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Common stock and other paid-in capital 1,195 1,343
Net fixed assets 7,318 6,261
Retained earnings 5,206 5,593
Intangible assets 8,996 5,855 Total shareholders™ equity 6,401 6,936
Other assets 1,984 1,734 Total liabilities and shareholders™ equity 22,660 20,101
Total assets 22,660 20,101

Note: Columns may not add because of rounding.
Source: PepsiCo, Inc., Annual Report, 1998.
Financial Statement Analysis 137

(all items expressed as a percentage of total assets)
Assets 1998 1997 Liabilities and Shareholders™ Equity 1998 1997
Current assets Current liabilities
Cash and equivalents 1.4 9.6 Debt due for repayment 17.3 0.0
Marketable securities 0.4 4.8 Accounts payable 17.1 18.0
Receivables 10.8 10.7 Other current liabilities 0.5 3.2
Inventories 4.5 3.6 Total current liabilities 34.9 21.2
Other current assets 2.2 2.4 Long-term debt 17.8 24.6
Total current assets 19.2 31.1 Other long-term liabilities 19.1 19.7
Fixed assets Total liabilities 71.8 65.5
Property, plant, and equipment 57.9 56.2 Shareholders™ equity
Less accumulated depreciation 25.6 25.0 Common stock and other paid-in capital 5.3 6.7
Net fixed assets 32.3 31.1 Retained earnings 23.0 27.8
Intangible assets 39.7 29.1 Total shareholders™ equity 28.2 34.5
Other assets 8.8 8.6 Total liabilities and shareholders™ equity 100.0 100.0
Total assets 100 100

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

of each asset. Instead, the accountant records the amount that the asset originally cost
and then, in the case of plant and equipment, deducts an annual charge for depreciation.
Pepsi also owns many valuable assets, such as its brand name, that are not shown on the
balance sheet.
Pepsi™s liabilities show the claims on the firm™s assets. These also are classified as
current versus long-term. Current liabilities are bills that the company expects to pay in
the near future. They include debts that are due to be repaid within the next year and
payables (that is, amounts the company owes to its suppliers). In addition to these short-
term debts, Pepsi has borrowed money that will not be repaid for several years. These
are shown as long-term liabilities.
After taking account of all the firm™s liabilities, the remaining assets belong to the
common stockholders. The shareholders™ equity is simply the total value of the assets
less the current and long-term liabilities.2 It is also equal to the amount that the firm has
raised from stockholders ($1,195 million) plus the earnings that have been retained and
reinvested on their behalf ($5,206 million).
Just as it is sometimes useful to provide a common-size income statement, so we can
also calculate a common-size balance sheet. In this case all items are reexpressed as a
percentage of total assets. Table A.10 is Pepsi™s common-size balance sheet. The table
shows, for example, that in 1998 cash and marketable securities fell from 9.6 percent of
Balance sheet that presents
total assets to 1.4 percent.
items as a percentage of
total assets.

2 If
Pepsi had also issued preferred stock, we would also need to deduct this before calculating the equity that
belonged to the common stockholders.

When a firm borrows money, it promises to make a series of interest payments and then
to repay the amount that it has borrowed. If profits rise, the debtholders continue to re-
ceive a fixed interest payment, so that all the gains go to the shareholders. Of course,
the reverse happens if profits fall. In this case shareholders bear all the pain. If times
are sufficiently hard, a firm that has borrowed heavily may not be able to pay its debts.
The firm is then bankrupt and shareholders lose their entire investment. Because debt
increases returns to shareholders in good times and reduces them in bad times, it is said
to create financial leverage. Leverage ratios measure how much financial leverage the
firm has taken on.

Debt Ratio. Financial leverage is usually measured by the ratio of long-term debt to
total long-term capital. Here “long-term debt” should include not just bonds or other
borrowing, but also the value of long-term leases.3 Total long-term capital, sometimes
called total capitalization, is the sum of long-term debt and shareholders™ equity. Thus
for Pepsi
long-term debt
Long-term debt ratio =
long-term debt + equity
= = .39
4,028 + 6,401
This means that 39 cents of every dollar of long-term capital is in the form of long-term
debt. Another way to express leverage is in terms of the company™s debt-equity ratio:
long-term debt 4,028
Debt-equity ratio = = = .63
equity 6,401
Notice that both these measures make use of book (that is, accounting) values rather
than market values.4 The market value of the company finally determines whether the
debtholders get their money back, so you would expect analysts to look at the face
amount of the debt as a proportion of the total market value of debt and equity. One rea-
son that they don™t do this is that market values are often not readily available. Does it
matter much? Perhaps not; after all, the market value of the firm includes the value of
intangible assets generated by research and development, advertising, staff training, and
so on. These assets are not readily saleable and, if the company falls on hard times, the
value of these assets may disappear altogether. Thus when banks demand that a bor-
rower keep within a maximum debt ratio, they are usually content to define this debt
ratio in terms of book values and to ignore the intangible assets that are not shown in
the balance sheet.
Notice also that these measures of leverage take account only of long-term debt.
Managers sometimes also define debt to include all liabilities:
total liabilities 16,259
Total debt ratio = = = .72
total assets 22,660

3A lease is a long-term rental agreement and therefore commits the firm to make regular rental payments.
4 In the case of leased assets accountants estimate the present value of the lease commitments. In the case of

long-term debt they simply show the face value. This can sometimes be very different from present values.
For example, the present value of low-coupon debt may be only a fraction of its face value.
Financial Statement Analysis 139

Therefore, Pepsi is financed 72 percent with debt, both long-term and short-term, and
28 percent with equity. We could also say that its ratio of total debt to equity is
16,259/6,401 = 2.54.
Managers sometimes refer loosely to a company™s debt ratio, but we have just seen
that the debt ratio may be measured in several different ways. For example, Pepsi could
be said to have a debt ratio of .39 (the long-term debt ratio) or .72 (the total debt ratio).
There is a general point here. There are a variety of ways to define most financial ra-
tios and there is no law stating how they should be defined. So be warned: don™t accept
a ratio at face value without understanding how it has been calculated.

Times Interest Earned Ratio. Another measure of financial leverage is the extent to
which interest is covered by earnings. Banks prefer to lend to firms whose earnings are
far in excess of interest payments. Therefore, analysts often calculate the ratio of earn-
ings before interest and taxes (EBIT) to interest payments. For Pepsi,
EBIT 2,581
Times interest earned = = = 8.0
interest payments 321
Pepsi™s profits would need to fall dramatically before they were insufficient to cover the
interest payment.
The regular interest payment is a hurdle that companies must keep jumping if they
are to avoid default. The times interest earned ratio (also called the interest cover ratio)
measures how much clear air there is between hurdle and hurdler. However, it tells only
part of the story. For example, it doesn™t tell us whether Pepsi is generating enough cash
to repay its debt as it becomes due.

Cash Coverage Ratio. We have pointed out that depreciation is deducted when cal-
culating the firm™s earnings, even though no cash goes out the door. Thus, rather than
asking whether earnings are sufficient to cover interest payments, it might be more in-
teresting to calculate the extent to which interest is covered by the cash flow from op-
erations. This is measured by the cash coverage ratio. For Pepsi,
EBIT + depreciation 2,581 + 1,234
Cash coverage ratio = = = 11.9
interest payments 321

A firm repays $10 million par value of outstanding debt and issues $10 million of new
Self-Test 1
debt with a lower rate of interest. What happens to its long-term debt ratio? What hap-
pens to its times interest earned and cash coverage ratios?

If you are extending credit to a customer or making a short-term bank loan, you are in-
terested in more than the company™s leverage. You want to know whether it will be able
to lay its hands on the cash to repay you. That is why credit analysts and bankers look
at several measures of liquidity. Liquid assets can be converted into cash quickly and
Ability of an
asset to be converted to
Think, for example, what you would do to meet a large, unexpected bill. You might
cash quickly at low cost.
have some money in the bank or some investments that are easily sold, but you would
not find it so simple to convert your old sweaters into cash. Companies also own assets
with different degrees of liquidity. For example, accounts receivable and inventories of

finished goods are generally quite liquid. As inventories are sold and customers pay their
bills, money flows into the firm. At the other extreme, real estate may be quite illiquid.
It can be hard to find a buyer, negotiate a fair price, and close a deal at short notice.
Managers have another reason to focus on liquid assets: the accounting figures are
more reliable. The book value of a catalytic cracker may be a poor guide to its true
value, but at least you know what cash in the bank is worth.
Liquidity ratios also have some less desirable characteristics. Because short-term as-
sets and liabilities are easily changed, measures of liquidity can rapidly become out-
dated. You might not know what the catalytic cracker is worth, but you can be fairly sure
that it won™t disappear overnight. Also, companies often choose a slack period for the
end of their financial year. For example, retailers may end their financial year in Janu-
ary after the Christmas boom. At these times the companies are likely to have more cash
and less short-term debt than during busier seasons.

Net Working Capital to Total Assets Ratio. We have seen that current assets are those
that the company expects to meet in the near future. The difference between the current
assets and current liabilities is known as net working capital. It roughly measures the
company™s potential reservoir of cash. Net working capital is usually positive. However,
Pepsi has some large short-term debt that needs to be repaid in the coming year, so its
net working capital is negative:
Net working capital = 4,362 “ 7,914 = “3,552
Managers often express net working capital as a proportion of total assets. For Pepsi,
Net working capital “3,552
= = “.16
Total assets 22,660

Current Ratio. Another measure that serves a similar purpose is the current ratio:
current assets 4,362
Current ratio = = = .55
current liabilities 7,914
So Pepsi has 55 cents in current assets for every $1 in current liabilities.
Rapid decreases in the current ratio sometimes signify trouble. For example, a firm
that drags out its payables by delaying payment of its bills will suffer an increase in cur-
rent liabilities and a decrease in the current ratio.
Changes in the current ratio can mislead, however. For example, suppose that a com-
pany borrows a large sum from the bank and invests it in marketable securities. Current
liabilities rise and so do current assets. Therefore, if nothing else changes, net working
capital is unaffected but the current ratio changes. For this reason, it is sometimes
preferable to net short-term investments against short-term debt when calculating the
current ratio.

Quick (or Acid-Test) Ratio. Some assets are closer to cash than others. If trouble
comes, inventory may not sell at anything above fire-sale prices. (Trouble typically
comes because the firm can™t sell its finished-product inventory for more than produc-
tion cost.) Thus managers often exclude inventories and other less liquid components of
current assets when comparing current assets to current liabilities. They focus instead
on cash, marketable securities, and bills that customers have not yet paid. This results
in the quick ratio:
Financial Statement Analysis 141

cash + marketable securities + receivables 311 + 83 + 2,453
Quick ratio = = = .36
current liabilities 7,914

a. A firm has $1.2 million in current assets and $1.0 million in current liabilities. If it
Self-Test 2
uses $.5 million of cash to pay off some of its accounts payable, what will happen to
the current ratio? What happens to net working capital?
b. A firm uses cash on hand to pay for additional inventories. What will happen to the
current ratio? To the quick ratio?

Cash Ratio. A company™s most liquid assets are its holdings of cash and marketable
securities. That is why analysts also look at the cash ratio:
cash + marketable securities 311 + 83
Cash ratio = = = .05
current liabilities 7,914
A low cash ratio may not matter if the firm can borrow on short notice. Who cares
whether the firm has actually borrowed from the bank or whether it has a guaranteed
line of credit that lets it borrow whenever it chooses? None of the standard liquidity
measures takes the firm™s “reserve borrowing power” into account.

Interval Measure. Instead of looking at a firm™s liquid assets relative to its current li-
abilities, it may be useful to measure whether liquid assets are large relative to the firm™s
regular outgoings. We ask how long the firm could keep up with its bills using only its
cash and other liquid assets. This is called the interval measure, which is computed by
dividing liquid assets by daily expenditures:
cash + marketable securities + receivables
Interval measure =
average daily expenditures from operations
For Pepsi the cost of goods sold amounted to $9,330 in 1998, administrative costs were
$8,912, and other expenses were $291. Therefore,
311 + 83 + 2,453
Interval measure = = 56.1
(9,330 + 8,912 + 291)/365


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