CHAPTER 5
USING FINANCIAL STATEMENT INFORMATION
BRIEF EXERCISE
BE5–1
Coke Pepsi
(a) ROE = Net Income/Average Stockholders Equity 33.6% 33.3%
ROA = (Net Income +[Interest Expense (1-Tax Rate)])/
Average Total Assets 17.3% 15.1% Common Equity Leverage = Net Income/(Net Income +
[Interest Expense(1-Tax Rate)]) 96.9% 96.9% Capital Structure Leverage = Average Total Assets/
Average Stockholders Equity    2.00    2.28 Return on Sales = Net Income + [Interest Expense
(1- Tax Rate)]/Net Sales 21.3%  13.7% Asset Turnover = Sales/Average Total Assets    .81    1.11
Coke and Pepsi return similar percentages on equity, but Coke is slightly better at generating a return from assets. Leverage is similar with Pepsi showing higher relative debt levels, according to the Capital Structure Leverage ratio.  Coke shows a large advantage on its margin on converting sales into profits, but Pepsi generates more sales from each dollar of assets.
(b) ROA x Common Equity Leverage x Capital Structure Leverage  =  ROE
Coke:    .173  x  ..969  x  2.00  =  .335 (rounding)
Pepsi:  .151  x    .969 x    2.28  =  .334 (rounding)
(c) Profit Margin x Asset Turnover    =  ROA
Coke: .213  x  .81  =  .173
Pepsi: .137  x 1.11  =  .152 (rounding)
(d) Coke has only a slight edge in ROE, but its ROA is over two points higher than that of Pepsi.
The advantage in ROA is driven by the much higher profit margin (21.3% versus 13.7%) of Coke.  Coke is better at converting sales into profits.
1
EXERCISES
E5–1
margin rateProfitability Ratios:
Return on Equity  =  Net Income  ÷  Average Stockholders’ Equity
2002:  $1,893  ÷  27,888    =  .068
2003:  $3,578  ÷  28,342.5    =  .126
Return on Sales  =  (Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Net Sales 2002:  ($1,893  + [0 x (1 - .29)])    ÷  $18,915    =  .100
2003:  ($3,578  + [0 x (1 - .29)])        ÷  $18,878  =      .190
Solvency Ratios:
Current Ratio  =  Current Assets  ÷  Current Liabilities
2002:  $  17,433  ÷  $  8,375  =    2.08
2003:  $  13,415  ÷      $  8,294  =    1.62
Leverage Ratios:
Capital Structure Leverage Ratio  =  Average Total Assets  ÷  Average Total Stockholders’ Equity
2002:  $36,516.5  ÷  $27,888  =  1.31
2003:  $37,451  ÷  $28,342.5 =  1.32
Overall, by examining the above computed ratios, it appears that Cisco would be a good investment. Profitability increased substantially from 2002 to 2003, while leverage remained constant.  The only ratio that would be somewhat negative is the decrease in solvency, but the current ratio is still adequate.
2
E5–2
Profitability Ratios:
Return on Equity  =  Net Income  ÷  Average Stockholders’ Equity
2002:  $3,117 ÷ 35,649 = .087
2003:  $5,641 ÷ 36,657 = .154
Return on Sales  =  (Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Net Sales  2002: ($3,117 + [194 x (1 - .24)])  ÷  $26,764  =  .122
2003: ($5,641 + [192 x (1 - .24)])  ÷  $30,141  =  .192
Solvency Ratios:
Current Ratio  =  Current Assets  ÷  Current Liabilities
2002: $18,925  ÷ $6,595 =    2.87
2003: $22,882  ÷ $6,879 =    3.33
Leverage Ratios:
Capital Structure Leverage Ratio  =  Average Total Assets  ÷  Average Total Stockholders’ Equity
2002:  $44,309.5  ÷ $35,649 =      1.24
2003:  $45,683.5      ÷ $36,657 =      1.25
Overall, by examining the above computed ratios, it appears that Intel would be a good  investment. The ROE and Return on Sales have increased from 2002 to 2003, as has solvency.  Leverage has remained low.
E5–3
Based on the information provided by Ginny’s Fashions, we can compute the following ratios:
1.Return on Equity  =  Net Income  ÷  Average Stockholders’ Equity
2005: $17,000  ÷ $31,000 = .548
2006: $18,000  ÷ $35,500 = .507
2.Return on Sales  =  (Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Net Sales
2005: $17,000 + [2000 (1 - .3)]  ÷  $70,000  =  .263
2006: $18,000 + [2000 (1 - .3)]  ÷  $74,000  =  .262
3
E5–3 Concluded
3.Current Ratio  =  Current Assets  ÷  Current Liabilities
2005: $14,000  ÷ $7,000 =    2.0
2006: $21,000  ÷ $9,000 =    2.33
4.Debt/Equity Ratio  =  Total Liabilities  ÷  Total Stockholders’ Equity
2005: $33,000  ÷ $31,000 =    1.065
2006: $33,000  ÷ $40,000 = .825
Generally, a lot more information is available to a bank loan officer to decide upon a long-term loan.
However, given the limited information, I would support only a short-term loan rather than a long-term loan. The return on equity has declined while the return on sales has remained stable, indicating that the company is not making any gains in its profitability. The current ratio is encouraging, indicating the company’s short-term solvency is not in question. In terms of cash flows, the company’s cash flow from operating activities is positive but declining considerably. It seems it is financing its asset base partly from long-term loans and partly from its own operations. Overall, as a bank loan officer, my bank’s interest will be safely protected if I approve only a short-term loan and not a long-term loan.
E5–4
a.
Profitability Ratios:
Return on Equity = Net Income ÷ Average Stockholders' Equity
= $16,500 ÷ [($29,000 + $36,500) ÷ 2]
= .504
Return on Assets  = (Net Income + [Interest Expense (1–Tax Rate)]) ÷ Average Total Assets = ($16,500 + [$5,000 x (1- .34)]) ÷ [($81,000 + $99,000) ÷ 2]
= .22
Earnings per Share = Net Income ÷ Average Number of Common Shares Outstanding
= $16,500 ÷ [(2,000 shares + 2,000 shares) ÷ 2]
= $8.25
Return on Sales  = (Net Income  + [Interest Expense (1 – Tax Rate)])÷ Net Sales
= ($16,500 + [$5,000 x (1 - .34)]) ÷ $72,000
= .275
Interest Coverage = (Net Income Before Taxes and Interest Expense) ÷ Interest Expense                            =    $30,000 ÷ $5,000
=      6.00
4
E5–4 Continued
Solvency Ratios:
Current Ratio = Current Assets ÷ Current Liabilities
= ($9,000 + $12,000 + $18,000) ÷ $16,500
=    2.36
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) ÷ Current Liabilities = ($9,000 + $12,000) ÷ $16,500
=    1.27
Activity Ratios:
Receivables Turnover = Net Credit Sales ÷ Average Accounts Receivable
= $72,000 ÷ [($9,000 + $12,000) ÷ 2]
=    6.86
Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
= $30,000 ÷ [($15,000 + $18,000) ÷ 2]
=    1.82
Capitalization Ratios:
Financial Leverage = Return on Equity – Return on Assets
= .504 – .22
= .284
Debt/Equity = Total Liabilities ÷ Total Stockholders' Equity
= ($16,500 + $46,000) ÷ ($20,000 + $5,000 + $11,500)
=    1.71
Market Ratios:
Price/Earnings Ratio  = Market Price per Share ÷ Earnings per Share
= $36 ÷ $8.25
=    4.36
Dividend Yield = Dividends per Share ÷ Market Price per Share
= ($9,000 ÷ 2,000 shares) ÷ $36
= .125
Return on Investment = (Market Price1 – Market Price0 + Dividends per Share) ÷
Market Price0
= ($36 – $30 + $4.50) ÷ $30
= .35
5

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