Chapter 5

Analyzing and Interpreting Financial Statements

Learning Objectives coverage by question
Miniexercises LO1 Prepare and analyze common size financial statements. LO2 Compute and interpret measures of return on investment, including return on equity (ROE), return on assets (ROA), and return on financial leverage (ROFL). LO3 Disaggregate ROA into profitability (profit margin) and efficiency (asset turnover) components. LO4 Compute and interpret measures of liquidity and solvency. LO5 Measure and analyze the effect of operating activities on ROE. LO6 Prepare pro forma financial statements. 15, 16, 19, 20 Exercises 35 Problems Cases

14, 17, 21, 22, 24

25, 26, 27, 28, 29, 30, 31, 34

36, 38, 41, 45

50

14, 17, 21, 22, 24

25, 26, 27, 28, 29, 30, 31, 34

36, 38, 41, 46, 47

48, 49, 50

18, 23

32, 33

37, 39, 42

40, 43

35

44

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-1

Cambridge Business Publishers, 2011 5-2 Financial Accounting, 3rd Edition

QUESTIONS
Q5-1. Return on investment measures profitability in relation to the amount of investment that has been made in the business. A company can always increase dollar profit by increasing the amount of investment (assuming it is a profitable investment). So, dollar profits are not necessarily a meaningful way to look at financial performance. Using return on investment in our analysis, whether as investors or business managers, requires us to focus not only on the income statement, but also on the balance sheet. ROE is the sum of return on assets (ROA) and the return that results from the effective use of financial leverage (ROFL). Increasing leverage increases ROE as long as ROA exceeds the after-tax interest rate. Financial leverage is also related to risk: the risk of potential bankruptcy and the risk of increased variability of profits. Companies must, therefore, balance the positive effects of financial leverage against their potential negative consequences. It is for this reason that we do not witness companies entirely financed with debt. Gross profit margins can decline because 1) the industry has become more competitive, and/or the firms products have lost their competitive advantage so that the company has had to reduce prices or is selling fewer units or 2) product costs have increased, or 3) the sales mix has changed from higher-margin/slowly-turning products to lowermargin/higher-turning products. Declining gross profit margins are usually viewed negatively. On the other hand, cost increases that reflect broader economic events or certain strategic product mix changes might not be viewed negatively. Reducing advertising or R&D expenditures can increase current operating profit at the expense of the long-term competitive position of the firm. Expenditures on advertising or R&D are more asset-like and create long-term economic benefits. Asset turnover measures the amount of revenue volume compared with the investment in an asset. Generally speaking, we want turnover to be higher rather than lower. Turnover measures productivity and an important company objective is to make assets as productive as possible. Since turnover is one of the components of ROE (via ROA), increasing turnover increases shareholder value. Turnover is, therefore, viewed as a value driver. ROE>ROA implies a positive return on financial leverage. This results from borrowed funds being invested in operating assets whose return (ROA) exceeds the cost of borrowing. In this case, borrowing money increases ROE.

Q5-2.

Q5-3.

Q5-4.

Q5-5.

Q5-6.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-3

Q5-7.

Common-size financial statements express balance sheet and income statement items in ratio form. Common-size balance sheets express each asset, liability and equity item as a percentage of total assets and common-size income statements express each line item as a percentage of sales. The ratio form facilitates comparison among firms of different sizes as well as across time for the same firm. The asset turnover ratio (AT) is the ratio of sales revenue to average total assets. The ratio is increased by increasing sales while holding assets constant, or by reducing assets without reducing sales. The most effective means of improving the ratio is to increase the efficient utilization of operating assets. This is done by improving inventory management practices, improving accounts receivable collection, and improving the efficient use of PP&E. The net in net operating assets, means operating assets net of operating liabilities. This netting recognizes that a portion of the costs of operating assets is paid for by parties other than the company. For example, payables and accrued expenses help fund inventories, wages, utilities, and other operating costs. Similarly, long-term operating liabilities also help fund the cost of long-term operating assets. Thus, these long-term operating liabilities are deducted from long-term operating assets. Companies must manage both the income statement and the balance sheet in order to maximize ROA. This is important, as many managers look only to the income statement and do not fully appreciate the value added by effective balance sheet management. The disaggregation of ROA into its profit margin and turnover components facilitates analysis of these two areas of focus. There are an infinite number of possible combinations of margin and turnover that will yield a given level of ROA. The relative weighting of profit margin and asset turnover is driven in large part by the companys business model. As a result, since companies in an industry tend to adopt similar business models, industries will generally trend toward points along the margin/turnover continuum. Liquidity refers to how much cash a company has, how much cash is coming in, and how much cash can be raised quickly. Companies must generate cash in order to pay their debts, pay their employees and provide their shareholders a return on investment. Cash is, therefore, critical to a companys survival. Ratio analysis relies on the data presented in the financial statements and is, therefore, dependent on the quality of those statements. Differences in the application of GAAP across companies or within the same company across time can affect the reliability of the analysis. Limitations of GAAP itself and differences in the make-up of the company (e.g., types of products or industries in which the company competes) can also affect the usefulness of ratio analysis.
Financial Accounting, 3rd Edition

Q5-8.

Q5-9.

Q5-10.

Q5-11.

Q5-12.

Q5-13.

Cambridge Business Publishers, 2011 5-4

MINI EXERCISES
M5-14. (15 minutes) a. ROE = $5,000/$500,000 = 1% ROA = $20,000/$1,000,000 = 2% ROFL = 1% - 2% = -1% b. Net profit margin = $5,000/$1,000,000 = 0.5% Asset turnover = $1,000,000/$1,000,000 = 1.0 Financial leverage = $1,000,000/$500,000 = 2.0 c. ROFL is negative for Sunder Company, indicating that financial leverage is hurting this company. The return on assets is insufficient to cover the interest cost of the debt. DuPont analysis masks this problem. The financial leverage ratio of 2.0 suggests (incorrectly) that leverage doubled the return. M5-15 (20 minutes) Target Corporation Common-size Balance Sheets Cash and cash equivalents.. Accounts receivable, net. Inventory.. Other current assets. Total current assets.. Property and equipment, net Other noncurrent assets. Total assets. Accounts payable.. Accrued liabilities.. Current portion of long-term debt and notes payable... Total current liabilities Long-term debt Deferred income taxes.. Other noncurrent liabilities.. Total shareholders' investment.. Total liabilities and shareholders' investment 2009 2.0% 18.3% 15.2% 4.2% 39.6% 58.4% 2.0% 100.0% 14.4% 6.6% 2.9% 23.8% 39.7% 1.0% 4.4% 31.1% 100.0% 2008 5.5% 18.1% 15.2% 3.6% 42.4% 54.1% 3.5% 100.0% 15.1% 7.0% 4.4% 26.4% 33.9% 1.1% 4.2% 34.4% 100.0%

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-5

M5-16 (20 minutes) Target Corporation Common-size Income Statement Year ended January 31, 2009 Sales.... 96.8% Net credit card revenues 3.2% Total revenues.. 100.0% Cost of sales. 68.0% Selling, general and administrative expenses 19.9% Credit card expenses. 2.5% Depreciation and amortization. 2.8% Earnings before interest expense and income taxes 6.8% Net interest expense.. 1.3% Earnings before income taxes. 5.4% Provision for income taxes.. 2.0% Net earnings. 3.4%

M5-17 (15 minutes) ($ millions) a. EBI = $2,214 + $866 x (1-.35) = $2,776.9 Average total assets = ($44,106 + $44,560)/2 = $44,333 ROA = $2,776.9/$44,333 = 6.26% b. PM = $2776.9/$62,884 = 4.42% AT = $62,884/$44,333 = 1.42 4.42% X 1.42 = 6.28%

M5-18 (20 minutes) a. 2009 current ratio = $17,488 / $10,512 = 1.66 2008 current ratio = $18,906 / $11,782 = 1.60 2009 quick ratio = ($864 + $8,084) / $10,512 = 0.85 2008 quick ratio = ($2,450 + $8,054) / $11,782 = 0.89 While the current ratio increased in 2009, the quick ratio decreased a bit. Current ratio above 1 is good for a retailer and Targets quick ratio is about average for a retailer. Target is fairly liquid.

Cambridge Business Publishers, 2011 5-6 Financial Accounting, 3rd Edition

M5-18 (continued) b. 2009 times interest earned = $4,402 / $866 = 5.08 2009 debt-to-equity = ($44,106 - $13,712) / $13,712 = 2.22 2008 debt-to-equity = ($44,560 - $15,307) / $15,307 = 1.91 Targets debt-to-equity increased slightly but is not at a particularly high level. c. Target is liquid and not excessively financially leveraged. Its times interest earned ratio indicates that earnings before interest and taxes is just over 5 times interest expense. Because the company generates significant operating profits and cash flow, we have no solvency concerns about Target. M5-19 (20 minutes) 3M Company Common-size Balance Sheets Cash and cash equivalent... Accounts receivable. Total inventories Other current assets Total current assets. Investments Property, plant and equipment, net.. Goodwill.. Intangible assets, net.. Prepaid pension and postretirement benefits.. Other assets.. Total assets Short-term borrowings and current portion of long-term debt. Accounts payable.. Accrued payroll.. Accrued income taxes. Other current liabilities Total current liabilities. Long-term debt. Other liabilities... Total liabilities Stockholders' equity, net Total liabilities and stockholders' equity 2008 8.7% 12.5% 11.8% 4.6% 37.6% 2.5% 27.0% 22.5% 5.5% 0.1% 4.8% 100.0% 6.1% 5.1% 2.5% 1.4% 7.8% 22.9% 20.2% 18.3% 61.3% 38.7% 100.0% 2007 10.0% 13.6% 11.5% 4.7% 39.8% 3.2% 26.7% 18.6% 3.2% 5.6% 2.9% 100.0% 3.6% 6.1% 2.3% 2.2% 7.5% 21.7% 16.3% 14.4% 52.4% 47.6% 100.0%

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-7

M5-20 (15 minutes) 3M Company Common-size Income Statements Net sales..... Operating expenses: Cost of sales.. Selling general and administrative expenses.. Research, development and related expenses (Gain)/loss on sale of businesses.. Total. Operating income Interest expense and income: Interest expense.. Interest income. Total. Income before income taxes and minority interest Provision for income taxes Minority interest Net income. 2008 100.0% 52.9% 20.8% 5.6% 0.1% 79.4% 20.6% 0.9% -0.4% 0.4% 20.2% 6.3% 0.2% 13.7% 2007 100.0% 52.1% 20.5% 5.6% -3.5% 74.7% 25.3% 0.9% -0.5% 0.3% 25.0% 8.0% 0.2% 16.7%

M5-21 (20 minutes) ($ millions) a. 2008 EBI = $3,460 + $215 x (1-.35) = $3,599.75 2008 Average total assets = ($25,547 + $24,694)/2 = $25,120.5 ROA = $3,599.75/$25,120.5 = 14.33% b. PM = $3,599.75/$25,269 = 14.2% AT = $25,269/$25,120.5 = 1.01 14.25% X 1.01 = 14.39%

Cambridge Business Publishers, 2011 5-8 Financial Accounting, 3rd Edition

M5-22 (15 minutes) ($ millions) a. ANF: Average total assets = ($2,848.1 + $2,567.6)/2 = $2,707.85 ROA = $272.3/$2,707.85 = 10.06% TJX: Average total assets = ($6,178.2 + $6,599.9)/2 = $6,389.05 ROA = $889.9 /$6,389.05 = 13.93% b. ANF: PM = $272.3 / $3,540.3 = 7.69% AT = $3,540.3 / $2,707.85 = 1.31 7.69% X 1.31 = 10.07% TJX: PM = $889.9 / $18,999.5 = 4.68% AT = $18,999.5 / $6,389.05 = 2.97 4.68% X 2.97 = 13.9% c. ANFs ROA is less than TJXs. TJX operates in the value-priced segment of its industry which explains its lower PM. As is typical of value-priced retailers, TJXs asset turnover is high its AT is more than double that of ANFs. On balance, TJXs business model appears to be more successful in 2008 as it is able to maintain both a high AT and a reasonable PM, resulting in higher ROA. M5-23 (20 minutes) ($ millions) a. Verizons current ratio for the two years presented is as follows: 2008 current ratio: $26,075 / $25,906 = 1.01 2007 current ratio: $18,698 / 24,741 = 0.76 Liquidity is increasing and in 2008, Verizons current ratio nudged above 1.0. We might want to know, however, whether Verizons current assets are concentrated in cash or relatively illiquid inventories, as well as the maturity schedule of its current liabilities. We would also like to know the average current ratio for the industry. This would help place Verizons numbers in perspective. b. Verizons times interest earned ratio for the two years is as follows: 2008 times interest earned = $11,578 / $1,819 = 6.37 2007 times interest earned = $11,321 / $1,829 = 6.19 Verizons times interest earned ratio has increased. 2008 debt-to-equity = $160,646 / $41,706 = 3.85 2007 debt-to-equity = $136,378 / $50,581 = 2.70 Verizons debt-to-equity ratio has increased, and is in excess of the 1.13 median for companies in the telecommunications industry.
Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-9

M5-23 (continued) Verizons operating cash flow to total liabilities ratio is as follows: 2008 OCFCL = $26,620 / [($160,646 + $136,378)/2] = 0.179 c. Verizon is carrying a significant amount of debt. Although its profitability and operating cash flow are fairly strong, neither is particularly high in relation to the companys liabilities and interest costs. There is some question, therefore, regarding the amount of additional debt that the company can take on. Given its significant capital expenditure requirements and its current debt load, Verizon may have to fund future capital expenditures with higher-cost equity. And, to the extent that its competitors are not as highly leveraged, this may negatively impact Verizons competitive position. M5-24 (30 minutes) $ millions Asset Turnover

Procter & Gamble......... $79,029/$139,413 = 0.57 McDonald's.................... $23,522.4/$28,926.6 = 0.81 Valero Energy................ $119,114/ $38,570 = 3.09 $ millions ART

Procter & Gamble......... $79,029/$6,299 = 12.55 McDonald's.................... $23,522.4/$992.5 = 23.7 Valero Energy................ $119,114/ $5,294 = 22.5 $ millions INVT

Procter & Gamble......... $38,898/$7,648 = 5.09 McDonald's.................... $5,586.1/$118.4 = 47.18 Valero Energy................ $107,429/ $4,355 = 24.67 $ millions PPET

Procter & Gamble......... $79,029/$20,051 = 3.94 McDonald's.................... $23,522.4/$20,619.6 = 1.14 Valero Energy................ $119,114/ $22,387 = 5.32

Cambridge Business Publishers, 2011 5-10 Financial Accounting, 3rd Edition

EXERCISES
E5-25 (30 minutes) a. ($ millions) Target Wal-Mart

[$2,214 + $866x(1-.35)] / $44,333 = 6.26 [($13,400 + $1,900x(1-.35)] / $163,472 = 8.95

b. ($ millions) Target Wal-Mart

PM = EBI / Sales [$2,214 + $866x(1-.35)] / $62,884 = 4.42

AT = Sales / Avg. Assets $62,884/$44,333 = 1.42

[($13,400 + $1,900x(1-.35)] / $405,607 = 3.61 $405,607/$163,472 = 2.48

c. Wal-Marts ROA is greater than Targets in fiscal 2008. Wal-Marts value pricing strategy is clearly evident in its lower PM, but this is more than offset by a higher asset turnover and, hence, Wal-Marts business model is somewhat more successful.

E5-26 (20 minutes) ($ millions) a. EBI Avg. Assets ROA b. PM AT c. Avg. Equity ROE ROFL Dell $2,478 + $74x(1-.35) = $2,526.1 ($26,500 + $27,561)/2 =$ 27,030.5 $2,526.1 / $27,030.5 = 9.35% $2,526.1 / $61,101 = 4.13% $61,101 / $27,030.5 = 2.26 ($4,271 + $3,735)/2 = $4,003 $2,478 / $4,003 = 61.9% 61.9% - 9.35% = 52.55% Apple $5,704 +$ 0 x(1-.35) = $5,704 ($53,851 + $39,572)/2 = $46,711.5 $5,704 / $46,711.5 = 12.21% $5,704 / $36,537 = 15.61% $36,537 / $46,711.5 = 0.78 ($27,832 + $21,030)/2 = $24,431 $5,704 / $24,431 = 23.35% 23.35% - 12.21% = 11.14%

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-11

E5-26 (continued) d. Apples ROA exceeds Dells. This is primarily the result of a significantly higher PM. Apples PM is the result of the popularity of its brand and its upscale image. Dells business model is based on outsourcing components and assembly to order resulting in a higher AT than Apple. Dell uses financial leverage much more effectively than Apple resulting in a higher ROE.

E5-27 (20 minutes) ($ millions) a. EBI Avg. Assets ROA b. PM AT c. Avg. Equity ROE ROFL CVS $3,212.1+$509.5x(1-.35)=$3,543.275 ($60,959.9+$54,721.9)/2=$57,840.9 $3,543.275/ $57,840.9 = 6.13% $3,543.275/$87,471.9=4.05% $87,471.9/$57,840.9=1.51 ($34,574.4+$31,321.9)/2 = $32,948.15 $3,212.1 / $32,948.15= 9.75% 9.75% - 6.13% = 3.62% Walgreen $2,006+$83x(1-.35)=$2,059.95 ($25,142+$22,410 /2 = $23,776 $2,059.95/ $23,776 = 8.66% $2,059.95/$63,335=3.25% $63,335/$23,776 = 2.66 ($14,376+$12,869)/2 =$13,622.5 $2,006 / $13,622.5 = 14.73% 14.73% - 8.66% = 6.07%

d. Walgreens ROE and ROA are higher than CVSs. CVSs PM is slightly higher than Walgreens, but its AT is significantly lower. The low PMs for both companies reflect the highly competitive retail pharmaceutical industry. Walgreens main advantage in 2008 lies in its use of financial leverage and its efficiency as reflected in its asset turnover.

Cambridge Business Publishers, 2011 5-12 Financial Accounting, 3rd Edition

E5-28 (30 minutes) ($ millions)

a.

ROE

2008: $5,292 / [($39,088+$42,762) / 2] = 12.93% 2007: $6,976 / [($36,752+$42,762) / 2] = 17.55% 2008: [$5,292+$488x(1-.35)] / [($50,715+$55,651) / 2] = 10.55% 2007: [$6,976+$793x(1-.35)] / [($55,651+$48,368) / 2] = 14.40% 2008: 12.93% - 10.55% = 2.38% 2007: 17.55% - 14.40% = 3.15%

b. ROA

ROFL

c.

Net Profit Margin Asset Turnover Financial Leverage

2008: $5,292 / $37,586 = 14.08% 2007: $6,976 / $38,334 = 18.20% 2008: $37,586 / [($50,715+$55,651) / 2] = 0.71 2007: $38,334 / [($55,651+$48,368) / 2] = 0.74 2008: [($50,715+$55,651) / 2] / [($39,088+$42,762) / 2] = 1.30 2007: [($55,651+$48,368) / 2] / [($36,752+$42,762) / 2] = 1.31

Intels financial leverage remained relatively stable from 2007 to 2008. Based on ROFL, leverage increased ROE by about 22% over ROA each year (2.38%/10.55%, 3.15%/14.40%). DuPont analysis suggests that leverage had a larger (30%) impact. This is consistent with the bias in DuPont analysis in that it tends to overstate the benefits of financial leverage. Offsetting this bias, DuPont analysis calculates the net profit margin, which is lower than PM because the numerator is net of interest costs. For comparison purposes, Intels PM ratios are presented below: PM ratio 2008: [$5,292+$488x(1-.35)] / $37,586 = 14.92% 2007: [$6,976+$793x(1-.35)] / $38,334 = 19.54%

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-13

E5-29 (30 minutes) ($ millions) a. ROE 2008: $401 / [($1,210+$1,115) / 2] = 34.49% 2007: $715 / [($1,115+$2,169) / 2] = 43.54% 2006: $678 / [($2,169+$2,093) / 2] = 31.82% b. ROA 2008: [$401+$131x(1-.35)] / [($5,661+$5,600) / 2] = 8.63% 2007: [$715+$74x(1-.35)] / [($5,600+$4,822) / 2] = 14.64% 2006: [$678+$43x(1-.35)] / [($4,822+$4,921) / 2] = 14.49% ROFL 2008: 34.49% - 8.63% = 25.86% 2007: 43.54% - 14.64% = 28.9% 2006: 31.82% - 14.49% = 17.33% c. ROE and ROA should be slightly higher in 2007 because of the extra week. d. Net Profit Margin 2008: $401 / $8,272 = 4.85% 2007: $715 / $8,828 = 8.10% 2006: $678 / $8,561 = 7.92% Asset Turnover 2008: $8,272 / [($5,661+$5,600) / 2] = 1.47 2007: $8,828 / [($5,600+$4,822) / 2] = 1.69 2006: $8,561 / [($4,822+$4,921) / 2] = 1.76 Financial Leverage 2008: 2007: 2006: [($5,661+$5,600) / 2] / [($1,210+$1,115) / 2] = 4.84 [($5,600+$4,822) / 2] / [($1,115+$2,169) / 2] = 3.17 [($4,822+$4,921) / 2] / [($2,169+$2,093) / 2] = 2.29

Nordstroms ROA decreased considerably in 2008, though its ROE remained higher than in 2006 due to increasing financial leverage. Nordstroms financial leverage increased from 2006 to 2008. Based on ROFL, leverage increased ROA by 2.2 times in 2006 ($31.82%/14.49%) while in 2008, leverage increased ROA by a factor of 4 (34.49%/8.63%). DuPont analysis suggests that leverage had a slightly larger impact (2.29 in 2006 and 4.84 in 2008) but the trend is the same. This is consistent with the bias in DuPont analysis in that it tends to overstate the benefits of financial leverage. Offsetting this bias, DuPont analysis calculates the net profit margin, which is lower than PM because the numerator is net of interest costs. For comparison purposes, Nordstroms PM ratios are presented below: PM ratio 2008: [$401+$131x(1-.35)] / $8,272 = 5.88% 2007: [$715+$74x(1-.35)] / $8,828 = 8.64%
Cambridge Business Publishers, 2011 5-14 Financial Accounting, 3rd Edition

2006: [$678+$43x(1-.35)] / $8,561 = 8.25% E5-30 (20 minutes) ($ millions) a. EBI Avg. Equity Avg. Assets ROE ROA ROFL b. PM AT $805.2+$149.8x(1-.35) = $902.57 ($5,564.2+$5,718.0)/2 = $5,641.1 ($13,006.0+$9,036.3)/2 = $11,021.15 $805.2 / $5,641.1 = 14.27% $902.57/ $11,021.15 = 8.19% 14.27% - 8.19% = 6.08% $902.57 / $23,083.8 = 3.9% $23,083.8 / $11,021.15 = 2.09

c. Staples has a relatively low profit margin and an asset turnover that is above 2.0. This is consistent with other firms in the retail industry, especially those who rely on a low-price, high-volume business model. E5-31 (20 minutes) ($ millions) a. EBI Avg. Equity Avg. Assets ROE ROA ROFL b. PM AT $447.0+$51.2x(1-.35) = $480.28 ($2,555.8+$2,073.0)/2 = $2,314.4 ($4,826.3+$4,666.6)/2 = $4,746.45 $447.0 / $2,314.4 = 19.31% $480.28/ $4,746.45 = 10.12% 19.31% - 10.12% = 9.19% $480.28 / $3,182.5 = 15.09% $3,182.5 / $4,746.45= 0.67

c. Intuit has a relatively high PM ratio and a low AT ratio. These numbers are consistent with the business model employed in the software industry. Contrast these numbers with those of Staples (E5-30). Intuit uses financial
Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-15

leverage effectively; leverage increased its ROA by a factor of 1.91 (19.31%/10.12%).

Cambridge Business Publishers, 2011 5-16 Financial Accounting, 3rd Edition

E5-32 (30 minutes) a. ($ millions) 2006 2007 2008 Current Ratio $5,202 / $7,191 = 0.72 $3,667 / $7,952 = 0.46 $3,716 / $8,939 = 0.42

Comcast has a current ratio less than 1.0 and it has declined from 2006 levels. Comcast is not very liquid. While the current ratio provides a useful point estimate of liquidity, it would be helpful to know when the cash flows from current assets will be realized and when the current liabilities will need to be paid. An excess of current maturities over near-term cash realization will cause a liquidity problem regardless of the level of the overall ratio. As well, we would like to know the current ratio for firms in this industry. b. ($ millions) 2006 2007 2008 Times interest earned $(3,594+2,064) / $2,064 = 2.74 $(4,349+2,289) / $2,289 = 2.90 $(4,058+2,439) / $2,439 = 2.66 Debt-to-equity $69,238 / $41,167 = 1.68 $72,077 / $41,340 = 1.74 $72,567 / $40,450 = 1.79

The times interest earned ratio is quite low and has remained relatively stable since 2006. Comcast is able to cover its interest expense, but not by a comfortable margin. Comcasts debt-to-equity ratio is relatively high between 1.68 and 1.79, and is increasing. c. Comcast has a relatively high level of debt. This, coupled with its relatively low liquidity, and low earnings relative to its interest charges causes some concern about its ability to increase its debt load significantly. This is especially troublesome given the significant levels of capital expenditures that will be required in order to upgrade its infrastructure in order to remain competitive.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-17

E5-33 (30 minutes) a. ($ millions) 2006 2007 2008 Current Ratio 50,014 / 38,964 = 1.28 47,932 / 43,894 = 1.09 43,242 / 42,451 = 1.02 OCFCL 5,003/[(39,833+38,964)/2] = 0.127 9,822/[(38,964+43,894)/2] = 0.237 9,281/[(43,894+42,451)/2] = 0.215

Siemens has a current ratio that is above than 1.0 but it has declined from 2006 levels. However, its OCFCL ratio improved in 2007 and 2008 relative to 2006. While the current ratio provides a useful point estimate of liquidity, the OCFCL ratio suggests that operations are not generating sufficient cash flow to cover short-term obligations. We would like to know the current ratio and OCFCL ratio for other firms in this industry. b. ($ millions) 2006 2007 2008 Times interest earned (3,418+525) / 525 = 7.51 (5,101+897) / 897 = 6.69 (2,874+834) / 834 = 4.45 Debt-to-equity 61,633 / 25,895 = 2.38 61,928 / 29,627 = 2.09 67,083 / 27,380 = 2.45

The times interest earned ratio is at acceptable levels, but is decreasing due to higher interest costs and lower earnings. Siemens debt-to-equity ratio is quite high between 2.09 and 2.45. c. Siemens has a high level of debt. This, along with the decline in the timesinterest-earned ratio, raises some concern about its ability to increase its debt load significantly.

Cambridge Business Publishers, 2011 5-18 Financial Accounting, 3rd Edition

E5-34 (30 minutes) ($ millions) a. EBI Avg. Equity Avg. Assets ROE ROA ROFL b. PM AT c. GPM INVT $967+$1x(1-.35) = $967.65 ($4,387+$4,274)/2 = $4,330.5 ($7,564+$7,838)/2 = $7,701 $967 / $4,330.5 = 22.33% $967.65/ $7,701 = 12.57% 22.33% - 12.57% = 9.76% $967.65 / $14,526 = 6.66% $14,526 / $7,701 = 1.89 $5,447 / $14,526 = 37.5% $9,079 / [($1,506 + $1,575)/2] = 5.89

d. The Gap showed strong performance in the year ended January 31, 2009 (hereafter, 2008). Its ROA was 12.57%, which is high in a recession year. ROE was over 22% indicating the effective use of financial leverage. Interest costs were low, suggesting that most of The Gaps dept is from operating liabilities (accounts payable and accrued expenses). Its profit margin and asset turnover ratios place The Gap in a strong position for this industry. As a point of comparison, Nordstrom has a PM ratio of 5.88 and an AT ratio of 1.47 in 2008. The GPM and INVT ratios are two important performance measures for retail companies such as The Gap. GPM measures the ability of the firm to sell its merchandise at reasonable margins while INVT provides evidence on inventory management and the popularity of its product line. Both measures are healthy for a retailer in the economy of 2008.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-19

E5-35 (20 minutes) The Gap, Inc. Common-size and Pro-forma Income Statements a., b. Net Sales. Cost of goods sold and occupancy costs. Gross profit Operating expenses Operating income Interest income Interest expense.. Earnings from continuing operations before income taxes. Income taxes. Earnings from continuing operations Loss from discontinued operations, net of income taxes Net earnings. 1/31/09 100.0% 62.5% 37.5% 26.8% 10.7% 0.3% 0.0% 10.9% 4.2% 6.7% -------6.7% 2/2/08 100.0% 63.9% 36.1% 27.8% 8.3% 0.7% 0.2% 8.9% 3.4% 5.5% 0.2% 5.3% 1/31/10 Pro forma $15,000 9,450 5,550 4,050 1,500 37 1 1,536 584 952 ------$ 952

c. The Gaps pro forma statements are based on a set of assumptions that determine the relationship between various expense items and sales revenue. The accuracy of the projection depends on the reliability of these estimates, which depends on managements ability to maintain a stable GPM ratio, maintain INVT ratio, and control operating expense ETS ratios.

Cambridge Business Publishers, 2011 5-20 Financial Accounting, 3rd Edition

PROBLEMS
P5-36 (45 minutes) ($ millions) a. EBI Avg. Equity Avg. Assets ROE ROA ROFL Nike $1,486.7+$46.7x(1-.35) = $1,517.06 ($8,693.1+$7,825.3)/2 = $8,259.2 ($13,249.6+$12,442.7)/2=$12,846.15 $1,486.7/ $8,259.2 = 18.0% $1,517.06/ $12,846.15= 11.81% 18.0% - 11.81% = 6.19% Adidas 644 + 203x(1-.35) = 775.95 (3,400+3,034)/2 = 3,217 (9,533+8,325)/2 = 8,929 644/3,217=20.02% 775.95/8,929=8.69% 20.02% - 8.69% = 11.33%

While Adidas reported a higher ROE, Nikes ROA was higher. The difference was caused by Adidas use of financial leverage which more than doubled its ROA. b. PM AT $1,517.06/ $19,176.1 = 7.91% $19,176.1 / $12,846.15 = 1.49 775.95/10,799 = 7.19% 10,799/8,929 = 1.21

Nikes PM ratio is only slightly higher than Adidass. Nikes higher ROA appears to be driven by more efficient use of assets, as its AT ratio is higher (1.49 vs. 1.21). c. GPM Operating ETS $8,604.4 / $19,176.1 = 44.87% $6,149.6 / $19,176.1 = 32.07% 5,256/10,799 = 48.67% 4,186/10,799 = 38.76%

Adidas reports a higher GPM ratio than Nike by about 4%. However, that is more than offset by higher operating expenses as a percentage of sales. d. ART INVT PPET $19,176.1/$ [(2,883.9+2,795.3)/2]=6.75 $10,571.7/$[(2,357+2,438.4)/2]=4.41 $19,176.1/$ [(1,957.7+1,891.1)/2]=9.96 10,799/[(1,624+1,459)/2]=7.0 5,543/[(1,995+1,629)/2]=3.06 10,799/[(886+702)/2]=13.6

Nikes INVT is significantly higher than Adidass, suggesting that Nike may be managing inventory more efficiently. Adidas has a higher PPET ratio, though both companies ratios are high. These are consistent with a business model that outsources most of the production. e. The two companies fiscal years overlap by seven months. Nikes income statement includes January through May 2009 while Adidas statements cover January through May 2008. (Both cover June through December 2008.)
Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-21

Economic conditions were worse in 2009 than 2008, so that should put Nike at a comparative disadvantage. P5-36 (continued) f. Normally, we would want to identify any major differences in the valuation of assets and the measurement of income between these two companies. For example, some assets are more likely to be valued at current value (rather than historical cost) under IFRS reporting. Such a difference would affect ratios such as ROA, AT, INVT and PPET. P5-37 (20 minutes) ($ millions) a. Current Ratio Quick Ratio Nike 2009: $9,734.0/$3,277.0 = 2.97 2008: $8,839.3/$3,321.5 = 2.66 2009: $(2,291.1+1,164+2,883.9)/ $3,277.0=1.93 2008: $(2,133.9+642.2+2,795.3)/ $3,321.5=1.68 Adidas 2008: 4,934/3,645= 1.35 2007: 4,138/2,615= 1.58 2008: (244+141+1,624)/3,645=0.55 2007: (295+86+1,459)/2,615= 0.70

Nike is more liquid than Adidas. Its current ratio is just under 3.0 and its quick ratio is almost 2.0. In fact, Nikes quick ratio is higher than Adidass current ratio. b. TIE 2009: ($1,956.5+$46.7)/$46.7=42.9 2008: ($2,502.9+$44.1)/$44.1=57.8 Debt-toEquity 2009: $4,556.5/$8,693.1=0.52 2008: $4,617.4/$7,825.3=0.59 2008: (904+203)/203=5.5 2007: (815+170)/170= 5.8 2008: 6,133/3,400=1.80 2007: 5,291/3,034=1.74

Nikes debt-to-equity ratio is very low and decreased slightly in 2009. Adidass debt-to-equity ratio went up in 2008. Both companies reported declining TIE ratios. c. Adidas relies on significantly greater amounts of debt financing than does Nike. This is evident by the debt-to-equity ratio. In addition, the TIE ratio for Nike is 8 times higher than for Adidas. Although Adidass TIE ratio is not too low, Nikes small amount of interest expense produces a very high TIE. Neither company should have difficulty meeting its debt obligations, but Adidas may not be able to borrow as much in the future (if needed).

Cambridge Business Publishers, 2011 5-22 Financial Accounting, 3rd Edition

P5-38 (45 minutes) ($ millions) a. EBI Avg. Equity Avg. Assets ROE ROA ROFL Home Depot $2,260+$624x(1-.35) = $2,665.6 ($17,777+$17,714)/2= $17,745.5 ($41,164+$44,324)/2=$42,744 $2,260/ $17,745.5 = 12.74% $2,665.6/ $42,744= 6.24% 12.74% - 6.24% = 6.50% Lowes $2,195+$280x(1-.35) = $2,377 ($18,055+$16,098)/2= $17,076.5 ($32,686+$30,869)/2=$31,777.5 $2,195/ $17,076.5 = 12.85% $2,377/ $31,777.5= 7.48% 12.85% - 7.48% = 5.37%

These two companies had almost identical ROEs for 2008. Lowes had a higher ROA (7.48% vs. 6.24% for Home Depot). Home Depot made up the difference by using financial leverage to its advantage. b. PM AT $2,665.6/ $71,288 = 3.74% $71,288 / $42,744 = 1.67 $2,377/ $48,230 = 4.93% $48,230 / $31,777.5 = 1.52

Lowes higher ROA is driven by a higher PM ratio. Home Depots AT ratio is a bit higher, suggesting that it is managing assets more efficiently. c. GPM Operating ETS $23,990 / $71,288 = 33.65% $19,631 / $71,288 = 27.54% $16,501 / $48,230 = 34.21% $12,715 / $48,230 = 26.36%

These two companies have almost identical profitability ratios. Lowes GPM ratio is slightly higher than that of the Home Depot, and its operating ETS ratio is slightly lower. Thus Lowes performed slightly better with respect to these two profitability measures. d. ART INVT $71,288/$[(972+1,259)/2]=63.91 $47,298/$[(10,673+11,731)/2]=4.22 $48,230/0 = N/A $31,729/$[(8,209+7,611)/2]=4.01

PPET $71,288/$[(26,234+27,476)/2]=2.65 $48,230/$[(22,722+21,361)/2]=2.19 Lowes reports no accounts receivable and Home Depot reports very small amounts of receivables. Neither company relies on customer credit to generate sales, so the ART ratio is not very informative. More important is the INVT ratio. Home Depots INVT is slightly higher than Lowes ratio. The same is true for the PPET ratio. These differences are consistent with the difference in the AT ratios noted earlier. Overall, the numbers suggest that Home Depot is managing inventories and PPE assets more efficiently. e. Overall, the performance of these two companies is very similar. Lowes reports a slightly higher ROE and ROA due to better profitability ratios (PM, GPM and ETS). Home Depot manages assets more efficiently. However, all differences are small.
Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-23

P5-39 (30 minutes) ($ millions) a. Current Ratio Quick Ratio Home Depot 2008: $13,362/$11,153 = 1.20 2007: $14,674/$12,706 = 1.15 2008: $(519+6+972)/$11,153=0.13 2007: $(445+12+1,259)/$12,706=0.14 Lowes 2008: $9,251/$8,022 = 1.15 2007: $8,686/$7,751 = 1.12 2008: $(245+416)/$8,022=0.08 2007: $(281+249)/$7,751=0.07

The current ratios of these two companies are very close. Both are above one, but not high. Quick ratios are very low due to the lack of receivables and low cash balances. Both companies rely on operating cash flow to cover liquidity needs. Given the lack of receivables, the INVT ratio becomes doubly important (see P5-38). Failure to turn inventories quickly would result in lower operating cash flow and liquidity problems. Hence, both companies emphasize inventory management. b. TIE 2008: ($3,590+$624)/$624=6.75 2007: ($6,620+$696)/$696=10.51 Debt-toEquity 2008: $23,387/$17,777=1.32 2007: $26,610/$17,714=1.50 2008: ($3,506+$280)/$280=13.52 2007: ($4,511+$194)/$194=24.25 2008: $14,631/$18,055=0.81 2007: $14,771/$16,098=0.92

For both companies, the debt-to-equity ratio decreased from 2007 to 2008 indicating less reliance on debt financing. Despite this trend, TIE ratios declined due to declining earnings. c. The Home Depot utilizes more debt financing than does Lowes. This results in a higher ROFL (see P5-38), as well as higher debt-to-equity and lower TIE ratios relative to Lowes. Lowes debt-to-equity ratio is less than 1.0, indicating that more than 50% of its financing is from owners.

Cambridge Business Publishers, 2011 5-24 Financial Accounting, 3rd Edition

P5-40A (20 minutes) ($ millions) a. NOPAT NOA Home Depot $2,312+$(145+624)x(1-.35) = $2,811.85 2008: $(41,164-6-36) - $(23,387-1,7679,667) = $29,169 2007: $(44,324-12-342)-$(26,6102,047-11,383) = $30,790 Avg. NOA b. RNOA c. NOPM NOAT ($29,169 + $30,790)/2 = $29,979.5 $2,811.85/$29,979.5 = 9.38% $2,811.85/$71,288 = 3.94% $71,288/$29,979.5 = 2.38 Lowes $2,195+$280x(1-.35) = $2,377 2008: $(32,686-416-253) $(14,631-1,021-5,039) = $23,446 2007: $(30,869-249-509)$(14,771-1,104-5,576) = $22,020 ($23,446 + $22,020)/2 = $22,733 $2,377/$22,733 = 10.46% $2,377/$48,230 = 4.93% $48,230/$22,733 = 2.12

d. Lowes reports a higher RNOA than does The Home Depot. This is consistent with the ROA numbers computed in P5-38 (ROA=6.24% for Home Depot and 7.48% for Lowes). Overall, operating returns make up 74% of Home Depots ROE (9.38%/12.74%) and 81% of Lowes ROE (10.46%/12.85%). Lowes has a higher net operating PM while Home Depot has a higher net operating AT.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-25

P5-41 (30 minutes) ($ millions) a. EBI Avg. Assets ROA PM AT 2008 $3,003+$442x(1-.35) = $3,290.3 ($31,879+$39,042)/2=$35,460.5 $3,290.3/ $35,460.5= 9.28% $3,290.3/ $51,486 = 6.39% $51,486 / $35,460.5 = 1.45 2007 $382+$246x(1-.35) = $541.9 ($39,042+$33,210)/2=$36,126 $541.9/ $36,126= 1.50% $541.9/ $49,692 = 1.09% $49,692 / $36,126 = 1.38

While a 2008 ROA of 9.28% is acceptable, UPSs 2007 ROA of 1.50% is extremely low. Although AT increased slightly in 2008, the primary cause of the increase in ROA was an increase in PM from 1.09% to 6.39%. It would appear from these two years that UPSs most effective strategy for increasing ROA is to maintain its AT ratio while trying to increase PM. b. Compensation ETS $26,063/$51,486 = 50.62% $31,745/$49,692 = 63.88%

The largest single expense on UPSs income statement is compensation. In 2007, the compensation was almost 64% of sales. By reducing this expense to just over 50% of sales, UPSs profit margin increased in 2008. c. Avg. Equity ROE d. ROFL ($6,780+$12,183)/2= $9,481.5 $3,003/ $9,481.5 = 31.67% 31.67% - 9.28% = 22.39% ($12,183+$15,482)/2= $13,832.5 $382/ $13,832.5 = 2.76% 2.76% - 1.50% = 1.26%

UPS relies heavily on debt financing. In 2008, when ROA was at an acceptable level, ROFL contributed 22.39% to ROE. However, in 2007 when ROA was very low, the high leverage only added 1.26% to ROE.

Cambridge Business Publishers, 2011 5-26 Financial Accounting, 3rd Edition

P5-42 (30 minutes) ($ millions) 2008 2007 a. Current $8,845/$7,817 = 1.13 $11,760/$9,840 = 1.20 Ratio Quick $(507+542+5,547+480)/$7,817=0.91 $(2,027+577+6,084+468)/$9,840=0.93 Ratio UPS current and quick ratios decreased slightly in 2008. The current ratio is above 1.0 and the quick ratio is only slightly lower than the current ratio because UPS does not carry inventory balances. b. TIE Debt-toEquity ($5,015+$442)/$442=12.35 $25,099/$6,780=3.70 ($431+$246)/$246=2.75 $26,859/$12,183=2.20

The TIE ratio increased dramatically in 2008 due to the increase in earnings. However, the debt-to-equity ratio also increased, indicating an increased dependence on debt financing. c. UPS relies heavily on debt financing. Although the company appears liquid, its ability to meet its obligations depends heavily on operating cash flow. The high (and increasing) debt-to-equity ratio suggests that UPS may have difficulty borrowing additional funds if needed. P5-43A (30 minutes) ($ millions) a. NOPAT NOA Avg. NOA b. RNOA United Parcel Service (UPS) $5,015+$(442-75)x(1-.35) = $5,253.55 2008: $(31,879-542-480) - $(25,099-2,074-7,797) = $15,629 2007: $(39,042-577-468) - $(26,859-3,512-440-7,506) = $22,596 ($15,629 + $22,596)/2 = $19,112.5 $5,253.55/$19,112.5 = 27.49%

UPS RNOA is 87% of its ROE (27.49%/31.67%). Thus, almost all of its return is from operations. c. NOPM NOAT $5,253.55/$51,486 = 10.20% $51,486/$19,112.5 = 2.69

d. These ratios provide a different picture of UPS relative to P5-42. Its high debtto-equity ratio is caused almost exclusively by operating liabilities. A major part of UPSs operating liabilities are related to compensation.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-27

P5-44B (45 minutes) a. United Parcel Service, Inc. Income Statements ($ millions) Revenue Compensation and benefits Other. Operating profit. Investment income Interest expense Income before income taxes. Income taxes. Net income. United Parcel Service, Inc. Balance Sheets ($ millions) Cash and equivalents.. Short-term investments.. Accounts receivable, net Finance receivables, net. Income tax receivable.. Deferred income taxes. Other current assets. Total current assets. Property, plant and equipment.. Pension and post retirement benefit assets.. Goodwill Intangible assets Other assets Total assets. Current maturities of long-term debt.. Accounts payable. Accrued wages and withholdings Other current liabilities Total current liabilities. Long-term debt. Accumulated postretirement benefit obligation.. Deferred taxes and other liabilities.. Total liabilities Shareowners' equity Total liabilities and shareowners' equity
Cambridge Business Publishers, 2011 5-28 Financial Accounting, 3rd Edition

2008 Actual $51,486 26,063 20,041 5,382 75 (442) 5,015 2,012 $ 3,003

2009 Pro forma $55,000 27,842 21,409 5,749 75 (442) 5,382 2,153 $ 3,229

2008 Actual $ 507 542 5,547 480 167 494 1,108 8,845 18,265 10 1,986 511 2,262 $31,879 $ 2,074 1,855 1,436 2,452 7,817 7,797 6,323 3,162 25,099 6,780 $31,879

2009 Pro forma $ 1,055 542 5,926 513 178 528 1,184 9,926 19,512 11 2,122 546 2,416 $34,533 $ 2,074 1,982 1,534 2,619 8,209 7,797 6,755 3,378 26,139 8,394 $34,533

b. United Parcel Service, Inc. Cash Flow Statement ($ millions) Operations: Net income. Adjustments: Depreciation and amortization..... Less increase in operating assets: Accounts receivable Finance receivables Tax receivable.. Deferred income taxes Other current assets Pension and post retirement benefit assets. Other assets.. Plus increase in operating liabilities: Accounts payable Accrued wages and withholdings.. Other current liabilities.. Accumulated postretirement benefit obligation. Deferred taxes and other liabilities. Cash flow from operations Investing activities: Investment in property, plant and equipment. Investment in goodwill and intangible assets. Cash used for investing activities... Financing activities: Dividends paid.. Cash used for financing activities... Net increase in cash Cash, December 31, 2008.. Pro forma cash, December 31, 2009.. 2009 Pro forma $3,229 1,925 (379) (33) (11) (34) (76) (1) (154) 127 98 167 432 216 5,506 (3,172) (171) (3,343) (1,615) (1,615) 548 507 1,055

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-29

P5-45 (20 minutes) a. Avg. total liabilities ($25,099+$26,859)/2 = $25,979 $442x(1-.35) / ($25,099+$26,859)/2 = 1.11% 9.28%-1.11% = 8.17% {[($25,099+$26,859)/2]/[($6,780+$12,183)/2]}x8.17% = 22.39%

Net interest rate (NIR) Spread (ROA NIR) b. ROFL

c. An ROFL of 22.39% is equal to the difference between ROE and ROA (31.67%9.28%) as calculated in P5-41. This suggests that 71% of UPSs ROE was generated by the effective use of financial leverage.

P5-46 (45 minutes) a., b. A summary of the ratios for these five companies appears in the following table. Calculations are provided below for each company. PM 17.69% 26.54% 20.76% 33.42% 17.83% GPM 57.29% 68.84% 70.96% 76.59% 83.20% R&D ETS 9.44% 17.46% 12.17% 20.15% 16.45% SG&A ETS 28.57% 30.90% 33.71% 30.93% 30.10%

ABT BMY JNJ MRK PFE

c. What is perhaps most remarkable is how similar these five companies are. For example, the SG&A ETS ratio ranges between 28.57% and 33.71%, with three of the five between 30% and 31%. GPM ranges from a low of 57.29% (ABT) to 83.2% (PFE), but the other three firms are between 68.84% and 76.59%. This suggests that the business models employed by these companies are very similar. The PM ratio shows a fairly wide variation, ranging from a low of 17.69% (ABT) to 33.42% (MRK). Interestingly, ABT appears to be the least profitable, with the lowest PM and GPM, yet it spends the least on R&D and SG&A expenses. At the same time, MRK (BMY) has the highest (second highest) PM and spends the most (second most) on R&D.

Cambridge Business Publishers, 2011 5-30 Financial Accounting, 3rd Edition

P5-46 (continued) Calculations of ratios for each firm follow: ($ millions) PM GPM R&D ETS SG&A ETS ($ millions) PM GPM R&D ETS SG&A ETS ($ millions) PM GPM R&D ETS SG&A ETS ($ millions) PM GPM R&D ETS SG&A ETS ($ millions) PM GPM R&D ETS SG&A ETS Abbott Laboratories (ABT) $4,880.7 + $528.5 x(1-.35) / $29,527.6 = 17.69% ($29,527.6 - $12,612.0) / $29,527.6 = 57.29% $2,786.0 / $29,527.6 = 9.44% $8,435.6 / $29,527.6 = 28.57% Bristol-Myers Squibb (BMY) $5,247 + $310 x(1-.35) / $20,527 = 26.54% ($20,527 - $6,396) / $20,527 = 68.84% $3,585 / $20,527 = 17.46% $6,342 / $20,527 = 30.90% Johnson & Johnson (JNJ) $12,949 + $435 x(1-.35) / $63,747 = 20.76% ($63,747 - $18,511) / $63,747 = 70.96% $7,758 / $63,747 = 12.17% $21,490 / $63,747 = 33.71% Merck (MRK) $7,808.4 + $251.3 x(1-.35) / $23,850.3 = 33.42% ($23,850.3 - $5,582.5) / $23,850.3 = 76.59% $4,805.3 / $23,850.3 = 20.15% $7,377.0 / $23,850.3 = 30.93% Pfizer (PFE) $8,104 + $782 x(1-.35) / $48,296 = 17.83% ($48,296 - $8,112) / $48,296 = 83.20% $7,945 / $48,296 = 16.45% $14,537 / $48,296 = 30.10%

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-31

P5-47 (45 minutes) a, b, c. BBY KR JWN SPLS WAG ROA 8.15% 6.88% 8.63% 7.47% 8.66% PM 2.59% 2.06% 5.67% 3.57% 3.25% AT 3.15 3.34 1.52 2.09 2.66 GPM 24.43% 22.94% 36.81% 27.06% 27.81% ART 37.23 87.86 4.60 17.18 25.21 INVT 7.19 12.07 5.84 7.55 6.51 PPET 12.04 5.92 4.08 10.37 6.16

Nordstrom (JWN) has the highest PM (5.67%) and the highest GPM (36.81%). It also has the lowest AT (1.52), ART (4.60), INVT (5.84) and PPET (4.08). JWN clearly achieves its ROA by emphasizing high profit margin. Kroger (KR) is at the opposite extreme from Nordstrom, emphasizing efficient asset management. Kroger has the highest AT and INVT. Inventory management is critical for a retail grocer. It also has very few receivables, so its ART is very high (87.86 times). Retail companies lease much of their store space. As a result, the PPET ratio depends on how these store leases are reported in the balance sheet. Lease accounting is discussed in Chapter 10. Calculations follow for each firm ($ millions): EBI ROA PM AT ART INVT PPET GPM Best Buy (BBY) $1,103 + $94 x (1-.35) = $1,164.1 $1,164.1 / $14,292 = 8.15% $1,164.1 / $45,015 = 2.59% $45,015 / $14,292 = 3.15 $45,015 / $1,209 = 37.23 $34,017 / $4,731 = 7.19 $45,015 / $3,740 = 12.04 ($45,015 - $34,017) / $45,015 = 24.43% Kroger (KR) $1,249 + $485 x (1-.35) = $1,564.25 $1,564.25 / $22,752 = 6.88% $1,564.25 / $76,000 = 2.06% $76,000 / $22,752 = 3.34 $76,000 / $865 = 87.86 $58,564 / $4,854 = 12.07 $76,000 / $12,830 = 5.92 ($76,000 - $58,564) / $76,000 = 22.94%

EBI ROA PM AT ART INVT PPET GPM

Cambridge Business Publishers, 2011 5-32 Financial Accounting, 3rd Edition

EBI ROA PM AT ART INVT PPET GPM

Nordstrom (JWN) $401 + $131 x (1-.35) = $486.15 $486.15 / $5,631 = 8.63% $486.15 / $8,573 = 5.67% $8,573 / $5,631 = 1.52 $8,573 / $1,865 = 4.60 $5,417 / $928 = 5.84 $8,573 / $2,102 = 4.08 ($8,573 - $5,417) / $8,573 = 36.81% Staples (SPLS) $805 + $28 x (1-.35) = $823.2 $823.2 / $11,021 = 7.47% $823.2 / $23,084 = 3.57% $23,084 / $11,021 = 2.09 $23,084 / $1,344 = 17.18 $16,837 / $2,229 = 7.55 $23,084 / $2,226 = 10.37 ($23,084 - $16,837) / $23,084 = 27.06% Walgreen (WAG) $2,006 + $83 x (1-.35) = $2,059.95 $2,059.95/ $23,776 = 8.66% $2,059.95 / $63,335 = 3.25% $63,335 / $23,776 = 2.66 $63,335 / $2,512 = 25.21 $45,722 / $7,019 = 6.51 $63,335 / $10,289 = 6.16 ($63,335 - $45,722) / $63,335 = 27.81%

EBI ROA PM AT ART INVT PPET GPM

EBI ROA PM AT ART INVT PPET GPM

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-33

CASES
C5-48 (30 minutes) a. Raising prices and/or reducing manufacturing costs are not necessarily independent solutions, and are likely related to other factors. The effect of a price increase on gross profit is a function of the demand curve for the companys product. If the demand curve is relatively elastic, a price increase will likely significantly reduce demand, thereby decreasing, rather than increasing, gross profit (an example is a 10% increase in price and a 20% decrease in demand). A price increase will have a more desired effect if the demand curve is relatively inelastic (a 10% price increase with a 3% decrease in demand). Cutting manufacturing costs will positively affect gross profit (via reduction of COGS) if the more inexpensively made product is not perceived to be of lesser quality, thereby reducing demand. b. Raising prices is difficult in competitive markets. As the number of product substitutes increases, companies are less able to raise prices. Rather, they must be able to effectively differentiate their products in some manner in order to reduce consumers substitution. This can be accomplished, for example, by product design and/or advertising. These efforts, however, likely entail additional cost, and, while gross profit might be increased as a result, SG&A expense may also increase with little effect on the bottom line. Manufacturing costs consist of raw materials, labor and overhead. Each can be targeted for cost reduction. A reduction of raw materials costs generally implies some reduction in product quality, but not necessarily. It might be the case that the product contains features that are not in demand by consumers. Eliminating those features will reduce product costs with little effect on selling price. Similarly, companies can utilize less expensive sources of labor (off-shore production, for example), that can significantly reduce product costs and increase gross profit provided that product quality is maintained. Finally, manufacturing overhead can be reduced by more efficient production. Wages and depreciation expense are two significant components of manufacturing overhead. These are largely fixed costs, and the per-unit product cost can often be reduced by increasing capacity utilization of manufacturing facilities (provided, of course, that the increased inventory produced can be sold). The bottom line is that increasing gross profit is a difficult process than can only be accomplished by effective management and innovation.

Cambridge Business Publishers, 2011 5-34 Financial Accounting, 3rd Edition

C5-49 (30 minutes) a. Working capital management is an important component of the management of a company. By reducing the level of working capital, companies reduce the costs of carrying excess assets. This can have a significantly positive effect on financial performance. Some common approaches to reducing working capital via reductions in receivables and inventories, and increases in payables, include the following: Reduce receivables Constricting the payment terms on product sales Better credit policies that limit credit to high-risk customers Better reporting to identify delinquencies Automated notices to delinquent accounts Increased collection efforts Prepayment of orders or billing as milestones are reached Use of electronic (ACH) payment Use of third-party guarantors, including bank letters of credit Reduce inventories Reduce inventory costs via less costly components (of equal quality), produce with lower wage rates, eliminate product features (costs) not valued by customers Outsource production to reduce product cost and/or inventories the company must carry on its balance sheet Reduce raw materials inventories via just-in-time deliveries Eliminate bottlenecks in manufacturing to reduce work-inprocess inventories Reduce finished goods inventories by producing to order rather than producing to estimated demand Increase payables Extend the time for payment of low or no-cost payablesso long as the relationship with suppliers is not harmed) b. The terms of payment that a company offers to its customers is a marketing tool, similar to product price and advertising programs. Many companies promote payment terms separately from other promotions (no payment for six months or interest-free financing, for example). As companies restrict credit terms, the level of receivables will likely decrease, thereby reducing working capital. The restriction of credit terms may also have the undesirable effect of reducing demand for the companys products. The cost of credit terms must be weighed against the benefits, and credit terms must be managed with care so as to optimize costs rather than minimize them. Credit policy is as much art as it is science.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-35

C5-49continued Likewise, the depth and breadth of the inventories that companies carry impact customer perception. At the extreme, inventory stock-outs result in not only the loss of current sales, but also the potential loss of future sales as customers are introduced to competitors and may develop an impression of the company as thinly stocked. Inventories are costly to maintain, as they must be financed, insured, stocked, moved, and so forth. Reduction in inventory levels can reduce these costs. On the other hand, the amount and type of inventories carried is a marketing decision and must be managed with care so as to optimize the level inventories, not necessarily to minimize them. One companys account payable is anothers account receivable. So, just as one company seeks to extend the time of payment, so as to reduce its working capital, so does the other company seek to reduce the average collection period so as to accomplish the same objective. Capable, dependable suppliers are a valuable resource for the company, and the supplier relation must be handled with care. All companies take as long to pay their accounts payable as the supplier allows in its credit terms. Extending the payment terms beyond that point begins to negatively impact the supplier relation, ultimately resulting in the loss of the supplier. The supplier relation must be managed with care so as to optimize the terms of payment, rather than necessarily to minimize them.

Cambridge Business Publishers, 2011 5-36 Financial Accounting, 3rd Edition

C5-50 (30 minutes) a. The list of parties that are affected by schemes to manage earnings is often much broader than first thought. It includes the following affected parties: 1. employees above and below the level at which the scheme is implemented 2. stockholders and elected members of the board of directors 3. creditors of the company (suppliers and lenders) and their employees, stockholders, and boards of directors 4. competitors of the company 5. the companys independent auditors 6. regulators and taxing authorities b. Managers often believe that earnings management activities will be shortlived, and will be curtailed once its operations turn around. Often, this does not prove to be the case. Interviews with managers and employees who have engaged in these activities often reveal that they started rather innocuously (just managing earnings to make the numbers in one quarter), but, quickly, earnings management became a slippery slope. Ultimately, the parties the company was trying to protect (shareholders, for example) are hurt more than they would have been had the company reported its results correctly, exposing problems early so that corrective action could be taken (possibly by removing managers) to protect the broader stakeholders in the company. c. Company managers are just ordinary people. They desire to improve their compensation, which is often linked to financial performance. Managers may act to maximize their current compensation at the expense of long-term growth in shareholder value. The reduction in the average employment period at all levels of the company has exacerbated the problem. d. Unfortunately, the separation of ownership and control often leads to less informed shareholders who are unable to effectively monitor the actions of the managers they have hired. To the extent that compensation programs are linked to financial measures, managers can use the flexibility given to them under GAAP to their benefit, even without violating GAAP per se. These actions can only be uncovered by effective auditing and enforced by an effective audit committee of the board. Corporate governance has grown considerably in importance following the accounting scandals of the early 2000s. The Sarbanes-Oxley Act mandates new levels of corporate governance. The stock market and the courts are helping to enforce this mandate.

Cambridge Business Publishers, 2011 Solutions Manual, Chapter 5 5-37