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Quiz 1. Calculating Ratios. Here are simplified financial statements of Phone Corporation from a

recent year:

INCOME STATEMENT

(figures in millions of dollars)

Net sales 13,194

Cost of goods sold 4,060

Other expenses 4,049

Depreciation 2,518

Earnings before interest and taxes (EBIT) 2,566

Interest expenses 685

Income before tax 1,881

Taxes 570

Net income 1,311

Dividends 856

156 APPENDIX A

BALANCE SHEET

(figures in millions of dollars)

End of Year Start of Year

Assets

Cash and marketable securities 89 158

Receivables 2,382 2,490

Inventories 187 238

Other current assets 867 932

Total current assets 3,525 3,818

Net property, plant, and equipment 19,973 19,915

Other long-term assets 4,216 3,770

Total assets 27,714 27,503

Liabilities and shareholdersâ€™ equity

Payables 2,564 3,040

Short-term debt 1,419 1,573

Other current liabilities 811 787

Total current liabilities 4,794 5,400

Long-term debt and leases 7,018 6,833

Other long-term liabilities 6,178 6,149

Shareholdersâ€™ equity 9,724 9,121

Total liabilities and shareholdersâ€™ equity 27,714 27,503

Calculate the following financial ratios:

a. Long-term debt ratio

b. Total debt ratio

c. Times interest earned

d. Cash coverage ratio

e. Current ratio

f. Quick ratio

g. Net profit margin

h. Inventory turnover

i. Days in inventory

j. Average collection period

k. Return on equity

l. Return on assets

m. Payout ratio

2. Interval Measure. Suppose that Phone Corp. shut down operations. For how many days

could it pay its bills?

3. Gross Investment. What was Phone Corp.â€™s gross investment in plant and other equipment?

4. Market Value Ratios. If the market value of Phone Corp. stock was $17.2 billion at the end

of the year, what was the market-to-book ratio? If there were 205 million shares outstand-

ing, what were earnings per share? The price-earnings ratio?

5. Common-Size Balance Sheet. Prepare a common-size balance sheet for Phone Corp. using

its balance sheet from problem 1.

6. Du Pont Analysis. Use the data for Phone Corp. to confirm that ROA = asset turnover Ă—

profit margin.

7. Du Pont Analysis. Use the data for Phone Corp. from problem 1 to

a. calculate the ROE for Phone Corp.

Financial Statement Analysis 157

b. demonstrate that ROE = leverage ratio Ă— asset turnover ratio Ă— profit margin Ă— debt

burden.

8. Asset Turnover. In each case, choose the firm that you expect to have a higher asset turnover

Practice ratio.

Problems a. Economics Consulting Group or Pepsi

b. Catalog Shopping Network or Neiman Marcus

c. Electric Utility Co. or Standard Supermarkets

9. Defining Ratios. There are no universally accepted definitions of financial ratios, but some

of the following ratios make no sense at all. Substitute the correct definitions.

long-term debt

a. Debt-equity ratio =

long-term debt + equity

EBIT â€“ tax

b. Return on equity =

average equity

net income + interest

c. Profit margin =

sales

total assets

d. Inventory turnover =

average inventory

current liabilities

e. Current ratio =

current assets

current assets â€“ inventories

f. Interval measure =

average daily expenditure from operations

sales

g. Average collection period =

average receivables/365

cash + marketable securities + receivables

h. Quick ratio =

current liabilities

10. Current Liabilities. Suppose that at year-end Pepsi had unused lines of credit which would

have allowed it to borrow a further $300 million. Suppose also that it used this line of credit

to borrow $300 million and invested the proceeds in marketable securities. Would the com-

pany have appeared to be (a) more or less liquid, (b) more or less highly leveraged? Calcu-

late the appropriate ratios.

11. Current Ratio. How would the following actions affect a firmâ€™s current ratio?

a. Inventory is sold at cost.

b. The firm takes out a bank loan to pay its accounts due.

c. A customer pays its accounts receivable.

d. The firm uses cash to purchase additional inventories.

12. Liquidity Ratios. A firm uses $1 million in cash to purchase inventories. What will happen

to its current ratio? Its quick ratio?

13. Receivables. Chikâ€™s Chickens has average accounts receivable of $6,333. Sales for the year

were $9,800. What is its average collection period?

14. Inventory. Salad Daze maintains an inventory of produce worth $400. Its total bill for pro-

duce over the course of the year was $73,000. How old on average is the lettuce it serves its

customers?

15. Inventory Turnover. If a firmâ€™s inventory level of $10,000 represents 30 daysâ€™ sales, what

is the annual cost of goods sold? What is the inventory turnover ratio?

158 APPENDIX A

16. Leverage Ratios. Lever Age pays an 8 percent coupon on outstanding debt with face value

$10 million. The firmâ€™s EBIT was $1 million.

a. What is times interest earned?

b. If depreciation is $200,000, what is cash coverage?

c. If the firm must retire $300,000 of debt for the sinking fund each year, what is its â€śfixed-

payment cash-coverage ratioâ€ť (the ratio of cash flow to interest plus other fixed debt pay-

ments)?

17. Du Pont Analysis. Keller Cosmetics maintains a profit margin of 5 percent and asset

turnover ratio of 3.

a. What is its ROA?

b. If its debt-equity ratio is 1.0, its interest payments and taxes are each $8,000, and EBIT

is $20,000, what is its ROE?

18. Du Pont Analysis. Torrid Romance Publishers has total receivables of $3,000, which repre-

sents 20 daysâ€™ sales. Average total assets are $75,000. The firmâ€™s profit margin is 5 percent.

Find the firmâ€™s ROA and asset turnover ratio.

19. Leverage. A firm has a long-term debt-equity ratio of .4. Shareholdersâ€™ equity is $1 million.

Current assets are $200,000 and the current ratio is 2.0. The only current liabilities are notes

payable. What is the total debt ratio?

20. Leverage Ratios. A firm has a debt-to-equity ratio of .5 and a market-to-book ratio of 2.0.

What is the ratio of the book value of debt to the market value of equity?

21. Times Interest Earned. In the past year, TVG had revenues of $3 million, cost of goods sold

of $2.5 million, and depreciation expense of $200,000. The firm has a single issue of debt

outstanding with face value of $1 million, market value of $.92 million, and a coupon rate

of 8 percent. What is the firmâ€™s times interest earned ratio?

22. Du Pont Analysis. CFA Corp. has a debt-equity ratio that is lower than the industry average,

but its cash coverage ratio is also lower than the industry average. What might explain this

seeming contradiction?

23. Leverage. Suppose that a firm has both floating rate and fixed rate debt outstanding. What

effect will a decline in market interest rates have on the firmâ€™s times interest earned ratio?

On the market value debt-to-equity ratio? Based on these answers, would you say that lever-

age has increased or decreased?

24. Interpreting Ratios. In each of the following cases, explain briefly which of the two com-

panies is likely to be characterized by the higher ratio:

a. Debt-equity ratio: a shipping company or a computer software company

b. Payout ratio: United Foods Inc. or Computer Graphics Inc.

c. Ratio of sales to assets: an integrated pulp and paper manufacturer or a paper mill

d. Average collection period: Regional Electric Power Company or Z-Mart Discount Out-

lets

e. Price-earnings multiple: Basic Sludge Company or Fledgling Electronics

25. Using Financial Ratios. For each category of financial ratios discussed in this material, give

some examples of who would be likely to examine these ratios and why.

26. Financial Statements. As you can see, someone has spilled ink over some of the entries in

Challenge the balance sheet and income statement of Transylvania Railroad. Can you use the follow-

Problem ing information to work out the missing entries:

Financial Statement Analysis 159

Long-term debt ratio .4

Times interest earned 8.0

Current ratio 1.4

Quick ratio 1.0

Cash ratio .2

Return on assets 18%

Return on equity 41%

Inventory turnover 5.0

Average collection period 71.2 days

INCOME STATEMENT

(figures in millions of dollars)

Net sales â€˘â€˘â€˘

Cost of goods sold â€˘â€˘â€˘

Selling, general, and administrative expenses 10

Depreciation 20

Earnings before interest and taxes (EBIT) â€˘â€˘â€˘

Interest expense â€˘â€˘â€˘

Income before tax â€˘â€˘â€˘

Tax â€˘â€˘â€˘

Net income â€˘â€˘â€˘

BALANCE SHEET

(figures in millions of dollars)

This Year Last Year

Assets

Cash and marketable securities â€˘â€˘â€˘ 20

Receivables â€˘â€˘â€˘ 34

Inventories â€˘â€˘â€˘ 26

Total current assets â€˘â€˘â€˘ 80

Net property, plant, and equipment â€˘â€˘â€˘ 25

Total assets â€˘â€˘â€˘ 105

Liabilities and shareholdersâ€™ equity

Accounts payable 25 20

Notes payable 30 35

Total current liabilities â€˘â€˘â€˘ 55

Long-term debt â€˘â€˘â€˘ 20

Shareholdersâ€™ equity â€˘â€˘â€˘ 30

Total liabilities and shareholdersâ€™ equity 115 105

1 Nothing will happen to the long-term debt ratio computed using book values, since the face

Solutions to values of the old and new debt are equal. However, times interest earned and cash coverage

Self-Test will increase since the firm will reduce its interest expense.

2 a. The current ratio starts at 1.2/1.0 = 1.2. The transaction will reduce current assets to $.7

Questions

million and current liabilities to $.5 million. The current ratio increases to .7/.5 = 1.4.

Net working capital is unaffected: current assets and current liabilities fall by equal

amounts.

160 APPENDIX A

b. The current ratio is unaffected, since the firm merely exchanges one current asset (cash)

for another (inventories). However, the quick ratio will fall since inventories are not in-

cluded among the most liquid assets.

3 Average daily expenses are (9,330 + 8,912 + 291)/365 = $50.8 million. Average accounts

payable are (3,870 + 3,617)/2 = 3,743.5 million. The average payment delay is therefore

3,743.5/50.8 = 73.7 days.

4 a. The firm must compensate for its below-average profit margin with an above-average

turnover ratio. Remember that ROA is the product of margin Ă— turnover.

b. If ROA equals the industry average but ROE exceeds the industry average, the firm must

have above-average leverage. As long as ROA exceeds the borrowing rate, leverage will

increase ROE.

5 Retailers maintain large inventories of goods, specifically the products they stock in their

stores. This shows up in the high net working capital ratio. Their profit margin on sales is

relatively low, but they make up for that low margin by turning over goods rapidly. The high

asset turnover allows retailers to earn an adequate return on assets even with a low profit

margin, and competition prevents them from increasing prices and margins to a level that

would provide a better ROA. In contrast, manufacturing firms have low turnover, and there-

fore need higher profit margins to remain viable.

MINICASE to use some of that stuff they taught you in the training course.â€ť

Burchetts Green had enjoyed the bank training course, but it was

Burchetts was familiar with the HH story. Founded in 1990, it

good to be starting his first real job in the corporate lending

had rapidly built up a chain of discount stores selling materials

group. Earlier that morning the boss had handed him a set of

for crafts and hobbies. However, last year a number of new store

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