The financial statements for castile products, inc., are given below:

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Financial Statement Analysis

LEARNING OBJECTIVES After studying Chapter 15, you should be able to: LO15-1 Prepare and interpret financial

statements in comparative and common-size form.

LO15-2 Compute and interpret financial ratios that managers use to assess liquidity.

LO15-3 Compute and interpret financial ratios that managers use for asset management purposes.

LO15-4 Compute and interpret financial ratios that managers use for debt management purposes.

LO15-5 Compute and interpret financial ratios that managers use to assess profitability.

LO15-6 Compute and interpret financial ratios that managers use to assess market performance.

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S

Keeping an Eye on Dividends

When the economy sours, investors look closely at a company's ability to pay dividends. In 2008, 36 of the Standard & Poor's 500 companies suspended $33.3 billion of dividend payments. Citigroup sliced its dividend 41%, Washington Mutual (now part of JPMorgan Chase) reduced its quarterly dividend per share from 15 cents to a penny, and CIT Group slashed its dividend by 60%. Some companies increase their market appeal during difficult economic times by remaining committed to generous dividend payments. For example, in 2008 Adrian Darley, of Ignis Asset Management, recommended investing in Vivendi, France Telecom, and Deutsche Telekom because these companies committed to making scheduled dividend payments that ranged from 4.9% to 7.2% of their respective stock prices. Sources: Andrea Tryphonides, “Dividends Replace P/Es as Stock Guides,” The Wall Street Journal, November 24, 2008, p. C2; Tom Lauricella, “Keeping the Cash: Slowdown Triggers Stingy Dividends,” The Wall Street Journal, April 21, 2008, p. C1; and Annelena Lobb, “Investors Lick Wounds from Dividend Cuts,” The Wall Street Journal, November 7, 2008, p. C1.

tockholders, creditors, and managers are examples of stakeholders that use financial statement analysis to evaluate a company's financial health and future prospects. Stockholders and creditors analyze a company's financial statements to estimate its potential for earnings growth, stock price appreciation, making dividend payments, and paying principal and interest

on loans. Managers use financial statement analysis for two reasons. First, it enables them to better understand how their company's financial results will be interpreted by stockholders and creditors for the purposes of making investing and lending decisions. Second, financial statement analysis provides managers with valuable feedback regarding their company's performance. For example, managers may study trends in their company's financial statements to assess whether performance has been

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improving or declining. Or, they may use financial statement analysis to benchmark their company's performance against world-class competitors.

In this chapter, we'll explain how managers prepare financial statements in comparative and common-size form and how they use financial ratios to assess their company's liquidity, asset management, debt management, profitability, and market performance.

Limitations of Financial Statement Analysis This section discusses two limitations of financial statement analysis that managers should always keep in mind—comparing financial data across companies and looking beyond ratios when formulating conclusions. Comparing Financial Data across Companies Comparisons of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare their financial data. For example, if one company values its inventories by the LIFO method and another company by the average cost method, then direct comparisons of their financial data such as inventory valuations and cost of goods sold may be misleading. Sometimes enough data are presented in footnotes to the financial statements to restate data to a comparable basis. Otherwise, managers should keep in mind any lack of comparability. Even with this limitation in mind, comparing key ratios with other companies and with industry averages often helps managers identify opportunities for improvement. Looking beyond Ratios Ratios should not be viewed as an end, but rather as a starting point. They raise many questions and point to opportunities for further analysis, but they rarely answer any questions by themselves. In addition to financial ratios, managers should consider various internal factors, such as employee learning and growth, business process performance, and customer satisfaction as well as external factors like industry trends, technological changes, changes in consumer tastes, and changes in broad economic indicators.

Statements in Comparative and Common-Size Form LO15-1 Prepare and interpret financial statements in comparative and common-size form.

An item on a balance sheet or income statement has little meaning by itself. Suppose a company's sales for a year were $250 million. In isolation, that is not particularly useful information. How does that stack up against last year's sales? How do the sales relate to the cost of goods sold? In making these kinds of comparisons, three analytical techniques are widely used:

1. Dollar and percentage changes on statements (horizontal analysis). 2. Common-size statements (vertical analysis).

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3. Ratios.

The first and second techniques are discussed in this section; the third technique is discussed in the remainder of the chapter. Throughout the chapter, we will illustrate these analytical techniques using the financial statements of Brickey Electronics, a producer of specialized electronic components. Dollar and Percentage Changes on Statements Horizontal analysis (also known as trend analysis) involves analyzing financial data over time, such as computing year-to-year dollar and percentage changes within a set of financial statements. Exhibits 15-1 and 15-2 show Brickey Electronics' financial statements in this comparative form. The dollar changes highlight the changes that are the most important economically; the percentage changes highlight the changes that are the most unusual.

EXHIBIT 15-1

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EXHIBIT 15-2

Horizontal analysis can be even more useful when data from a number of years are used to compute trend percentages. To compute trend percentages, a base year is selected and the data for all years are stated as a percentage of that base year. To illustrate, consider the sales and net income of McDonald's Corporation, the world's largest food service retailer, with more than 31,000 restaurants worldwide:

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By simply looking at these data, you can see that sales increased every year except 2009 and net income increased every year except 2007. However, recasting these data into trend percentages aids interpretation:

In the above table, both sales and net income have been restated as a percentage of the 2002 sales and net income. For example, the 2008 sales of $23,522 are 162% of the 2002 sales of $14,527. This trend analysis is particularly striking when the data are plotted as in Exhibit 15-3. McDonald's sales growth was impressive throughout the 10-year period, but net income was far more erratic. Notice that net income plummeted in 2007 and then fully recovered by 2008. In 2011, McDonald's earned record sales and profits.

EXHIBIT 15-3 McDonald's Corporation: Trend Analysis of Sales and Net Income

Common-Size Statements Horizontal analysis, which was discussed in the previous section, examines changes in financial statement accounts over time. Vertical analysis focuses on the relations among financial statement accounts at a given point in time. A common-size financial statement is a vertical analysis in which each financial statement account is expressed as a percentage. In income statements, all items are usually expressed as a percentage of sales. In balance sheets, all items are usually expressed as a

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percentage of total assets. Exhibit 15-4 contains Brickey Electronics' common-size balance sheet and Exhibit 15-5 contains its common-size income statement.

Notice from Exhibit 15-4 that placing all assets in common-size form clearly shows the relative importance of the current assets as compared to the noncurrent assets. It also shows that significant changes have taken place in the composition of the current assets over the last year. For example, accounts receivable have increased in relative importance and both cash and inventory have declined in relative importance. Judging from the sharp increase in accounts receivable, the deterioration in the cash balance may be a result of an inability to collect from customers.

The common-size income statement in Exhibit 15-5 states each line item as a percentage of sales. For example, the administrative expenses were 12.7% of sales last year and 11.3% of sales this year. If the quality and efficiency of Brickey's administrative services is holding constant or improving over time, then these two percentages suggest that this year Brickey managed its administrative resources more cost-effectively than last year. Beyond administrative expenses, managers also have a keen interest in other percentages disclosed in a common-size income statement and those will be discussed in a later section related to profitability ratios.

EXHIBIT 15-4

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EXHIBIT 15-5

Ratio Analysis—Liquidity LO15-2 Compute and interpret financial ratios that managers use to assess liquidity.

Liquidity refers to how quickly an asset can be converted to cash. Liquid assets can be converted to cash quickly, whereas ill-liquid assets cannot. Companies need to continuously monitor the amount of their liquid assets relative to the amount that they owe short-term creditors, such as suppliers. If a

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company's liquid assets are not enough to support timely payments to short-term creditors, this presents an important management problem that, if not remedied, can lead to bankruptcy.

This section uses Brickey Electronics' financial statements to explain one measure and two ratios that managers use to analyze their company's liquidity and its ability to pay short-term creditors. As you proceed through this section, keep in mind that all calculations are performed for this year rather than last year. Working Capital The excess of current assets over current liabilities is known as working capital.

The working capital for Brickey Electronics is computed as follows:

Managers need to interpret working capital from two perspectives. On one hand, if a company has ample working capital, it provides some assurance that the company can pay its creditors in full and on time. On the other hand, maintaining large amounts of working capital isn't free. Working capital must be financed with long-term debt and

equity—both of which are expensive. Furthermore, a large and growing working capital balance may indicate troubles, such as excessive growth in inventories. Therefore, managers often want to minimize working capital while retaining the ability to pay short-term creditors. Current Ratio A company's working capital is frequently expressed in ratio form. A company's current assets divided by its current liabilities is known as the current ratio:

For Brickey Electronics, the current ratio is computed as follows:

Although widely regarded as a measure of short-term debt-paying ability, the current ratio must be interpreted with great care. A declining ratio might be a sign of a deteriorating financial condition, or it might be the result of eliminating obsolete inventories or other stagnant current assets. An improving ratio might be the result of stockpiling inventory, or it might indicate an improving financial situation. In short, the current ratio is useful, but tricky to interpret.

The general rule of thumb calls for a current ratio of at least 2. However, many companies successfully operate with a current ratio below 2. The adequacy of a current ratio depends heavily on the composition of the assets. For example, as we see in the table below, both Worthington

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Corporation and Greystone, Inc., have current ratios of 2. However, they are not in comparable financial condition. Greystone is more likely to have difficulty meeting its current financial obligations because almost all of its current assets consist of inventory rather than more liquid assets such as cash and accounts receivable.

Acid-Test (Quick) Ratio The acid-test (quick) ratio is a more rigorous test of a company's ability to meet its short-term debts than the current ratio. Inventories and prepaid expenses are excluded from total current assets, leaving only the more liquid (or “quick”) assets to be divided by current liabilities.

The acid-test ratio measures how well a company can meet its obligations without having to liquidate or depend too heavily on its inventory. Ideally, each dollar of liabilities should be backed by at least $1 of quick assets. However, acid-test ratios as low as 0.3 are common.

The acid-test ratio for Brickey Electronics is computed below:

Although Brickey Electronics' acid-test ratio is within the acceptable range, a manager might be concerned about several trends revealed in the company's balance sheet. Notice in Exhibit 15-1 that short-term debts are rising, while the cash balance is declining. Perhaps the lower cash balance is a result of the substantial increase in accounts receivable. In short, as with the current ratio, the acid- test ratio should be interpreted with one eye on its basic components.

Ratio Analysis—Asset Management

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LO15-3 Compute and interpret financial ratios that managers use for asset management purposes.

A company's assets are funded by lenders and stockholders, both of whom expect those assets to be deployed efficiently and effectively. In this section, we'll describe various measures and ratios that managers use to assess their company's asset management performance. All forthcoming calculations will be performed for this year. Accounts Receivable Turnover The accounts receivable turnover and average collection period ratios measure how quickly credit sales are converted into cash. The accounts receivable turnover is computed by dividing sales on account (i.e., credit sales) by the average accounts receivable balance for the year:

Assuming that all of Brickey Electronics' sales were on account, its accounts receivable turnover is computed as follows:

The accounts receivable turnover can then be divided into 365 days to determine the average number of days required to collect an account (known as the average collection period).

The average collection period for Brickey Electronics is computed as follows:

This means that on average it takes 35 days to collect a credit sale. Whether this is good or bad depends on the credit terms Brickey Electronics is offering its customers. Many customers will tend to withhold payment for as long as the credit terms allow. If the credit terms are 30 days, then a 35- day average collection period would usually be

viewed as very good. On the other hand, if the company's credit terms are 10 days, then a 35-day average collection period is worrisome. A long collection period may result from having too many old uncollectible accounts, failing to bill promptly or follow up on late accounts, lax credit checks, and so on. In practice, average collection periods ranging all the way from 10 days to 180 days are common, depending on the industry.

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IN BUSINESS THE CHALLENGE OF COLLECTING CASH FROM CUSTOMERS When the economy soured Caroline's Desserts saw the percentage of its customers who make late payments jump from 2% to 18%. These late payments decreased the company's accounts receivable turnover, which in turn forced the company's owner to delay hiring more employees, to delay new equipment purchases, and to pay bills using personal funds. Similarly, the weak economy caused a large portion of Quality Service Associates Inc.'s customers to begin paying for their purchases in 45–60 days instead of the normal 30–45 days. The company's president said the “extra 15 to 20 days that people are not paying has had a pretty significant impact on my ability to keep up with my vendors.” Source: Simona Covel and Kelly K. Spors, “To Help Collect the Bills, Firms Try the Soft Touch,” The Wall Street Journal, January 22, 2009, pp. B1 and B6.

Inventory Turnover The inventory turnover ratio measures how many times a company's inventory has been sold and replaced during the year. It is computed by dividing the cost of goods sold by the average level of inventory [(Beginning inventory balance + Ending inventory balance) ÷ 2]:

Brickey's inventory turnover is computed as follows:

The number of days needed on average to sell the entire inventory (called the average sale period) can be computed by dividing 365 by the inventory turnover:

The average sale period varies from industry to industry. Grocery stores, with significant perishable stocks, tend to turn over their inventory quickly. On the other hand, jewelry stores tend to turn over their inventory slowly. In practice, average sales periods of 10 days to 90 days are common, depending on the industry.

A company whose inventory turnover ratio is much slower than the average for its industry may have too much inventory or the wrong sorts of inventory. Some managers argue that they must buy in large quantities to take advantage of quantity discounts. But these discounts must be compared to the added costs of insurance, taxes, financing, and risks of obsolescence and deterioration that result from carrying added inventories.

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Operating Cycle The operating cycle measures the elapsed time from when inventory is received from suppliers to when cash is received from customers. It is computed as follows:

Brickey Electronics' operating cycle is computed as follows:

A manager's goal is to reduce the operating cycle because it puts cash receipts in the company's possession sooner. In fact, if a company can shrink its operating cycle to fewer days than its average payment period for suppliers, it means the company is receiving cash from customers before it has to pay suppliers for inventory purchases. For example, if a company's operating cycle is 10 days and its average payment period to suppliers is 30 days, the company is receiving cash from customers 20 days before it pays its suppliers. In this example, the company could earn interest income on cash collections for 20 days before paying a portion of those receipts to suppliers. Conversely, if a company's operating cycle is much longer than its average payment period for suppliers, it creates the need to borrow money to fund its inventories and accounts receivable. In the case of Brickey Electronics, its operating cycle is very high, thereby suggesting that it needs to borrow money to fund its working capital.

IN BUSINESS INVENTORY MANAGEMENT IN THE APPAREL INDUSTRY Many apparel retailers such as Aéropostale are practicing a three-step inventory management tactic known as chasing. First, the retailer orders very small quantities of its new clothing styles from its suppliers. Second, the retailer determines which of its new clothing styles are popular with customers. Third, the retailer chases consumer demand by asking suppliers to very quickly ramp-up production of its most popular clothing styles. This tactic, if properly executed, enables retailers to not only reduce their average sale period and operating cycle, but it also helps them minimize price markdowns related to excess inventories and forgone sales related to out-of-stock items. Of course, tension inevitably arises with suppliers who greatly prefer large order quantities and 6–9 month lead times. Source: Elizabeth Holmes, “Tug-of-War in Apparel World,” The Wall Street Journal, July 16, 2010, pp. B1–B2.

Total Asset Turnover The total asset turnover is a ratio that compares total sales to average total assets. It measures how efficiently a company's assets are being used to generate sales. This ratio expands beyond current assets to include noncurrent assets, such as property, plant, and equipment. It is computed as follows:

Brickey Electronics' total asset turnover is computed as follows:

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A company's goal is to increase its total asset turnover. To do so, it must either increase sales or reduce its investment in assets. If a company's accounts receivable turnover and inventory turnover are increasing, but its total asset turnover is decreasing, it suggests the problem may relate to noncurrent asset utilization and efficiency. It also bears emphasizing that if all else holds constant, a company's total asset turnover will increase over time simply because the accumulated depreciation on plant and equipment grows over time.

Ratio Analysis—Debt Management LO15-4 Compute and interpret financial ratios that managers use for debt management purposes.

Managers need to evaluate their company's debt management choices from the vantage point of two stakeholders—long-term creditors and common stockholders. Long-term creditors are concerned with a company's ability to repay its loans over the long-run. For example, if a company paid out all of its available cash in the form of dividends, then nothing would be left to pay back creditors. Consequently, creditors often seek protection by requiring that borrowers agree to various restrictive covenants, or rules. These restrictive covenants typically include restrictions on dividend payments as well as rules stating that the company must maintain certain financial ratios at specified levels. Although restrictive covenants are widely used, they do not ensure that creditors will be paid when loans come due. The company still must generate sufficient earnings to cover payments.

Stockholders look at debt from a financial leverage perspective. Financial leverage refers to borrowing money to acquire assets in an effort to increase sales and profits. A company can have either positive or negative financial leverage depending on the difference between its rate of return on total assets and the rate of return that it must pay its creditors. If the company's rate of return on total assets exceeds the rate of return the company pays its creditors, financial leverage is positive. If the rate of return on total assets is less than the rate of return the company pays its creditors, financial leverage is negative. We will explore whether Brickey Electronics has positive or negative financial leverage later in the chapter. For now, you need to understand that if a company has positive financial leverage, having debt can substantially benefit common stockholders. Conversely, if a company has negative financial leverage, common stockholders suffer. Given the potential benefits of maintaining positive financial leverage, managers do not try to avoid debt, rather they often seek to maintain a level of debt that is considered to be normal within their industry.

In this section, we explain three ratios that managers use for debt management purposes, times interest earned ratio, debt-to-equity ratio, and the equity multiplier. All calculations are performed for this year.

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Times Interest Earned Ratio The most common measure of a company's ability to provide protection to its long-term creditors is the times interest earned ratio. It is computed by dividing earnings before interest expense and income taxes (i.e., net operating income) by interest expense:

For Brickey Electronics, the times interest earned ratio for this year is computed as follows:

The times interest earned ratio is based on earnings before interest expense and income taxes because that is the amount of earnings that is available for making interest payments. Interest expenses are deducted before income taxes are determined; creditors have first claim on the earnings before taxes are paid.

A times interest earned ratio of less than 1 is inadequate because interest expense exceeds the earnings that are available for paying that interest. In contrast, a times interest earned ratio of 2 or more may be considered sufficient to protect long-term creditors. Debt-to-Equity Ratio The debt-to-equity ratio is one type of leverage ratio that indicates the relative proportions of debt and equity at one point in time on a company's balance sheet. As the debt-to-equity ratio increases, it indicates that a company is increasing its financial leverage.

In other words, it is relying on a greater proportion of debt rather than equity to fund its assets. The debt-to-equity ratio is measured as follows:

Brickey's debt-to-equity ratio for this year is computed as follows:

At the end of this year, Brickey Electronics' creditors were providing 85 cents for each $1 being provided by stockholders.

Creditors and stockholders have different views about the optimal debt-to-equity ratio. Ordinarily, stockholders would like a lot of debt to take advantage of positive financial leverage. On the other hand, because equity represents the excess of total assets over total liabilities, and hence a buffer of protection for creditors, creditors would like to see less debt and more equity. In practice, debt-to- equity ratios from 0.0 (no debt) to 3.0 are common. Generally speaking, in industries with little

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financial risk, managers maintain high debt-to-equity ratios. In industries with more financial risk, managers maintain lower debt-to-equity ratios. Equity Multiplier The equity multiplier is another type of leverage ratio that indicates the portion of a company's assets funded by equity. Similar to the debt-to-equity ratio, as the equity multiplier increases, it indicates that a company is increasing its financial leverage. In other words, it is relying on a greater proportion of debt rather than equity to fund its assets. Instead of measuring amounts in the numerator and denominator at one point in time (as is done with the debt-to-equity ratio), the equity multiplier focuses on average amounts maintained throughout the year and it is measured as follows: