Fundamentals of Financial ManagementX

68 Part 2 Fundamental Concepts in Financial Management

Balance Sheet 3.3 THE BALANCE SHEET

A statement of the The balance sheet represents a “snapshot” of the firm’s position at a specific
firm’s financial position point in time. Figure 3-1 provides a simple illustration of a typical balance sheet.
at a specific point in The left side of the statement shows the assets that the company owns. The right
time. side shows the firm’s liabilities and equity, which represent claims against the
assets.

As Figure 3-1 indicates, assets are divided into two major categories: current
and long term. Current assets include cash plus other items that should be con-
verted to cash within one year, and they include cash and equivalents, accounts
receivable, and inventory.2 Long-term assets are those whose useful lives exceed
one year, and they include physical assets such as plant and equipment and
intellectual property such as patents and copyrights. Plant and equipment is
generally reported net of accumulated depreciation. Allied’s long-term assets
consist entirely of net plant and equipment, and we often refer to them as “net
fixed assets” for convenience.

The claims against assets are of two types—liabilities (or money the com-
pany owes creditors) and stockholders’ equity, which represents ownership

F I G U R E 3 - 1 A Typical Balance Sheet

Total Assets Total Liabilities and
Equity
Current Assets
Cash and equivalents Current Liabilities
Accounts receivable Accrued wages and taxes
Inventory Accounts payable
Notes payable
Long-Term (Fixed)
Assets Long-Term
Debt
Net plant and equipment
Other long-term assets

Stockholders’ Equity
Common stock
Retained earnings

Net Working Capital = Current Assets – Current Liabilities

2 Allied and most other companies hold some cash in bank checking accounts, and they also hold
short-term, interest-bearing securities that can be sold and thus converted to cash immediately with
a simple telephone call. Those securities are reported as “cash equivalents” and are included with
checking account balances for financial reporting purposes. If a company has other marketable secu-
rities, they will be shown as “Marketable securities” in the Current Assets section if they mature in
less than a year; otherwise, they will be shown in the Long-Term Assets section.

Chapter 3 Financial Statements, Cash Flow, and Taxes 69

much like a homeowner’s equity, which is the value of the house less the Retained Earnings
amount of any outstanding mortgage loan. Corporate liabilities are further That portion of the
divided into two major categories: current liabilities and long-term debt. Current firm’s earnings that has
liabilities are obligations that are due to be paid off within a year, and they been saved rather than
include accounts payable, accruals (the total of accrued wages and accrued paid out as dividends.
taxes), and notes payable that are due within one year. Long-term debt includes
long-term loans and bonds that have maturities longer than a year. Common Equity
(Net Worth)
Allied’s stockholders’ equity section is divided into two accounts—“com- The capital supplied by
mon stock” and “retained earnings.” The amount shown as common stock is, common stockholders:
essentially, the amount of cash that stockholders paid to the company when it common stock, paid-in
originally issued stock for use in acquiring assets. The retained earnings account capital, retained earn-
is built up over time as the firm “saves” a part of its earnings rather than paying ings, and, occasionally,
them all out as dividends. The breakdown of the stockholders’ equity accounts certain reserves.
is important for some purposes but not for others. For example, a potential
stockholder might want to know whether the company actually earned the Net Working Capital
funds reported in its equity account or whether they came mainly from selling Defined as current
stock. A potential creditor, on the other hand, would be primarily interested in assets minus current
the total equity provided by the firm’s owners and not with its source. We gen- liabilities. It is a fre-
erally aggregate the two stockholders’ equity accounts and call this sum com- quently used measure
mon equity, or net worth. of liquidity.

Notice that the balance sheet items are listed in order of their “liquidity,” or
the length of time it takes to convert them to cash (current assets) or their
expected useful lives (fixed assets). Similarly, the claims are listed in the order in
which they must be paid: Accounts payable must generally be paid within 30
days, notes payable within 90 days, and so on, down to the stockholders’ equity
accounts, which represent ownership and need never be “paid off.” A firm needs
enough cash and other liquid assets to pay its bills as they come due, so its
lenders, suppliers, and bond rating agencies keep an eye on its liquidity. Net
working capital, which is defined as current assets minus current liabilities, is a
frequently used measure of liquidity.

Table 3-1 shows Allied’s year-end balance sheets for 2005 and 2004. From the
2005 statement we see that it had $2 billion of assets—half current and half long
term. The $2 billion of assets were financed by $310 million of current liabilities,
$750 million of long-term debt, and $940 million of common equity represented
by 50 million shares outstanding. Its 2005 net working capital was $690 million
(the $1 billion of current assets less the $310 million of current liabilities). Com-
paring the balance sheets for 2005 and 2004, we see that Allied’s assets grew by
$320 million, or slightly more than 19 percent.

Several additional points about the balance sheet are worth noting:

1. Cash and equivalents versus other assets. Although the assets are all stated in
dollar terms, only the cash and equivalents account represents actual spend-
able money. Accounts receivable represent credit sales that have not yet been
collected. Inventories show the investment in raw materials, work-in-
process, and finished goods. Finally, net plant and equipment reflects the
amount Allied paid for its fixed assets, less accumulated depreciation. Allied
has $10 million of cash and equivalents, hence it can write checks totaling
that amount (versus current liabilities of $310 million due within a year). The
noncash assets should generate cash over time, but they do not represent
cash in hand, and the cash they would bring if they were sold today could be
higher or lower than their values as reported on the balance sheet.

2. Inventory accounting. Allied uses the FIFO (first-in, first-out) method to deter-
mine the inventory value shown on its balance sheet ($615 million), but it
could have used LIFO (last-in, first-out) or an average cost method. During a
period of rising prices, by assuming that old, low-cost inventory is sold first
and new, high-cost items are kept in stock, FIFO results in a relatively high

70 Part 2 Fundamental Concepts in Financial Management

TABLE 3-1 Allied Food Products: December 31 Balance Sheets
(Millions of Dollars)

Assets 2005 2004
Cash and equivalents
Accounts receivable $ 10 $ 80
Inventories 375 315
Total current assets 615 415
Net plant and equipment
Total assets $1,000 $ 810
1,000 870
Liabilities and Equity
Accounts payable $2,000 $1,680
Notes payable
Accruals $ 60 $ 30
Total current liabilities 110 60
Long-term bonds 140
130
Total debt $ 310 $ 220
Common stock (50,000,000 shares) 750
Retained earnings 580
Total common equity $1,060 $ 800
Total liabilities and equity 130
810 130
750
$ 940 $ 880
$2,000 $1,680

Book value per share ϭ $940/50 ϭ $18.80

Notes:
1. The bonds have a sinking fund requirement of $20 million a year. Sinking funds are discussed in

Chapter 7, but in brief, a sinking fund is used to help ensure the repayment of long-term debt.
Thus, Allied was required to pay off $20 million of its mortgage bonds during 2005. We include
the current portion of the long-term debt in notes payable, but in a more detailed balance sheet
it would be shown as a separate item under current liabilities.
2. Also, note that a relatively few firms use preferred stock, which we discuss in Chapter 9. Pre-
ferred can take several different forms, but it is generally like debt in the sense that it pays a
fixed amount each year. However, it is like common stock in the sense that a failure to pay the
preferred dividend does not expose the firm to bankruptcy. If a firm does use preferred, it is
shown on the balance sheet between Total debt and Common stock. There is no set rule on
how preferred should be treated when financial ratios are calculated—it could be considered as
debt or as equity—but as long as one is consistent in the treatment, either choice is appropriate.

balance sheet inventory value, a low cost of goods sold on the income state-
ment, and thus relatively high reported profits. (This is strictly accounting;
companies actually use older items first.) Allied uses FIFO, and because
inflation is present, (a) its balance sheet inventories are higher than they
would have been had it used LIFO, (b) its cost of goods sold is lower than it
would have been under LIFO, and (c) its reported profits are higher. In
Allied’s case, if the company had used LIFO in 2005, its balance sheet figure
for inventories would have been $585 million rather than $615 million, and
its earnings (which will be discussed in the next section) would have been
reduced by $18 million. Thus, the inventory valuation method can have a
significant effect on financial statements. This is important when an analyst
is comparing different companies, and the method used must be reported in
the notes to the financial statements.
3. Other sources of funds. Most companies (including Allied) finance their assets
with a combination of current liabilities, long-term debt, and common

Chapter 3 Financial Statements, Cash Flow, and Taxes 71

equity. As we noted earlier, some companies also use hybrid (combination)
securities such as preferred stock, convertible bonds, and long-term leases.
Preferred stock is a hybrid between common stock and debt, while convert-
ible bonds are debt securities that give the bondholder an option to exchange
bonds for shares of common stock. In the event of bankruptcy, preferred
stock ranks below debt but above common stock. When a firm has issued
preferred stock, its total equity includes common equity plus preferred stock.
Most firms do not use any preferred stock, and those that do generally do
not use much of it. Therefore, when we use the term “equity,” we mean
“common equity” unless otherwise noted.
4. Depreciation methods. Most companies prepare two sets of financial state-
ments—one for tax purposes and one for stockholder reporting. Generally,
they use the most accelerated depreciation method permitted under the law
for tax purposes but straight line for stockholder reporting. Accelerated
depreciation results in high depreciation charges, thus low taxable income
and therefore relatively low taxes, whereas straight-line depreciation results
in lower depreciation charges and high reported profits.3 Thus, accelerated
depreciation results in lower taxes in the current year while straight line
results in relatively high reported profits. However, Allied is a relatively con-
servative company, and it uses accelerated depreciation for both stockholder
reporting and tax purposes. Had Allied elected to use straight-line deprecia-
tion for stockholder reporting, its 2005 depreciation expense would have
been $25 million less, so the $1 billion shown for “net plant” on its balance
sheet would have been $25 million higher. More importantly, its reported net
income also would have been higher.
5. Market values versus book values. Companies use generally accepted account-
ing principles (GAAP) to determine the values reported on their balance
sheets. In most cases, these accounting numbers (often referred to as book
values) are different from the corresponding market values. For example,
Allied purchased its headquarters building in Chicago in 1979. Under GAAP,
the company must report the value of this asset at its historical cost (what it
originally paid for the asset in 1979) less accumulated depreciation. Given
that Chicago real estate prices have increased over the past 25 years, the cur-
rent market value of the building is much higher than its book value. Other
assets might also differ substantially from their values as based on historical
costs.

The book and market values of liabilities are normally fairly close to one
another, but this is not always true. When a company issues long-term debt,
the balance sheet reflects its par value. As we demonstrate in Chapter 7, if
interest rates change after debt was issued, its market value will be different
from its book value.

Finally, the book value of the company’s common equity is simply the
reported book value of the assets minus the book value of the liabilities.
Looking at Table 3-1, we see that the book value of Allied’s common equity
was $940 million in 2005. Because there were 50 million shares outstanding,
the book value per share was $18.80. By contrast, the market value of the
company’s common stock is its current price, $23, multiplied by the number
of shares outstanding, or $23 ϫ 50 ϭ $1,150 million. As is true for most com-
panies in 2006, shareholders are willing to pay more than book value for the
firm’s stock in part because the values of its fixed assets have increased due

3 Depreciation charges over an asset’s life are equal to the asset’s cost basis. Accelerated depreciation
results in relatively high depreciation in the early years, hence low taxes, then lower depreciation
and higher taxes later in the asset’s life. This is advantageous due to the time value of money.

72 Part 2 Fundamental Concepts in Financial Management

Income Statement to inflation and in part because shareholders expect the company’s future
earnings to grow. Allied, like most other companies, has learned how to
A report summarizing make investments that are expected to add to future profits. Apple Com-
the firm’s revenues and puter provides an excellent example of this “growth opportunity” phenome-
expenses during an non. When Apple first introduced the iPod, its balance sheet showed very lit-
accounting period, tle value for this product, but investors recognized that it was a great
generally a quarter or a product and would lead to high profits in spite of its low book value. They
year. then bid Apple’s stock up well above its book value.
6. The time dimension. The balance sheet may be thought of as a snapshot of the
firm’s financial position at a point in time—for example, on December 31,
2005. Thus, we see that on December 31, 2004, Allied had $80 million of cash
and equivalents, but that balance fell to $10 million by year-end 2005. The
balance sheet changes every day as inventories are increased or decreased, as
fixed assets are added or retired, as bank loans are increased or decreased,
and so on. Companies whose business is seasonal experience especially large
balance sheet changes over the year. For example, Allied’s inventories are
low just before the harvest season, but they are high just after the fall crops
have been harvested and processed. Similarly, most retailers have large
inventories just before Christmas but low inventories and high accounts
receivable just after Christmas. Therefore, firms’ balance sheets change dur-
ing the year, depending on the date at which the statement is constructed.

What is the balance sheet, and what information does it provide?

How is the order of the items shown on the balance sheet
determined?

A company has $2 million of cash and equivalents, $2 million of
inventory, $3 million of accounts receivable, $3 million of accounts
payable, $1 million of accruals, and $2 million of notes payable.
What is its net working capital? ($1 million)

Why might Allied’s December 31 balance sheet differ from its June
30 statement?

3.4 THE INCOME STATEMENT

Table 3-2 gives Allied’s 2005 and 2004 income statements. Net sales are shown
at the top of the statement, after which operating costs, interest, and taxes are
subtracted to obtain the net income available to common shareholders, which is
generally referred to as “net income.” Earnings and dividends per share are given
at the bottom of the income statement. Earnings per share (EPS) is called “the
bottom line,” denoting that of all the items on the income statement, EPS is gen-
erally the most important to stockholders. Allied earned $2.35 per share in 2005,
down from $2.44 in 2004, but it still increased the dividend from $1.06 to $1.15.4

Note that different firms have different financial structures, different tax sit-
uations, and different amounts of nonoperating assets. These differences can
cause two companies with similar operations to report different levels of net
income. For example, suppose two companies have identical operations—their
sales, operating costs, and assets are identical. However, one finances with debt

4 Companies must report “comprehensive income” as well as net income. Comprehensive income is
equal to net income adjusted to include several additional items, such as unrealized gains or losses
on marketable securities, classified as available for sale, when they are marked-to-market. For our
purposes in this introductory text, we assume that there are no such items.

Chapter 3 Financial Statements, Cash Flow, and Taxes 73

TABLE 3-2 Allied Food Products: Income Statements for Years
Ending December 31 (Millions of Dollars, Except for
Per-Share Data)

Net sales 2005 2004
Operating costs except depreciationa
Earnings before interest, taxes, and depreciation $3,000.0 $2,850.0
2,616.2 2,497.0
(EBITDA)b
Depreciation $ 383.8 $ 353.0
Earnings before interest and taxes (EBIT) 100.0 90.0
Less interest
Earnings before taxes (EBT) $ 283.8 $ 263.0
Taxes 88.0 60.0
Net income
Common dividends $ 195.8 $ 203.0
Addition to retained earnings 78.3 81.2

Per-share data: $ 117.5 $ 121.8
Common stock price $ 57.5 $ 53.0
Earnings per share (EPS)c $ 60.0 $ 68.8
Dividends per share (DPS)c
Book value per share (BVPS)c $ 23.00 $ 26.00
Cash flow per share (CFPS)c $ 2.35 $ 2.44
$ 1.15 $ 1.06
$ 18.80 $ 17.60
$ 4.35 $ 4.24

Notes:
a Operating costs include lease payments of $28 million.
b Allied has no amortization charges.
c Allied has 50 million shares of common stock outstanding. Note that EPS is based on net

income available to common stockholders. Calculations of EPS, DPS, BVPS, and CFPS for 2005

are as follows:

Earnings per share ϭ EPS ϭ Net income ϭ $117,500,000 ϭ $2.35
Common shares outstanding 50,000,000

Dividends per share ϭ DPS ϭ Dividends paid to common stockholders ϭ $57,500,000 ϭ $1.15
Common shares outstanding 50,000,000

Book value per share ϭ BVPS ϭ Total common equity ϭ $940,000,000 ϭ $18.80
Common shares outstanding 50,000,000

Cash flow per share ϭ CFPS ϭ Net income ϩ Depreciation ϩ Amortization ϭ $217,500,000 ϭ $4.35
Common shares outstanding 50,000,000

If a firm has options or convertibles outstanding, or if it recently issued new common stock,
then EPS calculations become a bit more complicated. See any financial accounting text for a
discussion.

and the other uses only common equity. Despite the fact their operating per-
formances are identical, the company with no debt (and therefore no interest
expense) would report higher net income because no interest is deducted from
its operating income. Consequently, if you want to compare companies’ operat-
ing performances, it is essential to focus on their earnings before deducting taxes
and interest payments. This is called earnings before interest and taxes (EBIT), and
it is often referred to as operating income:

EBIT ϭ Sales revenues Ϫ Operating costs (3-1)

From Allied’s income statement, we see that its operating income increased from
$263.0 million in 2004 to $283.8 million in 2005, yet the company’s 2005 net

74 Part 2 Fundamental Concepts in Financial Management

Depreciation income declined. This discrepancy occurred because Allied increased its debt in
The charge to reflect 2005, and the increased interest expense reduced its net income despite its
the cost of assets used higher operating income.
up in the production
process. Depreciation Taking a closer look at the income statement, we see that depreciation and
is not a cash outlay. amortization are important components of operating costs.5 Recall from account-
ing that depreciation is an annual charge against income that reflects the esti-
Tangible Assets mated dollar cost of the capital equipment and other tangible assets that were
Physical assets such as used up in the production process. Amortization amounts to the same thing,
plant and equipment. except represents the decline in value of intangible assets such as patents, copy-
rights, trademarks, and goodwill. Because they are so similar, depreciation and
Amortization amortization are generally lumped together for purposes of financial analysis on
A noncash charge the income statement and for other purposes. They both write off, or allocate,
similar to depreciation the costs of assets over their useful lives.
except that it is used
to write off the costs of Even though depreciation and amortization are reported as costs on the
intangible assets. income statements, they are not cash expenses—cash was spent in the past,
when the assets being written off were acquired, but no cash is paid out to cover
Intangible Assets depreciation. Therefore, managers, security analysts, and bank loan officers who
Assets such as patents, are concerned with the amount of cash a company is generating often calculate
copyrights, trademarks, EBITDA, defined as earnings before interest, taxes, depreciation, and amortiza-
and goodwill. tion. Allied has no amortization charges, so the depreciation and amortization
on the income statement shown in Table 3-2 is all depreciation. In 2005, EBITDA
EBITDA was $383.8 million. Subtracting the $100 million of depreciation from EBITDA
Earnings before left the company with $283.8 million of operating income (EBIT). After subtract-
interest, taxes, ing $88 million in interest and $78.3 million in taxes, Allied had $117.5 million in
depreciation, and net income.
amortization.
While the balance sheet can be thought of as a snapshot in time, the income
statement reports on operations over a period of time, for example, during the cal-
endar year 2005. Allied’s 2005 sales were $3 billion, and its net income was
$117.5 million. Income statements can cover any period of time, but most com-
panies prepare them monthly, quarterly, and annually. The quarterly and annual
statements are released to investors, while the monthly statements are used
internally for planning and control purposes, comparing actual results with fore-
casted (or “budgeted”) results. If revenues drop below or costs rise above the
forecasted levels, management should find out why and take corrective steps
before the problem becomes serious.

What is an income statement, and what information does it provide?

Why is earnings per share called “the bottom line”?

Differentiate between amortization and depreciation.

What are EBIT, operating income, and EBITDA?

Which is like a snapshot of the firm’s operations—the balance sheet
or the income statement—and which is more like a movie? Explain.

5 Industrial companies like Allied generally have few intangible assets, hence little if any amortiza-
tion. High-tech companies like Microsoft, which spend billions developing new products, and media
companies, when they produce movies like The Aviator, do have sizable intangible assets, hence
amortization is important for them. Actually, life would be simpler, and financial statements just as
informative, if the accountants just applied the term “depreciation” to the periodic write-off of all
assets, tangible and intangible alike. But until they change, we must continue using both terms.

We should note that prior to 2002 amortization was very important for companies that engaged
in mergers. If a company pays more than book value when it acquires another firm, the excess is
called “goodwill.” Prior to 2002, firms were required to amortize goodwill, and the annual amortiza-
tion charge reduced reported income by a like amount. After 2002, GAAP no longer required that
goodwill be amortized, and that greatly reduced amortization charges for companies in general.

Chapter 3 Financial Statements, Cash Flow, and Taxes 75

3.5 NET CASH FLOW Net Cash Flow
The actual net cash, as
As we discussed in Chapter 1, management’s goal should be to maximize the stock opposed to accounting
price. Because the value of any asset, including a share of stock, depends on the profit (net income), that
cash flows the asset is expected to produce, this means that managers should strive a firm generates during
to maximize the cash flows available to investors over the long run. A business’s a specified period.
net cash flow differs from its accounting profit because some of the revenues
and expenses listed on the income statement are not paid in cash during the year. Accounting Profit
A firm’s net income as
Allied and many other companies have zero noncash revenues, and deprecia- reported on its income
tion and amortization are the only noncash charges.6 Under these conditions, the statement.
relationship between net cash flow and net income can be expressed as follows:

Net cash flow ϭ Net income ϩ Depreciation and amortization (3-2)

We can illustrate Equation 3-2 with Allied’s 2005 data from Table 3-2:

Net cash flow ϭ $117.5 ϩ $100.0 ϭ $217.5 million

Depreciation is an important source of cash for Allied and most other compa-
nies, and it is important that you understand its financial implications. We
discuss depreciation in more depth in Chapter 12, but for a quick illustration,
suppose a machine with a life of five years and a zero salvage value was pur-
chased in 2005 for $100,000 and placed in service in 2006. The $100,000 purchase
price was paid in cash in 2005, but it does not show up as an expense in 2005;
rather, a portion of it is charged as a cost of production over each year of the
machine’s life. If the $100,000 were taken as an expense in 2005, then profits in
that year would be understated, but profits in each of the following five years
would be overstated. So, under accrual accounting rules an annual depreciation
charge is deducted from sales revenues when determining income in 2006
through 2010. However, the $100,000 cost of the machine was actually paid in
cash in 2005, and the depreciation charged against income from 2006 through
2010 does not involve a cash payment. Because depreciation is a noncash charge, it
must be added back to net income to obtain net cash flow. If we assume that all other
noncash items sum to zero, Equation 3-2 will hold and net cash flows are equal
to net income plus depreciation and amortization.

How do we estimate net cash flow, and how does it differ from
accounting profit?

In accounting, the emphasis is on net income. In finance, the pri-
mary emphasis is on cash flow. Why is this so?

3.6 STATEMENT OF CASH FLOWS

Its net cash flow represents the cash a business generates in a given year. How-
ever, the fact that a company generates a high cash flow does not necessarily
mean that the cash reported on its balance sheet is also high. Cash flow is not

6 Allied and most other companies have little if any noncash revenues, but this item can be impor-
tant for construction companies that work on multiyear projects, report income on a percentage of
completion basis, and then are paid only after the project is completed. Also, if a company has a
substantial amount of deferred taxes, which means that taxes actually paid are less than that
reported in the income statement, then this amount could also be added to net income when esti-
mating the net cash flow. Other adjustments could also be made, but a discussion of these details
would go beyond the scope of this text and is best left for advanced finance and accounting courses.

76 Part 2 Fundamental Concepts in Financial Management

Statement of Cash normally used just to build up the cash account. Rather, it is used in a variety of
ways, including paying dividends, increasing inventories, financing accounts
Flows receivable, investing in fixed assets, retiring debt, and buying back common stock.

A statement reporting Here is a quick summary to the key factors that affect a company’s cash
the impact of a firm’s balance:
operating, investing,
and financing activities 1. Cash flow. Other things held constant, a positive net cash flow leads to more
on cash flows over an cash in the bank. However, other things are generally not held constant, and
accounting period. cash flow is used for other things.

2. Changes in working capital. Increases in working capital (inventories and
receivables) are paid for with cash, so such increases decrease cash. On the
other hand, decreases in working capital increase cash. For example, if
inventories are to increase, the firm must use cash to purchase the addi-
tional inventory, whereas if inventories decrease, this generally means the
firm is selling inventories and not replacing them, hence generating cash.
Similarly, increases in current liabilities such as accounts payable increase
cash, whereas decreases in payables reduce it. This occurs because, if
payables increase, the firm has received additional credit from its suppliers,
which saves cash, while if payables decrease, the firm has used cash to pay
its suppliers.

3. Fixed assets. If a company invests in fixed assets, its cash position is reduced,
whereas if it sells fixed assets, this increases cash.

4. Security transactions and dividend payments. If a company issues stock or
bonds during the year, the funds raised will enhance its cash position. On
the other hand, if it uses cash to pay off outstanding debt, to buy back some
of its stock, or to pay dividends to shareholders, this will reduce cash.

Each of these factors is reflected in the statement of cash flows, which sum-
marizes the changes in a company’s cash position. The statement separates
activities into three categories:

1. Operating activities, which include net income, depreciation, and changes in
working capital other than cash and short-term debt.

2. Investing activities, which include purchases or sales of fixed assets.
3. Financing activities, which include raising cash by issuing short-term debt,

long-term debt, or stock, or using cash to pay dividends or to buy back out-
standing stock or bonds.

Accounting texts explain how to prepare the statement of cash flows; how-
ever, in finance we’re concerned with questions the statement can answer: Is the
firm generating enough cash to acquire the assets needed to support its growth?
Is it generating any extra cash that can be used to repay debt or to invest in new
products? Will internally generated cash be sufficient, or will the company have
to issue more common stock? This type of information is useful for both man-
agers and investors, so the statement of cash flows is an important instrument.
This statement, along with the cash budget, is used to help forecast a company’s
cash position.

Table 3-3 shows Allied’s statement of cash flows as it would appear in the
company’s annual report. The top section is most important, as it shows the cash
flows that were generated by and used in operations. Allied’s operations lost
cash flow—it was minus $2.5 million. This indicates that the company, in the nor-
mal course of business, was running a cash deficit. Its day-to-day operations
brought in $257.5 million, but the increase in receivables and inventories more
than offset this inflow, resulting in a negative $2.5 million cash flow from opera-
tions. Successful companies have large, positive cash flows from operations, as
this is what gives them value. Allied clearly had an operating problem in 2005.

Chapter 3 Financial Statements, Cash Flow, and Taxes 77

TABLE 3-3 Allied Food Products: Statement of Cash Flows
for 2005 (Millions of Dollars)

2005

I. OPERATING ACTIVITIES $117.5
Net Income before dividends
Additions (Sources of Cash) 100.0
Depreciation and amortizationa 30.0
Increase in accounts payable 10.0
Increase in accruals
Subtractions (Uses of Cash) (60.0)
Increase in accounts receivable (200.0)
Increase in inventories ($ 2.5)

Net cash provided by operating activities ($230.0)

II. LONG-TERM INVESTING ACTIVITIES $ 50.0
Cash used to acquire fixed assetsb 170.0
(57.5)
III. FINANCING ACTIVITIES
Increase in notes payable $162.5
Increase in bonds ($ 70.0)
Payment of dividends
80.0
Net cash provided by financing activities $ 10.0
Net decrease in cash and equivalents
Cash and equivalents at beginning of the year

IV. CASH AND EQUIVALENTS AT END OF THE YEAR

Notes:
a Depreciation and amortization are noncash charges, so they must be added back to net income

to show the actual cash flow from operations.
b The net increase in fixed assets was $130 million, but this is a net amount after deducting the

year’s depreciation expense. Depreciation must be added to the $130 million to show the actual
amount spent to purchase fixed assets. From the income statement, we see that the 2005 depre-
ciation expense was $100 million, so we show expenditures on fixed assets as $230 million.

The second section shows Allied’s long-term investing activities. The com-
pany purchased fixed assets totaling $230 million; this was the only long-term
investment it made during 2005.

When we add the results of Sections I and II, we see that Allied had a cash
deficit of $232.5 million in 2005. How was that deficit financed? This information
is provided in Section III, Financing Activities. Here we see that Allied borrowed
from banks (notes payable) and issued new bonds to bring in a total of $220
million, but it paid out $57.5 million in dividends to its stockholders, resulting in
a net inflow of $162.5 million from financing activities.

Allied’s deficit from operations and investment activities totaled $232.5
million, and it raised a net $162.5 million from financing activities, leaving a net
deficit of $70 million. How was this $70 million shortfall covered? It was covered
by drawing down the cash and equivalents account. The company started the
year with $80 million of cash and cash equivalents (marketable securities),
ended the year with only $10 million, hence used $70 million of its initial cash
holdings to cover its operating deficit and fixed assets investments.

Allied’s statement of cash flows should worry its managers and investors. It
was able to cover the operating deficit and the investments by heavy borrowing
and by drawing down its stockpile of cash and equivalents, but that obviously
can’t continue on into the future. In the long run, Section I should show good

78 Part 2 Fundamental Concepts in Financial Management

Massaging the Cash
Flow Statement

Profits as reported on the income statement can be If Allied Foods, in Table 3-3, had done this, the
“massaged” by changes in depreciation methods, $60 million increase in receivables, which is correctly
inventory valuation procedures, and so on, but “cash shown as a use of cash, would have been shifted to
is cash,” so management can’t mess with the cash the “Financing Activities” section, causing Allied’s cash
flow statement, right? Nope—wrong. A recent article provided by operations to rise from Ϫ$2.5 million to
in The Wall Street Journal described how Ford, Gen- ϩ$57.5 million. That would have made Allied look
eral Motors, and several other companies overstated better to investors and credit analysts, but it would
their operating cash flows, the most interesting sec- have been just smoke, mirrors, and accounting.
tion of the cash flow statement. Indeed, GM
reported more than twice as much cash from opera- GM’s treatment was uncovered by Professor
tions as it really had, $7.6 billion versus a true $3.5 Charles Mulford of Georgia Tech. The SEC then sent
billion. When GM sold cars to a dealer on credit, it GM a letter that basically required GM to change its
created an account receivable, which should be procedures. The company issued a statement that it
shown in the “Operating Activities” section as a use thought at the time it was acting in accordance with
of cash. However, GM classified these receivables as GAAP, but that it would reclassify its accounts in the
loans to dealers and reported them as a financing future. GM’s action was certainly not in the league of
activity. That decision more than doubled the WorldCom’s or Enron’s, but it does show that compa-
reported cash flow from operations. It didn’t effect nies sometimes do things to make their statements
the end-of-year cash, but it made operations look look better than they really are.
stronger than they really were.
Source: Diya Gullapalli, “Little Campus Lab Shakes Big
Firms,” The Wall Street Journal, March 1, 2005, p. C3.

Statement of operating cash flows; Section II should show spending on fixed assets that is
about equal to depreciation charges (to replace worn out fixed assets) plus a bit
Retained Earnings more to support growth; and Section III should show relatively little net borrow-
ing along with a “reasonable” amount of dividends (for an average company,
A statement reporting dividends amount to about 50 percent of net income). Finally, Section IV should
how much of the firm’s show a reasonably stable cash and equivalents balance from year to year. These
earnings were retained conditions obviously do not hold for Allied, so something should be done to
in the business rather right the ship. We will go into this more deeply in Chapter 4, when we move on
than paid as dividends. to a more detailed financial analysis of the financial statements.
The balance sheet
number reported for What is the statement of cash flows, and what are some questions it
retained earnings is the is designed to answer?
sum of the annual
retained earnings for If a company has high cash flows, does this mean that its cash and
each year of the firm’s equivalents will also be high? Explain.
history.
Identify and briefly explain the three types of activities shown in the
statement of cash flows.

3.7 STATEMENT OF RETAINED EARNINGS

The change in retained earnings between balance sheet dates is reported in the
statement of retained earnings. Table 3-4 shows that Allied earned $117.5 mil-
lion during 2005, paid out $57.5 million in common dividends, and plowed $60

Chapter 3 Financial Statements, Cash Flow, and Taxes 79

TABLE 3-4 Allied Food Products: Statement of Retained Earnings
for Year Ending December 31, 2005 (Millions of Dollars)

2005

Balance of Retained Earnings, December 31, 2004 $750.0
Add: Net Income, 2005 117.5
Less: Dividends to common stockholders (57.5)a

Balance of Retained Earnings, December 31, 2005 $810.0

Note:
a Here, and throughout the book, parentheses are sometimes used to denote negative numbers.

million back into the business. Thus, the balance sheet item “Retained earnings”
increased from $750 million at year-end 2004 to $810 million at year-end 2005.

Note that “retained earnings” represents a claim against assets, not assets per se.
Moreover, firms retain earnings for reinvestment in the business, which means
investing in plant and equipment, in inventories, and so on, not to pile up cash
in a bank account. Changes in retained earnings occur because common stock-
holders allow management to reinvest funds that otherwise could be distributed
as dividends. Thus, the retained earnings account reported on the balance sheet does
not represent cash and is not “available” for dividends or anything else.7

What is the statement of retained earnings, and what information
does it provide?

Why do changes in retained earnings occur?

Explain why the following statement is true: “The retained earnings
account reported on the balance sheet does not represent cash and is
not ‘available’ for dividend payments or anything else.”

3.8 USES AND LIMITATIONS OF
FINANCIAL STATEMENTS

The financial statements provide investors with a lot of useful information. You
can look through the statements and answer a number of important questions
such as these: How large is the company? Is it growing? Is it making or losing
money? Does it have a high percentage of current assets versus fixed assets? To
what extent does the firm use debt or equity to finance its assets? Does it rely
more on short-term or long-term debt? Has it issued any new debt or equity in
recent years? Has it made significant capital expenditures in recent years? Does
it have a lot of cash on hand or is a shortage looming, and has the cash balance
been rising or falling over time?

7 The amount reported in the retained earnings account is not an indication of the cash the firm has.
Cash (as of the balance sheet date) is found in the cash account, an asset account. A positive number
in the retained earnings account indicates only that the firm has in the past earned some income
and not paid out all of those earnings as dividends. Even though a company reports record
earnings and shows an increase in retained earnings, it still may be short of cash.

The same situation holds for individuals. You might own a new BMW (no loan), lots of clothes,
and an expensive stereo, hence have a high net worth, but if you had only 23 cents in your pocket
plus $5 in your checking account, you would still be short of cash.

80 Part 2 Fundamental Concepts in Financial Management

Financial Analysis
on the Internet

A wide range of valuable financial information is will also find links to the company’s financial state-
available on the Internet. With just a couple of clicks, ments and key ratios (under Financial Results), as
an investor can find the key financial statements for well as other information including analyst ratings,
most publicly traded companies. historical charts, earnings estimates, and a summary
of insider transactions. Both MSN Money and Yahoo!
Suppose you are considering the purchase of Finance allow you to export the financial state-
Disney stock, and you want to analyze its recent per- ments and historical prices to an Excel spreadsheet.
formance. Here’s a partial (but by no means a com- • Other sources for up-to-date market information are
plete) list of places you could go to get started: money.cnn.com and www.marketwatch.com/
news/. These sites also have areas where you can
• One source is Yahoo!’s finance Web site, finance obtain stock quotes along with company finan-
.yahoo.com.a Here you will find updated market cials, links to Wall Street research and SEC filings,
information along with links to a variety of inter- company profiles, and charts of the firm’s stock
esting research sites. Enter a stock’s ticker symbol, price plotted over time.
click on Go, and you will see the stock’s current • After accumulating all of this information, you may
price, along with recent news about the company. be looking for sites that provide opinions regard-
Click on Key Statistics and you will find a report ing the direction of the overall market and views
on the company’s key financial ratios. Links to the regarding the individual stock. Two popular sites
company’s financials (income statement, balance in this category are The Motley Fool’s Web site,
sheet, and statement of cash flows) can also be www.fool.com, and the site for TheStreet.com,
found. The Yahoo! site also has a list of insider www.thestreet.com.
transactions, so you can tell if a company’s CEO
and other key insiders are buying or selling the Keep in mind that this list is just a small subset
company’s stock. In addition, there is a message of the information available online. You should also
board where investors share opinions about the realize that sites come and go, and also change their
company, and there is a link to the company’s fil- content over time. New and interesting sites are con-
ings with the Securities and Exchange Commis- stantly being added to the Internet.
sion (SEC). Note also that, in most cases, a more
complete listing of SEC filings can be found at a To avoid redundancy, we have intentionally left off http://
www.sec.gov or at www.edgar-online.com. in all Web addresses given here. A quick way to change an
address is to highlight the portion of the address that is dif-
• Another Web site with similar information is MSN ferent and type in the appropriate letters of the new
Money (moneycentral.msn.com). After clicking the address. Once you’re finished just press Enter.
Investing and Stocks tabs, you enter the stock’s
ticker symbol. Then, you will see the current stock
price and a list of recent news stories. Here you

At the same time, investors need to be cautious when they review financial
statements. While companies are required to follow GAAP, managers still have
quite a lot of discretion in deciding how and when to report certain transac-
tions—see the box in Section 3.6 on GM’s treatment of accounts receivable from
its dealers. Consequently, two firms in exactly the same operating situation may
report financial statements that convey different impressions about their finan-
cial strength. Some variations may stem from legitimate differences of opinion
about the correct way to record transactions. In other cases, managers may
choose to report numbers in a way that helps them present either higher earn-
ings or more stable earnings over time. As long as they follow GAAP, such
actions are not illegal, but these differences make it harder for investors to com-
pare companies and gauge their true performances.

Unfortunately, as we noted in Chapter 1, there have also been cases where
managers overstepped the bounds and reported fraudulent statements. Indeed,

Chapter 3 Financial Statements, Cash Flow, and Taxes 81

a number of high-profile executives have faced criminal charges because of their
misleading accounting practices. For example, in June 2002 it was discovered
that WorldCom (now called MCI) had committed the most massive accounting
fraud of all time by recording more than $11 billion of ordinary operating costs
as capital expenditures, thus overstating net income by the same amount.

WorldCom’s published financial statements fooled most investors—investors
bid the stock price up to $64.50, and banks and other lenders provided the com-
pany with more than $30 billion of loans. Arthur Andersen, the firm’s auditor,
was faulted for not detecting the fraud. Their defense was that WorldCom’s
management had lied. WorldCom’s CFO pleaded guilty and was sentenced to 5
years in prison, while its CEO was sentenced to 25 years in prison. In the wake
of this and other recent accounting scandals, regulators and accounting profes-
sionals are issuing new standards to make financial statements more transparent
for investors and to create an environment where managers have strong incen-
tives to report truthful numbers.

Also, keep in mind that even if investors are provided with accurate
accounting data, it is really cash flow, not accounting income, that matters. Simi-
larly, when managers decide on which projects to accept, their focus should be
on cash flow. Therefore, when it comes to effective decision making, managers
and investors generally need to modify even the most accurate and transparent
financial statements to determine the relevant cash flows. We discuss this in the
next section.

Can an investor have complete confidence that the financial state-
ments of different companies are accurate and that the data reported
by one company are truly comparable to the data provided by
another?

Why might different companies account for similar transactions in
different ways?

3.9 MODIFYING ACCOUNTING DATA
FOR INVESTOR AND MANAGERIAL
DECISIONS

Thus far in the chapter we have focused on financial statements as they are
prepared by accountants and presented in the annual report. However, these
statements are designed more for use by creditors and tax collectors than for
managers and stock analysts. Therefore, certain modifications are helpful for
corporate decision-making and stock valuation purposes.

Recall from Chapter 1 that the firm’s primary financial objective is to maxi-
mize shareholder value. Investors provide companies with capital, and man-
agers create value for shareholders by investing this capital in productive assets.
In the following sections we discuss how financial managers and analysts use
accounting data to measure and evaluate corporate performance.

Operating Assets and Operating Capital

Companies raise funds from a variety of sources. The primary source is
investors, including stockholders, bondholders, and lenders such as banks.
Investors must be paid for the use of their money, with payment coming as
interest for bonds and other debt and as dividends plus capital gains for stock.

82 Part 2 Fundamental Concepts in Financial Management

Net Operating So, if a company obtains more assets than it actually needs, it will have raised
Working Capital too much capital and thus have unnecessarily high capital costs.
(NOWC)
Operating working Not all of the capital used to acquire assets is provided by investors—some of
capital less accounts the funds normally come from suppliers and are reported as accounts payable,
payable and accruals. It while other funds as reported on the balance sheet come as accrued wages and
is the working capital accrued taxes, which amount to short-term loans from workers and tax authori-
acquired with investor- ties. Generally, both accounts payable and accruals are “free” because no explicit
supplied funds. fee is charged for their use. These funds are commonly referred to as sponta-
neously generated, non-interest-bearing current liabilities. They are called “sponta-
neous” because they are generated spontaneously through normal business oper-
ations, not by a specific act such as going to a bank and borrowing money.

When evaluating a company’s overall position and value, analysts often
focus on net operating working capital (NOWC), defined as follows:8

Net operating All current assets All non-interest-

working ϭ NOWC ϭ required in Ϫ bearing current (3-3)

capital operations liabilities

Allied’s net operating working capital for 2005 was

All current All non-interest-

NOWC ϭ assets required Ϫ bearing

in operations current liabilities

ϭ a Cash and cash ϩ Accounts ϩ Inventories b Ϫ a Accounts ϩ Accruals b
equivalents receivable payable

ϭ A$10 ϩ $375 ϩ $615B Ϫ A$60 ϩ $140B
ϭ $800 million

For 2004, Allied’s net operating working capital (NOWC) was

Net operating working capital ϭ A$80 ϩ $315 ϩ $415B Ϫ A$30 ϩ $130B
ϭ $650 million

Thus, Allied’s NOWC increased by $150 million during 2005.
Working capital is important for several reasons. First, all companies must

carry some cash to “grease the wheels” of their operations. They continuously
receive checks from customers and write checks to suppliers, employees, and so
on. Because inflows and outflows do not coincide perfectly, firms must keep
some cash (and cash equivalents) in their bank accounts to conduct operations
without periodic disruptions. The same is true for most other current assets,
such as inventory and accounts receivable.

Allied and most other companies try to hold only as much cash and mar-
ketable securities as is required under normal operations—they don’t try to
operate like a bank and hold excess amounts of these assets. However, in some

8 Allied and many other companies have essentially zero nonoperating assets, but a number of com-
panies do have significant amounts of nonoperating assets, often held as marketable securities, and
report them on their balance sheets. Therefore, finance professionals typically differentiate operating
from nonoperating assets and use the term NOWC as we do.

Chapter 3 Financial Statements, Cash Flow, and Taxes 83

instances companies do accumulate more cash and marketable securities than
are needed in operations. Perhaps these funds are on hand because the firm just
sold a large bond issue and has not yet deployed the funds, or perhaps it is sav-
ing up funds for a specific purpose such as a merger or a major capital invest-
ment program. In these situations, the excess cash and marketable securities
should not be viewed as part of operating working capital—it is nonoperating
capital and is analyzed separately.

Also, as noted, accounts payable and accruals arise in the normal course of
operations, and each dollar of these current liabilities is a dollar that the com-
pany does not have to raise from investors to fund its current assets. Therefore,
we deduct these current liabilities from the operating current assets when calcu-
lating net operating working capital. However, those current liabilities that
charge interest, such as notes payable to banks, are investor-supplied capital,
and are not deducted when we calculate NOWC.

We see, then, that a company’s assets can be divided into two groups, operat-
ing assets (or operating capital) and nonoperating assets (or nonoperating capital).
Operating capital includes those current and net fixed assets that are necessary
to operate the business, while nonoperating assets include items like land held
for future use, stock in other companies, and marketable securities in excess of
those held for liquidity purposes.9 Moreover, firm’s holdings of nonoperating
assets are always based on unique, special conditions, and decisions regarding
them are similarly unique. Typically, the vast majority of assets are operating as
opposed to nonoperating, and the firm’s value is based on the cash flows that
those operating assets provide. Therefore, our focus in the book is on operating,
not on nonoperating, assets.

Companies typically use a combination of investor-supplied capital and non-
interest-bearing, spontaneous current liabilities to finance their required operating
assets. For example, when Allied opens a new plant, it needs to acquire fixed
assets (land, building, and equipment) and current assets (inventory and receiv-
ables). However, the suppliers who ship materials to Allied generally expect to
be paid 30 or so days later, so accounts payable, which are non-interest-bearing
current liabilities, help finance the new operations. Accrued wages and taxes
similarly reduce the amount of funds Allied’s investors must provide to acquire
the new operating assets. The amount of operating capital supplied by Allied’s
investors over the years, through December 31, 2005, is found as follows:

Total operating capital, ϭ Net operating ϩ Net fixed (3-4)
2005 working capital assets

ϭ $800 ϩ $1,000

ϭ $1,800 million

In the prior year, 2004, Allied’s total operating capital was

Total operating capital, 2004 ϭ $650 ϩ $870

ϭ $1,520 million

Therefore, Allied’s operating capital increased from $1,520 to $1,800 million
during 2005, or by $280 million.

9 To value a firm, analysts typically use the techniques we describe in the text to value the firm’s
operations and then add to that value the value of the nonoperating assets. To keep things simple,
we illustrate concepts with Allied Foods, which has only operating assets.

84 Part 2 Fundamental Concepts in Financial Management

Operating Cash Flows

Financial managers create value by obtaining funds and investing them in oper-
ating assets, and the cash flow generated through operations determines the
firm’s value. These cash flows are found as follows:

Depreciation and (3-5)
Operating cash flow ϭ EBIT(1 Ϫ Tax rate) ϩ amortization

Net Operating Profit Recall that EBIT is the firm’s operating income—it is what remains after sub-
After Taxes (NOPAT) tracting from sales all operating costs, including depreciation and amortization,
The profit a company but before subtracting taxes and interest. Investors are interested in after-tax
would generate if it cash flows, which are found by multiplying EBIT by one minus the tax rate. We
had no debt and held add back depreciation and amortization when calculating the cash flow because
only operating assets. they are noncash expenses.

Free Cash Flow EBIT(1 Ϫ Tax rate) is often referred to as NOPAT, or net operating profit
The cash flow actually after taxes, and it is the profit a company would generate if it had no debt and
available for distribu- held only operating assets.10 Thus, we can rewrite Equation 3-5 as follows:
tion to all investors
(stockholders and Operating cash flow ϭ NOPAT ϩ Depreciation and amortization (3-5a)
debtholders) after the
company has made all Using data from the income statement in Table 3-2, Allied’s 2005 NOPAT was
the investments in
fixed assets, new prod- NOPAT ϭ $283.8(1 Ϫ 0.4) ϭ $283.8(0.6) ϭ $170.3 million
ucts, and working capi-
tal necessary to sustain Because depreciation was the only noncash charge, Allied’s 2005 operating cash
ongoing operations. flow was

Operating cash flow ϭ NOPAT ϩ Depreciation and amortization
ϭ $170.3 ϩ $100
ϭ $270.3 million

Free Cash Flow

Earlier in the chapter we defined net cash flow as being equal to net income plus
noncash adjustments, typically net income plus depreciation. Note, though, that
cash flows cannot be maintained over time unless depreciating fixed assets are
replaced, and new products must also be developed. Therefore, management is
not completely free to use the available cash flow however it pleases. Therefore,
we now define another term, free cash flow, which is the cash flow actually avail-
able for payments to investors (stockholders and debtholders) after the company has
made the investments in fixed assets, new products, and working capital required to sus-
tain ongoing operations.

To be more specific, the value of a company’s operations depends on its
expected future free cash flows (FCF), defined as after-tax operating profit minus
the investments in working capital and fixed assets necessary to sustain the
business. Thus, free cash flow represents the cash that is actually available for
payments to investors. Therefore, managers make their companies more valu-
able by increasing their free cash flow.

10 For large, complex firms complications can arise. For additional information see Tim Koller, Marc
Goedhart, and David Wessels, Valuation: Measuring and Managing the Value of Companies, 4th edition
(New York: John Wiley & Sons, 2005); and G. Bennett Stewart III, The Quest for Value, 2nd edition
(New York: HarperCollins Publishers, 1999).

Chapter 3 Financial Statements, Cash Flow, and Taxes 85

The following equation can be used to calculate free cash flow:11

⌬ Net
FCF ϭ cEBIT(1 Ϫ T) ϩ andDeapmreocrtiaiztaiotinond Ϫ ≥expCeanpditiatul res ϩ owpoerrkaitningg¥

capital

ϭ Operating cash flow Ϫ Investment in operating capital

In 2005 Allied’s EBIT was $283.8 million, and its depreciation and amortization
was $100 million. Its fixed assets increased by $130 million after $100 million of
depreciation, so its capital expenditures must have been $230 million. Finally, its
net operating working capital (current assets less spontaneous current liabilities)
rose by $150 million. Therefore, its free cash flow was Ϫ$109.7 million:

FCF ϭ Operating cash flow Ϫ Investment in operating capital (3-6)

ϭ [$283.8(1 Ϫ 0.4) ϩ $100] Ϫ ($230 ϩ $150)

ϭ $270.3 Ϫ $380

ϭ Ϫ$109.7 million

Even though Allied’s operating cash flow was positive, its very high invest-
ment in operating capital resulted in a negative free cash flow. Because free cash
flow is what is available for distribution to investors, not only was there nothing
for investors, but investors actually had to put in more money to keep the busi-
ness going. Investors provided most of the needed funds as debt.

Is a negative free cash flow always bad? The answer is, Not necessarily; it
depends on why the free cash flow was negative. If FCF was negative because
NOPAT was negative, this is definitely bad, and it suggests that the company is
experiencing operating problems. However, many high-growth companies have
positive NOPAT but negative free cash flow because they must invest heavily in
operating assets to support rapid growth. There is nothing wrong with a nega-
tive cash flow if it results from profitable growth.

What is net operating working capital?

What is total operating capital?

What is NOPAT?

What is free cash flow? Why is free cash flow the most important
determinant of a firm’s value?

A company has NOPAT of $30 million, and its depreciation and
amortization expense is $10 million. During the year the company’s
gross capital expenditures (total purchases of fixed assets) were $20
million and its net operating working capital increased by $10
million. What is the company’s operating cash flow? ($40 million)
What is its free cash flow? ($10 million)

11 In the finance literature, free cash flow is defined in two ways: (1) cash flow available to both
stockholders and bondholders and (2) cash flow available to stockholders, that is, after interest pay-
ments. The first definition, which we prefer and incorporate into Equation 3-6, is the one most ana-
lysts use. FCF as found with Equation 3-6 can be discounted at the weighted average cost of capital
(WACC) to find the value of the firm, whereas FCF after interest must be discounted at the cost of
common stock to find the firm’s value. This distinction is discussed at length in advanced finance
courses, but the choice does not matter so long as the correct discount rate is used with each.

86 Part 2 Fundamental Concepts in Financial Management

3.10 MVA AND EVA

Market Value Added Assets as reported on the financial statements reflect historical, in-the-past, values,
(MVA) not current market values, and there are often substantial differences between the
The excess of the mar- two. Inflation results in differences, as do successful and unsuccessful operations.
ket value of equity For example, it cost Microsoft very little to develop its first operating system,
over its book value. but that system turned out to be worth many billions that were not shown on its
balance sheet. Of course, balance sheets must balance, so if the assets side of the
Economic Value statement totals to less than the market value of the firm’s assets, then so will
Added (EVA) the liabilities and capital side. Debt values are fixed by contract, so it is the
Excess of NOPAT over equity where the discrepancy between book and market values are concentrated.
capital costs.
To illustrate, consider the following situation. The firm was started with $1
million of assets at book value (historical cost), $500,000 of which was provided by
bondholders, and $500,000 by stockholders (50,000 shares purchased at $10 per
share). However, the firm was very successful, and its assets now produce $2 mil-
lion of free cash flow per year. Investors discount that free cash flow at a 10 per-
cent rate, resulting in a value of $20 million for the firm. After deducting the
$500,000 of debt, the market value of the equity is found to be $19.5 million ver-
sus the $500,000 stockholders invested in the firm. The stock price is $19,500,000/
50,000 ϭ $390 per share, so the firm’s managers have done a marvelous job for
the stockholders.

The accounting statements do not reflect market values, so they are not suf-
ficient for purposes of evaluating managers’ performance. To help fill this void,
financial analysts have developed two additional performance measures, the
first of which is MVA, or Market Value Added.12 MVA is simply the difference
between the market value of a firm’s equity and the book value as shown on the
balance sheet, with market value found by multiplying the stock price by the
number of shares outstanding. For our hypothetical firm, MVA is $19.5 million
Ϫ $0.5 million ϭ $19 million.

For Allied, which has 50 million shares outstanding and a $23 price, the
market value of the equity is $1,150 million versus a book value as shown on the
balance sheet in Table 3-1 of $940 million. Therefore, Allied’s MVA is $1,150 Ϫ $940
ϭ $210 million. This $210 million represents the difference between the money
Allied’s stockholders have invested in the corporation since its founding—
including retained earnings—versus the cash they could get if they sold the busi-
ness. The higher its MVA, the better the job management is doing for the firm’s
shareholders. Boards of directors often look at MVA when deciding on the com-
pensation a firm’s managers deserve. Note though, that just as all ships rise in a
rising tide, most firms’ stock prices rise in a rising stock market, so a positive
MVA may not be entirely attributable to management.

A related concept, Economic Value Added (EVA), sometimes called “eco-
nomic profit,” is closely related to MVA and is found as follows:

Net operating Annual dollar cost of capital
EVA ϭ profit after taxes Ϫ
(3-7)
1NOPAT 2

Total After-tax

ϭ EBIT 11 Ϫ T2 Ϫ ° investor-supplied ϫ percentage ¢

operating capital cost of capital

12 The concepts of EVA and MVA were developed by Joel Stern and Bennett Stewart, co-founders of
the consulting firm Stern Stewart & Company. Stern Stewart copyrighted the terms “MVA” and
“EVA,” so other consulting firms have given other names to these values. Still, MVA and EVA are the
terms most commonly used in practice. For more on MVA and EVA, see Stewart, The Quest for Value.

Chapter 3 Financial Statements, Cash Flow, and Taxes 87

EVA is an estimate of a business’s true economic profit for a given year, and it A Web site of interest con-
differs sharply from accounting net income primarily in that accounting income cerning federal tax law is
has no deduction for the cost of equity whereas this cost is deducted when cal- http://www.taxsites.com/
culating EVA.
federal.html. From this
If EVA is positive, then after-tax operating income exceeds the cost of the capi- home page one can visit
tal needed to produce that income, and management’s actions are adding value for other sites that provide
stockholders. Positive EVA on a yearly basis will help ensure that MVA is also pos- summaries of recent tax
itive. Note that whereas MVA applies to the entire firm, EVA can be determined legislation or current infor-
for divisions as well as for the company as a whole, so it is useful as a guide to mation on corporate and
“reasonable” compensation for divisional as well as top corporate managers. individual tax rates. The
official government Web
Define the terms “Market Value Added (MVA)” and “Economic site is http://www.irs.gov.
Value Added (EVA).”

How does EVA differ from accounting net income?

3.11 THE FEDERAL INCOME TAX SYSTEM

Corporations must pay out a significant portion of their income as taxes, and indivi-
duals are also taxed on their income. We summarize some important points about
the U.S. tax system here, based on 2004 provisions. A more detailed discussion is
provided in Web Appendix 3A accessed through the ThomsonNOW Web site.

Corporate Taxes

Corporate income is generally taxed by the federal government at rates that
begin at 15 percent and go up to 35 percent on taxable income of $10 million or
more.13 Thus, the corporate tax structure is progressive in the sense that higher
rates are imposed on companies with larger incomes. Most state governments
also impose income taxes on corporations, with 5 percent being a typical rate.
Therefore, larger companies generally pay a rate of about 40 percent on their
income, and we typically use 40 percent in our examples. The tax system is
incredibly complex, so we do not attempt to cover it in detail. However, as noted
above, we do provide a bit more tax information on the ThomsonNOW Web site.

Personal Taxes

Individuals are taxed by the federal government at rates that begin at 10 percent
and rise to 35 percent on incomes of $319,100 or more. Some states also impose a
state income tax, with rates varying across states. Note that income on invest-
ments held in pension accounts is not taxed until the money is withdrawn, pre-
sumably after retirement. Thus, a person might be in the 35 percent tax bracket
on his or her ordinary income, but the tax rate would be zero on income earned
in a 401(k) or other retirement account (and certain college savings plans).

Interest Paid

Borrowers must pay interest on their debts. For a business, the interest payments
are regarded as an expense, and they are deducted when calculating taxable
income. Individuals also incur debts and pay interest, but generally individuals
cannot deduct interest payments (the big exception is interest on home loans,
which, within limits, is deductible).

13 Actually, the marginal corporate tax rate goes up to 38 percent for income between $15,000,000
and $18,333,333; however, it then declines to 35 percent for taxable income above $18,333,333.

88 Part 2 Fundamental Concepts in Financial Management

Interest Earned

Most interest earned, whether by businesses or individuals, is taxable. An
important exception is that interest on most state and local government debt is
exempt from federal taxes. State and local bonds are often called “munis,” and
they are generally purchased by individuals in high tax brackets.

Dividends Paid

Corporations pay dividends, and dividends paid are generally not a deductible
expense. Thus, corporations can deduct interest paid but they cannot deduct
dividends. Thus, if a company had a combined federal-plus-state tax rate of 40
percent and $10 million of pre-tax cash income, it could pay out all $10 million
as interest but only $6 million of dividends because it would have to pay $4
million of taxes.14

Note that if one company uses a lot of debt financing, whereas another with
similar operations uses only common stock financing, the stock-financed com-
pany will have no interest, hence no interest tax deductions, hence a higher
income tax bill. The company that uses debt can thus pass more of its operating
income on to investors (stockholders and debtholders). For this reason, our tax
system encourages debt financing, as we discuss at length in the chapter on cap-
ital structure.

Dividends Received

Dividends received by an individual are taxed at the same tax rate as capital
gains, 15 percent.15 Note that this creates a double tax on dividend income—the
corporation that paid the dividend is first taxed, and then the individual who
receives it is taxed again. For corporate recipients, the situation is somewhat dif-
ferent—the corporation that receives dividend income can exclude some of the
dividends from its taxable income. This provision is in the Tax Code to minimize
the amount of triple taxation that would otherwise occur—one corporation
would pay dividends out of after-tax income, the second corporation would be
taxed again on that income, and the person who received dividends from the
second corporation would be taxed once more.

Tax Loss Carry-Back and Carry-Forward

Corporation income often fluctuates from year to year, so a firm might be taxed
at a 40 percent rate one year and then have a large loss the following year, hence
pay no taxes. The Tax Code allows firms to carry losses back to offset profits in
prior years, and, if losses haven’t been offset by past profits, to carry the remain-
ing losses forward to offset future profits. The effect of this provision is to cause
taxes to reflect average income over time.

Capital Gains

Capital gains are, generally speaking, defined as profits from the sale of assets
that are not normally bought and sold in the course of business. For individuals,
capital gains typically arise from the sale of stocks or bonds at a profit. Thus, if
someone buys some Microsoft stock for $10,000 and later sells it for $15,000, then
he or she will have a $5,000 capital gain. If the stock was held for less than a

14 This calculation is not exact, because the tax bill on $10 million of income would actually be
somewhat lower ($3.4 million) because some of the income would be taxed at lower rates.
15 If an individual is in the 10 percent tax bracket, the applicable tax rate is only 5 percent.

Chapter 3 Financial Statements, Cash Flow, and Taxes 89

year, the $5,000 gain is just added to ordinary income and taxed as such. If the
stock had been held for more than a year, then the gain will be taxed at a lower
rate. For someone in the top (35 percent) federal tax bracket, the long-term capi-
tal gains rate is generally 15 percent. Corporations face somewhat different rules,
and individual tax rates also vary a bit.

Depreciation

When a business buys an asset with a life greater than one year, it depreciates
the asset over the years in which it will be used. For stockholder reporting, the
company generally estimates the actual likely years of use, divides the cost by
the number of years, and charges the calculated value as a cost on the income
statement each year. (This is called “straight-line depreciation.”) However, for
tax purposes Congress has specified different depreciation rates for different
types of assets, and those rates generally result in higher depreciation charges
than what the company uses for stockholder reporting. We discuss depreciation
in greater detail in Chapter 12.

Small Businesses

If a business is a proprietorship or partnership, its income is allocated to its
owners in proportion to their ownership interests. If the same business is oper-
ated as a corporation, there are two possibilities. First, if the firm meets certain
requirements related to size and number of stockholders, then it can elect to be
taxed as an S corporation. In this case, for tax purposes it is treated like a part-
nership. An S corporation can thus enjoy the advantages of the corporate form
of organization yet still receive the tax advantages of a partnership. Most small
business corporations are actually set up as S corporations. If the firm does not
qualify for S corporation status, it is called a C corporation and is taxed at regu-
lar corporate tax rates.

Explain the statement, “Our tax rates are progressive.”

What is a “muni” bond, and how are these bonds taxed?

What are long-term capital gains?

How does our tax system influence the use of debt financing by
corporations?

Differentiate between S and C corporations.

Tying It All Together

The primary purposes of this chapter were to describe the basic financial
statements, to present some background information on cash flows, to dif-
ferentiate between net cash flow and accounting income, and to provide an
overview of the federal income tax system. In the next chapter, we build on
this information to analyze a firm’s financial statements.

90 Part 2 Fundamental Concepts in Financial Management

SELF-TEST QUESTIONS AND PROBLEMS
(Solutions Appear in Appendix A)

ST-1 Key terms Define each of the following terms:
ST-2
a. Annual report; balance sheet; income statement; statement of cash flows; statement
of retained earnings

b. Common stockholders’ equity, or net worth; retained earnings; net working
capital

c. Depreciation; tangible assets; amortization; intangible assets; EBITDA
d. Net cash flow; accounting profit
e. Operating assets; nonoperating assets
f. Total operating capital; net operating working capital
g. Net operating profit after taxes (NOPAT); operating cash flow; free cash flow
h. Market Value Added (MVA); Economic Value Added (EVA)
i. Progressive tax
j. Capital gain
k. S corporation; C corporation

Net income and cash flow Last year Rattner Robotics had $5 million in operating
income (EBIT). Its depreciation expense was $1 million; its interest expense was $1
million; and its corporate tax rate was 40 percent. At year-end it had $14 million in
current assets, $4 million in non-interest-bearing current liabilities, and $15 million in
net plant and equipment. Assume that Rattner’s only noncash item was depreciation.

a. What was the company’s net income?
b. What was its net cash flow?
c. What was its net operating profit after taxes (NOPAT)?
d. What was its operating cash flow?
e. What was its net operating working capital (NOWC)?
f. If operating capital at the end of the previous year was $24 million, what was the

company’s free cash flow (FCF) for the year?
g. If the firm had $4.5 million in retained earnings at the beginning of the year and

paid out a total dividend of $1.2 million, what was its retained earnings at the end
of the year?

QUESTIONS

3-1 What four financial statements are contained in most annual reports?

3-2 What do the numbers on financial statements actually represent?

3-3 Who are some of the basic users of financial statements, and how do they use them?

3-4 If a “typical” firm reports $20 million of retained earnings on its balance sheet, could
its directors declare a $20 million cash dividend without any qualms whatsoever?

3-5 Explain the following statement: “While the balance sheet can be thought of as a
snapshot of the firm’s financial position at a point in time, the income statement
reports on operations over a period of time.”

3-6 Financial statements are based on generally accepted accounting principles (GAAP)
and audited by CPA firms, so do investors need to worry about the validity of those
statements?

3-7 Differentiate between accounting profit and net cash flow. Why do those two numbers
differ?

3-8 Differentiate between operating cash flow and net cash flow. Why might those two
numbers differ?

Chapter 3 Financial Statements, Cash Flow, and Taxes 91

3-9 What’s the difference between NOPAT and net income? How does debt affect the rela-
3-10 tionship between these two items?
3-11
What is free cash flow? If you were an investor, why might you be more interested in
3-12 free cash flow than net income?
3-13
Would it be possible for a company to report negative free cash flow and still be highly
valued by investors; that is, could a negative free cash flow ever be a good thing in the
eyes of investors?

What does double taxation of corporate income mean? Could income ever be subject to triple
taxation?

How does the deductibility of interest and dividends by the paying corporation affect the
choice of financing (that is, the use of debt versus equity)?

PROBLEMS

Easy 3-1 Income statement Little Books Inc. recently reported $3 million of net income. Its EBIT
Problems 1–4 was $6 million, and its tax rate was 40 percent. What was its interest expense? [Hint:
Write out the headings for an income statement and then fill in the known values. Then
Intermediate divide $3 million of net income by (1 Ϫ T) ϭ 0.6 to find the pre-tax income. The differ-
Problems 5–10 ence between EBIT and taxable income must be the interest expense. Use this same pro-
cedure to work some of the other problems.]

3-2 Income statement Pearson Brothers recently reported an EBITDA of $7.5 million and net
income of $1.8 million. It had $2.0 million of interest expense, and its corporate tax rate
was 40 percent. What was its charge for depreciation and amortization?

3-3 Net cash flow Kendall Corners Inc. recently reported net income of $3.1 million and
depreciation of $500,000. What was its net cash flow? Assume it had no amortization
expense.

3-4 Statement of retained earnings In its most recent financial statements, Newhouse Inc.
reported $50 million of net income and $810 million of retained earnings. The previous
retained earnings were $780 million. How much dividends were paid to shareholders
during the year?

3-5 Balance sheet Which of the following actions are most likely to directly increase cash as
shown on a firm’s balance sheet? Explain, and state the assumptions that underlie your
answer.
a. It issues $2 million of new common stock.
b. It buys new plant and equipment at a cost of $3 million.
c. It reports a large loss for the year.
d. It increases the dividends paid on its common stock.

3-6 Statement of retained earnings Computer World Inc. paid out $22.5 million in total
common dividends and reported $278.9 million of retained earnings at year-end. The
prior year’s retained earnings were $212.3 million. What was the net income?

3-7 Statement of cash flows W.C. Cycling had $55,000 in cash at year-end 2004 and $25,000
in cash at year-end 2005. Cash flow from long-term investing activities totaled Ϫ$250,000,
and cash flow from financing activities totaled ϩ$170,000.

a. What was the cash flow from operating activities?
b. If accruals increased by $25,000, receivables and inventories increased by

$100,000, and depreciation and amortization totaled $10,000, what was the firm’s
net income?

3-8 Cash flow The Klaven Corporation had operating income (EBIT) of $750,000 and depre-
ciation expense of $200,000. It is 100 percent equity financed (no debt), and its corporate
tax rate is 40 percent. The firm had no amortization expense. What are net income, net
cash flow, and operating cash flow?

92 Part 2 Fundamental Concepts in Financial Management

3-9 MVA Henderson Industries has $500 million of common equity; its stock price is $60
3-10 per share; and its Market Value Added (MVA) is $130 million. How many common
shares are currently outstanding?

Cash flow Bailey Corporation’s income statement (dollars are in thousands) is
given here:

Sales $14,000,000
Operating costs excluding depreciation
7,000,000
and amortization $ 7,000,000
EBITDA
Depreciation and amortization 3,000,000
EBIT $ 4,000,000
Interest
EBT 1,500,000
Taxes (40%) $ 2,500,000
Net income
1,000,000
$ 1,500,000

Its total operating capital is $20 billion, and its total after-tax dollar cost of operating
capital is $2 billion. During the year, Bailey invested $1.3 billion in net operating
capital.

a. What is its NOPAT?
b. What is its net cash flow?
c. What is its operating cash flow?
d. What is its free cash flow?

Challenging 3-11 Income statement Hermann Industries is forecasting the following income statement:
Problems 11–14
Sales $8,000,000
Operating costs excluding depreciation
4,400,000
and amortization $3,600,000
EBITDA
Depreciation and amortization 800,000
EBIT $2,800,000
Interest
EBT 600,000
Taxes (40%) $2,200,000
Net income
880,000
$1,320,000

The CEO would like to see higher sales and a forecasted net income of $2,500,000.

Assume that operating costs (excluding depreciation and amortization) are 55 percent of
sales, and depreciation and amortization and interest expenses will increase by 10 per-
cent. The tax rate, which is 40 percent, will remain the same. What level of sales would
generate $2,500,000 in net income?

3-12 Financial statements The Davidson Corporation’s balance sheet and income statement
are given here:

Davidson Corporation: Balance Sheet as of December 31, 2005
(Millions of Dollars)

Assets Liabilities and Equity

Cash and equivalents $ 15 Accounts payable $ 120
Accounts receivable 515 Notes payable 220
Inventories 880 Accruals 280

Total current assets $1,410 Total current liabilities $ 620
Net plant and equipment 2,590 Long-term bonds 1,520

Total assets $4,000 Total debt $2,140
Common stock
260
(100 million shares) 1,600
Retained earnings $1,860
$4,000
Common equity
Total liabilities and equity

Chapter 3 Financial Statements, Cash Flow, and Taxes 93

Davidson Corporation: Income Statement for Year Ending December 31, 2005
(Millions of Dollars)

Sales $6,250
Operating costs excluding depreciation and amortization 5,230
EBITDA
Depreciation and amortization $1,020
EBIT 220
Interest
EBT $ 800
Taxes (40%) 180
Net income
Common dividends paid $ 620
Earnings per share 248

$ 372
$ 146
$ 3.72

a. All revenues were received in cash during the year and all costs except depreciation
and amortization were paid in cash during the year. What was net cash flow? How
was it different from reported accounting profit?

b. Construct the statement of retained earnings for December 31, 2005.
c. How much money has been reinvested in the firm over the years?
d. At the present time, how large a check could be written without it bouncing?
e. How much money must be paid to current creditors within the next year?

3-13 Free cash flow Financial information for Powell Panther Corporation is shown here:

Powell Panther Corporation: Income Statements for Year Ending December 31
(Millions of Dollars)

2005 2004

Sales $1,200.0 $1,000.0
Operating costs excluding
1,020.0 850.0
depreciation and amortization $ 180.0 $ 150.0
EBITDA
Depreciation and amortization 30.0 25.0
Earnings before interest and taxes $ 150.0 $ 125.0
Interest
Earnings before taxes 21.7 20.2
Taxes (40%) $ 128.3 $ 104.8
Net income
51.3 41.9
$ 77.0 $ 62.9

Common dividends $ 60.5 $ 46.4

Powell Panther Corporation: Balance Sheets as of December 31
(Millions of Dollars)

2005 2004

Assets $ 12.0 $ 10.0
Cash and equivalents 180.0 150.0
Accounts receivable 180.0 200.0
Inventories
$372.0 $360.0
Total current assets 300.0 250.0
Net plant and equipment
Total assets $672.0 $610.0

Liabilities and Equity $108.0 $ 90.0
Accounts payable 67.0 51.5
Notes payable 72.0 60.0
Accruals
$247.0 $201.5
Total current liabilities 150.0 150.0
Long-term bonds
$397.0 $351.5
Total debt 50.0 50.0
Common stock (50 million shares)
Retained earnings 225.0 208.5
$275.0 $258.5
Common equity
$610.0
Total liabilities and equity $672.0

94 Part 2 Fundamental Concepts in Financial Management

3-14 a. What was the 2005 NOPAT?
b. What were the 2004 and 2005 net operating working capital?
c. What were the 2004 and 2005 total operating capital?
d. What was the 2005 free cash flow?
e. How would you explain the large increase in 2005 dividends?

Income and cash flow analysis The Menendez Corporation expects to have sales of
$12 million in 2006. Costs other than depreciation and amortization are expected to be
75 percent of sales, and depreciation and amortization expenses are expected to
be $1.5 million. All sales revenues will be collected in cash, and costs other than
depreciation and amortization must be paid for during the year. The corporate
tax rate is 40 percent.

a. Set up an income statement. What is the expected net cash flow?
b. Suppose Congress changed the tax laws so that depreciation and amortization

expenses doubled and there were no changes in operations. What would happen to
reported profit and net cash flow?
c. Now suppose that Congress reduced depreciation and amortization expenses by 50
percent. How would profit and net cash flow be affected?
d. Would you prefer that Congress double or halve depreciation and amortization
expenses? Why?
e. Would a doubling of depreciation and amortization expenses possibly have an
adverse effect on stock price and on the ability to borrow money? Explain.

COMPREHENSIVE/SPREADSHEET
PROBLEM

3-15 Financial statements, cash flow, and taxes Laiho Industries’ 2004 and 2005 balance
sheets (in thousands of dollars) are shown below:

2005 2004

Cash $102,850 $ 89,725
Accounts receivable 103,365 85,527
Inventories 38,444 34,982

Total current assets $244,659 $210,234
Net fixed assets 67,165 42,436
Total assets
$311,824 $252,670

Accounts payable $ 30,761 $ 23,109
Accruals 30,477 22,656
Notes payable 16,717 14,217

Total current liabilities $ 77,955 $ 59,982
Long-term debt 76,264 63,914

Total liabilities $154,219 $123,896
Common stock 100,000 90,000
Retained earnings 57,605 38,774

Total common equity $157,605 $128,774
Total liabilities and equity $311,824 $252,670

a. Sales for 2005 were $455,150,000, and EBITDA was 15 percent of sales. Furthermore,
depreciation was 11 percent of net fixed assets, interest was $8,575,000, the corporate
tax rate was 40 percent, and Laiho pays 40 percent of its net income out in divi-
dends. The firm has no amortization expense. Given this information, construct
the 2005 income statement.

b. Construct the statement of retained earnings for the year ending December 31, 2005,
and the 2005 statement of cash flows.

c. Calculate net working capital and net operating working capital. What are the
differences in these two measures?

Chapter 3 Financial Statements, Cash Flow, and Taxes 95

d. Calculate total operating capital, NOPAT, operating cash flow, and free cash
flow for 2005.

e. Calculate the 2005 MVA. There were 10 million shares outstanding and the year-end
closing price was $17.25 per share.

f. If Laiho increased its dividend payout ratio, what effect would this have on its cor-
porate taxes paid? What effect would this have on the taxes paid by the company’s
shareholders?

Integrated Case

D’Leon Inc., Part I

3-16 Financial statements and taxes Donna Jamison, a 2000 graduate of the University of Florida with 4 years of bank-
ing experience, was recently brought in as assistant to the chairman of the board of D’Leon Inc., a small food pro-
ducer that operates in north Florida and whose specialty is high-quality pecan and other nut products sold in the
snack-foods market. D’Leon’s president, Al Watkins, decided in 2004 to undertake a major expansion and to “go
national” in competition with Frito-Lay, Eagle, and other major snack-food companies. Watkins felt that D’Leon’s
products were of a higher quality than the competition’s; that this quality differential would enable it to charge a
premium price; and that the end result would be greatly increased sales, profits, and stock price.

The company doubled its plant capacity, opened new sales offices outside its home territory, and launched an
expensive advertising campaign. D’Leon’s results were not satisfactory, to put it mildly. Its board of directors,
which consisted of its president and vice president plus its major stockholders (who were all local businesspeo-
ple), was most upset when directors learned how the expansion was going. Suppliers were being paid late and
were unhappy, and the bank was complaining about the deteriorating situation and threatening to cut off credit.
As a result, Watkins was informed that changes would have to be made, and quickly, or he would be fired. Also,
at the board’s insistence Donna Jamison was brought in and given the job of assistant to Fred Campo, a retired
banker who was D’Leon’s chairman and largest stockholder. Campo agreed to give up a few of his golfing days
and to help nurse the company back to health, with Jamison’s help.

Jamison began by gathering the financial statements and other data given in Tables IC3-1, IC3-2, IC3-3, and
IC3-4. Assume that you are Jamison’s assistant, and you must help her answer the following questions for
Campo. (Note: We will continue with this case in Chapter 4, and you will feel more comfortable with the analysis
there, but answering these questions will help prepare you for Chapter 4. Provide clear explanations, not just yes
or no answers!)

a. What effect did the expansion have on sales, NOPAT, net operating working capital (NOWC), total operating
capital, and net income?

b. What effect did the company’s expansion have on its net cash flow, operating cash flow, and free cash flow?
c. Looking at D’Leon’s stock price today, would you conclude that the expansion increased or decreased MVA?
d. D’Leon purchases materials on 30-day terms, meaning that it is supposed to pay for purchases within 30

days of receipt. Judging from its 2005 balance sheet, do you think D’Leon pays suppliers on time? Explain. If
not, what problems might this lead to?
e. D’Leon spends money for labor, materials, and fixed assets (depreciation) to make products, and still more
money to sell those products. Then, it makes sales that result in receivables, which eventually result in cash
inflows. Does it appear that D’Leon’s sales price exceeds its costs per unit sold? How does this affect the cash
balance?
f. Suppose D’Leon’s sales manager told the sales staff to start offering 60-day credit terms rather than the 30-
day terms now being offered. D’Leon’s competitors react by offering similar terms, so sales remain constant.
What effect would this have on the cash account? How would the cash account be affected if sales doubled
as a result of the credit policy change?
g. Can you imagine a situation in which the sales price exceeds the cost of producing and selling a unit of out-
put, yet a dramatic increase in sales volume causes the cash balance to decline?
h. Did D’Leon finance its expansion program with internally generated funds (additions to retained earnings
plus depreciation) or with external capital? How does the choice of financing affect the company’s financial
strength?

96 Part 2 Fundamental Concepts in Financial Management

i. Refer to Tables IC3-2 and IC3-4. Suppose D’Leon broke even in 2005 in the sense that sales revenues
equaled total operating costs plus interest charges. Would the asset expansion have caused the company
to experience a cash shortage that required it to raise external capital?

j. If D’Leon started depreciating fixed assets over 7 years rather than 10 years, would that affect (1) the
physical stock of assets, (2) the balance sheet account for fixed assets, (3) the company’s reported net
income, and (4) its cash position? Assume the same depreciation method is used for stockholder report-
ing and for tax calculations, and the accounting change has no effect on assets’ physical lives.

k. Explain how earnings per share, dividends per share, and book value per share are calculated, and what
they mean. Why does the market price per share not equal the book value per share?

l. Explain briefly the tax treatment of (1) interest and dividends paid, (2) interest earned and dividends
received, (3) capital gains, and (4) tax loss carry-back and carry-forward. How might each of these items
affect D’Leon’s taxes?

TA B L E I C 3 - 1 Balance Sheets 2005 2004

Assets $ 7,282 $ 57,600
Cash 632,160 351,200
Accounts receivable 715,200
Inventories 1,287,360
$1,926,802 $1,124,000
Total current assets 491,000
Gross fixed assets 1,202,950 146,200
Less accumulated depreciation 263,160
$ 344,800
Net fixed assets $ 939,790 $1,468,800
Total assets $2,866,592
$ 145,600
Liabilities and Equity $ 524,160 200,000
Accounts payable 636,808 136,000
Notes payable 489,600
Accruals $ 481,600
$1,650,568 323,432
Total current liabilities 723,432 460,000
Long-term debt 460,000 203,768
Common stock (100,000 shares) 32,592
Retained earnings $ 663,768
$ 492,592 $1,468,800
Total equity $2,866,592
Total liabilities and equity

Chapter 3 Financial Statements, Cash Flow, and Taxes 97

TA B L E I C 3 - 2 Income Statements

2005 2004

Sales $6,034,000 $3,432,000
Cost of goods sold 5,528,000 2,864,000
Other expenses 519,988 358,672
Total operating costs excluding
$6,047,988 $3,222,672
depreciation and amortization ($ 13,988) $ 209,328
EBITDA
Depreciation and amortization 116,960 18,900
EBIT ($ 130,948) $ 190,428
Interest expense
EBT 136,012 43,828
Taxes (40%) ($ 266,960) $ 146,600
Net income
(106,784)a 58,640
EPS ($ 160,176) $ 87,960
DPS
Book value per share ($ 1.602) $ 0.880
Stock price $ 0.110 $ 0.220
Shares outstanding $ 4.926 $ 6.638
Tax rate $ 2.25 $ 8.50
Lease payments
Sinking fund payments 100,000 100,000
40.00% 40.00%

40,000 40,000
0 0

Note:
a The firm had sufficient taxable income in 2003 and 2004 to obtain its full tax refund in 2005.

TA B L E I C 3 - 3 Statement of Retained Earnings, 2005

Balance of retained earnings, 12/31/04 $203,768
Add: Net income, 2005 (160,176)
Less: Dividends paid
(11,000)
Balance of retained earnings, 12/31/05 $ 32,592

98 Part 2 Fundamental Concepts in Financial Management

TA B L E I C 3 - 4 Statement of Cash Flows, 2005

OPERATING ACTIVITIES ($160,176)
Net income
116,960
Additions (Sources of Cash) 378,560
Depreciation and amortization 353,600
Increase in accounts payable
Increase in accruals (280,960)
(572,160)
Subtractions (Uses of Cash) ($164,176)
Increase in accounts receivable
Increase in inventories ($711,950)
Net cash provided by operating activities
$436,808
LONG-TERM INVESTING ACTIVITIES 400,000
Cash used to acquire fixed assets (11,000)

FINANCING ACTIVITIES $825,808
Increase in notes payable ($ 50,318)
Increase in long-term debt
Payment of cash dividends 57,600
Net cash provided by financing activities $ 7,282
Sum: net decrease in cash
Plus: cash at beginning of year
Cash at end of year

Please go to the ThomsonNOW Web site to access the
Cyberproblems.

Chapter 3 Financial Statements, Cash Flow, and Taxes 99

Access the Thomson ONE problems though the ThomsonNOW Web site. Use the Thomson
ONE—Business School Edition online database to work this chapter’s questions.

Exploring Starbucks’ Financial Statements

Over the past decade, Starbucks coffee shops have become an increasingly familiar part
of the urban landscape. Currently, the company operates more than 6,000 coffee shops
in all 50 states, the District of Columbia, and internationally, and in 2005 it had roughly
80,000 employees.

Thomson ONE can access a wealth of financial information for companies such as
Starbucks. To find some background information, begin by entering the company’s ticker
symbol, SBUX, and then selecting “GO.” On the opening screen, you will see a lot of
useful information, including a summary of what Starbucks does, a chart of its recent
stock price, EPS estimates, some recent news stories, and a list of key financial data and
ratios.

In researching a company’s operating performance, a good place to start is the
recent stock price performance. At the top of the Stock Price Chart, click on the section
labeled “Interactive Chart.” From this point, we are able to obtain a chart of the com-
pany’s stock price performance relative to the overall market, as measured by the S&P
500, between 1995 and 2005. To obtain a 10-year chart, go to “Time Frame,” click on
the down arrow, and select 10 years. Then, click on “Draw” and a 10-year price chart
should appear.

As you can see, Starbucks has had its ups and downs, but the company’s overall per-
formance has been quite strong, and it has beat the overall market handily.

We can also find Starbucks’ recent financial statements. Near the top of your screen,
click on the “Financials” tab to find the company’s balance sheet, income statement, and
statement of cash flows for the past 5 years. Clicking on the Microsoft Excel icon down-
loads these statements directly to a spreadsheet.

Discussion Questions

1. Looking at the most recent year available, what is the amount of total assets on Star-
bucks’ balance sheet? What percentage is fixed assets, such as plant and equipment,
and what percentage is current assets? How much has the company grown over the
years that are shown?

2. Does Starbucks have a lot of long-term debt? What are the chief ways in which Star-
bucks has financed assets?

3. Looking at the statement of cash flows, what factors can explain the change in the
company’s cash position over the last couple of years?

4. Looking at the income statement, what are the company’s most recent sales and net
income? Over the past several years, what has been the sales growth rate? What has
been the growth rate in net income?

5. Over the past few years, has there been a strong correlation between stock price per-
formance and reported earnings?

CHAPTE R

© AP PHOTO/RON EDMONDS4

ANALYSIS OF FINANCIAL
STATEMENTS1

Enron, WorldCom Lessons Learned from Enron and WorldCom

In early 2001, Enron appeared to be on top of the world. The high-flying energy
firm had a market capitalization of $60 billion, and its stock was trading at $80 a
share. Wall Street analysts were touting its innovations and management suc-
cess and strongly recommending the stock. Less than a year later, Enron had
declared bankruptcy, its stock was basically worthless, and investors had lost bil-
lions of dollars. This dramatic and sudden collapse left many wondering how so
much value could be destroyed in such a short period of time.

While Enron’s stock fell steadily throughout the first part of 2001, most
analysts voiced no concerns. The general consensus was that it was simply
caught up in a sell-off that was affecting the entire stock market and that its
long-run prospects remained strong. However, a hint of trouble came when
Enron’s CEO, Jeffrey Skilling, unexpectedly resigned in August 2001; he was
replaced by its chairman and previous CEO, Ken Lay. By the end of August, its
stock had fallen to $35 a share. Two months later, Enron stunned the financial
markets by announcing a $638 million loss, along with a $1.2 billion write-down
in its book value equity. The write-down, which turned out to be grossly inade-
quate, stemmed primarily from losses realized on a series of partnerships set up
by its CFO, Andrew Fastow. Shortly thereafter, it was revealed that Enron had

1 We have covered this chapter both early in the course and toward the end. Early coverage gives
students an overview of how financial decisions affect financial statements and results, and thus of
what financial management is all about. If it is covered later, after coverage of bond and stock valu-
ation, risk analysis, capital budgeting, capital structure, and working capital management, students
can better understand the logic of the ratios and see how they are used for different purposes.
Depending on students’ backgrounds, instructors may want to cover the chapter early or late.

Chapter 4 Analysis of Financial Statements 101

guaranteed the partnerships’ debt, so its true liabilities were far higher than the
financial statements indicated. These revelations destroyed Enron’s credibility,
caused its customers to flee, and led directly to its bankruptcy.

Not surprisingly, Enron’s investors and employees were enraged to learn
that its senior executives had received $750 million in salaries, bonuses, and
profits from stock options for good performance in the same year before the
company went bankrupt. During that year, senior executives were bailing out of
the stock as fast as they could, even as they put out misleading statements
touting the stock to their employees and outside investors. Fastow has since
pleaded guilty to fraud and is cooperating with authorities in the cases against
his former bosses, Lay and Skilling, who have been indicted for their roles in
Enron’s collapse and await trial.

After Enron declared bankruptcy, critics turned their attention to the com-
pany’s auditor, Arthur Andersen, and to certain Wall Street analysts who had
blindly recommended the stock over the years. Critics contended that the audi-
tors and analysts neglected their responsibilities because of conflicts of interest.
Andersen partners looked the other way because they didn’t want to compro-
mise their lucrative consulting contracts with Enron, and the analysts kept rec-
ommending the stock because they wanted to help the investment banking
side of their firms get more Enron business.

As if the Enron debacle was not enough, in June 2002 it was learned that
WorldCom, an even larger company, had “cooked its books” and inflated its
profits and cash flows by more than $11 billion. Shortly thereafter, WorldCom
collapsed, with many more billions of investor losses and thousands unem-
ployed. Enron had set up complicated partnerships to deceive investors, but
WorldCom simply lied, reporting normal operating costs as capital expenditures
and thus boosting its reported profits. Interestingly, Enron and WorldCom used
the same auditing firm, Arthur Andersen, which was itself put out of business,
causing about 70,000 employees to lose their jobs. It is also interesting to note
that Citigroup’s investment banking subsidiary, Salomon Smith Barney, earned
many millions in fees from WorldCom, and that Salomon’s lead telecom analyst,
Jack Grubman, who helped bring in this business, did not downgrade World-
Com to a sell until the very day the fraud was announced. At that point the
stock was selling for less than a dollar, down from a high of $64.50.

The Enron and WorldCom collapses caused investors throughout the world
to wonder if these companies’ misdeeds were isolated situations or were symp-
tomatic of undiscovered problems lurking in many other companies. Those
fears led to a broad decline in stock prices, and President Bush expressed
outrage at executives whose actions were imperiling our financial markets and
economic system. In response to these and other abuses, Congress passed the
Sarbanes-Oxley Act of 2002. One of its provisions requires the CEO and the
CFO to sign a statement certifying that the “financial statements and disclo-
sures fairly represent, in all material respects, the operations and financial condi-
tion” of the company. This will make it easier to haul off in handcuffs a CEO or
CFO who has misled investors.

Financial statements have undoubtedly improved in the last few years, and
they now provide a wealth of good information that can be used by managers,
investors, lenders, customers, suppliers, and regulators. As you will see in this
chapter, a careful analysis of a company’s statements can highlight its strengths
and shortcomings. Also, as you will see, financial analysis can be used to predict
how such strategic decisions as the sale of a division, a change in credit or
inventory policy, or a plant expansion will affect a firm’s future performance.

102 Part 2 Fundamental Concepts in Financial Management

Putting Things In Perspective

The primary goal of financial management is to maximize shareholders’
wealth over the long run, not to maximize accounting measures such as net
income or EPS. However, accounting data influence stock prices, and these
data can be used to understand why a company is performing the way it is
and to forecast where it is heading. Chapter 3 described the key financial
statements and showed how they change as a firm’s operations undergo
change. Now, in Chapter 4, we show how the statements are used by man-
agers to improve performance; by lenders to evaluate the likelihood of col-
lecting on loans; and by stockholders to forecast earnings, dividends, and
stock prices.

If management is to maximize a firm’s value, it must take advantage of
the firm’s strengths and correct its weaknesses. Financial analysis involves
(1) comparing the firm’s performance to other firms, especially those in the
same industry, and (2) evaluating trends in the firm’s financial position over
time. These studies help management identify deficiencies and then take
corrective actions. We focus here on how financial managers and investors
evaluate firms’ financial positions. Then, in later chapters, we examine the
types of actions management can take to improve future performance and
thus increase the firm’s stock price.

The most important ratio is the ROE, or return on equity, which is net
income to common stockholders divided by total stockholders’ equity.
Stockholders obviously want to earn a high rate of return on their invested
capital, and the ROE tells them the rate they are earning. If the ROE is
high, then the stock price will also tend to be high, and actions that
increase ROE are likely to increase the stock price. The other ratios provide
information about how well such assets as inventory, accounts receivable,
and fixed assets are managed, and about how the firm is financed. As we
will see, these factors all affect the ROE, and management uses the other
ratios primarily to help develop plans to improve the average ROE over the
long run.

4.1 RATIO ANALYSIS

Financial statements report both a firm’s position at a point in time and its oper-
ations over some past period. However, their real value lies in the fact that they
can be used to help predict future earnings and dividends. From an investor’s
standpoint, predicting the future is what financial statement analysis is all about,
while from management’s standpoint, financial statement analysis is useful both to
help anticipate future conditions and, more important, as a starting point for planning
actions that will improve future performance.

Chapter 4 Analysis of Financial Statements 103

Financial ratios are designed to help one evaluate a financial statement. For
example, Firm A might have debt of $5,248,760 and interest charges of $419,900,
while Firm B might have debt of $52,647,980 and interest charges of $3,948,600.
Which company is stronger? The burden of these debts, and the companies’ abil-
ity to repay them, can best be evaluated (1) by comparing each firm’s debt to its
assets and (2) by comparing the interest it must pay to the income it has avail-
able for payment of interest. Such comparisons involve ratio analysis.

In the paragraphs that follow, we will calculate Allied Food Products’ finan-
cial ratios for 2005, using data from the balance sheets and income statements
given in Tables 3-1 and 3-2. We will also evaluate the ratios relative to the indus-
try averages.2 Note that the dollar amounts in the ratio calculations are generally
in millions.

4.2 LIQUIDITY RATIOS Liquid Asset
An asset that can be
A liquid asset is one that trades in an active market and hence can be quickly converted to cash
converted to cash at the going market price, and a firm’s “liquidity position” quickly without having
deals with this question: Will the firm be able to pay off its debts as they come to reduce the asset’s
due in the coming year? As shown in Table 3-1 in Chapter 3, Allied has $310 mil- price very much.
lion of debt that must be paid off within the coming year. Will it have trouble
meeting those obligations? A full liquidity analysis requires the use of cash Liquidity Ratios
budgets, but by relating cash and other current assets to current liabilities, ratio Ratios that show the
analysis provides a quick, easy-to-use measure of liquidity. Two of the most relationship of a firm’s
commonly used liquidity ratios are discussed here. cash and other current
assets to its current
Current Ratio liabilities.

The primary liquidity ratio is the current ratio, which is calculated by dividing Current Ratio
current assets by current liabilities: This ratio is calculated
by dividing current
Current ratio ϭ Current assets assets by current
Current liabilities liabilities. It indicates
the extent to which
ϭ $1,000 ϭ 3.2ϫ current liabilities are
$310 covered by those
assets expected to be
Industry average ϭ 4.2ϫ converted to cash in
the near future.
Current assets include cash, marketable securities, accounts receivable, and
inventories. Allied’s current liabilities consist of accounts payable, short-term
notes payable, current maturities of long-term debt, accrued taxes, and accrued
wages.

If a company is getting into financial difficulty, it begins paying its bills
(accounts payable) more slowly, borrowing from its bank, and so on, all of which
increase current liabilities. If current liabilities are rising faster than current
assets, the current ratio will fall, and this is a sign of possible trouble. Allied’s
current ratio of 3.2 is well below the industry average, 4.2, so its liquidity posi-
tion is rather weak. Still, since its current assets are supposed to be converted to

2 In addition to the ratios discussed in this section, financial analysts sometimes employ a tool
known as common size analysis. To form a common size balance sheet, simply divide each asset and
liability item by total assets and then express the results as percentages. The resultant percentage
statement can be compared with statements of larger or smaller firms, or with those of the same
firm over time. To form a common size income statement, divide each income statement item by
sales. With a spreadsheet, which most analysts use, this is trivially easy.

104 Part 2 Fundamental Concepts in Financial Management

cash within a year, it is likely that they could be liquidated at close to their
stated value. With a current ratio of 3.2, Allied could liquidate current assets at
only 31 percent of book value and still pay off current creditors in full.3

Although industry average figures are discussed later in some detail, note
that an industry average is not a magic number that all firms should strive to
maintain—in fact, some very well-managed firms may be above the average
while other good firms are below it. However, if a firm’s ratios are far removed
from the averages for its industry, an analyst should be concerned about why
this variance occurs. Thus, a deviation from the industry average should signal
the analyst (or management) to check further.

Quick, or Acid Test, Ratio

Quick (Acid Test) The second most used liquidity ratio is the quick, or acid test, ratio, which is
Ratio calculated by deducting inventories from current assets and then dividing the
This ratio is calculated remainder by current liabilities:
by deducting invento-
ries from current assets Quick, or acid test, ratio ϭ Current assets Ϫ Inventories
and then dividing the Current liabilities
remainder by current
liabilities. ϭ $385 ϭ 1.2ϫ
$310
Asset Management
Ratios Industry average ϭ 2.2ϫ
A set of ratios that
measure how Inventories are typically the least liquid of a firm’s current assets, hence they are
effectively a firm is the assets on which losses are most likely to occur in the event of liquidation.
managing its assets. Therefore, this measure of a firm’s ability to pay off short-term obligations with-
out relying on the sale of inventories is important.

The industry average quick ratio is 2.2, so Allied’s 1.2 ratio is quite low in
comparison with other firms in its industry. Still, if the accounts receivable can
be collected, the company can pay off its current liabilities without having to liq-
uidate its inventories.

What are some characteristics of a liquid asset? Give some examples.
What two ratios are used to analyze a firm’s liquidity position?
Write out their equations.
Why is the current ratio the most commonly used measure of short-
term solvency?
Which current asset is typically the least liquid?
A company has current liabilities of $500 million, and its current ratio
is 2.0. What is its level of current assets? ($1,000 million) If this firm’s
quick ratio is 1.6, how much inventory does it have? ($200 million)

4.3 ASSET MANAGEMENT RATIOS

A second group of ratios, the asset management ratios, measures how effec-
tively the firm is managing its assets. These ratios answer this question: Does the
amount of each type of asset seem reasonable, too high, or too low in view of

3 1/3.2 ϭ 0.31, or 31%. Note also that 0.31($1,000) ϭ $310, the current liabilities balance.

Chapter 4 Analysis of Financial Statements 105

current and projected sales? When they acquire assets, Allied and other compa-
nies must obtain capital from banks or other sources. If a firm has too many
assets, its cost of capital will be too high and its profits will be depressed. On the
other hand, if assets are too low, profitable sales will be lost. The asset manage-
ment ratios described in this section are important.

Inventory Turnover Ratio

“Turnover ratios” are ratios where sales are divided by some asset, and as Inventory Turnover
the name implies, they show how many times the item is “turned over” during Ratio
the year. Thus, the inventory turnover ratio is defined as sales divided by This ratio is calculated
inventories: by dividing sales by
inventories.
Inventory turnover ratio ϭ Sales
Inventories

ϭ $3,000 ϭ 4.9ϫ
$615

Industry average ϭ 10.9ϫ

As a rough approximation, each item of Allied’s inventory is sold out and
restocked, or “turned over,” 4.9 times per year. “Turnover” is a term that origi-
nated many years ago with the old Yankee peddler, who would load up his
wagon with goods, then go off on his route to peddle his wares. The merchan-
dise was called “working capital” because it was what he actually sold, or
“turned over,” to produce his profits, whereas his “turnover” was the number of
trips he took each year. Annual sales divided by inventory equaled turnover, or
trips per year. If he made 10 trips per year, stocked 100 pans, and made a gross
profit of $5 per pan, his annual gross profit would be (100)($5)(10) ϭ $5,000. If
he went faster and made 20 trips per year, his gross profit would double, other
things held constant. So, his turnover directly affected his profits.

Allied’s turnover of 4.9 is much lower than the industry average of 10.9.
This suggests that it is holding too much inventory. Excess inventory is, of
course, unproductive and represents an investment with a low or zero rate of
return. Allied’s low inventory turnover ratio also makes us question the current
ratio. With such a low turnover, the firm may be holding obsolete goods not
worth their stated value.4

Note that sales occur over the entire year, whereas the inventory figure is for
one point in time. For this reason, it might be better to use an average inventory
measure.5 If the business is highly seasonal, or if there has been a strong upward
or downward sales trend during the year, it is especially useful to make an
adjustment. To maintain comparability with industry averages, however, we did
not use the average inventory figure.

4 A problem arises when calculating and analyzing the inventory turnover ratio. Sales are stated at
market prices, so if inventories are carried at cost, as they generally are, the calculated turnover
overstates the true turnover ratio. Therefore, it might be more appropriate to use cost of goods sold
in place of sales in the formula’s numerator. However, some established compilers of financial ratio
statistics such as Dun & Bradstreet use the ratio of sales to inventories carried at cost. To have a fig-
ure that can be compared with those published by Dun & Bradstreet and similar organizations, it is
necessary to measure inventory turnover with sales in the numerator, as we do here.
5 Preferably, the average inventory value should be calculated by summing the monthly figures dur-
ing the year and dividing by 12. If monthly data are not available, the beginning and ending figures
can be added and then divided by 2. Both methods adjust for growth but not for seasonal effects.

106 Part 2 Fundamental Concepts in Financial Management

Days Sales Days Sales Outstanding
Outstanding (DSO)
This ratio is calculated Days sales outstanding (DSO), also called the “average collection period”
by dividing accounts (ACP), is used to appraise accounts receivable, and it is calculated by dividing
receivable by average accounts receivable by average daily sales to find how many days’ sales are tied
sales per day; it indi- up in receivables. Thus, the DSO represents the average length of time that the
cates the average firm must wait after making a sale before receiving cash. Allied has 46 days sales
length of time the outstanding, well above the 36-day industry average:
firm must wait after
making a sale before DSO ϭ Days ϭ Receivables day ϭ Receivables
it receives cash. sales Average sales per Annual sales>365
outstanding
Fixed Assets Turnover
Ratio ϭ $375 ϭ $375 ϭ 45.625 days ≈ 46 days
The ratio of sales to $3,000>365 $8.2192
net fixed assets.
Industry average ϭ 36 days

Note that in this calculation we used a 365-day year. Some analysts use a 360-
day year; on this basis Allied’s DSO would have been slightly lower, 45 days.6

The DSO can also be evaluated by comparing it with the terms on which the
firm sells its goods. For example, Allied’s sales terms call for payment within 30
days, so the fact that 46 days’ sales, not 30 days’, are outstanding indicates that
customers, on the average, are not paying their bills on time. This deprives the
company of funds that could be used to reduce bank loans or some other type of
costly capital. Moreover, with a high average DSO, it is likely that a number of
customers are paying very late, and those customers may well be in financial
trouble, in which case Allied may never be able to collect the receivable.7 There-
fore, if the trend in DSO over the past few years has been rising, but the credit
policy has not been changed, this would be strong evidence that steps should be
taken to expedite the collection of accounts receivable.

Fixed Assets Turnover Ratio

The fixed assets turnover ratio measures how effectively the firm uses its plant
and equipment. It is the ratio of sales to net fixed assets:

Fixed assets turnover ratio ϭ Sales
Net fixed assets

ϭ $3,000 ϭ 3.0ϫ
$1,000

Industry average ϭ 2.8ϫ

6 It would be somewhat better to use average receivables, either an average of the monthly figures or
(Beginning receivables ϩ Ending receivables)/2 ϭ ($315 ϩ $375)/2 ϭ $345 in the formula. Had
average annual receivables been used, Allied’s DSO on a 365-day basis would have been
$345/$8.2192 ϭ 41.975 days, or approximately 42 days. The 42-day figure is a more accurate one,
but our interest is in comparisons, and because the industry average was based on year-end receiv-
ables, the 46-day number is better for our purposes. The DSO is discussed further in Part 6.
7 For example, if further analysis along the lines suggested in Part 6 indicated that 85 percent of the
customers pay in 30 days, then for the DSO to average 46 days, the remaining 15 percent must be
paying on average in 136.67 days. Paying that late suggests financial difficulties. In Part 6 we also
discuss refinements into this analysis, but a DSO of 46 days would alert a good analyst of the need
to dig deeper.

Chapter 4 Analysis of Financial Statements 107

Allied’s ratio of 3.0 times is slightly above the 2.8 industry average, indicating
that it is using its fixed assets at least as intensively as other firms in the indus-
try. Therefore, Allied seems to have about the right amount of fixed assets rela-
tive to its sales.

Potential problems may arise when interpreting the fixed assets turnover
ratio. Recall that fixed assets are shown on the balance sheet at their historical
costs, less depreciation. Inflation has caused the value of many assets that were
purchased in the past to be seriously understated. Therefore, if we compared an
old firm that had acquired many of its fixed assets years ago at low prices with a
new company with similar operations that had acquired its fixed assets only
recently, we would probably find that the old firm had the higher fixed assets
turnover ratio. However, this would be more reflective of when the assets were
acquired than of inefficiency on the part of the new firm. The accounting profes-
sion is trying to develop procedures for making financial statements reflect
current values rather than historical values, which would help us make better
comparisons. However, at the moment the problem still exists, so financial ana-
lysts must recognize that a problem exists and deal with it judgmentally. In
Allied’s case, the issue is not serious because all firms in the industry have been
expanding at about the same rate, hence the balance sheets of the comparison
firms are reasonably comparable.8

Total Assets Turnover Ratio

The final asset management ratio, the total assets turnover ratio, measures the Total Assets Turnover
turnover of all the firm’s assets, and it is calculated by dividing sales by total assets: Ratio
This ratio is calculated
Total assets turnover ratio ϭ Sales by dividing sales by
Total assets total assets.

ϭ $3,000 ϭ 1.5ϫ
$2,000

Industry average ϭ 1.8ϫ

Allied’s ratio is somewhat below the industry average, indicating that it is not
generating enough sales given its total assets. Sales should be increased, some
assets should be disposed of, or a combination of these steps should be taken.

Identify four ratios that are used to measure how effectively a firm
manages its assets, and write out their equations.

If one firm is growing rapidly and another is not, how might this
distort a comparison of their inventory turnover ratios?

If you wanted to evaluate a firm’s DSO, with what would you com-
pare it?

What potential problem might arise when comparing different firms’
fixed assets turnover ratios?

A firm has annual sales of $100 million, $20 million of inventory,
and $30 million of accounts receivable. What is its inventory
turnover ratio? (5ϫ) What is its DSO based on a 365-day year?
(109.5 days)

8 See FASB #89, Financial Reporting and Changing Prices (December 1986), for a discussion of the
effects of inflation on financial statements. The report’s age indicates how difficult the problem is.

108 Part 2 Fundamental Concepts in Financial Management

Financial Leverage 4.4 DEBT MANAGEMENT RATIOS
The use of debt
financing. The extent to which a firm uses debt financing, or financial leverage, has three
important implications: (1) By raising funds through debt, stockholders can con-
trol a firm with a limited amount of equity investment. (2) Creditors look to the
equity, or owner-supplied funds, to provide a margin of safety, so the higher the
proportion of the total capital provided by stockholders, the less the risk faced
by creditors. (3) If the firm earns more on its assets than the interest rate it pays
on debt, then using debt “leverages,” or magnifies, the return on equity, ROE.

Table 4-1 illustrates both the potential benefits and risks resulting from the
use of debt.9 Here we analyze two companies that are identical except for how
they are financed. Firm U (for “Unleveraged”) has no debt and thus 100 percent
common equity, whereas Firm L (for “Leveraged”) is financed with half debt at a
10 percent interest rate and half equity. Both companies have $100 of assets.
Their sales will range from $150 down to $75, depending on business conditions,
with an expected level of $100. Some of their operating costs (rent, the presi-
dent’s salary, and so on) are fixed and will be there regardless of the level of
sales, while other costs (some labor costs, materials, and so forth) will vary with
sales.10 When we deduct total operating costs from sales revenues, we are left
with operating income, or earnings before interest and taxes (EBIT).

Notice in the table that everything is the same for the leveraged and
unleveraged firms down through operating income—thus, they have the same
EBIT under the three states of the economy. However, things then begin to differ.
Firm U has no debt so it pays no interest, and its taxable income is the same as
its operating income, and it then pays a 40 percent state and federal tax to get to
its net income, which is $27 under good conditions and $0 under bad conditions.
When net income is divided by common equity, we get the ROE, which ranges
from 27 percent to 0 percent for Firm U.

Firm L has the same EBIT under each condition, but it uses $50 of debt with
a 10 percent interest rate, so it has $5 of interest charges regardless of business
conditions. This amount is deducted from EBIT to get to taxable income, taxes
are then taken out, and the result is net income, which ranges from $24 to Ϫ$5,
depending on conditions.11 At first blush it looks like Firm U is better off under
all conditions, but this is not correct—we need to consider how much the two
firms’ stockholders have invested. Firm L’s stockholders have put up only $50,
so when that investment is divided into net income, we see that their ROE under
good conditions is a whopping 48 percent (versus 27 percent for U) and is 12
percent (versus 9 percent for U) under expected conditions. However, L’s ROE
falls to Ϫ10 percent under bad conditions, which means that it would go bank-
rupt if those conditions last for several years.

There are two reasons for the leveraging effect: (1) Because interest is
deductible, the use of debt lowers the tax bill and leaves more of the firm’s oper-
ating income available to its investors. (2) If operating income as a percentage of

9 We discuss ROE in more depth later in the chapter, and we examine the effects of leverage in
detail in the chapter on capital structure.
10 The financial statements do not show the breakdown between fixed and variable operating costs,
but companies can and do make this breakdown for internal purposes. Of course, the distinction is
not always clear, because what’s a fixed cost in the very short run can become a variable cost over a
longer time horizon. It’s interesting to note that companies are moving toward making more of their
costs variable, using such techniques as increasing bonuses rather than base salaries, switching to
profit-sharing plans rather than fixed-pension plans, and outsourcing various parts and materials.
11 As we discussed in the last chapter, firms can carry losses back or forward for several years.
Therefore, if Firm L had profits and thus paid taxes in recent prior years, it could carry its loss
under bad conditions back and receive a credit (a check from the government). In Table 4-1 we
assume that the firm cannot use the carry-back/carry-forward provision.

Chapter 4 Analysis of Financial Statements 109

TA B L E 4 - 1 Effects of Financial Leverage on Stockholder Returns

FIRM U [UNLEVERAGED (NO DEBT)]

Current assets $ 50 Debt $0
Fixed assets 50 Common equity 100
Total assets Total liabilities and equity
$100 $100

BUSINESS CONDITIONS

Good Expected Bad

Sales revenues $150.0 $100.0 $75.0
Operating costs Fixed 45.0 45.0 45.0
Variable 60.0 40.0 30.0
Total operating costs 85.0 75.0
105.0
Operating income (EBIT) $ 45.0 $ 15.0 $ 0.0
Interest (Rate = 10%) 0.0 0.0
0.0
Earnings before taxes (EBT) $ 45.0 $ 15.0 $ 0.0
Taxes (Rate = 40%) 6.0 0.0
18.0
Net income (NI) $ 27.0 $ 9.0 $ 0.0
ROEU
27.0% 9.0% 0.0%
Current assets
Fixed assets FIRM L [LEVERAGED (SOME DEBT)]
Total assets
$ 50 Debt $ 50
50 Common equity 50
Total liabilities and equity
$100 $100

BUSINESS CONDITIONS

Good Expected Bad

Sales revenues $150.0 $100.0 $75.0
Operating costs Fixed 45.0 45.0 45.0
Variable 60.0 40.0 30.0
Total operating costs 85.0 75.0
105.0
Operating income (EBIT) $ 45.0 $ 15.0 $ 0.0
Interest (Rate = 10%) 5.0 5.0
5.0
Earnings before taxes (EBT) $ 40.0 $ 10.0 Ϫ$ 5.0
Taxes (Rate = 40%) 4.0 0.0
16.0
Net income (NI) $ 24.0 $ 6.0 Ϫ$ 5.0
ROEL 12.0% Ϫ10.0%
48.0%

assets exceeds the interest rate on debt, as it generally is expected to do, then a
company can use debt to acquire assets, pay the interest on the debt, and have
something left over as a “bonus” for its stockholders. Under the expected condi-
tions, our hypothetical firms expect to earn 15 percent on assets versus a 10 per-
cent cost of debt, and this, combined with the tax benefit of debt, pushes Firm
L’s expected rate of return on equity up far above that of Firm U.

We see, then, that firms with relatively high debt ratios have higher expected
returns when the economy is normal, but they are exposed to risk of loss when
the economy enters a recession. Therefore, decisions about the use of debt require
firms to balance higher expected returns against increased risk. Determining the
optimal amount of debt is a complicated process, and we defer a discussion of

110 Part 2 Fundamental Concepts in Financial Management

that subject to a later chapter on capital structure. For now, we simply look at
two procedures analysts use to examine the firm’s debt: (1) They check the bal-
ance sheet to determine the proportion of total funds represented by debt, and
(2) they review the income statement to see the extent to which fixed charges are
covered by operating profits.

Total Debt to Total Assets

Debt Ratio The ratio of total debt to total assets, generally called the debt ratio, measures
The ratio of total debt the percentage of funds provided by creditors:
to total assets.
Debt ratio ϭ Total debt
Times-Interest-Earned Total assets
(TIE) Ratio
The ratio of earnings ϭ $310 ϩ $750 ϭ $1,060 ϭ 53.0%
before interest and $2,000 $2,000
taxes (EBIT) to interest
charges; a measure of Industry average ϭ 40.0%
the firm’s ability to
meet its annual interest Total debt includes all current liabilities and long-term debt. Creditors prefer
payments. low debt ratios because the lower the ratio, the greater the cushion against cred-
itors’ losses in the event of liquidation. Stockholders, on the other hand, may
want more leverage because it can magnify expected earnings.

Allied’s debt ratio is 53.0 percent, which means that its creditors have
supplied more than half the total financing. As we will discuss in the capital
structure chapter, a number of factors affect a company’s optimal debt ratio. Nev-
ertheless, the fact that Allied’s debt ratio exceeds the industry average raises a red
flag, and this will make it relatively costly for Allied to borrow additional funds
without first raising more equity. Creditors will be reluctant to lend the firm more
money, and management would probably be subjecting the firm to the risk of
bankruptcy if it sought to borrow a substantial amount of additional funds.12

Times-Interest-Earned Ratio

The times-interest-earned (TIE) ratio is determined by dividing earnings before
interest and taxes (EBIT in Table 3-2) by the interest charges:

Times-interest-earned (TIE) ratio ϭ EBIT
Interest charges

ϭ $283.8 ϭ 3.2ϫ
$88

Industry average ϭ 6.0ϫ

The TIE ratio measures the extent to which operating income can decline before
the firm is unable to meet its annual interest costs. Failure to pay interest will
bring legal action by the firm’s creditors and probably result in bankruptcy. Note
that earnings before interest and taxes, rather than net income, is used in the
numerator. Because interest is paid with pre-tax dollars, the firm’s ability to pay
current interest is not affected by taxes.

12 The ratio of debt to equity is also used in financial analysis. The debt-to-assets (D/A) and debt-to-
equity (D/E) ratios are simply transformations of each other:

D>A D>E
D/E = 1 Ϫ D>A and D/A = 1 ϩ D>E

Chapter 4 Analysis of Financial Statements 111

Allied’s interest is covered 3.2 times. The industry average is 6 times, so
Allied is covering its interest charges by a relatively low margin of safety. Thus,
the TIE ratio reinforces the primary conclusion from our analysis of the debt
ratio, namely, that Allied would face difficulties if it attempted to borrow addi-
tional funds.

EBITDA Coverage Ratio EBITDA Coverage

The TIE ratio is useful for assessing the ability to meet interest charges on debt, Ratio
but it has two shortcomings: (1) Interest is not the only fixed financial charge—
companies must also retire debt on a fixed schedule, and many firms also lease A ratio whose numera-
assets and thus must make lease payments. If they fail to repay debt or meet tor includes all cash
lease payments, they can be forced into bankruptcy. (2) EBIT does not represent flows available to meet
all the cash flow available to service debt, especially if a firm has high deprecia- fixed financial charges
tion and/or amortization charges. To account for these deficiencies, bankers and and whose denomina-
others also use the EBITDA coverage ratio, which shows all of the cash flow tor includes all fixed
available for payments in the numerator and all of the required financial pay- financial charges.
ments in the denominator. This ratio is defined as follows:13

EBITDA ratio ϭ Interest ϩ EBITDA ϩ Lease payments payments
coverage Principal payments ϩ Lease

ϭ $383.8 ϩ $28 ϭ $411.8 ϭ 3.0ϫ
$88 ϩ $20 ϩ $28 $136

Industry average ϭ 4.3ϫ

Regarding the numerator, Allied had EBITDA of $383.8 million, consisting of
$283.8 million of operating income (EBIT) and $100 million of depreciation.
However, $28 million of lease payments were deducted when we calculated
EBITDA, yet that $28 million was available to meet financial charges. Therefore,
we must add it back to EBITDA, giving a total of $411.8 million that is available
for fixed financial charges.14 Fixed financial charges consisted of $88 million of
interest, $20 million of sinking fund payments, and $28 million of lease pay-
ments, for a total of $136 million.15 Therefore, Allied covered its fixed financial
charges by 3.0 times. However, if operating income declines, the coverage will
fall, and operating income certainly can decline. As Allied’s ratio is well below
the industry average, we again see that the company has a relatively high level
of debt.

13 Different analysts define the EBITDA coverage ratio in different ways. For example, some would
omit the lease payment information, and others would “gross up” principal payments by dividing
them by (1 Ϫ T) because these payments are not tax deductions, hence must be made with after-tax
cash flows. We included lease payments because, for many firms, they are quite important, and fail-
ing to make them can lead to bankruptcy just as surely as can failure to make payments on “regu-
lar” debt. We did not gross up principal payments because, if a company is in financial difficulty, its
tax rate will probably be zero, hence the gross up is not necessary whenever the ratio is really
important.
14 Lease payments are included in the numerator because, unlike interest, they were deducted when
EBITDA was calculated. We want to find all the funds that were available to service fixed charges,
so lease payments must be added to the EBIT and DA to find the funds that could be used to ser-
vice debt and meet lease payments.
15 A sinking fund is a required annual payment designed to reduce the balance of a bond or pre-
ferred stock issue. A sinking fund payment is like the principal repayment portion of the payment
on an amortized loan, but sinking funds are used for publicly traded bond issues, whereas amorti-
zation payments are used for bank loans and other private loans.

112 Part 2 Fundamental Concepts in Financial Management

The EBITDA coverage ratio is most useful for relatively short-term lenders
such as banks, which rarely make loans (except real estate–backed loans) for
longer than about five years. Over a relatively short period, depreciation-
generated funds can be used to service debt. Over a longer time, those funds
must be reinvested to maintain the plant and equipment or else the company
cannot remain in business. Therefore, banks and other relatively short-term
lenders focus on the EBITDA coverage ratio, whereas long-term bondholders
focus on the TIE ratio.

What are three important implications of financial leverage?

How does the use of financial leverage affect stockholders’ control
position?

How does the U.S. tax structure influence a firm’s willingness to
finance with debt?

How does the decision to use debt involve a risk-versus-return
trade-off?

Explain the following statement: “Analysts look at both balance
sheet and income statement ratios when appraising a firm’s finan-
cial condition.”

Name three ratios that are used to measure financial leverage, and
write out their equations.

A company has EBITDA of $500 million, interest payments of $50
million, lease payments of $40 million, and required principal
payments (due this year) of $30 million. What is its EBITDA cover-
age ratio? (4.5ϫ)

Profitability Ratios 4.5 PROFITABILITY RATIOS
A group of ratios that
show the combined Accounting statements reflect things that happened in the past, but they also
effects of liquidity, give us clues about what’s really important—what’s likely to happen in the
asset management, future. The liquidity, asset management, and debt ratios covered thus far tell us
and debt on operating something about the firm’s policies and operations. Now we turn to the
results. profitability ratios, which reflect the net result of all of the financing policies
and operating decisions.
Profit Margin on Sales
This ratio measures net Profit Margin on Sales
income per dollar of
sales; it is calculated by The profit margin on sales, calculated by dividing net income by sales, gives the
dividing net income by profit per dollar of sales:
sales.
Profit margin on sales ϭ Net income
Sales

ϭ $117.5 ϭ 3.9%
$3,000

Industry average ϭ 5.0%

Allied’s profit margin is below the industry average of 5 percent. This sub-par
result occurs because costs are too high. High costs, in turn, generally occur
because of inefficient operations. However, Allied’s low profit margin is also a

Chapter 4 Analysis of Financial Statements 113

GLOBAL PERSPECTIVES

Global Accounting Standards:
Can One Size Fit All?

These days you must be a good financial detective dards but only 55 percent thought universal adoption
to analyze financial statements, especially if the was achievable. Obviously, the globalization of account-
company operates overseas. Despite attempts to stan- ing standards is a huge endeavor—one that will
dardize accounting practices, there are still many dif- involve compromises between the IASB and FASB.
ferences in financial reporting in different countries that Part of the problem is that U.S. GAAP takes a rules-
create headaches for investors making cross-border based approach, while the IASB insists on using a
company comparisons. However, as businesses be- principles-based approach. With a rules-based sys-
come more global and more foreign companies list tem, companies can tell whether or not they are in
on U.S. stock exchanges, accountants and regulators compliance, but they can also develop ways to get
are realizing the need for a global convergence of around a rule and thus subvert its intent. With a prin-
accounting standards. As a result, the writing is on ciples-based system, there is greater uncertainty
the wall regarding accounting standards, and differ- about whether certain border-line procedures will be
ences are disappearing. allowed, but such a system makes it easier to prose-
cute on the basis of intent.
The effort to internationalize accounting standards
began in 1973 with the formation of the International A global accounting structure would enable
Accounting Standards Committee. However, in 1998 it investors and practitioners around the world to read
became apparent that a full-time rule-making body and understand financial reports produced anywhere
with global representation was necessary, so the Inter- in the world. In addition, it would enhance all com-
national Accounting Standards Board (IASB), with panies’ access to all capital markets, which would
members representing nine major countries, was improve investor diversification, reduce risk, and
established. The IASB was charged with the responsi- lower the cost of capital. However, it remains to be
bility for creating a set of International Financial seen whether the IASB’s lofty goal can be achieved.
Reporting Standards (IFRS) for European Union (EU)
companies by January 1, 2005, when more than 7,000 Sources: “All Accountants Soon May Speak the Same Lan-
publicly listed European companies were supposed to guage,” The Wall Street Journal, August 29, 1995, p. A15;
conform to these standards. In contrast, only 350 Euro- Jim Cole, “Global Standards Loom for Accounting,” East
pean companies were using international standards as Bay Business Times, November 12, 2001; “Accountants
of 2003. A number of other countries, including Aus- Struggle to Reconcile Rules,” BestWire, April 28, 2003;
tralia and other Pacific Rim countries, South Africa, “For and Against; Standards Need Time to Work,” Accoun-
Canada, Russia, Japan, and China are interested in tancy Age, June 5, 2003, p. 16; Larry Schlesinger, “Overview;
adopting IFRS. Bringing about a New Dawn,” Accountancy Age, Septem-
ber 4, 2003, p. 18; Cassell Bryan-Low, “Deals & Deal Mak-
A survey of senior executives from 85 financial ers: Accounting Changes Are in Store,” The Wall Street
institutions worldwide found that 92 percent of those Journal, September 10, 2003, p. C4; and Fay Hansen, “Get
responding favored a single set of international stan- Ready for New Global Accounting Standards,” January
2004, www.BusinessFinanceMag.com.

result of its heavy use of debt. Recall that net income is income after interest.
Therefore, if two firms have identical operations in the sense that their sales,
operating costs, and EBIT are the same, but if one firm uses more debt than the
other, it will have higher interest charges. Those interest charges will pull net
income down, and as sales are constant, the result will be a relatively low profit
margin. In this situation, the low profit margin would indicate a difference in
financing strategies, not an operating problem. Thus, the firm with the low
profit margin might end up with a higher rate of return on its stockholders’
investment due to its use of financial leverage.

Note too that while a high return on sales is good, other things held con-
stant, other things may not be held constant—we must also be concerned with
turnover. If a firm sets a very high price on its products, it may get a high return
on each sale but not make many sales. That might result in a high profit margin
but still not be optimal because total sales are low.

114 Part 2 Fundamental Concepts in Financial Management

We will see exactly how profit margins, the use of debt, and turnover inter-
act to affect overall stockholder returns shortly, when we examine the Du Pont
equation.

Return on Total Assets

Return on Total The ratio of net income to total assets measures the return on total assets (ROA)
Assets (ROA) after interest and taxes:
The ratio of the net
income to total assets. Return on total assets ϭ ROA ϭ Net income
Total assets
Basic Earning Power
(BEP) Ratio ϭ $117.5 ϭ 5.9%
This ratio indicates the $2,000
ability of the firm’s
assets to generate Industry average ϭ 9.0%
operating income; cal-
culated by dividing Allied’s 5.9 percent return is well below the 9 percent industry average. This is
EBIT by total assets. not good, but a low return on assets is not necessarily bad—it could result from
a conscious decision to use a lot of debt, in which case high interest expenses
will cause net income to be relatively low. Debt is part of the reason for Allied’s
low ROA. Never forget—you must look at a number of ratios, see what each
suggests, and then look at the overall situation when you judge the performance
of a company and try to figure out what it should do to improve.

Basic Earning Power (BEP) Ratio

The basic earning power (BEP) ratio is calculated by dividing earnings before
interest and taxes (EBIT) by total assets:

Basic earning power (BEP) ratio ϭ EBIT
Total assets

ϭ $283.8 ϭ 14.2%
$2,000

Industry average ϭ 18.0%

This ratio shows the raw earning power of the firm’s assets, before the influence
of taxes and leverage, and it is useful when comparing firms with different
degrees of financial leverage and tax situations. Because of its low turnover
ratios and poor profit margin on sales, Allied is not earning as high a return on
assets as the average food-processing company.16

16 A related ratio is the return on investors’ capital, defined as follows:

Return on investors’ capital ϭ Net income ϩ Interest
Debt ϩ Equity

The numerator shows the dollar returns to investors, the denominator shows the money investors
have put up, and the ratio itself shows the rate of return on all investors’ capital. This ratio is espe-
cially important in regulated industries such as electric utilities, where regulators are concerned
about companies’ using their monopoly power to earn excessive returns on investors’ capital. In
fact, regulators try to set electric rates at levels that will force the return on investors’ capital to
equal a company’s cost of capital as defined in Chapter 10.

Chapter 4 Analysis of Financial Statements 115

Return on Common Equity

The “bottom-line” accounting ratio is the return on common equity (ROE), Return on Common
found as follows:
Equity (ROE)
Return on common equity ϭ ROE ϭ Net income
Common equity The ratio of net income
to common equity;
ϭ $117.5 ϭ 12.5% measures the rate of
$940 return on common
stockholders’ invest-
ment.

Industry average ϭ 15.0%

Stockholders expect to earn a return on their money, and this ratio tells how well
they are doing in an accounting sense. Allied’s 12.5 percent return is below the
15 percent industry average, but not as far below as the return on total assets.
This somewhat better ROE is due to the company’s greater use of debt, a point
that we discussed earlier in the chapter.

Identify four profitability ratios, and write out their equations.

Why is the basic earning power ratio useful?

Why does the use of debt lower the ROA?

What does ROE measure? Since interest expense lowers profits and
thus the ROA, does using debt necessarily lower the ROE? Explain.

A company has $20 billion of sales and $1 billion of net income. Its
total assets are $10 billion, financed half by debt and half by com-
mon equity. What is its profit margin? (5%) What is its ROA? (10%)
What is its ROE? (20%) Would ROA increase if the firm used less
leverage? (yes) Would ROE increase? (no)

4.6 MARKET VALUE RATIOS Market Value Ratios

The ROE reflects the effects of all the other ratios and is the best single measure A set of ratios that
of performance in an accounting sense. Investors obviously like to see a high relate the firm’s stock
ROE, and high ROEs are generally positively correlated with high stock prices. price to its earnings,
However, other things come into play. As we saw earlier, financial leverage gen- cash flow, and book
erally increases the ROE but leverage also increases the firm’s risk, which value per share.
investors dislike. So, if a high ROE is achieved by the use of a very large amount
of debt, the stock price might well be lower than it would be with less debt and
a lower ROE. Similarly, investors are interested in growth, and if the current
ROE was achieved by holding back on research and development costs, which
will constrain future growth, this will not be regarded favorably.

This takes us to a final group of ratios, the market value ratios, which relate
the firm’s stock price to its earnings, cash flow, and book value per share. These
ratios give management an indication of what investors think of the company’s
risk and future prospects. If the liquidity, asset management, debt management,
and profitability ratios all look good, and if these conditions have been stable
over time, then the market value ratios will be high, the stock price will proba-
bly be as high as can be expected, and management has been doing a good job
and should be rewarded. Otherwise, changes might be needed.

116 Part 2 Fundamental Concepts in Financial Management

Price/Earnings Ratio

Price/Earnings (P/E) The price/earnings (P/E) ratio shows how much investors are willing to pay per
Ratio dollar of reported profits. Allied’s stock sells for $23, so with an EPS of $2.35 its
The ratio of the price P/E ratio is 9.8:
per share to earnings
per share; shows the Price per share
dollar amount investors Price>earnings 1P>E2 ratio ϭ Earnings per share
will pay for $1 of
current earnings. ϭ $23.00 ϭ 9.8ϫ
$2.35
Price/Cash Flow Ratio
The ratio of price per Industry average ϭ 11.3ϫ
share divided by cash
flow per share; shows As we will see in Chapter 9, P/E ratios are higher for firms with strong growth
the dollar amount prospects and relatively little risk. Allied’s P/E ratio is below the average for
investors will pay for $1 other food processors, so this suggests that the company is regarded as being
of cash flow. somewhat riskier than most, as having poor growth prospects, or both.

Price/Cash Flow Ratio

In some industries, stock price is tied more closely to cash flow rather than net
income. Consequently, investors often look at the price/cash flow ratio:

Price per share
Price>cash flow ϭ Cash flow per share

ϭ $23.00 ϭ 5.3ϫ
$4.35

Industry average ϭ 5.4ϫ

The calculation for cash flow per share was discussed in Chapter 3, but to
refresh your memory, it is equal to net income plus depreciation and amortiza-
tion divided by common shares outstanding. Allied’s price/cash flow ratio is
slightly below the industry average, once again suggesting that its growth
prospects are below average, its risk is above average, or both.

Note that for some purposes analysts look at multiples beyond just the
price/earnings and the price/cash flow ratios. For example, depending on the
industry, analysts may look at price/sales, price/customers, or price/(EBITDA
per share). Ultimately, though, value depends on earnings and cash flows, so if
these “exotic” ratios do not forecast future levels of EPS and cash flow, they may
turn out to be misleading.17

Market/Book Ratio

The ratio of a stock’s market price to its book value gives another indication of
how investors regard the company. Companies that are well regarded by
investors—which means companies with safe and growing earnings and cash

17 During the “Internet bubble” of the late 1990s and early 2000s, some Internet companies were
valued by multiplying the number of “hits” to a Web site times some sort of multiple. If those hits
translated to sales and profits, this procedure would have made sense, but generally they did not,
and the result was a vast overvaluation of stocks and a subsequent huge crash. Keep your eye on
earnings and cash flows.

Chapter 4 Analysis of Financial Statements 117

flows—sell at higher multiples of book value than those with low returns. First,
we find Allied’s book value per share:

Common equity
Book value per share ϭ Shares outstanding

ϭ $940 ϭ $18.80
50

Then we divide the market price per share by the book value per share to get the Market/Book (M/B)
market/book (M/B) ratio, which for Allied is 1.2 times: Ratio
The ratio of a stock’s
Market price per share market price to its
Market>book ratio ϭ M>B ϭ Book value per share book value.

ϭ $23.00 ϭ 1.2ϫ
$18.80

Industry average ϭ 1.7ϫ

Investors are willing to pay less for a dollar of Allied’s book value than for
one of an average food-processing company. This is consistent with our other
findings.

In today’s market (September 2005), the average Standard & Poor’s (S&P)
500 company had a market/book ratio of about 2.87.18 Because M/B ratios typi-
cally exceed 1.0, this means that investors are willing to pay more for stocks than
their accounting book values. This situation occurs primarily because asset val-
ues, as reported by accountants on corporate balance sheets, do not reflect either
inflation or “goodwill.” Thus, assets purchased years ago at preinflation prices
are carried at their original costs, even though inflation might have caused their
actual values to rise substantially, and successful going concerns have a value
greater than their historical costs.

If a company earns a low rate of return on its assets, then its M/B ratio will
be relatively low versus an average company. Some airlines, which have not
fared well in recent years, sell at M/B ratios well below 1.0, while very success-
ful firms such as Microsoft achieve high rates of return on their assets, resulting
in market values far in excess of their book values. In September 2005
Microsoft’s book value per share was about $4.49 versus a market price of
$26.28, so its market/book ratio was $26.28/$4.49 ϭ 5.9 times.

Describe three ratios that relate a firm’s stock price to its earnings,
cash flow, and book value per share, and write out their equations.

How do these market value ratios reflect investor’s opinions about a
stock’s risk and expected future growth?

What does the price/earnings (P/E) ratio show? If one firm’s P/E
ratio is lower than that of another, what are some factors that might
explain the difference?

How is book value per share calculated? Explain how inflation and
“goodwill” built up over time could cause book values to deviate
from market values.

18 This was obtained from the key ratios section shown in http://moneycentral.msn.com.