Solution manual accounting 21e by warreni ch 17

CHAPTER 17 FINANCIAL STATEMENT ANALYSIS CLASS DISCUSSION QUESTIONS Horizontal analysis is the percentage analysis of increases and decreases in corresponding statements The percent change in the cash balances at the end of the preceding year from the end of the current year is an example Vertical analysis is the percentage analysis showing the relationship of the component parts to the total in a single statement The percent of cash as a portion of total assets at the end of the current year is an example Comparative statements provide information as to changes between dates or periods Trends indicated by comparisons may be far more significant than the data for a single date or period Before this question can be answered, the increase in net income should be compared with changes in sales, expenses, and assets devoted to the business for the current year The return on assets for both periods should also be compared If these comparisons indicate favorable trends, the operating performance has improved; if not, the apparent favorable increase in net income may be offset by unfavorable trends in other areas You should first determine if the expense amount in the base year (denominator) is significant A 100% or more increase of a very small expense item may be of little concern However, if the expense amount in the base year is significant, then over a 100% increase may require further investigation Generally, the two ratios would be very close, because most service businesses sell services and hold very little inventory The amount of working capital and the change in working capital are just two indicators of the strength of the current position A comparison of the current ratio and the quick ratio, along with the amount of working capital, gives a better analysis of the current position Such a comparison shows: Current Preceding Year Year Working capital $42,500 $37,500 Current ratio 2.0 2.5 Quick ratio 0.8 1.2 It is apparent that, although working capital has increased, the current ratio has fallen from 2.5 to 2.0, and the quick ratio has fallen from 1.2 to 0.8 The bulk of Wal-Mart sales are to final customers that pay with credit cards or cash In either case, there is no accounts receivable Procter and Gamble, in contrast, sells almost exclusively to other businesses, such as Wal-Mart Such sales are “on account,” and thus, create accounts receivable that must be collected A recent financial statement showed Wal-Mart’s accounts receivable turning 109 times, while Procter and Gamble’s turned only 13 times No, an accounts receivable turnover of with sales on a n/30 basis is not satisfactory It indicates that accounts receivable are collected, on the average, in one-sixth of a year, or approximately 60 days from the date of sale Assuming that some customers pay within the 30-day term, it indicates that other accounts are running beyond 60 days It is also possible that there is a substantial amount of pastdue accounts of doubtful collectibility on the books a A high inventory turnover minimizes the amount invested in inventories, thus freeing funds for more advantageous use Storage costs, administrative expenses, and losses caused by obsolescence and adverse changes in prices are also kept to a minimum b Yes The inventory turnover could be high because the quantity of inventory on hand is very low This condition might result in the lack of sufficient goods on hand to meet sales orders c Yes The inventory turnover relates to the “turnover” of inventory during the year, while the number of days’ sales in inventory relates to the amount of inventory on hand at the end of the year Therefore, a business could have a high inventory turnover for the year, yet have a high number of days’ sales in inventory at the end of the year 10 The ratio of fixed assets to long-term liabilities increased from for the preceding year to 2.5 for the current year, indicating that the company is in a stronger position now than in the preceding year to borrow additional funds on a long-term basis 11 a Due to leverage, the rate on stockholders’ equity will often be greater than the rate on total assets This occurs because the amount earned on assets acquired through the use of funds provided by creditors exceeds the interest charges paid to creditors b Higher The concept of leverage applies to preferred stock as well as debt The rate earned on common stockholders’ equity ordinarily exceeds the rate earned on total stockholders’ equity because the amount earned on assets acquired through the use of funds provided by preferred stockholders normally exceeds the dividends paid to preferred stockholders 12 The earnings per share in the preceding year were $20 per share ($40/2), adjusted for the stock split in the latest year 13 A share of common stock is currently selling at 10 times current annual earnings 14 The dividend yield on common stock is a measure of the rate of return to common stockholders in terms of cash dividend distributions Companies in growth industries typically reinvest a significant portion of the amount earned in common stockholders’ equity to expand operations rather than to return earnings to stockholders in the form of cash dividends 15 During periods when sales are increasing, it is likely that a company will increase its inventories and expand its plant Such situations frequently result in an increase in current liabilities out of proportion to the increase in current assets and thus lower the current ratio EXERCISES Ex 17–1 a HOME-MATE APPLIANCE CO Comparative Income Statement For the Years Ended December 31, 2006 and 2005 2006 Amount Percent Sales Cost of goods sold Gross profit Selling expenses Administrative expenses Total operating expenses Income from operations Income tax expense Net income $500,000 275,000 $225,000 $ 90,000 60,000 $150,000 $ 75,000 25,000 $ 50,000 100.0% 55.0 45.0% 18.0% 12.0 30.0% 15.0% 5.0 10.0% Amount 2005 Percent $450,000 234,000 $216,000 $ 94,500 63,000 $157,500 $ 58,500 22,500 $ 36,000 100.0% 52.0 48 0% 21.0% 14.0 35.0% 13.0% 5.0 8.0% b The vertical analysis indicates that the cost of goods sold as a percent of sales increased by percentage points (55% – 52%) between 2005 and 2006 However, the selling expenses and administrative expenses improved by percentage points Thus, the net income as a percent of sales improved by percentage points Ex 17–2 a Speedway Motorsports, Inc Comparative Income Statement (in thousands of dollars) For the Years Ended December 31, 2002 and 2001 2002 Revenues: Admissions Event-related revenue NASCAR broadcasting revenue Other operating revenue Total revenues Expenses and other: Direct expense of events NASCAR purse and sanction fees Other direct expenses General and administrative Total expenses and other Income from continuing operations 2001 $141,315 122,172 77,936 34,537 $375,960 37.6% 32.5 20.7 9.2 100.0% $136,362 133,289 67,488 38,111 $375,250 36.3% 35.5 18.0 10.2 100.0% $ 69,297 61,217 87,427 57,235 $275,176 $100,784 18.4% 16.3 23.3 15.2 73.2% 26.8% $ 76,579 54,479 88,582 59,331 $278,971 $ 96,279 20.4% 14.5 23.6 15.8 74.3% 25.7% b While overall revenue did not change much between the two years, the overall mix of revenue sources did change somewhat The event-related revenues (such as concessions) declined as a percent of total revenues by three percentage points, while the percent of NASCAR broadcasting revenues to total revenues increased by nearly three (2.7) percentage points The expenses as a percent of total revenues shifted the most between the direct event expenses and NASCAR purse and sanction fees That is, the direct expenses as a percent of total revenues declined nearly two percentage points, while the NASCAR purse and sanction fees as a percent of total revenues increased by nearly two (1.8) percentage points Overall, the income from continuing operations increased a modest 1.1 percentage points of total revenues between the two years, which is a favorable trend As a further note, the income from continuing operations as a percent of sales exceeds 25% in both years, which is excellent Apparently, owning and operating motor speedways is a business that produces high operating profit margins Note to Instructors: The high operating margin is probably necessary to compensate for the extensive investment in speedway assets This is confirmed by the rate of operating income return on total assets of nearly 9% Ex 17–3 a HORIZON PUBLISHING COMPANY Common-Size Income Statement For the Year Ended December 31, 20— Horizon Publishing Company Amount Percent Sales Sales returns and allowances Net sales Cost of goods sold Gross profit Selling expenses Administrative expenses Total operating expenses Operating income Other income Other expense Income before income tax Income tax expense Net income $ 1,414,000 14,000 $ 1,400,000 504,000 $ 896,000 $ 574,000 154,000 $ 728,000 $ 168,000 16,800 $ 184,800 23,800 $ 161,000 56,000 $ 105,000 101.0% 1.0 100.0% 36.0 64.0% 41.0% 11.0 52.0% 12.0% 1.2 13.2% 1.7 11.5% 4.0 7.5% Publishing Industry Average 101.0% 1.0 100.0% 40.0 60.0% 39.0% 10.5 49.5% 10.5% 1.2 11.7% 1.7 10.0% 4.0 6.0% b The cost of goods sold is percentage points lower than the industry average, but the selling expenses and administrative expenses are 2.5 percentage points higher than the industry average The combined impact is for net income as a percent of sales to be 1.5 percentage points better than the industry average Apparently, the company is managing the cost of publishing books better than the industry but has slightly higher selling and administrative expenses relative to the industry The cause of the higher selling and administrative expenses as a percent of sales, relative to the industry, can be investigated further Ex 17–4 SANTA FE TILE COMPANY Comparative Balance Sheet December 31, 2006 and 2005 Amount 2006 Percent Amount 2005 Percent Current assets Property, plant, and equipment Intangible assets Total assets $260,000 500,000 40,000 $800,000 32.50% 62.50 5.00 100.00% $200,000 450,000 50,000 $700,000 28.57% 64.29 7.14 100.00% Current liabilities Long-term liabilities Common stock Retained earnings Total liabilities and stockholders’ equity $170,000 210,000 50,000 370,000 21.25% 26.25 6.25 46.25 $150,000 200,000 50,000 300,000 21.43% 28.57 7.14 42.86 $800,000 100.00% $700,000 100.00% Ex 17–5 a SCRIBE PAPER COMPANY Comparative Income Statement For the Years Ended December 31, 2006 and 2005 Sales Cost of goods sold Gross profit Selling expenses Administrative expenses Total operating expenses Income before income tax Income tax expense Net income 2006 Amount 2005 Amount $ 66,300 32,000 $ 34,300 $ 24,000 7,500 $ 31,500 $ 2,800 1,000 $ 1,800 $ 85,000 40,000 $ 45,000 $ 25,000 6,000 $ 31,000 $ 14,000 6,000 $ 8,000 Increase (Decrease) Amount Percent $ (18,700) (8,000) $ (10,700) $ (1,000) 1,500 $ 500 $ (11,200) (5,000) $ (6,200) – 22.00% – 20.00% – 23.78% – 4.00% 25.00% 1.61% – 80.00% – 83.33% – 77.50% b The net income for Scribe Paper Company decreased by approximately 77.5% from 2005 to 2006 This decrease was the combined result of a decrease in sales of 22% and higher expenses The cost of goods sold decreased at a slower rate than the decrease in sales, thus causing gross profit to decrease more than the decrease in sales In addition, selling and administrative expenses increased by 1.61% between 2005 and 2006 Ex 17–6 a (1) Working capital = Current assets – Current liabilities 2006: $875,000 – $250,000 = $625,000 2005: $795,000 – $265,000 = $530,000 Current assets Current liabilities $875,000 = 3.5 2005: $250,000 $795,000 = 3.0 $265,000 Quick assets Current liabilities $480,000 = 1.92 2005: $250,000 $424,000 = 1.6 $265,000 (2) Current ratio = 2006: (3) Quick ratio = 2006: b The liquidity of Marine Equipment has improved from the preceding year to the current year The working capital, current ratio, and quick ratio have all increased Most of these changes are the result of a decrease in current liabilities, specifically accounts (notes) payable, combined with an increase in the current assets Ex 17–7 a (1) Current ratio = Dec 28, 2002: (2) Quick ratio = Dec 28, 2002: Current assets Current liabilities $6,413 = 1.06 $6,052 Dec 28, 2001: $5,853 = 1.17 $4,998 Dec 28, 2001: $3,791 = 0.76 $4,998 Quick assets Current liabilities $4,376 = 0.72 $6,052 b The liquidity of PepsiCo has declined significantly over this time period Both the current and quick ratios have declined The current ratio declined from 1.17 to 1.06, and the quick ratio declined from 0.76 to 0.72 Neither of these declines is worrisome, however PepsiCo is a strong company with ample resources for meeting short-term obligations Ex 17–8 a The working capital, current ratio, and quick ratio are calculated incorrectly The working capital and current ratio incorrectly include Goodwill as a part of current assets Goodwill is an intangible asset and is noncurrent The quick ratio has the correct numerator (quick assets) but does not include accrued liabilities in the denominator The denominator of the quick ratio should be total current liabilities The correct calculations are as follows: Working capital = Current assets – Current liabilities $900,000 – $625,000 = $275,000 Current ratio = Current assets Current liabilities $900,000 = 1.44 $625,000 Quick ratio = Quick assets Current liabilities $275,000 + $123,000 + $172,000 = 0.912 $625,000 b Unfortunately, the working capital, current ratio, and quick ratio are all below the minimum threshold required by the bond indenture This may require the company to renegotiate the bond contract, including a possible unfavorable change in the interest rate Ex 17–9 a (1) Accounts receivable turnover: Current year: Net sales on account Average monthly accounts receivable $320,000 = 7.1 $45,070 Preceding year: (2) Number of days' sales in receivables: $300,000 = 6.5 $46,154 Accounts receivable, end of year Average daily sales on account $48,219 = 55.0 days $877 $52,603 Preceding year: = 64.0 days $822 Current year: $877 = $320,000 ÷ 365 days $822 = $300,000 ÷ 365 days b The collection of accounts receivable has improved This can be seen in both the increase in accounts receivable turnover and the reduction in the collection period The credit terms require payment in 60 days In the previous period, the collection period exceeded these terms However, the company apparently became more aggressive in collecting accounts receivable or more restrictive in granting credit to customers Thus, in the current period the collection period is within the credit terms of the company Ex 17–10 a (1) Accounts receivable turnover: Sears: Net sales on account Average accounts receivable $35,698 = 1.2 ($28,155 + $30,759) / Federated: $15,434 = 5.8 ($2,379 + $2,945 ) / (2) Number of days’ sales in receivables: Accounts receivable, end of year Average daily sales on account $30,759 = 314.5 days $97.8 $2,945 Federated: = 69.6 days $42.3 $97.8 = $35,698 ÷ 365 days $42.3 = $15,434 ÷ 365 days Sears: b Sears’ accounts receivable turnover is much less than Federated’s (1.2 for Sears vs 5.8 for Federated) Likewise, the number of days’ sales in receivables is much greater for Sears than for Federated (314.4 days for Sears vs 69.6 days for Federated) These differences must be interpreted with care Sears has significant MasterCard receivables with customers who have not made purchases from Sears, which represent receivables that no correspond to Sears’ sales Thus, it is not surprising that Sears has a much lower turnover than does Federated, since the accounts receivable include receivables that are outside of the Sears retail network In addition, we not know how much of the Sears or Federated sales are on credit; thus, it is not possible to accurately compare the number of days’ sales in receivables with credit terms Note to Instructors: The annual 10-K for Federated indicated that the sales through its proprietary credit card was $4,128 Thus, the accounts receivable turnover based on this number would be 1.6 ($4,128 ÷ $2,662), while the number of days’ sales in receivables would be 260.6 days ($2,945 ÷ $11.3) Thus, the calculations in part a above actually overstate Federated’s accounts receivable turnover and understates Federated’s credit card days’ sales in receivables This exercise helps the student see the importance of interpreting these ratios carefully In the case of Sears, much of the receivables are not related to Sears’ sales, which distorts the ratio In the case of Federated, only $4,128 million in sales were on account, thus actually overstating its accounts receivable turnover and understating its days’ sales in receivable, relative to the sales on account Prob 17–5B c Number o f t imes int erest charges earned Continued 4.000 3.500 3.000 2.500 2.000 1.500 1.000 0.500 0.000 2006 2005 2004 2003 2002 Year Industry num ber of tim es interest charges are earned Crane number of tim es interest charges are earned Number of times Net Income + Income tax expense + Interest expense interest charges = Interest expense were earned 2006: $141,000 = 1.38 $102,000 2003: $275,000 = 3.44 $80,000 2005: $160,000 = 1.68 $95,000 2002: $270,000 = 3.60 $75,000 2004: $215,000 = 2.53 $85,000 Prob 17–5B d Rat io o f liabilit ies t o st o ckho lders' equit y Continued 3.500 3.000 2.500 2.000 1.500 1.000 0.500 2006 2005 2004 2003 2002 Year Industry ratio of liabilities to stockholders' equity Crane ratio of liabilities to stockholders' equity Ratio of liabilities to stockholders’ equity = Total liabilities Total stockholders' equity 2006: $1,020,000 = 1.76 $580,000 2003: $800,000 = 2.00 $400,000 2005: $950,000 = 1.73 $550,000 2002: $750,000 = 3.00 $250,000 2004: $850,000 = 1.70 $500,000 Note: Total liabilities are determined by subtracting stockholders’ equity (ending balance) from the total assets (ending balance) Prob 17–5B Concluded Both the rate earned on total assets and the rate earned on stockholders’ equity have been moving in a negative direction in the last five years Both measures have moved below the industry average over the last two years The cause of this decline is driven by a rapid decline in earnings The use of debt can be seen from the ratio of liabilities to stockholders’ equity The ratio has declined over the time period and has declined below the industry average Thus, the level of debt relative to the stockholders’ equity has gradually improved over the five years Unfortunately, the earnings have declined at a faster rate, causing the rate earned on stockholders’ equity to decline The rate earned on total assets ran below the interest cost on debt in 2006, causing the rate earned on stockholders’ equity to drop below the rate earned on total assets This is an example of negative leverage The number of times interest charges were earned has been falling below the industry average for several years This is the result of low profitability combined with high interest costs (10%) The number of times interest is earned has fallen to a dangerously low level in 2006 The low profitability and time interest charges are earned in 2006, as well as the five-year trend, should be a major concern to the company’s management, stockholders, and creditors HOME DEPOT, INC., PROBLEM a Working capital (in millions): 2003: $3,882 ($11,917 – $8,035) 2002: $3,860 ($10,361 – $6,501) b Current ratio: 2003: 1.48 ($11,917 ÷ $8,035) 2002: 1.59 ($10,361 ÷ $6,501) c Quick ratio: 2003: 0.41 ($3,325 ÷ $8,035) 2002: 0.53 ($3,466 ÷ $6,501) d Accounts receivable turnover: 2003: 58.48 {$58,247 ÷ [($920 + $1,072)/2]} 2002: 61.03 {$53,553 ÷ [($835 + $920)/2]} e Number of days' sales in receivables: 2003: 6.72 [$1,072 ÷ ($58,247/365)] 2002: 6.27 [$920 ÷ ($53,553/365)] f Inventory turnover: 2003: 5.33 {$40,139 ÷ [($8,338 + $6,725)/2]} 2002: 5.63 {$37,406 ÷ [($6,725 + $6,556)/2]} g Number of days' sales in inventory: 2003: 75.82 days [$8,338 ÷ ($40,139/365)] 2002: 65.62 days [$6,725 ÷ ($37,406/365)] h Ratio of liabilities to stockholders’ equity: 2003: 0.52 ($10,209 ÷ $19,802) 2002: 0.46 ($8,312 ÷ $18,082) i Ratio of net sales to average total assets: 2003: 2.07 {$58,247 ÷ [($30,011 + $26,394)/2]} 2002: 2.24 {$53,553 ÷ [($26,394 + $21,385)/2]} j Rate earned on average total assets: 2003: 13.12% {($3,664 + 37) ÷ [($30,011 + $26,394)/2)]} 2002: 12.86% {($3,044 + 28) ÷ [($26,394 + $21,385)/2)]} k Rate earned on average common stockholders’ equity: 2003: 19.34% {$3,664 ÷ [($19,802 + $18,082)/2]} 2002: 18.4% {$3,044 ÷ [($18,082 + $15,004)/2]} Home Depot, Inc., Problem Concluded l Price-earnings ratio: 2003: 13.66 ($21.31 ÷ $1.56) 2002: 38.53 ($49.70 ÷ $1.29) m Percentage relationship of net income to net sales: 2003: 6.29% ($3,664 ÷ $58,247) 2002: 5.68% ($3,044 ÷ $53,553) Before reaching definitive conclusions, each measure should be compared with past years, industry averages, and similar firms in the industry a The working capital increased slightly b and c The working capital and the quick ratio declined modestly during 2003 d and e The accounts receivable turnover and number of days’ sales in receivables indicate a slight decrease in the efficiency of collecting accounts receivable The accounts receivable turnover decreased from 61.03 to 58.48 The number of days’ sales in receivables increased from 6.27 to 6.72 Both measures indicate, however, that Home Depot has significant cash sales, since the turnover is so high and the average collection period is so short If the credit sales were known, these ratios could be calculated with net credit sales on account in the numerator The resulting calculations could be compared to Home Depot’s credit policy f and g The results of these two analyses showed a decrease in the inventory turnover and an increase in the number of days’ sales in inventory Both trends are unfavorable Inventory management is critical to a retailer, so this ratio trend would warrant further analysis h The margin of protection to the creditors improved slightly in 2003 Overall, there is excellent protection to creditors i These analyses indicate a decrease in the effectiveness in the use of the assets to generate revenues j The rate earned on average total assets improved slightly during 2003 Overall, rates earned on assets that exceed 10% is usually considered good performance k The rate earned on average common stockholders’ equity in 2003 also increased This is also evidence of the positive use of leverage, since the rate earned on stockholders’ equity exceeds the rate earned on assets The rates earned on average common stockholders’ equity shown for these two years would be considered excellent performance l The price-earnings ratio dropped significantly from 2002 to 2003 This drop accompanied an overall drop in price-earnings ratios for the whole market during this time In addition, market participants are revaluing Home Depot’s growth prospects downward in light of the competition from Lowe’s Thus, even though earnings increased, the stock price declined m The percent of net income to net sales increased, from 5.68% to 6.29%, a favorable trend SPECIAL ACTIVITIES Activity 17–1 This position does not allow the shareholders to take advantage of leverage As a result, the return on shareholders' equity cannot be improved by using debt On the flip side, a low or no debt load does provide the company great flexibility in the case of a national calamity However, the “no debt” position only makes sense within the “national calamity” scenario Within normal business operations, most companies can assume some debt without much loss of flexibility or control Ice Mountain Brewery is competing against companies that will not be so inclined to avoid debt As a result, they will likely be able to grow faster than Ice Mountain The Ice Mountain management should consider the risk of not being able to keep up with the competition because of their conservative financing policies Activity 17–2 Sandra is concerned about the inventory and accounts receivable levels because she must determine their value Inventory that cannot be sold (or sold at a large discount) or accounts receivable that cannot be collected must be written down to reflect their reduced value Sandra has conducted the ratio analysis and interviewed Travis to help make this determination The inventory and accounts receivable levels have grown alarmingly Travis’s response to Sandra is not reassuring The inventory represents obsolete technology that is left over after the holiday season The accounts receivable have apparently grown from loosening the credit standards Sandra may need to insist on write-downs of the inventory and accounts receivable balances to reflect their net realizable values Travis is correct in pointing out that the current ratio has probably improved Thus, although Travis calls this “good,” it is only such if the current assets in the numerator are fairly valued Under these circumstances, the current ratio is probably overstated because the inventory and accounts receivable balances are inflated relative to their net realizable values Activity 17–3 Common-Size Statements Dell Computer Corp and Apple Computer Co Dell Computer For Year Ended Feb 1, 2002 Sales (net) Cost of goods sold Gross profit Operating expenses: Selling, general, and administrative Research and development Special charges Total operating expenses Operating income 100.00% 82.33 17.67% 8.93% 1.45 1.55 11.93% 5.74% Apple Computer For Year Ended Sept 29, 2001 100.00% 76.97 23.03% 21.22% 8.02 0.21 29.44% (6.41%) The common size analysis indicates that Dell and Apple are very different computer companies Dell's income from operations is 5.74% of sales, while Apple's was a –6.41% of sales There is over a 12 percentage point difference between the two companies What explains this difference? The gross profit for Dell was 17.67% of sales, which is fairly narrow Apple, in contrast, had a gross profit of 23.03% of sales, which is over points better than Dell's This suggests Apple is able to charge higher prices than Dell for its products (assuming that they are both equally efficient in making products) Apple's selling, general, and administrative expenses are at about 21.22% of sales, while Dell's is only 8.93% of sales Dell designed the business for efficiency, thus it operates on a low cost structure The selling, general, and administrative expenses not include expensive advertising campaigns, complex sales channel administration, or complex product support activities Apple, in contrast, has very large selling, general, and administrative costs as a percent of sales It attempts to sell a unique machine to a unique audience This requires significant SG&A effort Another big difference between the two companies is in research and development Dell's R&D is a narrow 1.45% of sales, while Apple's is a robust 8.02% of sales Essentially, Dell focuses its R&D effort on the final assembly of the computer Dell relies on its suppliers to develop innovation in the components and operating system software (Microsoft) Apple, on the other hand, must constantly spend R&D on computers, peripherals, and its own operating system software This is because Apple chooses not to follow the industry standards and thus must pave its own way on both hardware and software This feature of Apple also contributes to its larger selling, general, and administrative costs as a percent of sales The higher gross profit as a percent of sales is not enough to offset the higher SG&A and R&D costs as a percent of sales Thus, Apple ends up with a negative income from operations as a percent of sales Activity 17–4 a Rate earned on total assets: 2002: ($980) = –0.35% $285,882 2001: ($5,453) = –1.95% $279,967 2000: $3,467 = 1.25% $277,305 Net income Average total assets b Rate earned on total stockholders’ equity: 2002: ($980) = –14.65% $6,688 2001: ($5,453) = –41.32% $13,198 2000: $3,467 = 15.00% $23,107 c Earnings per share: Net income Average total stockholders' equity Net income − Preferred dividends Common shares outstanding 2002: ($980) − $15 = ($0.55) 1,819 2001: ($5,453) − $15 = ($3.00) 1,820 2000: $3,467 − $15 = $2.33 1,483 Activity 17–4 Continued d Dividend yield: Dividend per share of common stock Market price per share of common stock 2002: $0.40 = 2.95% $13.57 2001: $1.05 = 4.92% $21.32 2000: $1.80 = 7.47% $24.10 e Price-earnings ratio: Market price per share of common stock Earnings per share of common stock 2002: $13.57 = undefined ($0.55) 2001: $21.32 = undefined ($3.00) 2000: $24.10 = 10.34 $2.33 Ratio of average liabilities to average stockholders’ equity = Average liabilities ÷ Average stockholders’ equity 2002: $285,882 − $6,688 = 41.75 (or 4,175% of stockholders’ equity) $6,688 Activity 17–4 Concluded Ford’s leverage is the result of its financing arm The nature of financial institutions is to acquire debt money at a low interest rate and lend it out at a higher interest rate This is inherently a low risk business that allows financial institutions to acquire extensive debt resources with very little equity Banks acquire deposits (debt) in this manner Thus, financial institutions often have equity less than 10% of total assets Ford’s financing business skews the ratio of liabilities to stockholders’ equity so that it does not appear like a normal manufacturer Ford’s profitability plummeted from 2000 levels as the recession in 2001 arrived The rate earned on total assets and rate earned on stockholders’ equity fell dramatically As a result of this huge drop in business fortunes, Ford had to systematically cut the dividend, which reduced the dividend yield, even though the stock price was dropping The price-earnings (P/E) ratio is interesting In 2000, the P/E ratio was a very low 10.34 Thus, Ford had excellent earnings, but the market did not reward the company with a high stock price In 2001 and 2002, Ford had net losses, causing the P/E ratio to become undefined because the earnings per share was negative Shareholders know from history that Ford is a cyclical business When the economy is going well, the market price will not bid up the stock price with the earnings, causing the P/E ratio to be depressed In a sense, stockholders know it is only a matter of time before fortunes reverse When the economy moves into recession, the stock price drops, but not as dramatically as the profitability That is, the stock price cannot become negative (or zero) Again, stockholders know it is only a matter of time before economic fortunes reverse back up Activity 17–5 The following is an example of a solution A student’s actual solution will depend on the year of analysis Activity 17–6 a Rate earned on total assets: Marriott: Hilton: Net income Average total assets $236 = 2.72% $8,673 $176 = 1.96% $8,963 b Rate earned on total stockholders’ equity: Marriott: Hilton: c Net income Average total stockholders' equity $236 = 7.00% $3,373 $176 = 10.27 % $1,713 Number of Income before income tax expense + Interest expense times interest Interest expense charges are earned: Marriott: Hilton: $370 + $109 = 4.39 $109 $306 + $237 = 2.29 $237 d Ratio of liabilities to stockholders’ equity: Marriott: Hilton: $5,629 = 1.62 $3,478 $7,498 = 4.57 $1,642 Total liabilities Total stockholders' equity Activity 17–6 Concluded Summary Table: Marriott Hilton Rate earned on total assets 2.72% 1.96% Rate earned on stockholders’ equity 7.00% 10.27% Number of times interest charges are earned 4.39 2.29 Ratio of liabilities to stockholders’ equity 1.62 4.57 Marriott earns a higher rate earned on total assets (2.72% vs 1.96%), but a lower rate on stockholders’ equity (7.00% vs 10.27%), compared to Hilton The reason can be seen with the leverage formula Marriott has less leverage than does Hilton This is confirmed by the ratio of liabilities to stockholders’ equity, which shows the relative debt held by Marriott is 1.62 times the stockholders’ equity, compared to 4.57 times for Hilton Can Hilton manage this much debt? The number of times interest charges are earned shows that Marriott covers its interest charges 4.39 times The comparable ratio for Hilton is 2.29 Hilton’s operating income (before interest and taxes) is over twice its interest charges, which is marginal, but sufficient Hilton’s debt capacity is near a maximum In sum, Hilton earns a higher return for stockholders, but with greater risk ... did not change much between the two years, the overall mix of revenue sources did change somewhat The event-related revenues (such as concessions) declined as a percent of total revenues by three... 2001 $141,315 122 ,172 77,936 34,537 $375,960 37.6% 32.5 20.7 9.2 100.0% $136,362 133,289 67,488 38,111 $375,250 36.3% 35.5 18.0 10.2 100.0% $ 69,297 61, 217 87,427 57,235 $275 ,176 $100,784 18.4%... customers who have not made purchases from Sears, which represent receivables that no correspond to Sears’ sales Thus, it is not surprising that Sears has a much lower turnover than does Federated,