Gleim P2 Financial Statement Analysis PDF

1 Study Unit One Liquidity, Solvency, and Leverage Ratios 1.1 Common-Size Financial Statements................................................................................ 2 1.2...

1 Study Unit One Liquidity, Solvency, and Leverage Ratios 1.1 Common-Size Financial Statements................................................................................ 2 1.2 Liquidity............................................................................................................................ 4 1.3 Solvency........................................................................................................................... 10 1.4 Leverage........................................................................................................................... 15 This study unit is the first of three on financial statement analysis. The relative weight assigned to this major topic in Part 2 of the exam is 20%. The three study units are Study Unit 1: Liquidity, Solvency, and Leverage Ratios Study Unit 2: Profitability and Per-Share Ratios Study Unit 3: Activity Ratios and Earnings Quality This study unit discusses basic financial statement analysis as well as liquidity, solvency, and leverage. Topics covered include Liquidity Ratios Solvency Ratios Current ratio Total debt-to-total-capital ratio Quick (acid-test) ratio Debt to equity ratio Cash ratio Long-term debt to equity ratio Net working capital ratio Debt to total assets ratio Times interest earned ratio Earnings to fixed charges ratio Cash flow to fixed charges ratio Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 1: Liquidity, Solvency, and Leverage Ratios 1.1 Common-Size Financial Statements Percentages and Comparability Analyzing the financial statements of steadily growing firms and firms of different sizes within an industry presents certain difficulties. To overcome this obstacle, common-size statements restate financial statement line items in terms of a percentage of a given amount, such as total assets for a balance sheet or net sales for an income statement. Items on common-size financial statements are expressed as percentages of sales (on the income statement) or total assets (on the balance sheet). The base amount is assigned the value of 100%. On an income statement, sales is valued at 100%. All other amounts are a percentage of sales. On the balance sheet, total assets are 100%, as is the total of liabilities and stockholders’ equity. Each line item can be interpreted in terms of its proportion of the baseline figure. Example 1-1 Income Statement -- 2-Year Analysis External reporting format Common-size format Current Prior Current Prior Year Year Year Year Net sales $1,800,000 $1,400,000 Net sales 100.0% 100.0% Cost of goods sold (1,650,000) (1,330,000) Cost of goods sold (91.7%) (95.0%) Gross profit 150,000 70,000 Gross profit 8.3% 5.0% Selling expenses (50,000) (15,000) Selling expenses (2.8%) (1.1%) General & admin. expenses (15,000) (10,000) General & admin. expenses (0.8%) (0.7%) Operating income 85,000 45,000 Operating income 4.7% 3.2% Other revenues and gains 20,000 0 Other revenues and gains 1.1% 0.0% Other expenses and losses (35,000) (10,000) Other expenses and losses (1.9%) (0.7%) Income before taxes 70,000 35,000 Income before taxes 3.9% 2.5% Income taxes (40%) (28,000) (14,000) Income taxes (40%) (1.6%) (1.0%) Net income $ 42,000 $ 21,000 Net income 2.3% 1.5% Example 1-2 Balance Sheet -- 2-Year Analysis External reporting format Common-size format Current Prior Current Prior Assets: Year End Year End Assets: Year End Year End Current assets $ 760,000 $ 635,000 Current assets 42.2% 39.7% Noncurrent assets 1,040,000 965,000 Noncurrent assets 57.8% 60.3% Total assets $1,800,000 $1,600,000 Total assets 100.0% 100.0% Liabilities & stockholders’ equity: Liabilities & stockholders’ equity: Current liabilities $ 390,000 $ 275,000 Current liabilities 21.7% 17.2% Noncurrent liabilities 610,000 675,000 Noncurrent liabilities 33.9% 42.2% Total liabilities $1,000,000 $ 950,000 Total liabilities 55.6% 59.4% Stockholders’ equity 800,000 650,000 Stockholders’ equity 44.4% 40.6% Total liabilities and Total liabilities and stockholders’ equity $1,800,000 $1,600,000 stockholders’ equity 100.0% 100.0% Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Liquidity, Solvency, and Leverage Ratios 3 Common-size statements simplify analysis of differences among companies of various sizes or comparisons between a similar company and an industry average. For example, comparing the efficiency of a company with $1,800,000 of revenues with a company with $44 billion in revenues is difficult unless the numbers are reduced to a common denominator. Vertical and Horizontal Analysis The common-size statements provided are an example of vertical analysis (i.e., the percentages are based on numbers above or below in the same column). Another concept is horizontal analysis. It states the amounts for several periods as percentages of a base-year amount. These are often called trend percentages. One period is designated the base period, with which the other periods are compared. Each line item of the base period is thus 100%. Example 1-3 Horizontal Analysis Income statement External reporting format nd Current 2 Prior Year Prior Year Year Net sales $1,800,000 $1,400,000 $1,500,000 Cost of goods sold (1,650,000) (1,330,000) (1,390,000) Gross profit $ 150,000 $ 70,000 $ 110,000 Income statement Trend analysis nd Current 2 Prior Year Prior Year Year Net sales 120.0% 93.3% 100.0% Cost of goods sold 118.7% 95.7% 100.0% Gross profit 136.4% 63.6% 100.0% Even though sales and cost of goods sold declined only slightly from the base year to the next year, gross profit plunged (on a percentage basis). By the same token, when sales recovered in the current year, the gain in gross profit was (proportionally) greater than the increases in its two components. Trend analysis compares financial information for balances and amounts across statement periods. It allows financial analysts to identify patterns in data from year to year and make comparisons with competitors and industry benchmarks. This type of trend analysis also is used for business decisions. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 1: Liquidity, Solvency, and Leverage Ratios There is also a form of horizontal analysis that does not use common sizes. This method is used to calculate the growth (or decline) of key financial line items. For example, if a company’s sales increased from $100,000 to $120,000, there would be a column showing the percentage increase, which was 20% in this case. This is another form of management by exception. Managers can look at the percentage change column and see which accounts have experienced the most change since the previous period. Example 1-4 Percentage Change Current Year Prior Year Dollar Change Percentage Change Net sales $1,800,000 $1,400,000 $400,000 28.6% Cost of goods sold 1,650,000 1,330,000 320,000 24.1% Selling expenses 50,000 15,000 35,000 233.3% General & admin. expenses 15,000 10,000 5,000 50.0% 1.2 Liquidity Liquidity is a firm’s ability to pay its current obligations as they come due and thus remain in business in the short run. Liquidity reflects the ease with which assets can be converted to cash. Liquidity ratios measure this ability by relating a firm’s liquid assets to its current liabilities. Figure 1-1 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Liquidity, Solvency, and Leverage Ratios 5 Example 1-5 Balance Sheet RESOURCES FINANCING Current Prior Current Prior CURRENT ASSETS: Year End Year End CURRENT LIABILITIES: Year End Year End Cash and equivalents $ 325,000 $ 275,000 Accounts payable $ 150,000 $ 75,000 Available-for-sale securities 165,000 145,000 Notes payable 50,000 50,000 Accounts receivable (net) 120,000 115,000 Accrued interest on note 5,000 5,000 Notes receivable 55,000 40,000 Current maturities of L.T. debt 100,000 100,000 Inventories 85,000 55,000 Accrued salaries and wages 15,000 10,000 Prepaid expenses 10,000 5,000 Income taxes payable 70,000 35,000 Total current assets $ 760,000 $ 635,000 Total current liabilities $ 390,000 $ 275,000 NONCURRENT ASSETS: NONCURRENT LIABILITIES: Equity-method investments $ 120,000 $ 115,000 Bonds payable $ 500,000 $ 600,000 Property, plant, & equipment 1,000,000 900,000 Long-term notes payable 90,000 60,000 Less: Accum. depreciation (85,000) (55,000) Employee-related obligations 15,000 10,000 Goodwill 5,000 5,000 Deferred income taxes 5,000 5,000 Total noncurrent assets $1,040,000 $ 965,000 Total noncurrent liabilities $ 610,000 $ 675,000 Total liabilities $1,000,000 $ 950,000 STOCKHOLDERS’ EQUITY: Preferred stock, $50 par $ 120,000 $ 0 Common stock, $1 par 500,000 500,000 Additional paid-in capital 110,000 100,000 Retained earnings 70,000 50,000 Total stockholders’ equity $ 800,000 $ 650,000 Total liabilities and Total assets $1,800,000 $1,600,000 stockholders’ equity $1,800,000 $1,600,000 Example 1-6 Income Statement Current Prior Year Year Net sales $1,800,000 $1,400,000 Cost of goods sold (1,450,000) (1,170,000) Gross profit $ 350,000 $ 230,000 SG&A expenses (160,000) (80,000) Operating income $ 190,000 $ 150,000 Other revenues and losses (40,000) (25,000) Earnings before interest and taxes $ 150,000 $ 125,000 Interest expense (15,000) (10,000) Earnings before taxes $ 135,000 $ 115,000 Income taxes (40%) (54,000) (46,000) Net income $ 81,000 $ 69,000 The balance sheet and income statement above provide inputs for the examples throughout this study unit. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 6 SU 1: Liquidity, Solvency, and Leverage Ratios Current assets are the most liquid. They are expected to be converted to cash, sold, or consumed within 1 year or the operating cycle, whichever is longer. Ratios involving current assets thus measure a firm’s ability to continue operating in the short run. Current assets include, in descending order of liquidity, cash and equivalents; marketable securities; receivables (net of allowance for credit losses); inventories; and prepaid items. Current liabilities, by the same token, are ones that must be settled the soonest. Specifically, they are expected to be settled or converted to other liabilities within 1 year or the operating cycle, whichever is longer. Current liabilities include accounts payable, notes payable, current maturities of long-term debt, unearned revenues, taxes payable, wages payable, and other accruals. Net working capital reports the resources the company would have to continue operating in the short run if it had to liquidate all of its current liabilities at once. Net working capital = Current assets – Current liabilities Example 1-7 Change in Working Capital Current Year: $760,000 – $390,000 = $370,000 Prior Year: $635,000 – $275,000 = $360,000 Although the company’s current liabilities increased, its current assets increased by $10,000 more. Current Ratio The current ratio is the most common measure of liquidity. Example 1-8 Current Ratio Current Year: $760,000 ÷ $390,000 = 1.949 Prior Year: $635,000 ÷ $275,000 = 2.309 Although working capital increased in absolute terms ($10,000), current assets now provide less proportional coverage of current liabilities than in the prior year. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Liquidity, Solvency, and Leverage Ratios 7 A low ratio indicates a possible solvency problem. A firm with a low current ratio may become insolvent. Therefore, care should be taken when determining whether to extend credit to a firm with a low ratio. An overly high ratio indicates that management may not be investing idle assets productively. The quality of accounts receivable and merchandise inventory should be considered before evaluating the current ratio. Obsolete or overvalued inventory or receivables can artificially inflate the current ratio. The general principle is that the current ratio should be proportional to the operating cycle. Thus, a shorter cycle may justify a lower ratio. For example, a grocery store has a short operating cycle and can survive with a lower current ratio than could a gold mining company, which has a much longer operating cycle. Quick Ratio The quick (acid-test) ratio excludes inventories and prepaids from the numerator, recognizing that those assets are difficult to liquidate at their stated values. The quick ratio is thus a more conservative measure than the basic current ratio. This ratio measures the firm’s ability to easily pay its short-term debts and avoids the problem of inventory valuation. Example 1-9 Quick (Acid-Test) Ratio Current Year: ($325,000 + $165,000 + $120,000 + $55,000) ÷ $390,000 = 1.705 Prior Year: ($275,000 + $145,000 + $115,000 + $40,000) ÷ $275,000 = 2.091 In spite of its increase in total working capital, the company’s position in its most liquid assets deteriorated significantly. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 8 SU 1: Liquidity, Solvency, and Leverage Ratios Other Liquidity Ratios The cash ratio is an even more conservative variation of the quick ratio. Example 1-10 Cash Ratio Current Year: ($325,000 + $165,000) ÷ $390,000 = 1.256 Prior Year: ($275,000 + $145,000) ÷ $275,000 = 1.527 In this working capital measure, the company’s position declined, but coverage is still positive; i.e., the ratio is greater than 1. The cash flow ratio reflects the significance of cash flow for settling obligations as they become due. Example 1-11 Cash Flow Ratio The company’s cash flows from operations for the two most recent years were $382,000 and $291,000, respectively. This information would be found on the company’s statement of cash flows. Current Year: $382,000 ÷ $390,000 = 0.979 Prior Year: $291,000 ÷ $275,000 = 1.058 Unlike the prior year, the cash flows generated by the company in the most recent year were not sufficient to cover current liabilities. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Liquidity, Solvency, and Leverage Ratios 9 The net working capital ratio is the most conservative of the working capital ratios. Example 1-12 Net Working Capital Ratio Current Year: ($760,000 – $390,000) ÷ $1,800,000 = 0.206 Prior Year: ($635,000 – $275,000) ÷ $1,600,000 = 0.225 Current liabilities are taking a bigger “bite” out of working capital than in the prior year. Liquidity of Current Liabilities The liquidity of current liabilities is the ease with which a firm can issue new debt or raise new structured (convertible, puttable, callable, etc.) funds. The liquidity of current liabilities indicates the ease of funding or availability of sources of funding. A firm’s ability to borrow in the financial markets is generally a function of its size, reputation, creditworthiness, and capital levels. Raising liquidity during an adverse situation often requires a combination of both asset liquidity and liability liquidity. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 10 SU 1: Liquidity, Solvency, and Leverage Ratios 1.3 Solvency Solvency is the ability of a business to meet its long-term obligations. This ability is related to the relative extent of use of debt and equity financing. Solvency is a function of capital structure and degree of leverage (covered in Subunit 1.4). A firm’s capital structure includes its sources of financing, both long- and short-term. These sources may be in the form of debt (external sources) or equity (internal sources). Capital structure decisions affect the risk profile of a firm. For example, a company with a higher percentage of debt is riskier than a firm with a higher percentage of equity. Thus, equity investors will demand a higher rate of return compared with other providers of capital to compensate for the risk related to a higher use of financial leverage. But a company with a high level of equity will be able to borrow at lower rates. Debt holders will accept lower interest in exchange for the lower risk because of the equity cushion. Figure 1-2 Debt is the creditor interest in the firm. The following are advantages of debt to the issuer: Interest paid on debt is tax deductible. Control of the firm is not shared with debtholders. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Liquidity, Solvency, and Leverage Ratios 11 The following are disadvantages of debt to the issuer: Unlike returns on equity investments, the payment of interest and principal on debt is a legal obligation. If cash flow is insufficient, the firm could become insolvent. The legal requirement to pay interest and principal increases a firm’s risk and reduces its retained earnings. Because shareholders demand increased retained earnings, they are less likely to invest in the firm, thus decreasing the share price. Debt may require collateral, specific property pledged to a lender in case of default. The amount of debt financing available to the individual firm is limited. Generally accepted standards of the investment community usually require a certain debt-to-equity ratio. Beyond this limit, the cost of debt may rise rapidly or debt may not be available. Equity is the ownership interest in the firm. Equity is the permanent capital of an enterprise, contributed by the firm’s owners (shareholders) to obtain a return. A return on equity is uncertain because it is a residual interest in the firm’s assets, i.e., the claim left after all debt has been satisfied. Periodic returns to owners of excess earnings are dividends. The firm may be contractually obligated to pay dividends to preferred shareholders but not to common shareholders. The following are advantages of equity to the corporation: Common stock does not require a fixed dividend. Dividends are paid from profits when available. Common stock has no fixed maturity date for repayment of capital. The sale of common stock increases the creditworthiness of the firm by providing more capital (or money) for the corporation. The following are disadvantages of equity to the corporation: Cash dividends on common stock are not tax-deductible and are paid from after-tax profits. New common stock sales dilute earnings per share (EPS) available to current shareholders. Underwriting costs (e.g., fees to issue new common stock) typically are higher for common stock than for debt. Too much equity may raise the average cost of capital of the firm above its optimal level. Capital adequacy is a term normally used in connection with financial institutions. A bank must be able to pay depositors who demand their money on a given day and still be able to make new loans. Capital adequacy may be discussed in terms of Solvency (the ability to pay long-term obligations as they mature). Liquidity (the ability to pay for day-to-day ongoing operations). Reserves (the specific amount a bank must have available to pay depositors). Sufficient capital. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 12 SU 1: Liquidity, Solvency, and Leverage Ratios Capital Structure Ratios Capital structure ratios report the relative proportions of debt and equity in a firm’s capital structure at a given reporting date. The total debt-to-total-capital ratio measures the percentage of the capital structure provided by creditors. When total debt to total capital is low, the firm’s capital is supplied by the shareholders. Thus, creditors prefer this ratio to be low as a cushion against losses. Example 1-13 Total Debt-to-Total-Capital Ratio Current Year: $1,000,000 ÷ $1,800,000 = 0.556 Prior Year: $ 950,000 ÷ $1,600,000 = 0.594 The company became slightly less reliant on debt in its capital structure during the current year. Although total debt rose, equity rose by a greater percentage. The company is less leveraged than before. The debt to equity ratio is a direct comparison of the firm’s debt load versus its equity stake. Like the total debt-to-total-capital ratio, the debt to equity ratio reflects long-term debt-payment ability. Again, a low ratio means a lower relative debt burden and thus better chances of repayment of creditors. Example 1-14 Debt to Equity Ratio Current Year: $1,000,000 ÷ $800,000 = 1.25 Prior Year: $ 950,000 ÷ $650,000 = 1.46 The amount by which the company’s debts exceed its equity stake declined in the current year. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Liquidity, Solvency, and Leverage Ratios 13 The long-term debt to equity ratio reports the long-term debt burden carried by a company per dollar of equity. A low ratio means a firm will have an easier time raising new debt (since its low current debt load makes it a good credit risk). Example 1-15 Long-Term Debt to Equity Ratio Current Year: $610,000 ÷ $800,000 = 0.763 Prior Year: $675,000 ÷ $650,000 = 1.038 The company has greatly improved its long-term debt burden. It now carries less than one dollar of long- term debt for every dollar of equity. The debt to total assets ratio (also called the debt ratio) reports the total debt burden carried by a company per dollar of assets. Numerically, this ratio is identical to the debt to total capital ratio. Example 1-16 Debt to Total Assets Ratio Current Year: $1,000,000 ÷ $1,800,000 = 0.556 Prior Year: $ 950,000 ÷ $1,600,000 = 0.594 Although total liabilities increased in absolute terms, this ratio improved because total assets increased even more. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 14 SU 1: Liquidity, Solvency, and Leverage Ratios Earnings Coverage Ratios Earnings coverage ratios are a creditor’s best measure of a firm’s ongoing ability to generate the earnings that will allow it to service debt. The times interest earned ratio is an income statement approach to evaluating a firm’s ongoing ability to meet the interest payments on its debt obligations. For the ratio to be meaningful, net income cannot be used in the numerator. Since what is being measured is the ability to pay interest, earnings before interest and taxes (EBIT) is appropriate. The most accurate calculation of the numerator includes only earnings expected to recur. Consequently, unusual or infrequent items, discontinued operations, and the effects of accounting changes should be excluded. The denominator should include capitalized interest. Example 1-17 Times Interest Earned Ratio Current Year: $150,000 ÷ $15,000 = 10.00 times Prior Year: $125,000 ÷ $10,000 = 12.50 times The company is less able to comfortably pay interest expense. In the prior year, EBIT was twelve and a half times interest expense, but in the current year, it is only ten times. The earnings to fixed charges ratio (also called the fixed charge coverage ratio) extends the times interest earned ratio to include the interest portion associated with long-term lease obligations. Fixed charges include interest, required principal repayments, and leases. This is a more conservative ratio since it measures the coverage of earnings over all fixed charges, not just interest expense. The cash flow to fixed charges ratio removes the difficulties of comparing amounts prepared on an accrual basis. Cash from operations is after-tax. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Liquidity, Solvency, and Leverage Ratios 15 1.4 Leverage For the purpose of the CMA exam, be sure that you understand and can calculate both leverage ratios. However, calculating these ratios is just one aspect of how you could be tested on this topic. Candidates should be fully prepared to apply these calculations and demonstrate an understanding through multiple-choice or essay questions of how changes in cost structure may affect these ratios. Ensure that you understand what risks and advantages are associated with high operating or financial leverage. Types of Leverage Leverage is the relative amount of fixed cost in a firm’s overall cost structure. Leverage creates risk because fixed costs must be covered, regardless of the level of sales. Operating leverage arises from the use of a high level of plant and machinery in the production process, revealed through charges for depreciation, property taxes, etc. Financial leverage arises from the use of a high level of debt in the firm’s financing structure, revealed through amounts paid out for interest. Although leverage arises from items on the balance sheet, it is measured by examining its effects on the income statement. A general statement of leverage is Degree of Operating Leverage (DOL) Calculation of the DOL requires financial information prepared on the variable-costing basis, since variable costing isolates the use of fixed costs in the firm’s ongoing operations. Example 1-18 DOL -- Single Period A firm’s DOL varies with the level of sales, as shown below: Degree of Operating Leverage at Various Levels of Sales Sales volume: 100 Units 250 Units 500 Units 750 Units 1,000 Units Net sales ($1,000 per unit) $ 100,000 $ 250,000 $ 500,000 $ 750,000 $1,000,000 Variable costs ($800 per unit) (80,000) (200,000) (400,000) (600,000) (800,000) Contribution margin $ 20,000 $ 50,000 $ 100,000 $ 150,000 $ 200,000 Fixed costs (100,000) (100,000) (100,000) (100,000) (100,000) Operating income (loss) $ (80,000) $ (50,000) $ 0 $ 50,000 $ 100,000 Degree of operating leverage (DOL) (0.25) (1.00) Undef. 3.00 2.00 This firm breaks even at sales of 500 units. As the example demonstrates, DOL is not a meaningful measure when the firm incurs an operating loss. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 16 SU 1: Liquidity, Solvency, and Leverage Ratios Two versions of DOL are in common use. 1. The version shown on the previous page compares contribution margin and variable-basis operating income in a single reporting period. 2. The percentage-change version of DOL measures the changes in income statement amounts from one period to another. %Δ in operating income or EBIT DOL (%Δ) = %Δ in sales Note that, in this version, the numerator and denominator are different from those in the single-period version. Example 1-19 DOL -- Percentage Change Degree of Operating Leverage Period-to-Period Percentage Change Current Prior Year Year Net sales $1,800,000 $1,400,000 Cost of goods sold (1,450,000) (1,170,000) Gross margin $ 350,000 $ 230,000 SG&A expenses (160,000) (80,000) Operating income $ 190,000 $ 150,000 Other income and loss (40,000) (25,000) EBIT $ 150,000 $ 125,000 Interest expense (15,000) (10,000) Earnings before taxes $ 135,000 $ 115,000 Income taxes (40%) (54,000) (46,000) Net income $ 81,000 $ 69,000 Numerator: %Δ in EBIT = ($150,000 – $125,000) ÷ $125,000 = 20.00% Denominator: %Δ in sales = ($1,800,000 – $1,400,000) ÷ $1,400,000 = 28.57% Degree of operating leverage (DOL) = 20.00% ÷ 28.57% = 0.7 Every 1% change in sales generates a 0.7% change in EBIT. A firm with high operating leverage necessarily carries a greater degree of risk because fixed costs must be covered regardless of the level of sales. However, such a firm is also able to expand production rapidly in times of higher product demand. Thus, the more leveraged a firm is in its operations, the more sensitive operating income is to changes in sales volume. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 1: Liquidity, Solvency, and Leverage Ratios 17 Degree of Financial Leverage (DFL) The DFL also results from a pre-fixed-cost income to post-fixed-cost income comparison, this time on the firm’s financing structure. This formula isolates the effects of interest as the only truly fixed financing cost. Example 1-20 DFL -- Single Period Degree of Financial Leverage Single-Period Version Current Year Prior Year Net sales $1,800,000 $1,400,000 Cost of goods sold (1,450,000) (1,170,000) Gross margin $ 350,000 $ 230,000 SG&A expenses (160,000) (80,000) Operating income $ 190,000 $ 150,000 Other income and loss (40,000) (25,000) EBIT $ 150,000 $ 125,000 Interest expense (15,000) (10,000) Earnings before taxes $ 135,000 $ 115,000 Income taxes (40%) (54,000) (46,000) Net income $ 81,000 $ 69,000 Degree of financial leverage Current year: $150,000 ÷ $135,000 = $1.11 Prior year: $125,000 ÷ $115,000 = $1.09 The company needs $1.11 of EBIT to generate $1.00 of EBT. Last year, only $1.09 of EBIT was needed to generate $1.00 of EBT. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 18 SU 1: Liquidity, Solvency, and Leverage Ratios Two versions of DFL are in common use. 1. The version shown on the previous page compares EBIT and EBT from a single reporting period. 2. The percentage-change version examines the changes in income statement amounts over two periods. %Δ in net income DFL (%Δ) = %Δ in EBIT Note that in the percentage-change version, the numerator and denominator are different from those in the single-period version. Example 1-21 DFL -- Percentage Change Numerator: %Δ in net income = ($81,000 – $69,000) ÷ $69,000 = 17.39% Denominator: %Δ in EBIT = ($150,000 – $125,000) ÷ $125,000 = 20.00% Degree of financial leverage (DFL) = 17.39% ÷ 20.00% = 0.8695 Every 1% change in EBIT generates a 0.87% change in net income. A firm with high financial leverage necessarily carries a greater degree of risk because debt must be serviced regardless of the level of earnings. However, if such a firm is profitable, there is more residual profit for the shareholders after debt service (interest on debt is tax-deductible), reflected in higher earnings per share. Furthermore, debt financing permits the current equity holders to retain control. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  1 Study Unit Two Profitability and Per-Share Ratios 2.1 Profitability........................................................................................................................ 2 2.2 Factors Affecting Reported Profitability............................................................................ 8 2.3 Per-Share Ratios.............................................................................................................. 13 This study unit is the second of three on financial statement analysis. The relative weight assigned to this major topic in Part 2 of the exam is 20%. The three study units are Study Unit 1: Liquidity, Solvency, and Leverage Ratios Study Unit 2: Profitability and Per-Share Ratios Study Unit 3: Activity Ratios and Earnings Quality This study unit discusses profitability and market ratios. Topics covered in this study unit include Profitability Ratios Market Ratios Gross profit margin percentage Basic earnings per share Operating profit margin percentage Diluted earnings per share Net profit margin percentage Book value per share EBITDA margin percentage Price/earnings ratio Return on assets Market-to-book ratio Return on equity Price-sales ratio Sustainable growth rate Earnings yield Dividend payout ratio Dividend yield Shareholder return Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 2: Profitability and Per-Share Ratios 2.1 Profitability Income Statement Percentages Gross profit margin (also referred to as gross margin or gross profit) is the percentage of gross revenues that remains with the firm after paying for merchandise. It is calculated by subtracting cost of goods sold from net sales. The key analysis with respect to the gross profit margin is whether it remains stable with any increase or decrease in sales. Net sales – Cost of goods sold Gross profit margin percentage = Net sales For example, a 10% increase in sales should be accompanied by at least a 10% increase in gross profit. Thus, the gross profit margin should remain relatively constant at different sales levels. Operating profit margin is the percentage that remains after selling and general and administrative expenses have been paid. Operating income Operating profit margin percentage = Net sales The ratio of net operating income to sales may also be defined as earnings before interest and taxes (EBIT) divided by net sales. Net profit margin is the percentage that remains after other gains and losses (including interest expense) and income taxes have been added or deducted. Net income Net profit margin percentage = Net sales Example 2-1 Income Statement Percentages Dollars Percent Net sales $1,800,000 100.0% Cost of goods sold (1,450,000) (80.6%) Gross profit $ 350,000 19.4% (Gross profit margin) SG&A expenses (160,000) (8.9%) Operating income $ 190,000 10.6% (Operating profit margin) Other income and loss (40,000) (2.2%) EBIT $ 150,000 8.3% Interest expense (15,000) (0.8%) Earnings before taxes $ 135,000 7.5% Income taxes (40%) (54,000) (3.0%) Net income $ 81,000 4.5% (Net profit margin) Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 2: Profitability and Per-Share Ratios 3 Example 2-1 provides input for the examples throughout this subunit. The numerator may also be stated in terms of the net income available to common shareholders. Another form of the ratio excludes nonrecurring items from the numerator, e.g., unusual or infrequent items or discontinued operations, not items in the income statement under current U.S. GAAP. The result is sometimes called the net profit margin. This adjustment may be made for any ratio that includes net income. Still other numerator refinements are to exclude equity-based earnings and items in the other income and other expense categories. Earnings before interest, taxes, depreciation, and amortization (EBITDA) is a commonly used performance measure that approximates cash-basis profits from ongoing operations. EBITDA is arrived at by adding back the two major noncash expenses to EBIT. EBITDA is a controversial measure that is only used for companies that look bad under other ratios. Basically, it shows how a company is performing if fixed costs are ignored. EBITDA EBITDA margin percentage = Net sales There are numerous benefits to using EBITDA, including operational comparability and as a proxy for cash flows. For example, because depreciation and amortization do not require cash outlays, their exclusion results in a number approximating current cash flows. However, the disadvantages of EBITDA outweigh the advantages. Disadvantages of EBITDA ◙ Overstates income: EBITDA distorts reality. From a stockholder’s standpoint, investors are most concerned with the level of income and cash flow available after all expenses, including interest expense, depreciation expense, and income tax expense. ◙ Neglects working capital requirements: EBITDA may actually be a decent proxy for cash flows for many companies; however, this profit measure does not account for the working capital needs of a business. For example, companies reporting high EBITDA figures may actually have dramatically lower cash flows once working capital requirements (i.e., inventories, receivables, payables) are tabulated. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 2: Profitability and Per-Share Ratios Profitability Ratios Return on assets (ROA) (also called return on total assets, or ROTA), is a straightforward measure of how well management is deploying the firm’s assets in the pursuit of profit. Net income Return on assets = Average total assets Example 2-2 Return on Assets ROA = Net income ÷ Average total assets = $81,000 ÷ [($1,800,000 + $1,600,000) ÷ 2] = $81,000 ÷ $1,700,000 = 4.76% Return on equity (ROE) measures the return per owner dollar invested. Net income Return on equity = Average total equity Example 2-3 Return on Equity ROE = Net income ÷ Average total equity = $81,000 ÷ [($800,000 + $650,000) ÷ 2] = $81,000 ÷ $725,000 = 11.17% The difference in the two denominators used in ROA and ROE is total liabilities. ROE will therefore always be greater than ROA when there are liabilities. The relationship between the return on equity and the return on assets can be seen by the following formula: ROA = ROE × (1 – Debt ratio) The sustainable growth rate equals the return on equity times the difference of 1 and the dividend payout ratio. Sustainable growth rate = ROE × (1 – Dividend payout ratio) This ratio measures the potential growth of a firm without borrowing additional funds. The retention ratio, or the difference of 1 and the dividend payout ratio, is the portion of the income kept to grow the firm. The dividend payout ratio is covered in Subunit 2.3. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 2: Profitability and Per-Share Ratios 5 The DuPont Model -- ROA The DuPont model begins with the standard equation for ROA and breaks it down into two component ratios, one that focuses on the income statement and one that relates income to the balance sheet. This breakdown emphasizes that shareholder return may be explained in terms of both profit margin and the efficiency of asset management. Net income Net income Net sales DuPont Model for ROA = = × Average total assets Net sales Average total assets = Net profit margin × Total asset turnover Example 2-4 DuPont Model for Return on Assets ROA = Net profit margin × Total asset turnover = (Net income ÷ Net sales) × (Net sales ÷ Average total assets) = ($81,000 ÷ $1,800,000) × {$1,800,000 ÷ [($1,800,000 + $1,600,000) ÷ 2]} = 4.5% × 1.06 = 4.77% The two components of the DuPont equation are interrelated because they both involve net sales. Net profit margin may also be referred to as profit margin on sales. If net sales increase and net income remains the same, the net profit margin worsens because more sales are generating the same bottom line. Total asset turnover measures the level of capital investment relative to sales volume. If net sales increase and all other factors remain the same, the asset turnover ratio improves because more sales are being produced by the same amount of assets. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 6 SU 2: Profitability and Per-Share Ratios The DuPont Model -- ROE To examine the ROE ratio, it can be subdivided by the DuPont model into three different efficiency components. Net income Net sales Average total assets DuPont Model for ROE = × × Net sales Average total assets Average total equity Net profit margin × Asset turnover × Equity multiplier Example 2-5 DuPont Model for Return on Equity $81,000 $1,800,000 [($1,800,000 + $1,600,000) ÷ 2] ROE = × × $1,800,000 [($1,800,000 + $1,600,000) ÷ 2] [($800,000 + $650,000) ÷ 2] = 0.045 × 1.06 × 2.345 = 11.19% The net profit margin component examines efficiency in generating earnings from sales. It measures the amount of earnings for every $1 of sales. The asset turnover component examines how efficiently total resources are used to generate revenues. It measures the sales generated from each $1 of assets. The equity multiplier measures financial leverage. High leverage indicates greater reliance on debt to finance assets. Raising capital with debt increases the equity multiplier and improves return on equity. But additional debt may decrease solvency and increase the risk of bankruptcy. The DuPont Model itself is not specifically tested on the CMA exam, but candidates should understand the model conceptually and be able to calculate the individual components of the model. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 2: Profitability and Per-Share Ratios 7 Inconsistent Definitions CMA candidates must be alert to alternate definitions of terms used for calculating various ratios. Read each question carefully to identify whether the calculation is based on a modified definition. Under various return ratios, the numerator (“return”) may be adjusted by Subtracting preferred dividends to leave only income available to common stockholders Adding back minority interest in the income of a consolidated subsidiary (when invested capital is defined to include the minority interest) Adding back interest expense Adding back both interest expense and taxes so that the numerator is EBIT; this results in the basic earning power ratio, which enhances comparability of firms with different capital structures and tax planning strategies The denominator (“equity” or “assets”) may be adjusted by Excluding nonoperating assets, such as investments, intangible assets, and the other asset category Excluding unproductive assets, such as idle plant, intangible assets, and obsolete inventories Excluding current liabilities to emphasize long-term capital Excluding debt and preferred stock to arrive at equity capital Stating invested capital at market value Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 8 SU 2: Profitability and Per-Share Ratios 2.2 Factors Affecting Reported Profitability Among the many factors involved in measuring profitability are the definition of income; the stability, sources, and trends of revenue; revenue relationships; and expenses, including cost of sales. This analysis attempts to answer questions about the relevant income measure, income quality, the persistence of income, and the firm’s earning power. Income Estimates are necessary to calculate income, for example, allocations of revenue and expense over accounting periods, useful lives of assets, and amounts of future liabilities. Income is measured in accordance with a selection from among generally accepted accounting principles. For example, selecting between the accrual basis and cash basis of accounting. Accrual accounting records the financial effects of transactions and other events and circumstances when they occur rather than when their associated cash is paid or received. Under the cash basis, revenues are recognized when cash is received and expenses are recognized when cash is paid. Incentives for disclosure about the income measure vary with the interest group: financial analysts, auditors, accountants, management, directors, shareholders, competitors, creditors, and regulators. The pressures from some groups may lead to suboptimal financial reporting. Users have different needs, but financial statements are general purpose. For example, investors are interested in profitability, but creditors are interested in security. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 2: Profitability and Per-Share Ratios 9 Revenues Revenues are inflows or other enhancements of assets of the firm or settlements of its liabilities from delivering or producing goods, rendering services, or other activities that constitute the firm’s ongoing major or central operations. Revenue is recognized when realized or realizable and earned. Revenues are realized when goods or services have been exchanged for cash or claims to cash. For example, revenues are realized when inventory is exchanged for cash. Revenues are also realized when inventory is exchanged for claims to cash, which is recorded as a receivable by the party holding the claims. Revenues are realizable when goods or services have been exchanged for assets that are readily convertible into cash or claims to cash. Revenues are earned when the earning process has been substantially completed and the entity is entitled to the resulting benefits or revenues. The two conditions are usually met when goods are delivered or services are rendered, that is, at the time of sale, which is customarily the time of delivery. Below is the five-step model for recognizing revenue from contracts with customers. Step 1: Identify the contract(s) with a customer. Step 2: Identify the performance obligations in the contract. Step 3: Determine the transaction price. Step 4: Allocate the transaction price to the performance obligations in the contract. Step 5: Recognize revenue when (or as) a performance obligation is satisfied. The core principle is that an entity recognizes revenue for the transfer of promised goods or services to customers in an amount that reflects the consideration to which the entity expects to be entitled in the exchange. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 10 SU 2: Profitability and Per-Share Ratios Cost of Goods Sold and Gross Profit Margin Cost of goods sold is the single largest cost element for any seller of merchandise and thus has the greatest impact on profitability. A company’s gross profit margin is the percentage of its gross sales that it is able to keep after paying for merchandise. Example 2-6 Gross Profit and Gross Profit Margin Current Year Prior Year Gross sales $1,827,000 100.0% $1,418,000 100.0% Sales discounts (15,000) (0.8%) (10,000) (0.7%) Sales return and allowances (12,000) (0.7%) (8,000) (0.6%) Net sales $1,800,000 98.5% $1,400,000 98.7% Cost of goods sold (1,450,000) (79.4%) (1,170,000) (82.5%) Gross profit $ 350,000 19.1% $ 230,000 16.2% (Gross profit margin) A change in the gross profit margin can indicate that the firm has priced its products differently while maintaining the same cost structure or that it has changed the way it controls the costs of production and/or inventory management. Effects of Accounting Changes The types of accounting changes are changes in accounting principle, accounting estimates, and the reporting entity. Accounting changes and error corrections affect financial ratios. A change in accounting principle occurs when an entity Adopts a generally accepted principle different from the one previously used Changes the method of applying a generally accepted principle Changes to a generally accepted principle when the principle previously used is no longer generally accepted Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 2: Profitability and Per-Share Ratios 11 Retrospective application, if practicable, is required for all direct effects and the related income tax effects of a change in principle. Retrospective application requires that carrying amounts of assets, liabilities, and retained earnings at the beginning of the first period reported be adjusted for the cumulative effect of the new principle on all periods not reported. All periods reported must be individually adjusted for the period-specific effects of applying the new principle. An example of a direct effect is an adjustment of an inventory balance to implement a change in the method of measurement. Figure 2-1 A change in accounting estimate results from new information and a reassessment of the future benefits and obligations represented by assets and liabilities. Its effects should be accounted for only in the period of change and any future periods affected, i.e., prospective application should be used. A change in estimate inseparable from (effected by) a change in principle is accounted for as a change in estimate. An example is a change in a method of depreciation, amortization, or depletion of long-lived, nonfinancial assets. Figure 2-2 A change in reporting entity is retrospectively applied to interim and annual statements. Figure 2-3 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 12 SU 2: Profitability and Per-Share Ratios Accounting Errors An accounting error results from A mathematical mistake A mistake in the application of GAAP An oversight or misuse of facts existing when the statements were prepared A change to a generally accepted accounting principle from one that is not is an error correction, not an accounting change. An accounting error related to a prior period is reported as a prior-period adjustment by restating the prior-period statements. Restatement requires the same adjustments as retrospective application of a new principle. Error corrections related to prior periods result in restatement. After retrospective application or restatement, the comparative financial statements and ratios should be comparable and consistent. However, changing prior years’ net income and related EPS figures may undermine shareholders’ confidence in the accounting methods. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 2: Profitability and Per-Share Ratios 13 2.3 Per-Share Ratios Per-share ratios are an important part of ratio analysis. Investors rely on these ratios to evaluate performance and value companies. Candidates should be able to calculate, understand, and interpret the per-share ratios for the CMA exam. Earnings per Share (EPS) EPS is probably the most heavily relied-upon performance measure used by investors. EPS states the amount of current-period earnings that can be associated with a single share of a corporation’s common stock. EPS is only calculated for common stock because common shareholders are the residual owners of a corporation. Since preferred shareholders have superior claim to the firm’s earnings, amounts associated with preferred stock must be removed during the calculation of EPS. A corporation is said to have a simple capital structure if the following two conditions apply: 1. The firm has only common stock; i.e., there are no preferred shareholders with a superior claim to earnings in the form of dividends; and 2. The firm has no dilutive potential common stock. Potential common stock (PCS) is a security or other contract that may entitle the holder to obtain common stock. Examples include convertible securities, stock options and warrants, and contingently issuable common stock. Potential common stock is said to be dilutive if its inclusion in the calculation of EPS results in a reduction of EPS. A firm with a simple capital structure only has to report a single category of EPS, called basic earnings per share (BEPS). A firm with preferred stock or dilutive potential common stock must report two categories of EPS, BEPS and diluted earnings per share (DEPS). Basic Earnings Per Share EPS equals net income available to common shareholders divided by the average number of shares outstanding for the period. Net income available to common shareholders EPS = Weighted-average common shares outstanding Net income available to common shareholders is net income minus preferred dividends. Stock dividends and stock splits are deemed to have occurred at the beginning of the period. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 14 SU 2: Profitability and Per-Share Ratios Example 2-7 BEPS Numerator An entity has two classes of preferred stock. It declared a 4% dividend on its $100,000 of noncumulative preferred stock. The entity did not declare a dividend on its $200,000 of 6% cumulative preferred stock. Undistributed dividends for the past 4 years have accumulated on this stock. Below is an excerpt from the entity’s condensed income statement for the year: Income from continuing operations before income taxes $1,666,667 Income taxes (666,667) Income from continuing operations $1,000,000 Discontinued operations: Loss from operations of component unit -- Pipeline Division (including gain on disposal of $30,000) $(216,667) Income tax benefit 86,667 Loss on discontinued operations (130,000) Net income $ 870,000 The numerators for income from continuing operations and for net income are calculated as follows: Income from Continuing Operations Net Income Income statement amounts $1,000,000 $870,000 Declared or accumulated preferred dividends: Dividends declared on noncumulative preferred stock in the current period (4,000) (4,000) Dividends accumulated on cumulative preferred stock in the current period (12,000) (12,000) Income available to common shareholders $ 984,000 $854,000 Example 2-8 BEPS Denominator In Example 2-7, assume the following common stock transactions during the year just ended: Common Shares Portion Weighted Date Stock Transactions Outstanding of Year Average Jan 1 Beginning balance 240,000 × 2 ÷ 12 = 40,000 Mar 1 Issued 60,000 shares 300,000 × 5 ÷ 12 = 125,000 Aug 1 Repurchased 20,000 shares 280,000 × 3 ÷ 12 = 70,000 Nov 1 Issued 80,000 shares 360,000 × 2 ÷ 12 = 60,000 Total 295,000 The BEPS amounts for income from continuing operations and net income are $3.336 ($984,000 ÷ 295,000) and $2.895 ($854,000 ÷ 295,000), respectively. Basic loss per share (negative BEPS) from discontinued operations of $0.44 ($130,000 ÷ 295,000) is reported on the face of the income statement or in the notes. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 2: Profitability and Per-Share Ratios 15 Example 2-9 Effect of Stock Dividend and Stock Split on BEPS Denominator In Example 2-7, assume declaration of a 50% common stock dividend on June 1 and a 2-for-1 common stock split on October 1. Common Shares Restate for Restate for Portion Weighted Date Stock Transactions Outstanding Stock Div. Stock Split of Year Average Jan 1 Beginning balance 240,000 × 1.5 × 2 × 2 ÷ 12 = 120,000 Mar 1 Issued 60,000 shares 300,000 × 1.5 × 2 × 5 ÷ 12 = 375,000 Jun 1 Distributed 50% stock dividend 450,000 Aug 1 Repurchased 20,000 shares 430,000 × 2 × 3 ÷ 12 = 215,000 Oct 1 Distributed 2-for-1 stock split 860,000 Nov 1 Issued 80,000 shares 940,000 × 2 ÷ 12 = 156,667 Total 866,667 The BEPS amounts for income from continuing operations and net income are $1.135 ($984,000 ÷ 866,667) and $0.985 ($854,000 ÷ 866,667), respectively. Basic loss per share (negative BEPS) from discontinued operations of $0.15 ($130,000 ÷ 866,667) is reported in the income statement or in the notes. Diluted Earnings Per Share (DEPS) To calculate the diluted earnings per share: The numerator is increased by the amounts that would not have had to be paid if dilutive potential common stock had been converted, namely, dividends on convertible preferred stock and after-tax interest on convertible debt. The denominator is increased by the weighted-average number of additional shares of common stock that would have been outstanding if dilutive potential common stock had been converted. Per-Share Ratios Book value per share equals the amount of net assets available to the common shareholders divided by the number of common shares outstanding. When a company has preferred as well as common stock outstanding, the computation of book value per common share must consider potential claims by preferred shareholders, such as whether the preferred stock is cumulative and in arrears, or participating. It must also take into account whether the call price (or possibly the liquidation value) exceeds the carrying amount of the preferred stock. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 16 SU 2: Profitability and Per-Share Ratios The limitation of book value per share is that it is a valuation based solely on the amounts recorded in the books. Unlike market value, book value does not consider future earnings potential in determining a company’s valuation. The recorded values of assets on the books are subject to accounting estimates (e.g., choice of depreciation method) that may vary across companies within the same industry. Consequently, net assets may be overstated if estimates are inaccurate. Additionally, those same assets may be pledged as collateral on a loan. However, a pledge of collateral is not recorded as a liability on the books. Thus, book value will not account for this potential liability. The price-earnings (P/E) ratio equals the market price per share of common stock divided by EPS (or total market value divided by net income). Growth companies are likely to have high P/E ratios. A high P/E ratio reflects the stock market’s positive assessment of the firm’s earnings quality and prospects. Because of the widespread use of the P/E ratio and other measures, the relationship between accounting data and stock prices is crucial. Thus, managers have an incentive to “manage earnings,” sometimes by fraudulent means. A decrease in investors’ required rate of return will cause share prices to go up, which will result in a higher P/E ratio. A decline in the rate of dividend growth will cause the share price to decline, which will result in a lower P/E ratio. An increasing dividend yield indicates that share price is declining, which will result in a lower P/E ratio. Market-to-book ratio (also called the price-book ratio) is the market price per share divided by the book value per share. Well-managed firms should sell at high multiples of their book value, which reflects historical cost. Price-sales ratio is preferred by some analysts over profit ratios. Analysts who use the price-sales ratio believe that strong sales are the basic ingredient of profits and that sales are the item on the financial statements least subject to manipulation. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 2: Profitability and Per-Share Ratios 17 Other Market-Based Measures Increasing shareholder wealth is the fundamental goal of any corporation. The following ratios measure the degree of success toward this goal. Earnings yield is the rate of return on the purchase price of a share of common stock. It is the reciprocal of the P/E ratio and thus measures the amount of earnings an investor expects to receive per dollar invested. The earnings yield can be compared by investors to other types of investments to determine whether a given stock is comparable to other stocks in the industry or to alternative uses of the investment money. The dividend payout ratio measures what portion of accrual-basis earnings was actually paid out to common shareholders in the form of dividends. Growth companies tend to have a low payout, preferring to use earnings to continue growing the firm. A related ratio is the dividend yield. Investors in different circumstances have different perspectives on dividend yield. For example, a retiree wants regular income and therefore wants to see a high dividend yield. A person who is years away from retirement would prefer a lower dividend yield with the earnings reinvested in the business. Shareholder return measures the return on a purchase of stock. Ending stock price – Beginning stock price + Annual dividends per share Shareholder return = Beginning stock price Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  1 Study Unit Three Activity Ratios and Earnings Quality 3.1 Activity Ratios................................................................................................................... 2 3.2 Ratio Analysis and Earnings Quality............................................................................... 10 This study unit is the third of three on financial statement analysis. The relative weight assigned to this major topic in Part 2 of the exam is 20%. The three study units are Study Unit 1: Liquidity, Solvency, and Leverage Ratios Study Unit 2: Profitability and Per-Share Ratios Study Unit 3: Activity Ratios and Earnings Quality This study unit discusses activity ratios and earnings quality. Topics covered in this study unit include Accounts receivable turnover and days’ sales outstanding in receivables Inventory turnover and days’ sales in inventory Accounts payable turnover and days’ purchases in accounts payable Limitations of ratio analysis Earnings quality Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 2 SU 3: Activity Ratios and Earnings Quality 3.1 Activity Ratios Activity ratios measure how quickly the two major noncash assets (accounts receivable and inventory) are converted to cash. Activity ratios measure results over a period of time and thus draw information from the firm’s income statement as well as from the balance sheet. Example 3-1 Balance Sheet RESOURCES FINANCING Current Prior Current Prior CURRENT ASSETS: Year End Year End CURRENT LIABILITIES: Year End Year End Cash and equivalents $ 325,000 $ 275,000 Accounts payable $ 150,000 $ 75,000 Available-for-sale securities 165,000 145,000 Notes payable 50,000 50,000 Accounts receivable (net) 120,000 115,000 Accrued interest on note 5,000 5,000 Notes receivable 55,000 40,000 Current maturities of L.T. debt 100,000 100,000 Inventories 85,000 55,000 Accrued salaries and wages 15,000 10,000 Prepaid expenses 10,000 5,000 Income taxes payable 70,000 35,000 Total current assets $ 760,000 $ 635,000 Total current liabilities $ 390,000 $ 275,000 NONCURRENT ASSETS: NONCURRENT LIABILITIES: Equity-method investments $ 120,000 $ 115,000 Bonds payable $ 500,000 $ 600,000 Property, plant, & equipment 1,000,000 900,000 Long-term notes payable 90,000 60,000 Less: Accum. depreciation (85,000) (55,000) Employee-related obligations 15,000 10,000 Goodwill 5,000 5,000 Deferred income taxes 5,000 5,000 Total noncurrent assets $1,040,000 $ 965,000 Total noncurrent liabilities $ 610,000 $ 675,000 Total liabilities $1,000,000 $ 950,000 STOCKHOLDERS’ EQUITY: Preferred stock, $50 par $ 120,000 $ 0 Common stock, $1 par 500,000 500,000 Additional paid-in capital 110,000 100,000 Retained earnings 70,000 50,000 Total stockholders’ equity $ 800,000 $ 650,000 Total liabilities and Total assets $1,800,000 $1,600,000 stockholders’ equity $1,800,000 $1,600,000 Example 3-2 Income Statement Current Prior Year Year Net sales $1,800,000 $1,400,000 Cost of goods sold (1,450,000) (1,170,000) Gross profit $ 350,000 $ 230,000 SG&A expenses (160,000) (80,000) Operating income $ 190,000 $ 150,000 Other revenues and losses (40,000) (25,000) Earnings before interest and taxes $ 150,000 $ 125,000 Interest expense (15,000) (10,000) Earnings before taxes $ 135,000 $ 115,000 Income taxes (40%) (54,000) (46,000) Net income $ 81,000 $ 69,000 Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 3: Activity Ratios and Earnings Quality 3 The balance sheet and income statement on the previous page provide inputs for the examples throughout this subunit. Accounts Receivable Accounts receivable turnover measures the efficiency of accounts receivable collection. If a business is highly seasonal, a simple average of beginning and ending balances is inadequate. The monthly balances should be averaged instead. Example 3-3 Accounts Receivable Turnover All of the company’s sales are on credit. Accounts receivable at the beginning of the prior year were $105,000. Current Year: $1,800,000 ÷ [($120,000 + $115,000) ÷ 2] = 15.3 times Prior Year: $1,400,000 ÷ [($115,000 + $105,000) ÷ 2] = 12.7 times The company turned over its accounts receivable balance 2.6 more times during the current year, even as receivables were growing in absolute terms. Thus, the company’s effectiveness at collecting accounts receivable has improved noticeably. A higher turnover implies that customers may be paying their accounts promptly. Because sales are the numerator, higher sales without an increase in receivables will result in a higher turnover. Because receivables are the denominator, encouraging customers to pay quickly (thereby lowering the balance in receivables) also results in a higher turnover ratio. A lower turnover implies that customers are taking longer to pay. If the discount period is extended, customers will be able to wait longer to pay while still getting the discount. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 4 SU 3: Activity Ratios and Earnings Quality Days’ sales outstanding in receivables (also called the average collection period) measures the average number of days it takes to collect a receivable. Example 3-4 Days’ Sales Outstanding in Receivables Current Year: 365 days ÷ 15.3 times = 23.9 days* Prior Year: 365 days ÷ 12.7 times = 28.7 days *Uses rounded number (15.3 times). The result, 23.9 days, will be used in later figures. Because the denominator (calculated in Example 3-3) increased and the numerator is a constant, days’ sales will necessarily decrease. In addition to improving its collection practices, the company also may have become better at assessing the creditworthiness of its customers. Days’ sales outstanding in receivables can be compared with the firm’s credit terms to determine whether the average customer is paying within the credit period. Besides 365, other possible numerators for the days’ sales outstanding in receivables are 360 (for simplicity) and 300 (the number of business days in a year). Inventory Inventory turnover measures the efficiency of inventory management. In general, the higher the turnover, the better inventory is being managed. If a business is highly seasonal, a simple average of beginning and ending balances is inadequate. The monthly balances should be averaged instead. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected].  SU 3: Activity Ratios and Earnings Quality 5 Example 3-5 Inventory Turnover The balance in inventories at the beginning of the prior year was $45,000. Current Year: $1,450,000 ÷ [($85,000 + $55,000) ÷ 2] = 20.7 times Prior Year: $1,170,000 ÷ [($55,000 + $45,000) ÷ 2] = 23.4 times The company did not turn over its inventories as many times during the current year. This is to be expected during a period of growing sales (and building inventory level) and so is not necessarily a sign of poor inventory management. A higher turnover implies strong sales or that the firm may be carrying low levels of inventory. A lower turnover implies that the firm may be carrying excess levels of inventory or inventory that is obsolete. Because cost of goods sold is the numerator, higher sales without an increase in inventory balances result in a higher turnover. Because inventory is the denominator, reducing inventory levels also results in a higher turnover ratio. The ideal level for inventory turnover is industry specific, with the nature of the inventory items impacting the ideal ratio. For example, spoilable items such as meat and dairy products will mandate a higher turnover ratio than would natural resources such as gold, silver, and coal. Thus, a grocery store should have a much higher inventory turnover ratio than a uranium mine or a jewelry store. Days’ sales in inventory measures the efficiency of the company’s inventory management practices. Example 3-6 Days’ Sales in Inventory Current Year: 365 days ÷ 20.7 times = 17.6 days Prior Year: 365 days ÷ 23.4 times = 15.6 days Because the numerator is a constant, the decreased inventory turnover calculated meant that days’ sales tied up in inventory would increase. This is a common phenomenon during a period of increasing sales. However, it can also occur during periods of declining sales. Copyright © 2024 Gleim Publications, Inc. All rights reserved. Duplication prohibited. Reward for information exposing violators. Contact [email protected]. 6 SU 3: Activity Ratios and Earnings Quality Accounts Payable Accounts payable turnover measures the efficiency with which a firm manages the payment of vendors’ invoices. If a business is highly seasonal, a simple average of beginning and ending balances is inadequate. The monthly balances should be averaged instead. Example 3-7 Accounts Payable Turnover The company had current- and prior-year purchases of $1,480,000 and $1,180,000, respectively. Net accounts payable at the beginning of the prior year was $65,000. Current Year: $1,480,000 ÷ [($150,000 + $75,000) ÷ 2] = 13.2 times Prior Year: $1,180,000 ÷ [($75,000 + $65,000) ÷ 2] = 16.9 times The company now carries a much higher balance in payables, so it is not surprising that the balance is turning over less often. It also may be that the company was paying invoices too soon in the prior year. A higher turnover implies that the firm is taking less time to pay off suppliers and may indicate that the firm is taking advantage of discounts. A lower turnover implies that the firm is taking more time to pay off suppliers and forgoing discounts. Days’ purchases in accounts payable measures the average number of days it takes to settle a payable. Example 3-8 Days’ Purchases in Accounts Payable Current Year: 365 days ÷ 13.2 times = 27.7 days* Prior Year: 365 days ÷ 16.9 times = 21.6 d