CHAPTER 19: FINANCIAL STATEMENT ANALYSIS

CHAPTER 19: FINANCIAL STATEMENT ANALYSIS

PROBLEM SETS

1. The major difference in approach of international financial reporting standards and

U.S. GAAP accounting stems from the difference between principles and rules.
U.S. GAAP accounting is rules-based, with extensive detailed rules to be followed
in the preparation of financial statements; many international standards, European
Union adapted IFRS, allow much greater flexibility, as long as conformity with
general principles is demonstrated. Even though U.S. GAAP is generally more
detailed and specific, issues of comparability still arise among U.S. companies.
Comparability problems are still greater among companies in foreign countries.

2. Earnings management should not matter in a truly efficient market, where all publicly
available information is reflected in the price of a share of stock. Investors can see
through attempts to manage earnings so that they can determine a companys true
profitability and, hence, the intrinsic value of a share of stock. However, if firms do
engage in earnings management, then the clear implication is that managers do not
view financial markets as efficient.

3. Both credit rating agencies and stock market analysts are likely to be more or less
interested in all of the ratios discussed in this chapter (as well as many other ratios
and forms of analysis). Since the Moodys and Standard and Poors ratings assess
bond default risk, these agencies are most interested in leverage ratios. A stock
market analyst would be most interested in profitability and market price ratios.

4. ROA = ROS ATO

The only way that Crusty Pie can have an ROS higher than the industry average and
an ROA equal to the industry average is for its ATO to be lower than the industry
average.

5. ABCs Asset turnover must be above the industry average.

Debt
6. ROE (1 Tax Rate)[ ROA ( ROA Interest Rate) ]
Equity
ROEA > ROEB
Firms A and B have the same ROA. Assuming the same tax rate and assuming that
ROA > interest rate, then Firm A must have either a lower interest rate or a higher
debt ratio.

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Net Income Net Income Sales Assets

7. ROE
Equity Sales Assets Equity
= Net profit margin Asset turnover Leverage ratio
= 5.5% 2.0 2.2 = 24.2%

8. a. Lower bad debt expense will result in higher operating income.

b. Lower bad debt expense will have no effect on operating cash flow until Galaxy
actually collects receivables.

9. A. Certain GAAP rules can be exploited by companies in order to achieve specific

goals, while still remaining within the letter of the law. Aggressive assumptions,
such as lengthening the depreciable life of an asset (which are utilized to boost
earnings) result in a lower quality of earnings.

10. A. Off balance-sheet financing through the use of operating leases is acceptable
when used appropriately. However, companies can use them too aggressively in
order to reduce their perceived leverage. A comparison among industry peers and
their practices may indicate improper use of accounting methods.

11. A. A warning sign of accounting manipulation is abnormal inventory growth as

compared to sales growth. By overstating inventory, the cost of goods sold is
lower, leading to higher profitability.

Debt
12. ROE (1 t ) [ ROA ( ROA Interest Rate) ]
Equity
0.03 (0.65) [ ROA ( ROA 0.06) 0.5]
0.03 0.975 ROA 0.0195
0.975 ROA 0.0495
ROA 0.0508 5.08%

Net Income Net Income Taxable Income EBIT Sales Assets

13 ROE
Equity Taxable Income EBIT Sales Assets Equity
ROE 0.75 0.6 0.1 2.40 1.25 .135 13.5%

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14
.
a. Cash Flows from Investing Activities
Sale of Old Equipment $72,000
Purchase of Bus (33,000)
Net Cash Used in Investing Activities 39,000

b. Cash Flows from Financing Activities

Repurchase of Stock $(55,000)
Cash Dividend (80,000)
Net Cash Used in Financing Activities (135,000)

c. Cash Flows from Operating Activities

Cash Collections from Customers $300,000
Cash Payments to Suppliers (95,000)
Cash Payments for Interest (25,000)

Net Cash Provided by Operating Activities $180,000

Net Increase in Cash $84,000

CFA PROBLEMS

1. SmileWhite has higher quality of earnings for the following reasons:

SmileWhite amortizes its goodwill over a shorter period than does
QuickBrush. SmileWhite therefore presents more conservative earnings
because it has greater goodwill amortization expense.
SmileWhite depreciates its property, plant and equipment using an accelerated
depreciation method. This results in recognition of depreciation expense
sooner and also implies that its income is more conservatively stated.
SmileWhites bad debt allowance is greater as a percent of receivables.
SmileWhite is recognizing greater bad-debt expense than QuickBrush. If
actual collection experience will be comparable, then SmileWhite has the more
conservative recognition policy.

Net profits Net profits Sales Assets

2. a. ROE
Equity Sales Assets Equity

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CHAPTER 19: FINANCIAL STATEMENT ANALYSIS

= Net profit margin Total asset turnover Assets/equity

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Net profits 475 Sales 4, 750

0.100 10% 1.61
Sales 4750 Assets 2,950

Assets 2,950
1.40
Equity 475
2,100 4, 750 2,950
b. ROE 10% 1.61 1.40 .2262 22.62%
4, 750 2,950 2,100

1.79 0.55
c. g = ROE plowback 22.62% 15.67%
1.79

3. a. CF from operating activities = $260 $85 $12 $35 = $128

b. CF from investing activities = $8 + $30 $40 = $18

c. CF from financing activities = $32 $37 = $69

4. a. QuickBrush has had higher sales and earnings growth (per share) than
SmileWhite. Margins are also higher. But this does not mean that QuickBrush
is necessarily a better investment. SmileWhite has a higher ROE, which has
been stable, while QuickBrushs ROE has been declining. We can see the
source of the difference in ROE using DuPont analysis:
Component Definition QuickBrush SmileWhite
Tax burden (1 t) Net profits/pretax profits 67.4% 66.0%
Interest burden Pretax profits/EBIT 1.000 0.955
Profit margin EBIT/Sales 8.5% 6.5%
Asset turnover Sales/Assets 1.42 3.55
Leverage Assets/Equity 1.47 1.48
ROE Net profits/Equity 12.0% 21.4%
While tax burden, interest burden, and leverage are similar, profit margin and
asset turnover differ. Although SmileWhite has a lower profit margin, it has a far
higher asset turnover.

Sustainable growth = ROE plowback ratio

Ludlows
Plowback Sustainable
ROE estimate of
ratio growth rate
growth rate
QuickBrush 12.0% 1.00 12.0% 30%
SmileWhite 21.4% 0.34 7.3% 10%
Ludlow has overestimated the sustainable growth rate for both companies.
QuickBrush has little ability to increase its sustainable growth plowback

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already equals 100%. SmileWhite could increase its sustainable growth by

increasing its plowback ratio.

b. QuickBrushs recent EPS growth has been achieved by increasing book value
per share, not by achieving greater profits per dollar of equity. A firm can
increase EPS even if ROE is declining as is true of QuickBrush. QuickBrushs
book value per share has more than doubled in the last two years.
Book value per share can increase either by retaining earnings or by issuing new
stock at a market price greater than book value. QuickBrush has been retaining
all earnings, but the increase in the number of outstanding shares indicates that it
has also issued a substantial amount of stock.

5. a. ROE = operating margin interest burden asset turnover leverage tax burden
ROE for Eastover (EO) and for Southampton (SHC) in 2010 are found as follows:
EBIT SHC: 145/1,793 = 8.1%
profit margin =
Sales EO: 795/7,406 = 10.7%
Pretax profits
SHC: 137/145 = 0.94
interest burden =
EBIT EO: 600/795 = 0.75
Sales SHC: 1,793/2,104 = 0.85
asset turnover =
Assets EO: 7,406/8,265 = 0.90
Assets SHC: 2,104/1,167 = 1.80
leverage =
Equity EO: 8,265/3,864 = 2.14
Net profits SHC: 91/137 = 0.66
tax burden =
Pretax profits EO: 394/600 = 0.66
SHC: 7.8%
ROE
EO: 10.2%

b. The differences in the components of ROE for Eastover and Southampton are:
Profit margin EO has a higher margin
Interest burden EO has a higher interest burden because its pretax profits are
a lower percentage of EBIT
Asset turnover EO is more efficient at turning over its assets
Leverage EO has higher financial leverage
Tax Burden No major difference here between the two companies

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ROE EO has a higher ROE than SHC, but this is only in part due to
higher margins and a better asset turnover -- greater financial
leverage also plays a part.

c. The sustainable growth rate can be calculated as: ROE times plowback ratio.
The sustainable growth rates for Eastover and Southampton are as follows:
Plowback Sustainable
ROE
ratio* growth rate
Eastover 10.2% 0.36 3.7%
Southampton 7.8% 0.58 4.5%
*Plowback = (1 payout ratio)
EO: Plowback = (1 0.64) = 0.36
SHC: Plowback = (1 0.42) = 0.58
The sustainable growth rates derived in this manner are not likely to be
representative of future growth because 2010 was probably not a normal
year. For Eastover, earnings had not yet recovered to 2007-2008 levels;
earnings retention of only 0.36 seems low for a company in a capital intensive
industry. Southamptons earnings fell by over 50 percent in 2010 and its
earnings retention will probably be higher than 0.58 in the future. There is a
danger, therefore, in basing a projection on one years results, especially for
companies in a cyclical industry such as forest products.

6. a. The formula for the constant growth discounted dividend model is:
D 0 (1 g )
P0
k g
For Eastover:
$1.20 1.08
P0 $43.20
0.11 0.08
This compares with the current stock price of $28. On this basis, it appears
that Eastover is undervalued.
b. The formula for the two-stage discounted dividend model is:
D1 D2 D3 P3
P0
(1 k ) (1 k )
1 2
(1 k ) 3
(1 k ) 3
For Eastover: g1 = 0.12 and g2 = 0.08

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D0 = 1.20
D1 = D0 (1.12)1 = $1.34
D2 = D0 (1.12)2 = $1.51
D3 = D0 (1.12)3 = $1.69
D4 = D0 (1.12)3(1.08) = $1.82
D4 $1.82
P3 $60.67
k g 2 0.11 0.08
$1.34 $1.51 $1.69 $60.67
P0 1
2
3
$48.03
(1.11) (1.11) (1.11) (1.11) 3

This approach makes Eastover appear even more undervalued than was the
case using the constant growth approach.

c. Advantages of the constant growth model include: (1) logical, theoretical

basis; (2) simple to compute; (3) inputs can be estimated.
Disadvantages include: (1) very sensitive to estimates of growth; (2) g and k
difficult to estimate accurately; (3) only valid for g < k; (4) constant growth is an
unrealistic assumption; (5) assumes growth will never slow down; (6) dividend
payout must remain constant; (7) not applicable for firms not paying dividends.
Improvements offered by the two-stage model include:
(1) The two-stage model is more realistic. It accounts for low, high, or zero growth
in the first stage, followed by constant long-term growth in the second stage.
(2) The model can be used to determine stock value when the growth rate in the
first stage exceeds the required rate of return.

7. a. In order to determine whether a stock is undervalued or overvalued, analysts

often compute price-earnings ratios (P/Es) and price-book ratios (P/Bs); then,
these ratios are compared to benchmarks for the market, such as the S&P 500
index. The formulas for these calculations are:
Relative P/E =
Relative P/B =
To evaluate EO and SHC using a relative P/E model, Mulroney can calculate the
five-year average P/E for each stock, and divide that number by the 5-year average
P/E for the S&P 500 (shown in the last column of Table 19E). This gives the
historical average relative P/E. Mulroney can then compare the average historical
relative P/E to the current relative P/E (i.e., the current P/E on each stock, using

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the estimate of this years earnings per share in Table 19F, divided by the current
P/E of the market).
For the price/book model, Mulroney should make similar calculations, i.e.,
divide the five-year average price-book ratio for a stock by the five year
average price/book for the S&P 500, and compare the result to the current
relative price/book (using current book value). The results are as follows:
P/E model EO SHC S&P500
5-year average P/E 16.56 11.94 15.20
Relative 5-year P/E 1.09 0.79
Current P/E 17.50 16.00 20.20
Current relative P/E 0.87 0.79
Price/Book model EO SHC S&P500
5-year average price/book 1.52 1.10 2.10
Relative 5-year price/book 0.72 0.52
Current price/book 1.62 1.49 2.60
Current relative price/book 0.62 0.57
From this analysis, it is evident that EO is trading at a discount to its historical 5-
year relative P/E ratio, whereas Southampton is trading right at its historical 5-year
relative P/E. With respect to price/book, Eastover is trading at a discount to its
historical relative price/book ratio, whereas SHC is trading modestly above its 5-
year relative price/book ratio. As noted in the preamble to the problem (see CFA
Problem 5), Eastovers book value is understated due to the very low historical
cost basis for its timberlands. The fact that Eastover is trading below its 5-year
average relative price to book ratio, even though its book value is understated,
makes Eastover seem especially attractive on a price/book basis.

b. Disadvantages of the relative P/E model include: (1) the relative P/E measures
only relative, rather than absolute, value; (2) the accounting earnings estimate
for the next year may not equal sustainable earnings; (3) accounting practices
may not be standardized; (4) changing accounting standards may make
historical comparisons difficult.
Disadvantages of the relative P/B model include: (1) book value may be
understated or overstated, particularly for a company like Eastover, which has
valuable assets on its books carried at low historical cost; (2) book value may
not be representative of earning power or future growth potential; (3) changing
accounting standards make historical comparisons difficult.

8. ThefollowingtablesummarizesthevaluationandROEforEastoverandSouthampton:
Eastover Southampton
Stock Price $28.00 $48.00
Constant-growth model $43.20 $29.00
2-stage growth model $48.03 $35.50
Current P/E 17.50 16.00

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Current relative P/E 0.87 0.79

5-year average P/E 16.56 11.94
Relative 5 year P/E 1.09 0.79
Current P/B 1.62 1.49
Current relative P/B 0.62 0.57
5-year average P/B 1.52 1.10
Relative 5 year P/B 0.72 0.52
Current ROE 10.2% 7.8%
Sustainable growth rate 3.7% 4.5%
Eastover seems to be undervalued according to each of the discounted dividend
models. Eastover also appears to be cheap on both a relative P/E and a relative P/B
basis. Southampton, on the other hand, looks overvalued according to each of the
discounted dividend models and is slightly overvalued using the relative price/book
model. On a relative P/E basis, SHC appears to be fairly valued. Southampton does
have a slightly higher sustainable growth rate, but not appreciably so, and its ROE is
less than Eastovers.
The current P/E for Eastover is based on relatively depressed current earnings, yet
the stock is still attractive on this basis. In addition, the price/book ratio for
Eastover is overstated due to the low historical cost basis used for the timberland
assets. This makes Eastover seem all the more attractive on a price/book basis.
Based on this analysis, Mulroney should select Eastover over Southampton.

9. a. Net income can increase even while cash flow from operations decreases. This
can occur if there is a buildup in net working capital -- for example, increases
in accounts receivable or inventories, or reductions in accounts payable.
Lower depreciation expense will also increase net income but can reduce cash
flow through the impact on taxes owed.

b. Cash flow from operations might be a good indicator of a firm's quality of

earnings because it shows whether the firm is actually generating the cash
necessary to pay bills and dividends without resorting to new financing. Cash
flow is less susceptible to arbitrary accounting rules than net income is.

10. $1,200
Cash flow from operations = sales cash expenses increase in A/R
Ignore depreciation because it is a non-cash item and its impact on taxes is already
accounted for.

11. Both current assets and current liabilities will decrease by equal amounts. But this is
a larger percentage decrease for current liabilities because the initial current ratio is
above 1.0. So the current ratio increases. Total assets are lower, so turnover
increases.

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12. Considering the components of after-tax ROE, there are several possible explanations
for a stable after-tax ROE despite declining operating income:
1. Declining operating income could have been offset by an increase in non-operating
income (i.e., from discontinued operations, extraordinary gains, gains from changes in
accounting policies) because both are components of profit margin (net income/sales).
2. Another offset to declining operating income could have been declining interest rates
on any interest rate obligations, which would have decreased interest expense while
allowing pre-tax margins to remain stable.
3. Leverage could have increased as a result of a decline in equity from: (a) writing
down an equity investment, (b) stock repurchases, (c) losses; or, (d) selling new debt.
The effect of the increased leverage could have offset a decline in operating income.
4. An increase in asset turnover could also offset a decline in operating income. Asset
turnover could increase as a result of a sales growth rate that exceeds the asset growth
rate, or from the sale or write-off of assets.
5. If the effective tax rate declined, the resulting increase in earnings after tax could
offset a decline in operating income. The decline in effective tax rates could result
from increased tax credits, the use of tax loss carry-forwards, or a decline in the
statutory tax rate.

13. a.
2007 2011
Operating Income - Depreciation 38 3 76 9
(1) Operating margin = 6.5% 6.8%
Sales 542 979

Sales 542 979

(2) Asset turnover = 2.21 3.36
Total Assets 245 291

38 3 3
(3) Interest Burden = 0.914 1.0
38 3

Total Assets 245 291

(4) Financial Leverage = 1.54 1.32
Shareholders' Equity 159 220

Income Taxes 13 37
(5) Income tax rate = 40.63% 55.22%
Pretax Income 32 67
Using the Du Pont formula:
ROE = [1.0 (5)] (3) (1) (2) (4)
ROE(2007) = 0.5937 0.914 0.065 2.21 1.54 = 0.120 = 12.0%
ROE(2011) = 0.4478 1.0 0.068 3.36 1.32 = 0.135 = 13.5%

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(Because of rounding error, these results differ slightly from those obtained by
directly calculating ROE as net income/equity.)

b. Asset turnover measures the ability of a company to minimize the level of assets
(current or fixed) to support its level of sales. The asset turnover increased
substantially over the period, thus contributing to an increase in the ROE.
Financial leverage measures the amount of financing other than equity, including
short and long-term debt. Financial leverage declined over the period, thus
adversely affecting the ROE. Since asset turnover rose substantially more than
financial leverage declined, the net effect was an increase in ROE.

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