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Chapter 3

Chapter 3

CASH FLOWS AND FINANCIAL ANALYSIS

FOCUSThe first half of the chapter is focused on cash flow in business. The emphasis is on understanding

where cash comes from, what it's used for, and how to get that information out of financial statements.The second half of the chapter deals with financial analysis. A series of ratios are presentedalong with discussions of the kinds of problems they're designed to illuminate. Practical issues like theinterpretation of a long collection period are considered in detail.

PEDAGOGYCash Flows !tudents often find cash flow confusing, so e"tra care is taken to de#elop the ideas

carefully starting with e"amples from personal life. After mastering the basic concepts, we mo#e into business applications.

$atio Analysis %t's difficult to get students without business e"perience to appreciate ratioanalysis. They calculate ratios readily enough, but ha#e a hard time imagining what a particularcomparison or trend implies about operations. For this reason we'#e spent e"tra time on the

interpretation and implications of ratios.The comprehensi#e problem at the end of the chapter &problem () is designed to dri#e theinterpretation ideas home. *e suggest that you lecture on the material and assign the problem to begone o#er in class after students ha#e wrestled with it themsel#es. The numbers are straightforward,

but you can get a lot of mileage out of ha#ing the students role play the analyst and propose possiblereasons for the numerical results.

The solution in this manual will gi#e you a lot to work with. The problem and solution aredrawn from the author's e"perience in doing +ust this kind of analysis in business.

TEACHING OBJECTIVES!tudents should gain a thorough understanding of cash flow principles and the mechanics of

constructing cash flows from the balance sheet and income statement.They should also de#elop an appreciation of financial analysis. !pecial emphasis should be

gi#en to the interpretation of ratios. !tudents tend to compute ratios, state whether they're higher orlower than a comparati#e figure and stop. They should be forced to think of operational reasons whythe ratios are as they are.

OUTLINE %. F% A C%A- % F $/AT% 0 *12$2 2! %T C /2 F$ /, *1 4!2! %T, A

*1AT A$2 *2 - 5% 6 F $7A. 4sers of Financial %nformation

4sers include in#estors, #endors, and management.*hat each looks for

8. !ources of Financial %nformation Annual $eport and its biases, other sources. C. The rientation of the Analyst The analyst is critical and in#estigati#e, looking for current and potential problems.

%%. T12 !TAT2/2 T F CA!1 F- *!A. 1ow the !tatement of Cash Flows *orks 0 Preliminary

2"amples%ntroductory e"amples using personal assets and liabilities to ease into cash flow concepts.

8. 8usiness Cash Flows

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Chapter 3

#er#iew and diagrams of cash flow ideas. $ules for analy:ing changes in balance sheetaccounts.

C. Constructing the !tatement of Cash FlowsThe mechanics of creating the statement from beginning and ending balance sheets and anincome statement.

. Free Cash Flows

The cash a#ailable for distribution to in#estors after rein#estment needs are satisfied.%%%. $AT% A A-;!%!

escription of the idea and process.A. Comparisons

$atios gi#e the best information when compared with history, competitors, or budgetedfigures.

8. Common !i:e !tatementsThe income statement stated as percents of re#enue facilitates comparisons o#er time and

between firms.C. $atios

The general concept of ratio analysis, a#erage or ending #alues for balance sheet numbers,and ratio categories.

. -i

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Cash Flows and Financial Analysis

ANSWE ! There are three primary groups of users of financial informationI"#e$t%r$ use the information to assess whether or not they want to put money into the company.

2

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Chapter 3

D. utline the thinking behind ratio analysis in brief, general terms &a few linesE don't go into eachratio indi#idually).

ANSWE $atios are formed by di#iding sets &usually pairs) of numbers drawn from financialstatements. The magnitude of each ratio ser#es as a measure of the firm's performance with respect tosome aspect of its business. Taken together, ratios can gi#e an o#erall picture of how effecti#ely a firm

is being managed.. Financial ratios don't do you much good by themsel#es. 2"plain.

ANSWE ! Performance on particular ratios differs a great deal between types of business. Therefore,a ratio #alue doesn't mean much without a comparison to some standard that indicates whether

performance is good or bad. The common comparisons are with the competition, history, and budget.

G. *hat is the reasoning behind using the current ratio as a measure of li

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amount of debt that's too much, howe#er, most financial analysts feel that debt in e"cess of HI ofcapital &long term debt J e

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Chapter 3

ANSWE ! Construct a set of common si:e income statements to co#er the past three years to seewhich costs and e"penses are growing faster than re#enue.

3. The term Bli

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b. %f you also knew that *aterfordKs re#enues had risen by 9HI last year, would you beconcerned about the firmKs financial health7 *hy7 &*ords only.)

SOLUTION!a. *aterfordKs current account detail is

8eginning 2nding ChangeAccts $ec L , D( L3, H &L ,G3()%n#entory 3 9, D & 9,93 )Payables D99 9,H ,3 9Accruals 9 D ( 93G

Total &L9,(D9)

b. *e should be #ery concerned about *aterfordKs financial health. The percentage increases inrecei#ables and in#entory far outstrip the gain in sales re#enue. This indicates that the firm may beha#ing trouble collecting its recei#ables and has likely in#ested in in#entory it canKt sell. The fact that

payables ha#e also risen dramatically indicates *aterford may be ha#ing trouble paying its bills ontime. The magnitude of these increases makes it look like failure may be +ust around the corner.

A B+$,"e$$ State)e"t %- Ca$h F %/$ 0 Operat,"( A t,#,t,e$ 0E2a)p e 3.17 pa(e 8969. Timberline %nc. has the following current accounts last year. &LHHH)

8eginning 2nding 8eginning 2ndingCash L D( L 93 Accts Pay L9H( L 9Accts $ec , ( 9,9HD Accruals L G( 3%n#entory G 3 DCurr Assets L9,(D L3,93 Curr -iab. L3HH L9 (

%n addition, the company had sales re#enues of LG, (3,HHH and costs and e"penses &including interest

and ta") of LD,( H,HHH. epreciation of L , 9,HHH is included in the cost and e"pense figures.Construct a statement showing TimberlineKs Cash From perating Acti#ities including a detail

of changes in balance sheet accounts.

SOLUTION! et %ncome is

$e#enue LG, (3-ess

CostMe"pense D,( H et %ncome L , D3

Current account detail is

8eginning 2nding ChangeAccts $ec L , ( L9,9HD &LD( )%n#entory G 3 D (DPayables 9H( 9 & 93)Accruals G( 3 & 9) Total &L 9G)

ThenCash Flows From perating Acti#ities

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Chapter 3

et %ncome L , D3epreciation , 9

Change in current accts & 9G)Cash flow from operating acti#ities L9,DH

A B+$,"e$$ State)e"t %- Ca$h F %/$ 0 E2a)p e 3.1 pa(e 4563. -atigoe %nc. has the following financial statements for 9HN . %n addition the company paidstockholders di#idends of L9.G million and recei#ed L . from the sale of new stock. o fi"ed assetswere retired during the year. (Hint: That implies fixed asset purchases and depreciation are the changesin the gross fixed asset and accumulated depreciation accounts.)

Lat,(%e I" .Balance Sheet

For the period ended 9M3 MN&LHHH)

ASSETS9M3 MND 9M3 MN

Cash L3,9 ( L9, DAccounts $ecei#able D,G 3 (, INCO'E STATE'ENT%n#entory 9, H 3, (3 Period ended 9M3 MNC4$$2 T A!!2T! L93,(G L9 ,G

!ales L D,GFi"ed Assets C 6! 3(,9

6ross /rgn L39, 3( 6ross L ,HG LD9, epreciation L ,9 Accum. epreciation & D,H H) &( ,3H ) 2"pense L ,HH et L G,H( L9H, ( 28%T L H,3 3

%nterest ,HGT TA- A!!2T! L 9, ( L 9,DD9 28T LG,9 D

Ta" 3,DHD et %ncome L(,( H LIABILITIES

Accounts Payable L , GG L9,9HAccruals G(H D(C4$$2 T -%A8%-%T%2! L9, G L9,G 9

-ong0Term ebt L G,HHD L ,3(92

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SOLUTION! First summari:e the changes in working capital as follows.

Lat,(%e I" .Cha"(e$ ," W%r:,"( Cap,ta A %+"t$

For the period ended 9M3 MN

&LHHH)9HND 9HN Change

Accounts $ecei#able L D,G 3 L (, L9,39G%n#entory L 9, H L 3, (3 &L ,9 ()Accounts Payable L , GG L 9,9H L (HGAccruals L G(H L D( &L G )

L ,3GD

The !tatement of Cash Flows follows.

Lat,(%e I" .State)e"t %- Ca$h F %/$


OPE ATING ACTIVITIES!

et %ncome L(,( H epreciation L ,9 Change in *C L ,3GD

Cash from perating Acti#ities L ,99(

INVESTING ACTIVITIES!

%ncrease inFi"ed Assets &L ,H )

Cash from %n#esting Acti#ities &L ,H )

FINANCING ACTIVITIES!

ecrease in ebt &LD, (() i#idends Paid &L9,GHH) ew !tock !old L , HH Cash from Financing Acti#ities &L(,D(()

NET CASH FLOW ;586

e %" , ,at,%" 8eginning Cash L3,9 ( et Cash Flow &L (G ) 2nding Cash L9, D

H

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Chapter 3

. Fitch %ncKs financial statements are as follows

FITCH INCBalance Sheet


ASSETS9M3 MNH 9M3 MN

Cash L9, ( L9, DAccounts $ecei#able , 39 (, INCOME STATEMENT%n#entory 3,9 D 9, 3 Period ended 9M3 MNC4$$2 T A!!2T! L H,9 L , H

!ales L H,(HFi"ed Assets C 6! , DD 6ross L3(, 3 L3G, ( 6ross /rgn L9 ,39G Accum. epreciation &99, H) &9 , (9) 2"pense L G, D et L 9,( 3 L , H 28%T L , 9

%nterest HT TA- A!!2T! L99,D(D L9(,DH 28T L , 9Ta" 9,9 (

et %ncome L ,3GD LIABILITIES

Accounts Payable L , 9 L , 9HAccruals 3 ,99C4$$2 T -%A8%-%T%2! L9,H H L9,

-ong0Term ebt L , 93 L HG2

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The !tatement of Cash Flows follows.FITCH INC.

State)e"t %- Ca$h F %/$For the period ended 9M3 MN

&LHHH)


et %ncome L ,3GD epreciation L9,9 9 Change in *C L H

Cash from peratingActi#ities L ,D G


%ncrease inFi"ed Assets &L ,9D3)

Cash from %n#esting Acti#ities &L ,9D3)


ecrease in ebt &L , ) i#idends Paid &L3, HH) ew !tock !old L9,(HH Cash from Financing

Acti#ities &L9,H )

NET CASH FLOW < =8*

e %" , ,at,%" 8eginning Cash L9, ( et Cash Flow L 9 2nding Cash L9, D

(. A"tel Company has the following financial statements

A>TEL CO'PANYBa a" e Sheet

For the period ended 9M3 MN&LHHH)ASSETS

9M3 MNH 9M3 MNCash L3,( L9, D( A>TEL CO'PANYAccounts $ecei#able ,D 9 (,( 3 Ba a" e Sheet%n#entory 9,(D3 3,99H For the period end 9M3 MNC4$$2 T A!!2T! L 9, 9G L , D

9

A>TEL CO'PANYINCO'E STATE'ENT

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Chapter 3

!ales L3 ,99DFi"ed Assets C 6! G,G9( 6ross L99, D L9 ,3 H 6ross /argin L ,3H9 Accum. epreciation & 9, D) & 3,3 3) 2"pense L H, et L H,33 L ,H D 28%T L(, 3

%nterest D 3

T TA- A!!2T! L93, H L99,D9( 28T L ,D9Ta" , H(

et %ncome L3,LIABILITIES

Accounts Payable L ,(( L ,DH9Accruals 9 HC4$$2 T -%A8%-%T%2! L , 9 L9, H

-ong0Term ebt L D, 9 L ,HH92TEL CO'PANYCha"(e$ ," W%r:,"( Cap,ta A %+"t$


9HNH 9HN Change Accounts $ecei#able L ,D 9 L(,( 3 L , (G%n#entory L9,(D3 L3,99H &L D)Accounts Payable L ,(( L ,DH9 L Accruals L 9 L H L H

L DG

The !tatement of Cash Flows then follows directly.

3

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A>TEL CO'PANYState)e"t %- Ca$h F %/$



et %ncome L3, epreciation L , Change in *C L DG

Cash from peratingActi#ities L(,H H


%ncrease inFi"ed Assets &L , 9)

Cash from %n#esting Acti#ities &L , 9)


ecrease in ebt &L , H) i#idends Paid &L ,D9D) !tock $etired &L ,HHH) Cash from Financing

Acti#ities &L3, 3D)

NET CASH FLOW < ?356

e %" , ,at,%" 8eginning Cash L3,( et Cash Flow &L 3G) 2nding Cash L9, D(

. Fred 5lein started his own business recently. 1e began by depositing L(,HHH of his own money&e

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Chapter 3

in each of the current accounts from the information gi#en. The ending e

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!TAT2/2 T F CA!1 F- *!Cash Flow From perating Acti#ities

et %ncome L 9HHepreciation H

Change in Current Accounts & ,HHH)&L3, HH)

Cash Flow From %n#esting Acti#ities LHCash Flow From Financing Acti#ities LH et Cash Flow &L3, HH)

$econciliation8eginning Cash L(,HHH

et Cash Flow &L3, HH)2nding Cash L ,9HH

d. FredKs business is profitable in an accounting sense because net income is positi#e. 8ut things donKtlook so good from a cash flow perspecti#e, because heKs running out of money to pay his bills. Themain problem is that he hasnKt collected his recei#ables. !econdarily, he may ha#e purchased too muchin#entory to start out.

e. The business can easily fail while making an accounting profit. %ndeed, thatKs

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Chapter 3

new short0term debt for the same purpose of L (H,HHH, which was outstanding at year end. -ansing alsomade a scheduled payment of L(HH,HHH on an old long0term loan with which it had ac1Cash 9,D ( ,HD

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Accts payable 3, ,3HD Ta" , (9Accruals D G Current -iabs 3, 9 D,99 2AT ,99D

-ong term debt 3 , GH , 92

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Chapter 3

Se@)%+r C%rpState)e"t %- Ca$h F %/$

F%r the per,%& e"&e& 1* 31 >1

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6enerous di#idends are usually paid to stockholders when a firm is doing well, which could bethe case if the new product is a success. 8ut sometimes managements pay high di#idends in bad timesto create an illusion of success and confidence in the future. !uch a mo#e often has an element ofdesperation which might be the case if the new #enture was a failure.

/ore analysis is necessary to determine whatKs going on starting with an e"amination of lastyearKs income statement.

A Free Ca$h F %/ B+$,"e$$ A"a @$,$ 0 E2a)p e 3 * pa(e 8;6

H. A group of in#estors is considering buying the *heelwright Corporation, but does not want tocontribute to the companyKs financial support after the purchase. *heelwrightKs management hasoffered the following financial statements co#ering last year &L/ omitted)

%ncome !tatement 8alance !heets 8eginning 2nding

A!!2T!!ales HH Cash GC 6!R 3 Accts $ecei#able 3 9H

epreciation %n#entory 9 D6ross /argin H Current Assets 3 32"penses 9( Fi"ed Assets28%T 3( 6ross HH (%nterest D Accum eprec & 9) & )28T 9 et Fi"ed Assets GDTa"

et %ncome 9H Total Assets G 33RCost of 6oods !old

-%A8%-%T%2! @ 2=4%T;Accts Payable D 9Accruals

Current -iabilities 93 9Gebt D (G2

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%ncome !tatement and Cash Flow 2stimate$e#enues L ,HHH L 9, HH L 3,3 HCosts @ 2"penses , HH G, H H,

epreciation HH DHH HH28T , HH ,D9H , 9Ta" & HI) H D (

et %ncome G H ,H39 , D&plus) epreciation HH DHH HH&minus) changes in *MC HH HH (HH&minus) FMA Purchases 9,HHH 9,HHH 9,HHHCash Flows &L H) &L ) &L( 3)

b. ;es. These are free cash flows because they include the new in#estment necessary to replaceworn out e

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Chapter 3

28%T , G( 9 .G G,9GH 3H.%nterest 2"pense 93H 3. ,(HH D.H28T ,9 ( 9 . ,DGH 93.Ta" (HH .3 (, 9H .

et %ncome D ( 9. G, DH .3

b. The first thing to notice about the I columns is that -inden is significantly less profitablethat the industry norm. The difference is .(I of re#enues, which is significant. 1owe#er theoperating shortfall is far worse. Focusing on 28%T we can see that -inden is a #ery significant(.9I of re#enue less profitable than the industry standard. ThatKs enough to make thecompanyKs long0term sur#i#al

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SOLUTION!

C+rre"t at,%

Curr Assets M Curr -iabilities O L , D M L9, H O (.(

Q+, : at,% SCurr Assets − %n# M Curr -iabs O &L , D− L3,99H) M L9, H O .H

A#era(e C% e t,%" Per,%& ACP6

SAccts $ec M !ales × 3 H O S&L(,( 3 M L3 ,99D)× 3 H O ((.( days

I"#e"t%r@ T+r"%#er

C 6! M %n#entory O L G,G9( M L3,99H O .9× $ !ales M %n#entory O L3 ,99D M L3,99H O .3×

F,2e& A$$et T+r"%#er

!ales M Fi"ed Assets O L3 ,99D M L ,H D O 3.3×

T%ta A$$et T+r"%#er

!ales M Total Assets O L3 ,99D M L99,D9( O .×

De t at,%

S-ong Term ebt J Curr -iab M Total Assets O &L ,HH9 J L9, H) M L99,D9( O 3(.DI

De t t% E +,t@ at,%

-ong Term ebt 2

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Chapter 3

O . ×

et+r" %" Sa e$

et %ncome M !ales O L3, M L3 ,99D O . I

et+r" %" A$$et$

et %ncome M Total Assets O L3, M L99,D9( O 3.DI

et+r" %" E +,t@

et %ncome M 2

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a. Compute in#entory turno#er for orton using the following methods to calculate the in#entoryfigure . 2nd of year

9. A#erage of the beginning and end of year 3. A#erage of the ends of

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Chapter 3

L(,HHH,HHH− L ,3D(,HHH O L 9(,HHH.

. 2psom Co. manufactures furniture and sells about L H million a year at a gross margin of (I.a. *hat is the ma"imum in#entory le#el the firm can carry to maintain an in#entory turno#er

&based on C 6!) of .H7 b. %f the in#entory contains L .9 million of obsolete and damaged goods which doesn't turn

o#er at all, how fast would the acti#e in#entory ha#e to turn o#er to achie#e an o#erall turno#er rate of.H7

SOLUTION!a. First calculate C 6! from the gross margin percentage.

$e#enue L H.H/ HHI C 6! L99.H/ ((I 6ross /argin L .H/ (I

Then write the definition of %n#entory Turno#er, substitute, and sol#e for %n#entory.

%n#entory O L9.D(/

b. The acti#e in#entory would beL9.D(/ − L .9H/ O L .((/.

Then

otice how dramatically the presence of dead in#entory changes the actual turno#er performancere

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SOLUTION! -et the amount of borrowed money and purchased in#entory be N. Then after the purchase, both current assets and current liabilities will be increased by N, and the current ratiorestriction can be stated as follows

From which N O L D(,HHH

. !weet Tooth Cookies, %nc. has the following ratios

$ 2 O (I TMA turno#er O .9 $ ! O HI

*hat percentage of its assets are financed by e

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Chapter 3

O L ,9HH

4se that and the %n#entory Turno#er $atio to calculate %n#entory.

%n#entory Turno#er O C 6! M %n#entory 3.H O L ,9HH M %n#entory

%n#entory O L HH e"t use the ACP to calculate Accounts $ecei#able.

AM$ O L9(H

Then add and subtract to fill in the blanks as follows.

Cash L D( Accts Payable L GH Accts $ec L 9(H Accruals L H %n#entory L HH

Current Assets L , 9( Current -iabs LD(H

9H. ;ou are gi#en the following selected financial information for The 8lat: Corporation.

%ncome !tatement 8alance !heet

C 6! LD(H Cash L9(H et %ncome L H et Fi"edAssets L (H

$atios $ ! HI Current $atio 9.3 %n#entory Turno#er .H× ACP ( days ebt $atio G. 9I

Calculate accounts recei#able, in#entory, current assets, current liabilities, long0term debt, e

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ACP O SAccts $ec M !ales × 3 H ( O SAccts $ec M L , HH× 3 H Accts $ec O L9HH

Current Assets O Cash J Accts $ec J %n#entory

O L9(H J L9HH J L 9( O L(D(

Total Assets O Current Assets J et Fi"ed Assets O L(D( J L (H O L , 9(

Current Assets M Current -iabilities O Current $atio L(D( M Current -iabilities O 9.3 Current -iabilities O L9(H

ebt $atio O SCurr -iabs J -ong Term ebt M Total Assets

. G 9 O SL9(H J -T ebt M L , 9( -T ebt O L (H

2

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Chapter 3

Cash WWWWWWW AMP WWWWWWWAM$ WWWWWWW Accruals WWWWWWW%n#entory WWWWWWW CM- WWWWWWWCMA WWWWWWW ebt

et FMA WWWWWWW 2

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%n#entory 8alance L3HH,HHHp. 2"penses &e"cluding C6!) L , 9H,HHH

!hares utstanding 9GH,HHHA#erage %ssue Price of !hares L(.HH6ross /argin I HI%nterest $ate I

T%2 $atio%n#entory Turno#er 9Current $atio .(=uick $atio .D(Fi"ed Asset Turno#er .(

Complete the following abbre#iated financial statements and calculate per share ratiosindicated. & Hint: !tart by subtracting the formula for the

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Chapter 3

!tep 3 Q %n#entory Turno#er O Cost of 6oods !oldM%n#entory, so 9 O "M3HH,HHH. Therefore,Cost of 6oods !old is L3, HH,HHH.

!tep Q %f the 6ross /argin I is HI, the Cost of 6oods !old must be HI of $e#enues.Therefore, $e#enues " HI O L3, HH,HHH. $e#enues O L ,HHH,HHH.

!tep ( Q 6ross /argin O L ,HHH,HHH 0 L3, HH,HHH O L9, HH,HHH

!tep Q 6ross /argin minus perating 2"penses O 28%T. L9, HH,HHH 0 L , 9H,HHH OL ,9 H,HHH O 28%T.

!tep D Q T%2 O 28%TM%nterest 2"pense. O L ,9 H,HHHM%nterest 2"pense. %nterest 2"pense OL H,HHH

!tep Q -ong Term ebt " %nterest $ate O %nterest 2"pense. Therefore, -ong Term ebt " IO L H,HHH. L H,HHHM.H O L9,HHH,HHH O -ong Term ebt

!tep G Q Fi"ed Asset Turno#er O $e#enuesMFi"ed Assets. Therefore, .( O L ,HHH,HHHMFi"edAssets. Fi"ed Assets O L ,HHH,HHHM .( O L ,HHH,HHH.

!tep H Q Total Assets O Current Assets J Fi"ed Assets O L HH,HHH J L ,HHH,HHH O L , HH,HHH.

!tep Q Paid0%n Capital &Common !tock plus Paid0%n 2"cess) O umber of !hares " A#erage%ssue Price Per !hare. Paid0%n Capital O 9GH,HHH shares " L(Mshare O L , (H,HHH.

!tep 9 Q !ince Assets O -iabilities J 2alueM!hare O &Paid0%n Capital J $etained 2arnings)MU of !hares O &L , (H,HHHJ LD(H,HHH)M9GH,HHH O LD.(GMshare.

!tep Q /arketM8ook $atio O L .3DMLD.(G O 9. 9

e-er t% the INSIGHTS B%2 %" pa(e$ 193 19= e-%re atte)pt,"(pr% e)$ *3 a"& *=.

93. otice that the calculations called for here do not in#ol#e cost of capital. *illiam 2dwards, %nc.&*2%) had one million shares of common stock outstanding on 9M3 M9HNH. The stock had

been sold for an a#erage of L .HH per share and had a market price of L 3.9( per share on thatdate. *2% also had a balance of L(.H million in its retained earnings account on that date. Thefollowing pro+ection has been made for *2%Ks ne"t fi#e years of operations

;ear et %ncome i#idendsM!hare !hares A#erage !tock %ssued %ssue Price

Price 9M39H" LDHH,HHH L.9H one A L 3.D(9H"9 L H,HHH L.99 (H,HHH L .HH L .9(9H"3 LD(H,HHH L.9 HH,HHH L 3.(H L 3. H9H" LGHH,HHH L.9 (H,HHH L .(H L (.HH9H"( L H,HHH L.9 one A L (. H

3

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Compute the />A as of 9M3 MNH, and compute 2>A, the change in />A, as a result of eachsubseAM2>A analysis7

SOLUTION!

The market #alue each year is the number of shares outstanding at the end of the year times themarket #alue.

;ear !hares utstanding /arket Price /arket >alue9HNH ,HHH,HHH L 3.(H L 3,(HH,HHH9HN ,HHH,HHH L 3.D( L 3,D(H,HHH9HN9 ,H(H,HHH L .HH L ,DHH,HHH9HN3 , (H,HHH L 3. H L (, DH,HHH9HN ,9HH,HHH L (.HH L ,HHH,HHH9HN( ,9HH,HHH L (. H L , H,HHH

the book #alue is the sum of common stock, paid0in e"cess and retained earnings. Commonstock and paid0in e"cess together are the total issue price of the stock times the number ofshares issued. 2ach year, common stock plus paid0in e"cess grows by the issue price of newstock issued times the number of shares. $etained earnings is calculated each year by taking the

pre#ious yearKs retained earnings, adding net income and subtracting di#idends.

;ear Common !tock @ Paid0in 2"cess9HNH ,HHH,HHH shares times L Mshare O L ,HHH,HHH9HN 9HNH J new shares &none) O L ,HHH,HHH9HN9 9HN J (H,HHH shares L .HH O L ,DHH,HHH9HN3 9HN9 J HH,HHH shares L 3.(H O L H,H(H,HHH9HN 9HN3 J (H,HHH shares L .(H O L H,DD(,HHH9HN( 9HN J new shares &none) O L H,DD(,HHH

;ear $etained 2arnings9HNH L(,HHH,HHH9HN 9HNH J LDHH,HHH 0 LH.9H " ,HHH,HHH shares O L(,(HH,HHH9HN9 9HN J L H,HHH 0 LH.99 " ,H(H,HHH shares O L , HG,HHH9HN3 9HN9 J LD(H,HHH 0 LH.9 " , (H,HHH shares O L ,( 3,HHH9HN 9HN3 J LGHH,HHH 0 LH.9 " ,9HH,HHH shares O LD, D ,HHH9HN( 9HN J L H,HHH 0 LH.9 " ,9HH,HHH shares O LD, G(,HHH

;ear />A &/arket >alue Q 8ook >alue) Change in />A9HNH L(HH,HHH9HN L9(H,HHH &L9(H,HHH)9HN9 &L HG,HHH) &L3(G,HHH)9HN3 &LD 3,HHH) &L ( ,HHH)9HN L( ,HHH L D,HHH9H"( L H,HHH &L ,HHH)

/>A is pro+ected to ha#e ups and downs during the fi#e0year period with a net negati#e result.!tockholders should demand a more aggressi#e pro+ection if members of top management want

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Chapter 3

to keep their +obs. 8efore />A, the focus would ha#e stopped at net income and di#idends,which might ha#e seemed more than satisfactory.

9 . Prahm @ Associates had 28%T of L(/ last year. The firm carried an a#erage debt of L (/during the year on which it paid I interest. The company paid no di#idends and sold no new

stock. At the beginning of the year it had e

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b. The %P also establishes a price of L 9.(H for the shares in the current ownersK hands. 1ence theirshare of the company after the %P & HI) will be worth about

L 9.(H X HH,HHH O L3D,(HH,HHH

9 . C%)prehe"$,#e Pr% e). The Protek Company is a large manufacturer and distributor ofelectronic components. 8ecause of some successful new products marketed to manufacturers of

personal computers, the firm has recently undergone a period of e"plosi#e growth, more than doublingits re#enues o#er the last two years. 1owe#er, the growth has been accompanied by a marked decline in profitability and a precipitous drop in the company's stock price.

;ou are a financial consultant who has been retained to analy:e the company's performance andfind out what's going wrong. ;our in#estigati#e plan in#ol#es conducting a series of in0depth inter#iewswith management and doing some independent research on the industry. 1owe#er, before starting, youwant to focus your thinking to make sure you can ask the right

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Total Assets L ,9(H L9,H(( L9,(3(

-%A8%-%T%2! Accounts Payable L( L L 3 Accruals ( 9H 3H Current -iabilities LD L H L

Capital -ong0Term ebt L 3H L ,9 H L , HH 2

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e. ne hundred million shares of stock ha#e been outstanding for the entire period. The price of Protekstock in 9HN , 9HN9, and 9HN3 was L3G.9D, L9 . H, and L .(( respecti#ely. Calculate the firm's2arnings Per !hare &2P!), and its Price 2arnings $atio &PM2). *hat's happening to the PM27 To whatthings are in#estors likely to be reacting7 1ow would a slow down in personal computer sales affectyour reasoning7f. *ould you recommend Protek stock as an in#estment7 *hy might it be a #ery bad in#estment in the

near future7 *hy might it be a #ery good one7

SOLUTION!a.

*9>1 *9>* *9>3L I L I L I

!ales L ,(D HH.H L9, H HH.H L3,9 ( HH.HC 6! 3 H.H GH 3.H ,(H9 .H6ross /argin L G D H.H L ,9HH (D.H L ,D 3 ( .H

2"penses /arketing L3 9H.H L G( 93.( L 9 9D.H $ @ ( H.H 9 H.H 39D H.H Admin. 9 .H DG .( 9G G.HTotal 2"penses L HH 3 .H L ( 9.H L ,(H3 .H

28%T L3 D 99.H L3 ( (.H L9 H .H%nterest 3 .H G( .( 3 .

28T L9 .H L99H H. L D 3.Ta" GD . D( 3. H .92AT L D .G L ( .G L DD 9.

The common si:e statements gi#e us a hint that spending may ha#e gotten out of control duringthe period of heady growth. This isn't at all uncommon. People become focused on growth, and spendmoney too aggressi#ely. The problem is that current spending tends to raise the e"pense le el" whichcarries into the future. 2.g. people hired this year are on the payroll ne"t year unless they're let go.

Protek seems to ha#e fallen into the spending trap. otice that marketing e"pense is growingfaster than re#enue. *e can see this because /arketing is an increasing percent of re#enue o#er thethree0year period. The same is true of Administration, but to a lesser e"tent. This kind of a pattern isdangerous because the firm is establishing a spending base that will be difficult to reduce if sales le#eloff or decrease.

$@ appears to be flat as a percent of re#enue, but that too may be e"cessi#e, since we wouldgenerally e"pect that function to decrease somewhat as a percent as sales rise due to the non currentnature of the work. The /arketing increase is particularly troubling, because it's possible that the re#enue increaseis partially dri#en by an intense marketing andMor sales effort. %n other words, it's usually possible to

pump up sales by spending more on ad#ertising or sales personnel. 1owe#er, if the practice is carriedtoo far, the incremental re#enue costs more than it's worth and profit declines.

Cost is also increasing as a percent of re#enue. This can be due to se#eral things. The first possibility is e"cessi#e spending leading to the kind of inefficiency we +ust discussed in the e"pense

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areas. %n addition, howe#er, the factory could be suffering from an e"ternally dri#en increase in the costof raw materials.

Further, a cost ratio increase can come from a decrease in the price recei#ed for the product.That's a sales rather than a manufacturing issue, but it shows up on the cost ratio line. Price decreasescan happen in two ways. %n the first, competition dri#es list prices down with the knowledge ofmanagement. That happens in hi0tech business a lot as technology ad#ances. A more insidious

phenomenon comes about through discounting. %n some companies, the sales force has a great deal oflatitude in gi#ing customers price breaks.*hen generous discounts are offered consistently the effecti#e price recei#ed for product

declines and sales #olume increases. 1owe#er, profitability suffers.!till another phenomenon in#ol#es the mi" of product sold. %n most companies, high end

products carry the best profit margins. %f Protek's sales growth has been in low0end, low margin product, profitability can be e"pected to decline. That means the firm can't afford to spend as much tosupport the new sales as it did to support the older high0end sales. Companies often don't recogni:e thisand get caught in spending binds.

Another obser#ation is rele#ant. otice how large the increase in spending in the marketingarea is in absolute dollars. %n a three0year period the budget has gone from L3 / to L 9/, a growthof 9DGI. As a rule it's #ery difficult to manage that much growth efficiently. /ost managements +ustcan't hire, train, and e

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%ncrease inFi"ed Assets &L H ) &L3 ()

Cash from %n#esting

Acti#ities &L H ) &L3 ()FINANCING ACTIVITIES!

%ncrease in ebt L 3H L3 H Cash from Financing

Acti#ities L 3H L3 H

NET CASH FLOW < 19 < **

e %" , ,at,%"

8eginning Cash L 3H L H et Cash Flow L H L 99 2nding Cash L H L 9

Protek's !tatement of Cash Flows tells us se#eral #ery significant things. First, the cashgenerated by operations is declining fast. %f things continue in the direction they ha#e been going, thatsource will dry up altogether. The firm's money is going into Fi"ed Assets and *orking Capital. 8othof these should grow with the company, but they often grow faster causing cash shortages. *e'll get aninsight into whether or not Protek's asset growth is under control when we look at its ratios.

Protek's money is coming from borrowing. That is, increases in debt. This is probablyincreasing the firm's risk, especially as profitability is declining.

Free cash flows are clearly negati#e because of the firm's rapid growth. They aren't likely to be positi#e unless growth slows down substantially.

c. Protek's ratios are as follows.

P OTE CO'PANYat,% A"a @$,$

%ndustryA#erage 9HN 9HN9 9HN3

Current $atio .( .9 (. (.=uick $atio 3.9 9.G 3.G .HACP 9 days H days H days ( days%n#entory Turno#er D.(N D.HN .HN (.HNFi"ed Asset Turno#er . N .DN . N 9. NTotal Asset Turno#er .9N .3N .HN .3N

ebt $atio (3I ( I I DHIebt 2

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*e'll begin with the working capital situation. otice that the ACP is increasing dramatically.This is bad news. %t probably means the firm is selling to a lower class of customer on credit. Thatcould be another factor behind the re#enue growth. 2asier credit pumps sales, but may be bad for

profitability. There's a good chance the recei#ables balance contains some old and likely uncollectibleaccounts.

%n#entory turno#er is declining. That's another bad sign. %n times of rapid growth factoriestend to use material inefficiently in a effort to get product shipped. bsolete and unbalanced in#entorytends to pile up and rapidly becomes #alueless. This may be happening to Protek. The li

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The e"tended u Pont 2 D.9 3. .(

Protek's stock price is dropping. otice that 2P! fundamentally what an in#estor is buyingwith a share of stock is falling, but the stock's price is falling faster. That's because the PM2 ratio isalso falling and the price is the product of 2P! and PM2 !tock Price O 2P! × PM2.

The firm's performance establishes 2P!, but the market pins a PM2 on a stock. The PM2 isessentially a statement of what the market will pay for a dollar of earnings. 1igher B

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T TA- A!!2T! L D,H3H L G, DH 28T L3, 9Ta" ,(3D

et %ncome L9,3H(-%A8%-%T%2!Accounts Payable L , H L9,9 HAccruals (H 99H

C4$$2 T -%A8%-%T%2! L9,D H L9, 3H-ong0term ebt L ,39H L 9,33(2

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A( *;)!+< $ 17,030 $ 1 , 70

Northern ManufacturingS#MMA$% OF C&AN'ES TO C#$$ENTACCO#NTS

For the period ended 12 !1 "!

Account Sou"ce /4)se

Receivables $ 41,050 !nvento"# $ 41,2 0 a#ables $ 350

Acc"uals $ 4630$ 42,620

Northern ManufacturingSTATEMENT OF CAS& FLO(SFor the period ended 12 !1 "!

CAS= R&' & *RA+!(G AC+!>!+!*S

(et !nco e $ 2,305e."eciation $ 700

(et chan8es in cu""ent accts $ 42,620 $ 3 5

CAS= R&' !(>*S+!(G AC+!>!+!*S

u"chase of fi-e assets $ 41,500

CAS= R&' !(A(C!(G AC+!>!+!*S

!nc"ease / 4 ec"ease

in on8 +e" ebt $ 1,015Sale of Stoc9 $ 1,000ivi en ai $ 41,200

Cash f"o financin8 Activities $ 15

(*+ CAS= &? $ 4300

R*C&(C! !A+!&(

D

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Chapter 3

e8innin8 Cashalance

$ 500

(et Cash lo@ $ 4300*n in8 Cash alance $ 200

D(

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9 . Comparati#e historical financial statements for orthern /anufacturing of the preceding problem are as follows.

$T12$ /A 4FACT4$% 6% C /2 !TAT2/2 T!

For the years ended&LHHH)

1* 31 >1 1* 31 >* 1* 31 >3

!ales L D, (H L9H,( H L99,( HC 6! G, HH H, ( ,(H6ross /argin L ,D(H LG, ( L ,H(2"pense L(, H L(,DH9 L(,339

epreciation HH (H DHH28%T L9,GDH L3, G3 L(,H99%nterest HH G H , H28T L9, DH L9,( 3 L3, 9Ta" ,H33 ,(3D

et %ncome L ,3H9 L ,((H L9,3H(

i#idends Paid L (H LD(H L ,9HH!tock !old H H L ,HHH-ease Payments L(HH LDHH L HH

N%rther" 'a"+-a t+r,"(Ba a" e Sheet

F%r the @ear e"&e&9 1* 31 >1 1* 31 >* 1* 31 >3

A!!2T!Cash LG(( LG H L(HH L9HHAccounts $ecei#able 3, H3 3,(DH ,9(H D,3HH%n#entory 9, GH 3,H33 (, H , DHC4$$2 T A!!2T! L ,G LD,( 3 L ,G3H L 3,GDH

Fi"ed Assets L(, HH L , (H LD,(HH LG,HHH 6ross Accum. eprec. & , (H) & ,D(H) &9, HH) &3, HH) et L , (H L ,GHH L(, HH L(,GHH

T TA- A!!2T! L ,(G L 9, 3 L D,H3H L G, DH

-%A8%-%T%2!Accounts Payable L , H L , (H L , H L9,9 H

Accruals 3 ( D 9 (H 99HC4$$2 T -%A8%-%T%2! L9,9 ( L9,3G9 L9,D H L9, 3H-ong0term ebt LD, H( LD, G L ,39H L 9,33(2

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a. 4se the ANALYS program to prepare common si:e statements and a set of financial ratios for each of the last three years. otice that ANALYS calculates ratios using a#erage balance sheet figures whereappropriate.

b. Analy:e the results of ANALYS for orthern /anufacturing. The firm has been

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i-e Assets G"oss $ 7,500 $ ,000 Accu e."ec $

42,%00 $

43,100(*+ !X* ASS*+S $ 5,100 $ 5, 00

+&+A ASS*+S $ 17,030 $ 1 , 70

!A ! !+!*S Accounts a#able $ 1, 60 $ 2,210 Acc"uals $ 50 $ 220C)RR*(+

!A ! !+!*S $ 2,710 $ 2,%30

on8 +e" ebt $ 11,320 $ 12,335*:uit# $ 3,000 $ 5,105+&+A CA !+A $ 1%,320 $ 17,%%0

TOTAL L , E $ 17,030 $ 1 , 70

$ATIOS ANAL%SIS2+"!

LI-#I.IT% $ATIOSCu""ent Ratio 5 7;uic9 Ratio 3 1

ASSET MANA'EMENT $ATIOS AC 116 % a#s!nvento"# +u"nove" 1

i-e Asset +u"nove" 3+otal Asset +u"nove" 1 1

.EBT MANA'EMENT $ATIOSebt Ratio 7% 3ebt to *:uit# Ratio 2 % to 1

+!* % 3Cash Cove"a8e %

i-e Cha"8eCove"a8e

2

/$OFITABILIT% $ATIOS

R&S 10 2R&A 11 6R&* %5 2

MA$0ET AL#E $ATIOS* S $7 32

/* Ratio 0'a"9et to oo9 >alue Ratio % 1

D

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b. The steady increases in sales and profits look good, howe#er, there appear to be some problems incurrent assets. The ACP has gone from D days &poor to begin with) to H days. That implies theremay be some large uncollectible recei#ables. %n#entory turns ha#e also deteriorated indicating a

possible o#erstatement.-i

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CASH F O' INVESTING ACTIVITIES!

Purchase ofFi"ed Assets &L",""")

CASH F O' FINANCING ACTIVITIES!

%ncrease & ecrease) in -ong0Term ebt L","""

!ale of !tock """ i#idend Paid """ Cash from

Financing Acti#ities LN,NNN

NET CASH FLOW L NNN

e %" , ,at,%"

8eginning Cash 8alance L",""" et Cash Flow NNN 2nding Cash 8alance LN,NNN

Take all of the items shown in lower case """'s from the statements in the first part of yourspreadsheet. !ome will be single items like et %ncome and depreciation, but most will be differences

between beginning and ending balances like the increase or decrease in long0term debt or the change inrecei#ables. Finally, program the spreadsheet to add up the subtotals where the upper case NNN'sappear and display the reconciliation.

The trickiest part is keeping the signs straight in your subtractions for sources and uses. nceyou ha#e your program written, test it with the inputs to the CASHFLO program and see if you get thesame results.

3H. *rite your own analysis program to calculate a common si:e income statement and the ratiosintroduced in this chapter. To keep the e"ercise reasonably simple, +ust pro#ide for one year of ratiosand one common si:e statement.

Construct an input area in your spreadsheet in the form of an income statement and a balancesheet. %nput the accounts and ha#e the program calculate all totals and subtotals. efine your commonsi:e income statement alongside the input income statement by di#iding each input line item by re#enue.

efine your ratios in another area drawing the numerators and denominators from the input statements.Test your program using the 9HN3 statements for orthern /anufacturing from Problem 9 .

Compare your results with those of the ANALYS program.

H

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