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Learning Objectives 1 Learning Objectives 1 and 2and 2
Distinguish among Distinguish among profitability, liquidity, and profitability, liquidity, and
solvency.solvency.Calculate financial ratiosCalculate financial ratiosdesigned to measure adesigned to measure acompany’s profitability,company’s profitability,liquidity, and solvency.liquidity, and solvency.
Ratio analysisRatio analysis is a technique for analyzing is a technique for analyzingthe relationship between two items from athe relationship between two items from a
company’s financial statements for a given period.company’s financial statements for a given period.
Financial statements analysisFinancial statements analysis is the process is the processof looking beyond the face of the financialof looking beyond the face of the financial
statements to gain additional insightstatements to gain additional insightinto a company’s financial health.into a company’s financial health.
Stockholders’ equityStockholders’ equityPaid-in capital:Paid-in capital:Common stock, $10 par value,Common stock, $10 par value, 100,000 shares authorized, 4,000100,000 shares authorized, 4,000 shares issued and outstandingshares issued and outstanding $ 60,000$ 60,000Paid-in capital in excess of parPaid-in capital in excess of par – – common stockcommon stock 40,000 40,000
Total paid-in capitalTotal paid-in capital $100,000$100,000Retained earningsRetained earnings 59,181 59,181
Total stockholders’ equityTotal stockholders’ equity 159,181 159,181Total liabilities and stockholders’ equityTotal liabilities and stockholders’ equity $288,015$288,015
For the Year Ended May 31, For the Year Ended May 31, 20042004
Net salesNet sales $527,146$527,146Cost of goods soldCost of goods sold 295,834 295,834Gross profitGross profit $231,312$231,312Selling expensesSelling expenses $48,334$48,334Administrative expensesAdministrative expenses 72,189 72,189Total operating expensesTotal operating expenses 120,523 120,523Operating incomeOperating income $110,789$110,789Other revenues and expenses:Other revenues and expenses: Interest revenueInterest revenue $ 512$ 512 Interest expenseInterest expense (6,000 (6,000))Total other revenues and expensesTotal other revenues and expenses (5,488 (5,488))Income before income taxesIncome before income taxes $105,301$105,301Income taxesIncome taxes 42,120 42,120Net incomeNet income $ 63,181$ 63,181Earnings per shareEarnings per share $ 15.79$ 15.79
This ratio measures how efficiently theThis ratio measures how efficiently thecompany uses its assets to produce profits.company uses its assets to produce profits.
Return on assets =Return on assets =Net income before taxes ÷ Total assetsNet income before taxes ÷ Total assets
This ratio calculates the amount of salesThis ratio calculates the amount of salesproduced for a given level of assets used.produced for a given level of assets used.
Total asset turnover =Total asset turnover =Sales ÷ Total assetsSales ÷ Total assets
This ratio measures the amount of after-taxThis ratio measures the amount of after-taxnet income generated by a dollar of sales.net income generated by a dollar of sales.
Profit margin after income tax =Profit margin after income tax =Net income after taxes ÷ SalesNet income after taxes ÷ Sales
This ratio indicates how much after-tax incomeThis ratio indicates how much after-tax incomewas generated for a given level of equity.was generated for a given level of equity.
Return on equity after taxes =Return on equity after taxes =Net income after taxes ÷ Stockholders’ equityNet income after taxes ÷ Stockholders’ equity
This ratio calculates how much before-tax incomeThis ratio calculates how much before-tax incomewas generated for a given level of equity.was generated for a given level of equity.
Return on equity before taxes =Return on equity before taxes =(Net income after taxes + Income taxes)(Net income after taxes + Income taxes)
Liquidity ratios evaluate a firm’s abilityLiquidity ratios evaluate a firm’s abilityto generate sufficient cash toto generate sufficient cash to
meet its short-term obligations. meet its short-term obligations.
An asset’s liquidity describes the easeAn asset’s liquidity describes the easewith which it can be converted to cash.with which it can be converted to cash.
This ratio measures the company’s ability toThis ratio measures the company’s ability tomeet its current liabilities with current assets.meet its current liabilities with current assets.
Current ratio =Current ratio =Current assets ÷ Current liabilitiesCurrent assets ÷ Current liabilities
$190,637 ÷ $83,834 = 2.27 to 1$190,637 ÷ $83,834 = 2.27 to 1
This ratio is a stringent test of liquidityThis ratio is a stringent test of liquiditythat compares highly liquid currentthat compares highly liquid current
assets to current liabilities.assets to current liabilities.
Acid-test ratio = (Cash + ReceivablesAcid-test ratio = (Cash + Receivables+ Trading securities) ÷ Current liabilities+ Trading securities) ÷ Current liabilities
($128,384 + $9,450 + $0) ÷ $83,834= 1.64 to 1($128,384 + $9,450 + $0) ÷ $83,834= 1.64 to 1
This ratio indicates the level of salesThis ratio indicates the level of salesgenerated for a given level of working capital.generated for a given level of working capital.
Net sales to working capital = Sales ÷Net sales to working capital = Sales ÷(Current assets – Current liabilities)(Current assets – Current liabilities)
This ratio indicates the number of timesThis ratio indicates the number of timestotal merchandise inventory is purchasedtotal merchandise inventory is purchased(or finished goods inventory is produced)(or finished goods inventory is produced)
and sold during a period.and sold during a period.
Inventory turnover =Inventory turnover =Cost of sales ÷ InventoryCost of sales ÷ Inventory
Solvency ratios are of most interest toSolvency ratios are of most interest tostockholders, long-term creditors,stockholders, long-term creditors,
and company management.and company management.
Solvency is a company’s ability to meet the Solvency is a company’s ability to meet the obligations created by its long-term debt.obligations created by its long-term debt.
The The AlmanacAlmanac includes all includes allcompanies, public and private.companies, public and private.
Information provided in theInformation provided in the AlmanacAlmanacfor each industry is four pages.for each industry is four pages.
It consists of two tables.It consists of two tables.
This chapter emphasizes theThis chapter emphasizes the Almanac ofAlmanac ofBusiness and Industrial Financial RatiosBusiness and Industrial Financial Ratios..
Comparison of Elevation Comparison of Elevation Sports, Inc., to Industry Sports, Inc., to Industry
AveragesAveragesReturn on assetsReturn on assetsProfit margin before income taxesProfit margin before income taxesTotal asset turnoverTotal asset turnoverProfit margin after income taxProfit margin after income taxReturn on equity after income taxesReturn on equity after income taxesReturn on equity before income taxesReturn on equity before income taxesCurrent ratioCurrent ratioQuick ratioQuick ratioNet sales to working capitalNet sales to working capitalReceivables turnoverReceivables turnoverInventory turnoverInventory turnoverDebt ratioDebt ratioCoverage ratioCoverage ratio
Return on assetsReturn on assetsProfit margin before taxesProfit margin before taxesTotal asset turnoverTotal asset turnoverProfit margin after taxesProfit margin after taxesReturn on equity after taxesReturn on equity after taxesReturn on equity before taxesReturn on equity before taxesCurrent ratioCurrent ratioQuick ratioQuick ratioNet sales to working capitalNet sales to working capitalReceivables turnoverReceivables turnoverInventory turnoverInventory turnoverDebt ratioDebt ratioTotal liabilities to net worthTotal liabilities to net worth
1. Family Dollar Stores, Inc., is an industry1. Family Dollar Stores, Inc., is an industryleader in profitability and solvency.leader in profitability and solvency.
2. Family Dollar has improved the2. Family Dollar has improved thedistribution element of its supply chain.distribution element of its supply chain.
The evaluation process by natureThe evaluation process by naturedepends upon individual perception.depends upon individual perception.
3. Part of the company profitability and3. Part of the company profitability andliquidity will depend upon its increasingliquidity will depend upon its increasing
the inventory turnover ratio.the inventory turnover ratio.
4. If we choose to invest in a general4. If we choose to invest in a generalmerchandise discounter, Family Dollarmerchandise discounter, Family DollarStores, Inc., might be one to consider.Stores, Inc., might be one to consider.
Limitations of Ratio AnalysisLimitations of Ratio Analysis
2. The financial statements used to compute2. The financial statements used to computethe ratios are based on historical cost.the ratios are based on historical cost.
3. Figures from the balance sheet used to3. Figures from the balance sheet used tocalculate the ratios are year-end numbers.calculate the ratios are year-end numbers.
1. Attempting to predict the future using past1. Attempting to predict the future using pastresults depends upon the predictiveresults depends upon the predictive
value of the information used.value of the information used.
Limitations of Ratio AnalysisLimitations of Ratio Analysis
5. Lack of uniformity concerning what is5. Lack of uniformity concerning what isto be included in the numerators andto be included in the numerators and
denominators make comparisonsdenominators make comparisonsextremely difficult.extremely difficult.
4. Industry peculiarities create difficulty4. Industry peculiarities create difficultyin comparing the ratios of a companyin comparing the ratios of a company
in one industry with those of ain one industry with those of acompany in another industry.company in another industry.