Professional Documents
Culture Documents
Module 2
Chapters 3 and 5
Financial
Statements and
Ratio Analysis and
Time Value of
Money
Chapter 3
Financial
Statements and
Ratio Analysis
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Focus on Ethics
Take Earnings Reports at Face Value
Near the end of each quarter, many companies unveil their
quarterly performance.
Firms that beat analyst estimates often see their share
prices jump, while those that miss estimates by even a
small amount, tend to suffer price declines.
The practice of manipulating earnings in order to mislead
investors is known as earnings management.
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Caldwell Manufacturing
Industry average
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Liquidity Ratios
The current ratio measures the ability of the firm to
meet its short-term obligations.
Current ratio = Current assets Current liabilities
The current ratio for Bartlett Company in 2015 is:
$1,223,000 $620,000 = 1.97
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Matter of Fact
Determinants of Liquidity Needs
Large enterprises generally have well established
relationships with banks that can provide lines of credit and
other short-term loan products in the event that the firm
has a need for liquidity.
Smaller firms may not have the same access to credit, and
therefore they tend to operate with more liquidity.
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Matter of Fact
The importance of inventories:
From Table 3.5:
Company
Current ratio
Quick ratio
Dell
1.3
1.2
Home Depot
1.3
0.4
Lowes
1.3
0.2
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Activity Ratios
Inventory turnover measures the activity, or liquidity,
of a firms inventory.
Inventory turnover = Cost of goods sold Inventory
Applying this relationship to Bartlett Company in 2015
yields:
$2,088,000 $289,000 = 7.2
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Matter of Fact
Who Gets Credit?
Notice in Table 3.5 the vast differences across industries in
the average collection periods.
Companies in the building materials, grocery, and
merchandise store industries collect in just a few days,
whereas firms in the computer industry take roughly two
months to collect on their sales.
The difference is primarily due to the fact that these
industries serve very different customers.
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Matter of Fact
Sell It Fast
Observe in Table 3.5 that the grocery business turns over
assets faster than any of the other industries listed.
That makes sense because inventory is among the most
valuable assets held by these firms, and grocery stores
have to sell baked goods, dairy products, and produce
quickly or throw them away when they spoil.
On average, a grocery stores has to replace its entire
inventory in just a few days or weeks, and that contributes
to the rapid turnover of the firms total assets.
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Example 3.5
Patty Akers in incorporating her new business. She
needs an initial investment of $50,000. She is
considering a no-debt plan, under which she would
invest the full amount without borrowing. The
second option, the debt plan, involves investing
$25,000 and balancing the remainder at 12%.
Patty expects $30,000 in sales and $18,000 in
operating expenses and has a tax rate of 40%.
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Debt Ratios
The debt ratio measures the proportion of total
assets financed by the firms creditors.
Debt ratio = Total liabilities Total assets
The debt ratio for Bartlett Company in 2015 is
$1,643,000 $3,597,000 = 0.457 = 45.7%
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Profitability Ratios
Gross profit margin measures the percentage of
each sales dollar remaining after the firm has paid for
its goods.
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Market Ratios
The price/earnings (P/E) ratio measures the
amount that investors are willing to pay for each
dollar of a firms earnings.
Price Earnings (P/E) Ratio = Market price per share of
common stock Earnings per share
If Bartlett Companys common stock at the end of 2015 was
selling at $32.25, using the EPS of $2.90, the P/E ratio at
year-end 2015 is:
$32.25 $2.90 = 11.12
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where,
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Figure 3.2
DuPont
System of
Analysis
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Matter of Fact
Dissecting ROA
Return to Table 3.5 and examine the total asset turnover
figures for Dell and Home Depot.
Both firms turn their assets 1.6 times per year.
Dells ROA is 4.3%, but Home Depots is significantly
higher at 6.5%. Why?
The answer lies in the DuPont formula.
Notice that Home Depots net profit margin is 4.0%
compared to Dells 2.7%.
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Chapter 5
Time Value of
Money
Cash flow
$3,000
$5,000
$4,000
$3,000
$2,000
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Computational Tools
Financial calculators include preprogrammed financial
routines.
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Figure 5.4
Future Value Relationship
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PV (1 + 0.06) = $300
PV = $300/(1 + 0.06) = $283.02
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Figure 5.5
Present Value Relationship
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Annuities
An annuity is a stream of equal periodic cash flows,
over a specified time period. These cash flows can be
inflows of returns earned on investments or outflows
of funds invested to earn future returns.
An ordinary (deferred) annuity is an annuity for which
the cash flow occurs at the end of each period
An annuity due is an annuity for which the cash flow
occurs at the beginning of each period.
An annuity due will always be greater than an otherwise
equivalent ordinary annuity because interest will compound
for an additional period.
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$5,705.74
$6,153.29
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Matter of Fact
Kansas truck driver, Donald Damon, got the surprise
of his life when he learned he held the winning ticket
for the Powerball lottery drawing held November 11,
2009. The advertised lottery jackpot was $96.6
million. Damon could have chosen to collect his prize
in 30 annual payments of $3,220,000 (30 $3.22
million = $96.6 million), but instead he elected to
accept a lump sum payment of $48,367,329.08,
roughly half the stated jackpot total.
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Continuous Compounding
Continuous compounding involves the
compounding of interest an infinite number of times
per year at intervals of microseconds.
A general equation for continuous compounding
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Suppose you want to buy a house 5 years from now, and you
estimate that an initial down payment of $30,000 will be
required at that time. To accumulate the $30,000, you will wish
to make equal annual end-of-year deposits into an account
paying annual interest of 6 percent.
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Focus on Practice
New Century Brings Trouble for Subprime Mortgages
In 2006, some $300 billion worth of adjustable ARMs were
reset to higher rates.
In a market with rising home values, a borrower has the
option to refinance their mortgage, using some of the equity
created by the homes increasing value to reduce the
mortgage payment.
But after 2006, home prices started a three-year slide, so
refinancing was not an option for many subprime borrowers.
As a reaction to problems in the subprime area, lenders
tightened lending standards. What effect do you think this had
on the housing market?
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