Fae3e SM ch04 060914

Chapter 4.
Using Financial Statements for Investing and Credit

Decisions
Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses

Difficulty Rating for Exercises and Problems:
Easy: E4.12; E4.13: E4.14

Medium: E4.15; E4.16; E4.17; E4.18; E4.19
P4.23; P4.24; P4.25; P4.29; P4.32
Difficult: E4.20; E4.21; E4.22
P4.26; P4.27; P4.28; P4.30; P4.31
QUESTIONS
Q4.1 Using Financial Ratios to Evaluate Firm Performance. A financial ratio is

one accounting variable (e.g., net income) divided by a second, related
accounting variable (e.g., net sales). Financial ratios are useful because they
enable financial statement users:
1. To standardize firm performance, facilitating intra-firm and inter-firm

comparisons (e.g., comparing apples to apples).
2. To extract otherwise hidden data from the accounting numbers (e.g., to
calculate the number of days required to collect an account receivable or
to sell inventory).
Q4.2 Using Financial Leverage Effectively. In general, the use of debt financing by
a company will be effective so long as the return on assets (ROA) exceeds the
cost of borrowing (Kd). Thus, a good rule of thumb is that a business should
stop borrowing when its after-tax K d approaches or equals its ROA. As to when
borrowing is most (least) effective, debt financing produces the greatest (least)
returns to shareholders when the spread between K d and ROA is large (small).
Since ROA can be decomposed into the return on sales (ROS) and total asset
turnover (TAT), we can also see that leverage will be most (least) effective
when ROS is high (low) and/or when TAT is high (low). When a firm is able to
use leverage effectively, its ROE will exceed its ROA.
Cambridge Business Publishers, 2014

Solutions Manual, Chapter 4 4-1
Q4.3 Calculating the Return on Shareholders Equity. When a firm has no
preferred stock outstanding, or where a firm has preferred stock outstanding
but pays no dividends to its preferred shareholders (a rare situation but one that
might exist if a firm were financially distressed), the ROE and ROCE will yield
equivalent results. Some firms do use preferred stock financing, and normally,
these firms do pay regular dividends on their preferred shares. For these firms,
the calculation of ROCE may be a superior measure of the return on equity
because many members of the financial community regard preferred stock
financing as equivalent to debt financing (specifically, as a form of mezzanine
financing). Preferred stock financing is regarded as a form of debt financing
because of the economic similarity between preferred stock and unsecured
debt; that is, both forms of financing lack the voting rights associated with
common stock and both financial products are valued by investors principally
for their regular income stream. ROCE is used in preference to ROE by those
investment professionals who regard common stock financing as the only pure
form of equity financing.
Q4.4 Unlevering the Return on Assets. Unlike the return on equity (ROE) or the
return on common shareholders equity (ROCE), which evaluates the return to
only one investor group (i.e., the equity investors), the return on assets is a
broader measure of firm profitability which considers the return to all investor
groups (i.e., debt investors as well as equity investors). As such, some
investment professionals believe that the numerator of the ROA ratio must be
modified to appropriately measure the net income to all investors; and, this can
be accomplished by unlevering net income. Thus, the numerator becomes NIBI
(net income before interest) to reflect the actual return to all investor groups.
The add-back of interest expense is on an after-tax basis (i.e., (1-t x)) to reflect
the tax benefit associated with the tax-deductibility of interest expense, or what
is commonly referred to as the interest tax-shield. For firms that use debt
financing extensively, failing to unlever the ROA may unfairly penalize these
firms when inter-firm comparisons of ROA are undertaken. A second aspect of
unlevering the ROA is that it allows the financial data user to evaluate the
effectiveness of a firms operating decisions independent of its financing
decisions.

4-2 Financial Accounting for Executives & MBAs, 3 rd Edition
Q4.5 Evaluating a Firms Liquidity and Solvency. The Manhattan Companys
current balance sheet appears as follows:
Cash and cash equivalents $23.0 Current liabilities $90.0

Accounts receivable 24.5 Noncurrent liabilities 135.0
Total 225.0
Inventory 26.4 Shareholders equity 40.0
Other current assets 11.1
Total 85.0
Noncurrent assets 180.0
Total $265.0 Total $265.0
Liquidity:
Quick ratio = ($23 + $24.5) $90 = 0.53
Current ratio = $85 $90 = 0.94
Solvency
Total debt Total assets = ($225 $265) = 85%
Overall, while The Manhattan Company appears very liquid, it does not appear
very solvent, with over 85 percent of its assets financed with debt.
Q4.6 Evaluating Capital Intensity.
Bristol-Myers Coca-Cola General

Squibb Enterprises Electric
Capital-intensity ratio 44.2% 86.6% 22.2%
Somewhat surprisingly, Coca-Cola Enterprises is the most capital-intensive firm

with an intensity ratio of 86.6 percent, almost twice that of Bristol-Myers Squibb
(44.2 percent) and almost four times that of General Electric (22.2 percent).
Knowing a firms relative capital intensity helps an analyst better predict a firms
future cash flow needs.

Q4.7 Identifying the Unknown Companies.
Company 1. Bristol-Myers Squibb

Company 2. General Electric Co.
Company 3. Coca-Cola Enterprises
Company 1 has significant research and development expenses that would be

characteristic of a pharmaceutical company, whereas Company 3 has none,
which would likely reflect a bottling operation (e.g., Coca-Cola Enterprises) in
which all new product development is conducted by a parent company (i.e.,
Cola-Cola Company). Thus, by a process of elimination, General Electric is
identified as Company 2.
Q4.8 Evaluating the Return on Assets. The increase in the return on assets for
Company A resulted from increases in both the return on sales and total asset
turnover. The decrease in the return on assets for Company B resulted from a
large decline in its return on sales, which more than offset the modest increase
in its total asset turnover.
Q4.9 Evaluating the Return on Assets. The increase in Company Cs return on

assets was largely due to a significant increase in its return on sales, which
more than offset the decline in its total asset turnover. The increase in the
return on assets for Company D resulted from increases in both its return on
sales and its total asset turnover.
Q4.10 Evaluating the Return on Equity. Company Xs return on equity declined as a

result of a decline in both its return on sales and its financial leverage. These
latter two effects more than offset an increase in the firms total asset turnover.
Company Ys return on equity declined for similar reasons both the return on
sales and financial leverage declined, offsetting gains in its total asset turnover.

Q4.11 (Ethics Perspective) Ethics and Financial Analysts. The problem posed in
this ethical perspective, as is the case with most ethical dilemmas, is not that
people choose a maliciously unethical path, but rather that people face conflicts
of interest and choose the path that seems to be the most logical, or of least
resistance. Sell-side analysts, function within such a conflict of interest.
The problem with this conflict of interest is that, despite well-intentioned desires
to give their customers the most objective security purchase suggestions, at the
end of the day these sell-side analysts are employees of the investment bank
and they are expected to perform. The potential for abuse is clearly high under
such conditions of tension.
It can certainly be argued, however, that abuses such as these are not the path
to success. While the short-term may appear the path of least resistance, in
the aggregate the imperative to skew a financial recommendation is lacking in
business acumen. The ultimate success for Merrill Lynch lies in its professional
ability to consistently do what is right for the customer, regardless of short-term
gains.
(Note: This answer was based on the writing of Jasper Spencer-Scheurich.)

EXERCISES
E4.12 Analyzing Financial Statement Data.
Year 1 Year 2
Return on equity (ROE) 23.4% 26.8%
Return on assets (ROA)-levered 7.8% 10.7%
Return on sales (ROS) 12.3% 15.6%
Total asset turnover (TAT) 0.637 0.683
Financial leverage (LEV) 2.98x 2.51x
The trends for all of Bristol-Myer Squibbs (BMS) ratios are all very positive.
Profitability is up, as indicated by an increase in ROE, ROA, and ROS. Further,
asset management effectiveness is up (albeit, only marginally). Finally, BMS
dependency on debt is down. Given the strength of BMS ROE ratio, this
company does appear to be a good investment; but, inter-company
benchmarking would enable investors to determine if BMS was the best
pharmaceutical company to add to a diversified portfolio of securities.
E4.13 Analyzing Financial Statement Data.
Year 1 Year 2
Overall, Pfizers profitability ratios (ROE, ROA, and ROS) are all heading in the
wrong direction (downward), suggesting that now is not a good time to invest in
this company. The one bright spot is the marginal increase in TAT from 0.427 to
0.436; but, even that change is quite minor given the significant declines in
ROE, ROA, and ROS.

E4.14 Analyzing the Return on Equity.
Year 1 Year 2
Johnson and Johnsons (J&J) ROE increased from 26.7 percent in Year 1 to
27.5 percent in Year 2. This increase was fueled by an increase in ROA from
16.0 percent to 17.9 percent, and the increase in ROA was large enough to
offset the decline in LEV from 1.68x to 1.53x. The growth in ROA resulted from
a growth in ROS from 18.0 percent to 20.6 percent, and the growth in ROS was
sufficient to offset the decline in TAT from 0.89 to 0.87. Overall, J&Js growth in
ROE can be linked to its growth in ROS.
E4.15 Analyzing Financial Risk.
Year 1 Year 2
Liquidity:
Cash and marketable securities to total assets 24.6% 20.6%
Quick ratio 1.2x 1.3x
Current ratio 1.5x 1.8x
Solvency:
Long-term debt-to-total assets 34.0% 30.5%
Long-term debt to shareholders equity 1.01x 0.77x
Interest coverage 15.3x 13.9x
Bristol-Myers Squibbs (BMS) liquidity increased as evidenced by an increase

in both the quick and current ratios. The cash and marketable securities to total
asset ratio declined, but that decline was probably due to a decline in long-term
leverage (i.e., cash was used to reduce debt). BMSs solvency increased as
evidenced by the declines in both the long-term debt to total assets ratio and
the long-term debt-to-equity ratio. BMSs interest coverage declined slightly,
probably due to higher interest rates on the companys outstanding debt.

Year 1 Year 2
Liquidity:
Quick ratio 0.42 0.38
Current ratio 0.47 0.43
Solvency:
Long-term debt to total assets 49% 55%
General Electrics (GE) liquidity and solvency both declined from Year 1 to Year
2. Although the cash plus marketable securities to total assets remained stable,
both the quick and current ratios declined. With respect to solvency, GEs use
of debt financing increased from 49 percent to 55 percent, and the interest
coverage declined from 2.7 times to 2.46 times.
Year 1 Year 2
Liquidity:
Solvency:
Long-term debt to total assets 42.1% 39.9%
Coca-Cola Enterprises (CCE) liquidity declined as evidenced by all three

liquidity indicators. CCEs solvency, on the other hand, was mixed, with the use
of leverage declining from 42.1 percent to 40 percent, but with the firms ability
to cover existing debt service charges (i.e., the interest coverage ratio) also
declining from 2.32 times to just 2.25 times.

E4.18 Analyzing Asset Management Effectiveness.
Year 1 Year 2
Accounts receivable turnover 4.43x 5.69x
Receivable collection period 82.4 days 64.2 days
Inventory turnover 3.27x 2.88x
Inventory-on-hand period 111.6 days 126.7 days
Bristol-Myers Squibbs receivable management is much improved, with the

receivable collection period dropping 22 percent, from 82.4 days to 64.2 days;
however, the inventory management effectiveness declined over this same
period, with the inventory-on-hand period ballooning from 111.6 days to 126.7
days, an increase of 15.1 days or 13.5 percent.
E4.19 Analyzing Asset Management Effectiveness.
Year 1 Year 2
Coca-Cola Enterprises receivable and inventory management both improved.

The receivable collection period declined by 2.8 days, or 7.4 percent, from 37.9
days to 35.1 days, and the inventory-on-hand period declined marginally by 0.2
days, from 25.9 days to 25.7 days.
E4.20 Debt Covenants and Financial Analysis. At year-end 2013, The Mann
Corporations long-term debt to equity ratio is 0.75 ($625.5 $834.0), well
below the covenant restriction of a maximum ratio of 1:1. The companys
remaining borrowing capacity is $208,500 ($834,000 - $625,500), and the
maximum dividend that could be declared without violating the loan covenant is
also $208,500. If Mann declares a dividend of $100,000, its borrowing capacity
drops to $108,500 ($734,000 - $625,500)

E4.21 Estimating Sustainable Growth. Procter and Gamble (P & G):
2012 2011
Dividend payout ratio 57.1% 48.9%
Dividend retention rate 42.9% 51.1%
Return on equity 17.0% 17.4%
Sustainable growth rate 7.3% 8.9%
Actual growth rate 3.2% 4.6%
P & Gs sustainable growth rate exceeds the companys actual growth rate in
sales in both years. Thus, P & G has the capacity to grow at a faster rate than it
is actually growing, without straining its financial capacity.
E4.22 Estimating Sustainable Growth. Fossil, Inc.:
2012 2011
Dividend payout ratio 0.0% 0.0%
Dividend retention rate 100.0% 100.0%
Sustainable growth rate 27.8% 26.6%
Actual growth rate 11.3% 26.4%
Fossils sustainable growth rate was slightly higher than its actual sales growth
rate in 2011, but in 2012, the sustainable growth rate of 27.8 percent greatly
exceeded the actual growth rate of 11.3 percent. Fossil has the capacity to
ratchet up its growth in sales as the spread between the sustainable rate and
the actual rate is quite high.

PROBLEMS
P4.23 Analyzing Financial Statements.

Year 1 Year 2
Profitability
Return on shareholders equity (ROE) 23.4% 26.8%
Return on assets (ROA) 8.6% 11.5%
Return on sales (ROS)-levered 12.3% 15.6%
Gross profit margin ratio 69.1% 69.1%
Asset Management
Total asset turnover 0.637 0.683
Liquidity
Cash and marketable securities to total
assets 24.6% 20.6%
Quick ratio 1.2x 1.3x
Current ratio 1.5x 1.8x
Solvency
Long-term debt to total assets 34.1% 35.7%
Analysis:
Profitability is up as indicated by all of the companys profitability ratios.
Liquidity is up.
Solvency declined overall, although the interest coverage is up as is the
long-term debt to equity.
Asset management is mixed. Total asset turnover improved, as did
accounts receivable management; however, inventory management
declined.
Overall, Bristol-Myers Squibb appears to be a good investment but
without benchmarking the company against other competitors, it is
difficult to say that the company is the best investment opportunity in the
pharmaceutical industry.

P4.24 Analyzing Financial Data: Trend Analysis
1. Although sales were over 4 times greater in 2012 than in 2008, net income
grew by over 6.8 times in the same period. The reason is that sales are
growing faster than are expenses during the period. Possible explanations
include:
(a) The presence of economies of scale.
(b) Greater product margins.
2. Financial leverage = Total assets Shareholders equity
Thus:
2012 2011 2010 2009 2008
Financial leverage 1.49x 1.52x 1.57x 1.50x 1.62x
Even though debt did increase from 2008 to 2012, this data suggests that
Apple decreased its use of debt financing from 2008 through 2012 and
increased its use of equity financing.
3. Asset Turnover = Net sales Total assets
Thus:
2012 2011 2010 2009 2008
Asset turnover 0.89 0.93 0.87 0.90 1.04
This data suggests that the companys asset turnover decreased from 2008
to 2012. In 2008, every dollar of assets was generating $1.04 of sales. By
2012, each dollar of assets was only generating $0.89 of sales.
4. Apples cash and marketable securities have grown consistently over the
five-year period, with the 2012 balance in excess of $120 billion. Thus, the
company appears justified in declaring its dividend.

P4.25 Financial Statement Analysis and Debt Covenants.
1. The debt covenant would initially restrict the amount of the $200,000 bank
loan invested into new real estate investments to $170,000. The remaining
$30,000 must be kept on hand as a current asset to satisfy the current ratio
debt covenant of 2:1. Thus, at year-end 2013, Wilmots balance sheet would
appear as follows:
Wilmot Real Estate Co.

Balance Sheet
Assets Liabilities & Shareholders Equity

Current assets $220,000 Current liabilities $275,000 3)
Real estate investments 420,0001) Long-term liabilities 150,000
Other noncurrent assets 25,0002) Shareholders equity 240,000 4)
Total liabilities & shareholders
Total assets $665,000 equity $665,000
1)
Current assets (2012) $60,000
+ Portion of bank loan 30,000
+ 2013 cash sales 700,000
+ 2013 credit sales 50,000
- Payment of 2012 current liabilities (45,000)
- 2013 cash expenses (575,000)
Current assets (2013) $220,000
2)
Real estate investments (2012) $250,000
+ New investments in 2013 170,000
Real estate investments (2013) 420,000
3)
Current liabilities (2012) $45,000
- Payment on 2012 liabilities (45,000)
+ Unpaid expenses (2013) 75,000
+ Bank loan due in one year 200,000*
Current liabilities (2013) $275,000
* Assumes the bank loan is included in current liabilities
4)
Shareholders equity (2012) $140,000
+ Net income (2013) 100,000
Shareholders equity (2013) $240,000

2. Covenant compliance
Loan included in Loan excluded from

current liabilities current liabilities
Current assets $220,000 $220,000

= 0.80 = 2.93
Current liabilities $275,000 ($275,000 - $200,000)
3. Maximum dividend = $70,000.
Current assets ($220,000 - $70,000) $150,000

= = 2:1
Current liabilities ($275,000 - $200,000) $75,000
P4.26 Financial Statement Analysis Using the ROE Model: International.

1. Ratios
2012 2011
Profitability
a. ROE 15.8% 16.1%
b. ROA-levered 5.5% 5.7%
c. ROS 4.4% 4.4%
Leverage
d. Financial leverage 2.85 2.84
e. Total debt-to-equity ratio 1.85 1.84
f. Long-term debt-to-equity 0.56 0.58
Solvency/Liquidity
g. Current ratio 0.64 0.65
h. Quick ratio 0.32 0.33
i. Interest coverage 9.86x 8.32x
j. Accounts payable turnover 5.28x 5.28x
Asset turnover
k. Receivable turnover 24.29x 25.95x
l. Inventory turnover 16.48x 17.50x
m. Fixed asset turnover 2.51x 2.48x
n. Total asset turnover 1.27x 1.28x
Continued next page

1. Continued
o.
Tesco, PLC
Common-Size Group Income Statement
For the Years Ended February 2012 and 2011
2012 2011
Continuing operations
Revenue 100.0% 100.0%
Cost of sales -91.8% -91.5%
Gross profit 8.2% 8.5%
Administrative expenses -2.6% -2.7%
Profit on property-related items 0.6% 0.7%
Operating profit 6.2% 6.5%
Share of post-tax profits of joint ventures and
associates 0.1% 0.1%
Finance income 0.3% 0.2%
Finance costs -0.6% -0.8%
Profit before tax 5.9% 6.0%
Taxation -1.4% -1.4%
Profit for the year from continuing operations 4.6% 4.6%
Discontinued operations
Loss for the year from discontinued operations -0.2% -0.2%
Profit for the year 4.4% 4.4%
Attributed to:
Owners of the parent 4.3% 4.4%
Non-controlling interests 0.0% 0.0%
Note: Columns may not total exactly due to rounding.
Continued next page

1. Continued
p.
Tesco, PLC
Common-Size Group Balance Sheet
February 2012 and 2011
2012 2011
Non-current assets
Goodwill and other intangible assets 9.1% 9.2%
Property, plant, ad equipment 50.6% 51.7%
Investment property 3.9% 3.9%
Investment in joint ventures and associates 0.8% 0.7%
Other investments 3.0% 2.0%
Loans and advances to customers 3.7% 4.5%
Derivative financial instruments 3.4% 2.4%
Deferred tax assets 0.0% 0.1%
74.7% 74.5%
Current assets
Inventories 7.1% 6.7%
Trade and other receivables 5.2% 4.9%
Loans and advances to customers 4.9% 5.3%
Derivative financial instruments 0.1% 0.3%
Current tax assets 0.0% 0.0%
Short-term investments 2.4% 2.2%
Cash and cash equivalents 4.5% 5.1%
24.3% 24.6%
Assets of the disposal group and non-current assets classified
as held for sale 1.0% 0.9%
25.3% 25.5%
Current liabilities
Trade and other payables 22.1% 22.2%
Financial liabilities:
Borrowings 3.6% 2.9%
Derivative financial instruments and other liabilities 0.3% 0.5%
Customer deposits and deposits by banks 10.8% 10.8%
Current tax liabilities 0.8% 0.9%
Provisions 0.2% 0.1%
37.8% 37.6%
Liabilities of the disposal group classified as held for sale 0.1% 0.0%
Net current liabilities 12.6% 12.1%
Non-current liabilities
Financial liabilities:
Borrowings 19.5% 20.5%
Derivative financial instruments and other liabilities 1.4% 1.3%
Post-employment benefit obligations 3.7% 2.9%
Deferred tax liabilities 2.3% 2.3%
Provisions 0.2% 0.2%
27.0% 27.2%
Net assets 35.1% 35.2%
Equity
Share capital 0.8% 0.9%
Share premium 9.8% 10.4%
Other reserves 0.1% 0.1%
Retained earnings 24.4% 23.7%
Equity attributable to owners of the parent 35.0% 35.0%
Non-controlling interests 0.1% 0.2%
Total equity 35.1% 35.2%
Note: Columns may not total exactly due to rounding.

2. Analysis:
Tescos ROE and ROA slightly declined in 2012, while its ROS
remained the same.
Tescos use of leverage remained about the same between years,
with a slight increase in financial leverage and total debt-to-equity and
a slight decline in long-term debt to equity.
Tescos liquidity and solvency also remained fairly constant
between years (e.g., current ratio, quick ratio, and interest coverage
and accounts payable turnover).
Finally, Tescos asset turnover also remained fairly consistent
between years (e.g., receivable turnover, inventory turnover, fixed
asset turnover, and total asset turnover).
P4.27 (Appendix B) Pro Forma Financial Statements.
Pro forma Financial Statements: Handy Dan
Balance Sheet Excel Formulas

as of December 31 Forecast
Current Assets Year 1 Year 2 Year 3
Cash 10 14 20 CashY2*(1 + 40%)
Receivables 27 38 53 SalesY3/25.9
Inventory 153 214 300 Cost of goods soldY3/3.39
Total Current Assets 190 266 373
Property & equipment (at cost) 199 279 390 SalesY3/3.52
Accumulated Depreciation (9) (17) (28) Accumulated depreciationY2 + depreciation expenseY3
Total Assets 380 528 735
Current Liabilities
Accounts Payable 74 104 135 Cost of goods soldY3/7.55
Short-term Loans Payable 10 29 51 (Current assetsY3/2)-accounts payableY3
Total Current Liabilities 84 133 186 Current assetsY3 / 2.0
Long-term Debt 207 289 402
Total Liabilities 291 422 588 Total assetsY3*0.80
Stockholders' Equity
Paid-in Capital 50 62 96 Total stockholders' equityY3 retained earningsY3
Retained Earnings 39 44 51 From retained earnings statement
Total Stockholders' Equity 89 106 147 Total assetsY3 total liabilitiesY3
Total Liabilities and SE 380 528 735 Total assetsY3
Income Statement Excel Formulas

for year ending December 31 Year 2 Year 3
Sales 980 1,372 SalesY2*(1 + 40%)
Cost of Goods Sold (727) (1,017) Sales-Gross profit
Gross Profit 253 355 SalesY3*25.9%
Depreciation expense (8) (11) PPEGrossY2 / 30 + 0.5*PPEGrossY3-PPEGrossY2 /30

Other Operating Expenses (217) (303) SalesY3*22.1%
Operating Income 28 41 Gross profit - depreciation expense - other operating
Interest Expense (21) (30) expense + 0.5*(STLPY3-STLPY2)*6% + LTDY2*8%
STLPY2*6%
+ 0.5*(LTDY3-LTDY2)*8%
Income Before Income Tax Expense 7 11 Op Income - interest expense
Income Tax Expense (2) (4) Income before income tax expense*33.33%
Net Income 5 7 Income before income tax expense income tax expense
Continued next page

Continued
Statement of Retained Earnings Excel Formulas

the Year Ending December 31 Year 2 Year 3
Retained Earnings - beginning 39 44 Retained earningsY2
plus Net Income 5 7 Net incomeY3 (from income statement)
less Dividends 0 0 No dividends paid
Retained Earnings - end 44 51 Retained earningsY2 + net incomeY3-dividendsY3
Statement of Cash Flows

for the period ending December 31, Year 2 Year 3
Cash Flow From Operating Activities
Net income 5 7 Net incomeY3
plus depreciation 8 11 Depreciation expenseY3
(Increase) decrease in receivables (11) (15) ReceivablesY3 - receivablesY2
(Increase) decrease in inventory (61) (86) InventoryY3 - InventoryY2
Increase (decrease) in accounts 30 31 Accounts PayableY3 - Accounts PayableY2
Cash Flow from Operations (CFFO) (29) (52)
Cash Flow From Investing Activities
Purchases of property & equipment (80) (111) PPEGrossY3 - PPEGrossY2
Cash Flow from Investing (CFFI) (80) (111)
Cash Flow From Financing Activities

New short-term borrowing 19 22 Short-term loans payableY3 -Short-term loans payableY2
New long-term borrowing 82 113 Long-term debtY3 - long-term debtY2
New equity issues 12 34 Paid-in capitalY3 - paid-in capitalY2
Payment of dividend 0 0 From statement of retained earnings

Cash Flow from Financing (CFFF) 113 169
Net Cash Flow 4 6 CFO + CFI + CFF
Change in Cash (on balance sheet) 4 6 CashY3 - CashY2

Cash, beginning 10 14
Cash, ending 14 20
Although Handy Dans net income is projected to grow from $5 in Year 2 to $7

in Year 3, the cash flow from operations is projected to decline from $(29) in
Year 2 $(52) in Year 3.
P4.28 Benchmarking Firm Performance. Pfizer (PFE) is the most profitable of the
three firms if considering ROE and ROS, however Johnson & Johnson (J&J)
has the highest ROA. Also, Johnson & Johnson (J&J) has the highest total
asset turnover. But when considering the markets assessment of the three
firms as indicated by the price-to-earnings (P/E) multiple, BMY leads both PFE
and JNJ. The choice of which stock to add to ones portfolio is not clear-cut,
and really should consider how each stocks risk characteristics correlate with
the other stocks in the portfolio.

P4.29 Evaluating Financial Performance.
1. Size. Chevron Texaco is the largest of the three firms when evaluated
in terms of total assets or revenues, although Conoco Phillips is a close
second, with Marathon Oil a very distant third. Chevron Texacos total debt
to total assets ratio is 51.4 percent, as compared to 53.4 percent for Conoco
Phillips and 60.9 percent for Marathon Oil; thus, Chevron Texaco tends to
rely somewhat less on debt financing than does Conoco Phillips or
Marathon Oil.
2. Performance. Chevron Texaco performance was substantially better

than either of the other firms and performance does appear to be positively
correlated with firm size:
Size ROE
Chevron Texaco 29.5%
Conoco Philips 19.0%
Marathon Oil 15.5%
P4.30 (Appendix 4A) Calculating Unlevered Financial Ratios.
2012 2013
Unlevered return on sales 17% 18%
Total asset turnover 0.92 0.92
Financial leverage 2.98 2.51
Common equity share of earnings 0.95 0.95
P4.31 (Appendix C) Calculating the Cost of Equity.
2013: Cost of equity = 5.50 + 0.80 (7.50) = 11.50%

2012: Cost of equity = 5.25 + 0.75 (7.30) = 10.725%
2011: Cost of equity = 5.00 + 0.70 (7.00) = 9.90%

CORPORATE ANALYSIS
CA4.32 The Procter and Gamble Company.

a. Common-size income statements.
2012 2011 2010

Net sales 100.0% 100.0% 100.0%
Cost of products sold (50.7) (49.1) (47.8)
Selling, general and administrative
expense (31.6) (31.7) (32.0)
Goodwill and indefinite lived intangible
asset impairment charges (1.9) -- --
15.9 19.1 20.3
Operating income
Interest expense (0.9) (1.0) (1.2)
Other nonoperating income, net 0.3 0.4 0.1
Earnings before income taxes 15.3 18.5 19.2
Income taxes (4.1) (4.1) (5.2)
Net earnings from continuing
operations 11.1 14.4 14.0
Net earnings from discontinued
operations 1.9 0.3 2.6
Net earnings 13.0 14.7 16.6
Less net earnings attributable to
noncontrolling interests (0.2) (0.2) (0.1)
Net earnings attributable to Procter &
Gamble 12.9% 14.5% 16.4%
(Note: All columns may not total exactly due to rounding.)
Major trends:
Cost-of-products sold as a percent of net sales increased by 2.9% over
the three year period.
Selling, general and administrative expense as a percent of net sales
decreased from 2010 to 2011 and then again from 2011 to 2012.
Interest expense as a percent of net sales is down 0.3 percent over the
three year period.
Other non-operating income increased 0.3 percent from 2010 to 2011
and then fell 0.1 percent in 2012.
Income tax expense decreased 1.1 percent 2010 to 2011 and then
remained stable in 2012.
Net earnings as a percent of net sales attributable to Proctor & Gamble
is down 3.5 percent over the three year period.

b. Common-size balance sheets.
2012 2011
Cash and cash equivalents 3.4 2.0
Accounts receivable 4.6 4.5

Inventories 5.1 5.3
Deferred income taxes 0.8 0.8
Prepaid expenses and other current assets 2.8 3.2
Property, plant and equipment (net) 15.4 15.4
Goodwill and other intangible assets (net) 64.1 65.2
Other noncurrent assets 3.9 3.5
Total assets 100.0% 100.0%
Accounts payable 6.0 5.8

Accrued and other liabilities 6.3 6.7
Debt due within one year 6.6 7.2

Long-term debt 15.9 15.9
Deferred income taxes 7.7 8.0
Other noncurrent liabilities 9.1 7.2
Shareholders equity 48.4 49.2
Total liabilities and shareholders equity 100.0% 100.0%
(Note: Columns may not total exactly due to rounding.)
Major trends:
Cash and cash equivalents as a percent of total assets are up by 1.4
percent.
Net property, plant and equipment as a percent of total assets is flat,
suggesting little incremental capital investment.
Debt due with one year is down by 0.6 percent while long-term debt as a
percent of total assets is flat.
Other noncurrent liabilities are up by 1.9 percent.
Total shareholders equity as a percent of total assets is down 0.8
percentage points.

c. Ratio analysis:
The Procter and Gamble Company

Key Financial Ratio Analysis
Ratio 2012 2011

Return on shareholders equity 1) 16.6% 17.1%
Return on assets(levered) 8.1% 8.5%
Return on sales(levered) 12.9% 14.5%
Gross profit margin ratio 49.3% 50.9%
Receivable turnover 13.8 12.9
Inventory turnover 6.3 5.4
Asset turnover 0.63 0.59
Long-term debt to total assets2) 22.5% 23.1%
Interest coverage ratio 17.6x 19.0x
Financial leverage ratio 2.1x 2.0x
1)
Preferred stock dividends of $256 in 2012 and $233 in 2011 can be found in the statement of
shareholders equity.
2)
Long-term debt is defined as long-term debt and debt due within one year.
Major trends:
The ROE, ROA, ROS and gross profit margin all decreased from 2011 to
2012.
The receivable collection period is down 1.7 days.
The inventory-on-hand period is down 9.7 days.
The asset turnover, quick ratio, and current ratio all increased from 2011
to 2012.
Interest coverage ratio is down.

d. Overall Assessment:
Profitability decreased as evidenced by the absolute decrease in net earnings and also
by decreases in ROE, ROA, and ROS.
Asset management effectiveness was positive as evidenced by the improvement in total
asset turnover, receivable turnover, and inventory turnover.
The use of leverage was basically flat and the interest coverage ratio declined by 1.4
percentage point.
Drivers of declining profitability include:
Increased CGS a percent of sales (and hence, decreased ROS), partially

offset by increased total asset turnover,
CA4.33.Internet-based Analysis. No solution is provided as any solution would be

unique to the company selected.


Fae3e SM ch04 060914

Uploaded by

Document Information

Original Title

Copyright

Available Formats

Share this document

Share or Embed Document

Sharing Options

Did you find this document useful?

Is this content inappropriate?

Copyright:

Available Formats

Fae3e SM ch04 060914

Uploaded by

Copyright:

Available Formats

Chapter 4.

Using Financial Statements for Investing and Credit

Suggested Solutions to Questions, Exercises, Problems, and Corporate Analyses

Easy: E4.12; E4.13: E4.14

Q4.1 Using Financial Ratios to Evaluate Firm Performance. A financial ratio is

1. To standardize firm performance, facilitating intra-firm and inter-firm

Cambridge Business Publishers, 2014

Cambridge Business Publishers, 2014

Cash and cash equivalents $23.0 Current liabilities $90.0

Q4.6 Evaluating Capital Intensity.

Bristol-Myers Coca-Cola General

Somewhat surprisingly, Coca-Cola Enterprises is the most capital-intensive firm

Cambridge Business Publishers, 2014

Company 1. Bristol-Myers Squibb

Company 1 has significant research and development expenses that would be

Q4.9 Evaluating the Return on Assets. The increase in Company Cs return on

Q4.10 Evaluating the Return on Equity. Company Xs return on equity declined as a

Cambridge Business Publishers, 2014

(Note: This answer was based on the writing of Jasper Spencer-Scheurich.)

Cambridge Business Publishers, 2014

E4.12 Analyzing Financial Statement Data.

E4.13 Analyzing Financial Statement Data.

Cambridge Business Publishers, 2014

E4.15 Analyzing Financial Risk.

Bristol-Myers Squibbs (BMS) liquidity increased as evidenced by an increase

Cambridge Business Publishers, 2014

E4.17 Analyzing Financial Risk.

Coca-Cola Enterprises (CCE) liquidity declined as evidenced by all three

Cambridge Business Publishers, 2014

Bristol-Myers Squibbs receivable management is much improved, with the

E4.19 Analyzing Asset Management Effectiveness.

Coca-Cola Enterprises receivable and inventory management both improved.

Cambridge Business Publishers, 2014

E4.22 Estimating Sustainable Growth. Fossil, Inc.:

Cambridge Business Publishers, 2014

P4.23 Analyzing Financial Statements.

Cambridge Business Publishers, 2014

2. Financial leverage = Total assets Shareholders equity

3. Asset Turnover = Net sales Total assets

Cambridge Business Publishers, 2014

Wilmot Real Estate Co.

Assets Liabilities & Shareholders Equity

* Assumes the bank loan is included in current liabilities

Cambridge Business Publishers, 2014

Loan included in Loan excluded from

Current assets $220,000 $220,000

3. Maximum dividend = $70,000.

Current assets ($220,000 - $70,000) $150,000

P4.26 Financial Statement Analysis Using the ROE Model: International.

Continued next page

Cambridge Business Publishers, 2014

Note: Columns may not total exactly due to rounding.

Continued next page

Cambridge Business Publishers, 2014

Note: Columns may not total exactly due to rounding.

Cambridge Business Publishers, 2014

P4.27 (Appendix B) Pro Forma Financial Statements.

Pro forma Financial Statements: Handy Dan

Balance Sheet Excel Formulas

Income Statement Excel Formulas

Depreciation expense (8) (11) PPEGrossY2 / 30 + 0.5*PPEGrossY3-PPEGrossY2 /30

Continued next page

Statement of Retained Earnings Excel Formulas