Chapter 2

Introduction to Financial Statement Analysis

1. Consider the following potential events that might have taken place at Global
Conglomerate on December 30, 20x2. For each one, indicate which line items in
Global’s balance sheet would be affected and by how much. Also indicate the
change to Global’s book value of equity. (In all cases, ignore any tax
consequences for simplicity.)
a. Global used $20 million of its available cash to repay $20 million of its long-
term debt.
b. A warehouse fire destroyed $5 million worth of uninsured inventory.
c. Global used $5 million in cash and $5 million in new long-term debt to
purchase a $10 million building.
d. A large customer owing $3 million for products it already received declared
bankruptcy, leaving no possibility that Global would ever receive payment.
e. Global’s engineers discover a new manufacturing process that will cut the cost
of its flagship product by over 50%.
f. A key competitor announces a radical new pricing policy that will drastically
undercut Global’s prices.

2. In early 20x9, General Electric (GE) had a book value of equity of $105 billion, 10.5
billion shares outstanding, and a market price of $10.80 per share. GE also had
cash of $48 billion, and total debt of $524 billion. Three years later, in early 2012,
GE had a book value of equity of $116 billion, 10.6 billion shares outstanding with
a market price of $17 per share, cash of $84 billion, and total debt of $410 billion.
Over this period, what was the change in GE’s:
a. market capitalization?
b. market-to-book ratio?
c. enterprise value?

3. In mid-20x2, Abercrombie & Fitch (ANF) had a book equity of $1693 million, a price
per share of $35.48, and 82.55 million shares outstanding. At the same time, The
 Gap (GPS) had a book equity of $3017 million, a share price of $27.90, and
489.22 million shares outstanding.
a. What is the market-to-book ratio of each of these clothing retailers?
b. What conclusions can you draw by comparing the two ratios?

4. Quisco Systems has 6.5 billion shares outstanding and a share price of $18. Quisco is
considering developing a new networking product in house at a cost of $500
million. Alternatively, Quisco can acquire a firm that already has the technology
for $900 million worth (at the current price) of Quisco stock. Suppose that absent
the expense of the new technology, Quisco will have EPS of $0.80.
a. Suppose Quisco develops the product in house. What impact would the
development cost have on Quisco’s EPS? Assume all costs are incurred this
year and are treated as an R&D expense, Quisco’s tax rate is 35%, and the
number of shares outstanding is unchanged.
b. Suppose Quisco does not develop the product in house but instead acquires the
technology. What effect would the acquisition have on Quisco’s EPS this year?
(Note that acquisition expenses do not appear directly on the income statement.
Assume the firm was acquired at the start of the year and has no revenues or
expenses of its own, so that the only effect on EPS is due to the change in the
number of shares outstanding.)
c. Which method of acquiring the technology has a smaller impact on earnings?
Is this method cheaper? Explain.

5. Suppose your firm receives a $5 million order on the last day of the year. You fill
the order with $2 million worth of inventory. The customer picks up the entire
order the same day and pays $1 million upfront in cash; you also issue a bill for
the customer to pay the remaining balance of $4 million in 30 days. Suppose your
firm’s tax rate is 0% (i.e., ignore taxes). Determine the consequences of this
transaction for each of the following:
a. Revenues
b. Earnings
c. Receivables
d. Inventory
e. Cash

6. Nokela Industries purchases a $40 million cyclo-converter. The cyclo-converter

will be depreciated by $10 million per year over four years, starting this year.
Suppose Nokela’s tax rate is 40%.
 a. What impact will the cost of the purchase have on earnings for each of the next
four years?
b. What impact will the cost of the purchase have on the firm’s cash flow for the
next four years?

7. In fiscal year 20x1, Starbucks Corporation (SBUX) had revenue of $11.70 billion,
gross profit of $6.75 billion, and net income of $1.25 billion. Peet’s Coffee and
Tea (PEET) had revenue of $372 million, gross profit of $72.7 million, and net
income of $17.8 million.
a. Compare the gross margins for Starbucks and Peet’s.
b. Compare the net profit margins for Starbucks and Peet’s.
c. Which firm was more profitable in 2011?

8. In mid-20x2, Apple had cash and short-term investments of $27.65 billion,

accounts receivable of $14.30 billion, current assets of $51.94 billion, and current
liabilities of $33.06 billion.
a. What was Apple’s current ratio?
b. What was Apple’s quick ratio?
c. What is Apple’s cash ratio?
d. In mid-20x2, Dell had a cash ratio of 0.67, a quick ratio of 1.11 and a current
ratio of 1.35. What can you say about the asset liquidity of Apple relative to
Dell?

9. You are analyzing the leverage of two firms and you note the following (all values
in millions of dollars):

a. What is the market debt-to-equity ratio of each firm?

b. What is the book debt-to-equity ratio of each firm?
c. What is the interest coverage ratio of each firm?
d. Which firm may have more difficulty meeting its debt obligations? Explain.

10. In mid-20x2, United Airlines (UAL) had a market capitalization of $6.8 billion,
debt of $12.4 billion, and cash of $7.3 billion. United also had annual revenues of
$37.4 billion. Southwest Airlines (LUV) had a market capitalization of $6.6
billion, debt of $3.3 billion, cash of $3.3 billion, and annual revenues of $17.0
billion.
 a. Compare the market capitalization-to-revenue ratio (also called the price-to-
sales ratio) for United Airlines and Southwest Airlines.
b. Compare the enterprise value-to-revenue ratio for United Airlines and
Southwest Airlines.
c. Which of these comparisons is more meaningful? Explain.

11. For fiscal year 20x1, Peet’s Coffee and Tea (PEET) had a net profit margin of
4.78%, asset turnover of 1.73, and a book equity multiplier of 1.21.
a. Use this data to compute Peet's ROE using the DuPont Identity.
b. If Peet's managers wanted to increase its ROE by one percentage point, how
much higher would their asset turnover need to be?
c. If Peet's net profit margin fell by one percentage point, by how much would
their asset turnover need to increase to maintain their ROE?

12. For fiscal year 20x1, Starbucks Corporation (SBUX) had total revenues of $11.70
billion, net income of $1.25 billion, total assets of $7.36 billion, and total
shareholder’s equity of $4.38 billion.

a. Calculate Starbucks’ ROE directly, and using the DuPont Identity.

b. Comparing with the data for Peet’s in problem 41, use the DuPont Identity to
understand the difference between the two firms’ ROEs.

13. Consider a retailing firm with a net profit margin of 3.5%, a total asset turnover of
1.8, total assets of $44 million, and a book value of equity of $18 million.
a. What is the firm’s current ROE?
b. If the firm increased its net profit margin to 4%, what would be its ROE?
c. If, in addition, the firm increased its revenues by 20% (while maintaining this
higher profit margin and without changing its assets or liabilities), what would
be its ROE?