CHAPTER 14

Analysis of Operating Activities

THINKING BEYOND THE QUESTION How do operations create value for our business? Good business decisions require reliable and timely information about business activities. Accounting is the source of much of that information. Good accounting procedures and systems produce reliable and timely information. Bad accounting often results in bad information that conceals a companys actual performance and makes it difficult for users of that information to make good decisions. In recent years, examples of bad accounting by companies like Enron and WorldCom have made it apparent how important good accounting is to our economy. Bad accounting can mislead investors into believing a company is performing well when it is not. Good accounting systems should provide reliable information about a companys performance, good or bad. QUESTIONS Q14-1 Generally, in this situation, one would expect that profits would increase by a rate greater than the increase in sales. Since a large portion of the companys costs are fixed, the company has a high degree of operating leverage. This means that production and sales can increase fairly significantly with very little increase in costs. Therefore, a large portion of each new sales dollar is retained as profit. Q14-2 Generally, in this situation, one would expect that profits would increase by about the same rate as the increase in sales. Perhaps marginally faster. Since a large portion of the companys costs are variable, the company has a low degree of operating leverage. This means that there are few economies of scale to be realized from expanding production or sales. For most costs, if sales double, the cost will double. Therefore, about the same portion of each new sales dollar will be profit as was before. Q14-3 Frankly, no. A product differentiation strategy is typically built around enhancing the product. By imbuing the product with additional features or value it is expected that customers will pay more. A successful product differentiation strategy, therefore, should have the effect of
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increasing the profit margin percentage, not decreasing it. Further, as the product becomes more valuable (and expensive), some drop-off in sales volume might reasonably be expected. Therefore, the sales manager has the proposed effects exactly backwards. The new strategy should increase the profit margin with only a minor decrease (he hopes) in asset turnover. Q14-4 In general, one would expect this company to pursue a cost leadership strategy. The products are identical chemically, and unless the firm can add value by quicker delivery or in some other way, it is unlikely that product differentiation is a viable strategy. Therefore, the goods will compete on a basis of price alone, which constrains the profit margin available. This means that to earn a satisfactory return on assets, the company will have to emphasize asset turnover. The key to profitability will be low profit on each sale, but to make a lot of sales. Hence, to be financially successful, this firm will probably have to accomplish high asset turnover. Q14-5 The facts of this situation suggest a classic product differentiation strategy. New products are invented and introduced quickly. Because they are new and, for a period, without meaningful competition, they are likely able to command premium prices. For this reason, it is likely that the firm is able to earn a high profit margin. At the same time, the amount of assets necessary to invent and produce the goods is high. This suggests a low (at least lower) asset turnover when compared to competitors who later develop competitive products. Q14-6 The cost leadership strategy involves selling products at a low sales price relative to competitors. The low prices result in low profit margins. Profitability results from high sales volume. The product differentiation strategy involves selling products that have features different from those of competitors. This allows the goods to be sold at higher prices. These products are in demand because they provide value to customers above that provided by competing products. Profit margin should be high. This offsets a lower asset turnover. Q14-7 A cost leader must control its costs to permit it to keep its prices low and still earn a profit. Economies of scale are important. Economies of scale are achieved when a company can maintain sufficiently high volumes to take advantage of operating leverage and reduce unit costs. A cost leader would focus on producing and selling high-demand products. Asset turnover should be high and profit margin low for these companies. Companies using product differentiation focus on product development and customer service. They are willing to incur costs that permit them to create, produce, and market their products. Design and quality features

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are especially important. Advertising and promotion often are important for these companies to inform customers of the advantages of their products. Because these products provide extra value, they can be sold at higher prices than competing products and result in higher profit margins. All companies can increase return on assets and profits by controlling costs. Achieving higher production efficiency, reducing inventories and other assets, and high quality control can reduce investment costs and increase product demand. Q14-8 The major reason for a price decrease would be the increase in sales volume that would tend to follow. However, a price decrease will decrease the perunit profit. It may also, in this case, be in opposition to the operating strategy of the company, which appears to be following a product differentiation strategy rather than a cost leadership strategy. Prices should, in most cases, be set to maximize the estimated profit from the product. Before making a price decision, one might want marketing estimates of sales at various levels of price. Q14-9 Normally, cash flow from operations will be significantly higher than net income. Although net income is an estimate of the cash that is eventually to flow because of the periods operations, net income includes deductions for noncash expenses such as depreciation and amortization. The cash outflows related to plant and equipment and intangibles are investing cash flows, not operating. Therefore, depreciation and amortization expense is often the major reconciling item between net income and operating cash flow. In addition, any kind of expense estimated and taken before the cash flows can be a reconciling item. This often occurs when charges for restructuring, discontinued operations, or contingencies are taken against income. Changes in current assets and liabilities can also cause differences; for example, an inventory increase can use cash beyond the cost of goods sold deducted in the income statement. Q14-10 Trends of net income and net cash flow from operations depend on the length and nature of the operating cycle. Changes in income and cash flow may occur at about the same time in a company with a short cycle. Cash flow changes may lag behind income for a company with large, slowly collected receivables; the reverse may be true for companies that must buy inventory far ahead of sales. If a company is having financial troubles, it sometimes shows up in cash flow from operations before it does net income. If unsold inventory begins to pile up (because of unappealing products or poor production scheduling) or uncollectible accounts begin to grow (because of poor credit policies or a slowdown in the economy),

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cash flow is reduced. Net income is not necessarily reduced right away, but will be eventually as inventory has to be written off or the portion of doubtful accounts increased. Q14-11 Yes, there probably is a connection between cash flow problems and the low turnover of both inventory and receivables. Low rates of turnover mean that inventory or receivables are being converted into cash less rapidly than desired. The low turnovers result in a long operating cycle. That is, the time from inventory acquisition until cash collection from customers is longer than in a company with higher turnovers. This creates cash shortages. Accordingly, cash may not be available when bills need to be paid. Q14-12 The value of stock is the present value of expected future cash flows that will be derived from it. Growth results in an increase in future cash flows and, therefore, increases present value. Variability of earnings indicates uncertainty about future cash flows. As uncertainty increases, investors require a greater return as compensation for the uncertainty. Thus, expected cash flows are discounted at a higher rate, reducing present value. The effects can be summarized by the present value equation: Present value = expected cash flows required rate of return Growth increases expected cash flows. Uncertainty increases the required rate of return. Q14-13 Return on assets measures the relationship between net income and total investment. It reveals the average return on each dollar of assets, regardless of whether the asset was financed with debt or with equity. In contrast, return on equity measures the relationship between net income and the investment made by stockholders. It reveals the return on dollars invested made by stockholders. Return on assets = net income total assets Return on equity = net income total stockholders equity Q14-14 Financing decisions involve the capital structure of a company. They involve the extent to which the company will use debt and equity financing. This is related to whether financial leverage is used. Investing decisions involve the type of assets the company will acquire, as well as changes in those assets over time. These decisions affect operating leverage. Operating decisions involve how a company will use its assets to generate operating revenues and how it will control costs. Operating strategy refers to the way a company competes in markets for customers. Most companies adopt some variation of a cost leadership

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strategy or a product differentiation strategy. A company should adopt the operating strategy that it estimates will maximize operating profits. EXERCISES E14-1 Definitions of all terms are listed in the glossary. E14-2 A Unit price $ Estimated sales in units Sales revenue Variable expenses ($4 per unit) Fixed expenses Additional advertising Total expenses Pro forma operating profit 7 $ 200,000 1,400,000 800,000 300,000 1,100,000 $ 300,000 Strategy B 9 $ 135,000 1,215,000 540,000 300,000 840,000 $ 375,000 C 7 300,000 2,100,000 1,200,000 300,000 400,000 1,900,000 $ 200,000

Unless there are other considerations, the second, higher-priced strategy should be selected to maximize operating profit. E14-3 The financial objective here would be to minimize the loss on the concert, thus minimizing the amount that must be raised through contributions. The losses would be as follows: Ticket price Expected ticket sales Expected receipts Variable expenses ($2 per attendee) Fixed expenses Total expense Loss on concert $ 12 1,300 15,600 2,600 28,000 30,600 $ (15,000) $ 15 1,100 16,500 2,200 28,000 30,200 $ (13,700) $ 20 800 16,000

1,600 28,000 29,600 $(13,600)

The higher ticket price does minimize the loss. Nonprofit organizations do find that, if they are to remain solvent, they must use many of the same tools businesses use for financial decisions. They desire to provide their product in the most effective and efficient manner possible. However, they also have a not-for-profit purposehere, to bring music to the community. The board could decide that the greater loss on lower ticket prices was worthwhile because more people will enjoy the music. E14-4 Unit Price: Estimated sales, in units Estimated sales in dollars Variable expenses @ $30 Fixed expenses $100 200,000 $20,000,000 (6,000,000) (1,500,000) $125 160,000 $20,000,000 (4,800,000) (1,500,000) $160 125,000 $20,000,000 (3,750,000) (1,500,000)

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Expected operating profit

$12,500,000

$13,700,000

$14,750,000

It would appear that the company should aim to sell fewer units at a higher price per unit. To do this, it will need to differentiate the product from that of competitors so customers will pay the higher price. This strategy may increase the cost of goods sold expense or advertising expense or increase both expenses. In this case, the above financial analysis will have to be repeated to judge the feasibility of the strategy. E14-5 Company As profit margin indicates that it realizes only $0.05 of net income for each $1 of sales it earns. This low profit margin suggests that the company needs to sell a lot of its product to earn a profit. The companys asset turnover indicates that it is generating $6 in sales for every $1 in assets it owns. This high turnover also reflects a strategy of trying to make up in sales volume what it lacks in profit margin because the company is trying to generate a high sales volume in order to be profitable in spite of the low profit margin. This appears to be a cost leadership strategy. Company B seems to be completely different from A. Company B keeps $0.40 of every $1 it earns in sales and therefore shows it may be able to charge high prices and not have to sell as much product. Company Bs asset turnover is also consistent with this strategy and shows that the company generates only $0.75 of sales for every $1 of assets. Since B charges high prices, Bs sales volume does not have to be as great as As sales volume to be profitable. This appears to be a product differentiation strategy. Company C, according to the profit margin, realizes $0.25 of net income for each $1 in sales. The asset turnover ratio indicates that the company earns $1.20 in sales for every $1 of assets it has. Company C appears to have struck a middle ground between cost leadership and product differentiation. It is not as aggressive on price as is Company A, which suggests it has been able to differentiate its products from those of Company A. It is not as able to generate high margins as Company B, which suggests it has not achieved the same level of product differentiation as Company B and must therefore be more careful about costs than Company B. All companies are equally profitable as measured by their 30% return on assets. E14-6 Profit margin, asset turnover, and return on assets are provided below for Home Depot, Microsoft, and Procter & Gamble. Home Depot 6.84% Microsoft 22.20% Procter & Gamble 12.60%

Profit margin (net income sales)

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Asset turnover (sales assets) Return on assets (margin turnover)

1.879 12.85%

0.399 8.80%

0.901 11.40%

Home Depot seems to use a cost leadership strategy as evidenced by its relatively low profit margin (6.84%) and relatively large turnover ratio (1.879). We should note that Home Depot competes in a different industry than Procter & Gamble or Microsoft. A more meaningful comparison could be made between Home Depot and Lowes, for example. E14-7 Profit margin, asset turnover, and return on assets are provided below for Hershey Foods and Wrigley. Hershey Foods 13.34% 1.166 15.56% Wrigley 13.51% 1.152 15.57%

Profit margin (net income sales) Asset turnover (sales assets) Return on assets (margin turnover)

Interestingly, these two companies are almost identical in their key ratios profit margin, asset turnover, and return on assets. Profit margins and turnover are very strong. Thus, both companies are enjoying impressive returns on assets of about 15.6%. E14-8 Calculation of the components of return on assets will give some clues to operating strategy. Pats Place: Profit margin = $80,000 $220,000 = 36.4% Asset turnover = $220,000 $530,000 = 0.415 Return on assets = $80,000 $530,000 = 15.1% or Return on assets = 36.4% 0.415 = 15.1% Henrys Hangout: Profit margin = $30,000 $190,000 = 15.8% Asset turnover = $190,000 $210,000 = 0.90 Return on assets = $30,000 $210,000 = 14.3% or Return on assets = 15.8% 0.90 = 14.2% (rounding difference) (continued)

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Return on assets is similar for the two restaurants. But Pats has a higher profit margin and lower asset turnover, suggesting a product differentiation strategy. Henrys lower profit margin and higher asset turnover suggest a cost leadership strategy. The restaurants could generate more profit by controlling costs or by increasing revenue. Revenue may be improved by increasing the number of diners or the amount spent by each diner. Pats may want to concentrate on improved revenues; cost cutting could damage the distinctiveness, which allows for the high profit margins. Henrys may find cost cutting to be the right approach; a price increase can be quite damaging to sales volume for a business that depends on a cost leadership strategy. E14-9 Profit margin, asset turnover, and return on assets are provided below for Southwest and Delta airlines. Southwest Airlines 2004 2003 4.79% 7.44% 0.576 0.601 2.76% 4.47% Delta Air Lines 2004 2003 34.65% 5.49% 0.688 0.543 23.84% 2.98%

Profit margin (net income sales) Asset turnover (sales assets) Return on assets (margin turnover)

The airlines have similar asset turnover ratios. Southwest has positive profit margins, while Deltas profit margins are negative. Thus, our ratio analysis suggests Southwest is doing a better job controlling costs. Traditionally, Delta has been a full-service airline, while Southwest has traditionally competed by offering no frills air travel at reduced prices. E14-10 a. Profit margin Asset turnover 44.9% ($9,000 $20,036) Return on assets 8.4% ($1,683 $20,036) Days sales in inventory 100 (1,500 15) Average daily cost of 15 goods sold (5,500 365) Fixed asset turnover 2.3 (9,000 4,000) 2008 18.7% ($1,683 $9,000) 2007 14.2% ($852 $6,000) 56.3% ($6,000 $10,650) 8.0% ($852 $10,650) 100 (960 9.6) 9.6 (3,500 365) 2.4 (6,000 2,500) 2006 9.6% ($288 $3,000) 81.3% ($3,000 $3,692) 7.8% ($288 $3,692) 102 (500 4.9) 4.9 (1,800 365) 2 (3,000 1,500)

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b.

The companys profit margin has almost doubled over the three years, indicating more emphasis on a product differentiation strategy. It has probably raised prices to realize greater sales revenue and greater profit from those sales. The company probably also had to make its product (clothing) more differentiated from its competitors clothing to attract buyers. Over the years, the decrease, by almost half, in asset turnover is also consistent with the product differentiation strategy because the company is depending more on high profit margin than on selling a lot of product in order to be profitable. The companys days sales in inventory has been stable over the period shown. The companys strategy seems to be working since its return on assets and fixed asset turnover have increased over the years. Thunderbird Corporation 2008 2007 71.8% 2.7% 86.3% 9.0%

E14-11 a. Fasani Enterprises 2008 2007 Cash from operations net income Cash from operations total assets b. 297.1% 16.5% 249.2% 14.0%

Fasani is better at generating cash from assets. Net income can be looked upon as an estimate of the net cash that will eventually be collected because of the current periods operations. For Fasani, depreciation, decreased inventories, and increased payables reflect the main differences between net income and cash flow from operations. Fasanis cash flow from operations is also higher as a proportion of net income. A major difference between net income and cash flow for both firms is the noncash expenses of depreciation and amortization. In addition, Fasani has improved its cash flow by reducing inventories and increasing its payables. However, the increased payables will require more future cash flow. In contrast, Thunderbirds cash flow from operations has been substantially reduced by its large increases in receivables. (Are they having trouble with collections? The increase in sales doesnt appear to justify the large run-up in receivables.) Also negatively affecting Thunderbirds cash flow from operations is that they have used a lot of cash to reduce payables over the last two periods. Disneys earnings improved slightly from 2002 to 2003, and significantly between 2003 and 2004. Cash flows from operating activities followed a similar pattern. (continued)

c.

E14-12 a.

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In terms of investing activities, the company used more cash for investments in 2002 than in 2003 and 2004 combined. Thus, one may conclude that the company is not expanding at an increasing rate. Similarly, during 2002 the company had a net cash inflow from financing activities, yet used cash for financing activities (presumably to reduce debt) during 2003 and 2004. b. It should not be surprising that differences exist between net earnings and net cash from operating activities. Timing differences between accrual and cash flow measures of operating activities are common. Cash earned in 2003 might not be received until 2004, for example. In the long run, the trend in net cash from operating activities should approximate the trend in net earnings. Year-to-year fluctuations are common, however. Net earnings is more stable, usually, than net cash from operating activities. Accrual measurement recognizes the results of operating activities when the activities occur. These activities tend to occur at a more steady pace than the inflow and outflow of cash associated with the activities. Federated 2004 2003 2.98 2.83 4.573 4.751 40.52% 40.39% 8.96% 8.79% Wal-Mart 2004 2003 7.5 7.3 204.0 146.0 22.00% 22.00% 6.00% 6.00%

E14-13 Inventory turnover Accounts receivable turnover Gross profit margin Operating profit margin

Wal-Mart turns its inventory more rapidly than does Federated. However, Federated earns a higher gross profit margin and operating profit margin than does Wal-Mart. The very large accounts receivable turnover of WalMart is a function of very small accounts receivable balances resulting from the use of bank credit cards (such as Visa or MasterCard) on most noncash purchases. Several of Federateds department stores operate their own credit card systems. E14-14 1. Gross profit margin = Gross profit Sales revenue = $25,000 $50,000 = 50% Operating profit margin = Operating income Sales revenue = $16,000 $50,000 = 32% Profit margin = Net income Sales revenue = $10,400 $50,000 = 20.8%

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For every dollar of sales revenue that Crystal Corporation earns, it realizes $0.50 in gross profit, which includes $0.32 of operating profit, which in turn includes $0.21 in net income. E14-15 Inventory turnover = Cost of goods sold Inventory An increased inventory turnover means that either cost of goods sold went up or inventory went down. While an increase in cost of goods sold is an increase in an expense (which is not usually a good thing), it is positive in this case. All inventory will either be sold (and become cost of goods sold), or left on hand (and be ending inventory). It is usually better to maximize the inventory sold relative to the inventory not sold, thus increasing the inventory turnover. You have to look also at the bottom half of the ratio: inventory. An increase in inventory turnover may reflect a decrease in inventory, which is a good thing because a company does not want to have too much inventory around; it may become obsolete, and it is expensive to store inventory. A decrease in inventory means that the company is using less resources to generate the same amount of sales. It is, therefore, more efficient. Accounts receivable turnover = Operating revenues Accounts receivable Accounts receivable turnover measures the ability to convert revenues into cash. A higher ratio may reflect an increase in sales (which is good) or a decrease in accounts receivable (which is also good, since it shows the collection of cash from accounts receivable) or a combination of both. Gross profit margin = Gross profit Operating revenues and Operating profit margin = Operating income Operating revenues If the gross profit margin is high, it reflects the fact that the company is keeping its cost of goods sold down, relative to its sales. If the operating profit margin is high, it reflects the fact that the company is keeping its other operating expenses down, relative to its sales. Both ratios reflect efficiency, and the higher they are, the more efficient the company is. E14-16 a. Ratio 1. Inventory turnover (CGS inventory) 2. Accounts receivable turnover (sales accounts receivable) 3. Gross profit margin (gross profit sales) 2008 5.5 9.9 Calculation 11,481 2,093 14,472 1,466 2007 6.0 10.5 Calculation 11,606 1,947 13,971 1,330

20.7% 2,991* 14,472 16.9% 2,365** 13,971

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4. Operating profit margin (operating income sales) 11.3% 1,636 14,472 10.8% 1,509 13,971 5. Profit margin (net income sales) 8.1% 1,170 14,472 7.3% 1,020 13,971 6. Asset turnover (sales total assets) 1.06 14,472 13,707 1.09 13,971 12,829 7. Return on assets (net $1,020 income total assets) 8.5% 1,170 13,707 8.0% $12,829 8. Return on equity (net income SE) 26.7% 1,170 4,386 24.4% 1,020 4,180 9. Times interest earned (income before taxes interest expense) 1.6 1,636 1,000 1.7 1,509 900 10. Days sales in inventory (inventory average [2,093 (11,481 [1,947 (11,606 daily cost of goods sold) 67 365)] 61 365)] 11. Average accounts receivable collection period (accounts receivable average [1,466 (14,472 [1,330 (13,971 daily sales) 37 365)] 35 365)] 12. Fixed asset turnover (sales fixed assets) 1.81 14,472 8,000 1.86 13,971 7,500 * Sales ($14,472) cost of goods sold ($11,481) = gross margin ($2,991) ** Sales ($13,971) cost of goods sold ($11,606) = gross margin ($2,365) b. Overall, the companys financial performance improved somewhat over the previous year. This is shown by the improved return on equity (from 24.4% to 26.7%). The improvement is traceable to improved efficiency. All three margins (gross profit, operating profit, and profit margin) improved from the previous year. Effectiveness measures, such as inventory turnover, accounts receivable turnover and asset turnover, all decreased. This offsets some, but not all, of the improvements traceable to efficiency. Days sales in inventory and average accounts receivable collection period also increased. Amount $1,846 $871 $6,918 $1,050 Solution Sales accts receivable turnover ($10,377 5.62) CGS inventory turnover ($6,226 7.15) Add together all asset amounts Must first determine total liabilities and equity. Then plug this item.

E14-17 Missing item a. Accounts receivable b. Inventory c. Total assets d. Notes payable

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e. f.

Total liabilities & equity Gross profit

$6,918 $4,151

g. Rent expense $980 h. Total expenses $2,206 i. j. k. Income taxes $681 Net income $1,264 Return on equity 25.8%

Must be same amount as total assets. Sales revenue CGS ($10,377 $6,226) Must first determine total expenses. Then plug this amount. Gross profit income before taxes ($4,151 $1,945) Income before taxes 35% ($1,945 35%) Income before taxes taxes ($1,945 $681) Net income total equity ($1,264 ($3,400 + $1,491))

E14-18 Return on assets: $16,593 $750,330 = 2.2% Return on equity: $16,593 $110,284 = 15.0% Financial leverage can have a major effect on return to stockholders. General Electric has a very high amount of financial leverage, which greatly magnified return on equity, though the company paid a large amount of interest relative to its net income. Leverage does include a risk in a year of poor sales, required interest payments could magnify a loss. E14-19 a. i. ii. iii. iv. v. vi. 18.7% 0.449 8.4% 12.6% 1.08 4.1 ($5,049 $27,000) ($27,000 $60,108) ($5,049 $60,108) or (18.7% 44.9%) ($5,049 $40,070) ($27,000 $25,000) ($10,278 $2,500) (continued)

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b.

Return On equity Net income Equity

= =

Profit margin

Asset turnover

Financial leverage

Net income Operating revenues Total assets Operating Total Equity revenue assets

Profit margin is based on sales and how much of those sales the company keeps in profit, by minimizing expenses. These are operating activities. The asset turnover includes information about total assets. The purchase and sale of long-term assets are investing activities. Financial leverage includes information about stockholders equity and how it relates to total assets. This measures capital structure and therefore reflects financing activities. Overall, then, return on equity incorporates information about operating, financing, and investing activities. E14-20 a. McDonalds 2004 2003 0.12 0.09 0.68 0.66 0.08 0.06 1.96 2.16 0.16 0.12 Wendys 2004 2003 0.01 0.07 1.14 1.01 0.02 0.08 1.86 1.78 0.03 0.13

Profit margin (net income sales) Asset turnover (sales total assets) Return on assets (net income total assets) Financial leverage (total assets equity) Return on equity (net income equity)

b.

Overall, as measured by size of profits (dollars of net income) and total assets, McDonalds is a much larger company. The two companies earn their profits in very different ways. McDonalds profit margin is greater than Wendys. However, Wendys asset turnover is considerably larger than that of McDonalds. In 2003, Wendys produced a slightly higher ROA and ROE than did McDonalds. In 2004, McDonalds produced a dramatically higher ROA and ROE than did Wendys. McDonalds is slightly more leveraged than Wendys.

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E14-21 Attribute Asset growth Debt to assets Dividend payout* Equity growth Investing cash outflow Operating cash inflow Research and development expenditure Return on assets Return on equity Sales growth Magnitude of Attribute High Low Low Low High Low High Low High High Expected Company Value High High High Low High Low High Low High High

* Indicates a company has favorable opportunities in which to invest profits. E14-22 Accounting Information c Asset turnover e Financial leverage p Growth in assets j Growth in equity h Growth in sales g Growth in return on equity k Investing cash flow n Operating cash flow d Profit margin l Research and development m Return on assets a Return on equity b Fixed asset turnover f Times interest earned o Days sales in inventory i Average accounts receivable collection period E14-23 a. Measurement unitsDollar values are used to measure the elements (assets, liabilities, equity, revenues, and expenses) listed in the financial statements. Historical costsAll items listed in the balance sheet are recorded at historical cost, but one item for which this historical cost might go back a number of years is Buildings. (Inventory may be shown at lower of cost or market.) (continued)

b.

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c.

Accrual basisAccounts receivable usually stands for revenues that have been earned and recorded (and therefore accrued) but for which the cash has not yet been received. Also, wages payable reflects wages that have been accrued, because they are owed to employees that have worked in the past, but for which cash has not yet been paid. Also note, under GAAP, the recognition of revenues and expenses is on an accrual basis. Thus, the income statement items all reflect the accrual basis.

d.

Fiscal periodsThe headings of the financial statements provide information about the particular period of time covered and/or when it ended. MatchedCost of sales is matched with sales revenue so that the expense of the inventory sold is matched with the revenue earned from selling that inventory. Depreciation expense is matched with the use of the related assets. EstimationDepreciation expense is calculated by estimating the useful life of the asset and maybe the residual value also.

e.

f.

PROBLEMS P14-1 A. Profit margin (net income sales) Asset turnover (sales total assets) Return on assets (net income total assets) Return on equity (net income equity) Leverage B. Caterpillar 0.07 0.70 0.05 0.27 5.77 Kellogg 0.09 0.89 0.08 0.39 4.78 Eli Lilly 0.13 0.56 0.07 0.17 2.28

Caterpillar, Kellogg, and Eli Lilly are in three very different industries. Both Caterpillar and Kellogg employ leverage to a much greater extent than does Eli Lilly. As a result, Caterpillar and Kellogg produce a much larger ROE than does Eli Lilly, yet Lillys ROA is between that of Caterpillar and Kellogg. Lillys profit margins are higher than those of Caterpillar and Kellogg, yet Lillys asset turnover is slightly lower. Profit margin (net income operating revenues) Colony: $180 1,360 = 13.2% Vernon: $130 1,440 = 9.0% Asset turnover (operating revenues total assets) Colony: $1,360 1,900 = 0.72

P14-2 A.

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Vernon: $1,440 1,370 = 1.05 Fixed asset turnover (operating revenues fixed assets) Colony: $1,360 1,400 = 0.97 Vernon: $1,440 1,000 = 1.44 Return on assets (profit margin asset turnover) Colony: 13.2% 0.72 = 9.5% Vernon: 9.0% 1.05 = 9.5% B. Colony appears to charge higher prices for its products than Vernon. It earns more for each dollar of sales (13.2 for Colony versus 9 for Vernon). Vernon sells more of its products than Colony, however. Vernon sells $1.05 of products for each $1 invested in assets, whereas Colony sells 72 for each $1 invested. By charging lower prices, Vernon is able to sell more products. Colony earns a higher net income than Vernon, but each company earns the same return on assets. Therefore, neither company is more profitable than the other relative to the amount of assets in which the companies have invested. We can conclude that each company is profitable, but the companies use different strategies to create their profits. Colony apparently sells products with features or quality that are more desirable than those of Vernon. Customers are willing to pay more for these products, though they purchase fewer of them. Vernon competes by selling lower-price products and by selling a higher volume than Colony. C. Revenues, expenses, and assets determine the return on assets. Revenues depend on sales price and volume sold. There are two ways to increase revenues (and increase effectiveness): (1) raise prices and sell the same quantity, or (2) maintain prices and sell more quantity. There are two ways to increase net income (and increase efficiency): (1) increase revenues without increasing expenses, or (2) decrease expenses without decreasing revenues. Finally, in addition to increasing effectiveness or efficiency (as described above), a company can increase its return on assets by decreasing its total assets.

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P14-3

A. Selling price per case Estimated monthly sales (cases) Sales revenue Expenses: Fixed, per month Advertising, per month Variable per case ($17) Total monthly expenses Pro forma monthly profit Pro forma annual profit % return on $3 million investment B. Long 1 $ 29.00 11,000 $319,000 85,000 25,000 187,000 $297,000 $ 22,000 $264,000 8.8%

Strategy 2 $ 31.00 12,000 $372,000 85,000 40,000 204,000 $329,000 $ 43,000 $516,000 17.2% Operating

3 $ 34.00 7,500 $255,000 85,000 7,000 127,500 $219,500 $ 35,500 $426,000 14.2% Strategy

Life Pricing and By (student name)

Long Life is evaluating three possible selling strategies for its cereal: 1. Selling to supermarkets at $29 per case and spending a minimum of $25,000 per month on advertising 2. Selling to supermarkets at $31 per case and spending $40,000 per month on advertising 3. Selling to specialty stores for $34 per case and spending $7,000 per month for advertising in health food periodicals The average case of competitors cereals of the size we will sell is priced at $30 to grocery stores. Thus, the first option is based on cost leadership; our very healthy cereal would be priced slightly below the average cereal. The amount of advertising would be minimal for a brand sold in grocery stores. The second option relies on product differentiation; it assumes that, with advertising to inform them, some consumers would be willing to pay a premium for our product. The third option relies more heavily on product differentiation and is aimed only at the type of consumers who frequent these specialty stores. The table accompanying this report gives estimates of our profit from each strategy. The sales numbers are the results of our marketing research studies. The cost figures are from our internal accounting estimates. If all estimates are correct, the second strategy is the best option; we would sell to a wider base, grocery stores, at a price somewhat above the average cereal price. We would advertise more heavily to convince customers that our product has sufficient advantages to be worth the above-average price. C. Our marketing research is based on current market conditions. We may want to consider other outside information. Is the trend toward more healthful eating more likely to remain stable, to grow, or to

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fade? This may determine whether supermarkets continue to stock health foods; it is possible that they would once again become available only in specialty stores. General economic trends could also be a factor; will consumers be able to continue to pay a premium price for cereals? Thus, we may want to continue our research. However, based on current evidence, it appears that we should adopt the second strategy. P14-4 TO: FROM: DATE: SUBJECT: Marta Feliz (students name) (todays date) Pricing of new dishwasher line

With regard to pricing our new, quiet dishwasher, we will of course want to determine what selling price will maximize return to our stockholders. This would be the price that will maximize profit on the line through getting the highest possible excess of sales revenues over variable costs. We need to consider whether the low sound level is a sufficiently attractive feature to allow us to follow a product differentiation strategy for this model. If marketing research shows this to be a highly desired feature, we may be able to charge a significant premium and sell this dishwasher based on this feature. However, except for the low noise level, this is a standard model. If the sound level is not a high-demand feature, we may have to keep our profit margin low and sell based on a cost leadership strategy. This would result in a lower profit per machine, combined, however, with a higher volume of sales. We will want the following information before making a final decision about the pricing of this model: Marketing research results regarding the desirability of the low sound level Internal estimates of the costs of production at various levels, with particular emphasis on careful estimation of variable costs Estimates from our sales department, based on external research, of the level of sales that is probable at various prices P14-5 A. Discount Shoes probably would be located near lower-income residential areas and in lower-cost facilities. Buildings and equipment would not be fancy. Shoes might be stacked in metal racks by shoe size so customers could locate merchandise for themselves. Products would be low cost. Designs would be those for which high demand had been established. Specialized products, such as hiking boots or high-fashion designs, might not be available. A minimum of service would be provided. Few sales personnel would be available to assist customers. Inventory would be on display so customers could determine available merchandise for themselves. The lower cost might result in cash sales. (continued)

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Elegant Footwear probably would be located in shopping malls and high-cost shopping areas, near higher-income residential areas. Facilities would be relatively high cost. Stores would have special furnishings and displays. Products would be high cost with an emphasis on new designs and high quality. Customer service would be important. Staffing would be sufficient to handle the normal flow of customers. Sales staff would attempt to identify and meet customer needs. Most customers would probably pay with credit cards. B. Relative to each other, the companies should exhibit the following: Discount Shoes High volume and low price Low cost and margin Low labor and facility costs Low cost and high turnover Low investment Elegant Footwear Low volume and high price High cost and margin High labor and facility costs High cost and low turnover High investment

Sales revenues Cost of goods sold Operating expenses Merchandise inventory Plant assets

P14-6 Companies compete through product differentiation and cost leadership. Product differentiation focuses on product quality and features. Cost leadership focuses on cost control and low product prices. (a) The products of cost leadership companies tend to be those that are in high demand and that can be produced using standard designs. Products of product differentiated companies tend to be those for which different design features are demanded by different consumers. (b) Cost leadership companies attempt to keep the sales price per unit low to increase volume. Product differentiated companies can command a premium price for their products. (c) Profit margin is likely to be higher for product differentiation companies that can sell their products at higher prices relative to the costs of products because of the higher quality or improved features. (d) Asset turnover is likely to be higher for cost leadership companies that attempt to generate high sales volumes. (e) Cost leadership companies attempt to keep investment low to increase asset turnover and maintain low costs. Higher investments often are necessary for product differentiated companies to provide for the design and production of their products. The types of products sold and the competitive markets that companies face are major influences on the types of strategies they use. Products that can be produced or sold with relatively low investment or technology tend to be highly competitive and require a cost leadership strategy. Product differentiation often results when high levels of investment or technology are required.

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P14-7 (In millions) Profit margin (net income sales) Asset turnover (sales total assets) Return on assets (net income total assets) Cash flow from operations total assets A. 2004 0.064 2.146 0.137 0.190 Dell 2003 0.060 2.289 0.137 0.229 Apple 2004 2003 0.033 0.011 1.028 0.911 0.034 0.116 0.010 0.042

Dell is more successful at generating net income from its assets. Dell produced an ROA of about 14% in both years, while Apple produced an ROA of about 1% and 3% in 2003 and 2004, respectively. Both. Dell is more effective and more efficient than Apple, as evidenced by larger profit margins and asset turnover ratios. Once again, Dell is more successful in generating cash flows from its assets. For each dollar of assets, Dell generated 23 cents and 19 cents in 2003 and 2004, respectively. Apple generated about 4 cents and 12 cents for each dollar of assets during 2003 and 2004, respectively. Inventory turnover (cost of goods sold inventory) and gross profit margin [(sales cost of goods sold) sales] are computed as follows: Inventory turnover Park: 2008 2007 Schleifer: 2008 2007 $1,391 $115 = 12.10 $1,137 $216 = 5.26 $1,773 $132 = 13.43 $1,641 $355 = 4.62 Gross profit margin ($1,811 $1,391) $1,811 = 23.2% ($1,476 $1,137) $1,476 = 23.0% ($1,967 $1,773) $1,967 = 9.9% ($2,212 $1,641) $2,212 = 25.8%

B. C.

P14-8

A.

The companies are similar in their inventory turnover. Both appear to have moved inventory far faster in 2008 than in 2007, but this is largely because the ratio is calculated on a much smaller year-end inventory. It should be noted that Schleifer achieved its 2008 sales level at the cost of a drastically reduced gross profit margin. Park is clearly doing a better job of moving inventory out at a good selling price. (continued)

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B.

Receivable turnover (sales accounts receivable) can be computed as follows: Park, 2008: Park, 2007: Schleifer, 2008: Schleifer, 2007: $1,811 $317 = 5.71 $1,476 $314 = 4.70 $1,967 $299 = 6.58 $2,212 $386 = 5.73

Schleifer has collected receivables slightly faster than Park. C. Park, in 2008, generated a cash flow from operations that was about 2.6 times net income ($341 $131). The primary differences are decreases in inventories and increases in accounts payable, which may negatively affect cash flow in the following year. In 2007, Parks cash flow from operations was only slightly above net income, due in large part to a significant increase in accounts receivable. Schleifer generated a positive operating cash flow from a net loss in 2008, largely by decreasing inventories drastically. In 2007, a positive net income resulted in a negative cash flow from operations, primarily because of an increase in both accounts receivable and inventory. A negative operating cash flow is generally a sign of significant weakness in cash generation. P14-9 A. B. Sales grew by 12.2% from 2006 to 2007 [($3,336 $2,973) $2,973] and 11.5% from 2007 to 2008 [$3,720 $3,336) $3,336]. Percentage analysis of the income statement has the following results: Net sales Cost of sales Gross income Selling, general, and administrative expenses Trade names and goodwill amortization Operating income Interest expense Other, net Income before income taxes Income taxes Net income C. 2008 100.00% 68.5% 31.5% 15.7% 1.5% 14.4% (1.6)% 5.7% 18.4% 7.8% 10.6% 2007 100.00% 67.7% 32.3% 14.9% 1.0% 16.4% (2.3)% 0.4% 14.5% 5.7% 8.8% 2006 100.00% 67.9% 32.1% 15.5% 0.8% 15.7% (2.0)% 0.6% 14.3% 5.7% 8.6%

Because of increases in the cost of sales and in amortization of trade names and goodwill, operating income (as a percentage of sales) has decreased over the three-year period. One piece of good news is that interest expense had decreased. The biggest relative impact is in the effect of the item labeled Other, net. This large

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positive item in 2008 had the effect of overcoming the decrease in operating income such that net income (as a percentage of sales) actually increased nicely. Since nonoperating items are not part of the firms primary line of business, however, this is likely a one-time event that cannot be relied on to recur. Overall, the trend in profit margin looks positive, but it is only because of this one item. D. Despite sales increases of 12.2% and 11.5% over the last two years, the relationship of net income to sales has remained fairly constant. This is especially true if the item labeled Other, net is backed out. Therefore, it appears that most of the companys costs vary in proportion to sales. That is, if sales go up 10%, total costs go up about 10%. This implies that most of the companys costs are variable and it appears to have a low amount of operating leverage. Coca-Cola 2003 2002 0.631 0.248 0.207 0.637 0.279 0.156 PepsiCo 2003 0.541 0.177 0.132

P14-10 A. 2004 Gross profit margin (gross profit sales) Operating profit margin (operating profit sales) Profit margin (net income sales) B. 0.652 0.259 0.221 2004 0.542 0.180 0.144 2002 0.542 0.171 0.119

PepsiCos gross profit margin remained stable over the three-year period, indicating production costs relative to sales have not changed. However, PepsiCos operating profit margin improved during the three-year period. Thus, the company has been efficient in controlling general, selling, and administrative costs. Profit margins have improved from about 12% in 2002 to a little over 14% in 2004. Coca-Colas gross profit margin improved slightly from 2003 to 2004, indicating the company has been able to control production costs relative to sales volume. Operating profit margin declined in 2003, but rebounded somewhat in 2004. Overall, the companys profit margin improved from about 16% in 2002 to about 22% in 2004. Coca-Colas financial ratios were better than PepsiCos for each of the three years presented.

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P14-11 A.

Coca-Cola 2004 2003 Inventory turnover (cost of goods sold inventory) 5.38 Accounts receivable turnover (sales accounts receivable) 10.12 Asset turnover (sales assets) 0.70 Operating cash flow total assets 0.19 6.20 10.06 0.77 0.20

PepsiCo 2004 2003 8.70 9.76 1.05 0.18 8.77 9.53 1.06 0.17

B.

According to the inventory turnover ratio, PepsiCo is more successful in converting its investment in inventory into sales. According to the accounts receivable turnover ratio, Coca-Cola was marginally more successful in converting revenues to cash over the two years shown. For asset turnover, PepsiCo was more successful in using assets to sell products. PepsiCo had a slight increase in its operating cash flow relative to its assets while Coca-Cola had a slight decrease. Both companies cash from operations is greater than its net income. Hasbro 2004 2003 0.11 1.83 0.14 2.87 PepsiCo 2004 2003 0.18 1.20 0.17 1.21

C.

P14-12 A. Cash flow from operations total assets Cash flow from operations net income

Operating cash flow compared to total assets: Hasbro has not been as effective as PepsiCo at generating operating cash flows from its assets. Operating cash flow compared to net income: The biggest single factor in both years, causing Hasbros and PepsiCos operating cash flows to exceed net income, was the depreciation and amortization. B. Accounts receivable turnover (sales accounts receivable) 5.18 5.16 9.76 9.53 Hasbro 2004 2003 PepsiCo 2004 2003

A higher accounts receivable ratio indicates that credit sales are being collected in cash more rapidly. Accordingly, for any given period, a greater portion of sales has been collected in cash. Therefore, PepsiCo, in 2004 and 2003, collected a greater portion of its sales in cash than did Hasbro; or, PepsiCo is collecting its accounts receivable faster than Hasbro.

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P14-13 A. Profit margin (net income sales) Asset turnover (sales assets) Return on assets (net income total assets) Financial leverage (assets equity) Return on equity (net income equity) 3M Corp 2004 2003 Eastman 2004 2003 PM 0.149 0.132 PM 0.026 0.047 ATO 0.966 1.036 ATO 1.121 0.929

3M Corp. 2004 2003 0.149 0.966 0.144 1.995 0.288 0.132 1.036 0.137 2.232 0.305 FL 1.995 2.232 FL 4.959 5.987 =

Eastman Chemical 2004 2003 0.026 1.121 0.029 4.959 0.144 ROE 0.288 0.305 ROE 0.144 0.259 0.047 0.929 0.043 5.987 0.259

Note: You may observe a slight rounding difference in the ROE calculations using the two methods. B. According to the profit margin percentage (PM), 3M Corp. has been much more efficient than Eastman Chemical in both 2003 and 2004. Eastmans profit margin was positive in 2004, yet negative in 2003. Eastman and 3M have comparable turnover ratios of about 1 for both years. Eastman Chemical has more financial leverage than 3M. Increased financial leverage brings increased risk. Even considering the greater leverage used by Eastman, 3Ms average return on equity over the two years surpasses that of Eastman. P14-14 A. Given the facts presented, Big Bend is likely to be using a product differentiation strategy, while Longbow is probably using the cost leadership strategy. Product differentiation requires that the firm be able to offer special features or qualities that customers are willing to pay for. This sounds like what Big Bend does by selling specialty products in small batches that are custom-made. On the other hand, cost leadership requires that goods be sold in large quantities to keep production and selling costs low. This sounds like what Longbow is doing. An analysis of the numerical data, though, is needed to verify or refute these initial conclusions. (continued)

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B. Year 2008 results Profit margin (net income sales revenue) Asset turnover (sales revenue total assets) Return on assets (net income total assets) Big Bend 9.1% ($3.68 $40.3) 1.18 ($40.3 $34.2) 10.8% ($3.68 $34.2) Longbow 3.1% ($6.4 $206.5) 5.41 ($206.5 $38.2) 16.8% ($6.4 $38.2)

It does appear that Big Bend relies on a high profit margin more than it does on asset turnover to generate profits. This is consistent with the product differentiation strategy. Longbow, on the other hand, relies more on a high asset turnover than on a high margin. This is consistent with the cost leadership strategy. C. Year 2007 results Profit margin (net income sales revenue) Asset turnover (sales revenue total assets) Return on assets (net income total assets) Big Bend 8.7% ($3.13 $35.9) 1.19 ($35.9 $30.2) 10.4% ($3.13 $30.2) Longbow 3.0% ($5.8 $193.3) 5.35 ($193.3 $36.1) 16.1% ($5.8 $36.1)

Big Bend managed to increase its strength (profit margin) while its asset turnover was essentially unchanged. Overall, these small changes caused return on assets to increase modestly ( 4/10 of 1%). Longbow had minor increases in both its strength (asset turnover) and in profit margin. Together, these minor increases caused return on assets to increase a bit more (7/10 of 1%). D. Return on equity (net income equity) 2008 2007 E. Big Bend 36.9% ($3.68 $9.96) 35.5% ($3.13 $8.82) Longbow 37.0% ($6.4 $17.3) 35.6% ($5.8 $16.3)

Which strategy is most successful depends on the measure chosen to represent success. Generally, the measure used is return on equity. By that measure, the results of the two companies are equally successful. This suggests that one strategy is not necessarily better than the other. They are merely two different ways of earning profits. It is important, however, that managers and investors understand the strategy being used so that they can assess whether it is successful or not. If the managers and investors of these two firms are pleased with a return on equity in the mid-30% range, the strategy has been successful. If they have been seeking a higher return, they may have

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to rework their strategies. This would also include issues of operating leverage and financial leverage. P14-15 A. Growth rates: 2004 Sara Lee Total assets Common stockholders equity Sales Dell Total assets Common stockholders equity Sales B. 0.037 0.437 0.070 0.248 0.289 0.171 2003 0.128 0.178 0.038 0.143 0.038 0.136 2002 0.347 0.553 0.060 0.010 0.165 0.023 2001 0.124 0.091 0.011 0.192 0.059 0.262 Average 0.079 0.269 0.045 0.143 0.055 0.137

Both companies report wide fluctuations in their growth rates over the periods evaluated. During 2002, all of Dells changes declined from the previous year. However, in 2004 most of the ratios shown above improved relative to 2001. Dells average growth rates for total assets and sales exceeded those of Sara Lee. However, Sara Lees common stockholders equity grew (on average) at a faster rate than did Dells. Generally, investors like a growing company. Greater sales and profits in the future translate into greater returns for investors.

P14-16 A. 2008 BillboardsRUs: Return on assets (net income total assets) Return on equity (net income stock equity) Market to book value (total market value stock equity) Outdoor SignCorp: Return on assets (net income total assets) Return on equity (net income stock equity) Market to book value (total market value stock equity) B. 6.5% 20.4% 3.5 12.1% 32.9% 5.8 2007 1.7% 6.0% 3.0 12.5% 38.2% 5.7 2006 6.5% 19.8% 3.3 6.9% 23.8% 2005 7.6% 22.5% 3.5 15.8% 42.1%

6.6 6.1 (continued)

Outdoor SignCorps return on assets has been significantly higher than that of BillboardsRUs. This suggests superior operating

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performance. Both companies have returns on equity that are much higher than returns on assets, pointing to positive use of financial leverage. In the last three years, earnings per share has climbed significantly for Outdoor SignCorp but has been relatively static for BillboardsRUs. C. While both companies appear to be performing well, Outdoor SignCorp appears to have given its stockholders better value in recent years. The market value of the stock has responded as expected to these conditions. John, Inc. 1. Profit margin 2008 2007 7% 5% ($57 $825) ($37 $770) 35% 35% ($285 $825) ($266 $770) 14% 10% ($117 $825) ($77 $770) 0.51 0.50 ($825 $1,630) ($770 $1,530) 10.6 10.5 ($825 $78) ($770 $73) 3.7 ($504 $136) 2% ($37 $1,530) 0.91 ($770 $850) 3.9 (77 20) 98 (136 504 365) 35 (365 10.5) Roberta Company 2008 2007 4% 9% ($14 $352) ($30 $330) 29% 35% ($102 $352) ($114 $330) 9% 16% ($32 $352) ($54 $330) 0.41 0.43 ($352 $850) ($330 $765) 9.0 9.7 ($352 $39) ($330 $34) 2.9 ($250 $85) 2% ($14 $850) 0.59 ($352 $600) 3.2 (32 10) 3.0 ($216 $71) 4% ($30 $765) 0.60 ($330 $550) 6.8 (54 8)

P14-17 A.

2. Gross profit margin 3. Operating profit margin 4. Asset turnover 5. Accounts receivable turnover 6. Inventory 3.9 turnover ($540 $139) 7. Return on 3% assets ($57 $1,630) 8. Fixed asset 0.92 turnover ($825 $900) 9. Times 3.9 interest (117 30) earned 10. Days sales in 94 inventory (139 540 365) 11. Average collection period for accounts receivable 34 (365 10.6)

124 120 (85 250 365) (71 216 365) 41 (365 9) 38 (365 9.7)

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B.

This table identifies which company had the better value for each ratio during each year. Company with better ratio value 2008 2007 1. Profit margin John Roberta 2. Gross profit margin John same 3. Operating profit margin John Roberta 4. Asset turnover John John 5. Accounts receivable turnover John John 6. Inventory turnover John John 7. Return on assets John Roberta 8. Fixed asset turnover John John 9. Times interest earned John Roberta 10. Days sales in inventory John John 11. Average collection pd. for A/R John John Change from 2007 to 2008 John Roberta improvement decline no change decline improvement decline improvement decline improvement decline improvement decline improvement decline improvement decline no change decline improvement decline improvement decline

C. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. D. Profit margin Gross profit margin Operating profit margin Asset turnover Accounts receivable turnover Inventory turnover Return on assets Fixed asset turnover Times interest earned Days sales in inventory Average collection pd. for A/R

Overall, John Company had the better performance during the period studied. Of the 22 observations reported in section B, John Company had more favorable results 17 times. Of the 11 observations reported in section C, John Company had favorable results in 9 cases while Roberta Company had none.

P14-18 Financial statements give only a partial view of a business entity, but that part is very important. The statements summarize the effects of past transactions. Statements have evolved as a relatively efficient way of giving the decision maker a summarized, approximate view of the financial affairs of the company. From a set of financial statements, it is possible to learn the companys financial position at a point in the past, including a limited amount of detail about its assets and its obligations. Thus the reader has some idea of what the company owns and of its committed future obligations to make payments. From the income statement and the operating section of the cash flows statement, the reader can see how efficient and effective

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the company is at generating current or future cash through its operations. However, statements are limited as tools for predicting the future of a company. They are summaries; they report on the past; they make extensive use of estimates. Also, they report only the financial transactions of the company. They cannot, for example, specify the strengths or weaknesses of the company management and workforce. They do not report on signs of favorable or unfavorable future market possibilities for the company. Many other nonquantitative factors do not appear in the statements. A suppliers ability to remain in business and avoid cash flow problems might be indicated by its ability to generate cash from operations. The operating section of the cash flows statement reports on this for a given period. The income statement can be viewed as an estimate of the eventual cash flow from a given periods operations. Return on assets is a sign of ability to generate income. The ratio of cash flow from operations to net income indicates an ability to convert income to cash. Receivables and inventory turnover are indicators of the ability to sell inventory and then collect the cash. Additional capital will be attracted by a company that shows ability to give a high return to stockholders. This is indicated by the above signs of general financial health and ability to generate cash, plus, in many cases, the use of financial leverage to generate return for shareholders that is higher than return on assets. P14-19 A. Measurement rules determine which attributes of the transformation process are entered into the accounting system. They involve both amounts and timing. Reporting rules determine the type and format of information reported in financial statements for external users. Measurement and reporting rules help to make financial statements of one company comparable with those of another. They make it possible for investors and other users to compare companies in a meaningful way. An audit is an independent assessment of whether financial statements appear to be fairly presented. It is performed by a firm of certified public accountants in the United States; in many other countries, these are called chartered accountants. Auditing standards help to ensure that the auditing process is carried out in a manner that is likely to detect unfairly stated reports. It is easier to establish standards on a national basis than on a worldwide basis, given differences in culture, customs, languages, and law. But differing standards for measuring, reporting, and auditing make comparison of businesses in different nations difficult. This is a handicap in many kinds of global commerce, including the selection of investments across national boundaries.

B.

C.

D. E.

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P14-20 Financial Analysis Comparison December 31, 2008 The Book Wermz Book Farm $6,230,000 $20,584,000 3,426,500 13,390,200 2,803,500 7,193,800 2,155,000 5,212,600 648,500 1,981,200 190,000 670,500 458,500 1,310,700 160,475 458,745 $ 298,025 $ 851,955 $1,987,600 $5,623,000 $3,370,000 0.4500 0.1041 0.0478 1.7239 1.1079 0.0530 1.6685 0.0884 $5,845,000 $13,254,000 $6,687,000 0.3495 0.0962 0.0414 2.2909 1.5530 0.0643 1.9821 0.1274

Sales Cost of goods sold Gross profit Operating expense Operating income Interest expense Pretax income Income taxes Net income Inventory Total assets Stockholders equity Gross profit margin Operating profit margin Profit margin Inventory turnover Asset turnover Return on assets Financial leverage Return on equity 1. Cost leadership

Special Editions $4,896,200 2,153,100 2,743,100 1,852,000 891,100 106,000 785,100 274,785 $ 510,315 $2,246,000 $6,895,000 $4,826,000 0.5603 0.1820 0.1042 0.9586 0.7101 0.0740 1.4287 0.1057

2. Product differentiation 3. Evaluation

Book Farm: low profit margin and high asset (inventory) turnover Special Editions: high profit margin and low asset (inventory) turnover The Book Wermz appears to be following a cost leadership strategy (low profit margin and high turnover) but the strategy has been less successful than that of Book Farm. (continued)

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4. Financial leverage

Financial leverage is beneficial to all of the companies. Book Farm is using more leverage than its competitors, resulting in higher return on equity. 4 a 5 b 6 d 7 b 8 a 9 c 10 b

P14-21 1 a CASES C14-1 A. and B. General Mills 2004 2003 0.095 0.087 0.600 0.576 0.057 0.050 Microsoft 2004 2003 0.222 0.234 0.399 0.394 0.088 0.092 Procter & Gamble 2004 2003 0.126 0.120 0.901 0.992 0.114 0.119 2 d 3 c

Profit margin Turnover Return on assets

General Mills profit margin, turnover, and return on assets all improved from 2003 to 2004. The companys profit margin and ROA are less than those of both Microsoft and Procter & Gamble. General Mills turnover is greater than Microsofts and less than Procter & Gambles. General Mills is a product differentiator. They produce high quality products for a variety of markets. The companys Big G cereals command a premium price over store-brand, discount cereals. The product differentiation strategy typically results in relatively low asset turnover ratios with relatively large profit margins. C. Receivables turnover Inventory turnover Gross profit margin 2004 10.96 6.19 0.405 2003 10.72 5.65 0.419

General Mills receivables turnover and inventory turnover improved from 2003 to 2004, while the companys gross profit margin declined slightly. The company is doing a better job collecting accounts receivable and minimizing the time inventory remains on hand. However, a decline in gross profit margin suggests the companys production costs have increased relative to sales.

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D. Return on equity Return on assets 2004 0.201 0.057 2003 0.220 0.050

Return on equity declined slightly between 2003 and 2004, while return on assets increased modestly. Income increased about 15% between 2003 and 2004, yet equity increased about 26%. Therefore, the decline in ROE is caused by the large increase in the denominator (equity) relative to the smaller increase in the numerator (net income). E. Lists of estimated items could include depreciation and amortization lives, allowance for doubtful accounts, pension liabilities, contingencies, asset impairments, interest rates used in any present value calculations, and numerous other items. Net Income Revenues: $1,300 50 units 30 or 25 weeks Maintenance and operating costs: $200 50 units 52 weeks Management costs Depreciation: Building: $4,000,000 20 years Other assets*: $950,000 5 years Net income 30 Weeks $1,950,000 1,625,000 (520,000) (250,000) (200,000) (190,000) $ 790,000 25 Weeks $ (520,000) (250,000) (200,000) (190,000) $ 465,000 25 Weeks $ (520,000) (250,000) 855,000 (200,000) $ 655,000

C14-2

A.

Cash Flow from Operating Activities 30 Weeks Revenues: $1,300 50 units 30 or 25 weeks $1,950,000 1,625,000 Maintenance and operating costs: $200 50 units 52 weeks (520,000) Management costs (250,000) Cash flow from operating activities 1,180,000 Required reinvestment (200,000) Cash flow to investors $ 980,000

* Other assets = $5,500,000 = $4,000,000 for buildings + $250,000 for land + $300,000 reserve + $950,000 Cash flow is more relevant to the investment decision. Investors are interested in the cash flow they will receive. Depreciation does not affect this cash flow and, therefore, is not especially relevant. Individual investors will be taxed on profits earned from their invest-

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ments. Net income is relevant for determining taxable income to the investors. (continued) B. Present value assuming 30-week average rental: Present value of 10 periods of $980,000 discounted at 10% = $980,000 6.14457 = Present value of $1,200,000 received at the end of 10 periods = $1,200,000 0.38554 = Present value of expected future cash flows Investment required Net present value Present value assuming 25-week average rental: Present value of 10 periods of $655,000 discounted at 10% = $655,000 6.14457 = Present value of $1,200,000 received at the end of 10 periods = $1,200,000 0.38554 = Present value of expected future cash flows Investment required Net present value C.

$ 6,021,679 462,648 $ 6,484,327 5,500,000 $ 984,327

$ 4,024,693 462,648 $ 4,487,341 5,500,000 $ (1,012,659)

Operating results are particularly sensitive to operating leverage in this case because all expenses are fixed. Any change in revenues has a direct effect on net income and cash flow from operating activities. Therefore, the accuracy of the estimate of the number of weeks units will be rented is particularly important. If the condominiums rent for 30 weeks per year, on average, as expected, the present value of the investment is positive. If the condominiums rent for 25 weeks per year, the present value is negative. The decision to invest depends on how reliable investors believe the estimates to be, alternative investments available to the clients, and how much risk investors are willing to take. Sales CGS Wages Commissions Transportation Insurance and misc. Depreciation Operating income Interest Net income Expected $ 1,000,000 300,000 100,000 150,000 80,000 30,000 80,000 260,000 36,000 $ 224,000 Minimum $ 700,000 210,000 100,000 105,000 56,000 30,000 80,000 119,000 36,000 $ 83,000

D.

C14-3

A.

B.

(1)

ROA = $224,000 $500,000 = 44.8% ROE = $224,000 $200,000 = 112% Profit margin = $224,000 $1,000,000 = 22.4%

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Asset turnover = $1,000,000 $500,000 = 2.0

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Chapter 14

(2)

ROA = $83,000 $500,000 = 16.6% ROE = $83,000 $200,000 = 41.5% Profit margin = $83,000 $700,000 = 11.9% Asset turnover = $700,000 $500,000 = 1.4

C.

PVA = A IF $300,000 = A 3.60478 = $83,223 PV Beg. 300,000 252,777 Int. Exp. 36,000 30,333 Payment 83,223 83,223 Principal 47,223 52,890 $ 224,000 80,000 304,000 (100,000) (204,000) $ 0 PV End 252,777 199,887 $ 83,000 80,000 163,000 (100,000) (63,000) $ 0

D.

Cash Flow from Operating Activities Net income Add depreciation Cash flow from operating activities Cash flow for investing activities* Cash flow for financing** Net cash flow

* The $100,000 or reinvestment is in the cash flow statement as investing cash flow. ** Total payments for principal and interest would be $83,223 each year, though the amounts of principal and interest would vary each year according to the amortization schedule. The principal repayment in the first year is $47,223. In addition, all cash flows not reinvested or used to pay off debt are distributed to owners. This would also be financing cash flow. The distribution to owners would be $15,678 ($156,777 10) per owner each year for sales of $1,000,000 and $1,578 ($15,777 10) per owner each year for sales of $700,000. E. For sales of $1,000,000 Present value = ($156,777 3.60478) + ($200,000 0.56743) = $565,147 + $113,486 = $678,633 Net present value (present value cost) = $678,633 $200,000 = $478,633 The positive net present value indicates that the investment would earn more than 12% and therefore would be a good decision. For sales of $700,000 Present value = ($15,777 3.60478) + ($200,000 0.56743) = $56,873 + $113,486 = $170,359 Net present value = $170,359 $200,000 = $29,641 The negative net present value indicates that the investment would earn less than 12% and therefore would not be a good decision. (continued)

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F.

The companys expected earnings and cash flows are sufficient to justify the investment. The investment is risky because of the high potential variability of sales and because of the financial leverage. If sales do not meet expectations, the debt payments must still be made and the return to owners drops quickly. The reliability of the sales estimate is important. Operating leverage is not a particular problem because most of the costs are variable. Therefore, they decrease in proportion to sales. Unless sales fall well below their expected value, the company will generate a positive net present value. The potential return is high. If the sales numbers are reliable, this is probably a good investment.