Week 3

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Week 3 – Assignment: Outline Aspects of Financial Ratios

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Research financial analysis using financial ratios. Identify and describe the five most important ratios for a potential equity investor. Explain the reasoning for your selection. Illustrate your discussion using numerical examples and respond to the following questions:

1. Identify and describe the five most important ratios for a potential bond investor in a corporate bond issuance. Explain the reasoning for your selection. Illustrate your discussion using numerical examples.

2. Identify and describe the five most important ratios for a potential bank investment in a short-term corporate loan. Explain the reasoning for your selection. Illustrate your discussion using numerical examples.

3. Identify and describe the five most important ratios for a potential shareholder to assess prior to making a stock purchase in a company. Explain the reasoning for your selection. Illustrate your discussion using numerical examples.

4. Review the article by Kaminski, Wetzel, & Guan. (2004). Describe the research question being addressed. Discuss the methods used and the conclusions reached by the study.

Support your paper with a minimum of five (5) external resources In addition to these specified resources, other appropriate scholarly resources, including older articles, may be included.
Length: 5-7 pages not including title and reference pages
Your paper should demonstrate thoughtful consideration of the ideas and concepts presented in the course and provide new thoughts and insights relating directly to this topic. Your response should reflect scholarly writing and current APA standards.

Indicates long-term debt-paying ability
Consider only recurring income
Exclude discontinued operations
Exclude extraordinary items
Exclude (add back) to income
Interest and Income tax expenses
Equity losses (earnings) of nonconsolidated subsidiaries
Net income—Noncontrolling interest
Include interest capitalized
Times Interest Earned

Times Interest Earned—Continued

Comparisons
3 to 5 years of historical data
Lowest value is the primary indicator of interest coverage
Industry competitors and averages
Secondary analysis
Interest coverage on long-term debt
Use only interest on long-term debt
Short-run coverage
Add back noncash expenses to recurring income
Less conservative
Times Interest Earned—Continued

Times Interest Earned- Short-Run Variation

Indicates a firm’s ability to cover fixed charges
Fixed Charge Coverage

Fixed charges include
Interest portion of operating lease payments
General approximation is to include 1/3 of payments
SEC requires specific calculation using lease terms
May also include
Depreciation, depletion, and amortization
Debt principal payments
Pension payments
Substantial preferred stock dividends
The more items included as “fixed charges,” the more conservative the ratio
Fixed Charge Coverage—Continued

Indicates the firm’s long-term debt-paying ability
Total liabilities
Includes short-term liabilities, reserves, deferred tax liability, noncontrolling interests, redeemable preferred stock, and any other non current liability
Indicates the percentage of assets financed by creditors
Debt Ratio

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Comparisons
Competitors and industry averages
Variations in application
Short-term liabilities
Exclude as they are not part of long-term source of funds
Include as they become part of the total source of funds
Liabilities that do not necessarily represent a commitment to pay out funds in the future
Debt Ratio—Continued

Reserves
Matches an expense but do not represent definite commitments to pay out funds in the future
Infrequently used in U.S. GAAP statements
Include in ratio for conservative application
Debt Ratio and Certain Liabilities

Deferred Income Taxes
Difference between income tax expense and income taxes payable
Recognized as a liability by GAAP; include in ratio
A company reports deferred taxes as
A net current amount
A net noncurrent amount
Referred as soft accounts
Debt Ratio and Certain Liabilities—Continued

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Noncontrolling Interest
Proportion of a consolidated entity that is not owned by the controlling parent company
Appears on the balance sheet as part of stockholders’ equity
Some firms exclude from ratio as it does not represent a commitment to pay funds to outsiders
Included in ratio for conservative application
Debt Ratio and Certain Liabilities—Continued

Redeemable Preferred Stock
Not disclosed under stockholders’ equity
Exclude from ratio; does not present a normal debt relationship
Included in ratio for conservative application
Debt Ratio and Certain Liabilities—Continued

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Determines the entity’s long-term debt-paying ability
Helps determine how well creditors are protected in case of insolvency
Comparisons
Competitors and industry averages
Debt/Equity Ratio

Determines the entity’s long-term debt payment ability
Indicates how well creditors are protected in case of the firm’s insolvency
More conservative than debt ratio or debt/equity ratio due to exclusion of intangibles
Debt to Tangible Net Worth Ratio

Current debt/net worth ratio
Indicates a relationship between current liabilities and funds contributed by shareholders
The higher the proportion of funds provided by current liabilities, the greater the risk
Total capitalization ratio
Compares long-term debt to total capitalization
Total capitalization consist of long-term debt, preferred stock, and common stockholders’ equity
The lower the ratio, the lower the risk
Other Long-Term Debt-Paying Ability Ratios

Fixed asset/equity ratio
The extent to which shareholders have provided funds in relation to fixed assets
Subtracting intangibles from shareholders’ equity will result in more conservative ratio
The higher the fixed assets in relation to equity, the greater the risk
Other Long-Term Debt-Paying Ability Ratios—Continued

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Consider the assets of the firm when determining the long-term debt-paying ability
Ability for analysis is limited
Financial statements do not disclose market or liquidation value
Certain assets may have market value significantly greater then carrying value
Certain assets may have earnings potential in the future
Long-Term Assets versus Long-Term Debt

Capital leases
Asset and liability are reported on the balance sheet
Operating leases
Reported as expense on the income statement
Supplemental analysis using future payments
One-third can be estimated as interest
Two-thirds can be added to the fixed assets and long-term liabilities for debt ratio analyses
Long-Term Leasing

Employee Retirement Income Security Act (ERISA)
Includes provisions requiring
Minimum funding of plans
Minimum rights to employees upon termination of their employment
Creation of a special federal agency, the Pension Benefit Guaranty Corporation (PBGC)
Pension Plans

Defines the contributions of the company to the pension plan
Employer bears no risk for future growth of plan
No complexity in estimating company’s pension liability or pension expense
401(k) is a type of defined contribution plan
Trend analysis
Compare three years of pension expense in relationship to operating revenue and income before income taxes; note any balance sheet items
Defined Contribution Plan

Defines the benefits to be received by the participants in the plan
Employer must fund sufficiently to achieve benefit
Note actuarial assumptions inherent in the plan
Interest (discount) rates
Employee turnover
Mortality rates
Compensation
Pension benefits
Defined Benefit Plan

Trend analysis
Compare three years of pension expense in relationship to operating revenue and income before income taxes
Compare benefit obligations to plan assets
Underfunding represents a potential liability
Overfunding represents an opportunity to reduce future pension expense and/or reduce related costs
Note the net balance sheet liability (asset) recognized
Defined Benefit Plan—Continued

Prior to 1993, accrual was not required
Transition costs may be
Amortized over 20 years or
Expensed in the year of adopting the new recognition practice
Analysis is similar to defined benefit plans for pension
Postretirement Benefits
Other than Pensions

An association of two or more businesses established for a special purpose
Consolidation
Done by the parent firm if it has control using a pro-rata share
Carried in an investment account
Analysis
Review footnote that relates to the joint venture
Off-balance sheet commitments represent potential liabilities
Joint Ventures

An existing condition involving uncertainty as to possible gain or loss to an enterprise
Will be resolved when one or more future events occur or fail to occur
Loss contingencies that are not accrued are included in the footnotes
Gain contingencies are not accrued
Review contingency note for possible liabilities and gain contingencies not disclosed on the balance sheet
Contingencies

Disclosure is required of
The face or contract amount
Nature and terms of the instrument
Amount of the potential loss
Entity’s collateral policy and description of the collateral it currently holds
Accounting loss occurs when
The co-party fails to perform the terms of contract
Changes in market make a instrument less valuable or more troublesome
Financial Instruments with
Off-Balance-Sheet Risk

Disclosure is required of the extent of risk from exposures to individuals or groups of counterparties in the same industry or region
Small companies are particularly susceptible to concentration risk
Financial Instruments
with Concentrations of Credit Risk

Disclosure of financial instrument’s fair value is required
On-balance sheet assets and liabilities
Off-balance sheet assets and liabilities
If estimation of fair value is not practicable
Descriptive information pertinent to estimating fair value is provided
Disclosures About
Fair Value of Financial Instruments

Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Noncontrolling Interest
Times Interest Earned =
Interest Expense, Including Capitalized
Interest
(Recurring Earnings + Noncash Expense),
Excluding Interest Expense, Tax Expense,
Equity Earnings, and Noncontrolling Inte
rest
Times Interest Earned =
Interest Expense, Including Capitalized
Interest
Recurring Earnings, Excluding Interest
Expense, Tax Expense, Equity Earnings,
and Noncontrolling Interest + Interest
Portion of Rentals
Fixed Charge Coverage =
Interest Expense, Including Capitalized
In
terest + Interest Portion of Rentals
Total Liabilities
Debt Ratio =
Total Assets
Total Liabilities
Debt/Equity Ratio =
Shareholders’ Equity
Total Liabilitites
Debt to Tangible Net Worth Ratio =
Shareholders’ Equity Intangible Assets
–

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The primary financial analysis of profit ratios should include only those items of income arising from normal operations
Excludes
Discontinued operations
Extraordinary items
Profitability Measures

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Also referred to as return on sales
Reflects net income dollars generated by each dollar of sales
Potential distortion can be caused by “other income” and “other expense” items from net income, as these do not relate to net sales
Net Profit Margin

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Measures the activity of the assets and the ability of the firm to generate sales through the use of the assets
Potential distortion
Investments
Construction in progress
Other assets that do not relate to net sales
Total Asset Turnover

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Measures the ability to utilize assets to create profits
Average total assets
For internal analysis use month-end amounts
For external analysis use beginning and ending amounts
If necessary, consistent use of end-of-year amounts, instead of averages
Return on Assets

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DuPont analysis separates return on assets into net profit margin and total asset turnover
Separating the ratio into the two elements allows for improved analysis of the causes for the change in the percentage of return on assets
DuPont Return on Assets

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Consider only operating assets and income
Operating assets exclude
Construction in progress
Long-term investments
Intangibles
‘Other’ assets
Operating income includes only
Net sales less the cost of sales
Operating expenses
May give significantly different results
Reflective of ROA from primary business
DuPont Analysis Variation

DuPont analysis of the return on operating assets:

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Measures the ability to make productive use of property, plant, and equipment by generating sales dollars
Exclude construction in progress from net fixed assets
Possible distortions
Old fixed assets
Labor-intensive industry
Sales to Fixed Assets

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Measures income earned on invested capital and how well the firm utilizes its asset base
Evaluates enterprise performance without regard to financing sources
Return on Investment (ROI)

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Measures the return to common and preferred stockholders
Return on Total Equity
Adjustments for redeemable preferred stock
Deduct dividends from net income (numerator)
Deduct stock value from total equity (denominator)

Common equity = Total Stockholders’ Equity
− Preferred Capital − Noncontrolling Interest

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Includes the return to all suppliers of funds, both long- and short-term, by both creditors and investors
Return on Total Asset Variation
Differs from the return on assets ratio and return on investment
It does not lend itself to DuPont Analysis

Rate of
return on Measures
return to providers of Typical result
Assets All funds Lowest (includes all assets)
Investment Long-term funds Higher than ROA (relative small amount of short-term funds)
Total equity Equity Higher than ROI (measures return only to shareholders)

The Relationship Between Profitability Ratios

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The Relationship Between Profitability Ratios—Continued
Rate of
return on Measures
return to providers of Typical result
Common equity Common equity Highest
Common shareholders absorb greatest degree of risk
Requires that return to preferred shareholders exceed funds paid to preferred shareholders

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Comparing gross profit with net sales is termed the gross profit margin
Gross Profit Margin
Net Sales Revenue
− Cost of Goods Sold
= Gross Profit
Beginning Inventory
+ Purchases of Inventory
− Ending Inventory

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Analysis helps the following ways:
Managers budget gross profit levels into their predictions of profitability
Used in cost control
Estimate inventory levels for interim financial statements and insured losses in merchandising industries
Used by auditor and Internal Revenue Service to judge accuracy of accounting systems

Gross Profit Margin Analysis

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Operating segments
Separate financial information is available
Evaluated by the chief operating decision maker
Requires information about
Countries in which the firm earns revenues and holds assets
Major customers
Segment Reporting

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Disclosures
The way the operating segments are determined
Products and services by the operating segments
Differences between the measurements used in reporting segment and firm’s general-purpose financial information
Profitability trends can also be shown as revenues by major product lines
Segment Reporting—Continued

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Charged directly to retained earnings
Changes in accounting principles
Realization of income tax benefits of preacquisition operating loss carryforwards of purchased subsidiaries
Changes in accounting entity
Correction of errors in prior periods
Gains and Losses from Prior Period Adjustments

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Items not included in net income
Reported as a separate component of shareholders’ equity
Foreign currency translation adjustments
Unrealized holding gains and losses from available-for-sale marketable securities
Changes to stockholders’ equity resulting from additional minimum pension liability adjustments
Unrealized gains and losses from derivative instruments
Comprehensive Income

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Traditional profitability analysis includes items related to net income
Items of accumulated other comprehensive income are excluded from analysis
Consider supplemental analysis including other comprehensive income items for
Return on assets
Return on investment
Return on total equity
Return on common equity
Comprehensive Income—Continued

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It is a hypothetical or projected amount
Release timed to coincide with release of GAAP financial results
Sarbanes-Oxley Act of 2002 requires
Reconciling of pro forma data to GAAP financial condition and results of operations
Pro-Forma Financial Information

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Unaudited financial reports covering fiscal periods of less than one year
SEC requires limited financial data be provided on Form 10-Q
Certain quarterly information is disclosed in notes to the annual report
Interim reports are an integral part of the annual report
Less reliable than annual reports as contain more estimates
Interim Reports

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Net Income Before Noncontrolling Interes
t,
Equity Income, and Nonrecurring Items
Net Profit Margin =
Net Sales
Net Sales
Total Asset Turnover =
Average Total Assets
Net Income Before Noncontrolling
Interest and Nonrecurring Items
Return on Assets =
Average Total Assets
Return on Assets = Net Profit Margin To
tal Asset Turnover
´
Return on Net Profit Total Asset
Assets = Margin × Turnover
Firm A
Year 1 10% = 4.0% × 2.5
Year 2 8% = 4.0% × 2.0

Firm B
Year 1 10% = 4.0% × 2.5
Year 2 8% = 3.2% × 2.5

Net Income BeforeNet Income Before
Noncontrolling InterestNoncontrolling In
terest
and Nonrecurring Itemsand Nonrecurring I
temsNet Sales
= ×
Average Total AssetsNet salesAverage Tot
al Assets

Return on
Net Profit
Total Asset

Assets
=
Margin
×
Turnover

Firm A
Year 1
10%
=
4.0%
×
2.5
Year 2
8%
=
4.0%
×
2.0
Firm B
Year 1
10%
=
4.0%
×
2.5
Year 2
8%
=
3.2%
×
2.5
Operating Income
Operating Income Margin =
Net Sales
Net Sales
Operating Asset Turnover =
Average Operating Assets
Return on Operating assets =
Operating Income
Average Operating Assets
DuPont ReturnOperatingOperating
On = Income × Asset
Operating AssetsMarginTurnover
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Net Sales
Sales to Fixed Assets =
Average Net Fixed Assets
(Exclude Construction in Progress)
Net Income Before Noncontrolling
Interest and Nonrecurring Items +
[(Interest Expense) × (1 Tax Rate)]
Return on Investment =
Average (Long-Term Liabilities + Equity)
–
Net Income Before Nonrecurring Items
Dividends on Redeemable Preferred Stock
Return on Equity =
Average Total Equity
–
Net income Before Nonrecurring
Items Preferred Dividends
Return on Common Equity =
Average Common Equity
–
Net Income + Interest Expense
Return on Total Asset Variation =
Average Total Assets
Gross Profit
Gross Profit Margin =
Net Sales

Chapter 6
Liquidity of Short-Term Assets; Related
Debt-Paying Ability

Current assets (1) are in the form of cash, (2) will be realized in cash, or (3) conserve the use of cash
Within the operating cycle of a business or one year, whichever is longer
Typical examples
Cash, marketable securities, receivables, inventories, and prepayments
Current Assets

The time period between the acquisition of goods and the final cash realization from sales
Operating Cycle
Purchase inventory
Cash sale to customer
Purchase material
Produce finished product
Sell to customer on credit
Collect amount due from customer

Retail and Wholesale
Manufacturing

Unrestricted
Available for deposit or to pay creditors
Reported as current asset
Restricted
Maybe reported as current but must disclose restrictions
Eliminate cash and related current liability when measuring short-term debt-paying ability
Current Assets: Cash

Compensating balance
A portion of loan proceeds required to remain on deposit in the bank
Increases effective interest rate
Against short-term borrowings
Separately stated in the current asset section or notes
Against long-term borrowings
Separately stated as noncurrent assets under either investments or other assets
Current Assets: Cash—Continued

The cash account on the balance sheet is usually entitled
Cash
Cash and equivalents, or
Cash and certificates of deposit
Analysis issues
Determining a fair valuation for the asset
Determining the liquidity of the asset
Current Assets: Cash—Continued

To qualify as a marketable security
The investment must be readily marketable
Intention to convert it to cash within the year or the operating cycle, whichever is longer
Examples
Treasury bills, short-term notes of corporations, government bonds, corporate bonds, preferred stock, and common stock
Debt and equity securities are carried at fair value
Current Assets: Marketable Securities

Claims to future cash inflows
Accounts receivables
Notes receivables
Arise from sales to customers
Trade receivables
Valuation problems
The entity incurs costs for the use of the funds, until receivables are collected
Collection might not be made
Current Assets: Receivables

Valuation of receivables
Waiting period is ignored
Assume stipulated rate of interest is fair
Notes that are noninterest-bearing, or carry an unreasonable rate, or are for an amount different from value of transaction are recorded at present value
Causes of impairment
Uncollectibility
Discounts allowed
Allowances given
Sales returns
Current Assets: Receivables—Continued

Impairment—Accrue (allowance method)
Based on estimate of receivables’ realizable value
Set up allowance
Expense recognized on income statement
Asset reduced by “Allowance for Doubtful Debts” account
Charge-off of a specific receivable
Reduces accounts receivable and allowance for doubtful accounts
No impact on income statement or net assets
Current Assets: Receivables—Continued

Impairment—Direct write-off
Alternative to accrual method when
Receivables are not material or
Amount for accrual cannot be reasonably estimated
Charge-off of a specific receivable
Recognize expense
Reduce asset
Bad debt expense likely to be recognized in a year subsequent to the sale
Does not match expense with revenue
Current Assets: Receivables—Continued

Trade receivables
Typically collected within 30 days
Installment receivables
May be carried as a current asset, yet collection may be significantly longer than trade receivables
Usually considered to be lower quality than trade receivables
Current Assets: Receivables—Continued

Customer concentration
May impair the quality of receivables if a large portion of receivables is from a few customers
Liquidity measures
Number of days’ sales in receivables
Accounts receivable turnover
Current Assets: Receivables—Continued

Should mirror the company’s credit terms
Indicates the length of time that the receivables have been outstanding
Use of the natural business year (lower sales at year-end) can understate result
Compare
Firm’s data for several years
Other firms in the industry and industry averages
Days’ Sales in Receivables

Causes for overstatement
Sales volume expands materially late in the year
Uncollectibles should have been written off
A company seasonally dates invoices
Receivables are on the installment basis
Causes for understatement
Sales volume decreases materially late in the year
A material amount of sales are on a cash basis
A company has a factoring arrangement in which a material amount of the receivables is sold
Days’ Sales in Receivables—Continued

Indicates the liquidity of receivables
Determining average gross receivables
End of year and beginning of year base points for average mask seasonal fluctuations
For internal analysis, use monthly or weekly amounts
For external analysis, use quarterly data
Accounts Receivable Turnover

Similar to days’ sales in receivables except average gross receivables are used
Should reflect firm’s credit and collection policies
Accounts Receivable Turnover in Days

Held for sale in the ordinary course of business
Used in the production of goods
Trading concern
Single (merchandise) inventory account
Manufacturing concern
Three distinct inventory accounts
Raw materials inventory
Work-in-process inventory
Finished goods inventory
Current Assets: Inventories

Perpetual
A continuous record of physical quantities is maintained
Inventory and cost of goods sold are updated as sales and purchases take place
Records are verified through physical inventory
Periodic
Periodic physical counts to determine quantity
Attach costs to ending inventory based on selected cost flow assumption(s)
Current Assets: Inventories—Continued

Specific identification
Tracking of specific cost normally impractical
Exceptions to this are large and/or expensive items
If specific costs are used, it is referred to as the specific identification method
Cost flow assumptions
FIFO (first-in, first-out)
LIFO (last-in, first-out)
Averaging
Inventory Cost

First inventory acquired is the first sold
Cost of goods sold includes oldest costs
Current costs are not matched against current revenue
Inflates profits during a time of inflation
Ending inventory reflects latest costs
Approximates replacement cost
Low turnover can distort the approximation of replacement cost
FIFO Cost Flow Assumption

Cost of latest acquired goods are matched against sales revenue
Improves the matching of current costs against current revenue
Profit is reflective of replacement cost
Ending inventory contains oldest costs
Inventory valuation can be based on costs that are years or decades old
LIFO Cost Flow Assumption

Determines a midpoint to calculate cost
Results in an inventory amount and a cost of goods sold amount somewhere between FIFO and LIFO
During times of inflation
Inventory is more than LIFO and less than FIFO
Cost of goods sold is less than LIFO and more than FIFO
Average Cost

Cost Flow Assumption Example

800 units of ending inventory are valued at the most recent costs
800 units of ending inventory are valued at the oldest costs
2,100 units available for sale

Cost Flow Assumption Example

800 units of ending inventory are valued at average unit cost
Ending inventory (800 × $7.95) = $6,360
Cost of goods sold ($16,700 − $6,360) = $10,340
2,100 units available for sale

If LIFO method is being used, short-term debt-paying ability is understated
Understatement is reduced by reported operating expenses that reduce gross profit to net income
Replacement cost of the inventory usually exceeds the reported inventory cost, even if FIFO is used
Analysis Problems and Inventory

Cash flow is higher when LIFO is used for tax reporting
LIFO generally results in a lower profit LIFO profit reflects current costs of sales
FIFO inventory is closer to replacement value of the asset
LIFO reserve
Measures the spread between LIFO and FIFO inventory value
Discloses the approximate FIFO inventory value
Impact on Financial Statements

Cost flow assumptions use historical data
If “utility” (market) is below cost, inventory must be written down to reflect the diminished value
Market is defined in terms of
Replacement cost
Net realizable value
Inventory: Lower-of-Cost-or-Market

Days’ sales in inventory
Inventory turnover in times per year
Inventory turnover in days
Liquidity of Inventory

Indicates the length of time needed to sell all inventory on hand
Use of a natural business year
Understates number of day’s sale in inventory
Overstates liquidity of inventory
Days’ Sales in Inventory

Implications of extremes
A high inventory would result in the number of days’ sales in inventory to be overstated and the liquidity to be understated
A low inventory would result in an unrealistic days’ sales in inventory; lost sales
Days’ Sales in Inventory—Continued

Indicates the liquidity of inventory
Determining average inventory
End of year and beginning of year base points for average mask seasonal fluctuations
For internal analysis use monthly or weekly amounts
For external analysis use quarterly data
Inventory Turnover

Comparison Issues
Use caution when comparing a mix of natural and calendar year companies
Cost flow assumption issues
LIFO yields lower inventory value and higher inventory turnover
Inter-industry comparisons may not be reasonable
Inventory Turnover—Continued Comparison Issues

Inventory Turnover in Days

The period between acquisition of goods and the final cash realization from sales
Current Assets: Operating Cycle
Subject to potential understatement from understatement of turnover measures
Use of LIFO inventory
Use of a natural business year
Averages are computed based on beginning-of-year and end-of-year data

Prepayments
Unexpired costs for which payment has been made
Consumed within an operating cycle or a year, whichever is longer
Have minor influence on short-term debt-paying ability
Valuation is taken as the cost that has been paid
No liquidity computation is needed as prepayment will not result in a receipt of cash
Current Assets: Prepayments

Will be realized in cash or conserve the use of cash within the operating cycle of the business or one year, whichever is longer
If material, and nonrecurring, may distort liquidity
Examples
Property held for sale
Advances or deposits
Current Assets: Other

Obligations whose liquidation is reasonably expected to require
The use of existing resources properly classifiable as current asset
The creation of other current liabilities
Typical Examples
Accounts payable, notes payable, accrued wages, accrued taxes, collections received in advance, and current portions of long-term liabilities
Carried at its face value
Current Liabilities

Liquidity Ratios

Indicates short-run solvency of a business
Subject to understatement if certain assets are understated (i.e., LIFO inventory)
Longitudinal comparison appropriate
Inter-firm comparison is of no value because of their size differences
Working Capital

Determines short-term debt-paying ability
Focus is on the relationship between current assets and current liabilities
Inter-firm comparison is possible and meaningful
Minimum current ratio is 2.00
Decreased current ratio indicates lower liquidity
Industry averages provide contextual benchmarks
Considerations
Quality of inventory and receivables
Inventory cost flow assumptions
Current Ratio

Measures the immediate liquidity of the firm
Relates the most liquid assets to current liabilities
Excludes inventory
A more conservative computation excludes other current assets that do not represent current cash flow
Minimum acid-test ratio is 1.00
Industry averages provide contextual benchmarks
Consideration
Quality of receivables
Acid-Test (Quick) Ratio

Extremely conservative
Unrealistic for a firm to have sufficient cash and securities to cover all its current liabilities
Appropriate context
Firms with naturally slow-moving inventories and receivables
Firms that are highly speculative
Cash Ratio

Measures the turnover of working capital per year
Analyst compare this data with historical data, competitors, and industry averages to determine the adequacy of working capital
Assessment
Low ratio indicates unprofitable use of working capital
High ratio indicates that the firm is undercapitalized

Sales to Working Capital

Liquidity is better than indicated by financial statements
Unused bank credit lines
Long-term assets can be converted to cash quickly
A firm may be in a very good long-term debt position
Liquidity is weaker than indicated by financial statements
Co-signer on debt of another entity
Subject to recourse obligation
Significant contingent (unaccrued) liabilities
Other Liquidity Considerations

Gross Receivables
Days’ Sales in Receivables =
Net Sales365
Net Sales
Accounts Receivable Turnover =
Average Gross Receivables
Average Gross Receivables
Average Receivable Turnover in Days =
Net Sales365
DateDescription
Number
of Units
Cost per
Unit
Total
Cost
Cost of
Goods Sold
01-JanBeginning inventory200 6.00$ 1,200$
01-MarPurchase1,200 7.00 8,400
01-JulPurchase300 9.00 2,700
01-OctPurchase400 11.00 4,400
2,100 16,700$
FIFO
01-OctPurchase400 11.00$ 4,400$
01-JulPurchase300 9.00 2,700
01-MarPurchase100 7.00 700
Ending inventory800 7,800$
Cost of Goods Sold8,900$
LIFO
01-JanBeginning inventory200 6.00$ 1,200$
01-MarPurchase600 7.00 4,200
Ending inventory800 5,400$
Cost of goods sold11,300$
Sheet1

Date Description Number of Units Cost per Unit Total Cost Cost of Goods Sold
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 1,200 7.00 8,400
1-Jul Purchase 300 9.00 2,700
1-Oct Purchase 400 11.00 4,400
2,100 $ 16,700
FIFO
1-Oct Purchase 400 $ 11.00 $ 4,400
1-Jul Purchase 300 9.00 2,700
1-Mar Purchase 100 7.00 700
Ending inventory 800 $ 7,800
Cost of Goods Sold $ 8,900
LIFO
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 600 7.00 4,200
Ending inventory 800 $ 5,400
Cost of goods sold $ 11,300

Sheet2

Sheet3

AVERAGE COST
DateDescription
Number of
Units
Cost per
UnitTotal Cost
01-JanBeginning inventory200 6.00$ 1,200$
01-MarPurchase1,200 7.00 8,400
01-JulPurchase300 9.00 2,700
01-OctPurchase400 11.00 4,400
2,100 16,700$
Total Cost$16,700
Average unit cost = $7.95
Total Units2,100
==
Sheet1

AVERAGE COST
Date Description Number of Units Cost per Unit Total Cost
1-Jan Beginning inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 1,200 7.00 8,400
1-Jul Purchase 300 9.00 2,700
1-Oct Purchase 400 11.00 4,400
2,100 $ 16,700
1-Oct Purchase 400 11.00 4,400
1-Jul Purchase 300 9.00 2,700
1-Mar Purchase 100 7.00 700
Ending inventory 800 7,800
Cost of Goods Sold 8,900
LIFO
1-Jan Beginning Inventory 200 $ 6.00 $ 1,200
1-Mar Purchase 600 7.00 4,200
Ending inventory 800 $ 5,400
Cost of Goods Sold $ 11,300

Sheet2

Sheet3

Ending Inventory
Days’ Sales in Inventory
Cost of Goods Sold365
=
Cost of Goods Sold
Inventory Turnover =
Average Inventory
Average Inventory
Inventory Turnover in Days =
Cost of Goods Sold365
365
Inventory Turnover per Year =
Inventory Turnover in Days
Operating Cycle = Accounts Receivable Tu
rnover in Days + Inventory Turnover in D
ays

Current Assets Inventory
Acid-Test (Quick) Ratio =
Current Liabilities
–
Current Assets
Current Ratio =
Current Liabilities
Cash Equivalents
+ Marketable Securities
+ Net Receivables
Acid-Test (Quick) Ratio =
Current Liabilities
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ç÷
ç÷
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Working Capital = Current Assets Curren
t Liabilities
–
Cash Equivalents + Marketable Securities
Cash Ratio =
Current Liabilities
Sales
Sales to Working Capital =
Average Working Capital

The use of financing with a fixed charge is termed financial leverage
Interest as related to debt financing
A contractual obligation
Must be paid regardless of entity’s current profits
Contrast with dividends that are discretionary
Interest is tax deductible
Reduces taxable income
Reduces income tax expense
Financial Leverage

Exhibit 9-1—Dowell Company
Percentage change in net income increase [A] is greater than percentage change in EBIT [B] due to the fixed nature of interest expense

Computation of the Degree of Financial Leverage
The degree of financial leverage is the multiplication factor by which the net income changes in respect to changes in EBIT
A more simple formula for degree of financial leverage

Degree of financial leverage calculations should exclude
Noncontrolling interest
Equity income
Nonrecurring items
Computation of the Degree of Financial Leverage—Continued

The amount of income earned on a share of common stock during an accounting period
Required disclosure for corporate income statements
Pertains only to common stock
Earnings per Common Share

Per share amounts for discontinued operations and extraordinary items must be presented
In the income statement and the notes to the financial statements
Earnings per share for recurring items are significant for primary analysis
Retroactive recognition must be given to events such as stock dividend and stock split
Earnings per Common Share—Continued

Earnings pertain to an entire fiscal period
Average common shares outstanding is used for parity of information
Current guidelines require basic and diluted earnings per share presentation
Diluted earnings per share is calculated the same as basic plus the dilutive effect of potentially dilutive securities
Convertible securities, warrants, or other rights that upon conversion or exercise could in the aggregate dilute earnings per common share are potential dilutive securities
Earnings per Common Share—Continued

Weighted Average Common Outstanding Shares
Months Shares Are Outstanding Shares Outstanding × Fraction of Year Outstanding = Weighted Average
January–June 10,000 6/12 5,000
July–September 12,000 3/12 3,000
October–December 15,000 3/12 3,750
11,750

Measures the relationship between the market price of a share of common stock and that stock’s current earnings per share
Use of diluted earnings per share gives a more conservative price/earnings ratio
Price/Earnings Ratio

Interpretation
High-growth-potential firms have higher P/E ratios
P/E ratio is a function of the market
Compare with
Competitors
Industry average
Exchange averages
Price/Earnings Ratio—Continued

Reflects the proportion of current earnings retained for internal growth
Trend analysis is improved by exclusion of nonrecurring items
Higher percentage typically found in growth firms
Percentage of Earnings Retained

Measures the portion of current earnings per common share being paid out in dividends
A stable dividend policy is developed by consideration of recurring earnings
Lower payout typically found in growth firms
Dividend Payout

Indicates the relationship between the dividends per common share and the market price per common share
The yield depends on a firm’s dividend policy and market price
Dividend Yield

Preferred equity should be measured at liquidation value, if available
Market value and book value
Book value reflects past unrecovered asset costs
Market value reflects the potential of the firm
Book Value per Share

Recognize an expense for all employee services received in share-based payment transactions, using a fair-value-based method
Similar to SFAS No. 123 (R)
Allocate option fair value to the service period
Date of grant through vesting date
Noncompensatory plans
Encourage widespread ownership by employees
Slight discount from fair value
No compensation expense is recognized
Stock Options

Impact of options can be substantial
It may result in lower net income and earnings per share
Following formula is used to determine the materiality of options:
Stock Options—Continued

Sometimes offered to employees in lieu of stock option plans
Restrictions
Employee cannot sell stock for a specified period of time
Employees may forfeit their shares if they leave employer before vesting
Awards may be linked to financial goals
Restricted Stock

Gives the employee right to receive compensation in cash or stock or in a combination of both
Based on the difference between option price and market price
Expense is a function of market price
Year-end spread is measured
Compensation expense is spread minus prior recognition, multiplied by number of shares of stock appreciation rights outstanding
Stock Appreciation Rights

% Change in Net Income
Degree of Financial Leverage =
% Change in EBIT
Earnings Before Interest and Tax
Degree of Financial Leverage =
Earnings Before Tax
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ç÷
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Earnings Before Interest, Tax,
Noncontrolling Interest,
All-Inclusive Degree
Equity Income, and Nonrecurring Items
=
Earnings Before Tax,
of Financial Leverage
Noncontrolling Interest,
Equity Income,
and Nonrecurring Items
Net Income Preferred Dividend
Earning per Share =
Weighted Average Number of Common
Shares Outstanding
–
Market Price per Share
Price/Earings Ratio =
Diluted Earnings per Share,
Before Nonrecurring Items
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–
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Net Income Before Nonrecurring
Percentage of
Items All Dividends
=
Net Income Before Nonrecurring Items
Earnings Retained
Dividends per Common Share
Dividend Payout ratio =
Diluted Earnings per Share
Before Nonrecurring Items
Dividends per Common Share
Dividend Yield =
Market Price per Common Share
Total Shareholders’ Equity
Preferred Stock Equity
Book Value per Share =
Number of Common Shares
Outstanding
–
Net Income Before Net Income Before
Nonrecurring Items not Nonrecurring It
ems
Including Option ExpenseIncluding Option
Expense
Net Income Before Nonrecurring Items
Not Including O
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–
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ption Expense

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