Chapter 03: Financial Analysis
SMITH CORPORATION
Current Assets
Liabilities
Cash ……………………………
$ 35,000
Accounts payable ………………
$ 75,000
Marketable securities ……
7,500
Bonds payable (long-term) ….
210,000
Accounts receivable ……..
70,000
Inventory …………………….
75,000
Long-Term Assets
Stockholders’ Equity
Fixed assets …………………
$500,000
Common stock …………………..
$ 75,000
Less: Accum. dep. ………
(250,000)
Paid-in capital ……………………
30,000
Net fixed assets* ………….
250,000
Retained earnings ………………
47,500
Total assets ……………..
$437,500
Total liab. and equity ………..
$437,500
*Use net fixed assets in computing fixed asset turnover.
SMITH CORPORATION
$1,000,000
600,000
400,000
224,000
50,000
126,000
21,000
105,000
52,500
$ 52,500
†Includes $7,000 in lease payments.
3-37. Solution:
Jones and Smith Comparison
One way of analyzing the situation for each company is to
compare the respective ratios for each. Examining those ratios
which would be most important to a supplier or short-term lender
and a stockholder.
Chapter 03: Financial Analysis
Jones Corp.
Smith Corp.
Profit margin
7.4%
5.25%
Return on assets (investments)
18.5%
12.00%
Return on equity
28.9%
34.4%
Receivable turnover
15.63x
Average collection period
Inventory turnover
Fixed asset turnover
4x
Total asset turnover
Current ratio
Quick ratio
Debt to total assets
65.1%
Times interest earned
24.13x
6x
Fixed charge coverage
13.33x
4.75x
Fixed charge coverage
calculation
(200/15)
(133/28)
3-37. (Continued)
a. Since suppliers and short-term lenders are most concerned with
liquidity ratios, Smith Corporation would get the nod as having
b. Stockholders are most concerned with profitability. In this
category, Jones has much better ratios than Smith. Smith does
have a higher return on equity than Jones, but this is due to its
much larger use of debt. Its return on equity is higher than
Chapter 03: Financial Analysis
SMITH CORPORATION
Sales (on credit) ……………………………………
$1,000,000
Cost of goods sold …………………………………
600,000
Gross profit …………………………………………..
400,000
Selling and administrative expense……….
224,000
50,000
Operating profit …………………………………….
126,000
Interest expense …………………………………….
21,000
Earnings before taxes……………………………..
Tax expense ………………………………………….
52,500
COMPREHENSIVE PROBLEM
Comprehensive Problem 1.
Lamar Swimwear (trend analysis and industry comparisons)(LO3) Bob Adkins has recently
been approached by his first cousin, Ed Lamar, with a proposal to buy a 15 percent interest in
Lamar Swimwear. The firm manufactures stylish bathing suits and sunscreen products.
Mr. Lamar is quick to point out the increase in sales that has taken place over the last three years
as indicated in the income statement, Exhibit 1. The annual growth rate is 25 percent. A balance
sheet for a similar time period is shown in Exhibit 2, and selected industry ratios are presented in
Exhibit 3. Note the industry growth rate in sales is only 10 to 12 percent per year.
There was a steady real growth of 3 to 4 percent in gross domestic product during the period
under study.
Chapter 03: Financial Analysis
Comprehensive Problem 1 (Continued)
Exhibit 1
LAMAR SWIMWEAR
Income Sheet
20X1
20X2
20X3
Sales (all on credit) ………………………………………
$1,200,000
$1,500,000
$1,875,000
Cost of goods sold ………………………………………..
800,000
1,040,000
1,310,000
Gross profit …………………………………………………
$ 400,000
$ 460,000
$ 565,000
Selling and administrative expense* ……………….
239,900
274,000
304,700
Operating profit (EBIT) ………………………………..
$ 160,100
$ 186,000
$ 260,300
Interest expense ……………………………………………
35,000
45,000
85,000
Net income before taxes ……………………………….
$ 125,100
$ 141,000
$ 175,300
Taxes ………………………………………………………….
36,900
49,200
55,600
Net income ………………………………………………….
$ 88,200
$ 91,800
$ 119,700
Shares …………………………………………………………
30,000
30,000
38,000
Earnings per share ………………………………………..
$ 2.94
$ 3.06
$ 3.15
*Includes $15,000 in lease payments for each year.
Exhibit 2
LAMAR SWIMWEAR
Balance Sheet
Assets
20X1
20X2
20X3
Cash…………………………………………………………..
$ 30,000
$ 40,000
$ 30,000
Marketable securities …………………………………..
20,000
25,000
30,000
Accounts receivable …………………………………….
170,000
259,000
360,000
Inventory ……………………………………………………
230,000
261,000
290,000
Total current assets ………………………………….
$ 450,000
$ 585,000
$ 710,000
Net plant and equipment ………………………………
650,000
765,000
1,390,000
Total assets …………………………………………………
$1,100,000
$1,350,000
$ 2,100,000
Liabilities and Stockholders’ Equity
Accounts payable ………………………………………..
$ 200,000
$ 310,000
$ 505,000
Accrued expenses………………………………………..
20,400
30,000
35,000
Total current liabilities ……………………………..
$ 220,400
$ 340,000
$ 540,000
Long-term liabilities…………………………………….
325,000
363,600
703,900
Total liabilities ………………………………………..
$ 545,400
$ 703,600
$ 1,243,900
Common stock ($2 par) ……………………………….
60,000
60,000
76,000
Capital paid in excess of par …………………………
190,000
190,000
264,000
Retained earnings ………………………………………..
304,600
396,400
516,100
Total stockholders’ equity…………………………
$ 554,600
$ 646,400
$ 856,100
Total liabilities and stockholders’ equity ………..
$1,100,000
$1,350,000
$2, 100,000
Chapter 03: Financial Analysis
Exhibit 3
Selected Industry Ratios
20X1
20X2
20X3
Growth in sales …………………………….
—
10.00%
12.00%
Profit margin ………………………………..
7.71%
7.82%
7.96%
Return on assets (investment) …………
7.94%
8.86%
8.95%
Return on equity ……………………………
14.31%
15.26%
16.01%
Receivable turnover ………………………
9.02x
8.86x
9.31x
Average collection period ………………
39.9 days
40.6 days
38.7 days
Inventory turnover ………………………..
4.24x
5.10x
5.11x
Fixed asset turnover ………………………
1.60x
1.64x
1.75x
Total asset turnover ……………………….
1.05x
1.10x
1.12x
Current ratio …………………………………
1.96x
2.25x
2.40x
Quick ratio …………………………………..
1.37x
1.41x
1.38x
Debt to total assets ………………………..
43.47%
43.11%
44.10%
Times interest earned …………………….
6.50x
5.99x
6.61x
Fixed charge coverage …………………..
4.70x
4.69x
4.73x
Growth in EPS ……………………………..
—
10.10%
13.30%
The stock in the corporation has become available due to the ill health of a current stockholder,
who is in need of cash. The issue here is not to determine the exact price for the stock, but rather
whether Lamar Swimwear represents an attractive investment situation. Although Mr. Adkins
has a primary interest in the profitability ratios, he will take a close look at all the ratios. He has
no fast and firm rules about required return on investment, but rather wishes to analyze the
overall condition of the firm. The firm does not currently pay a cash dividend, and return to the
investor must come from selling the stock in the future. After doing a thorough analysis
(including ratios for each year and comparisons to the industry), what comments and
recommendations do you offer to Mr. Adkins?
CP 3-1. Solution:
Lamar Swimwear
20X1
20X2
20X3
Growth in sales
(Company)
25%
25%
(Industry)
10%
12%
Profit margin
(Company)
7.35%
6.12%
6.38%
(Industry)
7.71%
7.96%
Return on assets
(Company)
8.02%
6.80%
5.70%
(Industry)
7.94%
8.68%
8.95%
Return on equity
(Company)
15.90%
14.20%
13.98%
(Industry)
14.31%
15.26%
16.01%
Receivable turnover
(Company)
7.06x
5.79x
5.21x
(Industry)
9.02x
8.86x
9.31x
Average collection
(Company)
62.2 days
69.1 days
(Industry)
39.9 days
40.6 days
38.7 days
Inventory turnover
(Company)
5.22x
5.75x
6.47x
(Industry)
4.24x
5.10x
5.11x
Fixed asset turnover
(Company)
1.85x
1.96x
1.35x
(Industry)
1.60x
1.64
1.75x
Total asset turnover
(Company)
1.09x
1.11x
0.89x
(Industry)
1.05x
1.10x
1.12x
Current ratio
(Company)
2.04x
1.72x
1.31x
(Industry)
1.96x
2.25x
2.40x
Quick ratio
(Company)
1.00x
0.78x
(Industry)
1.37x
1.41x
1.38x
(Company)
49.58%
52.12%
59.23%
Times interest
(Company)
4.57x
4.13x
3.06x
(Industry)
Fixed charge
(Company)
3.50x
3.35x
2.75x
(Industry)
(Company)
—-
4.1%
2.9%
CP 3-1. (Continued)
Discussion of Ratios
While Lamar Swimwear is expanding its sales much more rapidly than
others in the industry, there are some clear deficiencies in their
performance. These can be seen in terms of a trend analysis over time as
well as a comparative analysis with industry data.
The previously mentioned slower turnover of assets can be analyzed
through the turnover ratios. A problem can be found in accounts
Chapter 03: Financial Analysis
CP 3-1. (Continued)
The liquidity ratios also are not encouraging. Both the current and quick
ratios are falling against a stable industry norm of approximately two to
one and one to one, respectively.
Investment Comments:
He would probably have difficulty justifying such an investment based
on the performance of the firm. There are no dividend payouts, so return
Comprehensive Problem 2
Sun Microsystems (trends, ratios stock performance) (LO3) Sun Microsystems is a leading
supplier of computer-related products, including servers, workstations, storage devices, and
network switches.
In the letter to stockholders as part of the 2001 annual report, President and CEO Scott G.
McNealy offered the following remarks:
Fiscal 2001 was clearly a mixed bag for Sun, the industry, and the economy as a whole. Still,
we finished with revenue growth of 16 percent—and that’s significant. We believe it’s a good
indication that Sun continued to pull away from the pack and gain market share. For that, we
owe a debt of gratitude to our employees worldwide, who aggressively brought costs down—
even as they continued to bring exciting new products to market.
The statement would not appear to be telling you enough. For example, McNealy says the
year was a mixed bag with revenue growth of 16 percent. But what about earnings? You can
delve further by examining the income statement in Exhibit 1. Also, for additional analysis of
other factors, consolidated balance sheet(s) are presented in Exhibit 2 on page 92.
1. Referring to Exhibit 1, compute the annual percentage change in net income per common
share-diluted (second numerical line from the bottom) for 1998–1999, 1999–2000, and
2000–2001.
2. Also in Exhibit 1, compute net income/net revenue (sales) for each of the four years.
Begin with 1998.
3. What is the major reason for the change in the answer for Question 2 between 2000 and
2001? To answer this question for each of the two years, take the ratio of the major
income statement accounts to net revenues (sales).
Cost of sales
Research and development
Selling, general and administrative expense
Provision for income tax
4. Compute return on stockholders’ equity for 2000 and 2001 using data from Exhibits 1
and 2.
In 2009, Sun Microsystems was acquired by Oracle Corporation.
Chapter 03: Financial Analysis
Comprehensive Problem 2 (Continued)
Exhibit 1
SUN MICROSYSTEMS INC.
Summary Consolidated Statement of Income (in millions)
2001
2000
1999
1998
Dollars
Dollars
Dollars
Dollars
Net revenues ………………………………………..
$18,250
$15,721
$11,806
$9,862
Costs and expenses:
Cost of sales …………………………………..
10,041
7,549
5,670
4,713
Research and development ………………
2,016
1,630
1,280
1,029
Selling, general and administrative ……
4,544
4,072
3,196
2,826
Goodwill amortization …………………….
261
65
19
.4
In-process research and development ..
77
12
121
176
Total costs and expenses ………………………..
16,939
13,328
10,286
8,748
Operating Income …………………………………
1,311
2,393
1,520
1,114
Gain (loss) on strategic investments ………..
(90)
208
–
–
Interest income, net ……………………………….
363
170
85
48
Litigation settlement ……………………………..
–
–
–
–
Income before taxes ………………………………
1,584
2,771
1,605
1,162
Provision for income taxes …………………….
603
917
575
407
Cumulative effect of change
in accounting principle, net …………………
(54)
–
–
–
Net income …………………………………………..
$ 927
$ 1,854
$ 1,030
$ 755
Net income per common share—diluted ….
$ 0.27
$ 0.55
$ 0.31
$ 0.24
Shares used in the calculation of net
income per common share—diluted ………..
3,417
3,379
3,282
3,180
5. Analyze your results to Question 4 more completely by computing ratios 1, 2a, 2b, and 3b
(all from this chapter) for 2000 and 2001. Actually, the answer to ratio 1 can be found as part
of the answer to question 2, but it is helpful to look at it again.
What do you think was the main contributing factor to the change in return on stockholders’
equity between 2000 and 2001? Think in terms of the Du Pont system of analysis.
6. The average stock prices for each of the four years shown in Exhibit 1 were as follows:
1998 11¼
1999 16¾
2000 28½
2001 9½
a. Compute the price/earnings (P/E) ratio for each year. That is, take the stock price shown
above and divide by net income per common stock-dilution from Exhibit 1.
b. Why do you think the P/E has changed from its 2000 level to its 2001 level?
A brief review of P/E ratios can be found under the topic of Price-Earnings Ratio
Applied to Earnings per Share in Chapter 2.
Chapter 03: Financial Analysis
Comprehensive Problem 2 (Continued)
Exhibit 2
SUN MICROSYSTEMS, INC
Consolidated Balance Sheets (in millions)
Assets
2001
2000
Current assets:
Cash and cash equivalents ……………………………………………………………
$ 1,472
$ 1,849
Short-term investments ………………………………………………………………..
387
626
Accounts receivable, net allowances of $410 in 2001 and
$534 in 2000 ……………………………………………………………………………
2,955
2,690
Inventories………………………………………………………………………………….
1,049
557
Deferred tax assets ………………………………………………………………………
1,102
673
Prepaids and other current assets …………………………………………………..
969
482
Total current assets …………………………………………………………………..
$7,934
$6,877
Property, plant and equipment, net ……………………………………………………
2,697
2,095
Long-term investments ……………………………………………………………………
4,677
4,496
Goodwill, net of accumulated amortization of $349 in 2001 and
$88 in 2000 ………………………………………………………………………………..
2,041
163
Other assets, net ……………………………………………………………………………..
832
521
$18,181
$14,152
Liabilities and Stockholders’ Equity
Current liabilities:
Short-term borrowings …………………………………………………………………
$ 3
$ 7
Accounts payable ………………………………………………………………………..
1,050
924
Accrued payroll-related liabilities ………………………………………………….
488
751
Accrued liabilities and other …………………………………………………………
1,374
1,155
Deferred revenues and customer deposits ……………………………………….
1,827
1,289
Warranty reserve …………………………………………………………………………
314
211
Income taxes payable …………………………………………………………………..
90
209
Total current liabilities ………………………………………………………………
$5,146
$4,546
Deferred income taxes …………………………………………………………………….
744
577
Long-term debt and other obligations………………………………………………..
1,705
1,720
Total debt ………………………………………………………………………………..
$ 7,595
$ 6,843
Commitments and contingencies
Stockholders’ equity:
Preferred stock, $0.001 par value, 10 shares authorized (1 share which
has been designated as Series A Preferred participating stock): no
shares issued and outstanding …………………………………………………….
–
–
Common stock and additional paid-in–capital, $0.00067 par value, 7,200
shares authorized; issued: 3,536 shares in 2001 and 3,495 shares in 2000 …
6,238
2,728
Treasury stock, at cost: 288 shares in 2001 and 301 shares in 2000 ………
(2,435)
(1,438)
Deferred equity compensation ………………………………………………………….
(73)
(15)
Retained earnings……………………………………………………………………………
6,885
5,959
Accumulated other comprehensive income (loss) ……………………………….
(29)
75
Total stockholders’ equity ……………………………………………………………..
$10,586
$7,309
Chapter 03: Financial Analysis
$18,181
$14,152
7. The book values per share for the same four years discussed in the preceding question were:
1998 $1.18
1999 $1.55
2000 $2.29
2001 $3.26
a. Compute the ratio of price to book value for each year.
b. Is there any dramatic shift in the ratios worthy of note?
CP 3-2. Solution
Sun Microsystems
1. Percentage change in net income per common share—diluted
1999
$ .31
2000
$ .55
2001
$ .27
$ .07
$ .24
$–.28
2. Profit margin
1998 1999 2000 2001
3. Percent of net revenue
2000 2001
Net revenues $15,721 $18,250
Cost of sales 7,549 48.02% 10,041 55.02%
Chapter 03: Financial Analysis
CP 3-2. (Continued)
4. Return on stockholders’ equity
2000 2001
5.
2000 2001
1.
Net income
Net revenues (sales)
11.79% 5.08%
13.09% 5.08%
3.b.
( ) ( ) ( )
Return on assets 13.09% 5.08%
1 Debt/Assets 1 .484 1 .418
− − −
Chapter 03: Financial Analysis
CP 3-2. (Continued)
6.a. P/E = Stock price/Net income per common share—diluted (EPS)
P/E 46.9 54.0 51.8 35.2
7.a. Price to book value = Stock price/book value
1998 1999 2000 2001
b. Once again, the sharp falloff in price to book value between 2000