Part 2
Financial Tools
Chapters in This Part
Chapter 3 Financial Statements and Ratio Analysis
Chapter 4 Cash Flow and Financial Planning
Chapter 5 Time Value of Money
Integrative Case 2: Merit Enterprise Corp.
Chapter 3
Financial Statements and Ratio Analysis
Instructor’s Resources
Chapter Overview
This chapter examines the four key components of the stockholders’ report: the income statement, the balance
sheet, the statement of retained earnings, and the statement of cash flows. All major items on the income
statement and balance sheet are reviewed along with rules for consolidating foreign and domestic financial
statements (FASB No. 52). Next, the discussion turns to use of income-statement/balance-sheet figures to
assess a firm’s financial condition. Three types of comparative analysis are noted—cross-sectional, time-
series, and combined—and specific ratios for such analysis are presented for five perspectives on firm
condition—liquidity, activity, debt, profitability, and market. Each ratio is illustrated using the last public
financial statements of Whole Foods Market, Inc., just before it was acquired by Amazon. The meaning of
deviations of performance ratios from industry benchmarks (as well as differences across industries) is also
explored. The chapter ends with a complete (cross-sectional and time-series) ratio analysis of Whole Foods.
The DuPont system is integrated into the example to show how profit margin, sales volume, and leverage
interact to determine return on equity.
Suggested Answer to Opener-in-Review
Students were told Kroger reported sales of $27.61 billion and cost of goods sold of $21.47 billion for the
quarter ending January 28, 2017 and then asked to calculate gross profit margin for the quarter.
Answers to Review Questions
3-1. Generally accepted accounting principles (GAAP), the Financial Accounting Standards Board (FASB),
and the Public Company Accounting Oversight Board (PCAOB) all play significant roles in the
financial reporting of publicly traded firms. GAAP refers to the basic guidelines firms should use in
3-2 The four major financial statements are the:
Income Statement, which summarizes firm operating results over a specified time period. It is a
Balance Sheet, which summarizes firm financial condition at a given point in time. It is a “stock”
Statement of Retained Earnings, which reconciles net income earned during the year (and any cash
dividends paid) with the change in retained earnings from the beginning to the end of the year. It is
The Statement of Cash Flows summarizes cash inflows and outflows experienced by a firm over a
3-3 Notes to the Financial Statements offer important background details for firm financial statements.
3-4 FASB Statement No. 52 governs rules for consolidating a firm’s foreign and domestic financial
statements. The statement requires U.S.-based companies to translate foreign-currency-denominated
3-5 Current and prospective shareholders care about ratios bearing on expected cash flows and uncertainty
about those flows because risk and return drive stock price. Creditors, on the other hand, focus on ratios
3-6 Cross-sectional analysis involves comparing performance ratios for different firms at a specific point in
same firm’s performance over time (such as quarter-to-quarter or year-over-year).
3-7 An analyst should focus on significant differences between firm ratios and those of a designated peer
(competitor, group of competitors, or industry average), irrespective of whether the ratio is above or
3-8 Analyzing financial data from different points in the year could lead to inaccurate conclusions because
of seasonality. For example, many retailers post more sales in the fourth quarter than in the other three
3-9 The current ratio is a better metric when current assets are all reasonably liquid while the quick ratio is
preferred if the firm operates with high levels of illiquid inventory.
3-10 Most firms listed in Table 3.5 are large players in their industries; such firms typically rely on credit
lines with banks for emergency cash. Put another way, small firms “self-insure” against liquidity risk
with a high current ratio while large firms insure through bank credit. Whole Foods, as a
3-11 Average collection period, or average age of accounts receivable, is useful in evaluating a firms credit
and collection policies. It equals accounts receivable divided by average daily sales. Interpreting the
ratio (in cross-section or time series analysis) requires context—specifically, what are the firm’s credit
3-12 Financial leverage refers to a firm’s reliance on debt (or other types of fixed-cost financing such as
preferred stock) to fund ongoing operations. Financial leverage is important because greater reliance on
3-13 The debt and debt-to-equity ratios gauge firm indebtedness (leverage). Specifically, the debt ratio is
thepercentage of firm assets financed by debt, while the debt-to-equity ratio is the relative proportion of
debt and equity in the firm’s funding mix. Higher debt and debt-to-equity ratios correspond to greater
3-14 The three profitability ratios found on a common-size income statement are (1) gross profit margin, (2)
operating profit margin, and (3) net profit margin. Gross margin is thepercentage of each sales dollar
3-15 Firms with high gross profit but low net profit margins have high large expenses other than the cost of
which will reduce its net profit margin relative to industry competitors that use little or no debt.
3-16 Return on assets (ROA) equals earnings available to common stockholders divided by total assets;
return on equity (ROE) is earnings divided by common stock equity. ROA and ROE have the same
3-17 The price-earnings ratio (P/E) captures what investors will pay for a dollar of earnings while the
market/book (M/B) ratio shows market perception of firm value relative to the historical cost of assets.
Both ratios embody a forward-looking perspective in that their numerators reflect investor expectations
about future cash flows and the riskiness of those flows. Interpreting these ratios for a specific firm is
3-18. Liquidity ratios measure firm capacity to meet current (short-term) financial commitments while
activity ratios capture how rapidly a firm can convert various accounts into cash or sales. Debt ratios
gauge a firm’s dependence on creditors to finance ongoing operations and ability to service these
3-19. The analyst should use a “level, peer, trend” approach for each of the five perspectives on firm
condition (liquidity, activity, debt, profitability, and market). “Level” means starting with computation
of multiple ratios for each of the five perspectives and then determining whether the ratios tell a
consistent story. If, for example, the current ratio is high (indicating strong liquidity), but the quick
3-20 The DuPont system of analysis breaks firm return on equity (ROE) into three components: profitability
(net profit margin), asset efficiency (total-asset turnover), and leverage (the debt ratio). This breakdown
Suggested Answer to Global Focus Box:
More Countries Adopt International Financial Reporting Standards
What costs and benefits might be associated with a switch to IFRS in the United States?
The benefit is global standardization of accounting standards, which would allow American companies with
foreign operations (or foreign companies with American operations) to reduce financial-reporting costs by
using only one set of accounting policies/procedures—at least for operations in the 80+ countries now
Suggested Answer to Focus on Ethics Box: Earnings Shenanigans
Logitech understated potential warranty expenses by assuming customers would submit defective-product
claims within one quarter—even though warranties extended for many years. Suppose instinct tells you the
assumption is reasonable and ethical because problems with electronic devices occur soon after purchase or
not at all. What evidence might you compile to challenge your instincts and satisfy auditors?
If assumptions about warranty expense are material (i.e., significantly affect earnings), the firm should
develop a warranty-expense policy grounded in historical experience and then apply that policy consistently
differs significantly across devices, the next step is selecting products similar (and dissimilar) to the one for
which a warranty-expense policy is being developed. The firm should build a case by noting exactly why one
Answers to Warm-Up Exercises
E3-1 Preparing income statements (LG 1) (Note that this solution assumes a 21% corporate tax
rate as per the Tax Cuts and Jobs Act. A previous version of this problem listed the tax
rate as 35%).
Answer: a. Income Statement ($000,000)
Sales revenue $345.0
Less: Cost of goods sold 255.0
Gross profits $90.0
b. Taxes = (Corporate tax rate) (Net profits before taxes) = 0.21 $18 million = $3.78 million,
c. EPS = Net profits after taxes / Shares outstanding = $14.22 million / 4.25 million = $3.34
Addition to retained earnings = (Net profit after taxes) – (Total dividends paid)
E3-2 Income statements and balance sheets (LG 1)
Answer: On income statements, calculations begin with sales revenue and end with net profits after taxes.
There is no guarantee a firm will be profitable. If net profits after taxes is positive, the firm earns a
E3-3 Statement of retained earnings (LG 1)
Answer: Cooper Industries, Inc.
Statement of Retained Earnings ($000)
Year Ending December 31, 2019
Retained earnings balance (January 1, 2019) $25,320
Plus: Net profits after taxes (for 2019) 5,150
E3-4 Current ratios and quick ratios (LG 3)
Answer: Between 2014 and 2019, Bluestone’s current ratio rose while the quick ratio fell. Inventory
appears in the numerator of the current ratio (as part of current assets), but not in the quick ratio.
E3-5 The DuPont System (LG 6)
Answer: Return on equity (ROE) = 4.5% 0.72 1.43 = 4.63%. The DuPont system allows decomposition
of firm ROE into a profit-on-sales component (net profit margin), an efficiency-of-asset-use
component (total asset turnover), and a use-of-financial-leverage component (financial leverage