Horizontal analysis examines how a particular item on a financial statement such as sales or cost of goods sold behaves over time. Vertical analysis involves analysis of items on an income statement or balance sheet for a single period. In vertical analysis of the income statement, all items are typically stated as a percentage of sales. In vertical analysis of the balance sheet, all items are typically stated as a percentage of total assets.
By looking at trends, an analyst hopes to get some idea of whether a situation is improving, remaining the same, or deteriorating. Such analyses can provide insight into what is likely to happen in the future. Rather than looking at trends, an analyst may compare one company to another or to industry averages using common-size financial statements. 16-3Price-earnings ratios reflect investors’ expectations concerning future earnings. The higher the price-earnings ratio, the greater the growth in earnings investors expect.
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For this reason, two companies might have the same current earnings and yet have quite different price-earnings ratios.
By definition, a stock with current earnings of $4 and a price-earnings ratio of 20 would be selling for $80 per share. 16-4A rapidly growing tech company would probably have many opportunities to make investments at a rate of return higher than stockholders could earn in other investments. It would be better for the company to invest in such opportunities than to pay out dividends and thus one would expect the company to have a low dividend payout ratio. 16-5The dividend yield is the dividend per share divided by the market price per share. The other source of return on an investment in stock is increases in market value.
Financial leverage results from borrowing funds at an interest rate that differs from the rate of return on assets acquired using those funds. If the rate of return on the assets is higher than the interest rate at which the funds were borrowed, financial leverage is positive and stockholders gain. If the return on the assets is lower than the interest rate, financial leverage is negative and the stockholders lose. 16-7If the company experiences big variations in net cash flows from operations, stockholders might be pleased that the company has no debt.
In hard times, interest payments might be very difficult to meet. On the other hand, if investments within the company can earn a rate of return that exceeds the interest rate on debt, stockholders would get the benefits of positive leverage if the company took on debt. 16-8The market value of a share of common stock often exceeds the book value per share. Book value represents the cumulative effects on the balance sheet of past activities, evaluated using historical prices. The market value of the stock reflects investors’ expectations about the company’s future earnings.
For most companies, market value exceeds book value because investors anticipate future earnings growth. 16-9A 2 to 1 current ratio might not be adequate for several reasons. First, the composition of the current assets may be heavily weighted toward slow-turning and difficult-to-liquidate inventory, or the inventory may contain large amounts of obsolete goods. Second, the receivables may be low quality, including large amounts of accounts that may be difficult to collect.
The company’s major problem seems to be the increase in cost of goods sold, which increased from 58. 6% of sales last year to 62. 3% of sales this year. This suggests that the company is not passing the increases in costs of its products on to its customers. As a result, cost of goods sold as a percentage of sales has increased and gross margin has decreased.
This change has been offset somewhat by reduction in administrative expenses as a percentage of sales. Note that administrative expenses decreased from 10. 3% to only 8. 9% of sales over the two years. However, this decrease was not enough to completely offset the increased cost of goods sold, so the company’s net income decreased as a percentage of sales this year. Exercise 16-2 (30 minutes) 1. Calculation of the gross margin percentage: 2. Calculation of the earnings per share: 3. Calculation of the price-earnings ratio: 4. Calculation of the dividend payout ratio: 5. Calculation of the dividend yield ratio:
The most noticeable thing about the assets is that the accounts receivable have been increasing at a rapid rate—far outstripping the increase in sales. This disproportionate increase in receivables is probably the chief cause of the decrease in cash over the five-year period. The inventory seems to be growing at a well-balanced rate in comparison with sales. Liabilities: The current liabilities are growing more rapidly than the total current assets. The reason is probably traceable to the rapid buildup in receivables in that the company doesn’t have the cash needed to pay bills as they come due.
Both of these rates of return are smaller than the return that the company is earning on its total assets; thus, the difference goes to the common stockholders. Exercise 16-7 (30 minutes) 1. Gross margin percentage: 2. Current ratio: 3. Acid-test ratio: 4. Debt-to-equity ratio: 5. Average collection period: Exercise 16-7 (continued) 6. Average sale period: 7. Times interest earned: 8. Book value per share: Exercise 16-8 (20 minutes) 1. Earnings per share: 2. Dividend payout ratio: 3. Dividend yield ratio: 4. Price-earnings ratio: Exercise 16-9 (20 minutes) 1. Return on total assets: 2.
Both the current ratio and the acid-test ratio are well below the industry average and are trending downward. At the present rate, it will soon be impossible for the company to pay its bills as they come due. c. The drain on the cash account seems to be a result mostly of a large buildup in accounts receivable and inventory. Notice that the average age of the receivables has increased by five days since last year, and now is 10 days over the industry average. Many of the company’s customers are not taking their discounts because the average collection period is 28 days and collections terms are 2/10, n/30.
This suggests financial weakness on the part of these customers, or sales to customers who are poor credit risks. Problem 16-12 (continued) d. The inventory turned only five times this year as compared to over six times last year. It takes nearly two weeks longer for the company to turn its inventory than the average for the industry (73 days as compared to 60 days for the industry). This suggests that inventory stocks are higher than they need to be. e. In the authors’ opinion, the loan should be approved only if the company gets its accounts receivable and inventory back under control.
If the accounts receivable collection period is reduced to about 20 days, and if the inventory is pared down enough to reduce the turnover time to about 60 days, enough funds could be released to substantially improve the company’s cash position. Then a loan might not even be needed. Problem 16-13 (60 minutes) This Year Last Year 1. a. Net income $280,000 $196,000 Less preferred dividends 20,000 20,000 Net income remaining for common (a) $260,000 $176,000 Average number of common shares (b) 50,000 50,000 Earnings per share (a) ? (b) $5. 20 $3. 52 b. Dividends per share (a) $1. 80 $1. 50
If investors were willing to pay 12 times current earnings for Sabin’s stock, it would be selling for about $62. 40 per share (12 ? $5. 20), rather than for only $40 per share. Problem 16-13 (continued) This Year Last Year e. Total stockholders’ equity $1,600,000 $1,430,000 Less preferred stock 250,000 250,000 Common stockholders’ equity (a) $1,350,000 $1,180,000 Number of common shares outstanding (b) 50,000 50,000 Book value per share (a) ? (b) $27. 00 $23. 60 The market value is above book value for both years. However, this does not necessarily indicate that the stock is overpriced.
The stock’s downside risk seems small because it is now selling for only 7. 7 times earnings to 12 times earnings for other companies in the industry. In addition, its earnings are strong and trending upward, and its return on common equity (20. 6%) is extremely good. Its return on total assets (12. 1%) compares well with that of the industry. The risk, of course, is whether the company can get its cash problem under control. Conceivably, the cash problem could worsen, leading to an eventual reduction in profits through inability to operate, a discontinuance of dividends, and a precipitous drop in the market price of the company’s stock.
This does not seem likely, however, because the company has borrowing capacity available, and can easily control its cash problem through more careful management of accounts receivable and inventory. The client must understand, of course, that there is risk in the purchase of any stock; the risk seems well justified in this case because the upward potential of the stock is great if the company gets its problems under control.
Net income before interest and income taxes (a) $1,560,000 $1,020,000 Interest expense (b) $360,000 $300,000 Times interest earned (a) ? (b) 4. 3 3. 4 4. Both net income and sales are up from last year. The return on total assets has improved from 5. 1% to 6. 8%, and the return on common equity is up from 4. 9% to 9. 2%. But this is the only bright spot. Virtually all other ratios are below what is typical of the industry, and, more important, they are trending downward. The deterioration in the gross margin percentage, while not large, is worrisome. Sales and inventories have increased substantially.
Ordinarily, this should result in an improvement in the gross margin percentage due to fixed costs being spread over a greater number of units. However, the gross margin percentage has declined. Notice particularly that the average collection period has lengthened to 52 days—about three weeks over the industry average. One wonders if the increase in sales was obtained at least in part by extending credit to high-risk customers. Notice also that the debt-to-equity ratio is rising rapidly. If the $3,000,000 loan is granted, the ratio will rise further to 1. 09. What the company probably needs is more equity—not more debt.
The company’s current position has declined substantially between the two years. Cash this year represents only 5. 6% of total assets, whereas it represented 10. 5% last year (cash + marketable securities). In addition, both accounts receivable and inventory are up from last year, which helps to explain the decrease in the cash account. The company is building inventories, but not collecting from customers. (See Problem 16-14 for a ratio analysis of the current assets. ) Apparently a part of the financing required to build inventories was supplied by short-term creditors, as evidenced by the increase in current liabilities.
Looking at the income statement, as noted in the solution to the preceding problem there has been a slight deterioration in the gross margin percentage. Ordinarily, the increase in sales (and in inventories) should have resulted in an increase in the gross margin percentage because fixed manufacturing costs would be spread across more units. Note that the selling and administrative expenses are down as a percentage of sales—possibly because many of them are likely to be fixed. Problem 16-16 (45 minutes) Effect on Ratio Reason for Increase, Decrease, or No Effect 1. Decrease
Declaring a cash dividend will increase current liabilities, but have no effect on current assets. Therefore, the current ratio will decrease. 2. Increase A sale of inventory on account will increase the quick assets (cash, accounts receivable, marketable securities) but have no effect on the current liabilities. For this reason, the acid-test ratio will increase. The same effect would result regardless of whether the inventory was sold at cost, at a profit, or at a loss. That is, the acid-test ratio would increase in all cases; the only difference would be the amount of the increase. 3. Increase The interest rate on the bonds is only 8%.
Since the company’s assets earn at a rate of return of 10%, positive leverage would come into effect, increasing the return to the common stockholders. 4. Decrease A decrease in net income would mean less income available to cover interest payments. Therefore, the times-interest-earned ratio would decrease. 5. Increase Payment of a previously declared cash dividend will reduce both current assets and current liabilities by the same amount. An equal reduction in both current assets and current liabilities will always result in an increase in the current ratio, so long as the current assets exceed the current liabilities.
No Effect The dividend payout ratio is a function of the dividends paid per share in relation to the earnings per share. Changes in the market price of a stock have no effect on this ratio. Problem 16-16 (continued) Effect on Ratio Reason for Increase, Decrease, or No Effect 7. Increase A write-off of inventory will reduce the inventory balance, thereby increasing the turnover in relation to a given level of sales. 8. Decrease Sale of inventory at a profit will increase the assets of a company. The increase in assets will be reflected in an increase in retained earnings, which is part of stockholders’ equity.
An increase in stockholders’ equity will result in a decrease in the ratio of assets provided by creditors as compared to assets provided by owners. 9. Decrease Extended credit terms for customers means that customers on the average will be taking longer to pay their bills. As a result, the accounts receivable will “turn over,” or be collected, less frequently during a given year. 10. Decrease A common stock dividend will result in a greater number of shares outstanding, with no change in the underlying assets. The result will be a decrease in the book value per share.
No Effect Book value per share is dependent on historical costs of already completed transactions as reflected on a company’s balance sheet. It is not affected by current market prices for the company’s stock. 12. No Effect Payments on account reduce cash and accounts payable by equal amounts; thus, the net amount of working capital is not affected. 13. Decrease The stock dividend will increase the number of common shares outstanding, thereby reducing the earnings per share. Problem 16-16 (continued) Effect on Ratio Reason for Increase.
Payments to creditors will reduce the total liabilities of a company, thereby decreasing the ratio of total debt to total equity. 15. Decrease A purchase of inventory on account will increase current liabilities, but will not increase the quick assets (cash, accounts receivable, marketable securities). Therefore, the ratio of quick assets to current liabilities will decrease. 16. No Effect Write-off of an uncollectible account against the Allowance for Bad Debts will have no effect on total current assets. For this reason, the current ratio will remain unchanged.
The price-earnings ratio is obtained by dividing the market price per share by the earnings per share. If the earnings per share remains unchanged, and the market price goes up, then the price-earnings ratio will increase. 18. Decrease The dividend yield ratio is obtained by dividing the dividend per share by the market price per share. If the dividend per share remains unchanged and the market price goes up, then the yield will decrease. Problem 16-17 (30 minutes) a. It is becoming more difficult for the company to pay its bills as they come due. Although the current ratio has improved over the three years, the acid-test ratio is down.
Also notice that the accounts receivable and inventory are both turning more slowly, indicating that an increasing portion of the current assets is being made up of these items, from which bills cannot be paid. b. Customers are paying their bills more slowly in Year 3 than in Year 1. This is evidenced by the decline in accounts receivable turnover. c. The total of accounts receivable is increasing. This is evidenced both by a slowdown in turnover and in an increase in total sales. d. The level of inventory undoubtedly is increasing. Notice that the inventory turnover is decreasing.
Even if sales (and cost of goods sold) just remained constant, this would be evidence of a larger average inventory on hand. However, sales are not constant, but rather are increasing. With sales increasing (and undoubtedly cost of goods sold also increasing), the average level of inventory must be increasing as well to service the larger volume of sales. e. The market price is going down. The dividends paid per share over the three-year period are unchanged, but the dividend yield is going up. Therefore, the market price per share of stock must be decreasing. f. The amount of earnings per share is increasing.
Again, the dividends paid per share have remained constant. However, the dividend payout ratio is decreasing. In order for the dividend payout ratio to be decreasing, the earnings per share must be increasing. g. The price-earnings ratio is going down. If the market price of the stock is going down [see Part (e) above], and the earnings per share are going up [see Part (f) above], then the price-earnings ratio must be decreasing. h. In Year 1 and in Year 2 there was negative leverage because in both years the return on total assets exceeded the return on common equity.