Discussion due 8/22 5pm
I have attached a word document with the instructions and also attached chapter 1-3 as reference guide. If you are able to complete the assignment correctly please accept
Copyright Information (bibliographic)
Document Type: Book Chapter
Title of Book: Financial Management Theory and Practice (16th Edition)
Author(s) of Book: Eugene F. Brigham, Michael C. Ehrhardt
Chapter Title: Chapter 3 Analysis of Financial Statements
Author(s) of Chapter: Eugene F. Brigham, Michael C. Ehrhardt
Year: 2020
Publisher: Cengage Learning
Place of Publishing: the United States of America
The copyright law of the United States (Title 17, United States Code) governs the making of
photocopies or other reproductions of copyrighted materials. Under certain conditions
specifies in the law, libraries and archives are authorized to furnish a photocopy or other
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user may be liable for copyright infringement.
Analysis of Financial
Statements
Even though Twitter Inc. had not yet had a profitable quarter based on generally
accepted accounting principles (GAAP), its stock price jumped by 18% on September
26, 2017, when it reported minus $21 million in earnings before interest, taxes,
depreciation, and amortization (EBITDA). The reason for the positive stock reaction?
First, a loss of $21 million was better than the $103 million loss it reported in the
previous quarter. Second, Twitter stated that it might report positive EBITDA in its
next report.
Most companies guide analysts by providing estimates of future revenues.
According to a survey by the National Investors Relations Institute, 94% of respondents
in 2014 provided some form of guidance for analysts and investors. Despite the high
proportion of companies that provide guidance, a 2015 survey by Integrated Corporate
Relations reports that over half of the responding investment professionals don’t think
guidance is vital for determining whether to recommend purchasing a company’s
stock. It appears as though many investors rely on other types of information, including
ratio analysis.
Source: See the reports at www.cnbc.com/2017/10/26/twitter-earnings-q3-revenue-eps-and-maus.html,
http://files.shareholder.com/downloads/AMDA-2FS26X/5619402910x0x961127/658476E7-9D8B
-4 B 17-BES D-B 77034D21FC E/TWTR_ Q3 _17 _Earn in gs_Press_Release. pdf, www. ma rketwatch .com
/news/markets/earningswatch.asp, http://niri.org/Main-Menu-Category/resource/publications/Executive
-Alert/2014-Executive-Alert-Archive/NIRI-Guidance-Practices-Survey-2014-Report-102214.aspx, and
http://icrinc.com/en/pdfs/xchange/XChange_2015_ICR_Survey.pdf.
101
102 Part 1 The Company and Its Environment
Intrinsic Value,Free Cash Flow, and Financial Statements
The intrinsic value of a firm is determined by the present This chapter explains how to use financial statements to
value of the expected future free cash flows (FCFs) when evaluate a company’s profitability, required capital invest-
discounted at the weighted average cost of capital (WACC). ments, business risk, and mix of debt and equity .
Net operating profit after taxes
Required investments in operating capital
Free cash flow
(FCF)
FCF1 FCF2 FCF.,
Value=—–+—–+ … +—–
(1 + WACC)l (1 + WACC)2 (1 + WACC)
‘
Weighted
average cost of
capital (WACC)
Market interest rates
Cost of debt
Cost of equity
Firm’s debt/equity mix
Market risk aversion Firm’s business risk
!JJ(Ce
The textbook’s Web site
contains on Excel file that
will guide you through the
chapter’s co/cu/otions.
The file for this chapter is
Ch03 Tool Kit.xlsx, and
we encourage you to open
the file and follow along
as you read the chapter.
WWW
See www.zacks.com for
o source of standardized
financial statements.
Financial statement analysis involves (1) comparing a firm’s performance with that of
other firms in the same industry and (2) evaluating trends in the firm’s financial posi
tion over time. Managers use financial analysis to identify situations needing attention,
potential lenders use financial analysis to determine whether a company is creditworthy,
and stockholders use financial analysis to help predict future earnings, dividends, and
free cash flow. This chapter will explain the similarities and differences among these uses.
3-1 Financial Analysis
When we perform a financial analysis, we conduct the following steps.
3-la Gather Data
The first step in financial analysis is to gather data. As discussed in Chapter 2, financial
statements can be downloaded from many different Web sites. One of our favorites is
Zacks Investment Research, which provides financial statements in a standardized for
mat. If you cut and paste financial statements from Zacks into a spreadsheet and then
perform a financial analysis, you can quickly repeat the analysis on a different company
by pasting that company’s financial statements into the same cells of the spreadsheet. In
other words, you do not need to reinvent the wheel every time you analyze a company.
3-lb Examine the Statement of Cash Flows
Some financial analysis can be done with virtually no calculations. For example, we
always look to the statement of cash flows first, particularly the net cash provided by
0
0
(
Chapter 3 Analysis of Financial Statements 103
operating activities. Downward trends or negative net cash flow from operations almost
always indicates problems. The statement of cash flows section on investing activities
shows whether the company has made a big acquisition, especially when compared with
prior years’ net cash flows from investing activities. A quick look at the section on financ
ing activities also reveals whether a company is issuing debt or buying back stock; in other
words, is the company raising capital from investors or returning it to them?
Recall from the previous chapter (Figure 2-4) that MicroDrive generated $163 million
from its operating activities but invested $420 million in new fixed assets. To make these
purchases, MicroDrive borrowed heavily.
3-1c Calculate and Examine the Return on Invested
Capital and Free Cash Flow
After examining the statement of cash flows, we calculate the net operating profit after
taxes (NOPAT) and the total net operating capital. We use these measures to calculate the
operating profitability ratio (OP), the capital requirement ratio (CR), the return on in
vested capital (ROIC), and the free cash flow (FCF), as described in Chapter 2.
The ROIC provides a vital measure of a firm’s overall performance. If the ROIC is
greater than the company’s weighted average cost of capital (WACC), then the company
usually is adding value. If the ROIC is less than the WACC, then the company usually
has serious problems. No matter what the ROIC tells us about overall performance, it is
important to examine specific activities with different financial ratios.
We calculated these measures for MicroDrive in the previous chapter (see Figure 2-6)
and report them here for convenience:
MicroDrive (Millions of Dollars)
Net operating working capital (NOWC) =
Total net operating capital =
Net operating profit after taxes (NOPAT) =
Operating profitability ratio (OP) = NOPAT/Sales =
Capital requirement ratio (CR) = (Total net operating capital/Sales) =
Return on invested capital (ROIC) = NOPAT/Total net operating capital =
Free cash flow (FCF) = NOPAT – Net investment in operating capital =
2018
$710
$2,490
$330
6.88%
51.88%
13.3%
NIA
2019
$1,000
$3,000
$300
6.00%
60.00%
10.0%
-$210
MicroDrive’s operating profitability fell from 6.88% to 6.00%, and its capital require
ment ratio increased from 51.88% to 60%, indicating that MicroDrive is not generating
enough in sales from its operating capital. The result is a decline in its ROIC from 13.3%
to 10.0%, which is less than MicroDrive’s 11.5% cost of capital. We will use ratio analysis
in the following sections to identify the root causes of the ROI C’s decline.
3-1d Begin Ratio Analysis
Financial ratios are designed to extract important information that might not be obvi
ous simply from examining a firm’s financial statements. For example, suppose Firm A
owes $5 million in debt while Firm B owes $50 million. Which company is in a stronger
financial position? It is impossible to answer this question without first standardizing
each firm’s debt relative to total assets and earnings. Such standardized comparisons are
provided through ratio analysis.
104 Part l The Company and Its Environment
We will calculate the 2019 financial ratios for MicroDrive Inc. using data from the
balance sheets and income statements given in Figure 3-1; dollar amounts are in millions.
Recall from Chapter 2 that MicroDrive reports only net plant, property, and equipment
(PP&E) on its balance sheets instead of separately reporting cumulative depreciation and
cumulative PP&E. For the sake of clarity, we break down the income statement’s costs
of goods sold into two components: (1) costs of goods sold excluding depreciation and
(2) depreciation (MicroDrive has no amortization charges).
SELF -TEST
What insights does the Statement of Cash Flows provide regarding financial analysis?
What insights are provided by the (1) net operating profit after taxes (NOPAT); (2) operating
profitability ratio (OP); (3) capital requirement ratio (CR); (4) return on invested capital (ROJC);
and (5) free cash flow (FCF)?
3-2 Profitability Ratios
Profitability is the net result of a number of policies and decisions. The ratios examined
thus far provide an overview of a firm’s operations, but the profitability ratios go on to
show the combined effects of liquidity, asset management, and debt on operating and
financial results.
3-2a Net Profit Margin
The net profit margin, also called the profit margin on sales or just the profit margin, is
calculated by dividing net income by sales. It gives the profit per dollar of sales:
Net income available to
common stockholders
Net profit margin =
Sales
MicroDrive’s net profit margin is:
$248
Net profit margin = –
$
— = 4.96 = 5.0%
5,000
Industry average = 6.2%
MicroDrive’s net profit margin is below the industry average, but why is this so? Is it
due to inefficient operations, high interest expenses, or both?
Instead of just comparing net income to sales, many analysts also break the income
statement into smaller parts to identify the sources of a low net profit margin. For exam
ple, the operating profit margin is defined as:
EBIT
Operating profit margin = –
al S es
The operating profit margin identifies how a company is performing with respect to
its operations before the impact of interest expenses is considered.
Chapter 3 Analysis of Financial Statements
FIGURE3-1
MicroDrive Inc.: Balance Sheets and Income Statements for Years Ending December 31 (Millions of Dollars, Except for Per Share Data)
A B C D E
15 Balance Sheets 2019 2018
16 Assets
17 Cash and equivalents $100 $102
18 Short-term investments 10 40
19 Accounts receivable 500 384
20 Inventories 1,000 774
21 Total current assets $1,610 $1,300
22 Net property, plant & equipment (PP&E) 2,000 1,780
23 Total assets $3,610 $3,080
24
25 Liabilities and Equity
26 Accounts payable $200 $180
27 Notes payable 150 28
28 Accruals 400 370
29 Total current liabilities $750 $578
30 Long-term bonds 520 350
31 Total liabilities $1,270 $928
32 Preferred stock 100 100
33 Common stock 500 500
34 Retained earnings 1,740 1,552
35 Total common equity $2,240 $2,052
36 Total llablllties and equity $3,610 $3,080
37
38 Income Statements 2019 2018
39 Net sales $5,000 $4,800
40 Costs of goods sold except depreciation 3,900 3,710
41 Depreciation” 200 180
42 Other operating expenses 500 470
43 Earnings before interest and taxes (EBIT) $400 $440
44 Less Interest 60 40
45 Pre-tax earnings $340 $400
46 Taxes (25%) 85 100
47 Net income before preferred dividends $255 $300
48 Preferred dividends 7 7
49 Net income available to common stockholders $248 $293
so
51 Additional Information
52 Common dividends $60.0 $59.4
53 Addition to retained earnings $188.0 $233.6
54 Number of common shares 60 60
55 Common stock price per share $31.00 $45.00
56 Lease payments $28 $28
57 Bonds’ required sinking fund payments $20 $20
58 Tax rate 25% 25%
Source: See the file Ch03 Tool Klt.xlsx. Numbers are reported as rounded values for clarity but are calculated using Exce/’s full precision. Thus,
intermediate calculations using the figure’s rounded values will be inexact.
Note:
‘MicroDrive has no amortization charges, so we omit them from the item name.
105
106
I
Part l The Company and Its Environment
MicroDrive’s operating margin is:
$400
Operating profit margin = –
$
— = 8.0%
5,000
Industry average = 9.0%
Some analysts drill even deeper by breaking operating costs into their components.
For example, the gross profit margin is defined as:
. Sales – Cost of goods sold including depreciation
Gross profit margm =
al IS es
The gross profit margin identifies the gross profit per dollar of sales before any other
expenses are deducted.
Rather than calculate each type of profit margin here, later in the chapter we will
use common size analysis and percent change analysis to focus on different parts of the
income statement. In addition, we will use the DuPont equation to show how the ratios
interact with one another.
Sometimes it is confusing to have so many different types of profit margins. To sim
plify the situation, we will focus primarily on the net profit margin throughout the book
and call it the profit margin.
3-2b Basic Earning Power (BEP) Ratio
The basic earning power (BEP) ratio is calculated by dividing earnings before interest
and taxes (EBIT) by total assets:
EBIT
Basic earning power (BEP) ratio =
al Tot assets I
The World Might Be Flat, but Global Accounting Is Bumpy!
The Case of IFRS versus FASB
In a flat world, distance is no barrier. Work flows to where it
can be done most efficiently, and capital flows to where it can
be invested most profitably. If a radiologist in India is more
efficient than one in the United States, then images will be
e-mailed to India for diagnosis; if rates of return are higher in
Brazil, then investors throughout the world will provide fund
ing for Brazilian projects. One key to “flattening” the world
is agreement on common standards. For example, there are
common Internet standards so that users throughout the
world are able to communicate.
A glaring exception to standardization is in accounting.
The Securities and Exchange Commission (SEC) in the United
States requires firms to comply with standards set by the Fi
nancial Accounting Standards Board (FASB). But the European
Union requires all EU-listed companies to comply with the
International Financial Reporting Standards (IFRS), as defined
by the International Accounting Standards Board (IASB).
IFRS tends to rely on general principles, whereas FASB
standards are rules-based. As we write this in 2018, some prog
ress toward standardizing accounting rules has been made,
but it does not seem likely that the United States and the EU
will be using the same accounting rules in the near future.
To keep abreast of developments in IFRS/GAAP convergence, visit the IASB
Web site at www.iasb.org and the FASB Web site at www.fasb.org.
Chapter 3 Analysis of Financial Statements
For MicroDrive, the ratio is:
$400
Basic earning power (BEP) ratio= — = 11.1%
$3,610
Industry average = 13.8%
107
This ratio shows the earning power of the firm’s assets before the influence of taxes
and leverage, and it is useful for comparing firms with different tax situations and different
degrees of financial leverage. MicroDrive has a lower BEP than its peers, partly because
its profit margin is low and partly because it manages assets inefficiently, as we show in
Section 3-3.
3-2c Return on Total Assets
The ratio of net income to total assets measures the return on total assets (ROA) after
interest and taxes. This ratio is also called the return on assets and is defined as follows:
Net income available to
common stockholders
Return on assets = ROA = ——–
Total assets
For MicroDrive, the ROA is:
$248
Return on assets = — = 6.87% = 6.9%
$3,610
Industry average = 9.6%
MicroDrive’s 6.9% return is well below the 9.6% average for the industry. This low
return is due to (1) the company’s low basic earning power and (2) high interest costs
resulting from its above-average use of debt. Both of these factors cause MicroDrive’s net
income to be relatively low.
3-2d Return on Common Equity
The ratio of net income to common equity measures the return on common equity
(ROE), which is often called just the return on equity:
Net income available to
Return on
. = ROE =
common stockholders
common equity Common equity
MicroDrive’s ROE is:
$248
Return on equity=-
$
–= 11.1%
2,240
Industry average = 13.6%
Stockholders invest to earn a return on their money, and this ratio tells how well they
are doing in an accounting sense. MicroDrive’s 11.1% return is below the 13.6% industry
average but not as far below as its return on total assets. This somewhat better result is due
to the company’s greater use of debt, a point that we explain later in the chapter.
108 Part 1 The Company and Its Environment
SELF -TEST
Identify and write out the equations for four profitability ratios.
Why is the basic earning power ratio useful?
Why does the use of debt lower ROA?
What does ROE measure?
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts
receivable = $30, inventories = $100, net fixed assets = $500, accounts payable = $20,
accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt= $200, and
total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold
(excluding depreciation) = $450, depreciation = $50, other operating expenses = $100, interest
expense = $20, and tax rate = 25%. Calculate the following ratios: Net profit margin (18.3%),
operating profit margin (26.8%), basic earning power ratio (32.8%), return on total assets
(22.4%), and return on common equity (36.1%).
A company has $200 billion of sales and $10 billion of net income. Its total assets are $100 billion,
financed half by debt and half by common 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)
3-3 Asset Management Ratios
Asset management ratios measure how effectively a firm is managing its assets. For this
reason, they are also called efficiency ratios. If a company has excessive investments
in assets, then its operating capital is unduly high, which reduces its free cash flow and
ultimately its stock price. On the other hand, if a company does not have enough assets,
then it may lose sales, which would hurt profitability, free cash flow, and the stock price.
Therefore, it is important to have the right amount invested in assets. Ratios that analyze
the different types of assets are described in this section.
3-3a Evaluating Total Assets: The Total Assets
Turnover Ratio
The- total assets turnover ratio measures the dollars in sales that are generated for each
dollar that is tied up in assets:
Sales
Total assets turnover ratio =
al Tot assets
For MicroDrive, the ratio is:
$5,000
Total assets turnover ratio = — = 1.39 = 1.4
$3,610
Industry average = 1.5
I
MicroDrive’s ratio is somewhat below the industry average, indicating that the com
pany is not generating as much business (relative to its peers), given its total asset invest
ment. In other words, MicroDrive uses its assets relatively inefficiently. The following
ratios can be used to identify the specific asset classes that are causing this problem.1
‘Sales occur throughout the year, but assets are reported at end of the period. For a growing company or a
company with seasonal variation, it would be better to use average assets held during the year when calculating
turnover ratios. However, we use year-end values for all turnover ratios so that we are more comparable with
most reported industry averages.
(
Chapter 3 Analysis of Financial Statements
3-3b Evaluating Fixed Assets: The Fixed
Assets Turnover Ratio
109
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:
Sales
Fixed assets turnover ratio =
fix d Net e assets
MicroDrive’s fixed assets turnover ratio is:
$5,000
Fixed assets turnover ratio = — = 2.5
$2,000
Industry average = 2.7
I
MicroDrive’s ratio of 2.5 is a little below the industry average, indicating that the firm is
using its fixed assets less intensively than its peers.
Inflation can cause problems when interpreting the fixed assets turnover ratio because
fixed assets are reported using the historical costs of the assets instead of current replace
ment costs that may be higher due to inflation. Therefore, a mature firm with fixed assets
acquired years ago might well have a higher fixed assets turnover ratio than a younger
company with newer fixed assets that are reported at inflated prices relative to the histori
cal prices of the older assets. However, this would reflect the difficulty accountants have in
dealing with inflation rather than inefficiency on the part of the new firm. You should be
alert to this potential problem when evaluating the fixed assets turnover ratio.
3-3c Evaluating Receivables: The Days
Sales Outstanding
Days sales outstanding (DSO), also called the average collection period (ACP), is used to
appraise accounts receivable, and it is calculated by dividing accounts receivable by aver
age daily sales to find the number of days’ sales that are tied up in receivables. Thus, the
DSO represents the average length of time that the firm must wait after making a sale be
fore receiving cash, which is the average collection period. MicroDrive’s DSO is 37, above
the 29-day industry average:
Days sales Receivables Receivables DSO = = ——– = ——-
outstanding Average sales per day Annual sales/365
MicroDrive’s DSO is about 37 days:
$500 $500
DSO =
$ /
= –
$
– = 36.50 days = 37 days
5,000 365 13.7
Industry average = 29 days
I
MicroDrive’s sales terms call for payment within 30 days. The fact that 37 days of sales
are outstanding indicates that customers, on average, are not paying their bills on time. As
with inventory, high levels of accounts receivable cause high levels of net operating work
ing capital (NOWC), which hurts FCF and stock price.
110 Part 1 The Company and Its Environment
A customer who is paying late may be in financial trouble, which means MicroDrive
may have a hard time collecting the receivable. Therefore, if the trend in DSO has been
rising unexpectedly, steps should be taken to review credit standards and to expedite the
collection of accounts receivable.
3-3d Evaluating Inventories: The Inventory
Turnover Ratio
The inventory turnover ratio is defined as costs of goods sold (COGS) divided by inven
tories. 2 The previous ratios use sales instead of COGS. However, sales revenues include
costs and profits, whereas inventory usually is reported at cost. Therefore, the inventory
turnover ratio compares inventory with costs rather than sales:
COGS
Inventory turnover ratio = —-
Inventories I
MicroDrive’s income statement in Figure 3-1 separately reports depreciation and the
portion of costs of goods sold that is not comprised of depreciation, which is helpful when
calculating cash flows. However, we need the total COGS for calculating the inventory
turnover ratio. MicroDrive has no amortization charges, and virtually all depreciation is
associated with producing its products. MicroDrive’s COGS is:
COGS = Costs of goods sold except depreciation + Depreciation
= $3,900 + $200 = $4,100 million
We can now calculate MicroDrive’s inventory turnover:
COGS $4,100
Inventory turnover ratio = = –
$
— = 4.1
Inventory 1,000
Industry average = 5.3
As a rough approximation, each item of MicroDrive’s inventory is sold out and restocked,
or “turned over,” 4.1 times per year.
MicroDrive’s turnover of 4.1 is lower than the 5.3 industry average. This suggests that
MicroDrive is holding too much inventory. High levels of inventory add to net operat
ing working capital, which reduces FCF, which leads to lower stock prices. In addition,
MicroDrive’s low inventory turnover ratio makes us wonder whether the firm is holding
obsolete goods not worth their stated value.
In summary, MicroDrive’s low fixed assets turnover ratio, high DSO, and low inven
tory turnover ratio each cause MicroDrive’s total assets turnover ratio to be lower than the
industry average.
SELF -TEST
Identify four ratios that measure how effectively a firm is managing its assets, and write out
their equations.
What problem might arise when comparing firms’ fixed assets turnover ratios?
‘We calculate the turnover ratio using the ratio of COGS to inventories because most sources report the turn
over ratio this way. However, you should be aware that a few sources, such as Dun & Bradstreet, define inven
tory turnover as the ratio of sales to inventories.
(
esource
See Ch03 Tool Kit.xlsx
for alt calculations.
Chapter 3 Analysis of Financial Statements
Morris Corporation has the following information on its balance sheets: Cash = $40, accounts
receivable = $30, inventories = $100, net fixed assets = $500, accounts payable = $20,
111
accruals = $10, short-term debt (matures in less than a year) = $25, long-term debt = $200, and
total common equity = $415. Its income statement reports: Sales = $820, costs of goods sold
(excluding depreciation) = $450, depreciation = $50, other operating expenses = $100, interest
expense = $20, and tax rate = 25%. Calculate the following ratios: total assets turnover (1.2),
fixed assets turnover (1.6), days sales outstanding (based on a 365-day year) (13.4), inventory
turnover (5.0). (Hint: This is the same company used in the previous Self-Test.)
A firm has $200 million annual sales, $180 million costs of goods sold, $40 million of inventory,
and $60 million of accounts receivable. What is its inventory turnover ratio? (4.5) What is its DSO
based on a 365-day year? (109.5 days)
3-4 Liquidity Ratios
As shown in Figure 3-1, MicroDrive has current liabilities of$750 million that it must pay
off within the coming year. Will it have trouble satisfying those obligations? Liquidity
ratios attempt to answer this type of question. We discuss two commonly used liquidity
ratios in this section.
3-4a The Current Ratio
Current assets normally include cash, marketable securities, accounts receivable, and in
ventories. Current liabilities consist of accounts payable, short-term notes payable, current
maturities of long-term debt, accrued taxes, and other accrued expenses. The current
ratio measures liquidity by comparing the current assets to the current liabilities:
Current assets
Current ratio =
1 bil Current ia ities
MicroDrive’s current ratio is:
$1,610
Current ratio = — = 2.147 = 2.1
$750
Industry average = 2.3
I
MicroDrive has a slightly lower current ratio than the average for its industry. 3 Is this
good or bad? Sometimes the answer depends on who is asking the question. For example,
suppose a supplier is trying to decide whether to extend credit to MicroDrive. In general,
creditors like to see a high current ratio. If a company starts to experience financial dif
ficulty, it will begin paying its bills (accounts payable) more slowly and borrowing more
from its bank, so its current liabilities will be increasing. If current liabilities are rising
faster than current assets, then the current ratio will fall, and this could spell trouble.
Because the current ratio provides the best single indicator of the extent to which the
claims of short-term creditors are covered by assets that are expected to be converted to
cash fairly quickly, it is the most commonly used measure of short-term solvency.
Now consider the current ratio from a shareholder’s perspective. A high current ratio
could mean that the company has a lot of money tied up in nonproductive assets, such
as excess cash or marketable securities. Or perhaps the high current ratio is due to large
‘A good source for industry ratios and for S&P 500 ratios is CS!Market.com: http://csimarket.com/Industry
/industry_Financial_Strength_Ratios.php.
112 Part 1 The Company and Its Environment
inventory holdings, which might become obsolete before they can be sold. Thus, share
holders might not want a high current ratio.
An industry average is not a magic number that all firms should strive to maintain
in fact, some well-managed firms will be above the average, while other good firms will
be below it. However, if a firm’s ratios are far from the averages for its industry, this is a
red flag, and analysts should be concerned about why the variance occurs. For example,
suppose a low current ratio is traced to low inventories. Is this a competitive advan
tage resulting from the firm’s mastery of just-in-time inventory management, or is it an
Achilles’ heel that is causing the firm to miss shipments and lose sales? Ratio analysis
doesn’t answer such questions, but it does point to areas of potential concern.
3-4b The Quick Ratio
The quick ratio, also called the acid test ratio, is calculated by deducting inventories from
current assets and then dividing the remainder by current liabilities:
k
Current assets – Inventories
Quic ratio=———-
Current liabilities
MicroDrive’s quick ratio is:
$1,610 – $1,000
Quick ratio = —— = 0.81 = 0.8
$750
Industry average = 1.0
I
A liquid asset is one that trades in an active market, so it can be converted quickly to
cash at the going market price. Inventories are typically the least liquid of a firm’s cur
rent assets; hence, they are the current assets on which losses are most likely to occur in
a bankruptcy. Therefore, a measure of the firm’s ability to pay off short-term obligations
without relying on the sale of inventories is important.
MicroDrive’s quick ratio is just below the industry average and is below 1.0. This
means that MicroDrive would have to liquidate inventory in order to pay off current lia
bilities should the need arise.
How does MicroDrive compare to S&P 500 companies? There has been a steady decline
in the average liquidity ratios of S&P 500 companies during the past decade. As we write
this in 2018, the average current ratio is about 1.5, and the average quick ratio is about 0.6, so
MicroDrive and its industry peers are a little more liquid than the typical S&P 500 company.
SELF -TEST
Identify two ratios to use to analyze a firm’s liquidity position, and write out their equations.
What are the characteristics of a liquid asset? Give some examples.
Which current asset is typically the least liquid?
A company has the following information on its balance sheets: Cash = $40, accounts receivable =
$30, inventories = $100, net fixed assets = $500, accounts payable = $20, accruals = $10, short
term debt (matures in less than a year) = $25, long-term debt = $200, and total common equity =
$415. What is its current ratio? (3.1) Its quick ratio? (1.3)
Morris Corporation has current liabilities of $800 million, and its current ratio is 2.5. What is its
level of current assets? ($2,000 million) If this firm’s quick ratio is 2, how much inventory does it
have? ($400 million)
(
Chapter 3 Analysis of Financial Statements 113
3-5 Debt Management Ratios
The extent to which a firm uses debt financing is called financial leverage. Here are
three important implications: (1) Stockholders can control a firm with smaller invest
ments of their own equity if they fin
