Fa4e Sm Ch05

Chapter 5 Analyzing and Interpreting Financial Statements Learning Objectives – coverage by question MiniExercises LO1 – Prepare and analyze common size financial statements. LO2 – Compute and interpret measures of return on investment, including return on equity (ROE), return on assets (ROA), and return on financial leverage (ROFL). LO3 – Disaggregate ROA into profitability (profit margin) and efficiency (asset turnover) components. LO4 – Compute and interpret measures of liquidity and solvency.

15, 16, 19, 20

14, 17, 21, 22, 24

Exercises

Cases and Projects

35

36, 38,

25 - 31, 34

41, 45

14, 17,

25, 27 - 31,

36, 38,

21, 22, 24

34

41, 46, 47

18, 23

32, 33

37, 39, 42

LO5 – Appendix 5A: Measure and analyze the effect of operating activities on ROE. LO6 – Appendix 5B: Prepare pro forma financial statements.

Problems

50

48 - 50

50

40, 43

35

44

©Cambridge Business Publishers, 2014 Solutions Manual, Chapter 5

5-1

DISCUSSION QUESTIONS Q5-1.

Return on investment measures profitability in relation to the amount of investment that has been made in the business. A company can always increase dollar profit by increasing the amount of investment (assuming it is a profitable investment). So, dollar profits are not necessarily a meaningful way to look at financial performance. Using return on investment in our analysis, whether as investors or business managers, requires us to focus not only on the income statement, but also on the balance sheet.

Q5-2.

ROE is the sum of return on assets (ROA) and the return that results from the effective use of financial leverage (ROFL). Increasing leverage increases ROE as long as ROA exceeds the after-tax interest rate. Financial leverage is also related to risk: the risk of potential bankruptcy and the risk of increased variability of profits. Companies must, therefore, balance the positive effects of financial leverage against their potential negative consequences. It is for this reason that we do not witness companies entirely financed with debt.

Q5-3.

Gross profit margins can decline because 1) the industry has become more competitive, and/or the firm’s products have lost their competitive advantage so that the company has had to reduce prices or is selling fewer units or 2) product costs have increased, or 3) the sales mix has changed from highermargin/slowly-turning products to lower-margin/higher-turning products. Declining gross profit margins are usually viewed negatively. On the other hand, cost increases that reflect broader economic events or certain strategic product mix changes might not be viewed negatively.

Q5-4.

Reducing advertising or R&D expenditures can increase current operating profit at the expense of the long-term competitive position of the firm. Expenditures on advertising or R&D are more asset-like and create long-term economic benefits.

Q5-5.

Asset turnover measures the amount of revenue volume compared with the investment in an asset. Generally speaking, we want turnover to be higher rather than lower. Turnover measures productivity and an important company objective is to make assets as productive as possible. Since turnover is one of the components of ROE (via ROA), increasing turnover increases shareholder value. Turnover is, therefore, viewed as a value driver.

Q5-6.

ROE>ROA implies a positive return on financial leverage. This results from borrowed funds being invested in operating assets whose return (ROA) exceeds the cost of borrowing. In this case, borrowing money increases ROE.

Q5-7.

Common-size financial statements express balance sheet and income statement items in ratio form. Common-size balance sheets express each asset, liability and equity item as a percentage of total assets and common-size income statements express each line item as a percentage of sales. The ratio form facilitates comparison among firms of different sizes as well as across time for the same firm.

©Cambridge Business Publishers, 2014 5-2

Financial Accounting, 4th Edition

Q5-8.

The asset turnover ratio (AT) is the ratio of sales revenue to average total assets. The ratio is increased by increasing sales while holding assets constant, or by reducing assets without reducing sales. The most effective means of improving the ratio is to increase the efficient utilization of operating assets. This is done by improving inventory management practices, improving accounts receivable collection, and improving the efficient use of PP&E.

Q5-9.

The ―net‖ in net operating assets, means operating assets ―net‖ of operating liabilities. This netting recognizes that a portion of the costs of operating assets is paid for by parties other than the company. For example, payables and accrued expenses help fund inventories, wages, utilities, and other operating costs. Similarly, long-term operating liabilities also help fund the cost of longterm operating assets. Thus, these long-term operating liabilities are deducted from long-term operating assets.

Q5-10. Companies must manage both the income statement and the balance sheet in order to maximize ROA. This is important, as many managers look only to the income statement and do not fully appreciate the value added by effective balance sheet management. The disaggregation of ROA into its profit margin and turnover components facilitates analysis of these two areas of focus. Q5-11. There are an infinite number of possible combinations of margin and turnover that will yield a given level of ROA. The relative weighting of profit margin and asset turnover is driven in large part by the company’s business model. As a result, since companies in an industry tend to adopt similar business models, industries will generally trend toward points along the margin/turnover continuum. Q5-12. Liquidity refers to how much cash a company has, how much cash is coming in, and how much cash can be raised quickly. Companies must generate cash in order to pay their debts, pay their employees and provide their shareholders a return on investment. Cash is, therefore, critical to a company’s survival. Q5-13. Ratio analysis relies on the data presented in the financial statements and is, therefore, dependent on the quality of those statements. Differences in the application of GAAP across companies or within the same company across time can affect the reliability of the analysis. Limitations of GAAP itself and differences in the make-up of the company (e.g., types of products or industries in which the company competes) can also affect the usefulness of ratio analysis.


5-3

MINI EXERCISES M5-14. (15 minutes) a. ROE = $5,000/$500,000 = 1% ROA = $20,000/$1,000,000 = 2% ROFL = 1% - 2% = -1% b. Net profit margin = $5,000/$1,000,000 = 0.5% Asset turnover = $1,000,000/$1,000,000 = 1.0 Financial leverage = $1,000,000/$500,000 = 2.0 c. ROFL is negative for Sunder Company, indicating that financial leverage is hurting this company. The return on assets is insufficient to cover the interest cost of the debt. DuPont analysis masks this problem. The financial leverage ratio of 2.0 suggests (incorrectly) that leverage doubled the return.

M5-15. (20 minutes) TARGET CORPORATION Common-size Balance Sheets Cash and cash equivalents……………………………………. Accounts receivable, net………………………………………. Inventory…………………………………………………………. Other current assets……………………………………………. Total current assets…………………………………………….. Property and equipment, net………………………………….. Other noncurrent assets……………………………………….. Total assets………………………………………………………

2012 1.7% 12.7% 17.0% 3.9% 35.3% 62.5% 2.2% 100.0%

2011 3.9% 14.1% 17.4% 4.0% 39.4% 58.3% 2.3% 100.0%

Accounts payable………………………………………………. Accrued liabilities……………………………………………….. Current portion of long-term debt and notes payable............ Total current liabilities…………………………………………. Long-term debt………………………………………………….. Deferred income taxes…………………………………………. Other noncurrent liabilities……………………………………. Total shareholders' investment………………………………. Total liabilities and shareholders' investment………………..

14.7% 7.8% 8.1% 30.6% 29.4% 2.6% 3.5% 33.9% 100.0%

15.2% 7.6% 0.3% 23.0% 35.7% 2.1% 3.7% 35.4% 100.0%



M5-16 (20 minutes) TARGET CORPORATION Common-size Income Statement Year ended: January 28, 2012 Sales………………………………..……………………………….. 98.0% Net credit card revenues………………………………………….. 2.0% Total revenues……………………………………………………… 100.0% Cost of sales………………………………………………………… 68.5% Selling, general and administrative expenses…………………… 20.2% Credit card expenses………………………………………………. 0.6% Depreciation and amortization…………………………………….. 3.1% Earnings before interest expense and income taxes…………… 7.6% Net interest expense……………………………………………….. 1.2% Earnings before income taxes…………………………………….. 6.4% Provision for income taxes………………………………………… 2.2% Net earnings………………………………………………………… 4.2%

M5-17. (15 minutes) ($ millions) a. EWI = $2,929 + $869 x (1-.35) = $3,493.8 Average total assets = ($46,630 + $43,705)/2 = $45,167.5 ROA = $3,493.8/$45,167.5 = 7.74% b. PM = $3,493.8/$69,865 = 5.00% AT = $69,865 /$45,167.5= 1.547 5.00% X 1.547 = 7.74%

M5-18. (20 minutes) a. 2012 current ratio = $16,449 / $14,827 = 1.15 2011 current ratio = $17,213 / $10,070 = 1.71 2012 quick ratio = ($794 + $5,927) / $14,827 = 0.47 2011 quick ratio = ($1,712 + $6,153 / $10,070 = 0.78 Both of these ratios declined over the year, as Target’s cash balance dropped by about $1 billion and its borrowings due within the year increased by more than $3.5 billion. Current ratio above 1 is good for a retailer and Target’s quick ratio is about average for a retailer. Target is fairly liquid, even with the declines in these ratios, but it would be worthwhile to see whether these changes represent a trend. continued next page ©Cambridge Business Publishers, 2014 Solutions Manual, Chapter 5

5-5

M5-18. concluded b. 2012 times interest earned = ($4,456 + $869) / $869 = 6.12 2012 debt-to-equity = ($46,630 - $15,821) / $15,821= 1.95 2011debt-to-equity = ($43,705 - $15,487) / $15,487 = 1.82 Target’s debt-to-equity increased slightly but is not at a particularly high level. c. Target is liquid and not excessively financially leveraged. Its times interest earned ratio indicates that earnings before interest and taxes is just over 6 times interest expense. Because the company generates significant operating profits and cash flow, we have no solvency concerns about Target.

M5-19. (20 minutes) 3M COMPANY Common-size Balance Sheets Cash and cash equivalent……………………………………... Accounts receivable……………………………………………. Total inventories………………………………………………… Other current assets…………………………………………… Total current assets…………………………………………… Investments……………………………………………………… Property, plant and equipment, net…………………………… Goodwill………………………………………………………….. Intangible assets, net…………………………………………… Prepaid pension and postretirement benefits………………… Other assets…………………………………………………….. Total assets………………………………………………………

2011 11.7% 12.2% 10.8% 4.0% 38.7% 3.3% 24.3% 22.3% 6.1% 0.1% 5.2% 100.0%

2010 14.8% 12.0% 10.5% 3.2% 40.5% 2.3% 24.1% 22.6% 6.0% 0.3% 4.2% 100.0%

Short-term borrowings and current portion of long-term debt. Accounts payable……………………………………………….. Accrued payroll………………………………………………….. Accrued income taxes………………………………………… Other current liabilities………………………………………… Total current liabilities………………………………………… Long-term debt………………………………………………… Other liabilities…………………………………………………… Total liabilities…………………………………………………… Stockholders' equity, net……………………………………… Total liabilities and stockholders' equity………………………

2.2% 5.2% 2.1% 1.1% 6.6% 17.2% 14.2% 18.4% 49.8% 50.2% 100.0%

4.2% 5.5% 2.6% 1.2% 6.7% 20.2% 13.9% 12.8% 46.9% 53.1% 100.0%



M5-20. (15 minutes) 3M COMPANY Common-size Income Statements Net sales…………………………………………………..... Operating expenses: Cost of sales……………………………………………... Selling general and administrative expenses………… Research, development and related expenses………. Operating income………………………………………….. Interest expense and income: Interest expense…………………………………………. Interest income…………………………………………… Total………………………………………………………… Income before income taxes and minority interest……… Provision for income taxes………………………………… Net income……………………………………………………

2011 $29,611 100.0% 53.0% 20.8% 5.3% 20.9%

2010 $26,662 100.0% 51.9% 20.5% 5.4% 22.2%

0.6% -0.1% 0.5% 20.4% 5.7% 14.7%

0.7% -0.1% 0.6% 21.6% 6.0% 15.6%

M5-21. (20 minutes) ($ millions) a. 2011 EWI = $4,357+ $186 x (1-.35) = $4,477.9 2011 Average total assets = ($31,616 + $30,156)/2 = $30,886 ROA = $4,477.9/$30,886 = 14.50% b. PM = $4,477.9/$29,611 = 15.12% AT = $29,611/($31,616 +$30,156)/2 = 0.959 15.12% X 0.959 = 14.50%


5-7

M5-22. (15 minutes) ($ millions) a. URBN:

TJX:

b. URBN:

Average total assets = ($1,483.7 + $1,794.3)/2 = $1,639.0 ROA = $185.2/$1,639.0= 11.30% Average total assets = ($8,281.6 + $7,971.8)/2 = $8,126.7 ROA = $1,526.5 /$8,126.7= 18.78% PM = $185.2 / $2,473.8= 7.49% AT = $2,473.8 / $1,639.0= 1.51 7.49% X 1.51 = 11.30%

TJX:

PM = $1,526.5 / $23,191.5 = 6.58% AT = $23,191.5 /$8,126.7 = 2.85 6.58% X 2.85 = 18.78%

c. URBN’s ROA is less than TJX’s. TJX operates in the value-priced segment of its industry which explains its lower PM. As is typical of value-priced retailers, TJX’s asset turnover is high – its AT is almost double that of URBN. On balance, TJX’s business model appears to be more successful in 2011 as it is able to maintain both a high AT and a reasonable PM, resulting in higher ROA.

M5-23. (20 minutes) ($ millions) a. Verizon’s current ratio for the two years presented is as follows: 2011 current ratio: $30,939 / $30,761 = 1.01 2010 current ratio: $22,348 / $30,597 = 0.73 Liquidity is increasing and in 2011, Verizon’s current ratio nudged above 1.0. We might want to know, however, whether Verizon’s current assets are concentrated in cash or relatively illiquid inventories, as well as the maturity schedule of its current liabilities. We would also like to know the median current ratio for the industry (1.41). This would help place Verizon’s numbers in perspective. continued next page



M5-23. concluded b. Verizon’s times interest earned ratio for the two years is as follows: 2011 times interest earned = $13,310 / $2,827 = 4.71 2010 times interest earned = $15,207 / $2,523 = 6.03 Verizon’s times interest earned ratio has decreased, but remains significantly higher than the industry median (3.12). 2011 debt-to-equity = $144,553 / $85,908 = 1.68 2010 debt-to-equity = $133,093 / $86,912 = 1.53 Verizon’s debt-to-equity ratio has increased, and is just slightly below the 1.76 median for companies in the telecommunications industry. Verizon’s operating cash flow to current liabilities ratio is as follows: 2008 OCFCL = $29,780 / [($30,761 + $30,597)/2] = 0.97 c. Verizon is carrying a significant amount of debt. Although its profitability and operating cash flow are fairly strong, neither is particularly high in relation to the company’s liabilities and interest costs. Verizon’s liquidity appears below that of many others in its industry, and its debt-to-equity is now just below the median for communications companies. There is some question, therefore, regarding the amount of additional debt that the company can take on. Given its significant capital expenditure requirements and its current debt load, Verizon may have to fund future capital expenditures with higher-cost equity. And, to the extent that its competitors are not as highly leveraged, this may negatively impact Verizon’s competitive position.


5-9

M5-24. (30 minutes) a. $ millions

Asset Turnover

Procter & Gamble .............................. $83,680/$135,299 = 0.62 McDonald's........................................ $27,006/$32,483 = 0.0.83 Valero Energy ................................... $125,987/ $40,202 = 3.13 b. $ millions

ART

Procter & Gamble .............................. $83,680/$6,172 = 13.56 McDonald's........................................ $27,006/$1,257 = 21.48 Valero Energy ................................... $125,987/ $6,645 = 18.96 $ millions

INVT

Procter & Gamble .............................. $42,391/$7,050 = 6.01 McDonald's........................................ $6,167/$113 = 54.58 Valero Energy ................................... $115,719/ $5,285 = 21.90 $ millions

PPET

Procter & Gamble .............................. $83,680/$20,835 = 4.02 McDonald's........................................ $27,006/$22,448 = 1.20 Valero Energy ................................... $125,987/ $23,923 = 5.27 c. For all three companies, these ratios reflect differences in their businesses, and the overall AT ratio is related to the three individual ratios as seen in Exhibit 5.8 in the chapter. Valero has the highes AT: it collects from its customers very quickly and carries small amounts of inventory relative to its cost of goods sold. It also has the lowest level of property, plant and equipment relative to its sales. Procter & Gamble’s ratios are influenced by the relative strength of its largest customer (WalMart), resulting in higher inventory levels and slower collections. In addition, P&G has a large level of intangible assets, as we will see in Chapter 8, so its PPET is relatively high, but its AT is the lowest of the three. McDonald’s inventory turnover is very quick because of its perishable nature, and its receivable turnover is higher because most customers pay in cash. The receivables result from the payments due from franchisees.



EXERCISES E5-25. (30 minutes) a. ($ millions) Target

[$2,929 + $869x(1-.35)] / $45,168 = 7.74%

Wal-Mart

[($16,387 + $2,322x(1-.35)] / $446,950 = 9.57%

b. ($ millions) Target Wal-Mart

PM = EWI / Sales

AT = Sales / Avg. Assets

[$2,929 + $869x x(1-.35)] / $69,865 = 5.00%

$69,865/$45,168 = 1.55

[($16,387 + $2,322x (1-.35)] / $446,950 = 4.00%

$446,950/$187,094 = 2.39

c. Wal-Mart’s ROA is greater than Target’s in fiscal 2011. Wal-Mart’s value pricing strategy is clearly evident in its lower PM, but this is more than offset by a higher asset turnover and, hence, Wal-Mart’s business model is somewhat more successful.

E5-26. (20 minutes) a. Case Assets Non-interest-bearing liabilities Interest-bearing liabilities Shareholders’ equity Earnings before interest and taxes Interest expense Earnings before taxes Tax expense (40%) Net income ROE ROA ROFL

A 1,000

B 1,000

C 1,000

D 1,000

E 1,000

F 1,000

0 0 1000

0 250 750

0 500 500

0 500 500

200 0 800

200 300 500

120 0 120 48 72

120 25 95 38 57

120 50 70 28 42

80 50 30 12 18

100 0 100 40 60

80 30 50 20 30

7.2% 7.2% 0.0%

7.6% 7.2% 0.4%

8.4% 7.2% 1.2%

3.6% 4.8% -1.2%

7.5% 6.0% 1.5%

6.0% 4.8% 1.2%

continued next page ©Cambridge Business Publishers, 2014 Solutions Manual, Chapter 5

5-11

M5-26. concluded b. These three cases differ only in the amount of interest-bearing liabilities used to finance the firm. As leverage increases, the return to shareholders’ equity (ROE) increases. However, the return on assets (ROA) does not change, because the ROA is independent of the way that the business was financed. c. However, financial leverage (the use of liabilities to finance the firm) does not always work in favor of shareholders. The liability holders require a fixed return (6% aftertax = 10% x (1 – 40%)), and in order for leverage to work in favor of shareholders, the overall return on assets must exceed this fixed return. In case C, the return on assets is 7.2% > 6%, so ROFL is positive. In case D, the return on assets is 4.8% < 6%, so ROFL is negative. In case E, the return on assets equals the after-tax return required on interestbearing liabilities, but the company has only non-interest-bearing liabilities. The ROA is greater than zero, so ROFL is positive. In essence, the rate required on liabilities is the ―break-even‖ ROA in order for ROFL to be positive. d. In case F, there is a mixture of liability types. Even though ROA is less than the amount needed for interest-bearing liabilities, ROFL is positive because some of company F’s liabilities require no interest. The general relationship among these variables is the following: ROE = ROA + ROA*(NL/SE) + [ROA – (1 – t)*i]*(IL/SE) where

A = Assets, NL = non-interest-bearing liabilities, IL = interest-bearing liabilities, SE = shareholders’ equity, t = tax rate, i = pre-tax interest rate on interest-bearing liabilities, ROE = return on shareholders’ equity, and ROA = return on assets.



E5-27. (20 minutes) ($ millions)

a.

CVS

Walgreen

$3,457+$588x(1-.35)=$3,839.2

$2,714+$89x(1-.35)=$2,771.9

($64,543 + $62,169)/2=$63,356.0

($27,454+$26,275 /2 = $36,864.5

$3,839.2/ $63,356.0 = 6.06%

$2771.9/ $26,864.5 = 10,32%

PM

$3,839.2/$107,100=3.58%

$2,771.9/$72,184=3.84%

AT

$107,100/$63,356.0=1.69

$72,184/$26,864.5 = 2.69

($38,051+$37,700)/2 = $37,875.5

($14,847+$14,400)/2 =$14,623.5

ROE

$3,457 / $37,875.5= 9.13%

$2,714 / $14,623.5 = 18.56%

ROFL

9.13% - 6.06% = 3.07%

18.56% - 10.32% = 8.24%

EWI Avg. Assets ROA

b.

c.

Avg. Equity

d. Walgreen’s ROE and ROA are higher than CVS’s. CVS’s PM is slightly lower than Walgreen’s, but its AT is significantly lower. The low PMs for both companies reflect the highly competitive retail pharmaceutical industry. Walgreen’s main advantage in 2011 lies in its use of financial leverage and its efficiency as reflected in its asset turnover. However, the asset turnover differences would have to be examined further, because Walgreens is (at the time of this writing) an active user of operating leases that do not show up on its balance sheet. Chapter 10 looks at this important topic.

E5-28. (30 minutes) ($ millions) a. ROE

2011: $12,942 / [($45,911+$49,430) / 2] = 27.15% 2010: $11,464 / [($49,430+$41,704) / 2] = 25.16%

b. ROA

2011: [$12,942+$41x(1-.35)] / [($71,119+$63,186) / 2] = 19.31% 2010: [$11,464+$0x(1-.35)] / [($63,186+$53,095) / 2] = 19.72%

ROFL

2011: 27.15% - 19.31% = 7.84% 2010: 25.16% - 19.72% = 5.44% continued next page


5-13

E5-28. concluded c. Net Profit Margin 2011: $12,942 / $53,999= 23.97% 2010: $11,464 / $4.,623 = 26.28% Asset Turnover

2011: $53,999 / [($71,119+$63,186) / 2] = 0.804 2010: $43,623 / [($63,186+$53,095) / 2] = 0.750

Financial Leverage

2011: [($71,119+$63,186) / 2] / [($45,911+$49,430) / 2] = 1.41 2010: [($63,186+$53,095) / 2] / [($49,430+$41,704) / 2] = 1.28

Intel’s financial leverage increased from 2010 to 2011. Even though the company’s ROA dropped a bit from 2010 to 2011, the ROE went up due to the financial leverage. Based on ROFL, leverage increased ROE by about 41% over ROA in 2011, versus a 28% increase in 2010. These increases correspond to the DuPont financial leverage measure in this case because Intel’s borrowing costs are so low. In general, there is a bias in DuPont analysis in that it tends to overstate the benefits of financial leverage. Offsetting this bias, DuPont analysis calculates the net profit margin, which is lower than PM because the numerator is net of interest costs. For comparison purposes, Intel’s PM ratios are presented below. In 2010, PM equals the NPM because Intel reported no interest expense. PM ratio

2011: [$12,942+$41x x(1-.35)] / $53,999 = 24.02% 2010: [$11,464+$0x (1-.35)] / $43,623 = 26.28%

E5-29. (30 minutes) ($ millions) a. ROE

2011: $850 / [($138+$1,477) / 2] = 105.26% 2010: $805 / [($1,477+$2,184) / 2] = 43.98% 2009: $448 / [($2,184+$1,875) / 2] = 22.07%

b. ROA

2011: [$850+$246x(1-.35)] / [($6,108+$6,451) / 2] = 16.08% 2010: [$805+$208x(1-.35)] / [($6,451+$7,173) / 2] = 13.80% 2009: [$448+$237x(1-.35)] / [($7,173+$6,972) / 2] = 8.51%

ROFL

2011: 105.26% - 16.08% = 89.18% 2010: 43.98% - 13.80% = 30.17% 2009: 22.07% - 8.51% = 13.56% continued next page



E5-29. concluded c. ROE and ROA should be slightly higher in 2007 because of the extra week. d. Net Profit Margin

2011: $850 / $10,364 = 8.20% 2010: $805 / $9,613 = 8.37% 2009: $448 / $8,632 = 5.19%

Asset Turnover

2011: $10,364 / [($6,108+$6,451) / 2] = 1.650 2010: $9,613 / [($6,451+$7,173) / 2] = 1.411 2009: $8,632 / [($7,173+$6,972) / 2] = 1.221

Financial Leverage

2011: 2010: 2009:

[($6,108+$6,451) / 2] / [($138+$1477) / 2] = 7.776 [($6,451+$7,173) / 2] / [($1,477+$2,184) / 2] = 3.721 [($7,173+$6,972) / 2] / [($2,184+$1,875) / 2] = 3.485

Limited Brands’ ROA increased slightly from 2010 to 2011 (mostly due to better asset turnover), but its ROE skyrocketed! During both 2011 and 2010, Limited Brands borrowed, paid dividends to shareholders and used cash to repurchase and retire common shares. Its debt-to-equity ratio is 43.3 at the end of fiscal year 2011, so the ROE is greater than 100%. This level of returns is exceptional for shareholders, but the company’s condition could be precarious if its performance were to deteriorate. The DuPont analysis shows that the net profit margin decreased from 2010 to 2011, but the asset turnover improved significantly. Based on ROFL, leverage increased ROA by 2.6 times in 2009 (22.07%/8.51%) while in 2011, leverage increased ROA by a factor of 6.5 (105.26%/16.08%). DuPont analysis suggests that leverage had a slightly larger impact (3.485 in 2009 and 7.776 in 2011) but the trend is the same. This is consistent with the bias in DuPont analysis in that it tends to overstate the effects of financial leverage. Offsetting this bias, DuPont analysis calculates the net profit margin, which is lower than PM because the numerator is net of interest costs. For comparison purposes, Nordstrom’s PM ratios are presented below: PM ratio

2011: [$850+$246x (1-.35)] / $10,364 = 9.74% 2010: [$805+$208x (1-.35)] / $9,613 = 9.78% 2009: [$448+$237x(1-.35)] / $8,632 = 6.97%


5-15

E5-30. (20 minutes) ($ millions) a. EWI

$984+$174x(1-.35) = $1,097.1

Avg. Equity

($7,022+$6,951)/2 = $6,986.5

Avg. Assets

($13,431+$13,912)/2 = $13,671.5

ROE

$984 / $6,986.5 = 14.08%

ROA

$1,097.1/ $13,671.5 = 8.02%

ROFL

14.08% - 8.02% = 6.06%

b. PM AT

$1,097.1 / $25,022 = 4.49% $25,022 / $13,671.5 = 1.83

c. Staples has a relatively low profit margin and an asset turnover that is close to 2.0. This ratio combination is consistent with a low-price, high-volume business model. However, compared to the retail industry, Staples is doing just a little above the median on both of these ratios. As a result its ROA is above the industry median, but its ROE is lower (reflecting a lower ROFL).

E5-31. (20 minutes) ($ millions) a.

b.

EWI

$634+$60x(1-.35) = $673.0

Avg. Equity

($2,616+$2,821)/2 = $2,718.5

Avg. Assets

($5,110+$5,198)/2 = $5,154.0

ROE

$634 / $2,718.5= 23.32%

ROA

$673.0/ $5,154.0= 13.06%

ROFL

23.32% - 13.06% = 10.26%

PM

$673.0/ $3,851 = 17.48%

AT

$3,851 / $5,154.0= 0.747

c. Intuit has a relatively high PM ratio and a low AT ratio. These numbers are consistent with the business model employed in the software industry. Contrast these numbers with those of Staples (E5-30). Intuit uses financial leverage effectively; leverage increased its ROA by a factor of 1.79 (23.32%/13.06%). ©Cambridge Business Publishers, 2014 5-16


E5-32. (30 minutes) a.

($ millions)

Current Ratio

2009

$3,223 / $7,249 = 0.445

2010

$8,886 / $8,234 = 1.079

2011

$8,573 / $13,241 = 0.647

The big differences between 2010 and 2011 can be attributed, in part, to Comcast’s acquisition of 51% of NBC Universal. At the end of 2011, Comcast has a current ratio less than 1.0 and does not appear to be very liquid. While the current ratio provides a useful point estimate of liquidity, it would be helpful to know when the cash flows from current assets will be realized and when the current liabilities will need to be paid. Although current assets remained pretty constant from 2010 to 2011, there was a big decline in cash and a big increase in receivables. And the increase in current liabilities was due to operating liabilities, not an increase in financial liabilities. b.

($ millions)

Times interest earned

Debt-to-equity

2009

$(5,106+2,348) / $2,348 = 3.17

$69,922 / $42,811 = 1.63

2010

$(6,104+2,156) / $2,156 = 3.83

$74,100 / $44,434 = 1.67

2011

$(8,207+2,505) / $2,505 = 4.28

$110,163 / $47,655 = 2.31

The times interest earned ratio is improving, probably due to increasing profits and the favorable interest rate environment in these years. Comcast is able to cover its interest expense by a margin that is above the median for the industry.. Comcast’s debt-to-equity ratio is relatively high and growing at 2.31, which is above the industry median. c. Comcast’s current ratio is significantly lower than the industry median (0.647 versus 1.41) and bears watching. Further examination of the cash flows from operating activities could be useful. At present, Comcast is able to cover its interest expense by a margin that exceeds the median for the industry (4.30 versus 3.12). Comcast’s debt-to-equity ratio is relatively high and growing at 2.31, which is above the industry median, 1.76. d. Comcast has a relatively high level of debt and relatively low liquidity. However, its increasing profitability and interest coverage that is above the industry median provide some reassurance that it will be able to service its liabilities and continue to make further investments.


5-17

E5-33. (30 minutes) a.

($ millions)

Current Ratio

OCFCL

2009

€43,634 / €36,486 = 1.196

€6,246/[(€42,451+€36,486)/2] = 0.158

2010

€49,648 / €40,591 = 1.223

€9,447/[(€36,486+€40,591)/2] = 0.245

2011

€52,813 / €43,560 = 1.212

€7,767/[(€40,591+€43,560)/2] = 0.185

Siemens has a current ratio that is above 1.0 and has been steady over these years. However, its OCFCL ratio improved in 2011 and 2010 relative to 2009. While the current ratio provides a useful point estimate of liquidity, the OCFCL ratio suggests that operations are not generating sufficient net cash flow to cover short-term obligations, but it would be useful to also get a sense of the volume of resource flows relative to the current liabilities. b.

($ millions)

Times interest earned

Debt-to-equity

2009

€(3,891+2,213) / €2,213 = 2.76

€67,639 / €27,287 = 2.48

2010

€(5,811+1,890) / €1,890 = 4.07

€73,731 / €29,096 = 2.53

2011

€(9,242+1,716) / €1,716 = 6.39

€72,087 / €32,156 = 2.24

The times interest earned ratio is increasing and at acceptable levels, but is increasing due to lower interest costs and higher earnings. Siemens’ debt-to-equity ratio is quite high between 2.25 and 2.5. c. It’s always a good idea to look into the numbers that make up the ratios before coming to conclusions. For instance, Siemens’ current liabilities include about €12.5 billion in unearned revenue, representing more than a quarter of its current liabilities. In the normal course of business, this liability doesn’t need to be paid – rather Siemens must provide the agreed-upon services and products to the customers. It’s not easy to place Siemens into one of the industry groups in Exhibit 5.13, but its DE ratio appears to be higher than any industry median except tobacco and utilities. However, its TIE appears to be in a satisfactory range. And, the company’s size and diversified businesses give it a stability that can reassure lenders.



E5-34. (30 minutes) ($ millions) a.

b.

c.

EWI

$833+$74x(1-.35) = $881.1

Avg. Equity

($2,755+$4,080)/2 = $3,417.5

Avg. Assets

($7,422+$7,065)/2 = $7,243.5

ROE

$833 / $3,417.5= 24.37%

ROA

$881.1/ $7,243.5= 12.16%

ROFL

24.37% - 12.16% = 12.21%

PM

$881.1/ $14,549 = 6.06%

AT

$14,549 / $7,243.5= 2.009

GPM

$5,274 / $14,549 = 36.25%

INVT

$9,275 / [($1,615 + $1,620)/2] = 5.734

d. The Gap showed strong performance in the year ended January 28.2012 (hereafter, 2011), though not as strong as 2010. Its ROA was 12.16%, which is high for the retail industry. ROE was over 22% indicating the effective use of financial leverage. Interest costs were low, suggesting that most of The Gap’s debt is from operating liabilities (accounts payable and accrued expenses). Its profit margin and asset turnover ratios place The Gap in a strong position for this industry. The GPM and INVT ratios are two important performance measures for retail companies such as The Gap. GPM measures the ability of the firm to sell its merchandise at reasonable margins while INVT provides evidence on inventory management and the popularity of its product line. Both measures are healthy for a retailer in the economy of 2011.


5-19

E5-35. (20 minutes) a, b. THE GAP, INC. Common-size and Pro-forma Income Statements 2012 Pro forma 2011 2010 Net Sales…………………………………. 100.0% 100.0% $15,000 Cost of goods sold and occupancy costs……………………………………... 63.8% 59.8% 9,600 Gross profit……………………………….. 36.2% 40.2% 5,400 Operating expenses……………………... 26.4% 26.7% 3,900 Operating income………………………… 9.9% 13.4% 1,500 Interest income…………………………… 0.5% -0.1% -5 Interest expense…………………………. 0.0% 0.0% 74 Earnings from continuing operations before income taxes………………….... 9.4% 13.5% 1,431 Income taxes……………………………... 3.7% 5.3% 558 Net earnings………………………..……. 5.7% 8.2% $ 873 c. The Gap’s pro forma statements are based on a set of assumptions that determine the relationship between various expense items and sales revenue. The accuracy of the projection depends on the reliability of these estimates, which depends on management’s ability to maintain a stable GPM ratio, maintain INVT ratio, and control operating expense ETS ratios.



PROBLEMS P5-36. (45 minutes) ($ millions)

a.

Nike

Adidas

EWI

$2,223+$33x(1-.35) = $2,244.5

€670 + €115x(1-.30) = €750.5

Avg. Equity

($10,381+$9,843)/2 = $10,112.0

(€5,331+€4,623)/2 = €4,977.0

Avg. Assets

($15,465+$14,998)/2=$15,231.5

(€11,380+€10,618)/2 = €10,999.0

ROE

$2,223/ $10,112.0= 21.98%

€670/€4,977.0=13.46%

ROA

$2,244.5/ $15,231.5= 14.74%

€750.5/€10,999.0=6.82%

ROFL

21.98% - 14.73% = 7.25%

13.46% - 6.82% = 6.64%

Nike’s performance on both measures of profitability exceeded that of Adidas. We can examine possible reasons for that difference by looking at the ratios below. b.

PM

$2,244.5/ $24,128 = 9.30%

€750.5/€13,344 = 5.62%

AT

$24,128 / $15,231.5= 1.584

€13,344 /€10,999.0= 1.213

Nike’s PM ratio is significantly higher than Adidas’s, as is its AT ratio. So, Nike’s higher ROA appears to be driven by both superior margins and more efficient use of assets. c.

GPM

$10,471 / $24,128 = 43.40%

€6,344/€13,344 = 47.54%

Operating ETS

$7,431 / $24,128 = 30.80%

€5,333/€13,344 = 39.97%

Adidas reports a higher GPM ratio than Nike by about 4%. However, that is more than offset by higher operating expenses as a percentage of sales. d.

ART

$24,128 /$[(3,280+3,138)/2]=7.519

€13,344 /€[(1,707+1,667)/2]=7.910

INVT

$13,657/$[(3,350+2,715)/2]=4.504

€7,000/€[(2,482+2,119)/2]=3.043

PPET

$24,128 /$[(2,279+2,115)/2]=10.982

€13,344 /€[(963+855)/2]=14.680

Nike’s INVT is significantly higher than Adidas’s, suggesting that Nike may be managing inventory more efficiently. Adidas has a higher PPET ratio, though both companies’ ratios are high. These are consistent with a business model that outsources most of the production. continued next page


5-21

P5-36. concluded e. The two companies’ fiscal years overlap by seven months. Nike’s income statement includes January through May 2012 while Adidas’ statements cover January through May 2011. (Both cover June through December 2011.) Economic conditions were not materially different in 2012 than 2011, so the comparisons involving income statement accounts shouldn’t be affected too much. However, companies that experience seasonality will have balance sheets that look different at different points in time. For instance, a company might have lower inventory levels just after a busy season, and choosing that point for the end of its fiscal year would produce a higher value for INVT than a fiscal year just prior to its busy season. f. Normally, we would want to identify any major differences in the valuation of assets and the measurement of income between these two companies. For example, some assets are more likely to be valued at current value (rather than historical cost) under IFRS reporting. Such a difference would affect ratios such as ROA, AT, INVT and PPET.

P5-37. (20 minutes) ($ millions) a. Current Ratio Quick Ratio

Nike

Adidas

2012: $11,531/$3,865 = 2.983

2011: €6,435/€4,281= 1.503

2011: $11,297/$3,958 = 2.854

2010: €5,880/€3,908= 1.505

2012: $(2,317+1,440+3,280)/$3,865=1.821

2011: €(906+465+1,707)/€4,281=0.719

2011: $(1,955+2,583+3,138)/$3,865=1.939

2010: €(1,156+233+1,667)/€3,908= 0.782

Nike is more liquid than Adidas. Its current ratio is just under 3.0 and its quick ratio is almost 2.0. In fact, Nike’s quick ratio is higher than Adidas’s current ratio. b. TIE Debt-to-Equity

2012: ($2,983+$33)/$33=91.39

2011: (€927+€115)/€115=9.06

2011: ($2,844+$34)/$34=84.65

2010: (€806+€113)/€113= 8.13

2012: $5,084/$10381=0.490

2011: €6,049/€5,331=1.135

2011: $5,155/$9,843=0.524

2010: €5,995/€4,623=1.297

Nike’s debt-to-equity ratio is very low and decreased slightly in 2012. Adidas’s debt-toequity ratio is higher, but also went down in 2011. Both companies reported increasing TIE ratios. c.

Adidas relies on significantly greater amounts of debt financing than does Nike. This is evident by the debt-to-equity ratio. In addition, the TIE ratio for Nike is 9 times higher than for Adidas. Although Adidas’s TIE ratio is not too low, Nike’s small amount of interest expense produces a very high TIE. Neither company should have difficulty meeting its debt obligations, but Adidas may not be able to borrow as much in the future (if needed).



P5-38. (45 minutes) ($ millions) a.

Home Depot

Lowe’s

EWI

$3,883+$606x(1-.35) = $4,276.9

$1,839+$379x(1-.35) = $2,085.4

Avg. Equity

($17,898+$18,889)/2= $18,393.5

($16,533+$18,112)/2= $17,322.5

Avg. Assets

($40,518+$40,125)/2=$40,321.5

($33,559+$33,699)/2=$33,629

ROE

$3,883/ $18,393.5= 21.11%

$1,839/ $17,322.5= 10.62%

ROA

$4,276.9/ $40,321.5= 10.61%

$2,085.4/ $33,629= 6.20%

ROFL

21.11% - 10.61% = 10.50%

10.62% - 6.20% = 4.42%

In 2011, Home Depot’s profitability exceeded that of Lowe’s, both in return to shareholders and in return on assets. Home Depot also had a larger proportional effect from the use of leverage. b.

PM

$4,276.9/ $70,395 = 6.08%

$2,085.4/ $50,208 = 4.15%

AT

$70,395 / $40,321.5= 1.746

$50,208 / $33,629= 1.493

Home Depot has a higher PM ratio, so it makes more money for every dollar of sales, and it also generates more sales for every dollar of resources, suggesting that it is managing assets more efficiently. c.

GPM

$24,262 / $70,395 = 34.47%

$17,350 / $50,208 = 34.56%

Operating ETS

$17,601 / $70,395 = 25.00%

$14,073 / $50,208 = 28.03%

These two companies have almost identical gross profit margins. Lowe’s GPM ratio is slightly higher than that of the Home Depot, but its operating ETS ratio is higher. Overall, Home Depot performed slightly better with respect to these two profitability measures. d.

ART

$70,395 /$[(1,245+1,085)/2]=60.43

$50,208 /0 = N/A

INVT

$46,133/$[(10,325+10,625)/2]=4.40

$32,858/$[(8,355+8,321)/2]=3.941

PPET

$70,395 /$[(24,448+25,060)/2]=2.844

$50,208 /$[(21,970+22,089)/2]=2.279

Lowe’s reports no accounts receivable and Home Depot reports very small amounts of receivables. Neither company relies on customer credit to generate sales, so the ART ratio is not very informative. More important is the INVT ratio. Home Depot’s INVT is more than 10% higher than Lowe’s ratio. The same is true for the PPET ratio. These differences are consistent with the difference in the AT ratios noted earlier. Overall, the numbers suggest that Home Depot is managing inventories and PPE assets more efficiently. e. Overall, It appears that Home Depot performed better than Lowe’s in 2011. Its ratio values are either equal to or better than Lowe’s in almost every category. Over this time period, Home Depot’s stock price increased substantially (on the order of 30%), while Lowe’s stock price was relatively unchanged. ©Cambridge Business Publishers, 2014 Solutions Manual, Chapter 5

5-23


Current Ratio

Quick Ratio

Home Depot

Lowe’s

2011: $14,520/$9,376 = 1.549

2011: $10,072/$7,891 = 1.276

2010: $13,479/$10,122 = 1.332

2010: $9,967/$7,119 = 1.400

2011: $(1,987+1,245)/$9,379=0.345

2011: $(1,014+286)/$7,891=0.165

2010: $(545+1,085)/$10,122=0.161

2010: $(652+471)/$7,119=0.158

The current ratios of these two companies are very close in 2010, but diverged in 2011, with Home Depot improving and Lowe’s declining. Both are above one.. Quick ratios are very low due to the lack of receivables and low cash balances. Both companies rely on operating cash flow to cover liquidity needs. Given the lack of receivables, the INVT ratio becomes doubly important (see P5-38). Failure to turn inventories quickly would result in lower operating cash flow and liquidity problems. Hence, both companies emphasize inventory management. b.

TIE

Debt-to-Equity

2011: ($6,068+$606)/$606=11.013

2011: ($2,906+$379)/$379=8.668

2010: ($5,273+$530)/$530=10.949

2010: ($3,228+$340)/$340=10.494

2011: $22,620/$17,898=1.264

2011: $17,026/$16,533=1.030

2010: $21,236/$18,889=1.124

2010: $15,587/$18,112=0.861

For both companies, the debt-to-equity ratio increased from 2010 to 2011indicating more reliance on debt financing. Despite this trend, Home Depot’s TIE ratios increased. Lowe’s TIE decreased due to declining earnings and increased interest expense. c. The Home Depot utilizes more debt financing than does Lowe’s and is slightly higher than the median retail firm. This results in a higher ROFL (see P5-38), as well as higher debt-to-equity. Both firms have TIE ratios that are above the median for the retail industry.



P5-40.A (20 minutes) ($ millions) a.

Home Depot

Lowe’s

NOPAT

$3,883+$(606 - 13)x(1 - .35) = $4,268.45

$1,839+$(379 - 8)x(1 - .35) = $2,080.15

NOA

2011: $(40,518 - 135) - $(22,620 – 30 10,758) = $28,551

2011: $(33,559 - 286-504) - $(17,026 – 592 - 7,035) = $23,370

2010: $(40,125-139) - $(21,236 - 1,042 8,707) = $28,499

2010: $(33,699 - 471-1,008) - $(15,587 – 36 - 6,537) = $23,206

Avg. NOA

($28,551 + $28,499)/2 = $28,525.0

($23,370 + $23,206)/2 = $23,288.0

b.

RNOA

$4,268.45/$28,252.0 = 14,96%

$2,080.15/$23,288.0 = 8.93%

c.

NOPM

$4,268.45/$70,395 = 6.06%

$2,080.15/$50,208 = 4.14%

NOAT

$70,395/$28,525 = 2.468

$50,208/$23,288 = 2.156

d. Lowe’s reports a lower RNOA than does The Home Depot, and the pattern in the operating results parallels that in the total-firm results in P5-38. This is consistent with the ROA numbers computed in P5-38 (ROA=10.61% for Home Depot and 6.20% for Lowe’s). Overall, we would expect operating companies to have higher RNOA than ROA, because their core business is the operations of the company, not investing in financial assets. And, if management seeks to earn a favorable return for shareholders, they must expect a higher return on their operations than they have to pay for borrowed funds.


5-25


2011

2010

EWI

$3,804+$348x(1-.35) = $4,030.2

$3,338+$354x(1-.35) = $3,568.1

Avg. Assets

($34,701+$33,597)/2=$34,149.0

($33,597+$31,882)/2=$32,740.0

ROA

$4,030.2/ $34,149.0= 11.80%

$3,568.1/ $32,740.0= 10.90%

PM

$4,030.2/ $53,105 = 7.59%

$3,568.1/ $49,545 = 7.20%

AT

$53,105 / $34,149.0= 1.555

$49,545 / $32,740.0= 1.513

UPS’ return on assets appears healthy in both years. Although AT increased slightly in 2011, the primary cause of the increase in ROA was an increase in PM from 7.20% to 7.59%. b.

Compensation ETS

$27,575/$53,105 = 51.93%

$26,557/$49,545 = 53.60%

The largest single expense on UPS’s income statement is compensation. Reducing this expense by almost 2 percentage points (of sales) caused UPS’s profit margin to increase in 2011. c.

d.

Avg. Equity

($7,108+$8,047)/2= $7,577.5

($8,047+$7,696)/2= $7,871.5

ROE

$3,804/ $7,577.5 = 50.20%

$3,338/ $7,871.5 = 42.41%

ROFL

50.20% - 11.80% = 38.40%

42.41% - 10.90% = 31.51%

UPS relies heavily on debt financing. In 2011 and 2010, when ROA was at an acceptable level, ROFL produced an ROE between 3 and 4 times as large as ROA.




2011

2010

Current Ratio

$12,284/$6,514 = 1.886

$11,569/$5,902 = 1.960

Quick Ratio

$(3,034+1,241+6,246)/$6,514=1.615

$(3,370+711+5,627)/$5,902=1.645

UPS current and quick ratios decreased slightly in 2011. The current ratio is close to 2.0 and the quick ratio is only slightly lower than the current ratio because UPS does not carry inventory balances. b.

TIE

($5,776+$348)/$348=17.598

($5,290+$354)/$354=15.944

Debt-to-Equity

$27,593/$7,108=3.882

$25,550/$8,047=3.175

The TIE ratio increased dramatically in 2011 due to the increase in earnings. However, the debt-to-equity ratio also increased, indicating an increased dependence on debt financing. c. UPS relies heavily on liability financing. The company’s current ratio and quick ratio are in line with the medians of the Business Services industry but, being a capital-intensive business, their debt-to-equity ratio is significantly higher than the median. Although the company appears liquid, its ability to meet its obligations depends heavily on operating cash flow. The high (and increasing) debt-to-equity ratio suggests that UPS may have difficulty borrowing additional funds if needed. P5-43.A (30 minutes) ($ millions) a.

United Parcel Service (UPS)

NOPAT

$3,804+$(348-44)x(1-.35) = $4001.6

NOA

2011: $(34,701-1,241-303) - $(27,593-33-11,095) = $16,692 2010: $(33,597-711-458) - $(25,550-355-10491) = $17,724

Avg. NOA

($16,692 + $17,724)/2 = $17,208

b.

RNOA

$4001.6/$17,208 = 23.25%

c.

NOPM

$4001.6/$53,105 = 7.54%

NOAT

$53,105/$17,208 = 3.086

d. UPS invests only small amounts in non-operating assets (less than 5% of total assets). So, when UPS invests borrowed funds in its operations, it earns a return above 20%, at least in 2011. Because its borrowing costs are significantly less than 20%, the financial leverage works in favor of the shareholders.


5-27

P5-44.B (45 minutes) a. UNITED PARCEL SERVICE, INC. Income Statements 2011 Actual $53,105 27,575 19,450 47,025 6,080 44 (348) 5,776 1,972 $ 3,804

($ millions) Revenue……………………………………………… Compensation and benefits……………………….. Other………………………………………………….. Operating profit……………………………………… Investment income………………………………….. Interest expense……………………………………… Income before income taxes……………………….. Income taxes………………………………………….. Net income……………………………………………..

2012 Pro forma $57,000 29,597 20,877 50,474 6,526 44 (348) 6,222 2,178 $40,449

UNITED PARCEL SERVICE, INC. Balance Sheets ($ millions) Cash and equivalents…………………………………. Marketable securities………………………………….. Accounts receivable, net……………………………… Deferred income taxes………………………………… Other current assets………………………………….. Total current assets…………………………………… Property, plant and equipment………………………. Goodwill………………………………………………… Intangible assets……………………………………….. Non-current investments and restricted cash ……… Other assets…………………………….……………… Total assets……………………….…………………….

$

Current maturities of long-term debt………………… Accounts payable………………………………………. Accrued wages and withholdings……………………. Self-insurance reserves ………………………………. Other current liabilities………………………………… Total current liabilities………………………………… Long-term debt………………………….……………… Pension and postretirement obligation……………… Deferred taxes liabilities……………………………….. Other noncurrent liabilities…………………………….. Total liabilities…………………………………………... Shareowners' equity…………………………………… Total liabilities and shareowners' equity……………..

$

$

$

2011 Actual 3,034 1,241 6,246 611 1,152 12,284 17,621 2,101 585 303 1,807 34,701

2012 Pro forma $ 4,055 1,241 6,704 656 1,236 13,892 18,913 2,255 628 303 1,940 $37,931

33 2,300 1,843 781 1,557 6,514 11,095 5,505 1,900 2,579 27,593 7,108 34,701

$ 33 2,469 1,978 838 1,671 6,989 11,095 5,909 2,039 2,768 28,801 9,130 $37,931

continued next page



P5-44.B concluded b. UNITED PARCEL SERVICE, INC. Cash Flow Statement ($ millions) Operations: Net income…………………………………………………. Adjustments: Depreciation and amortization…………………..……... Less change in operating assets: Accounts receivable……………………………………… Deferred income taxes…………………………………… Other current assets……………………………………… Plus change in operating liabilities: Accounts payable………………………………………… Accrued wages and withholdings…………………….. Self-insurance reserves Other current liabilities………………………………….. Accumulated postretirement benefit obligation….…. Deferred taxes and other liabilities……………………. Other noncurrent liabilities Cash flow from operations………………………………

2012 Pro forma $4,044 1,995 (458) (45) (84) 169 135 57 114 404 139 189 6,659

Investing activities: Investment in property, plant and equipment………. Investment in goodwill and intangible assets………. Investment in other noncurrent assets Cash used for investing activities……………………...

(3,287) (197) (133) (3,617)

Financing activities: Dividends paid…………………………………………….. Cash used for financing activities……………………...

(2,022) (2,022)

Net increase in cash……………………………………… Cash, December 31, 2011……………………………….. Pro forma cash, December 31, 2012…………………..

1,020 3,034 1 4,054

1

Off by $1 from the pro forma balance sheet due to rounding.


5-29

P5-45. (20 minutes) a. Avg. total liabilities

($27,593+$25,550)/2 = $26,571.5

Net interest rate (NIR)

$348x(1-.35) / 26,571.5 = 0.85%

Spread (ROA – NIR)

11.80%-0.85% = 10.95%

b. ROFL

{[26,571.5]/[7,577.5]}x10.96% = 38.4%

c. An ROFL of 38.4% is equal to the difference between ROE and ROA (50.2%-11.8%) as calculated in P5-41. This suggests that 76% of UPS’s ROE was generated by the effective use of financial leverage.

P5-46. (45 minutes) a, b. A summary of the ratios for these five companies appears in the following table. Calculations are provided below for each company. ABT

BMY

JNJ

GSK

PFE

PM

13.06%

25.20%

15.44%

22.07%

16.53%

GPM

60.00%

73.65%

68.69%

73.23%

77.63%

R&D ETS

10.63%

18.07%

11.61%

14.64%

13.51%

SG&A ETS

32.84%

24.29%

32.25%

32.23%

28.87%

c. What is perhaps most remarkable is how similar these five companies are. For example, the SG&A ETS ratio ranges between 24% and 33%, with three of the five AT 32%. GPM ranges from a low of 60% (ABT) to 78% (PFE), but the other three firms are between 69% and 74%. This suggests that the business models employed by these companies are very similar. The PM ratio shows a fairly wide variation, ranging from a low of 13% (ABT) to 25% (BMY). Interestingly, ABT appears to be the least profitable, with the lowest PM and GPM, yet it spends the least on R&D. At the same time, BMY has the highest PM and spends the most on R&D. continued next page



P5-46. concluded Calculations of ratios for each firm follow: ($ millions) PM GPM

Abbott Laboratories (ABT) $4,728 + $530 x(1-.35) / $38,851 = 13.06% ($38,851 - $15,541) / $38,851 = 60.00%

R&D ETS

$4,129 / $38,851 = 10.63%

SG&A ETS

$12,757 / $38,851 = 32.84%

($ millions)

Bristol-Myers Squibb (BMY)

PM GPM

$5,260 + $145 x(1-.35) / $21,244 = 25.20% ($21,244 - $5,598) / $21,244 = 73.65%

R&D ETS

$3,839 / $21,244 = 18.07%

SG&A ETS

$5,160 / $21,244 = 324.29%

($ millions)

Johnson & Johnson (JNJ)

PM GPM

$9,672 + $571 x(1-.35) / $65,030 = 15.44% ($65,030 - $20,360) / $65,030 = 68.69%

R&D ETS

$7,548 / $65,030 = 11.61%

SG&A ETS

$20,969 / $65,030 = 32.25%

($ millions)

GlaxoSmithKline (GSK)

PM GPM

£5,458+ £799x(1-..265) / £27,387= 22.07% (£27,387- £7,332) / £27,387= 73.23%

R&D ETS

£4,009/ £27,387= 14.64%

SG&A ETS

£8,826/ £27,387= 32.23%

($ millions)

Pfizer (PFE)

PM GPM

$10,051 + $1,681 x(1-.35) / $67,425 = 16.53% ($67,425- $15,085) / $67,425= 77.63%

R&D ETS

$9,112 / $67,425= 13.51%

SG&A ETS

$19,468 / $67,425= 28.87% ©Cambridge Business Publishers, 2014

Solutions Manual, Chapter 5

5-31

P5-47. (45 minutes) ROA PM AT ART INVT PPET GPM

Best Buy 0.64% 0.22% 3.00 21.87 6.56 13.90 24.8%

Kroger 3.74% 0.97% 3.85 100.75 14.19 6.32 20.9%

Nordstrom 9.64% 7.07% 1.36 5.36 6.20 4.54 39.4%

Staples 8.03% 4.38% 1.83 12.50 7.63 11.84 26.9%

Walgreens 10.32% 3.84% 2.69 29.18 6.70 6.36 28.4%

Nordstrom (JWN) has the highest PM (7.07%) and the highest GPM (39.4%). It also has the lowest AT (1.36), ART (5.36), INVT (6.20) and PPET (4.54). JWN clearly achieves its ROA by emphasizing high profit margin. Kroger (KR) is at the opposite extreme from Nordstrom, emphasizing efficient asset management. Kroger has the highest AT and INVT. Inventory management is critical for a retail grocer. It also has very few receivables, so its ART is very high (100.75 times). Fiscal year 2011 was not a successful one for Best Buy (BBY), with very low PM. Retail companies lease much of their store space. As a result, the PPET ratio depends on how these store leases are reported in the balance sheet. Lease accounting is discussed in Chapter 10. Calculations follow for each firm ($ millions): Best Buy (BBY) EWI

$22 + $134 x (1-.35) = $109.10

ROA

$109.1/ $16,927 = 0.64%

PM

$109.1/ $50,705 = 0.22%

AT

$50,705 / $16,927 = 3.00

ART

$50,705 $2,318 = 21.87

INVT

$38,113 / $5,814 = 6.56

PPET

$50,705 / $3,647 = 13.90

GPM

($50,705 - $38,113) / $50,705 = 24,8%

EWI

Kroger (KR) $596 + $435 x (1-.35) = $878.75

ROA

$878.75/ $23,491 = 3.74%

PM

$878.75/ $90,374 = 0.97%

AT

$90,374 / $23,491 = 3.85

ART

$90,374 / $897 = 100.75

INVT

$71,494 / $5,040 = 14.19

PPET

$90,374 / $14,306 = 6.32

GPM

($90,374 - $71,494) / $90,374 = 20.9% continued next page



P5-47. concluded

EWI

Nordstrom (JWN) $683 + $132 x (1-.35) = $768.80

ROA

$768.80/ $7,977 = 9.64%

PM

$768.80/ $10,877 = 7.07%

AT

$10,877/ $7,977 = 1.36

ART

$10,877/ $2,030 = 5.36

INVT

$6,592 / $1,063 = 6.20

PPET

$10,877/ $2,394 = 4.54

GPM

($10,877- $6,592) / $10,877= 39.4%

EWI

Staples (SPLS) $984 + $174 x (1-.35) = $1,097.10

ROA

$1,097.10/ $13,671 = 8.03%

PM

$1,097.10/ $25,022 = 4.38%

AT

$25,022 / $13,671 = 1.83

ART

$25,022 / $2,002 = 12.50

INVT

$18,280 / $2,396 = 7.63

PPET

$25,022 / $2,114 = 11.84

GPM

($25,022 - $18,280) / $25,022 = 26.9%

EWI

Walgreen (WAG) $2,714 + $89 x (1-.35) = $2,771.85

ROA

$2,771.85/ $26,865 = 10.32%

PM

$2,771.85/ $72,184 = 3.84%

AT

$72,184 / $26,865 = 2.69

ART

$72,184 / $2,474 = 29.18

INVT

$51,692 / $7,711 = 6.70

PPET

$72,184 / $11,355 = 6.36

GPM

($72,184 - $51,692) / $72,184 = 28.4%


5-33

CASES and PROJECTS C5-48. (30 minutes) a. Raising prices and/or reducing manufacturing costs are not necessarily independent solutions and are likely related to other factors. The effect of a price increase on gross profit is a function of the demand curve for the company’s product. If the demand curve is relatively elastic, a price increase will likely significantly reduce demand, thereby decreasing, rather than increasing, gross profit (an example is a 10% increase in price and a 20% decrease in demand). A price increase will have a more desired effect if the demand curve is relatively inelastic (a 10% price increase with a 3% decrease in demand). Cutting manufacturing costs will positively affect gross profit (via reduction of COGS) if the more inexpensively made product is not perceived to be of lesser quality, thereby reducing demand. b. Raising prices is difficult in competitive markets. As the number of product substitutes increases, companies are less able to raise prices. Rather, they must be able to effectively differentiate their products in some manner in order to reduce consumers’ substitution. This can be accomplished, for example, by product design and/or advertising. These efforts, however, likely entail additional cost, and, while gross profit might be increased as a result, SG&A expense may also increase with little effect on the bottom line. Manufacturing costs consist of raw materials, labor and overhead. Each can be targeted for cost reduction. A reduction of raw materials costs generally implies some reduction in product quality, but not necessarily. It might be the case that the product contains features that are not in demand by consumers. Eliminating those features will reduce product costs with little effect on selling price. Similarly, companies can utilize less expensive sources of labor (off-shore production, for example), that can significantly reduce product costs and increase gross profit provided that product quality is maintained. Finally, manufacturing overhead can be reduced by more efficient production. Wages and depreciation expense are two significant components of manufacturing overhead. These are largely fixed costs, and the per-unit product cost can often be reduced by increasing capacity utilization of manufacturing facilities (provided, of course, that the increased inventory produced can be sold). The bottom line is that increasing gross profit is a difficult process than can only be accomplished by effective management and innovation.



C5-49. (30 minutes) a. Working capital management is an important component of the management of a company. By reducing the level of working capital, companies reduce the costs of carrying excess assets. This can have a significantly positive effect on financial performance. Some common approaches to reducing working capital via reductions in receivables and inventories, and increases in payables, include the following: 

Reduce receivables  Constricting the payment terms on product sales  Better credit policies that limit credit to high-risk customers  Better reporting to identify delinquencies  Automated notices to delinquent accounts  Increased collection efforts  Prepayment of orders or billing as milestones are reached  Use of electronic (ACH) payment  Use of third-party guarantors, including bank letters of credit



Reduce inventories  Reduce inventory costs via less costly components (of equal quality), produce with lower wage rates, eliminate product features (costs) not valued by customers  Outsource production to reduce product cost and/or inventories the company must carry on its balance sheet  Reduce raw materials inventories via just-in-time deliveries  Eliminate bottlenecks in manufacturing to reduce work-in-process inventories  Reduce finished goods inventories by producing to order rather than producing to estimated demand



Increase payables  Extend the time for payment of low or no-cost payables—so long as the relationship with suppliers is not harmed)

continued next page


5-35

C5-49. concluded b. The terms of payment that a company offers to its customers is a marketing tool, similar to product price and advertising programs. Many companies promote payment terms separately from other promotions (no payment for six months or interest-free financing, for example). As companies restrict credit terms, the level of receivables will likely decrease, thereby reducing working capital. The restriction of credit terms may also have the undesirable effect of reducing demand for the company’s products. The cost of credit terms must be weighed against the benefits, and credit terms must be managed with care so as to optimize costs rather than minimize them. Credit policy is as much art as it is science. Likewise, the depth and breadth of the inventories that companies carry impact customer perception. At the extreme, inventory stock-outs result in not only the loss of current sales, but also the potential loss of future sales as customers are introduced to competitors and may develop an impression of the company as ―thinly stocked.‖ Inventories are costly to maintain, as they must be financed, insured, stocked, moved, and so forth. Reduction in inventory levels can reduce these costs. On the other hand, the amount and type of inventories carried is a marketing decision and must be managed with care so as to optimize the level inventories, not necessarily to minimize them. One company’s account payable is another’s account receivable. So, just as one company seeks to extend the time of payment, so as to reduce its working capital, so does the other company seek to reduce the average collection period so as to accomplish the same objective. Capable, dependable suppliers are a valuable resource for the company, and the supplier relation must be handled with care. All companies take as long to pay their accounts payable as the supplier allows in its credit terms. Extending the payment terms beyond that point begins to negatively impact the supplier relation, ultimately resulting in the loss of the supplier. The supplier relation must be managed with care so as to optimize the terms of payment, rather than necessarily to minimize them.



C5-50. (30 minutes) a. The list of parties that are affected by schemes to manage earnings is often much broader than first thought. It includes the following affected parties: 1. employees above and below the level at which the scheme is implemented 2. stockholders and elected members of the board of directors 3. creditors of the company (suppliers and lenders) and their employees, stockholders, and boards of directors 4. competitors of the company 5. the company’s independent auditors 6. regulators and taxing authorities b. Managers often believe that earnings management activities will be short-lived, and will be curtailed once its operations ―turn around.‖ Often, this does not prove to be the case. Interviews with managers and employees who have engaged in these activities often reveal that they started rather innocuously (just managing earnings to ―make the numbers‖ in one quarter), but, quickly, earnings management became a slippery slope. Ultimately, the parties the company was trying to protect (shareholders, for example) are hurt more than they would have been had the company reported its results correctly, exposing problems early so that corrective action could be taken (possibly by removing managers) to protect the broader stakeholders in the company. c. Company managers are just ordinary people. They desire to improve their compensation, which is often linked to financial performance. Managers may act to maximize their current compensation at the expense of long-term growth in shareholder value. The reduction in the average employment period at all levels of the company has exacerbated the problem. d. Unfortunately, the separation of ownership and control often leads to less informed shareholders who are unable to effectively monitor the actions of the managers they have hired. To the extent that compensation programs are linked to financial measures, managers can use the flexibility given to them under GAAP to their benefit, even without violating GAAP per se. These actions can only be uncovered by effective auditing and enforced by an effective audit committee of the board. Corporate governance has grown considerably in importance following the accounting scandals of the early 2000s. The Sarbanes-Oxley Act mandates new levels of corporate governance. The stock market and the courts are helping to enforce this mandate.


5-37

Fa4e Sm Ch05

Recommend Documents