equity?
22. Working Capital. What happened to net working capital during the year?
23. Income Statement. Construct an income statement for Fincorp for 1999 and 2000. What
were retained earnings for 2000? How does that compare with the increase in shareholders™
equity between the two years?
24. Earnings per Share. Suppose that Fincorp has 500,000 shares outstanding. What were
earnings per share?
25. Taxes. What was the firm™s average tax bracket for each year? Do you have enough infor-
mation to determine the marginal tax bracket?
26. Balance Sheet. Examine the values for depreciation in 2000 and net fixed assets in 1999
and 2000. What was Fincorp™s gross investment in plant and equipment during 2000?
27. Cash Flows. Construct a statement of cash flows for Fincorp for 2000.
28. Book versus Market Value. Now suppose that the market value (in thousands of dollars) of
Fincorp™s fixed assets in 2000 is $6,000, and that the value of its long-term debt is only
Accounting and Finance 131

$2,400. In addition, the consensus among investors is that Fincorp™s past investments in de-
veloping the skills of its employees are worth $2,900. This investment of course does not
show up on the balance sheet. What will be the price per share of Fincorp stock?

29. Taxes. Reconsider the data in problem 10 which imply that you have $100,000 of total pre-
tax income to allocate between your salary and your firm™s profits. What allocation will min-
Problem imize the total tax bill? Hint: Think about marginal tax rates and the ability to shift income
from a higher marginal bracket to a lower one.

1 Cash and equivalents would increase by $100 million. Property, plant, and equipment would
Solutions to
increase by $400 million. Long-term debt would increase by $500 million. Shareholders™ eq-
Self-Test uity would not increase: assets and liabilities have increased equally, leaving shareholders™
equity unchanged.
Questions 2 a. If the auto plant were worth $14 billion, the equity in the firm would be worth $14 “ $4
= $10 billion. With 100 million shares outstanding, each share would be worth $100.
b. If the outstanding stock were worth $8 billion, we would infer that the market values the
auto plant at $8 + $4 = $12 billion.

3 Period: 1 2 3
Sales 0 150 0
“ Change in accounts receivable 0 150 (150)
“ Cost of goods sold 0 100 0
“ Change in inventories 100 (100) 0
Net cash flow “100 0 +150

The net cash flow pattern does make sense. The firm expends $100 in period 1 to produce
the product, but it is not paid its $150 sales price until period 3. In period 2 no cash is
4 a. An increase in inventories uses cash, reducing the firm™s net cash balance.
b. A reduction in accounts payable uses cash, reducing the firm™s net cash balance.
c. An issue of common stock is a source of cash.
d. The purchase of new equipment is a use of cash, and it reduces the firm™s net cash

5 Firm A Firm B
EBIT 100 100
Interest 60 0
Pretax income 40 100
Tax (35% of pretax income) 14 35
Net income 26 65
Note: Figures in millions of dollars.

Taxes owed by Firm A fall from $21 million to $14 million. The reduction in taxes is 35 per-
cent of the extra $20 million of interest income. Net income does not fall by the full $20 mil-
lion of extra interest expense. It instead falls by interest expense less the reduction in taxes,
or $20 million “ $7 million = $13 million.
6 For a single taxpayer with taxable income of $70,000, total taxes paid are

(.15 — $25,750) + [.28 — (62,450 “ 25,750)] + [.31 — (70,000 “ 62,450)] = $16,479

The marginal tax rate is 31 percent, but the average tax rate is only 16,479/70,000 = .235, or
23.5 percent.

For the married taxpayers filing jointly with taxable income of $70,000, total taxes paid are

(.15 — $43,050) + [.28 — (70,000 “ 43,050)] = $14,003.50

The marginal tax rate is 28 percent, and the average tax rate is 14,003.50/70,000 = .200, or
20.0 percent.
Financial Ratios
Leverage Ratios
Liquidity Ratios
Efficiency Ratios
Profitability Ratios

The Du Pont System
Other Financial Ratios

Using Financial Ratios
Choosing a Benchmark

Measuring Company Performance
The Role of Financial Ratios

ivide and conquer” is the only practical strategy for presenting a complex

D topic like financial management. That is why we have broken down the
financial manager™s job into separate areas: capital budgeting, dividend
policy, equity financing, and debt policy. Ultimately the financial manager
has to consider the combined effects of decisions in each of these areas on the firm as
a whole. Therefore, we devote all of Part Six to financial planning. We begin by look-
ing at the analysis of financial statements.
Why do companies provide accounting information? Public companies have a vari-
ety of stakeholders: shareholders, bondholders, bankers, suppliers, employees, and
management, for example. These stakeholders all need to monitor how well their inter-
ests are being served. They rely on the company™s periodic financial statements to pro-
vide basic information on the profitability of the firm.
In this material we look at how you can use financial statements to analyze a firm™s
overall performance and assess its current financial standing. You may wish to under-
stand the policies of a competitor or the financial health of a customer. Or you may need
to check your own firm™s financial performance in meeting standard criteria and deter-
mine where there is room for improvement.
We will look at how analysts summarize the large volume of accounting information
by calculating some key financial ratios. We will then describe these ratios and look at
some interesting relationships among them. Next we will show how the ratios are used
and note the limitations of the accounting data on which most ratios are based. Finally,
we will look at some measures of firm performance. Some of these are expressed in
ratio form; some measure how much value the firm™s decisions have added.
After studying this material you should be able to
Calculate and interpret measures of a firm™s leverage, liquidity, efficiency, and prof-
Use the Du Pont formula to understand the determinants of the firm™s return on its
assets and equity.
Evaluate the potential pitfalls of ratios based on accounting data.
Understand some key measures of firm performance such as market value added and
economic value added.

Financial Ratios
We have all heard stories of whizzes who can take a company™s accounts apart in min-
utes, calculate a few financial ratios, and discover the company™s innermost secrets. The
truth, however, is that financial ratios are no substitute for a crystal ball. They are just
a convenient way to summarize large quantities of financial data and to compare firms™
performance. Ratios help you to ask the right questions: they seldom answer them.

Financial Statement Analysis 135

(figures in millions of dollars)
Net sales $22,348
Cost of goods sold 9,330
Other expenses 291
Selling, general, and administrative expenses 8,912
Depreciation 1,234
Earnings before interest and taxes (EBIT) 2,581
Net interest expense 321
Taxable income 2,260
Taxes 270
Net income 1,990
Allocation of net income
Addition to retained earnings 1,233
Dividends 757

Note: Numbers may not add because of rounding.
Source: PepsiCo, Inc., Annual Report, 1998.

We will describe and calculate four types of financial ratios:
• Leverage ratios show how heavily the company is in debt.
• Liquidity ratios measure how easily the firm can lay its hands on cash.
• Efficiency or turnover ratios measure how productively the firm is using its assets.
• Profitability ratios are used to measure the firm™s return on its investments.
We introduced you to PepsiCo™s financial statements in Accounting and Finance.
Now let™s analyze them. For convenience, Tables A.7 and A.9 present again Pepsi™s in-
come statement and balance sheet.
The income statement summarizes the firm™s revenues and expenses and the differ-
ence between the two, which is the firm™s profit. You can see in Table A.7 that after de-
Financial statement that
ducting the cost of goods sold and other expenses, Pepsi had earnings before interest
shows the revenues,
and taxes (EBIT) of $2,581 million. Of this sum, $321 million was used to pay debt in-
expenses, and net income of
terest (remember interest is paid out of pretax income), and $270 was set aside for taxes.
a firm over a period of time.
The net income belonged to the common stockholders. However, only a part of this in-
come was paid out as dividends, and the remaining $1,233 million was plowed back
into the business.1
The income statement in Table A.7 shows the number of dollars that Pepsi earned in
1998. When making comparisons between firms, analysts sometimes calculate a com-
STATEMENT Income mon-size income statement. In this case all items in the income statement are
statement that presents expressed as a percentage of revenues. Table A.8 is Pepsi™s common-size income
items as a percentage of statement. You can see, for example, that the cost of goods sold consumes nearly 42
revenues. percent of revenues, and selling, general, and administrative expenses absorb a further
40 percent.
Whereas the income statement summarizes activity during a period, the balance
sheet presents a “snapshot” of the firm at a given moment. For example, the balance
Financial statement that
sheet in Table A.9 is a snapshot of Pepsi™s assets and liabilities at the end of 1998.
shows the value of the firm™s
assets and liabilities at a
1 This is in addition to $1,234 million of cash flow earmarked for depreciation.
particular time.

(all items expressed as a percentage of revenues)
Net sales 100
Cost of goods sold 41.7
Other expenses 1.3
Selling, general, and administrative expenses 39.9
Depreciation 5.5
Earnings before interest and taxes (EBIT) 11.5
Net interest expense 1.4
Taxable income 10.1
Taxes 1.2
Net income 8.9
Allocation of net income 0
Addition to retained earnings 5.5
Dividends 3.4

Note: Numbers may not add because of rounding.
Source: PepsiCo, Inc., Annual Report, 1998.

The accountant lists first the assets that are most likely to be turned into cash in the
near future. They include cash itself, short-term securities, receivables (that is, bills that
have not yet been paid by the firm™s customers), and inventories of raw materials, work-
in-process, and finished goods. These assets are all known as current assets. The sec-
ond main group of assets consists of long-term assets such as buildings, land, machin-
ery, and equipment. Remember that the balance sheet does not show the market value
(figures in millions of dollars)
Assets 1998 1997 Liabilities and Shareholders™ Equity 1998 1997
Current assets Current liabilities
Cash and equivalents 311 1,928 Debt due for repayment 3,921 0
Marketable securities 83 955 Accounts payable 3,870 3,617
Receivables 2,453 2,150 Other current liabilities 123 640
Inventories 1,016 732 Total current liabilities 7,914 4,257
Other current assets 499 486 Long-term debt 4,028 4,946
Total current assets 4,362 6,251 Other long-term liabilities 4,317 3,962
Fixed assets Total liabilities 16,259 13,165
Property, plant, and equipment 13,110 11,294
Shareholders™ equity
Less accumulated depreciation 5,792 5,033


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