Chapter 03

The Stockholders’Report
Every corporation has many and varied uses for the standardized records and reports of its financial activities.
reports must be prepared for regulators, creditors (lenders), owners, and management. The guidelines used to
pre- pare and maintain financial records and reports are known as generally accepted accounting principles
(GAAP). These accounting practices and procedures are authorized by the accounting profession’s rule-setting
body, the Financial Ac- counting Standards Board (FASB).
In addition, the Sarbanes-Oxley Act of 2002, enacted in an effort to eliminate the many disclosure and
conflict-of-interest problems of corporations, established the Public Company Accounting Oversight Board
(PCAOB), a not-for-profit corporation that oversees auditors of public corporations. The PCAOB is charged
with protecting the interests of investors and furthering the public interest in the preparation of informative,
fair, and independent audit reports. The expectation is that it will instill confidence in investors with regard to
the accuracy of the audited financial statements of public companies.
Publicly owned corporations with more than $5 million in assets and 500 or more stockholders are required
by the U.S. Securities and Exchange Commission (SEC)—the federal regulatory body that governs the sale
and listing of securities— to provide their stockholders with an annual stockholders’ report. The stockhold-
ers’ report summarizes and documents the firm’s financial activities during the past year. It begins with a
letter to the stockholders from the firm’s chief executiveofficer or chairman of the board.

THE LETTER TO STOCKHOLDERS

The letter to stockholders is the primary communication from management. It describes the events
that are considered to have had the greatest effect on the firm during the year. It also typically
discusses management philosophy, corporate governance issues, strategies, and actions as well as plans
for the coming year.
THE FOUR KEY FINANCIAL STATEMENTS
The four key financial statements required by the SEC for reporting to sharehold- ers are (1) the income
statement, (2) the balance sheet, (3) the statement of stock- holders’ equity, and (4) the statement of
cash flows.
Income Statement
The income statement provides a financial summary of the firm’s operating results during a specified period.
Most common are income statements cover- ing a 1-year period ending at a specified date, ordinarily December
31 of the calendar year. Many large firms, however, operate on a 12-month financial cycle, or fis- cal year,
that ends at a time other than December 31. In addition, monthly income statements are typically
prepared for use by management, and quar- terly statements must be made available to the stockholders of
publicly owned corporations.
this amount does not consider financial and tax costs. (Operating profit is often called earnings before
interest and taxes, or EBIT.) Next, the financial cost—interest expense—is subtracted from operating
profits

2015 2014
Sales revenue $3,074 $2,567
Less: Cost of goods sold 2,088 1,711
Gross profits $ 986 $ 856
Less: Operating expenses
Selling expense $ 100 $ 108
General and administrative expenses 194 187
Lease expensea 35 35

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 Depreciation expense 239 223
Total operating expense $ 568 $ 553
Operating profits $ 418 $ 303
Less: Interest expense 93 91
Net profits before taxes $ 325 $ 212
Less: Taxes 94 64
Net profits after taxes $ 231 $ 148
Less: Preferred stock dividends 10 10
Earnings available for common stockholders $ 221 $ 138

Earnings per share (EPS)b $2.90 $1.81

Dividend per share (DPS)c $1.29 $0.75
to find net profits (or earnings) before taxes. After subtracting $93,000 in 2015 interest, Bartlett Company had
$325,000 of net profits before taxes.
Next, taxes are calculated at the appropriate tax rates and deducted to deter- mine net profits (or earnings)
after taxes, also referred to as net income. Bartlett Company’s net profits after taxes for 2015 were $231,000.
Any preferred stock dividends must be subtracted from net profits after taxes to arrive at earnings available for
common stockholders, which is the amount earned by the firm on behalf of the common stockholders during
the period.
Dividing earnings available for common stockholders by the number of shares of common stock outstanding
results in earnings per share (EPS). EPS represent thenumber of dollars earned during the period on behalf of each
outstanding share of common stock. In 2015, Bartlett Company earned $221,000 for its common stock- holders,
which represents $2.90 for each outstanding share.
The actual cash divi- dend per share (DPS), which is the dollar amount of cash distributed during the pe- riod
on behalf of each outstanding share of common stock, paid in 2015 was $1.29.
Balance Sheet
The balance sheet presents a summary statement of the firm’s financial position at a given time. The statement
balances the firm’s assets (what it owns) against itsfinancing, which can be either debt (what it owes) or equity
(what was provided by owners). Bartlett Company’s balance sheets as of December 31 of 2015 and 2014 are
presented in Table 3.2. They show a variety of asset, liability (debt), and equity accounts.
An important distinction is made between short-term and long-term assets and liabilities. The current
assets and current liabilities are short-term assets and liabilities, which means that they are expected to be
converted into cash (current assets) or paid (current liabilities) within 1 year or less.
All other assets and liabil- ities, along with stockholders’ equity, which is assumed to have an infinite
life, are considered long-term, or fixed, because they are expected to remain on the firm’s books for more than
1 year.
As is customary, the assets are listed from the most liquid—cash—down to the least liquid.
Marketable securities are very liquid short-term investments, such as U.S. Treasury bills or certificates
of deposit, held by the firm. Becausethey are highly liquid, marketable securities are viewed as a form of cash
(“near cash”).
Accounts receivable represent the total monies owed the firm by its cus- tomers on credit sales.
Inventories include raw materials, work in process (par- tially finished goods), and finished goods held by the
firm. The entry for gross fixed assets is the original cost of all fixed (long-term) assets owned by the firm.1 Net
fixed assets represent the difference between gross fixed assets and accumu- lated depreciation, the total
expense recorded for the depreciation of fixed assets.The net value of fixed assets is called their book value.
Like assets, the liabilities and equity accounts are listed from short-term to long-term.
Current liabilities include accounts payable, amounts owed for credit purchases by the firm; notes
payable, outstanding short-term loans, typically from commercial banks and interest is charged on notes
payable
accruals, amounts owed for services for which a bill may not or will not be received. Examples of accruals
include taxes due the gov- ernment and wages due employees.
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 Long-term debt represents debt for which payment is not due in the current year. Stockholders’ equity
represents the own- ers’ claims on the firm. The preferred stock entry shows the historical proceeds from the
sale of preferred stock ($200,000 for Bartlett Company).
Next, the amount paid by the original purchasers of common stock is shown by two entries, common stock
and paid-in capital in excess of par on common stock.
1. The common stock entry is the par value of common stock.
2. Paid-in capital in excess of par represents the amount of proceeds in excess of the par value re- ceived
from the original sale of common stock. The sum of the common stock and paid-in capital accounts divided
by the number of shares outstanding repre- sents the original price per share received by the firm on a single
issue of commonstock.
Assets 2015 2014
Cash $ 363 $ 288
Marketable securities 68 51
Accounts receivable 503 365
Inventories 289 300
Total current assets $1,223 $1,004
Land and buildings $2,072 $1,903
Machinery and equipment 1,866 1,693
Furniture and fixtures 358 316
Vehicles 275 314
Other (includes financial leases) 98 96
Total gross fixed assets (at cost) $4,669 $4,322
Less: Accumulated depreciation 2,295 2,056
Net fixed assets $2,374 $2,266
Total assets $3,597 $3,270

Liabilities and Stockholders’ Equity

Accounts payable $ 382 $ 270
Notes payable 79 99
Accruals 159 114
Total current liabilities $ 620 $ 483
Long-term debt (includes financial leases) 1,023 967
Total liabilities $1,643 $1,450
Preferred stock: cumulative 5%, $100 par, 2,000 $ 200 $ 200
Common stock: $2.50 par, 100,000 shares authorized, shares
issued and outstanding in 2015: 76,262; in 2014: 76,244 191 190
Paid-in capital in excess of par on common stock 428 418
Retained earnings 1,135 1,012
Total stockholders’ equity (200+191+428+1135) $1,954 $1,820
Total liabilities and stockholders’ equity $3,597 $3,270

Finally, retained earnings represent the cumulative total of all earnings, net of dividends, that have been
retained and reinvested in the firm since its inception. It is important to recognize that retained earnings
are not cash but rather have beenused to finance the firm’s assets.
Statement of Retained Earnings

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The statement of retained earnings is an abbreviated form of the statement of stockholders’ equity. Unlike the
statement of stockholders’ equity, which shows all equity account transactions that occurred during a given year,
the statement ofretained earnings reconciles the net income earned during a given year, and any cash dividends
paid, with the change in retained earnings between the start and the end of that year.

Retained earnings balance (January 1, 2015) $1,012

Plus: Net profits after taxes (for 2015) 231
Less: Cash dividends (paid during 2015)
Preferred stock 10
Common stock 98
Total dividends paid $ 108
Retained earnings balance (December 31, 2015) $1,135

Statement of Cash Flows

The statement of cash flows is a summary of the cash flows over the period of concern. The statement
provides insight into the firm’s operating, investment, and financing cash flows and reconciles them with
changes in its cash and mar- ketable securities during the period.

Cash Flow from Operating Activities

Net profits after taxes $ 231
Depreciation +239
Increase in accounts receivable -( 138)a
Decrease in inventories +11
Increase in accounts payable +112
Increase in accruals + 45
Cash provided by operating activities $ 500
Cash Flow from Investment Activities
Increase in gross fixed assets ( 347)
Change in equity investments in other firms 0
Cash provided by investment activities ($ 347)
Cash Flow from Financing Activities
Decrease in notes payable (20)
Increase in long-term debts 56
Changes in stockholders’ equity b 11
Dividends paid ( 108)
Cash provided by financing activities ($ 61)
Net increase in cash and marketable securities $ 92

aAs is customary, parentheses are used to denote a negative number, which in this case is a cash outflow.
b
Retained earnings are excluded here because their change is actually reflected in the combination of the “net
profits after taxes” and “dividends paid” entries. (MCQ)
Asset increase (Less)
Assets decrease (Plus)
Liabilities increase (Plus)
Liabilities decrease (Less)
Depreciation (Plus)
Dividend paid (Less)
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 The current policy is described in Financial Accounting Standards Board (FASB) Standard No. 52, which
mandates that U.S.–based companies translate their foreign-currency-denominated assets and liabilities into
U.S. dollars for con- solidation with the parent company’s financial statements. This process is doneby using a
technique called the current rate (translation) method, under which all a U.S. parent company’s foreign-
currency-denominated assets and liabilities are converted into dollar values using the exchange rate prevailing
at the fiscal year ending date (the current rate). Income statement items are treated simi- larly. Equity
accounts, on the other hand, are translated into dollars by using the exchange rate that prevailed when the
parent’s equity investment was made (the historical rate). Retained earnings are adjusted to reflect each year’s
oper- ating profits or losses.

Using Financial Ratios

The information contained in the four basic financial statements is of major sig- nificance to a variety of interested
parties who regularly need to have relative measures of the company’s performance. Relative is the key word
here, because the analysis of financial statements is based on the use of ratios or relative values. Ratio analysis
involves methods of calculating and interpreting financial ratios to analyze and monitor the firm’s performance.
The basic inputs to ratio analysisare the firm’s income statement and balance sheet.

INTERESTED PARTIES
Ratio analysis of a firm’s financial statements is of interest to shareholders, credi- tors, and the firm’s own
management.
1. Both current and prospective shareholders are interested in the firm’s current and future level of risk and
return, which directlyaffect share price.
2. The firm’s creditors are interested primarily in the short-term li- quidity of the company and its ability to make
interest and principal payments. A secondary concern of creditors is the firm’s profitability; they want
assurance thatthe business is healthy.
3. Management, like stockholders, is concerned with all aspects of the firm’s financial situation, and it attempts
to produce financial ratios that will be considered favorable by both owners and creditors. In addition, man-
agement uses ratios to monitor the firm’s performance from period to period.
The difference between shareholders and stockholders is that a shareholder buys shares from the company, and
they invest their money in buying those shares, while stockholders buy stocks from a particular company or
purchase them from a stock market
There is no real difference between the terms, and their usage often depends on regional preferences. For
instance, “shareholder” is commonly used in the United Kingdom and many Commonwealth countries, whereas
“stockholder” is frequently used in the United States. It’s also worth noting that different companies may use
different terms in their corporate communications, but the rights and responsibilities of a shareholder and a
stockholder are the same.
Cross-sectional analysis involves the comparison of different firms’ financial ra- tios at the same point in time.
Analysts are often interested in how well a firm has performed in relation to other firms in its industry.
Frequently, a firm will compare its ratio values with those of a key competitor or with a group of com-petitors that
it wishes to emulate. This type of cross-sectional analysis, called benchmarking, has become very popular.
Comparison to industry averages is also popular. It is also possible to derive financial ratios for yourself using
financial information reported in financial databases, such as Compustat.
Analysts have to be very careful when drawing conclusions from ratio com- parisons. It’s tempting to
assume that if one ratio for a particular firm is above the industry norm, it is a sign that the firm is
performing well, at least along the di- mension measured by that ratio. However, ratios may be above or
below the in- dustry norm for both positive and negative reasons, and it is necessary to deter- mine why a

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firm’s performance differs from its industry peers. Thus, ratio analysis on its own is probably most useful in
highlighting areas for further investigation.
Time-Series Analysis
Time-series analysis evaluates performance over time. Comparison of current to past performance, using ratios,
enables analysts to assess the firm’s progress. De- veloping trends can be seen by using multiyear comparisons.
Any significant year-to-year changes may be symptomatic of a problem, especially if the same trend is not an
industry-wide phenomenon.

Combined Analysis
The most informative approach to ratio analysis combines cross-sectional and time-series analyses. A
combined view makes it possible to assess the trend in the behavior of the ratio in relation to the trend for
the industry.
CAUTIONS ABOUT USING RATIO ANALYSIS
Before discussing specific ratios, we should consider the following cautions abouttheir use:
1.Ratios that reveal large deviations from the norm merely indicate the possi- bility of a problem. Additional
analysis is typically needed to determine whether there is a problem and to isolate the causes of the problem.
2.A single ratio does not generally provide sufficient information from which to judge the overall performance
of the firm. However, if an analysis is con- cerned only with certain specific aspects of a firm’s financial position,
one or two ratios may suffice.
3.The ratios being compared should be calculated using financial statements dated at the same point in time
during the year. If they are not, the effects ofseasonality may produce erroneous conclusions and decisions.
4.It is preferable to use audited financial statements for ratio analysis. If they have not been audited, the data in
them may not reflect the firm’s true finan-cial condition.
5.The financial data being compared should have been developed in the same way. The use of differing
accounting treatments—especially relative to inven- tory and depreciation—can distort the results of ratio
comparisons, regard- less of whether cross-sectional or time-series analysis is used.
6.Results can be distorted by inflation, which can cause the book values of inven- tory and depreciable assets to
differ greatly from their replacement values. Ad- ditionally, inventory costs and depreciation write-offs can differ from
their true values, thereby distorting profits. Without adjustment, inflation tends to cause older firms (older assets) to
appear more efficient and profitable than newer firms (newer assets). Clearly, in using ratios, you must be careful
when comparing older with newer firms or comparing a firm to itself over a long period of time.
CATEGORIES OF FINANCIAL RATIOS
Financial ratios can be divided for convenience into five general categories:
1. liquidity,
2. activity,
3. debt,
4. profitability, and
5. market ratios.
Liquidity, activity, and debt ratios primarily measure risk. Profitability ratios
measure return. Marketratios capture both risk and return.
Liquidity Ratios
The liquidity of a firm is measured by its ability to satisfy its short-term obligations asthey come due. Liquidity
refers to the solvency of the firm’s overall financial position,or the ease with which it can pay its bills.
Because a common precursor to financial distress and bankruptcy is low or declining liquidity, these ratios
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can provide early signs of cash flow problems and impending business failure. Clearly, it is desirable that a
firm is able to pay its bills, so having enough liquidity for day-to-day opera- tions is important. However,
liquid assets, like cash held at banks and marketable securities, do not earn a particularly high rate of return,
so shareholders will not wanta firm to overinvest in liquidity. Firms have to balance the need for safety that
liquid- ity provides against the low returns that liquid assets generate for investors. The two basic measures of
liquidity are the current ratio and the quick (acid-test) ratio.
CURRENT RATIO
The current ratio, one of the most commonly cited financial ratios, measures the firm’s ability to meet its short-
term obligations. It is expressed as

Current ratio = Current assets ÷ Current liabilities (3.1)

The current ratio for Bartlett Company in 2015 is

$1,223,000 ÷ $620,000 = 1.97
A higher current ratio indicates a greater degree of liquidity. How much liquidity a firm needs depends on a
variety of factors, including the firm’s size, its access to short-term financing sources like bank credit lines,
and the volatility of its business. For example, a grocery store whose revenues are relatively predictable may
not needas much liquidity as a manufacturing firm who faces sudden and unexpected shifts in demand for its
products. The more predictable a firm’s cash flows, the lower the ac- ceptable current ratio. Because Bartlett
Company is in a business with a relatively predictable annual cash flow, its current ratio of 1.97 should be
quite acceptable.
QUICK (ACID-TEST) RATIO
The quick (acid-test) ratio is similar to the current ratio except that it excludes in- ventory, which is generally the
least liquid current asset. The generally low liquidityof inventory results from two primary factors:
(1) Many types of inventory cannot be easily sold because they are partially completed items, special-purpose
items, and the like; and
(2) inventory is typically sold on credit, which means that it be- comes an account receivable before being
converted into cash.
(3)An additional problem with inventory as a liquid asset is that the times when companies face the most dire
need for liquidity, when business is bad, are precisely the times when it is most difficult to convert
inventory into cash by selling it. The quick ratio is calculated as

Current assets - Inventory

Quick ratio = (3.2)
Current liabilities

The quick ratio for Bartlett Company in 2015 is

$1,223,000 - $289,000 $934,000
= = 1.51
$620,000 $620,000

As with the current ratio, the quick ratio level that a firm should strive to achieve depends largely on the
nature of the business in which it operates. The quick ratio provides a better measure of overall liquidity
only when a firm’s in- ventory cannot be easily converted into cash. If inventory is liquid, the current ratio
is a preferred measure of overall liquidity.

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Activity Ratios
Measure the speed with which various accounts are converted into sales or cash, or inflows or outflows.
Activity ratios measure the speed with which various accounts are converted into sales or cash, or inflows or
outflows. In a sense, activity ratios measure how efficiently a firm operates along a variety of dimensions such as
inventory manage- ment, disbursements, and collections. A number of ratios are available for measuring the
activity of the most important current accounts, which include inventory, accounts receivable, and accounts
payable. The efficiency with which total assets are used can also be assessed.
Inventory turnover
commonly measures the activity, or liquidity, of a firm’s in- ventory. It is calculated as

Inventory turnover = Cost of goods sold ÷ Inventory (3.3)

Applying this relationship to Bartlett Company in 2015 yields

$2,088,000 ÷ $289,000 = 7.2
The resulting turnover is meaningful only when it is compared with that of other firms in the same industry
or to the firm’s past inventory turnover. An inventory turnover of 20 would not be unusual for a grocery
store, whose goods are highly perishable and must be sold quickly, whereas an aircraft manufacturer
might turn its inventory just four times per year.
Another inventory activity ratio measures how many days of inventory the firm has on hand. Inventory
turnover can be easily converted into an average age of inventory by dividing it into 365. For Bartlett
Company, the average age of inventory in 2015 is 50.7 days (kept in hand) (365 ÷ 7.2). This value can also
be viewed as the average number of days’ sales in inventory.
Average number of days’ sales in inventory. how many days of inventory the firm has on hand.

AVERAGE COLLECTION PERIOD

The average amount of time needed to collect accounts receivable.

The average collection period, or average age of accounts receivable, is useful in evaluating credit and
collection policies. It is arrived at by dividing the average daily sales into the accounts receivable balance:2

Accounts receivable
Average collection period =
Average sales per day
(3.4)
Accounts receivable
=
Annual sales
365

503000/3074000/365=59.7 DAYS

On average, it takes the firm 59.7 days to collect an account receivable.

The average collection period is meaningful only in relation to the firm’s credit terms. If Bartlett Company
extends 30-day credit terms to customers, an average col-lection period of 59.7 days may indicate a poorly
managed credit department, collec-tion department, or both. It is also possible that the lengthened collection
period re-sulted from an intentional relaxation of credit-term enforcement in response to competitive
pressures. If the firm had extended 60-day credit terms, the 59.7-day average collection period would be

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quite acceptable. Clearly, additional information is needed to evaluate the effectiveness of the firm’s credit and
collection policies.
The formula as presented assumes, for simplicity, that all sales are made on a credit basis. If that is not the case,
average credit sales per day should be substituted for average sales per day.(MCQ)

AVERAGE PAYMENT PERIOD

The average amount of time needed to pay accounts payable
The average payment period, or average age of accounts payable, is calculated in the same manner as the
average collection period:

Accounts payable
Average payment period =
Average purchases per day
(3.5)
Accounts payable ÷
=
Annual purchases
365

The difficulty in calculating this ratio stems from the need to find annual pur- chases,3 a value not
available in published financial statements. Ordinarily, pur- chases are estimated as a given percentage
of cost of goods sold. If we assume that Bartlett Company’s purchases equaled 70 percent of its cost of
goods sold in 2015, its average payment period is
382000/2088000*0.70/365=95.4 DAYS

The 95.4 days is meaningful only in relation to the average credit terms extended to the firm. If Bartlett
Company’s suppliers have extended, on average, 30-day credit terms, an analyst would give Bartlett a low
credit rating because it was tak- ing too long to pay its bills. Prospective lenders and suppliers of trade
credit are interested in the average payment period because it provides insight into the firm’s bill-paying
patterns.
Technically, annual credit purchases—rather than annual purchases—should be used in calculating this ratio. For simplicity,
this refinement is ignored here.(MCQ)

TOTAL ASSET TURNOVER

The total asset turnover indicates the efficiency with which the firm uses its assets to generate sales. Total
asset turnover is calculated as

Total asset turnover = Sales ÷ Total assets (3.6)

3074000/3597000=0.85

which means that the company turns over its assets 0.85 times per year.
Generally, the higher a firm’s total asset turnover, the more efficiently its assets have been used. This measure is
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probably of greatest interest to management because it indicates whether the firm’s operations have been
financially efficient.

Debt Ratios
The debt position of a firm indicates the amount of other people’s money being used to generate profits. In
general, the financial analyst is most concerned with long-term debts because these commit the firm to a
stream of contractual pay- ments over the long run. The more debt a firm has, the greater its risk of being
unable to meet its contractual debt payments. Because creditors’ claims must be satisfied before the earnings
can be distributed to shareholders, current and pro- spective shareholders pay close attention to the firm’s
ability to repay debts. Lenders are also concerned about the firm’s indebtedness.
In general, the more debt a firm uses in relation to its total assets, the greaterits financial leverage. (MCQ)
Financial leverage is the magnification of risk and return through the use of fixed-cost financing, such as
debt and preferred stock. (MCQ)
The more fixed-cost debt a firm uses, the greater will be its expected risk and return. (MCQ)

Balance sheets No-debt plan Debt plan

Current assets $20,000 $20,000
Fixed assets 30,000 30,000
Total assets $50,000 $50,000
Debt (12% interest) $ 0 $25,000
(1) Equity 50,000 25,000
Total liabilities and equity $50,000 $50,000

Income Statements
Sales $30,000 $30,000
Less: Operating expenses 18,000 18,000
Operating profits $12,000 $12,000
Less: Interest expense 0 0.12 3 $25,000 5 3,000
Net profits before taxes $12,000 $ 9,000
Less: Taxes (rate 40%) 4,800 3,600
(2) Net profits after taxes $ 7,200 $ 5,400
Return on equity 3 (2) , (1) 4 7200/50000=14.4 5400/25000=21.6

EXAMPLE:Patty Akers is in the process of incorporating her new business. After much anal- ysis, she
determined that an initial investment of $50,000—$20,000 in current assets and $30,000 in fixed assets—is
necessary. These funds can be obtained in either of two ways. The first is the no-debt plan, under which she
would invest the full $50,000 without borrowing. The other alternative, the debt plan, in- volves investing
$25,000 and borrowing the balance of $25,000 at 12% annualinterest.
Patty expects $30,000 in sales, $18,000 in operating expenses, and a 40% tax rate. Projected balance
sheets and income statements associated with the two plans are summarized in Table 3.6. The no-debt plan
results in after-tax profits of
$7,200, which represent a 14.4% rate of return on Patty’s $50,000 investment.
The debt plan results in $5,400 of after-tax profits, which represent a 21.6% rateof return on Patty’s investment of
$25,000. The debt plan provides Patty with a higher rate of return, but the risk of this plan is also greater
because the annual
$3,000 of interest must be paid whether Patty’s business is profitable or not.
The previous example demonstrates that with increased debt comes greater risk as well as higher potential return.
Therefore, the greater the financial leverage, the greater the potential risk and return. A detailed discussion of the
effect of debt on the firm’s risk, return, and value is included in Chapter 12. Here, we emphasize the use of financial
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leverage ratios to assess externally a firm’s debt position.
There are two general types of leverage measures: measures of the degree ofindebtedness and measures of the ability
to service debts.
1. The degree of indebted- ness measures the amount of debt relative to other significant balance sheet
amounts. Two popular measures of the degree of indebtedness are the
A..debt ratio
B.. and the debt-to-equity ratio.
The second type of leverage measures, the
2. ability to service debts, reflect a firm’s ability to make the payments required on a scheduled basis over
the life of a debt. The term to service debts simply means to pay debts on time. The firm’s ability to pay certain
fixed charges is measured using coverage ratios.
Typically, higher coverage ratios are preferred (especially by the firm’s lenders), but a very high ra- tio
might indicate that the firm’s management is too conservative and might be able to earn higher returns by
borrowing more. In general, the lower the firm’s coverage ratios, the less certain it is to be able to pay
fixed obligations. If a firm is unable to pay these obligations, its creditors may seek immediate repayment,
which in most instances would force a firm into bankruptcy. Two popular cover- age ratios are the times
interest earned ratio and the fixed-payment coverage ratio.
DEBT RATIO
The debt ratio measures the proportion of total assets financed by the firm’s creditors. The higher this
ratio, the greater the amount of other people’s money being used to generate profits. The ratio is
calculated as

Debt ratio= Total liabilities / Total assets (3.7)

The debt ratio for Bartlett Company in 2015 is

$1,643,000 , $3,597,000 = 0.457 = 45.7,
This value indicates that the company has financed close to half of its assets with debt. The higher this ratio, the
greater the firm’s degree of indebtedness and the more financial leverage it has.
DEBT-TO-EQUITY RATIO
The debt-to-equity ratio measures the relative proportion of total liabilties to common stock equity used to finance
the firm’s assets. As with debt ratio, the higher this ratio, the greater the firm’s use of financial leverage. The
debt-to- equity ratio is calculated as

Debt to equity ratio = Total liabilities / Common stock equity (3.8)

The debt-to-equity ratio for Bartlett Company in 2015 is

$1,643,000 /$1,754,000 = 0.937 = 93.7,
This result tells us that for every $1.00 common stockholders have invested in Bartlett Company, the
company owes about 94 cents to creditors. The value for common stock equity ($1,754,000) was found by
subtracting the $200,000 of preferred stock equity from the total stockholders’ equity of $1,954,000. It is
important to note that several methods exist for calculating the debt-to-equity ratio. A common
alternative uses only long-term debt in the numerator.
TIMES INTEREST EARNED RATIO
The times interest earned ratio, sometimes called the interest coverage ratio, mea- sures the firm’s ability to
make contractual interest payments. The higher its value, the better able the firm is to fulfill its interest
obligations. The times inter- est earned ratio is calculated as
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 Times interest earned ratio = Earnings before interest and taxes / Interest (3.9)

The times interest earned ratio for Bartlett Company seems acceptable. A value of at least 3.0—and
preferably closer to 5.0—is often suggested. The firm’s earnings be- fore interest and taxes could shrink by
as much as 78 percent [(4.49 2 1.0) 4 4.49] and the firm would still be able to pay the $93,000 in interest it
owes. Thus, the firm has a large margin of safety.
FIXED-PAYMENT COVERAGE RATIO
The fixed-payment coverage ratio measures the firm’s ability to meet all fixed- payment obligations such
as loan interest and principal, lease payments, and pre- ferred stock dividends. As is true of the times
interest earned ratio, the higher thisvalue, the better. The formula for the fixed-payment coverage ratio is
Fixed
payment Earnings before interest and taxes + Lease payments
=
coverage Interest + Lease payments +
ratio 51Principal payments + Preferred stock dividends 2 * 31> 11 - T246
(3.10)

where T is the corporate tax rate applicable to the firm’s income. The term 1/(1
T) is included to adjust the after-tax principal and preferred stock dividend pay- ments back to a before-tax
equivalent that is consistent with the before-tax values of all other terms. Applying the formula to Bartlett
Company’s 2015 data yields
Fixed@payment $418,000 + $35,000
=
coverage ratio $93,000 + $35,000 + 5($71,000 + $10,000) * 31>(1 - 0.29)46
$453,000
= = 1.87
$242,000

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Because the earnings available are nearly twice as large as its fixed-payment obli- gations, the firm appears safely
able to meet the latter.
Like the times interest earned ratio, the fixed-payment coverage ratio mea- sures risk. The lower the
ratio, the greater the risk to both lenders and owners, and the greater the ratio, the lower the risk. This
ratio allows interested parties toassess the firm’s ability to meet additional fixed-payment obligations
without be- ing driven into bankruptcy
Profitability Ratios
COMMON-SIZE INCOME STATEMENTS
A useful tool for evaluating profitability in relation to sales is the common-size income statement. Each item on
this statement is expressed as a percentage of sales. Common-size income statements are especially useful when
comparing perfor- mance across years because it is easy to see if certain categories of expenses are trending up
or down as a percentage of the total volume of business that the com- pany transacts. Three frequently cited
ratios of profitability that come directly from the common-size income statement are (1) the gross profit margin,
(2) the operat- ing profit margin, and (3) the net profit margin.
Common-size income statements for 2015 and 2014 for Bartlett Company arepresented and evaluated in
Table 3.7 on page 129. These statements reveal that the firm’s cost of goods sold increased from 66.7 percent
of sales in 2014 to 67.9 percentin 2015, resulting in a worsening gross profit margin. However, thanks to a
decrease in total operating expenses, the firm’s net profit margin rose from 5.4 percent of salesin 2014 to 7.2
percent in 2015. The decrease in expenses more than compensated forthe increase in the cost of goods sold. A
decrease in the firm’s 2015 interest expense(3.0 percent of sales versus 3.5 percent in 2014) added to the
increase in 2015 profits.
GROSS PROFIT MARGIN
The gross profit margin measures the percentage of each sales dollar remaining after the firm has paid for
its goods. The higher the gross profit margin, the better (that is, the lower the relative cost of merchandise
sold). The gross profit margin is calculated as
Sales - Cost of goods sold = Gross profits
Gross profit margin = (3.11)
Sales Sales

Bartlett Company’s gross profit margin for 2015 is

3074000-2088000/3074000=32.1
OPERATING PROFIT MARGIN
The operating profit margin measures the percentage of each sales dollar remain- ing after all costs and
expenses other than interest, taxes, and preferred stock dividends are deducted. It represents the “pure
profits” earned on each sales dollar. Operating profits are “pure” because they measure only the profits
earned on operations and ignore interest, taxes, and preferred stock dividends. A high operating profit
margin is preferred. The operating profit margin is calculated as

Operating profit margin = Operating profits ÷ Sales (3.12)

Bartlett Company’s operating profit margin for 2015 is

$418,000 ÷ $3,074,000 = 0.136 = 13.6,
This value is labeled (2) on the common-size income statement in Table 3.7.

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 NET PROFIT MARGIN
The net profit margin measures the percentage of each sales dollar remaining af- ter all costs and
expenses, including interest, taxes, and preferred stock dividends, have been deducted. The higher the
firm’s net profit margin, the better. The net profit margin is calculated as

Net profit
Bartlett Company’s = earnings
marginnet available
profit margin for common
for 2015 is stockholders / Sales (3.13)

$221,000 / $3,074,000 = 0.072 = 7.2,

The net profit margin is a commonly cited measure of the firm’s success with re- spect to earnings on sales.
“Good” net profit margins differ considerably across indus-tries. A net profit margin of 1 percent or less would
not be unusual for a grocery store,whereas a net profit margin of 10 percent would be low for a retail jewelry
store.
EARNINGS PER SHARE (EPS)
The firm’s earnings per share (EPS) is generally of interest to present or prospec- tive stockholders and
management. As we noted earlier, EPS represents the num-ber of dollars earned during the period on
behalf of each outstanding share of common stock. Earnings per share is calculated as

Earnings available for common stockholders

Earnings per share = (3.14)
Number of shares of common stock outstanding

This figure represents the dollar amount earned on behalf of each outstanding share of common stock. The
dollar amount of cash actually distributed to each shareholderis the dividend per share (DPS), which, as
noted in Bartlett Company’s income state- ment (Table 3.1), rose to $1.29 in 2015 from $0.75 in 2014. EPS is
closely watched by the investing public and is considered an important indicator of corporate success.
RETURN ON TOTAL ASSETS (ROA) / return on investment (ROI).
The return on total assets (ROA), often called the return on investment (ROI), measures the overall effectiveness of
management in generating profits with its available assets. The higher the firm’s return on total assets, the better. The
returnon total assets is calculated as

ROA = Earnings available for common stockholders ÷ Total assets (3.15)

$221,000 ÷ $3,597,000 = 0.061 = 6.1,

This value indicates that the company earned 6.1 cents on each $1.00 of common stockholders’ asset
investment. When a firm has preferred stock outstanding, the return on assets can be calculated for all
stockholders by dividing the net profits after taxes by total assets. In this case, you would arrive at an ROA
of 6.4 percent.
RETURN ON EQUITY (ROE)
The return on equity (ROE) measures the return earned on the common stock- holders’ investment in the
firm. Generally, the owners are better off the higher is this return. Return on equity is calculated as

The ROE for Bartlett Company in 2015 is

ROE = Earnings available for common stockholders ÷ Common stock equity (3.16)
$221,000 ÷ $1,754,000 = 0.126 = 12.6,

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The calculated ROE of 12.6 percent indicates that during 2015 Bartlett earned
12.6 cents on each $1.00 of common stock equity. Here again, some analysts will elect to calculate
ROE across stockholders when preferred stock is out- standing. In this case, net profits after taxes
($231,000) is divided by total stockholders’ equity ($1,954,000) to arrive at return on total stockholders’
eq- uity of 11.8 percent. More often than not, publicly traded companies will not have preferred stock,
so the return on total stockholders’ equity will, more of- ten than not, be the same as the ROE for
common equity. The same can be said for the ROA calculations.

Book value per share Common stock equity

= (3.18)
of common stock Number of shares of common stock outstanding
Market Ratios
Market ratios relate the firm’s market value, as measured by its current share price, to certain
accounting values. These ratios give insight into how investors in the marketplace believe that the firm is
doing in terms of risk and return. They tend to reflect, on a relative basis, the common stockholders’
assessment of all aspects of the firm’s past and expected future performance. Here we consider two widely
quoted market ratios, one that focuses on earnings and another that con- siders book value.
PRICE/EARNINGS (P/E) RATIO
The price/earnings (P/E) ratio is commonly used to assess the owners’ appraisal of share value. The P/E
ratio measures the amount that investors are willing to pay for each dollar of a firm’s earnings. The level
of this ratio indicates the degree of confidence that investors have in the firm’s future performance. The
higher the P/E ratio, the greater the investor confidence. The P/E ratio is calculated as

P/E ratio = Market price per share of common stock ÷ Earnings per share (3.17)

If Bartlett Company’s common stock at the end of 2015 was selling at $32.25, the P/E ratio, using the EPS of
$2.90, at year-end 2015 is
$32.25 ÷ $2.90 = 11.12
This figure indicates that investors were paying $11.12 for each $1.00 of earn- ings. The P/E ratio is most
informative when applied in cross-sectional analysis using an industry average P/E ratio or the P/E ratio of
a benchmark firm.
MARKET/BOOK (M/B) RATIO
The market/book (M/B) ratio provides an assessment of how investors view the firm’s performance. It relates the
market value of the firm’s shares to its book— strict accounting—value. To calculate the firm’s M/B ratio, we first
need to find the book value per share of common stock

Book value per share Common stock equity

= (3.18)
of common stock Number of shares of common stock outstanding

Substituting the appropriate values for Bartlett Company from its 2015 balance sheet, we get
Book value per share $1,754,000
= = $23.00
of common stock 76,262

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The formula for the market/book ratio is

Market price per share of common stock

Market/book (M/B) ratio = (3.19)
Book value per share of common stock

Substituting Bartlett Company’s end of 2015 common stock price of $32.25 and its $23.00 book value per
share of common stock (calculated above) into the M/Bratio formula, we get
$32.25 ÷ $23.00 = 1.40
This M/B ratio means that investors are currently paying $1.40 for each $1.00 of book value of Bartlett
Company’s stock.
The stocks of firms that are expected to perform well—improve profits, in- crease their market
share, or launch successful products—typically sell at higher M/B ratios than the stocks of firms
with less attractive outlooks. Simply stated, firms expected to earn high returns relative to their risk
typically sell at higher M/B multiples. Clearly, Bartlett’s future prospects are being viewed favorably
by investors, who are willing to pay more than their book value for the firm’s shares. Like P/E ratios,
M/B ratios are typically assessed cross-sectionally to get a feel for the firm’s return and risk
compared to peer firms.
DUPONT SYSTEM OF ANALYSIS
The DuPont system of analysis is used to dissect (explore) the firm’s financial statements and to assess
its financial condition. It merges the income statement and balance sheet into two summary measures
of profitability, return on total assets (ROA) and return on common equity (ROE). Figure 3.2 depicts
the basic DuPont system with Bartlett Company’s 2015 monetary and ratio values. The upper portion of
the chart summarizes the income statement activities, and the lower portion sum- marizes the balance
sheet activities.
This value is the same as that calculated directly in Section 3.6 (page 130). The Du- Pont formula
enables the firm to break down its return into profit-on-sales and effi- ciency-of-asset-use
components. Typically, a firm with a low net profit margin has a high total asset turnover, which
results in a reasonably good return on total assets. Often, the opposite situation exists.

This value is the same as that calculated directly in Section 3.6 (page 130). The Du- Pont formula
enables the firm to break down its return into profit-on-sales and effi- ciency-of-asset-use
components. Typically, a firm with a low net profit margin has a high total asset turnover, which
results in a reasonably good return on total assets. Often, the opposite situation exists.

16
 The 12.6 percent ROE calculated by using the modified DuPont formula is the same as that
calculated directly (page 131).
The FLM is also often referred to as the equity multiplier, and it is sometimes calculated using total
stockholder’s equity in the denominator. Regardless of whether one chooses to use common stock equity
or total stockholders’ equity, it is important to realize that the multiplier, the debt ratio, and debt-to-
equity ratio are all related such that any one of them can be directly calculated from the other two. For
example, using the debt-to-equity and debt ratios shown on page 126, we can calculate the multiplier as
0.937 / 0.457 = 2.05
In this case, we see that the debt-to-equity ratio divided by the debt ratio provides us with the
financial leverage multiplier. Just be sure that your choices of liabili- ties and stockholder equity are
consistent across the three measures when relating them to one another.
Applying the DuPont System
The advantage of the DuPont system is that it allows the firm to break its return on equity into a profit-
on-sales component (net profit margin), an efficiency-of- asset-use component (total asset turnover), and
a use-of-financial-leverage com- ponent (financial leverage multiplier). The total return to owners can
therefore beanalyzed in these important dimensions.
The use of the DuPont system of analysis as a diagnostic tool is best explained using Figure 3.2.
Beginning with the rightmost value—the ROE—the financial analyst moves to the left,
dissecting and analyzing the inputs to the formula to isolate the probable cause of the resulting
above-average (or below-average) value.
FOCUS ON VALUE
Financial managers review and analyze the firm’s financial statements periodically, both to uncover
developing problems and to assess the firm’s progress toward achieving its goals. These actions are
aimed at preserving and creating value for thefirm’s owners. Financial ratios enable financial
managers to monitor the pulse of thefirm and its progress toward its strategic goals. Although
financial statements and financial ratios rely on accrual concepts, they can provide useful insights
into important aspects of risk and return (cash flow) that affect share price.

17
 SHORT NOTES

generally accepted accounting principles (GAAP) The practice and procedure guidelines used to prepare and
maintain financial records and reports; authorized by the Financial Accounting Standards Board (FASB).
Financial Accounting Standards Board (FASB) The accounting profession’s rule-setting body, which authorizes
generally accepted
accounting principles (GAAP).
Public Company AccountingOversight Board (PCAOB)
A not-for-profit corporation established by the Sarbanes- Oxley Act of 2002 to protect the interests of investors and
further the public interest in the preparation of informative, fair, and independent audit reports.
stockholders’ report Annual report that publicly owned corporations must provide to stockholders; it summarizes and
documents the firm’s financial activities during the past year.
letter to stockholders Typically, the first element of theannual stockholders’ report andthe primary communication
from management.

income statement
Provides a financial summary of the firm’s operating results during a specified period.

dividend per share (DPS) The dollar amount of cash distributed during the period on behalf of each outstandingshare
of common stock.
balance sheet
Summary statement of the firm’s financial position at agiven point in time.

current assets
Short-term assets, expected to be converted into cash within 1 year or less.
current liabilities
Short-term liabilities, expectedto be paid within 1 year or less.
long-term debt
Debt for which payment is not due in the current year.
paid-in capital in excessof par
The amount of proceeds inexcess of the par value received from the original sale of common stock.
retained earnings
The cumulative total of all earnings, net of dividends, that have been retained and reinvested in the firm since its inception.
statement of stockholders’ equity
Shows all equity account transactions that occurredduring a given year.
statement of retainedearnings
Reconciles the net income earned during a given year, and any cash dividends paid, with the change in retained earnings
between the start and the end ofthat year. An abbreviated form of the statement of stockholders’ equity.

statement of cash flows Provides a summary of the firm’s operating, investment, and financing cash flows and
reconciles them with changes in its cash and marketable securities (cash equivelents) during the period.

notes to the financialstatements

Explanatory notes keyed to relevant accounts in the statements; they provide detailed information on the accounting
policies, procedures, calculations, and transactions underlying entriesin the financial statements.

Financial Accounting Standards Board (FASB)Standard No. 52 Mandates that U.S.–based companies translate
their foreign-currency-denominated assets and liabilities into U.S. dollars, for consolidation with the parent
company’s financialstatements. This process is done by using the current rate (translation) method.

current rate (translation)method

Technique used by U.S.–basedcompanies to translate their foreign-currency-denominated assets and liabilities into U.S.
dollars, for consolidation with the parent company’s financial statements, using the year-end(current) exchange rate.

ratio analysis
Involves methods of calculating and interpreting financial ratios to analyze and monitor the firm’s performance.

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 cross-sectional analysis
Comparison of different firms’ financial ratios at the same pointin time; involves comparing the firm’s ratios with those of
other firms in its industry or with industry averages.
benchmarking
A type of cross-sectional analysis in which the firm’s ratio values are compared withthose of a key competitor or with a
group of competitors that it wishes to emulate.

time-series analysis
Evaluation of the firm’s financial performance over time using financial ratio analysis.
liquidity
A firm’s ability to satisfy its short-term obligations as theycome due.
current ratio
A measure of liquidity calculated by dividing the firm’scurrent assets by its current liabilities.
quick (acid-test) ratio
A measure of liquidity calculated by dividing the firm’s current assets minus inventory by its current liabilities.

activity ratios
Measure the speed with which various accounts are converted into sales or cash, or inflows or outflows.

inventory turnover
Measures the activity, or liquidity, of a firm’s inventory.
average age of inventory
Average number of days’ salesin inventory. how many days of inventory the firm has on hand.
average collection period
The average amount of time needed to collect accounts receivable.
average payment period
The average amount of time needed to pay accounts payable.
total asset turnover
Indicates the efficiency with which the firm uses its assets togenerate sales.

financial leverage
The magnification of risk and return through the use of fixed-cost financing, such as debt and preferred stock.

degree of indebtedness
Measures the amount of debtrelative to other significant balance sheet amounts.
ability to service debts
The ability of a firm to makethe payments required on a scheduled basis over the lifeof a debt.
coverage ratios
Ratios that measure the firm’s ability to pay certain fixed charges.
debt ratio
Measures the proportion of total assets financed by the firm’s creditors.
debt-to-equity ratio
Measures the relative proportion of total liabilities and common stock equity usedto finance the firm’s total assets.
times interest earned ratio
Measures the firm’s ability to make contractual interest payments; sometimes called theinterest coverage ratio.

fixed-payment coverageratio
Measures the firm’s ability tomeet all fixed-payment obligations.
common-size incomestatement
An income statement in which each item is expressed as a percentage of sales.
gross profit margin
Measures the percentage of each sales dollar remaining after the firm has paid for its goods.
operating profit margin
Measures the percentage of each sales dollar remaining after all costs and expenses other than interest, taxes, and
preferred stock dividends are deducted; the “pure profits” earned on each sales dollar.
net profit margin
Measures the percentage of each sales dollar remaining after all costs and expenses,including interest, taxes,
and preferred stock dividends, have been deducted.

19
 return on total assets (ROA)
Measures the overall effectiveness of management in generating profits with its available assets; also called thereturn on
investment (ROI).
return on equity (ROE)
Measures the return earned onthe common stockholders’ investment in the firm.
market ratios
Relate to the firm’s market value, asmeasured by its current share price, to certain accounting values.
price/earnings (P/E) ratio
Measures the amount that investors are willing to pay for each dollar of a firm’s earnings; the higher the P/E ratio, the
greater the investor confidence.
market/book (M/B) ratio
Provides an assessment of how investors view the firm’s performance. Firms expected to earn high returns relative to
their risk typically sell at higher M/B multiples.
DuPont system of analysis
System used to dissect the firm’s financial statements and to assess its financial condition.
DuPont formula
Multiplies the firm’s net profit margin by its total asset turnover to calculate the firm’sreturn on total assets (ROA).

modified DuPont formula

Relates the firm’s return on total assets (ROA) to its return on equity (ROE) using the financialleverage multiplier (FLM).

financial leverage multiplier(FLM)

The ratio of the firm’s total assets to its common stock equity.
=Total assets / common stock equity

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