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profitability (earnings before interest and taxes, as well as earnings after taxes) is more easily
distinguished – especially when we compare it with the smaller percentage improvement
in sales. Moreover, the indexed income statements give us information on the magnitude
of absolute changes in profits and expenses. With common-size statements, we have no
information about how the absolute amounts change over time.
In summary, the standardization of balance sheet and income statement items as percent-
ages of totals and as indexes to a base year often gives us insights additional to those obtained
from the analysis of financial ratios. Common-size and index analysis is much easier when
a computer spreadsheet program, such as Excel, is employed. The division calculations by
rows or columns can be done quickly and accurately with such a program – but it is up to
you, the analyst, to interpret the results.

Key Learning Points

l Financial analysis, though varying according to the l Financial ratios can be divided into five basic types:
particular interests of the analyst, always involves liquidity, leverage (debt), coverage, activity, and
the use of various financial statements – primarily the profitability. No one ratio is itself sufficient for realistic
balance sheet and income statement. assessment of the financial condition and perform-
l The balance sheet summarizes the assets, liabilities, ance of a firm. With a group of ratios, however, rea-
and owners’ equity of a business at a point in time, sonable judgments can be made. The number of key
and the income statement summarizes revenues and ratios needed for this purpose is not particularly large
expenses of a firm over a particular period of time. – about a dozen or so.
l International and national accounting standard setters, l The usefulness of ratios depends on the ingenuity and
are working toward “convergence” in accounting experience of the financial analyst who employs them.
standards around the world. “Convergence” aims to By themselves, financial ratios are fairly meaning-
narrow or remove accounting differences so that less; they must be analyzed on a comparative basis.
investors can better understand financial statements Comparing one company with similar companies and
prepared under different accounting frameworks. industry standards over time is crucial. Such a com-
l A conceptual framework for financial analysis pro- parison uncovers leading clues in evaluating changes
vides the analyst with an interlocking means for and trends in the firm’s financial condition and pro-
structuring the analysis. For example, in the analysis fitability. This comparison may be historical, but it
of external financing, one is concerned with the firm’s may also include an analysis of the future based on
funds needs, its financial condition and performance, projected financial statements.
and its business risk. Upon analysis of these factors, l Additional insights can be gained by common-size and
one is able to determine the firm’s financing needs index analysis. In the former, we express the various
and to negotiate with outside suppliers of capital. balance sheet items as a percentage of total assets and
l Financial ratios are the tools used to analyze finan- the income statement items as a percentage of net
cial condition and performance. We calculate ratios sales. In the latter, balance sheet and income state-
because in this way we get a comparison that may prove ment items are expressed as an index relative to an
more useful than the raw numbers by themselves. initial base year.

Summary of Key Ratios

LIQUIDITY
Current assets Measures ability to meet current
CURRENT = debts with current assets.
Current liabilities
Current assets less inventories Measures ability to meet current
ACID-TEST (QUICK) = debts with most-liquid (quick)
Current liabilities
current assets.

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LEVERAGE
Total debt Indicates the extent to which debt
DEBT-TO-EQUITY = financing is used relative to equity
Shareholders’ equity
financing.
Total debt Shows the relative extent to which
DEBT-TO-TOTAL-ASSETS = the firm is using borrowed
Total assets
money.
COVERAGE
EBIT* Indicates ability to cover interest
INTEREST COVERAGE = charges; tells number of times
Interest expense
interest is earned.
ACTIVITY
Annual net credit sales Measures how many times the
RECEIVABLE TURNOVER (RT) = receivables have been turned over
Receivables**
(into cash) during the year;
provides insight into quality of
the receivables.
RECEIVABLE TURNOVER Average number of days
365
IN DAYS (RTD) = receivables are outstanding
(Average collection period) RT before being collected.
Cost of goods sold Measures how many times the
INVENTORY TURNOVER (IT) = inventory has been turned over
Inventory**
(sold) during the year; provides
insight into liquidity of inventory
and tendency to overstock.
INVENTORY TURNOVER 365 Average number of days the
IN DAYS (ITD) = inventory is held before it is
IT
turned into accounts receivable
through sales.
TOTAL ASSET TURNOVER Net sales Measures relative efficiency of
= total assets to generate sales.
(Capital turnover) Total assets**
PROFITABILITY
Net profit after taxes Measures profitability with respect
NET PROFIT MARGIN = to sales generated; net income per
Net sales
dollar of sales.
RETURN ON INVESTMENT Measures overall effectiveness in
Net profit after taxes
(ROI) = generating profits with available
(Return on assets) Total assets** assets; earning power of invested
capital.
= NET PROFIT MARGIN × TOTAL ASSET TURNOVER
Net profit after taxes Net sales
= ×
Net sales Total assets**
Net profit after taxes Measures earning power on
RETURN ON EQUITY (ROE) = shareholders’ book-value
Shareholders’ equity**
investment.
= NET PROFIT × TOTAL ASSET × EQUITY
MARGIN TURNOVER MULTIPLIER
Net profit after taxes Net sales Total assets**
= × ×
Net sales Total assets** Shareholders’ equity**

*Earnings before interest and taxes.

**An average, rather than an ending, balance may be needed.

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6 Financial Statement Analysis

Cash $ Notes and payables $100,000

Accounts receivable Long-term debt
Inventory Common stock $100,000
Plant and equipment Retained earnings $100,000
Total assets Total liabilities and
$ shareholders’ equity $

4. Kedzie Kord Company had the following balance sheets and income statements over the
last three years (in thousands):

20X1 20X2 20X3

Cash $ 561 $ 387 $ 202
Receivables 1,963 2,870 4,051
Inventories 2,031 2,613 3,287
Current assets $ 4,555 $ 5,870 $ 7,540
Net fixed assets 2,581 4,430 4,364
Total assets $ 7,136 $10,300 $11,904
Payables $ 1,862 $ 2,944 $ 3,613
Accruals 301 516 587
Bank loan 250 900 1,050
Current liabilities $ 2,413 $ 4,360 $ 5,250
Long-term debt 500 1,000 950
Shareholder’s equity 4,223 4,940 5,704
Total liabilities and
shareholder’s equity $ 7,136 $10,300 $11,904
Sales $11,863 $14,952 $16,349
Cost of goods sold 8,537 11,124 12,016
Selling, general, and
administrative expenses 2,276 2,471 2,793
Interest 73 188 200
Profit before taxes $ 977 $ 1,169 $ 1,340
Taxes 390 452 576
Profit after taxes $ 587 $ 717 $ 764

Using common-size and index analysis, evaluate trends in the company’s financial condi-
tion and performance.

Problems
1. The data for various companies in the same industry are as follows:

COMPANY
A B C D E F
Sales (in millions) $10 $20 $8 $5 $12 $17
Total assets (in millions) 8 10 6 2.5 4 8
Net income (in millions) 0.7 2 0.8 0.5 1.5 1

Determine the total asset turnover, net profit margin, and earning power for each of the
companies.
2. Cordillera Carson Company has the following balance sheet and income statement for
20X2 (in thousands):

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BALANCE SHEET INCOME STATEMENT

Cash $ 400 Net sales (all credit) $12,680
Accounts receivable 1,300 Cost of goods sold 8,930
Inventories 2,100 Gross profit $ 3,750
Current assets $3,800 Selling, general, and
Net fixed assets 3,320 administration expenses 2,230
Total assets $7,120 Interest expense 460
Profit before taxes $ 1,060
Accounts payable $ 320 Taxes 390
Accruals 260 Profit after taxes $ 670
Short-term loans 1,100
Current liabilities $1,680
Long-term debt 2,000
Net worth 3,440
Total liabilities and net worth $7,120

Notes: (i) current period’s depreciation is $480; (ii) ending inventory for 20X1 was $1,800.

On the basis of this information, compute (a) the current ratio, (b) the acid-test ratio,
(c) the average collection period, (d) the inventory turnover ratio, (e) the debt-to-net-worth
ratio, (f ) the long-term debt-to-total-capitalization ratio, (g) the gross profit margin,
(h) the net profit margin, and (i) the return on equity.
3. Selected financial ratios for RMN, Incorporated, are as follows:

20X1 20X2 20X3

Current ratio 4.2 2.6 1.8
Acid-test ratio 2.1 1.0 0.6
Debt-to-total-assets 23% 33% 47%
Inventory turnover 8.7× 5.4× 3.5×
Average collection period 33 days 36 days 49 days
Total asset turnover 3.2× 2.6× 1.9×
Net profit margin 3.8% 2.5% 1.4%
Return on investment (ROI) 12.1% 6.5% 2.8%
Return on equity (ROE) 15.7% 9.7% 5.4%

a. Why did return on investment decline?

b. Was the increase in debt a result of greater current liabilities or of greater long-term
debt? Explain.
4. The following information is available on the Vanier Corporation:
BALANCE SHEET AS OF DECEMBER 31, 20X6 (in thousands)
Cash and marketable securities $500 Accounts payable $ 400
Accounts receivable ? Bank loan ?
Inventories ? Accruals 200
Current assets ? Current liabilities ?
Long-term debt 2,650
Net fixed assets ? Common stock and retained earnings 3,750
Total assets ? Total liabilities and equity ?

INCOME STATEMENT FOR 20X6 (in thousands)

Credit sales $8,000
Cost of goods sold ?
Gross profit ?
Selling and administrative expenses ?
Interest expense 400
Profit before taxes ?
Taxes (44% rate) ?
Profit after taxes ?

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OTHER INFORMATION
Current ratio 3 to 1
Depreciation $500
Net profit margin 7%
Total liabilities/shareholders’ equity 1 to 1
Average collection period 45 days
Inventory turnover ratio 3 to 1

Assuming that sales and production are steady throughout a 360-day year, complete the
balance sheet and income statement for Vanier Corporation.
5. A company has total annual sales (all credit) of $400,000 and a gross profit margin of
20 percent. Its current assets are $80,000; current liabilities, $60,000; inventories, $30,000;
and cash, $10,000.
a. How much average inventory should be carried if management wants the inventory
turnover to be 4?
b. How rapidly (in how many days) must accounts receivable be collected if management
wants to have an average of $50,000 invested in receivables? (Assume a 360-day year.)
6. Stoney Mason, Inc., has sales of $6 million, a total asset turnover ratio of 6 for the year, and
net profits of $120,000.
a. What is the company’s return on assets or earning power?
b. The company is considering the installation of new point-of-sales cash registers
throughout its stores. This equipment is expected to increase efficiency in inventory
control, reduce clerical errors, and improve record keeping throughout the system. The
new equipment will increase the investment in assets by 20 percent and is expected to
increase the net profit margin from 2 to 3 percent. No change in sales is expected. What
is the effect of the new equipment on the return on assets ratio or earning power?
7. The long-term debt section of the balance sheet of the Queen Anne’s Lace Corporation
appears as follows:

91/4% mortgage bonds $2,500,000

123/8% second mortgage bonds 1,500,000
101/4% debentures 1,000,000
141/2% subordinated debentures 1,000,000
$6,000,000

If the average earnings before interest and taxes of the company is $1.5 million and all debt
is long term, what is the overall interest coverage?
8. Tic-Tac Homes has had the following balance sheet statements the past four years (in
thousands):
20X1 20X2 20X3 20X4
Cash $ 214 $ 93 $ 42 $ 38
Receivables 1,213 1,569 1,846 2,562
Inventories 2,102 2,893 3,678 4,261
Net fixed assets 2,219 2,346 2,388 2,692
Total assets $5,748 $6,901 $7,954 $9,553
Accounts payable $1,131 $1,578 $1,848 $2,968
Notes payable 500 650 750 750
Accruals 656 861 1,289 1,743
Long-term debt 500 800 800 800
Common stock 200 200 200 200
Retained earnings 2,761 2,812 3,067 3,092
Total liabilities and
shareholders’ equity $5,748 $6,901 $7,954 $9,553

Using index analysis, what are the major problems in the company’s financial condition?

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9. US Republic Corporation balance sheet, December 31, 20X3

ASSETS LIABILITIES AND SHAREHOLDERS’ EQUITY

Cash $ 1,000,000 Notes payable, bank $ 4,000,000
Accounts receivable 5,000,000 Accounts payable 2,000,000
Inventory 7,000,000 Accrued wages and taxes 2,000,000
Fixed assets, net 17,000,000 Long-term debt 12,000,000
Preferred stock 4,000,000
Common stock 2,000,000
Retained earnings 4,000,000
Total liabilities and
Total assets $30,000,000 shareholders’ equity $30,000,000

US Republic Corporation statement of income and retained earnings,

year ended December 31, 20X3

Net sales
Credit $16,000,000
Cash 4,000,000
Total $20,000,000
Cost and Expenses
Cost of goods sold $12,000,000
Selling, general, and administrative expenses 2,200,000
Depreciation 1,400,000
Interest 1,200,000 $16,800,000
Net income before taxes $ 3,200,000
Taxes on income 1,200,000
Net income after taxes $ 2,000,000
Less: Dividends on preferred stock 240,000
Net income available to common shareholders $ 1,760,000
Add: Retained earnings at 1/1/X3 2,600,000
Subtotal $ 4,360,000
Less: Dividends paid on common stock 360,000
Retained earnings 12/31/X3 $ 4,000,000

a. Fill in the 20X3 column in the table that follows.

US Republic Corporation
INDUSTRY
RATIO 20X1 20X2 20X3 NORMS
1. Current ratio 250% 200% 225%
2. Acid-test ratio 100% 90% 110%
3. Receivable turnover 5.0× 4.5× 6.0×
4. Inventory turnover 4.0× 3.0× 4.0×
5. Long-term debt/total capitalization 35% 40% 33%
6. Gross profit margin 39% 41% 40%
7. Net profit margin 17% 15% 15%
8. Return on equity 15% 20% 20%
9. Return on investment 15% 12% 12%
10. Total asset turnover 0.9× 0.8× 1.0×
11. Interest coverage ratio 5.5× 4.5× 5.0×

b. Evaluate the position of the company using information from the table. Cite specific
ratio levels and trends as evidence.
c. Indicate which ratios would be of most interest to you and what your decision would
be in each of the following situations:
(i) US Republic wants to buy $500,000 worth of merchandise inventory from you,
with payment due in 90 days.
(ii) US Republic wants you, a large insurance company, to pay off its note at the bank
and assume it on a 10-year maturity basis at a current rate of 14 percent.

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 ChAPTER 3 Financial Statements and Ratio Analysis 143

confidently, had the capability to build any product and could do so using a lean
manufacturing model. The firm would soon be profitable, claimed the CEO, because
the company used state-of-the-art technology to build a variety of products while
keeping inventory levels low. As a business press reporter, you have calculated some
ratios to analyze the financial health of the firm. Bluestone’s current ratios and quick
ratios for the past 6 years are shown in the following table:

2010 2011 2012 2013 2014 2015

Current ratio 1.2 1.4 1.3 1.6 1.8 2.2
Quick ratio 1.1 1.3 1.2 0.8 0.6 0.4

What do you think of the CEO’s claim that the firm is lean and soon to be
profitable? (Hint: Is there a possible warning sign in the relationship between the
two ratios?)

LG 6 E3–5 If we know that a firm has a net profit margin of 4.5%, total asset turnover of 0.72,
and a financial leverage multiplier of 1.43, what is its ROE? What is the advantage
to using the DuPont system to calculate ROE over the direct calculation of earnings
available for common stockholders divided by common stock equity?

Problems All problems are available in MyFinancelab.

LG 1 P3–1 Reviewing basic financial statements The income statement for the year ended
December 31, 2015, the balance sheets for December 31, 2015 and 2014, and
the statement of retained earnings for the year ended December 31, 2015, for
Technica, Inc., are given below and on the following page. Briefly discuss the form
and informational content of each of these statements.

Technica, Inc., Income Statement for the Year Ended

December 31, 2015

Sales revenue $600,000

Less: Cost of goods sold 460,000
Gross profits $140,000
Less: Operating expenses
General and administrative expenses $ 30,000
Depreciation expense 30,000
Total operating expense $ 60,000
Operating profits $ 80,000
Less: Interest expense 10,000
Net profits before taxes $ 70,000
Less: Taxes 27,100
Earnings available for common stockholders $ 42,900

Earnings per share (EPS) $2.15

144 PART 2 Financial Tools

Technica, Inc., Balance Sheets

December 31
Assets 2015 2014
Cash $ 15,000 $ 16,000
Marketable securities 7,200 8,000
Accounts receivable 34,100 42,200
Inventories 82,000 50,000
Total current assets $138,300 $116,200
Land and buildings $150,000 $150,000
Machinery and equipment 200,000 190,000
Furniture and fixtures 54,000 50,000
Other 11,000 10,000
Total gross fixed assets $415,000 $400,000
Less: Accumulated depreciation 145,000 115,000
Net fixed assets $270,000 $285,000
Total assets $408,000 $401,200

Liabilities and Stockholders’ Equity

Accounts payable $ 57,000 $ 49,000
Notes payable 13,000 16,000
Accruals 5,000 6,000
Total current liabilities $ 75,000 $ 71,000
Long-term debt $150,000 $160,000
Common stock equity (shares outstanding: $110,200 $120,000
19,500 in 2015 and 20,000 in 2014)
Retained earnings 73,100 50,200
Total stockholders’ equity $183,300 $170,200
Total liabilities and stockholders’ equity $408,300 $401,200

Technica, Inc., Statement of Retained Earnings

for the Year Ended December 31, 2015

Retained earnings balance (January 1, 2015) $50,200

Plus: Net profits after taxes (for 2015) 42,900
Less: Cash dividends (paid during 2015) 20,000
Retained earnings balance (December 31, 2015) $73,100

LG 1 P3–2 Financial statement account identification Mark each of the accounts listed in the
following table as follows:
a. In column (1), indicate in which statement—income statement (IS) or balance
sheet (BS)—the account belongs.
b. In column (2), indicate whether the account is a current asset (CA), current liabil-
ity (CL), expense (E), fixed asset (FA), long-term debt (LTD), revenue (R), or
stockholders’ equity (SE).
 ChAPTER 3 Financial Statements and Ratio Analysis 145

(1) (2)
Account name Statement Type of account
Accounts payable
Accounts receivable
Accruals
Accumulated depreciation
Administrative expense
Buildings
Cash
Common stock (at par)
Cost of goods sold
Depreciation
Equipment
General expense
Interest expense
Inventories
Land
Long-term debts
Machinery
Marketable securities
Notes payable
Operating expense
Paid-in capital in excess of par
Preferred stock
Preferred stock dividends
Retained earnings
Sales revenue
Selling expense
Taxes
Vehicles

LG 1 P3–3 Income statement preparation David Chan operates Speedy Delivery Service Company,
a fleet of delivery trucks in a large metropolitan area, and has just completed his first full
year in business. During the year, the company billed $420,000 for delivery services.
David has a total of 11 employees (10 truck drivers and a clerical assistant). In addition
to his own monthly salary of $5,000, David paid annual salaries of $12,100 and
$10,000 to each of the truck drivers and the clerical assistant, respectively. Employment
taxes and benefit costs for David and his employees totaled $42,600 for the year. Sundry
expenses, including office supplies, totaled $12,400 for the year. In addition, David
spent $22,000 during the year on tax-deductible travel and entertainment associated
with client visits and new business development. Lease payments for the rented office
space (a tax-deductible expense) were $2,800 per month. Depreciation expense on the
office furniture and delivery trucks was $16,300 for the year. During the year, David
paid an interest of $18,000 on the $150,000 borrowed to start the business. The
company was subject to an average tax rate of 40% during 2014.
a. Prepare an income statement for Speedy Delivery Service Company for the year
ended December 31, 2014.
b. Evaluate the financial performance of the company in 2014.
146 PART 2 Financial Tools

Personal Finance Problem

LG 1 P3–4 Income statement preparation Adam and Arin Adams have collected their personal
income and expense information and have asked you to put together an income and
expense statement for the year ended December 31, 2015. The following informa-
tion is received from the Adams family.

Adam’s salary $45,000 Utilities $ 3,200

Arin’s salary 30,000 Groceries 2,200
Interest received 500 Medical 1,500
Dividends received 150 Property taxes 1,659
Auto insurance 600 Income tax, Social Security 13,000
Home insurance 750 Clothes and accessories 2,000
Auto loan payment 3,300 Gas and auto repair 2,100
Mortgage payment 14,000 Entertainment 2,000

a. Create a personal income and expense statement for the period ended December
31, 2015. It should be similar to a corporate income statement.
b. Did the Adams family have a cash surplus or cash deficit?
c. If the result is a surplus, how can the Adams family use that surplus?

LG 1 P3–5 Calculation of EPS and retained earnings Zerbel Company Limited ended the year
with a net profit before taxes of $361,000 in 2015. The company is subject to a
40% tax rate, and committed to pay $52,000 in preferred stock dividends before dis-
tributing any earnings on the 200,000 shares of common stock currently outstanding.
a. Calculate Zerbel’s 2015 earnings per share (EPS).
b. If the firm paid common stock dividends of $0.60 per share, how many dollars
would go to retained earnings?

LG 1 P3–6 Balance sheet preparation Use the appropriate items from the following list to pre-
pare in good form Mellark’s Baked Goods balance sheet at December 31, 2015.

Value ($000) at Value ($000) at

Item December 31, 2015 Item December 31, 2015
Accounts payable $ 220 Inventories $ 375
Accounts receivable 450 Land 100
Accruals 55 Long-term debts 420
Accumulated depreciation 265 Machinery 420
Buildings 225 Marketable securities 75
Cash 215 Notes payable 475
Common stock (at par) 90 Paid-in capital in excess
Cost of goods sold 2,500 of par 360
Depreciation expense 45 Preferred stock 100
Equipment 140 Retained earnings 210
Furniture and fixtures 170 Sales revenue 3,600
General expense 320 Vehicles 25
 ChAPTER 3 Financial Statements and Ratio Analysis 147

Personal Finance Problem

LG 1 P3–7 Balance sheet preparation Adam and Arin Adams have collected their personal
asset and liability information and have asked you to put together a balance sheet
as of December 31, 2015. The following information is received from the Adams
family.

Cash $ 300 Retirement funds, IRA $ 2,000

Checking 3,000 2014 Sebring 15,000
Savings 1,200 2010 Jeep 8,000
IBM stock 2,000 Money market funds 1,200
Auto loan 8,000 Jewelry and artwork 3,000
Mortgage 100,000 Net worth 76,500
Medical bills payable 250 Household furnishings 4,200
Utility bills payable 150 Credit card balance 2,000
Real estate 150,000 Personal loan 3,000

a. Create a personal balance sheet as of December 31, 2015. It should be similar to

a corporate balance sheet.
b. What must the total assets of the Adams family be equal to by December 31, 2015?
c. What was their net working capital (NWC) for the year? (Hint: NWC is the dif-
ference between total liquid assets and total current liabilities.)

LG 1 P3–8 Effect of net income on a firm’s balance sheet Relaxing Resort Group reported net
income of $1,736,000 for the year ended December 31, 2015. Show how Relaxing
Resort Group’s balance sheet would change from 2014 to 2015 depending on how
Relaxing Resort Group “spent” those earnings as described in the situations that
appear below.

Relaxing Resort Group Balance Sheet as of December 31, 2014

Assets Liabilities and Stockholders’ Equity
Cash $ 120,000 Accounts payable $ 170,000
Marketable securities 56,000 Short-term notes 76,000
Accounts receivable 66,000 Current liabilities $ 246,000
Inventories $ 130,000 Long-term debt $3,210,500
Current assets $ 372,000 Total liabilities $3,456,500
Equipment $3,928,000 Common stock $ 500,000
Buildings $1,600,000 Retained earnings $1,964,500
Fixed assets $5,528,000 Stockholders’ equity $2,464,500
Total assets $5,900,000 Total liabilities and equity $5,921,000

a. Relaxing Resort Group paid no dividends during the year and invested the funds
in marketable securities.
b. Relaxing Resort Group paid dividends totaling $800,000 and used the balance of
the net income to retire (pay off) long-term debt.
c. Relaxing Resort Group paid dividends totaling $800,000 and invested the
balance of the net income in building a new coffee lounge.
d. Relaxing Resort Group paid out all $1,736,000 as dividends to its stockholders.
148 PART 2 Financial Tools

LG 1 P3–9 Initial sale price of common stock B&J Dental Group has one issue of preferred
stock and one issue of common stock outstanding. Given B&J’s stockholders’ equity
account that follows, determine the original price per share at which the firm sold its
single issue of common stock.

Stockholders’ Equity ($000)

Preferred stock $ 375
Common stock ($0.50 par, 500,000
shares outstanding) 250
Paid-in capital in excess of par on
common stock 2,376
Retained earnings 950
Total stockholders’ equity $3,951

LG 1 P3–10 Statement of retained earnings Hayes Enterprises began 2015 with a retained earn-
ings balance of $1,151,000. During 2015, the firm earned $528,000 after taxes.
From this amount, preferred stockholders were paid $98,000 in dividends. At year-
end 2015, the firm’s retained earnings totaled $1,324,000. The firm had 100,000
shares of common stock outstanding during 2015.
a. Prepare a statement of retained earnings for the year ended December 31, 2015,
for Hayes Enterprises. (Note: Be sure to calculate and include the amount of cash
dividends paid in 2015.)
b. Calculate the firm’s 2015 earnings per share (EPS).
c. How large a per-share cash dividend did the firm pay on common stock during
2015?

LG 1 P3–11 Changes in stockholders’ equity Listed are the equity sections of balance sheets
for years 2014 and 2015 as reported by Golden Mine, Inc. The overall value of
stockholders’ equity has risen from $2,370,000 to $9,080,000. Use the statements
to discover how and why that happened.

Golden Mine, Inc.

Balance Sheets (partial)

Stockholders’ equity 2014 2015

Common stock ($1.00 par)
Authorized: 5,000,000 shares
Outstanding: 1,200,000 shares 2015 $1,200,000
600,000 shares 2014 $ 600,000
Paid-in capital in excess of par 250,000 5,500,000
Retained earnings 1,520,000 2,380,000
Total stockholders’ equity $2,370,000 $9,080,000

The company paid total dividends of $240,000 during fiscal 2015.

a. What was Golden Mine’s net income for fiscal 2015?
b. How many new shares did the corporation issue and sell during 2015?
c. What was the average price per share of the new stock sold during 2015?
d. At what average price per share did Golden Mine’s original 600,000 shares sell?
 ChAPTER 3 Financial Statements and Ratio Analysis 149

LG 2 LG 3 P3–12 Ratio comparisons Robert Arias recently inherited a stock portfolio from his uncle.
Wishing to learn more about the companies in which he is now invested, Robert per-
LG 4 LG 5 forms a ratio analysis on each one and decides to compare them to one another.
Some of his ratios are listed below.

Ratio Island Burger Fink Roland

Electric Utility Heaven Software Motors
Current ratio 1.10 1.3 6.8 4.5
Quick ratio 0.90 0.82 5.2 3.7
Debt ratio 0.68 0.46 0.0 0.35
Net profit margin 6.2% 14.3% 28.5% 8.4%

Assuming that his uncle was a wise investor who assembled the portfolio with care,
Robert finds the wide differences in these ratios confusing. Help him out.
a. What problems might Robert encounter in comparing these companies to one
another on the basis of their ratios?
b. Why might the current and quick ratios for the electric utility and the fast-food
stock be so much lower than the same ratios for the other companies?
c. Why might it be all right for the electric utility to carry a large amount of debt,
but not the software company?
d. Why wouldn’t investors invest all their money in software companies instead of
in less profitable companies? (Focus on risk and return.)

LG 3 P3–13 Liquidity management Bauman Company’s total current assets, total current liabili-
ties, and inventory for each of the past 4 years follow:

Item 2012 2013 2014 2015

Total current assets $16,950 $21,900 $22,500 $27,000
Total current liabilities 9,000 12,600 12,600 17,400
Inventory 6,000 6,900 6,900 7,200

a. Calculate the firm’s current and quick ratios for each year. Compare the resulting
time series for these measures of liquidity.
b. Comment on the firm’s liquidity over the 2012–2013 period.
c. If you were told that Bauman Company’s inventory turnover for each year in the
2012–2015 period and the industry averages were as follows, would this infor-
mation support or conflict with your evaluation in part b? Why?

Inventory turnover 2012 2013 2014 2015

Bauman Company 6.3 6.8 7.0 6.4
Industry average 10.6 11.2 10.8 11.0
150 PART 2 Financial Tools

Personal Finance Problem

LG 3 P3–14 Liquidity ratio Joyce Cheung has compiled some of her personal financial data to
determine her liquidity position. The data are as follows.

Account Amount
Cash $5,300
Marketable securities 1,800
Checking account 2,500
Credit card payables 2,300
Short-term notes payable 1,090

a. Calculate Joyce’s liquidity ratio.

b. Several of Joyce’s friends have told her that they have liquidity ratios of about
1.9. How would you analyze Joyce’s liquidity relative to her friends?

LG 3 P3–15 Inventory management Efficient Production Incorporation has annual sales of $5.8
million and a gross profit margin of 30%. Its end-of-quarter inventories are

Quarter Inventory
1 $ 300,000
2 570,000
3 890,000
4 430,000

a. Find the average quarterly inventory, and use it to calculate the firm’s inventory
turnover and the average age of inventory.
b. Assuming that the company is in an industry with an average inventory turnover
of 4.8, how would you evaluate the activity of Efficient Production’s inventory?

LG 3 P3–16 Accounts receivable management Speedy Manufacturing Company’s end-of-year

accounts receivable balance consists of amounts originating in the months indicated
below. The company had annual sales of $3.2 million. The company extends 30-day
credit terms.

Month of origin Accounts receivable

July $ 2,500
August 3,600
September 63,250
October 21,100
November 54,000
December 298,000
Year-end accounts receivable $442,450

a. Use the year-end total to evaluate the company’s collection system.

b. If 75% of the company’s sales occur between July and December, would this
information affect the validity of your conclusion in part a? Explain.
 ChAPTER 3 Financial Statements and Ratio Analysis 151

LG 3 P3–17 Interpreting liquidity and activity ratios The new owners of Bluegrass Natural
Foods, Inc., have hired you to help them diagnose and cure problems that the com-
pany has had in maintaining adequate liquidity. As a first step, you perform a liquid-
ity analysis. You then do an analysis of the company’s short-term activity ratios.
Your calculations and appropriate industry norms are listed.

Ratio Bluegrass Industry norm

Current ratio 4.5 4.0
Quick ratio 2.0 3.1
Inventory turnover 6.0 10.4
Average collection period 73 days 52 days
Average payment period 31 days 40 days

a. What recommendations relative to the amount and the handling of inventory

could you make to the new owners?
b. What recommendations relative to the amount and the handling of accounts
receivable could you make to the new owners?
c. What recommendations relative to the amount and the handling of accounts
payable could you make to the new owners?
d. What results, overall, would you hope your recommendations would achieve?
Why might your recommendations not be effective?

LG 4 P3–18 Debt analysis Springfield Bank is evaluating Creek Enterprises, which has requested
a $4,000,000 loan, to assess the firm’s financial leverage and financial risk. On the
basis of the debt ratios for Creek, along with the industry averages (see the top of
the next page) and Creek’s recent financial statements (following), evaluate and
recommend appropriate action on the loan request.

Creek Enterprises Income Statement for the Year Ended December 31, 2015
Sales revenue $30,000,000
Less: Cost of goods sold 21,000,000
Gross profits $ 9,000,000
Less: Operating expenses
Selling expense $ 3,000,000
General and administrative expenses 1,800,000
Lease expense 200,000
Depreciation expense 1,000,000
Total operating expense $ 6,000,000
Operating profits $ 3,000,000
Less: Interest expense 1,000,000
Net profits before taxes $ 2,000,000
Less: Taxes (rate 5 40%) 800,000
Net profits after taxes $ 1,200,000
Less: Preferred stock dividends 100,0000
Earnings available for common stockholders $ 1,100,000
152 PART 2 Financial Tools

Creek Enterprises Balance Sheet December 31, 2015

Industry averages
Assets Liabilities and Stockholders’ Equity Debt ratio 0.51
Cash $ 1,000,000 Accounts payable $ 8,000,000 Times interest
Marketable securities 3,000,000 Notes payable 8,000,000 earned ratio 7.30
Accounts receivable 12,000,000 Accruals 500,000 Fixed-payment
Inventories 7,500,000 Total current liabilities $16,500,000 coverage ratio 1.85
Total current assets $23,500,000 Long-term debt (includes
Land and buildings $11,000,000 financial leases)b $20,000,000
Machinery and equipment 20,500,000 Preferred stock (25,000
Furniture and fixtures 8,000,000 shares, $4 dividend) $ 2,500,000
Gross fixed assets (at cost)a $39,500,000 Common stock (1 million
Less: Accumulated depreciation 13,000,000 shares at $5 par) 5,000,000
Net fixed assets $26,500,000 Paid-in capital in excess of
Total assets $50,000,000 par value 4,000,000
Retained earnings 2,000,000
Total stockholders’ equity $13,500,000
Total liabilities and
stockholders’ equity $50,000,000
a
The firm has a 4-year financial lease requiring annual beginning-of-year payments of $200,000. Three
years of the lease have yet to run.
b
Required annual principal payments are $800,000.

LG 5 P3–19 Profitability analysis In early 2013, Pepsi reported revenues of $65.64 billion with earn-
ings available for common stockholders of $6.12 billion. Pepsi’s total assets at the time
were $74.64 billion. Meanwhile, one of Pepsi’s competitors, Dr. Pepper, reported sales of
$6.01 billion with earnings of $0.63 billion. Dr. Pepper had assets of $8.87 billion. Which
company was more profitable? Why is it hard to get a clear answer to this question?

LG 5 P3–20 Common-size statement analysis A common-size income statement for Creek Enter-
prises’ 2014 operations follows. Using the firm’s 2015 income statement presented in
Problem 3–18, develop the 2015 common-size income statement and compare it with
the 2014 statement. Which areas require further analysis and investigation?

Creek Enterprises Common-Size Income Statement

for the Year Ended December 31, 2014

Sales revenue ($35,000,000) 100.0%

Less: Cost of goods sold 65.9
Gross profits 34.1%
Less: Operating expenses
Selling expense 12.7%
General and administrative expenses 6.3
Lease expense 0.6
Depreciation expense 3.6
Total operating expense 23.2
Operating profits 10.9%
Less: Interest expense 1.5
Net profits before taxes 9.4%
Less: Taxes (rate 5 40%) 3.8
Net profits after taxes 5.6%
Less: Preferred stock dividends 0.1
Earnings available for common stockholders 5.5%
 ChAPTER 3 Financial Statements and Ratio Analysis 153

LG 4 LG 5 P3–21 The relationship between financial leverage and profitability Pelican Paper, Inc.,
and Timberland Forest, Inc., are rivals in the manufacture of craft papers. Some fi-
nancial statement values for each company follow. Use them in a ratio analysis that
compares the firms’ financial leverage and profitability.

Item Pelican Paper, Inc. Timberland Forest, Inc.

Total assets $10,000,000 $10,000,000
Total equity (all common) 9,000,000 5,000,000
Total debt 1,000,000 5,000,000
Annual interest 100,000 500,000
Total sales 25,000,000 25,000,000
EBIT 6,250,000 6,250,000
Earnings available for 3,690,000 3,450,000
common stockholders

a. Calculate the following debt and coverage ratios for the two companies. Discuss
their financial risk and ability to cover the costs in relation to each other.
1. Debt ratio
2. Times interest earned ratio
b. Calculate the following profitability ratios for the two companies. Discuss their
profitability relative to one another.
1. Operating profit margin
2. Net profit margin
3. Return on total assets
4. Return on common equity
c. In what way has the larger debt of Timberland Forest made it more profitable
than Pelican Paper? What are the risks that Timberland’s investors undertake
when they choose to purchase its stock instead of Pelican’s?

LG 6 P3–22 Ratio proficiency McDougal Printing, Inc., had sales totaling $40,000,000 in fiscal year
2015. Some ratios for the company are listed below. Use this information to determine
the dollar values of various income statement and balance sheet accounts as requested.

McDougal Printing, Inc.

Year Ended December 31, 2015

Sales $40,000,000
Gross profit margin 80%
Operating profit margin 35%
Net profit margin 8%
Return on total assets 16%
Return on common equity 20%
Total asset turnover 2
Average collection period 62.2 days

Calculate values for the following:

a. Gross profits
b. Cost of goods sold
154 PART 2 Financial Tools

c. Operating profits
d. Operating expenses
e. Earnings available for common stockholders
f. Total assets
g. Total common stock equity
h. Accounts receivable

LG 6 P3–23 Cross-sectional ratio analysis Use the financial statements below and on the next
page for Fox Manufacturing Company for the year ended December 31, 2015, along
with the industry average ratios below to do the following:
a. Prepare and interpret a complete ratio analysis of the firm’s 2015 operations.
b. Summarize your findings and make recommendations.

Fox Manufacturing Company Income Statement

for the Year Ended December 31, 2015

Sales revenue $600,000

Less: Cost of goods sold 460,000
Gross profits $140,000
Less: Operating expenses
General and administrative expenses $ 30,000
Depreciation expense 30,000
Total operating expense 60,000
Operating profits $ 80,000
Less: Interest expense 10,000
Net profits before taxes $ 70,000
Less: Taxes 27,100
Net profits after taxes (Hint: Earnings available for common
stockholders as there are no preferred stockholders) $ 42,900
Earnings per share (EPS) $2.15

Ratio Industry average, 2015

Current ratio 2.35
Quick ratio 0.87
Inventory turnovera 4.55
Average collection perioda 35.8 days
Total asset turnover 1.09
Debt ratio 0.300
Times interest earned ratio 12.3
Gross profit margin 0.202
Operating profit margin 0.135
Net profit margin 0.091
Return on total assets (ROA) 0.099
Return on common equity (ROE) 0.167
Earnings per share (EPS) $3.10
a
Based on a 365-day year and on end-of-year figures.
 ChAPTER 3 Financial Statements and Ratio Analysis 155

Fox Manufacturing Company Balance Sheet

December 31, 2015

Assets

Cash $ 15,000
Marketable securities 7,200
Accounts receivable 34,100
Inventories 82,000
Total current assets $138,300
Net fixed assets 270,000
Total assets $408,300

Liabilities and Stockholders’ Equity

Accounts payable $ 57,000

Notes payable 13,000
Accruals 5,000
Total current liabilities $ 75,000
Long-term debt $150,000
Common stock equity
(20,000 shares outstanding) $110,200
Retained earnings 73,100
Total stockholders’ equity $183,300
Total liabilities and stockholders’ equity $408,300

LG 6 P3–24 Financial statement analysis The financial statements of Zach Industries for the year
ended December 31, 2015, follow.

Zach Industries Income Statement

for the Year Ended December 31, 2015

Sales revenue $160,000

Less: Cost of goods sold 106,000
Gross profits $ 54,000
Less: Operating expenses
Selling expense $ 16,000
General and administrative expenses 10,000
Lease expense 1,000
Depreciation expense 10,000
Total operating expense $ 37,000
Operating profits $ 17,000
Less: Interest expense 6,100
Net profits before taxes $ 10,900
Less: Taxes 4,360
Net profits after taxes $ 6,540
156 PART 2 Financial Tools

Zach Industries Balance Sheet December 31, 2015

Assets
Cash $ 500
Marketable securities 1,000
Accounts receivable 25,000
Inventories 45,500
Total current assets $ 72,000
Land $ 26,000
Buildings and equipment 90,000
Less: Accumulated depreciation 38,000
Net fixed assets $ 78,000
Total assets $150,000

Liabilities and Stockholders’ Equity

Accounts payable $ 22,000
Notes payable 47,000
Total current liabilities $ 69,000
Long-term debt 22,950
Common stocka 31,500
Retained earnings 26,550
Total liabilities and stockholders’ equity $ 150,000
a
The firm’s 3,000 outstanding shares of common stock closed
2015 at a price of $25 per share.

a. Use the preceding financial statements to complete the following table. Assume that
the industry averages given in the table are applicable for both 2014 and 2015.

Ratio Industry average Actual 2014 Actual 2015

Current ratio 1.80 1.84
Quick ratio 0.70 0.78
Inventory turnovera 2.50 2.59
Average collection perioda 37.5 days 36.5 days
Debt ratio 65% 67%
Times interest earned ratio 3.8 4.0
Gross profit margin 38% 40%
Net profit margin 3.5% 3.6%
Return on total assets 4.0% 4.0%
Return on common equity 9.5% 8.0%
Market/book ratio 1.1 1.2

a
Based on a 365-day year and on end-of-year figures.

b. Analyze Zach Industries’ financial condition as it is related to (1) liquidity,

(2) activity, (3) debt, (4) profitability, and (5) market. Summarize the company’s
overall financial condition.
 ChAPTER 3 Financial Statements and Ratio Analysis 157

LG 6 P3–25 Integrative: Complete ratio analysis Given the following financial statements
(following and on the next page), historical ratios, and industry averages, calculate
Sterling Company’s financial ratios for the most recent year. (Assume a 365-day year.)

Sterling Company Income Statement for the Year Ended December 31, 2015
Sales revenue $ 10,000,000
Less: Cost of goods sold 7,500,000
Gross profits $ 2,500,000
Less: Operating expenses
Selling expense $ 300,000
General and administrative expenses 650,000
Lease expense 50,000
Depreciation expense 200,000
Total operating expense $ 1,200,000
Operating profits $ 1,300,000
Less: Interest expense 200,000
Net profits before taxes $ 1,100,000
Less: Taxes (rate 5 40%) 440,000
Net profits after taxes $ 660,000
Less: Preferred stock dividends 50,000
Earnings available for common stockholders $ 610,000

Earnings per share (EPS) $3.05

Sterling Company Balance Sheet December 31, 2015

Assets Liabilities and Stockholders’ Equity
Cash $ 200,000 Accounts payablea $ 900,000
Marketable securities 50,000 Notes payable 200,000
Accounts receivable 800,000 Accruals 100,000
Inventories 950,000 Total current liabilities $ 1,200,000
Total current assets $ 2,000,000 Long-term debt (includes
Gross fixed assets (at cost) $12,000,000 financial leases) $ 3,000,000
Less: Accumulated depreciation 3,000,000 Preferred stock (25,000 shares,
Net fixed assets $ 9,000,000 $2 dividend) $ 1,000,000
Other assets 1,000,000 Common stock (200,000
Total assets $12,000,000 shares at $3 par)b 600,000
Paid-in capital in excess of
par value 5,200,000
Retained earnings 1,000,000
Total stockholders’ equity $ 7,800,000
Total liabilities and stockholders’ equity $12,000,000
a
Annual credit purchases of $6,200,000 were made during the year.
b
On December 31, 2015, the firm’s common stock closed at $39.50 per share.
158 PART 2 Financial Tools

Analyze its overall financial situation from both a cross-sectional and a time-series
viewpoint. Break your analysis into evaluations of the firm’s liquidity, activity, debt,
profitability, and market.

Historical and Industry Average Ratios for Sterling Company

Industry average,
Ratio Actual 2013 Actual 2014 2015
Current ratio 1.40 1.55 1.85
Quick ratio 1.00 0.92 1.05
Inventory turnover 9.52 9.21 8.60
Average collection period 45.6 days 36.9 days 35.5 days
Average payment period 59.3 days 61.6 days 46.4 days
Total asset turnover 0.74 0.80 0.74
Debt ratio 0.20 0.20 0.30
Times interest earned ratio 8.2 7.3 8.0
Fixed-payment coverage ratio 4.5 4.2 4.2
Gross profit margin 0.30 0.27 0.25
Operating profit margin 0.12 0.12 0.10
Net profit margin 0.062 0.062 0.053
Return on total assets (ROA) 0.045 0.050 0.040
Return on common equity (ROE) 0.061 0.067 0.066
Earnings per share (EPS) $1.75 $2.20 $1.50
Price/earnings (P/E) ratio 12.0 10.5 11.2
Market/book (M/B) ratio 1.20 1.05 1.10

LG 6 P3–26 DuPont system of analysis Use the following ratio information for Johnson Interna-
tional and the industry averages for Johnson’s line of business to:
a. Construct the DuPont system of analysis for both Johnson and the industry.
b. Evaluate Johnson (and the industry) over the 3-year period.
c. Indicate in which areas Johnson requires further analysis. Why?

Johnson 2013 2014 2015

Financial leverage multiplier 1.75 1.75 1.85
Net profit margin 0.059 0.058 0.049
Total asset turnover 2.11 2.18 2.34
Industry averages
Financial leverage multiplier 1.67 1.69 1.64
Net profit margin 0.054 0.047 0.041
Total asset turnover 2.05 2.13 2.15

LG 6 P3–27 Complete ratio analysis, recognizing significant differences Home Health, Inc., has
come to Jane Ross for a yearly financial checkup. As a first step, Jane has prepared a
complete set of ratios for fiscal years 2014 and 2015. She will use them to look for
significant changes in the company’s situation from one year to the next.
 ChAPTER 3 Financial Statements and Ratio Analysis 159

Home Health, Inc., Financial Ratios

Ratio 2014 2015
Current ratio 3.25 3.00
Quick ratio 2.50 2.20
Inventory turnover 12.80 10.30
Average collection period 42.6 days 31.4 days
Total asset turnover 1.40 2.00
Debt ratio 0.45 0.62
Times interest earned ratio 4.00 3.85
Gross profit margin 68% 65%
Operating profit margin 14% 16%
Net profit margin 8.3% 8.1%
Return on total assets 11.6% 16.2%
Return on common equity 21.1% 42.6%
Price/earnings ratio 10.7 9.8
Market/book ratio 1.40 1.25

a. To focus on the degree of change, calculate the year-to-year proportional change

by subtracting the year 2014 ratio from the year 2015 ratio and then dividing the
difference by the year 2014 ratio. Multiply the result by 100. Preserve the posi-
tive or negative sign. The result is the percentage change in the ratio from 2014
to 2015. Calculate the proportional change for the ratios shown here.
b. For any ratio that shows a year-to-year difference of 10% or more, state whether
the difference is in the company’s favor or not.
c. For the most significant changes (25% or more), look at the other ratios and cite
at least one other change that may have contributed to the change in the ratio
that you are discussing.

LG 1 P3–28 ETHICS PROBLEM Do some reading in periodicals or on the Internet to find out
more about the Sarbanes-Oxley Act’s provisions for companies. Select one of those
provisions, and indicate why you think financial statements will be more trustwor-
thy if company financial executives implement this provision of SOX.

Spreadsheet Exercise
The income statement and balance sheet are the primary reports that a firm
constructs for use by management and for distribution to stockholders, regulatory
bodies, and the general public. They are the primary sources of historical financial
information about the firm. Dayton Products, Inc., is a moderate-sized
manufacturer. The company’s management has asked you to perform a detailed
financial statement analysis of the firm.