Chapter 15 – Lecture Notes
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2. A related measure called the average sale
period is computed as shown.
a. It measures the number of days being
taken, on average, to sell the entire
inventory one time.
b. Norton Corporation’s average sale
period of 28.67 days is computed as
shown.
Helpful Hint: Ask students to intuitively answer what
happens to the turnover ratios when accounts
receivable or inventory increase. Stress that
understanding the ratio is preferred to memorizing the
formula.
iii. Operating cycle
1. The operating cycle is calculated as shown.
a. It measures the elapsed time from
when inventory is received from
suppliers to when cash is received
from customers.
b. Norton Corporation’s operating cycle
is 42.34 days.
iv. Total asset turnover
1. The total asset turnover is calculated as
shown.
a. It measures how efficiently a
company’s assets are being used to
generate sales. This ratio expands
beyond current assets to include
noncurrent assets.
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b. Norton Corporation’s total asset
turnover for this year is 1.53.
VI. Ratio analysis – debt management
Learning Objective 4: Compute and interpret financial
ratios that managers use for debt management
purposes.
A. Managers compute a variety of ratios for debt
management purposes. The information shown for
Norton Corporation will be used to calculate its debt
management ratios.
i. Times interest earned ratio
1. The times interest earned ratio is calculated
as shown.
a. It is the most common measure of a
company’s ability to protect its long–
term creditors.
b. It is based on earnings before interest
and income taxes because that is the
amount of earnings that is available for
making interest payments.
c. A ratio of less than 1 is inadequate.
2. Norton Corporation’s times interest earned
ratio of 11.5 times is computed as shown.
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ii. Debt–to-equity ratio
1. The debt-to-equity ratio is computed as
shown.
a. It indicates the relative proportions of
debt and equity on a company’s
balance sheet.
b. Creditors and stockholders have
different views when defining the
optimal debt-to-equity ratio.
(1). Stockholders like a lot of debt if
the company’s rate of return on its
assets exceeds the rate of return
paid to creditors.
(2). Creditors prefer less debt and
more equity because equity
represents a buffer of protection.
c. In practice, debt-to-equity ratios
from 0.0 to 3.0 are common.
2. Norton Corporation’s debt–to-equity ratio of
0.48 is computed as shown.
iii. The equity multiplier
1. The equity multiplier is computed as shown.
a. It indicates the portion of a company’s
assets that are funded by equity.
b. It focuses on average amounts
maintained throughout the year rather
than amounts at one point in time.
2. Norton Corporation’s equity multiplier of
1.56 is computed as shown.
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VII. Ratio analysis – assessing profitability
Learning Objective 5: Compute and interpret financial
ratios that managers use to assess profitability.
A. The information shown for Norton Corporation will be
used to calculate its profitability ratios.
i. Gross margin percentage
1. The gross margin percentage is calculated as
shown.
a. It should be more stable for retailing
companies than for other companies
because the cost of goods sold in
retailing companies excludes fixed
costs.
2. Norton Corporation’s gross margin
percentage for this year of 71.6% is
computed as shown.
ii. Net profit margin percentage
1. The net profit margin percentage is
calculated as shown.
a. In addition to cost of goods sold, it
also looks at how selling and
administrative expenses, interest
expense, and income tax expense
influence performance.
2. Norton Corporation’s net profit margin
percentage for this year of 10.9% is
computed as shown.
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iii. Return on total assets
1. The return on total assets is computed as
shown.
a. Adding interest expense back to net
income enables the return on assets to
be compared for companies with
different amounts of debt or over time
for a single company that has changed
its mix of debt and equity.
2. Norton Corporation’s return on assets for
this year (18.19%) is computed as shown.
iv. Return on equity
1. The return on equity is computed as shown.
a. This measure indicates how well the
company used the owners’ investments
to earn net income.
2. Norton Corporation’s return on equity for
this year (25.91%) is computed as shown.
3. The return on equity can also be computed
using the DuPont formula shown on this
slide.
v. Financial leverage
1. Financial leverage results from the
difference between the rate of return the
company earns on investments in its own
assets and the rate of return that the
company must pay its creditors.
a. Positive financial leverage exists if
the rate of return on the company’s
assets exceeds the rate of return the
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company pays its creditors. In this
case, having some debt in a company’s
capital structure can benefit
shareholders.
b. Negative financial leverage exists if
the rate of return on the company’s
assets is less than the rate of return the
company pays its creditors. In this
case, the common stockholder suffers
by having debt in the capital structure.
Quick Check – financial leverage
VIII. Ratio analysis – assessing market performance
Learning Objective 6: Compute and interpret financial
ratios that managers use to assess market performance.
A. The information shown for Norton Corporation will be
used to calculate its market performance ratios.
i. Earnings per share
1. Earnings per share is computed as shown.
a. The average number of common
shares outstanding is computed by
adding the shares outstanding at the
beginning of the year to the shares
outstanding at the end of the year and
dividing by two.
b. Managers analyze this ratio because
earnings form the basis for dividend
payments and future increases in the
value of shares of stock.
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2. Norton Corporation’s earnings per share for
this year ($2.42) is computed as shown.
ii. Price-earnings ratio
1. The price-earnings ratio is computed as
shown.
a. A higher price-earnings ratio means
that investors are willing to pay a
premium for a company’s stock
because of its optimistic future
growth prospects.
2. Norton Corporation’s price-earnings ratio
for this year (8.26 times) is computed as
shown.
iii. Dividend payout ratio
1. The dividend payout ratio is computed as
shown.
a. Investors who seek market price
growth would like this ratio to be
small, whereas investors who seek
dividends prefer it to be large.
2. Norton Corporation’s dividend payout ratio
for this year (82.6%) is computed as shown.
iv. Dividend yield ratio
1. The dividend yield ratio is computed as
shown.
a. This ratio measures the investor’s rate
of return (in the form of cash
dividends only) when buying common
stock at the current market price.
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2. Norton Corporation’s dividend yield ratio
for this year (10%) is computed as shown.
v. Book value per share
1. The book value per share is computed as
shown.
a. It measures the amount that would be
distributed to holders of each share
of common stock if all assets were
sold at their balance sheet carrying
amounts and if all creditors were
paid off. This measure is based
entirely on historical cost.
2. Norton Corporation’s book value per share
at the end of this year ($8.55) is computed as
shown. Notice:
a. The book value per share of $8.55
does not equal the market value per
share of $20. This is because the
market price reflects expectations
about future earnings and
dividends, whereas the book value
per share is based on historical cost.
IX. Summary of ratios and sources of comparative ratio
data
A. This slide contains a listing of published sources that
provide comparative ratio data organized by
industry.
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