ESC Rennes School of Business Financial Analysis Solutions Booklet 2018-2019 PDF

ESC RENNES SCHOOL OF BUSINESS Solutions Booklet FI403-Financial Analysis 2018-2019 Table of Content Solutions Exercises Session 1.......................................................................................................... 2 Solutions Exercises Session 2................................

ESC RENNES SCHOOL OF BUSINESS Solutions Booklet FI403-Financial Analysis 2018-2019 Table of Content Solutions Exercises Session 1.......................................................................................................... 2 Solutions Exercises Session 2.......................................................................................................... 8 Solutions Exercises Session3. Short-Term Analysis....................................................................... 20 Solutions Exercises Session 4. Long-Term Analysis....................................................................... 25 Solutions Exercises Session 5. Profitability Analysis...................................................................... 35 Solutions Exercises Session 6. Investor’s Perspective................................................................... 45 Solutions Exercises Session 7. Cash Flow Analysis........................................................................ 52 Page 1/59 Solutions Exercises Session 1 Exercise 1: 1. Company issued shares of stock for $25,000 cash. 2. Company purchased $7,000 of equipment on account. 3. Company received $8,000 cash in exchange for services performed. 4. Company paid $850 for this month’s rent. Page 2/59 Exercise 2: Airlines International Balance Sheet December 31, 2008 ASSETS Current assets: Cash $ 28,837 Marketable securities 10,042 Accounts receivable $ 67,551 Less: Allowance for doubtful accounts 248 67,303 Inventory 16,643 Prepaid expenses 3,963 Total current expenses $ 126,788 Investment and special funds 11,901 Property, plant, and equipment: Property, plant and equipment $809,980 Less: Accumulated depreciation 220,541 589,439 Other assets 727 Total assets $ 728,855 LIABILITIES AND STOCKHOLDERS’ EQUITY: Current Liabilities: Accounts payable $ 77,916 Accrued expenses 23,952 Unearned transportation revenue 6,808 Current installments of long-term debt 36,875 Total current liabilities $ 145,551 Long-term debt, less current portion 393,808 Deferred income taxes 42,070 Stockholders’ equity: Common stock (par $0.50) $ 7,152 Capital in excess of par 72,913 Retained earnings 67,361 Total stockholders’ equity 147,426 Page 3/59 Total liabilities and stockholders’ equity $ 728,855 Page 4/59 Exercise 3 Alleg, Inc. Balance Sheet December 31, 2008ASSETS Current assets: Cash $ 13,000 Marketable securities 17,000 Accounts receivable 26,000 Inventories 30,000 Total current assets 86,000 Plant and equipment: Land and buildings 57,000 Machinery and equipment 125,000 Less: Accumulated depreciation 182,000 Total plant and equipment 61,000 121,000 Intangibles: Goodwill 8,000 Patents 10,000 18,000 Other assets 50,000 Total assets $275,000 LIABILITIES AND STOCKHOLDERS’ EQUITY Current liabilities: Accounts payable $ 15,000 Current maturities of long-term debt 11,000 Total current liabilities 26,000 Long-term liabilities: Mortgages payable 80,000 Bonds payable 70,000 Deferred income taxes 18,000 Total long-term liabilities 168,000 Stockholders’ equity: Common stock, no par value 21,000 shares authorized at $1 par value, 10,000 shares issued 10,000 Additional paid-in capital 38,000 Retained earnings 33,000 Total stockholders’ equity 81,000 Total liabilities and stockholders’ equity $275,000 Page 5/59 Exercise 4 : a. Decher Automotives Income Statement For the Year Ended December 31, 2008 Sales $1,000,000 Cost of sales Beginning inventory $ 650,000 Purchases 460,000 Merchandise available for sale $ 1,110,000 Less: Ending inventory (440,000) Cost of sales 670,000 Gross profit 330,000 Operating expense: Selling expenses $ 43,000 Administrative expenses 62,000 105,000 Operating income 225,000 Other income: Dividend income 10,000 235,000 Other expense: Interest expense (20,000) Income before taxes and extraordinary items 215,000 Income taxes (100,000) Income before extraordinary items 115,000 Extraordinary items: flood loss, net of tax (30,000) Net income $ 85,000 b. Earnings per share: Before extraordinary items $ 1.15 Extraordinary items (loss) (0.30) Net income $ 0.85 Page 6/59 c. Decher Automotives Income Statement For the Year Ended December 31, 2008 Revenue: Sales $1,000,000 Other income 10,000 Total revenue $1,010,000 Expenses: Cost of sales $ 670,000 Operating expense 105,000 Interest expense 20,000 (795,000) Income before taxes and extraordinary items $ 215,000 Income taxes (100,000) Income before extraordinary items $ 115,000 Extraordinary items: flood loss, net of tax (30,000) Net income $ 85,000 Exercise 5: a. A h. B p. A b. A i. C q. A c. A j. B r. A d. B k. B s. A e. B l. B t. B f. A m. A u. B g. A n. B v. A Page 7/59 Solutions Exercises Session 2 Exercise 1: a. Kelly Securities, Inc. and Subsidiaries Balance Sheets December 31, 2006 and December 31, 2005 Vertical Common-Size Analysis In Percentage 2006 2005 Assets Current assets Cash and equivalents 8.1 4.9 Trade accounts receivable, less allowances 57.0 61.2 Prepaid expenses and other current assets 3.1 3.6 Deferred taxes 2.0 2.6 Total current assets 70.2 72.3 Property and equipment Land and buildings 4.2 4.5 Equipment, furniture, and leasehold improvements 21.2 22.7 Accumulated depreciation (13.8) (14.5) Net property and equipment 11.6 12.6 Noncurrent deferred taxes 2.4 1.7 Goodwill, net 6.6 6.7 Other assets 9.2 6.7 Page 8/59  Total assets 100.0 100.0 (In Percentage) Liabilities and Stockholders’ Equity 2006 2005 Current liabilities: Short-term borrowings 4.7 4.3 Accounts payable 9.0 8.4 Accrued payroll and related taxes 18.7 20.0 Accrued insurance 1.6 2.6 Income and other taxes 4.6 4.3 Total current liabilities 38.7 39.7 Noncurrent liabilities Accrued insurance 3.9 4.2 Accrued retirement benefits 4.9 4.4 Other long-term liabilities.9.6 Total noncurrent liabilities 9.7 9.1 Stockholders’ equity Capital stocks $1.00 par value Class A common stock 2.5 2.8 Class B common stock.2.3 Treasury stock Class A common stock (5.3) (6.9) Class B common stock (.0) (.0) Paid-in capital 2.2 2.1 Earnings invested in the business 50.0 52.4 Accumulated other comprehensive income 2.1.6 Total stockholders’ equity 51.6 51.2 Total liabilities and stockholders’ equity 100.0 100.0 Page 9/59 Page 10/59 b. Kelly Services, Inc. and Subsidiaries Balance Sheets December 31, 2006 and December 31, 2005 Horizontal Common-Size Analysis In Percentage Assets 2006 2005 Current assets Cash and equivalents 185.8 100.0 Trade accounts receivable, less allowances 104.3 100.0 Prepaid expense and other current assets 95.2 100.0 Deferred taxes 87.4 100.0 Total current assets 108.7 100.0 Property and equipment Land and buildings 105.0 100.0 Equipment, furniture, and leasehold improvements 104.5 100.0 Accumulated depreciation 106.1 100.0 Net property and equipment 102.7 100.0 Noncurrent deferred taxes 160.4 100.0 Goodwill, net 109.4 100.0 Other assets 154.4 100.0 Total assets 111.9 100.0 Page 11/59  In Percentage Liabilities and Stockholders’ Equity 2006 2005 Current liabilities: Short-term borrowings 121.7 100.0 Accounts payable 120.3 100.0 Accrued payroll and related taxes 104.2 100.0 Accrued insurance 70.9 100.0 Income and other taxes 120.1 100.0 Total current liabilities 109.1 100.0 Noncurrent Liabilities Accrued insurance 105.1 100.0 Accrued retirement benefits 125.3 100.0 Other long-term liabilities 167.8 100.0 Total noncurrent liabilities 118.9 100.0 Stockholders’ equity Capital stock Class A common stock 100.0 100.0 Class B common stock 99.6 100.0 Treasury stock Class A common stock 86.6 100.0 Class B common stock 100.0 100.0 Paid-in capital 118.6 100.0 Earnings invested in the business 106.8 100.0 Accumulated other comprehensive income 386.4 100.0 Total stockholders’ equity 112.9 100.0 Total liabilities and stockholders’ equity 111.9 100.0 Page 12/59 c. Vertical Common-Size Analysis Assets Material increase in cash and equivalents Material decrease in trade accounts receivable, less allowances Material increase in noncurrent deferred taxes Material increase in other assets Liabilities Material decrease in accrued insurance Material increase in accrued retirement benefits Material increase in other long-term liabilities Stockholders’ Equity Material decrease in treasury stock, Class A common stock Material increase in accumulated other comprehensive income Horizontal Common-Size Analysis Assets Very material increase in cash and equivalents Material decrease in deferred taxes Very material increase in noncurrent deferred taxes Very material increase in other assets Liabilities Material increase in short-term borrowings, accounts payable, income and other taxes, and accrued retirement benefits Very material increase in other long-term liabilities Very material decrease in accrued insurance Page 13/59 Stockholders’ Equity Material increase in paid-in capital Very material increase in accumulated other comprehensive income Material decrease in treasury stock, Class A common stock Page 14/59 Exercise 2: a. Kelly Services, Inc. and Subsidiaries Statement of Earnings For the three fiscal years ended December 31, 2006 Vertical Common-Size Analysis* 2006 2005 2004 Revenue from services 100.0 100.0 100.0 Cost of services 83.5 83.8 84.0 Gross Profit 16.5 16.2 16.0 Selling, general, and administrative expenses 15.1 15.2 15.4 Earnings from operations 1.4 1.0.6 Other income (expense), net.0.0.0 Earnings from continuing operations before taxes 1.4 1.0.6 Income taxes.4.3.2 Earnings from continuing operations 1.0.7.4 Earnings from discontinued operations, net of tax.1.0.0 Net earnings 1.1.7.4 *Some rounding differences Page 15/59 b. Kelly Services, Inc. and Subsidiaries Statement of Earnings For the three fiscal years ended December 31, 2006 Horizontal Common-Size Analysis 2006 2005 2004 Revenues from services 113.6 106.5 100.0 Cost of services 113.0 106.3 100.0 Gross Profit 117.2 107.6 100.0 Selling, general, and administrative expense 111.6 105.2 100.0 Earnings from operations 254.0 164.8 100.0 Other income (expense), net N/A 21.7 100.0 Earnings from continuing operations before taxes 266.1 168.9 100.0 Income taxes 214.4 137.4 100.0 Earnings from continuing operations 294.7 186.3 100.0 Earnings from discontinued operations, net of tax 351.3 171.3 100.0 Net earnings 299.3 185.1 100.0 Page 16/59 c. Vertical Common-Size Analysis Earnings from operations increased materially. This carried over to earnings from continuing operations before taxes, earnings from continuing operations, net earnings, and income taxes Horizontal Common-Size Analysis Material increases in revenue from services, cost of services, gross profit, selling, general and administrative expenses, and income taxes Very material increase in earnings from operations, earnings from continuing operations before taxes, earnings from continuing operations, earnings from discontinued operations, net of tax, and net earnings Page 17/59 Exercise 3 Change Analysis Item Year 1 Year 2 Amount Percent 1 4,000 ----- (4,000) (100) 2 5,000 (3,000) (8,000) ----- 3 (9,000) 2,000 11,000 ----- 4 7,000 ----- (7,000) (100) 5 ----- 15,000 15,000 ----- Exercise 4 : a. December 31, Increase (Decrease) 2008 2007 Dollars Percent Net sales $30,000 $28,000 $2,000 107.1 Cost of goods sold 20,000 19,500 500 102.6 Gross profit 10,000 8,500 1,500 117.7 Selling, general, and administrative expense 3,000 2,900 100 103.5 Operating income 7,000 5,600 1,400 125.0 Interest expense 100 80 20 125.0 Income before taxes 6,900 5,520 1,380 125.0 Income tax expense 2,000 1,600 400 125.0 Net income 4,900 3,920 980 125.0 b. Net Sales increased substantially more than Cost of Goods Sold. Net Sales increased substantially more than Selling, General, and Administrative Expense. Interest Expense, Income Tax Expense, and Net Income increased materially faster than Net Sales. Page 18/59 Exercise 5: a. 5 Most ratios are computed comparing selected income statement and balance sheet numbers. b. 1 A figure from the year’s statement is compared with a base selected from the current year. This would be described as a vertical common-size statement. c. 3 Since we do not know the resources employed, Fremont Electronics could be more profitable than Columbus Electronics in relation to resources employed. d. 5 The fact that financial services may be private independent firms does not relate to industry ratios being considered as absolute norms for a given industry. Page 19/59 Solutions Exercises Session3. Short-Term Analysis Exercise 1: Current Assets Current Current Assets – Inventory Acid-Test = = Current Liabilities Ratio Current Liabilities Ratio Current Assets $1,000,000 – Inventory = 2.5 = 2.0 $400,000 $400,000 Current Assets = $1,000,000 $1,000,000 – Inventory = $800,000 $1,000,000 – $800,000 = Inventory $200,000 = Inventory Inventory Turnover = Cost of Sales Inventory C os t o f Sa le s = 3 Inventory C os t o f Sa le s = 3 $200,000 Cost of Sales = $600,000 Page 20/59 Exercise 2: a. Gross Receivables Days’ sales in receivables = Net Sales/365 $220,385 + $11,180 2007: = 71.62 days $1,180,178/365 $240,360 + $12,300 2006: = 41.92 days $2,200,000/365 b. Net Sales Accounts receivable turnover = Average Gross Receivables $1,180,178 4.87 times 2007: = ($240,360 + $12,300 + $220,385 + $11,180) / 2 per year $2,200,000 8.98 times 2006: = ($230,180 + $7,180 + $240,360 + $12,300) / 2 per year c. The Hawk Company receivables have been much less liquid in 2007 in comparison with 2006. The days' sales in receivables at the end of the year have increased from 41.92 days in 2006 to 71.62 days in 2007. The accounts receivable turnover declined in 2007 to 4.87 from a turnover of 8.98 in 2006. These figures represent a major deterioration in the liquidation of receivables. The reasons for this deterioration should be determined. Some possible reasons are a major customer not paying its bills, a general deterioration of all receivable accounts, or a change in the Hawk Company credit terms. Page 21/59 Exercise 3 a. (1) Working Capital: 2007: $500,000 - $340,000 = $160,000 2006: $400,000 - $300,000 = $100,000 (2) Current Ratio: 2007: $500,000 / $340,000 = 1.47 to 1 2006: $400,000 / $300,000 = 1.33 to 1 (3) Acid-Test Ratio: 2007: $500,000 - $250,000 = 0.74 to 1 $340,000 2006: $400,000 - $200,000 = 0.67 to 1 $300,000 (4) Accounts Receivable Turnover: 2007: $1,400,000 = 13.02 times per year ($110,000 + $105,000)/2 2006: $1,500,000 = 13.04 times per year ($120,000 + $110,000)/2 (5) Inventory Turnover: 2007: $1,120,000 = 4.98 times per year ($200,000 + $250,000)/2 2006: $1,020,000 = 4.25 times per year ($280,000 + $200,000)/2 (6) Inventory Turnover In Days: 2007: 365/4.98 = 73.29 days 2006: 365/4.25 = 85.88 days b. The short-term liquidity of the firm has improved between 2006 and 2007. The working capital increased by $60,000, while the current ratio increased from 1.33 to 1.47. The acid-test ratio increased from 0.67 to 0.74. Using a rule of thumb of two for the current ratio and one for the acid-test, this firm needs to improve its current liquidity position. The accounts receivable turnover stayed the same, while the inventory turnover Page 22/59  improved from 4.25 to 4.98. The days' sales in inventory improved from 85.88 to 73.29 days. Much of the improvement in the current position can be attributed to the improved control of the inventory. Exercise 4 : a. First-In, First-Out (FIFO): Ending Inventory August 1, Purchase 200 @ $7.00 $1,400 November 1, Purchase 200 @ $7.50 1,500 $2,900 Remaining cost is cost of goods sold ($10,900 - $2,900) $8,000 b. Last-In, First-Out (LIFO): Ending Inventory January 1, Inventory (400 x $5.00) = $2,000 Remaining cost is cost of goods sold ($10,900 - $2,000) $8,900 c. Average Cost (Weighted Average): Total Cost $10,900 Average Cost = = = $6.06 Total Units 1,800 Ending Inventory (400 x $6.06) = $2,424 Remaining cost is cost of goods sold ($10,900 - $2,424) $8,476 d. Specific Identification: March 1, Purchase cost $6.00 Ending Inventory (400 x $6.00) = $2,400 Remaining cost is cost of goods sold ($10,900 - $2,400) $8,500 Page 23/59 Exercise 5: a. Yum Brands, Inc. The current ratio declined slightly while the acid-test ratio improved materially. Panera Bread The current ratio declined slightly while the acid-test declined substantially. Starbucks The current ratio declined substantially and the acid test declined materially. b. Based on the current ratio and the acid-test ratio, there is a material difference in the liquidity of these firms. Panera Bread has the best liquidity position, followed by Starbucks, and then Yums Brands. Page 24/59 Solutions Exercises Session 4. Long-Term Analysis Exercise 1: Recurring Earnings, Excluding Interest Expense, Tax Times Interest Earned = Expense, Equity Earnings, and Minority Earnings Interest Expense, Including Capitalized Interest Earnings before interest and tax: Net sales $ 1,079,143 Cost of sales (792,755) Selling and administration (264,566) $ 21,822 $21,822 a. Times Interest Earned = = 5.06 times per year $4,311 b. Cash basis times interest earned: $21,822 + $40,000 $61,822 = = 14.34 times per year $4,311 $4,311 Page 25/59 Exercise 2: Recurring Earnings, Excluding Interest Expense, Tax a. Times Interest Earned = Expense, Equity Earnings, and Minority Earnings Interest Expense, Including Capitalized Interest Income before income taxes and extraordinary charges $ 36 Plus interest 16 (1) Adjusted income 52 (2) Interest expense $ 16 Times Interest Earned: (1) divided by (2) = 3.25 times per year Recurring Earnings, Excluding Interest Expense, Tax Expense, Equity Earnings, and Minority Earnings + b. Fixed Charge Coverage = Interest Portion of Rentals Interest Expense, Including Capitalized Interest + Interest Portion of Rentals Adjusted income from part (a) $ 52 1/3 of operating lease payments (1/3 x $150) 50 (1) Adjusted income, including rentals $ 102 Interest expense $ 16 1/3 of operating lease payments 50 (2) Adjusted interest expense $ 66 Fixed charge coverage: (1) ÷ (2) = 1.55 times per year Page 26/59 Exercise 3 Total Liabilities $174,979 a. Debt Ratio = = = 41.2% Total Assets $424,201 Total Liabilities $174,979 b. Debt/Equity Ratio = = = 70.2% Stockholders’ Equity $249,222 c. Ratio of Total Debt to Tangible Net Worth = Total Liabilities $174,979 $174,979 = = = 70.9% Tangible Net Worth $249,222 – $2,324 $246,898 d. Kaufman Company has financed over 41% of its assets by the use of funds from outside creditors. The Debt/Equity Ratio and the Debt to Tangible Net Worth Ratio are over 70%. Whether these ratios are reasonable depends upon the stability of earnings. Page 27/59  Exercise 4 : Times Debt to Interest Debt Debt/Equity Tangible Transaction Earned Ratio Ratio Net Worth a. Purchase of buildings financed by mortgage - + + + b. Purchase of inventory on short-term loan at 1% over prime rate - + + + c. Declaration and payment of cash dividend 0 + + + d. Declaration and payment of stock dividend 0 0 0 0 e. Firm increases profits by cutting cost of sales + - - - f. Appropriation of retained earnings 0 0 0 0 g. Sale of common stock 0 - - - h. Repayment of long-term bank loan + - - - i. Conversion of bonds to common stock + - - - j. Sale of inventory at greater than cost + - - - Page 28/59 Exercise 5: a. Times Interest Earned: Times interest earned relates earnings before interest expense, tax, minority earnings, and equity income to interest expense. The higher this ratio, the better the interest coverage. The times interest earned has improved materially in strengthening the long-term debt position. Considering that the debt ratio and the debt to tangible net worth have remained fairly constant, the probable reason for the improvement is an increase in profits. The times interest earned only indicates the interest coverage. It is limited in that it does not consider other possible fixed charges, and it does not indicate the proportion of the firm’s resources that have come from debt. Debt Ratio: The debt ratio relates the total liabilities to the total assets. The lower this ratio, the lower the proportion of assets that have been financed by creditors. For Arodex Company, this ratio has been steady for the past three years. This ratio indicates that about 40% of the total assets have been financed by creditors. For most firms, a 40% debt ratio would be considered to be reasonable. The debt ratio is limited in that it relates liabilities to the book value of total assets. Many assets would have a value greater than book value. This tends to overstate the debt ratio and, therefore, usually results in a conservative ratio. The debt ratio does not consider immediate profitability and, therefore, can be misleading as to the firm’s ability to handle long-term debt. Debt to Tangible Net Worth: The debt to tangible net worth relates total liabilities to shareholders' equity less intangible assets. The lower this ratio, the lower the proportion of tangible assets that has been financed by creditors. Arodex Company has had a stable ratio of approximately 81% for the past three years. This indicates that creditors have financed 81% as much as the shareholders after eliminating intangibles from the shareholders contribution – for most firms, this would be considered to be reasonable. The debt to tangible net worth ratio is more conservative than the debt ratio because of the elimination of intangible items. It is also conservative for the same reason that the debt ratio was conservative, in that book value is used for the assets and many assets have a value greater than book value. The debt to tangible Page 29/59  net worth ratio also does not consider immediate profitability and, therefore, can be misleading as to the firm's ability to handle long-term debt. Collective inferences one may draw from the ratios of Arodex Company: Overall it appears that Arodex Company has a reasonable and improving long-term debt position. The debt ratio and the debt to tangible net worth ratios indicate that the proportion of debt appears to be reasonable. The times interest earned appears to be reasonable and improving. The stability of earnings and comparison with industry ratios will be important in reaching a conclusion on the long-term debt position of Arodex Company. b. Ratios are based on past data. The future is what is important, and uncertainties of the future cannot be accurately determined by ratios based upon past data. Ratios provide only one aspect of a firm's long-term debt-paying ability. Other information, such as information about management and products, is also important. A comparison of this firm's ratios with ratios of other firms in the same industry would be helpful in order to decide if the ratios are reasonable. Page 30/59 Exercise 6: Recurring Earnings, Excluding Interest Expense, Tax a. 1. Times Interest Earned = Expense, Equity Earnings, and Minority Earnings Interest Expense, Including Capitalized Interest $162,000 = 8.1 times per year $20,000 Total Liabilities 2. Debt Ratio = Total Assets $193,000 = 32.2% $600,000 Total Liabilities 3. Debt/Equity Ratio = Stockholders’ Equity $193,000 = 47.4% $407,000 Total Liabilities 4. Debt to Tangible Net Worth Ratio = Tangible Net Worth $193,000 = 49.9% $407,000 – $20,000 b. New asset structure for all plans: Assets Current Assets $ 226,000 Property, plant and equipment 554,000 Intangibles 20,000 Total assets $ 800,000 Liabilities and Equity Plan A Current Liabilities $ 93,000 $200,000,000/100 = Long-term debt 100,000 2,000,000 shares Preferred stock 250,000 Page 31/59  Common equity 357,000 No change in net income $ 800,000 Plan B Current Liabilities $ 93,000 $200,000,000/10 = Long-term debt 100,000 20,000,000 shares Preferred stock 50,000 Common stock 120,000 Premium on common stock 300,000 Retained earnings 137,000 No change in net income $ 800,000 Plan C Current liabilities $ 93,000 Operating income $ 162,000 Long-term debt 300,000 Interest expense 52,000* Preferred stock 50,000 $ 110,000 Common equity 357,000 Taxes (40%) 44,000 $ 800,000 Net income $ 66,000 *$20,000 + 16%($200,000) = $52,000 Recurring Earnings, Excluding Interest Expense, Tax 1. Times Interest Earned = Expense, Equity Earnings, and Minority Earnings Interest Expense, Including Capitalized Interest Plan A Plan B Plan C $162,000 $162,000 $162,000 3.1 = 8.1 times = 8.1 times = $20,000 $20,000 $52,000 times Total Liabilities 2. Debt Ratio = Total Assets Plan A Plan B Plan C $193,000 $193,000 $393,000 = 24.1% = 24.1% = 49.1% $800,000 $800,000 $800,000 Total Liabilities 3. Debt/Equity Ratio = Stockholders’ Equity Plan A Plan B Plan C Page 32/59  $193,000 $193,000 $393,000 = 31.8% = 31.8% = 96.6% $607,000 $607,000 407,000 Total Liabilities 4. Debt to Tangible Net Worth = Tangible Net Worth Plan A Plan B Plan C $193,000 $193,000 $393,000 = 32.9% = 32.9% = 101.6% $607,000 – $20,000 $607,000 – $20,000 $407,000 – $20,000 c. Preferred Stock Alternative: Advantages: 1. Lesser drop in earnings per share than under the common stock alternative. 2. Not the absolute reduction in earnings that accompanied the debt alternative. 3. There would be an improvement in the Debt Ratio, Debt/Equity Ratio, and Total Debt to Tangible Net Worth Ratio. 4. Does not have the reduced times interest earned that accompanied alternative of issuing long-term debt. Disadvantage: 1. An increase in the fixed preferred dividend charge that the firm must pay before any dividends can be paid to common stockholders. Common Stock Alternative: Advantages: 1. No increase in fixed obligations. 2. There would be an improvement in the Debt Ratio, Debt/Equity Ratio, and the Total Debt to Tangible Net Worth Ratio. 3. Not the absolute reduction in earnings that accompanied the debt alternative. Page 33/59 4. Does not have the reduced times interest earned that accompanied alternative of issuing long-term debt. Disadvantage: 1. Maximum dilution in earnings per share of the three alternatives. Long-Term Bonds Alternative: Advantage: 1. Higher earnings per share than with common stock. Disadvantages: 1. Material decline in Times Interest Earned. 2. A material increase in the Debt Ratio, Debt/Equity Ratio, and Total Debt to Tangible Net Worth Ratio. 3. Absolute reduction in earnings. 4. Increase in the interest fixed charge that must be paid. d. The 10% preferred stock increased the preferred dividends which are not tax deductible; therefore, the cost of these funds is the 10% amount. The 16% bonds are tax deductible and, therefore, the after-tax cost is 9.6% [16% x (1-.40)]. Page 34/59 Solutions Exercises Session 5. Profitability Analysis Exercise 1: Net Income Before Minority Share of Earnings, Equity Income and Nonrecurring Net Profit Margin = Items Net Sales 2007 2006 $52,500 $40,000 $1,050,000 $1,000,000 = 5.00% = 4.00% Net Income Before Minority Share of Return on Assets = Earnings and Nonrecurring Items Average Total Assets 2007 2006 $52,500 $40,000 $230,000 $200,000 = 22.83% = 20.00% Net Sales Total Asset Turnover = Average Total Assets 2007 2006 $1,050,000 $1,000,000 $230,000 $200,000 =4.57 times =5.00 times per year per year Net Income Before Nonrecurring Items – Return on Common Equity = Preferred Dividends Average Common Equity 2007 2006 $52,500 $40,000 $170,000 $160,000 Page 35/59  = 30.88% = 25.00% Ahl Enterprise has had a substantial rise in profit to sales. This is somewhat tempered by a reduction in asset turnover. Given a slight rise in common equity, there is a substantial rise in return on common equity. Page 36/59 Exercise 2: a. 2007 2006 Sales 100.0% 100.0% Cost of goods sold 60.7 60.8 Gross profit 39.3 39.2 Selling expense 14.6 20.0 General expense 10.0 8.3 Operating income 14.7 10.9 Income tax 5.9 4.2 Net income 8.8% 6.7% b. Starr Canning has had a sharp decrease in selling expense coupled with only a modest rise in general expenses giving an overall rise in the net profit margin. Page 37/59 Exercise 3 $1,589,150 a. = 122.72% $1,294,966 2007 sales were 122.72% of those in 2006. $138,204 b. = 100.80% $137,110 2007 net earnings were 100.80% of those in 2006. Net Income Before Minority Share of Earnings, Equity c. 1. Net Profit Margin = Income and Nonrecurring Items Net Sales 2007 2006 $149,260 $149,760 = = 9.39% 11.56% $1,589,150 $1,294,966 Net Income Before Minority Share of 2. Return on Assets = Earnings and Nonrecurring Items Ending Total Assets 2007 2006 $149,260 $149,760 = = 10.38% 12.67% $1,437,636 $1,182,110 Net Sales 3. Total Asset Turnover = Average Total Assets 2007 2006 $1,589,150 $1,294,966 = 1.11 times = 1.10 times $1,437,636 $1,182,110 Net Profit Total Asset 4. DuPont Analysis: Return on Assets = x Margin Turnover Page 38/59 2007 10.42* = 9.39% x 1.11 2006 12.72* = 11.56% x 1.10 *Rounding causes the difference from the 10.38% and 12.67% computed in (2). Page 39/59 5. 2007 2006 Operating income Net sales $ 1,589,150 $ 1,294,966 Less: Cost of product sold $ 651,390 $ 466,250 Research and development expenses 135,314 113,100 General and selling 526,680 446,110 Operating income $ 275,766 $ 269,506 Operating Income Operating Income Margin = Net Sales 2007 2006 $275,766 $269,506 $1,589,150 $1,294,966 = 17.35% = 20.81% Operating Income 6. Return on Operating Assets = Ending Operating Assets 2007 2006 $275,766 $269,506 $1,411,686 $1,159,666 = 19.53% = 23.24% Net Sales 7. Operating Asset Turnover = Ending Operating Assets 2007 2006 $1,589,150 $1,294,966 $1,411,686 $1,159,666 = 1.13 times per = 1.12 times per year year Operating Operating 8. DuPont Analysis: Return on Assets = Income Margin x Asset Turnover 2007: 19.61%* = 17.35% x 1.13 2006: 23.31%* = 20.81 x 1.12 Page 40/59  *Rounding causes the difference from the 19.53% and 23.24% computed in (6). Net Income Before Minority Share of Earnings and Nonrecurring Items 9. Return on Investment = + [(Interest Expense) x (1 – Tax Rate)] Ending (Long-Term Liabilities) + Equity 2007 2006 Net earnings before minority share $ 149,260 $ 149,760 Interest expense 18,768 11,522 Earnings before tax 263,762 271,500 Provision for income tax 114,502 121,740 Tax rate 43.4% 44.8% 1 – tax rate 56.6% 55.2% Interest expense x (1 – tax rate) 10,623 6,360 Net earnings before minority share + interest expense x 1(1 – tax rate)] 159,883 156,120 Long-term debt and equity 1,019,420 933,232 Return on investment 15.7% 16.7% Net Income Before Nonrecurring Items – 10. Return on Common Equity = Preferred Dividends Ending Common Equity 2007 2006 $138,204 $137,110 $810,292 $720,530 = 17.06% = 19.03% d. Profits in relation to sales, assets, and equity have all declined. Turnover has remained stable. Overall, although absolute profits have increased in 2007, compared with 2006, the profitability ratios show a decline Page 41/59 Exercise 4 : Net Income Before Minority Share of a. 1. Return on Assets = Earnings and Nonrecurring Items End of Year Total Assets 2007 2006 2005 (A) $ 2,100,000 $ 1,950,000 $ 1,700,000 $ 2,600,000 $ 2,300,000 $ 2,200,000 7,000,000 6,200,000 5,800,000 100,000 100,000 100,000 10,000,000 9,000,000 8,300,000 (B) $ 19,700,000 $ 17,600,000 $ 16,400,000 (A) ÷ (B) 10.66% 11.08% 10.37% Net Income Before Minority Share of Earnings and Nonrecurring Items 2. Return on Investment = + [(Interest Expense) x (1 – Tax Rate)] End of Year (Long-Term Liabilities + Equity) Estimated tax rate: 2007 2006 2005 (1) Provision for income taxes $ 1,500,000 $ 1,450,000 $ 1,050,000 (2) Income before tax 3,600,000 3,400,000 2,750,000 Tax rate = (1) ÷ (2) 41.67% 42.65% 38.18% 1 – tax rate 58.33% 57.35% 61.82% (3) Interest expense x (1 – tax rate) $800,000 x 58.33% $ 466,640 $600,000 x 57.35% $ 344,100 $550,000 x 61.82% $ 340,010 (4) Net income $ 2,100,000 $ 1,950,000 $ 1,700,000 (3) + (4)(A) $ 2,566,640 $ 2,294,100 $ 2,040,010 Long-term debt $ 7,000,000 $ 6,200,000 $ 5,800,000 Preferred stock 100,000 100,000 100,000 Common equity 10,000,000 9,000,000 8,300,000 (B) $ 17,100,000 $ 15,300,000 $ 14,200,000 (A) ÷ (B) 15.01% 14.99% 14.37% Page 42/59  Net Income Before Nonrecurring Items – Dividends on 3. Return on Total Equity = Redeemable Preferred Stock Ending Total Equity 2007 2006 2005 $2,100,000 $1,950,000 $1,700,000 $100,000 + $10,000,000 $100,000 + $9,000,000 $100,000 + $8,300,000 = 20.79% = 21.43% = 20.24% Net Income Before Nonrecurring Items – 4. Return on Common Equity = Preferred Dividends Ending Common Equity 2007 2006 2005 $2,100,000 – $14,000 $1,950,000 – $14,000 $1,700,000 – $14,000 $10,000,000 $9,000,000 $8,300,000 = 20.86% = 21.51% = 20.31% b. Return on assets improved in 2006 and then declined in 2007. Return on investment improved each year. Return on total equity improved and then declined. Return on common equity improved and then declined. In general, profitability has improved in 2006 over 2005 but was down slightly in 2007. c. The use of long-term debt and preferred stock both benefited profitability. Return on common equity is slightly more than return on total equity, indicating a benefit from preferred stock. Page 43/59  Return on total equity is substantially higher than return on investment, indicating a benefit from long-term debt. Exercise 5: a. 4 Interest expense represents a recurring item. b. 5 Ideally, return on common equity will indicate the highest return. This is the way it should be since the common equity holders take the most risk. c. 3 A selling price increase would increase the gross profit. d. 2 It would not be feasible to estimate administrative expenses by using gross profit analysis. e. 2 Total asset turnover measures the ability of the firm to generate sales through the use of assets. Page 44/59 Solutions Exercises Session 6. An Investor’s Perspective Analysis Exercise 1: Earnings Before Interest and Tax Degree of Financial Leverage = Earnings Before Tax $975,000 + $70,000 $1,045,000 = = 1.07 $975,000 $975,000 Page 45/59 Exercise 2: Earnings Before Interest and Tax a. Degree of Financial Leverage = Earnings Before Tax $1,000,000 = $800,000 = 1.25 b. Prior earnings before interest and tax $ 1,000,000 10% increase 100,000 Adjusted income before interest and tax $ 1,100,000 Interest 200,000 Income before tax $ 900,000 Tax (50% rate) 450,000 Net income 450,000 Earnings will increase by 12.5% to $450,000 ($400,000 x 112.5% = $450,000) c. $800,000 200,000 600,000 300,000 $300,000 This is a decline in profit of 25%, with a decline in earnings before interest and tax of 20%. Page 46/59 Exercise 3 Net Income before nonrecurring items – All a. 1. Percentage of Earnings Retained = Dividends Net Income before nonrecurring items 2007 2006 2005 Net income (B) $ 9,100,000 $ 13,300,000 $ 16,500,000 Less: Cash dividends (A) (6,080,000) (5,900,000) (6,050,000) $ 3,020,000 $ 7,400,000 $ 10,450,000 (A) ÷ (B) 33.19% 55.64% 63.33% Market Price Per Share 2. Price/Earnings Ratio = Fully Diluted Earnings Per Share 2007 2006 2005 $41.25 $35.00 $29.00 $2.30 $3.40 $4.54 = = = 6.39 17.93 10.29 Dividends Per Common Share 3. Dividend Payout = Fully Diluted Earnings Per Share 2007 2006 2005 $1.90 $1.90 $1.90 $2.30 $3.40 $4.54 = 82.61% = 55.88% = 41.85% Dividends Per Common Share 4. Dividend Yield = Market Price Per Common Share 2007 2006 2005 $1.90 $1.90 $1.90 $41.25 $35.00 $29.00 = 4.61% = 5.43% = 6.55% Page 47/59  Market Price Value 5. Book Value Per Share = Ratio of Market Price to Book Value 2007 2006 2005 $41.25 $35.00 $29.00 120.5% 108.0% 105.0% = $34.23 = $32.41 = $27.62 b. The percentage of earnings retained materially declined. The related ratio, dividend payout, materially increased. The price earnings ratio materially increased, which is difficult to explain, considering the decline in earnings and the other ratios computed. The dividend yield has declined each year, while the book value per share increased each year. The increase in market price and the increase in price earnings ratio appears to be explained by the increase in order backlog at year-end and the increase in net contracts awarded. Page 48/59 Exercise 4 : Net Income before nonrecurring items – All a. 1. Percentage of Earnings Retained = Dividends Net Income before nonrecurring items 2007 2006 Cash dividends $0.80 x 25,380,000 $0.76 x 25,316,000 $20,304,000 $19,240,160 Preferred dividends 4,567,000 930,000 Total dividends 24,871,000 20,170,160 Net income (B) 32,094,000 31,049,000 Net income – dividends (A) 7,223,000 10,878,840 Percentage of earnings retained (A) ÷ (B) 22.51% 35.04% Market Price Per Share 2. Price/Earnings Ratio = Fully Diluted Earnings Per Share 2007 2006 $12.94 $15.19 $1.08 $1.14 = 11.98% = 13.32% Dividends Per Common Share 3. Dividend Payout = Fully Diluted Earnings Per Share 2007 2006 $0.80 $0.76 $1.08 $1.14 = 74.07% = 66.67% Dividends Per Common Share 4. Dividend Yield = Market Price Per Common Share 2007 2006 $0.80 $0.76 $12.94 $15.19 Page 49/59  = 6.18% = 5.00% Common Equity 5. Book Value Per Share = Common Shares Outstanding 2007 2006 Total assets $ 1,264,086,000 $ 1,173,924,000 Less: total liabilities (823,758,000) (742,499,000) Less: nonredeemable preferred stock (16,600,000) (16,600,000) Common equity (A) $ 423,728,000 $ 414,825,000 Shares outstanding (B) + 25,380,000 + 25,316,000 Book value per share (A) ÷ (B) $16.70 $16.39 b. Having the percentage of earnings retained decline provides mixed feelings. It implies that more is going to shareholders, but at the same time, earnings retained for growth have diminished. The rise in the dividend payout ratio supports this position. The price/earnings ratio has declined as a result of the drop in price. This decline indicates lower shareholder expectations but might also indicate a good time to buy. Dividend yield is up, caused by the rise in dividends and more so by the drop in price. Book value per share is up. However, book value is above market, which shows that the investors do not view the assets as worth their book value. This is not a good sign. Overall the signals are mixed. There is not enough information to determine if this is a good investment. Page 50/59 Exercise 5: a. 3 2007 2006 2005 EPS previously reported ----- $100 $.80 2007 declared a 4-for-1 stock split.25.20 2007 reported.30 EPS.30.25.20 b. 4 New EBIT $ 2,000,000 Prior EBIT 1,000,000 (a) $ 1,000,000 Financial leverage (b) 1.5 (a) x (b) $ 1,500,000 c. 4 Adjust the shares in 2007 by adding 10% additional shares. Divide the previous number of shares for 2007 by the new number of shares. This is the percentage of the previous reported earnings per share that should be reported as the adjusted earnings per share. For illustration, assume the following; (A) Previous shares 100,000 10% stock dividend 10,000 (B) New number of shares 110,000 (A) ÷ (B) 100,000/110,000 =.909 d. 3 The price/earnings ratio usually reflects investor’s opinions of the future prospects for the firm. e. 4 Degree of financial leverage gives a perspective on risk in the capital structure. Page 51/59 Solutions Exercises Session 7. Cash Flow Analysis Exercise 1: Page 52/59 Exercise 2: Page 53/59 Exercise 3 Page 54/59 Page 55/59 Exercise 4 : Page 56/59 Page 57/59 Page 58/59 Copyright Cengage Learning. Gibson C.H, “’Financial Reporting and Analysis”, Ed. 11. Page 59/59