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CHAPTER 23
QUESTIONS
1. In addition to identifying a company’s
weaknesses, financial statement analysis
can be used to predict a company’s future
profitability and cash flows based on its
past performance.

profitability, efficiency, and leverage. For
each of these components, a single ratio is
used to give a summary measure of how
the company is performing in that area. The
summary measures follow:
Profitability: Return on sales
Efficiency: Asset turnover
Leverage: Assets-to-equity
Once the DuPont framework calculations
have given a general picture of a company’s performance, more detailed ratios can
be computed to yield specific information
about each of the three areas.

2. Comparative financial statements provide a
better indication of the nature and trends of
changes affecting a business enterprise.
Absolute amounts, in the absence of a
benchmark, are not very good indications
of performance or efficiency. Comparative
statements at least provide a basis for
judgment with respect to other periods of

time or industry data.

6. a. Inventory turnover is computed by dividing the cost of goods sold for the period
by the average inventory.
b. In arriving at a rate of inventory turnover, it is essential that the inventory figures used to compute the average inventory be representative. If the beginning and ending balances are unusually
high or low, the turnover rate may be
misleading.
c. A rising inventory turnover rate indicates
that a smaller amount of capital is tied
up in inventory for a given volume of
business. This may indicate more efficient buying and merchandising policies.
However, if the turnover rate is higher
than for other firms in the industry, it
may indicate dangerously low levels of
inventory, exposing the firm to the risk of
inventory shortages and running out of
stock.

Comparative statements are more useful if
there is uniformity of presentation and content, consistency of application of accounting principles, and disclosure of significant
changes in circumstances and the resulting
impact of those changes.
3. Analysis of financial ratios does not reveal
the underlying causes of a firm’s problems.
Financial statement analysis only identifies
the problem areas. The only way to find out
why the financial ratios look bad is to
gather information from outside the financial statements: ask management, read
press releases, talk to financial analysts
who follow the firm, and/or read industry

newsletters. Financial ratio analysis does
not give the final answers, but it does point
out areas about which more detailed questions should be asked.
4. A common-size financial statement is a financial statement for which each number in
a given year is standardized by a measure
of the size of the company in that year. A
common standardization is to divide all financial statement numbers by sales for the
year. Common-size statements make possible a ready comparison of financial data for
companies of different size—either the
same company in different years or different companies at the same point in time.

7. a. Times interest earned. Computed by
dividing earnings before interest and
taxes (operating income) by interest
expense for the period. This measures
a company’s ability to meet interest
payments and suggests the security afforded to creditors.
b. Return on equity. Computed by dividing
net income by stockholders’ equity.
This measurement indicates management’s effectiveness in employing the
funds provided by the stockholders in
generating profits.

5. The DuPont framework decomposes return on equity into three components:

979


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Chapter 23

c. Earnings per share. Computed by dividing net income by the weighted average number of common shares outstanding. EPS is a number useful in
evaluating the level of cash dividends
per share relative to income and in
evaluating the market price per share
relative to income.
d. Price-earnings ratio. Computed by dividing market price per share by earnings per share. The P/E ratio shows
how much investors are willing to pay
for each dollar of current earnings and
is an indication of what investors believe about a company’s future growth
prospects.
e. Dividend payout ratio. Computed by dividing cash dividends by net income.
This ratio reveals what fraction of income a company distributes to shareholders in the form of cash dividends.
f. Book-to-market ratio. Computed by dividing total book value of equity by the
total market value of shares outstanding. This ratio reveals how the market
is currently valuing the net investment
in a company relative to the amount of
investment originally provided by the
stockholders. Book-to-market ratios are
usually less than 1.0, indicating that the
market value of the firm is greater than
the total equity funds provided by the
stockholders.
8. One of the factors affecting overall firm
performance is the ability to invest in an
asset and sell it at a profit. The turnover
of the assets affects the return on assets
because a profit will be made each time

the operating cycle is completed (investment in asset, selling the asset to a customer, collection of cash). If within a
given accounting period an organization
completes more than one operating cycle,
the resulting return on total assets will be
a function of the profit percentage on
each sale and the number of completed
operating cycles. Thus, the return on assets may be increased by either increasing the turnover of assets or by increasing the profit made on each sale.
9. The return on assets equals the ROE
when total assets equal total stockhold-

ers’ equity, meaning that there are no
liabilities. Overall, the ROE will always
exceed the return on assets (unless a
company’s liabilities exceed its assets);
however, on marginal or new investments, this will be true only if the return
on the new assets exceeds the cost of
obtaining the additional funds.
10. Ratio comparisons can yield misleading
implications if the ratios come from companies with differing accounting practices. Differences in accounting methods
can make one company look superior to
another even though they are economically identical. For example, if one company uses a 10-year life for depreciating
fixed assets and another depreciates similar assets over a 15-year life, the decreased depreciation expense for the
second company will make it look more
profitable even in the absence of real differences in operating performance.
11. The price equals the amount of dividends
divided by the required rate of return on
equity capital less the expected dividend
growth rate. The equation is as follows:
Price =


Forecasted Dividend Next Year
r–g

where r is the required rate of return on equity capital and g is the expected future dividend growth rate.
12. Once a business has run out of innovative
ideas, growth via new projects will not increase its value to existing shareholders
because the discounted present value of
new projects is exactly offset by the initial
cost of the projects. So, once the ―terminal
year‖ is reached when it is expected that
the company will have no new aboveaverage ideas, the valuation impact of any
additional growth can be ignored.
13. a. Equity valuation is difficult.
b. Price/earnings valuation is simple and
often relatively accurate, but it begs the
question of identifying the underlying
determinants of value.
c. The most useful part of equity valuation
is often what it reveals about what investors must believe about a stock in
order to give it its current market price.


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981

PRACTICE EXERCISES
PRACTICE 23–1 PREPARING A COMMON-SIZE INCOME STATEMENT
Sales ........................................

Cost of goods sold.................
Operating expenses:
Marketing expense ..........
R&D expense ....................
Administrative expense ..
Operating income...................
Interest expense .....................
Income before income
taxes ..................................
Income tax expense ...............
Net income ..............................

Year 3
$ 350,000
(163,000)

Year 2
100.0% $ 260,000
46.6
(144,000)

Year 1
100.0% $ 300,000
55.4
(156,000)

(21,000)
(27,000)
(45,000)
$ 94,000

(6,000)

6.0
(21,000)
7.7
(6,000)
12.9
(50,000)
26.9% $ 39,000
1.7
(11,000)

8.1
2.3
19.2
15.0% $
4.2

(22,000)
(14,000)
(48,000)
60,000
(7,000)

7.3
4.7
16.0
20.0%
2.3


$ 88,000
(25,000)
$ 63,000

25.1% $ 28,000
7.1
(8,000)
18.0% $ 20,000

10.8% $ 53,000
3.1
(20,000)
7.7% $ 33,000

17.7%
6.7
11.0%

100.0%
52.0

Note: Minor adjustments to the percentage computations have been made to counteract the
cumulative effect of rounding.

PRACTICE 23–2 INTERPRETING A COMMON-SIZE INCOME STATEMENT
In Year 2, overall profitability declined for many reasons. Cost of goods sold, marketing expense, administrative expense, and interest expense all increased as a percentage of sales. A partial explanation for these increases could be that Company A has
a large element of fixed costs in its cost structure. Thus, costs don’t decline very
much when sales volume declines. The only two expenses to decline as a percentage
of sales were R&D and income tax (because of lower income). The decline in R&D
expense is symptomatic of a company that is trying to maintain profitability in the

short run. Of course, if R&D dries up in the long run, the company will slowly lose its
advantage in the market place.
Year 3 saw a reversal of all of the bad trends in Year 2. Cost of goods sold, marketing
expense, administrative expense, and interest expense all decreased as a percentage
of sales. R&D expense increased as a percentage of sales, perhaps to make up for
the temporary decline in Year 2.
PRACTICE 23–3 PREPARING A COMMON-SIZE BALANCE SHEET
Year 3
Cash......................................... $ 8,000
Accounts receivable ..............
18,000
Inventory .................................
36,000
Current assets ........................ $ 62,000
Property, plant, and
equipment (net) ................
138,000
Total assets ...................... $ 200,000

*Difference due to rounding

Year 2
2.3% $ 8,000
5.1
37,000
10.3
47,000
17.7% $ 92,000

Year 1

3.1% $ 6,000
14.2
18,000
18.1
36,000
35.4% $ 60,000

2.0%
6.0
12.0
20.0%

39.4
126,000
57.1% $ 218,000

48.5
123,000
83.8%* $ 183,000

41.0
61.0%


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PRACTICE 23–4 INTERPRETING A COMMON-SIZE BALANCE SHEET

In Year 2, total assets were 83.8% of sales, compared to just 61.0% of sales in
Year 1. This indicates a decrease in efficiency because more assets are needed
for each dollar of sales. In Year 2, each asset was used less efficiently than it was
in Year 1. Cash, accounts receivable, inventory, and net property, plant, and
equipment all increased as a percentage of sales.
In Year 3, total assets were 57.1% of sales, compared to 83.8% of sales in Year 2 and
61.0% of sales in Year 1. This indicates a substantial increase in efficiency compared
to Year 2 because fewer assets are needed for each dollar of sales. In Year 3, each
asset was used more efficiently than it was in Year 2. Cash, accounts receivable, inventory, and net property, plant, and equipment all decreased as a percentage of
sales.
PRACTICE 23–5 COMPUTING THE DUPONT FRAMEWORK RATIOS
1.
2.
3.
4.

Return on equity
Return on sales
Asset turnover
Assets-to-equity ratio

Year 3
60.0%
18.0%
1.75
1.90

Year 2
21.3%
7.7%

1.19
2.32

Year 1
37.1%
11.0%
1.64
2.06

PRACTICE 23–6 INTERPRETING THE DUPONT FRAMEWORK RATIOS
Return on equity in Year 1 was 37.1%, which is a very good ROE; good companies
have ROEs consistently above 15%. The decrease in ROE to 21.3% in Year 2 was the
result of a combination of lower profitability (return on sales decreased from 11.0% to
7.7%) and lower efficiency (asset turnover decreased from 1.64 to 1.19). This was partially counterbalanced by an increase in leverage in Year 2; the assets-to-equity ratio
increased from 2.06 to 2.32.
In Year 3, both profitability and efficiency increased, resulting in a ROE of 60.0%
compared to 21.3% in Year 2. The ROE in Year 3 is also significantly higher than in
Year 1 (60.0% compared to 37.1%). In Year 3, profitability is higher than in Year 1
(18.0% compared to 11.0%). In addition, efficiency is higher than in Year 1 (asset
turnover increased from 1.64 to 1.75). This is partially offset by lower leverage in Year
3 (1.90 assets to equity compared to 2.06 in Year 1).
PRACTICE 23–7 ACCOUNTS RECEIVABLE RATIOS
1.
2.

Accounts receivable turnover
Average collection period

Year 3
12.7

28.7

Year 2
9.5
38.6


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983

PRACTICE 23–8 INVENTORY RATIOS
1.
2.

Year 3
Inventory turnover
3.9
Number of days’ sales in inventory 92.9

Year 2
3.5
105.1

PRACTICE 23–9 FIXED ASSET TURNOVER
Fixed asset turnover

Year 3
2.65


Year 2
2.09

PRACTICE 23–10 MARGIN AND TURNOVER
Return on equity = Return on sales

Asset turnover

Assets-to-equity ratio

Company A: 18.0% 1.75 1.90 = 60.0% (rounded)
Company B: 7.8% 2.75 1.90 = 40.8%
Company C: 24.7% 0.87 1.90 = 40.8%
Company A has the highest ROE (60.0%); Companies B and C have the same ROE of
40.8%. In addition, each company is the same on the leverage dimension with an assets-to-equity ratio of 1.90. But each company is very different in terms of its pairing
of margin and turnover (return on sales and asset turnover). Company C has very
high margins (24.7%) but low turnover (0.87). Company B is at the other extreme with
low margins (7.8%) and high turnover (2.75). Company A is in the middle. This exercise illustrates that in the cases of companies B and C, many
companies can attain the same overall ROE with vastly different business
approaches in terms of margin and turnover.
PRACTICE 23–11 DEBT RATIO AND DEBT-TO-EQUITY RATIO
1.
2.

Debt ratio
Debt-to-equity ratio

Year 3
47.5%

0.90

Year 2
56.9%
1.32

Year 1
51.4%
1.06

Year 3
15.67

Year 2
3.55

Year 1
8.57

Year 3
1.44

Year 2
1.56

Year 1
1.67

PRACTICE 23–12 TIMES INTEREST EARNED
Times interest earned

PRACTICE 23–13 CURRENT RATIO
Current ratio


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PRACTICE 23–14 CASH FLOW ADEQUACY RATIO
Operating activities:
Net income ............................................................................
Depreciation .........................................................................
Increase in accounts receivable .........................................
Decrease in inventory ..........................................................
Increase in accounts payable ..............................................
Cash flow from operating activities ............................................

$ 780
300
(150)
75
100
$ 1,105

Investing activities:
Cash used to purchase property, plant, and equipment ...
Financing activities:
Cash from issuance of additional shares of stock ............
Cash used to repay long-term loans...................................

Cash dividends paid ............................................................
Cash flow from financing activities .............................................

$

(400)

$

200

$1,000
(600)
(200)

Cash flow from operating activities ............................................
Total primary cash requirements ($400 + $600 + $200) .............
Cash flow adequacy ratio.............................................................

$ 1,105
÷ $1,200
0.92

PRACTICE 23–15 EARNINGS PER SHARE AND DIVIDEND PAYOUT RATIO
1.
Net income ........................................................................
Weighted shares outstanding .........................................
Earnings per share ...........................................................

Company S Company T

$ 1,000
$ 15,000
÷
200
÷ 10,000
$
5.00
$
1.50

Dividends ..........................................................................
Net income ........................................................................
Dividend payout ratio .......................................................

Company S Company T
$
50
$ 6,000
÷ $1,000
÷ $15,000
5.0%
40.0%

2.

Company T is more likely to be an older company in a low-growth industry. Mature
companies typically pay a higher proportion of their net income as dividends. The
40% dividend payout ratio for Company T is typical of older, more mature companies
in the United States. High-growth companies usually have lower dividend payout
ratios, often 0%.



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985

PRACTICE 23–16 PRICE-EARNINGS RATIO AND BOOK-TO-MARKET RATIO
1.

2.

Company M
Net income ........................................................................ $ 5,000
Weighted shares outstanding ......................................... ÷
625
Earnings per share ........................................................... $
8.00

Company N
$
65,000
÷ 125,000
$
0.52

Stock price per share .......................................................
Earnings per share ...........................................................
Price-earnings ratio ..........................................................


$
÷

$
÷

64.00
$8.00
8.0

35.00
$0.52
67.3

Company M Company N
Stock price per share ....................................................... $ 64.00 $
35.00
Weighted shares outstanding .........................................
625
125,000
Total market value of equity ............................................ $ 40,000 $ 4,375,000
Total stockholders’ equity ...............................................
Total market value of equity ............................................
Book-to-market ratio ........................................................

$ 56,000
÷ $40,000
1.40

$ 600,000

÷$4,375,000
0.14

Company N is more likely to be in a high-growth industry. High P/E ratios and low
book-to-market ratios are indicative of a company that is expected to grow significantly in the future.
PRACTICE 23–17 EQUITY VALUATION USING DIVIDENDS AND P/E RATIO
1.

Dividends/r: $0.65/0.12 = $5.42

2.

Next Year’s Dividends/(r – g): ($0.65 × 1.07)/(0.12 – 0.07) = $13.91

3.

Earnings per share

P/E Ratio: $1.53

18 = $27.54


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PRACTICE 23–18 EQUITY VALUATION USING DISCOUNTED FREE CASH FLOW
Present Value of Forecasted Free Cash Flow for Burton Dee

Free Cash Flow Value for Most Recent Year = $3,500
4 Years of 25% Growth
Constant Free Cash Flow Thereafter
12% Required Rate of Return

Free cash flow ............................
Present value as of the
end of current year;
using 12% rate of return ........
Total present value ....................

Year +1
$ 4,375

Year +2
$5,469

Year +3
$6,836

Year +4
$8,545

Year +5
and After
$ 8,545

$ 3,906

$4,360


$4,866

$5,430

$45,254

$63,816

*Value of the perpetuity at the end of Year +4 = $8,545/0.12 = $71,208; PV at
end of current year = $45,254
Price = $63,816/3,000 shares = $21.27/share


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EXERCISES
23–19.
1.

2013
$950,000
595,000
$355,000
115,000
$240,000
45,000

$195,000
72,000
$123,000

Sales .......................................
Cost of goods sold ................
Gross profit ............................
Selling and general expenses
Operating income ..................
Interest expense .....................
Income before income taxes
Income taxes ..........................
Net income ...........................

%
100.0
62.6
37.4
12.1
25.3
4.7
20.5*
7.6
12.9

2012
$600,000
325,000
$275,000
94,000

$181,000
35,000
$146,000
57,000
$ 89,000

%
100.0
54.2
45.8
15.7
30.2*
5.8
24.3*
9.5
14.8

*Differences due to rounding
2.

Return on sales for Xenon in 2013 is 12.9% compared to 14.8% in 2012. The
cause of the decrease in the return on sales is that cost of goods sold as a
percentage of sales is much higher in 2013 (62.6%) compared to 2012
(54.2%). This increase is partially offset by lower selling and general expenses, lower interest expense, and lower income taxes in 2013.

23–20.
1.
Cash ........................................
Accounts receivables (net) ...
Inventories ..............................

Property, plant, and
equipment (net).....................
Total assets .........................
Sales .......................................
2.

2013
43,000
31,000
71,000

%
3.6
2.6
5.9

106,000
$ 251,000
$ 1,200,000

8.8
20.9

$

2012
22,000
42,000
33,000


%
2.2
4.2
3.3

59,000
$ 156,000
$ 1,000,000

5.9
15.6

$

Total assets as a percentage of sales for Gubler in 2013
pared to 15.6% in 2012. This means that Gubler needed
place in 2013 to generate $1 of sales than in 2012. Both
property, plant, and equipment increased substantially as
sales in 2013.

are 20.9% commore assets in
inventories and
a percentage of


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23–21.
Return on equity = Net income/Stockholders’ equity
= (Net income/Sales) (Sales/Total assets)
(Total assets/Stockholders’ equity)
= Return on sales Asset turnover Assets-to-equity ratio

Retail jewelry stores ..............
Retail grocery stores .............
Electric service companies ...
Legal services firms ..............

Return
on
Sales
4.0%
1.4
6.9
7.3

Asset
Turnover
1.5
5.6
0.5
3.5

Assetsto-Equity
Ratio
1.6
1.8

2.6
1.7

Return
on
Equity
9.6%
14.1
9.0
43.4

23–22.
2013
$275,000

2012
$ 220,000

$ 65,000
$ 75,000

$ 30,000
$ 65,000

$ 70,000

$ 47,500

a. Accounts receivable turnover ..................................... 3.93 times


4.63 times

Average receivables ....................................................

2013
$ 70,000

2012
$ 47,500

Sales .............................................................................
Average daily sales (sales/365)...................................

$275,000
$
753

$ 220,000
$
603

b. Average collection period ...........................................

93.0 days

78.8 days

Sales .............................................................................

2013

$275,000

2012
$ 220,000

$155,000
$190,000

$ 160,000
$ 155,000

$172,500

$ 157,500

c. Fixed asset turnover .................................................... 1.59 times

1.40 times

Sales .............................................................................
Net receivables:
Beginning of year ...................................................
End of year ..............................................................
Average receivables [(beginning
balance + ending balance)/2] .................................

Property, plant, and equipment:
Beginning of year ...................................................
End of year ..............................................................
Average fixed assets [(beginning

balance + ending balance)/2] .................................


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23–23.
Gross profit percentage*..................................
Inventory turnover—average inventory† .........
Number of days’ sales in average inventory‡ .
Inventory turnover—ending inventory§ ..........
Number of days’ sales in ending inventory#...

989

2013
28%
2.4
152 days
2.0
183 days

2012
2011
25%
13%
2.7
4.3
135 days 85 days
2.5

2.6
146 days 140 days

COMPUTATIONS:
*Gross profit/Sales:
2011: $10,000/$75,000 = 0.13
2012: $25,000/$100,000 = 0.25
2013: $35,000/$125,000 = 0.28
†

Cost of goods sold/Average inventory:
2011: $65,000/[($5,000 + $25,000)/2] = 4.3
2012: $75,000/[($25,000 + $30,000)/2] = 2.7
2013: $90,000/[($30,000 + $45,000)/2] = 2.4

‡

365 days/Inventory turnover rate (average inventory):
2011: 365/4.3 = 85 days (rounded)
2012: 365/2.7 = 135 days
2013: 365/2.4 = 152 days

§

Cost of goods sold/Ending inventory:
2011: $65,000/$25,000 = 2.6
2012: $75,000/$30,000 = 2.5
2013: $90,000/$45,000 = 2.0

#


365 days/Inventory turnover rate (ending inventory):
2011: 365/2.6 = 140 days (rounded)
2012: 365/2.5 = 146 days
2013: 365/2.0 = 183 days

With the increased sales volume, the gross profit percentage has increased
and the inventories also have increased, both relatively and in absolute
amount. The increase in inventories is reflected in the inventory turnover rate
and the increased number of days’ sales in average inventory. This inventory
condition may result in higher expenses for handling and carrying the inventory and a greater vulnerability to losses in the case of a decline in sales volume or prices. It may be noted that the unfavorable trend resulting from increasing inventories is not fully manifested by use of average inventories. By
using ending inventory figures, the unfavorable trend becomes even more apparent.


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23–24.
Results of Operations

Initial operating income ......................
Operating income on $800,000
borrowed .........................................
Interest expense ($800,000 0.12) .....
Income before income taxes...............
Income taxes (40%) .............................
Net income ...........................................
Average stockholders’ equity .............


Without
Borrowed
Capital
$ 230,000

If
Borrowed
Capital
Earns
15%
$ 230,000

If
Borrowed
Capital
Earns
8%
$ 230,000

0
0
$ 230,000
(92,000)
$ 138,000

120,000
(96,000)
$ 254,000
(101,600)

$ 152,400

64,000
(96,000)
$ 198,000
(79,200)
$ 118,800

$ 740,000

$ 740,000

$ 740,000

20.59%

16.05%

Return on average stockholders’ equity.

18.65%

Return on equity is increased by borrowing whenever the return on the acquired assets is greater than the interest on the borrowed funds.
23–25.

Company A:

Company B:

Return on

Sales

Asset
Turnover

=

Return on
Average
Total Assets

$125,000
$6,000,000

$6,000,000
$1,200,000

=

$125,000
$1,200,000

2.08%

5.0

=

10.42%


$600,000
$6,000,000

$6,000,000
$6,000,000

=

$600,000
$6,000,000

10.00%

1.0

=

10.00%

Company A is the discount store because it has the greater asset turnover.
Company B is the gift shop because it has the greater return on sales.


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23–26.

991


1. Return on equity:
Common stock, $1 par .................
Additional paid-in capital .............
Retained earnings ........................
Total equity ................................

2013
$ 250,000
2,000,000
250,000
$2,500,000

2012
$ 220,000
1,430,000
150,000
$1,800,000

2011
$ 220,000
1,430,000
100,000
$1,750,000

Net income .................................
Total equity

$190,000
$2,500,000


$110,000
$1,800,000

$90,000
$1,750,000

6.1%

5.1%

Return on equity ............................

7.6%

2. Times interest earned:
2013

2012

2011

8% bonds payable ........................

$800,000

$800,000

$ 800,000

Interest expense (0.08) .................


$ 64,000

$ 64,000

$ 64,000

Net income ....................................
Add back interest expense ..........
Earnings before interest ..............

$190,000
64,000
$254,000

$110,000
64,000
$174,000

$ 90,000
64,000
$ 154,000

Earnings before interest
.............
Interest expense

$254 ,000
$64,000


$174 ,000
$64,000

$154,000
$64,000

Times interest earned ..................

4.0 times

2.7 times

2.4 times

2013

2012

2011

Net income
............
Number of $1 par shares

$190,000
250,000

$110,000
220,000


$90,000
220,000

Earnings per share .......................

$0.76

$0.50

$0.41

2013

2012

2011

Dividends
....................................
Net income

$90,000
$190,000

$60,000
$110,000

$40,000
$90,000


Dividend payout ratio ...................

47.4%

54.5%

44.4%

2013

2012

2011

3. Earnings per share:

4. Dividend payout ratio:

5. Price-earnings ratio:

Year-end stock price per share
..
Earnings per share

$22
$0.76

$25
$0.50


$12
$0.41

Price-earnings ratio ......................

28.9

50.0

29.3


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23–26. (Concluded)
6. Book-to-market ratio:
2013
Year-end stock price per share ... $
22
Number of $1 par shares .............
250,000
Total market value ........................ $5,500,000

2012
2011
$
25 $

12
220,000
220,000
$5,500,000 $ 2,640,000

$ 2,500,000
Total equity
......................
$ 5,500,000
Total market value

$ 1,800,000 $ 1,750,000
$ 5,500,000 $ 2,640,000

Book-to-market ratio......................

0.45

0.33

0.66

23–27.
Financing Alternative

Current Ratio

Debt-to-Equity Ratio

a. Operating lease


$600 ,000
= 2.14
$280 ,000

$690,000
$885 ,000 *

= 0.78

b. Equity

$600 ,000
= 2.14
$280 ,000

$690,000
$1,385,000

= 0.50

c. Long-term loan

$600 ,000
= 2.14
$280 ,000

$1,190,000
$885,000


= 1.34

$600 ,000
= 1.40
$430 ,000

$1,190,000
$885,000

= 1.34

d.

Long-term loan,
short-term loan

*$600,000 + $975,000 – $280,000 – $410,000 = $885,000
The operating lease (a) and the equity financing (b) alternatives satisfy both
of the loan covenants.
23–28.
1.

Current ratio =

Current assets =
Current liabilities

Total assets Property, plant, and equipment
=
Current liabilities

$432,000 $294,000 = 1.5
Current liabilities

$138,000
= Current liabilities = $92,000
1.5
Current liabilities = Accounts payable + Income taxes payable
$92,000 = Accounts payable + $25,000
Accounts payable = $67,000


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23–28. (Concluded)
2.

Total liabilities
= 0.8
Total stockholders' equity

Total liabilities = 0.8 (Total stockholders’ equity)
Total liabilities + Total stockholders’ equity = Total assets
0.8 (Total stockholders’ equity) + Total stockholders’ equity = $432,000
1.8 (Total stockholders’ equity) = $432,000
Total stockholders’ equity = $240,000
Total stockholders’ equity = Common stock + Retained earnings
$240,000 = $300,000 + Retained earnings

Retained earnings = $(60,000)
3. Inventory turnover based on sales and ending inventory =
Sales
= 15
Ending inventory
Inventory turnover based on cost of goods sold and ending inventory =
Cost of goods sold
= 10.5
Ending inventory
Cost of goods sold
Ending inventory = Sales =
10.5
15
Sales
= 15
Cost of goods sold
10.5

Sales = 15
10.5

Cost of goods sold

Sales – Cost of goods sold = Gross margin
15 (Cost of goods sold) – (Cost of goods sold) = $315,000
10.5

4.5
(Cost of goods sold) = $315,000
10.5

Cost of goods sold =

$315,000
= $735,000
4.5 /10.5

Cost of goods sold
= 10.5
Ending inventory

$735,000
= Ending inventory
10.5
Ending inventory = $70,000


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Chapter 23

23–29.
1. Constant Future Dividends: Dividends/r: $0.35/0.14 = $2.50
2. Constant Dividend Growth: Forecasted Dividend Next Year/(r – g):
($0.35 × 1.05)/(0.14 – 0.05) = $4.08
3. P/E Multiple: Earnings × P/E Ratio: $2.80 19 = $53.20
4. Free Cash Flow:
Present Value of Forecasted Free Cash Flow for DeeAnn
Most Recent Free Cash Flow Value = $12,800
4 Years of 25% Growth

Constant Free Cash Flow Thereafter
14% Required Rate of Return
Year +5
Year +1
Year +2
Year +3 Year +4 and After
Free cash flow ............................
$16,000
$20,000
$25,000 $31,250 $ 31,250
Present value as of the
end of current year;
using 14% rate of return ........
$14,035
$15,389
$16,874 $18,503 $132,161
Total present value ....................

$196,962

*Value of the perpetuity at the end of Year +4 = $31,250/0.14 = $223,214;
PV at end of current year = $132,161
Price = $196,962/4,000 = $49.24/share
5. As discussed in the text of the chapter, valuation using the
price/earnings ratio is simple and often relatively accurate. With this
model, we are allowing the market to do most of the work for us in
terms of forecasting industry growth rates, setting an appropriate rate
of return, and so forth. This model is often used in getting a ballpark estimate for the appropriate price of a company’s shares, especially when
a company is issuing shares for the first time. However, this model is a
black box that avoids consideration of the fundamental operating performance forecasts for a company.



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PROBLEMS
23–30.
1.

Probe Corporation
Common-Size Income Statements
For the Year Ended December 31
2013
Amount
Percent
Net sales .................................... $280,000
100%
Cost of goods sold....................
198,000
71
Gross profit ............................... $ 82,000
29%
Selling and general expenses ..
50,000
18
Operating income...................... $ 32,000
11%
Other expenses .........................

40,000
14
Income (loss) before income
taxes ........................................... $ (8,000)
(3)%
Income taxes (refund) ...............
(3,000)
(1)
Net income (loss) ...................... $ (5,000)
(2)%

2012
Amount
Percent
$ 230,000
100%
110,000
48
$ 120,000
52%
53,000
23
$ 67,000
29%
28,000
12
$ 39,000
16,000
$ 23,000


17%
7
10%

Differences due to rounding
2. Probe Corporation is having a severe problem with its cost of goods sold. The
decrease in gross profit percentage from 52% to 29% is a significant drop. If
Probe is a manufacturing company, there may be excess spoilage or quality problems in production. As a result of the cost problem, Probe experienced a net loss
in 2013 as opposed to a significant net income in 2012. A detailed examination of
cost of goods sold is necessary to complete this evaluation.


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Chapter 23

23–31.
1.

2.

Stay-Trim Company and Tone-Up Company
Common-Size Balance Sheet
December 31, 2013
Stay-Trim
Company
Assets
Current assets ...............................................................
46%

Long-term investments .................................................
5
Land, buildings, and equipment (net) ..........................
43*
Intangible assets ...........................................................
1
Other assets ...................................................................
5
Total assets .................................................................
100%
Liabilities and Stockholders’ Equity
Current liabilities ...........................................................
14%
Long-term liabilities ......................................................
23
Deferred revenues .........................................................
4*
Total liabilities .............................................................
41%
Preferred stock ..............................................................
5%
Common stock...............................................................
27
Additional paid-in capital ..............................................
18
Retained earnings .........................................................
9
Total stockholders’ equity ............................................
59%
Total liabilities and stockholders’ equity ..................

100%
*Rounded down to achieve 100%.
**Rounded up to achieve 100%

Tone-Up
Company
20%
23
43
9**
5
100%
15%
25
6
46%
8%
17
15
14
54%
100%

Stay-Trim Company is financed by more equity than is Tone-Up Company.
Stay-Trim has a much higher percentage of its assets in the form of current
assets. Further investigation is necessary. Although the breakdown of current
assets is not given, added information may show that Stay-Trim’s current assets are primarily obsolete inventories, whereas Tone-Up’s current assets may
consist mainly of cash. Also, differences in inventory valuation methods could
change the results.



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23–32.
1. a.

b.

Return on sales = Net income/Net sales
Company A

Company B

Company C

$9,600
= 16.00%
$60,000

$1,850
= 6.61%
$28,000

$360 = 1.71%
$21,000

Asset turnover = Net sales/Total assets


$60,000
= 0.39
$155,400
c.

$21,500
= 1.90
$11,300

$3,200 = 1.89
$1,690

Return on assets = Net income/Total assets, or
= Return on sales Asset turnover
$9,600 = 6.18%
$155,400

e.

$21,000
= 6.56
$3,200

Assets-to-equity ratio = Total assets/Total equity
$155,400 = 2.55
$61,000

d.


$28,000
= 1.30
$21,500

$1,850 = 8.60%
$21,500

$360 = 11.25%
$3,200

Return on equity = Net income/Total equity
$9,600 = 15.74%
$61,000

$1,850
= 16.37%
$11,300

$360 = 21.30%
$1,690

2. The large utility is Company A. (The large investment in assets, the low asset
turnover, and high return on sales suggest Company A is the utility.)
The large grocery store is assumed to be Company C. (Company C has a low return on sales and a high asset turnover.)
Therefore, the large department store is Company B.
23–33.
1. Accounts receivable turnover:
Net sales...................................................................
Net receivables:
Beginning of year ...............................................

End of year .........................................................
Average receivables ................................................
Accounts receivable turnover ................................

2013

2012

$630,000

$560,000

$95,000
$120,000
$107,500
5.86

$60,000
$95,000
$77,500
7.23


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23–33. (Concluded)
2. Average collection period:

Receivables at end of year ......................................
Net sales...................................................................
Average daily sales (net sales/365) ........................
Average collection period .......................................
3. Inventory turnover:
Cost of goods sold ..................................................
Inventory:
Beginning of year ...............................................
End of year .........................................................
Average inventory ...................................................
Inventory turnover ...................................................
4.
Number of days’ sales in inventory:
Inventory at end of year ..........................................
Average daily cost of goods sold (365-day year) ..
Number of days’ sales in inventory .......................

$120,000
$630,000
$1,726
69.5

$95,000
$560,000
$1,534
61.9

$325,000

$290,000


$180,000
$230,000
$205,000
1.59

$140,000
$180,000
$160,000
1.81

2013

2012

$230,000
$890
258.4

$180,000
$795
226.4

2013

2012

$225,000

$230,000


$40,000
$60,000
$50,000
4.5 times

$30,000
$40,000
$35,000
6.6 times

$260,000

$250,000

$65,000
$60,000
$62,500
4.2 times

$60,000
$65,000
$62,500
4.0 times

$150,000

$130,000

$40,000

$60,000
$50,000
3.0 times

$35,000
$40,000
$37,500
3.5 times

23–34.
1. a. Finished goods turnover:
Cost of goods sold ............................................
Average finished goods inventory:
Beginning of year .........................................
End of year ....................................................
Average .........................................................
Finished goods turnover ...................................
b. Goods in process turnover:
Cost of goods manufactured ............................
Average goods in process inventory:
Beginning of year .........................................
End of year ....................................................
Average .........................................................
Goods in process turnover ...............................
c. Raw materials turnover:
Cost of materials used in production ...............
Average raw materials inventory:
Beginning of year .........................................
End of year ....................................................
Average .........................................................

Raw materials turnover .....................................


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23–34. (Concluded)
2. The inventory turnovers are not all moving in the same direction. Both the finished goods inventory and the raw materials inventory turnovers are decreasing,
whereas the goods in process inventory turnover increased slightly. The greatest
concern is with the finished goods inventory. In two years, this inventory has
doubled ($30,000 to $60,000), while the cost of goods sold actually decreased
slightly in 2013. This may indicate an obsolescence problem. The matter should
be investigated. The raw materials inventory also has increased in absolute
amount, but more raw materials are being used in production, so the decrease in
inventory turnover for raw materials is not as significant as it is for finished
goods. Overall, there seems to be a problem in inventory control that should be
resolved.
23–35.
1. a. Return on equity:
No-par common, $10 stated value...............
Additional paid-in capital .............................
Retained earnings ........................................
Total equity ................................................

2013
$ 500,000
510,000
196,000

$1,206,000

2012
$400,000
400,000
171,000
$971,000

2011
$ 400,000
400,000
190,000
$ 990,000

Net income .................................................
Total equity

$180,000
$1,206,000

$131,000
$971,000

$208,000
$990,000

Return on equity ...........................................

14.9%


13.5%

21.0%

b. Return on sales:
2013
Net income
...................................................
Net sales

$180,000
$1,400,000

Return on sales.............................................

12.9%

2012

2011

$131,000 $208,000
$1,100,000 $1,220,000
11.9%

17.0%

c. Asset turnover:
2013


Ne t sale s
................................................
Total assets
Asset turnover ..............................................

$1,400,000
$1,700,000

2012

2011

$1,100,000 $1,220,000
$1,500,000 $1,550,000

0.82

0.73

0.79

2013

2012

2011

d. Assets-to-equity ratio:
Total assets .................................................
Total equity


Assets-to-equity ratio ...................................

$1,700,000
$1,206,000
1.41

$1,500,000 $1,550,000
$971,000
$990,000
1.54

1.57


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23–35. (Continued)
e. Return on assets:
2013
Net income
.................................................
Total assets

Return on assets ..........................................

2012


2011

$180,000
$131,000 $208,000
$1,700,000 $1,500,000 $1,550,000
10.6%

8.7%

13.4%

f. Current ratio:
Cash...............................................................
Accounts receivable (net) ............................
Inventory .......................................................
Prepaid expenses .........................................
Total current assets ...................................

2013
$ 50,000
300,000
380,000
30,000
$760,000

2012
$ 40,000
320,000
420,000

10,000
$ 790,000

2011
$ 75,000
250,000
350,000
40,000
$ 715,000

Accounts payable .........................................
Wages, interest, and dividends payable .....
Income tax payable ......................................
Miscellaneous current liabilities..................
Total current liabilities...............................

$120,000
25,000
29,000
10,000
$184,000

$ 185,000
25,000
5,000
4,000
$ 219,000

$ 220,000
25,000

30,000
10,000
$ 285,000

Total current assets
...............................
Total current liabilities

$760,000
$184,000

$790,000
$219,000

$715,000
$285,000

Current ratio ..................................................

4.13

3.61

2.51

g. Dividend payout ratio:
Dividends paid
.............................................
Net income


2013
$155,000
$180,000

Dividend payout ratio ...................................

86.1%

2012
2011
$150,000 $208,000
$131,000 $208,000
114.5%

100.0%


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23–35. (Concluded)
2. Return on equity improved in 2013 compared to 2012 (14.9% vs. 13.5%), but both
of these values are still well below ROE in 2011 (21.0%). The reasons for the increase in 2013 are an increase in profitability (return on sales is up to 12.9% from
11.9% in 2012) and efficiency (asset turnover of 0.82 vs. 0.73). Both of these factors combine to result in a significant increase in return on assets in 2013 compared to 2012 (10.6% vs. 8.7%).
Current ratio is very high in 2013 (4.13), even higher than in 2012 (3.61). To shortterm creditors, this high current ratio means that Sunshine is almost certain to be
able to pay its debts in the short run. However, for investors, this high current ratio may be bad news because it could indicate that Sunshine is not being efficient
at managing its current assets. Along the same lines, the assets-to-equity ratio is
lower in 2013, indicating that Sunshine is borrowing less relative to the level of

stockholder investment. Sunshine may be able to increase ROE by more aggressive leveraging of stockholders’ equity.
Dividend payout ratio in 2012 exceeded 100%. It looks like this was an attempt to
keep dividends up even when net income had declined drastically from 2011. The
level of dividends in 2013 is about the same as in 2012. Overall, Sunshine’s dividend payout ratio is quite high; this is a sign that the company is older and without many growth opportunities.
Overall, the ratios in 2013 show an improvement over 2012 but have still not recovered to the 2011 levels.
23–36.
1. a. Accounts receivable turnover:
2013
2012
2011
Net sales........................................................ $1,400,000 $1,100,000 $1,220,000
Net receivables:
Beginning of year ....................................
$320,000
$250,000
$250,000
End of year ...............................................
$300,000
$320,000
$250,000
Average receivables [(beginning
balance + ending balance)/2] ..................
$310,000
$285,000
$250,000
Accounts receivable turnover .....................

4.52 times 3.86 times 4.88 times

b. Average collection period:

Average receivables .....................................

2013
$310,000

2012
$285,000

2011
$250,000

Net sales........................................................ $1,400,000 $1,100,000 $1,220,000
Average daily sales (sales/365) ...................
$3,836
$3,014
$3,342
Average collection period ............................
80.8 days 94.6 days 74.8 days


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23–36. (Continued)
c. Inventory turnover:
Cost of goods sold .......................................
Inventory:
Beginning of year ....................................

End of year ...............................................
Average inventory [(beginning
balance + ending balance)/2] ..................
Inventory turnover ........................................

2013
$760,000

2012
$600,000

2011
$610,000

$420,000
$380,000

$350,000
$420,000

$350,000
$350,000

$400,000
1.90 times

$385,000 $350,000
1.56 times 1.74 times

d. Number of days’ sales in inventory:

Average inventory ........................................
Cost of goods sold (COGS) .........................
Average daily COGS (COGS/365) ................
Number of days’ sales in inventory ............

2013
2012
2011
$400,000 $385,000 $350,000
$760,000 $600,000 $610,000
$2,082
$1,644
$1,671
192.1 days 234.2 days 209.5 days

e. Fixed asset turnover:
Net sales........................................................
Land, buildings, and equipment:
Beginning of year .....................................
End of year ................................................
Average fixed assets [(beginning
balance + ending balance)/2] ..................
Fixed asset turnover ....................................

2013
2012
2011
$1,400,000 $1,100,000 $1,220,000
$600,000
$760,000


$690,000
$600,000

$690,000
$690,000

$680,000 $645,000
2.06 times 1.71 times

$690,000
1.77 times

f. Debt ratio:
Total assets ...................................................
Less: Total equity [see 23–35(1a)]...............
Total liabilities ............................................

2013
2012
2011
$1,700,000 $1,500,000 $1,550,000
1,206,000
971,000
990,000
$ 494,000 $ 529,000 $ 560,000

Total liabilities
.............................................
Total assets


$494,000
$529,000 $560,000
$1,700,000 $1,500,000 $1,550,000

Debt ratio.......................................................

29.1%

35.3%

36.1%

2013

2012

2011

g. Debt-to-equity ratio:
Total liabilities
Total equity .............................................
Debt-to-equity ratio ......................................

$494,000 $529,000
$1,206,000 $971,000
0.41

0.54


$560,000
$990,000
0.57


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1003

23–36. (Continued)
h. Times interest earned:

i.

8% bonds payable ........................................

2013
$ 300,000

2012
$ 300,000

2011
$250,000

Interest expense (0.08) .................................

$ 24,000


$ 24,000

$ 20,000

Income before taxes .....................................
Add back interest expense ..........................
Earnings before interest and taxes .............

$ 300,000
24,000
$ 324,000

$ 220,000
24,000
$ 244,000

$360,000
20,000
$380,000

Earnings before interest and taxes
............
Interest expense

$324,000
$24,000

$244,000 $380,000
$24,000 $20,000


Times interest earned ..................................

13.5 times

10.2 times 19.0 times

Earnings per share:
2013
Net income
...........
Number of $10 stated value shares

Earnings per share .......................................
j.

$180,000
50,000

2012

$131,000
40,000

2011

$208,000
40,000

$3.60


$3.28

$5.20

2013

2012

2011

$25
$3.28

$50
$5.20

Price-earnings ratio:
Year-end stock price per share
..................
Earnings per share

$35
$3.60

Price-earnings ratio ......................................

9.7

7.6


2013

2012

9.6

k. Book-to-market ratio:
2011

Year-end stock price per share ................... $
35 $
25 $
50
Number of $10 stated value shares .............
50,000
40,000
40,000
Total market value ..................................... $1,750,000 $ 1,000,000 $2,000,000
Total equity
......................................
Total market value

Book-to-market ratio ....................................

$1,206,000 $971,000 $990,000
$1,750,000 $1,000,000 $2,000,000
0.69

0.97


0.50