financial ratios as perceived by commercial loan · pdf filethe 10 financial ratios that...

chapter

Expanded Analysis

This chapter reviews special areas related to the usefulness of ratios and financialanalyses. These special areas are as follows: (1) financial ratios as perceived bycommercial loan departments, (2) financial ratios as perceived by corporate con-

trollers, (3) financial ratios as perceived by certified public accountants, (4) financialratios as perceived by chartered financial analysts, (5) financial ratios used in annualreports, (6) degree of conservatism and quality of earnings, (7) forecasting financial fail-ure, (8) analytical review procedures, (9) management’s use of analysis, (10) use ofLIFO reserves, (11) graphing financial information, (12) management of earnings, (13)the housing bust, and (14) valuation.

Financial Ratios as Perceived by CommercialLoan DepartmentsFinancial ratios can be used by a commercial loan department to aid the loan officers indeciding whether to grant a commercial loan and in maintaining control of a loan onceit is granted.1 In order to gain insights into how commercial loan departments viewfinancial ratios, a questionnaire was sent to the commercial loan departments of the 100largest banks in the United States. Usable responses were received from 44% of them.

A list of 59 financial ratios was drawn from the financial literature, textbooks, andpublished industry data for this study. The study set three objectives: (1) the significanceof each ratio, in the opinion of commercial loan officers, (2) how frequently each ratiois included in loan agreements, and (3) what a specific financial ratio primarily mea-sures, in the opinion of commercial loan officers. For the primary measure, the choiceswere liquidity, long-term debt-paying ability, profitability, or other. Exhibit 11-1 liststhe ratios included in this study.

MOST SIGNIFICANT RATIOS AND THEIR PRIMARYMEASUREExhibit 11-2 displays the 10 financial ratios given the highest significance rating by thecommercial loan officers, as well as the primary measure of these ratios. The highestrating is a 9, and the lowest rating is a 0.

Most of the ratios given a high significance rating were regarded primarily as mea-sures of liquidity or debt. Only 2 of the top 10 ratios measure profitability, 5 measuredebt, and 3 measure liquidity. The two profitability ratios were two different computa-tions of the net profit margin: (1) net profit margin after tax and (2) net profit marginbefore tax. Two of the top three ratios were measures of debt, and the other ratio was ameasure of liquidity. The debt/equity ratio was given the highest significance rating,with the current ratio the second highest. We can assume that the financial ratios ratedmost significant by commercial loan officers would have the greatest influence on a loandecision.

RATIOS APPEARING MOST FREQUENTLY INLOAN AGREEMENTSA commercial bank may elect to include a ratio as part of a loan agreement. This wouldbe a way of using ratios to control an outstanding loan. Exhibit 11-3 contains a list of

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E X H I B I T

11-1RATIOS RATED BY COMMERCIAL LOAN OFFICERS

Ratio Ratio

Cash ratio Sales/fixed assetsAccounts receivable turnover in days Sales/working capitalAccounts receivable turnover—times per year Sales/net worthDays’ sales in receivables Cash/salesQuick ratio (acid-test) Quick assets/salesInventory turnover in days Current assets/salesInventory turnover—times per year Return on assets:Days’ sales in inventory before interest and taxCurrent debt/inventory before taxInventory/current assets after taxInventory/working capital Return on operating assetsCurrent ratio Return on total invested:Inventory/current assets before taxInventory/working capital after taxCurrent ratio Return on equity:Net fixed assets/tangible net worth before taxCash/total assets after taxQuick assets/total assets Net profit margin:Current assets/total assets before taxRetained earnings/total assets after taxDebt/equity ratio Retained earnings/net incomeTotal debt as a % of net working capital Cash flow/current maturities ofTotal debt/total assets long-term debtShort-term debt as a % of total invested capital Cash flow/total debtLong-term debt as a % of total invested capital Times interest earnedFunded debt/working capital Fixed charge coverageTotal equity/total assets Degree of operating leverageFixed assets/equity Degree of financial leverageCommon equity as a % of total invested capital Earnings per shareCurrent debt/net worth Book value per shareNet worth at market value/total liabilities Dividend payout ratioTotal asset turnover Dividend yieldSales/operating assets Price/earnings ratio

Stock price as a % of book value

E X H I B I T

11-2COMMERCIAL LOAN DEPARTMENTS

Most Significant Ratios and Their Primary Measures

RatioSignificance

RatingPrimaryMeasure

Debt/equity 8.71 DebtCurrent ratio 8.25 LiquidityCash flow/current maturities of long-term debt 8.08 DebtFixed charge coverage 7.58 DebtNet profit margin after tax 7.56 ProfitabilityTimes interest earned 7.50 DebtNet profit margin before tax 7.43 ProfitabilityDegree of financial leverage 7.33 DebtInventory turnover in days 7.25 LiquidityAccounts receivable turnover in days 7.08 Liquidity

C H A P T E R 1 1 Expanded Analysis464


the 10 financial ratios that appear most frequently in loan agreements, along with an indication ofwhat each ratio primarily measures. For the two ratios that do not have a primary measure indicated,there was no majority opinion as to what the ratio primarily measured. Six of the ratios that appearmost frequently in loan agreements primarily measure debt, two primarily measure liquidity, andnone primarily measure profitability.

The two top ratios, debt/equity and current ratio, were given the highest significance rating. Thedividend payout ratio was the third most likely ratio to appear in loan agreements, but it was not ratedas a highly significant ratio. Logically, this ratio appears in loan agreements as a means of controllingthe outflow of cash for dividends.

Financial Ratios as Perceived by CorporateControllersTo get the views of corporate controllers on important issues relating to financial ratios, a question-naire was sent to the controllers of the companies included in the Fortune 500 list of the largestindustrials.2 The study excluded companies 100% owned or controlled by another firm. The surveyreceived a usable response rate of 19.42%. The questionnaire used the same ratios used for the com-mercial loan department survey. The three objectives of this study were the determination of: (1) thesignificance of a specific ratio as perceived by controllers, (2) which financial ratios are included ascorporate objectives, and (3) the primary measure of each ratio.

MOST SIGNIFICANT RATIOS AND THEIR PRIMARY MEASUREExhibit 11-4 displays the 10 financial ratios given the highest significance rating by the corporate con-trollers, along with the primary measure of these ratios. The highest rating is a 9 and the lowest is a 0.

The financial executives gave the profitability ratios the highest significance ratings. The highestrated debt ratio was debt/equity, while the highest rated liquidity ratio was the current ratio. In com-paring the responses of the commercial loan officers and the controllers, the controllers rate the prof-itability ratios as having the highest significance, while the commercial loan officers rate the debtand liquidity ratios the highest.

KEY FINANCIAL RATIOS INCLUDED AS CORPORATE OBJECTIVESMany firms have selected key financial ratios to be included as part of their corporate objectives.The next section of the survey was designed to determine what ratios the firms used in their

E X H I B I T

11-3COMMERCIAL LOAN DEPARTMENTS

Ratios Appearing Most Frequently in Loan Agreements

Ratio

Percentage of Banks IncludingRatio in 26% or More of Their

Loan AgreementsPrimaryMeasure

Debt/equity 92.5 DebtCurrent ratio 90.0 LiquidityDividend payout ratio 70.0 *Cash flow/current maturities of long-term debt 60.3 DebtFixed charge coverage 55.2 DebtTimes interest earned 52.6 DebtDegree of financial leverage 44.7 DebtEquity/assets 41.0 *Cash flow/total debt 36.1 DebtQuick ratio (acid-test) 33.3 Liquidity

*No majority primary measure indicated in this survey.

C H A P T E R 1 1 Expanded Analysis 465


corporate objectives. Exhibit 11-5 lists the 10 ratios most likely to be included in corporate objec-tives according to the controllers. Nine of the ratios included in Exhibit 11-5 were also includedin Exhibit 11-4. One ratio, accounts receivable turnover in days, appears in the top 10 ratios inrelation to corporate objectives but not in the top 10 significant ratios. One ratio, the price/earnings ratio, appears in the top 10 ratios in relation to significance but not in the top 10 ratiosused for corporate objectives.

Logically, there would be a high correlation between the ratios rated as highly significant andthose included in corporate objectives. The debt/equity ratio and the current ratio are rated higher onthe objectives list than on the significance list. This makes sense since a firm has to have somebalance in its objectives between liquidity, debt, and profitability.

Financial Ratios as Perceived by CertifiedPublic AccountantsA questionnaire was sent to one-third of the members of the Ohio Society of Certified PublicAccountants who were registered as a partner in a CPA firm.3 A total of 495 questionnaires weresent, and the usable response rate was 18.8%.

E X H I B I T

11-4CORPORATE CONTROLLERS


RatioSignificance


Earnings per share 8.19 ProfitabilityReturn on equity after tax 7.83 ProfitabilityNet profit margin after tax 7.47 ProfitabilityDebt/equity ratio 7.46 DebtNet profit margin before tax 7.41 ProfitabilityReturn on total invested capital after tax 7.20 ProfitabilityReturn on assets after tax 6.97 ProfitabilityDividend payout ratio 6.83 Other*Price/earnings ratio 6.81 Other*Current ratio 6.71 Liquidity

*Primary measure indicated to be other than liquidity, debt, or profitability. The ratios rated this way tend to be related to stock analysis.

E X H I B I T

11-5RATIOS APPEARING IN CORPORATE OBJECTIVES AND THEIR PRIMARY MEASURES

Ratio

Percentage of Firms Indicating Thatthe Ratio Was Included in

Corporate ObjectivesPrimaryMeasure

Earnings per share 80.6 ProfitabilityDebt/equity ratio 68.8 DebtReturn on equity after tax 68.5 ProfitabilityCurrent ratio 62.0 LiquidityNet profit margin after tax 60.9 ProfitabilityDividend payout ratio 54.3 OtherReturn on total invested capital after tax 53.3 ProfitabilityNet profit margin before tax 52.2 ProfitabilityAccounts receivable turnover in days 47.3 LiquidityReturn on assets after tax 47.3 Profitability



This questionnaire used the same ratios as were used for the commercial loan department and cor-porate controllers. The specific objectives of this study were to determine the following from theviewpoint of the CPA:

1. The specific financial ratios that CPAs view primarily as a measure of liquidity, debt, and profitability.

2. The relative importance of the financial ratios viewed as a measure of liquidity, debt, or profitability.

Exhibit 11-6 displays the 10 financial ratios given the highest significance rating by the CPAs andthe primary measure of these ratios. The highest rating is a 9 and the lowest is a 0.

The CPAs gave the highest significance rating to two liquidity ratios—the current ratio and theaccounts receivable turnover in days. The highest rated profitability ratio was after-tax return onequity, and the highest rated debt ratio was debt/equity.

Financial Ratios as Perceived by Chartered FinancialAnalysts4

Exhibit 11-7 displays the 10 financial ratios given the highest significance rating by chartered finan-cial analysts (CFAs) and the primary measure of these ratios. Again, the highest rating is a 9 and thelowest rating is a 0.

E X H I B I T

11-6CPAS


RatioSignificance


Current ratio 7.10 LiquidityAccounts receivable turnover in days 6.94 LiquidityAfter-tax return on equity 6.79 ProfitabilityDebt/equity ratio 6.78 DebtQuick ratio (acid-test) 6.77 LiquidityNet profit margin after tax 6.67 ProfitabilityNet profit margin before tax 6.63 ProfitabilityReturn on assets after tax 6.39 ProfitabilityReturn on total invested capital after tax 6.30 ProfitabilityInventory turnover in days 6.09 Liquidity

E X H I B I T

11-7CHARTERED FINANCIAL ANALYSTS


RatioSignificance


Return on equity after tax 8.21 ProfitabilityPrice/earnings ratio 7.65 *Earnings per share 7.58 ProfitabilityNet profit margin after tax 7.52 ProfitabilityReturn on equity before tax 7.41 ProfitabilityNet profit margin before tax 7.32 ProfitabilityFixed charge coverage 7.22 DebtQuick ratio (acid-test) 7.10 LiquidityReturn on assets after tax 7.06 ProfitabilityTimes interest earned 7.06 Debt

*Primary measure indicated to be other than liquidity, debt, or profitability. The ratios rated this way tend to be related to stock analysis.



The surveyed CFAs gave the highest significance ratings to profitability ratios, with the exceptionof the price/earnings ratio. Return on equity after tax received the highest significance by a wide mar-gin. Four of the next five most significant ratios were also profitability ratios—earnings per share,net profit margin after tax, return on equity before tax, and net profit margin before tax.

The price/earnings ratio—categorized by the analysts as an ‘‘other’’ measure—received the sec-ond highest significance rating. CFAs apparently view profitability and what is being paid for thoseprofits before turning to liquidity and debt.

The two highest rated debt ratios were fixed charge coverage and times interest earned, rated sev-enth and tenth, respectively. Both of these ratios indicate a firm’s ability to carry debt. The highestrated debt ratio relating to the balance sheet was the debt/equity ratio, rated as the eleventh most sig-nificant. Surprisingly, more significance was placed on debt ratios relating to the ability to carry debtthan on those relating to the ability to meet debt obligations.

The highest rated liquidity ratio was the acid-test ratio, rated eighth. The second highest liquidityratio was the current ratio, rated twentieth.5

Financial Ratios Used in Annual ReportsFinancial ratios are used to interpret and explain financial statements.6 Used properly, they can beeffective tools in evaluating a company’s liquidity, debt position, and profitability. Probably no toolis as effective in evaluating where a company has been financially and projecting its financial futureas the proper use of financial ratios.

A firm can use its annual report effectively to relate financial data by the use of financial ratios.To determine how effectively firms use ratios to communicate financial data, the annual reports of100 firms identified in the Fortune 500 industrial companies were reviewed. The 100 firms repre-sented the first 20 of each 100 in the Fortune 500 list. The objective of this research project was todetermine (1) which financial ratios were frequently reported in annual reports, (2) where the ratioswere disclosed in the annual reports, and (3) what computational methodology was used to computethese ratios.

Exhibit 11-8 indicates the ratios disclosed most frequently in the annual reports reviewed andthe section of the annual report where the ratios were located. The locations were the president’s

E X H I B I T

11-8RATIOS DISCLOSED MOST FREQUENTLY IN ANNUAL REPORTS*

NumberIncluded

President’sLetter

ManagementDiscussion

ManagementHighlights

FinancialReview

FinancialSummary

Earnings per share 100 66 5 98 45 93Dividends per share 98 53 10 85 49 88Book value per share 84 10 3 53 18 63Working capital 81 1 1 50 23 67Return on equity 62 28 3 21 23 37Profit margin 58 10 3 21 23 35Effective tax rate 50 2 1 2 46 6Current ratio 47 3 1 16 12 34Debt/capital 23 9 0 4 14 23Return on capital 21 6 2 8 8 5Debt/equity 19 5 0 3 8 8Return on assets 13 4 1 2 5 10Dividend payout 13 3 0 0 6 6Gross profit 12 0 1 0 11 3Pretax margin 10 2 0 3 6 6Total asset turnover 7 1 0 0 4 4Price/earnings ratio 7 0 0 0 1 6Operating margin 7 1 0 2 6 1Labor per hour 5 0 2 2 2 2

*Numbers represent both absolute numbers and percentages, since a review was made of the financial statements of 100 firms.



letter, management discussion, management highlights, financial review, and financial summary. Inmany cases, the same ratio was located in several sections, so the numbers under the sections inExhibit 11-8 do not add up to the total number of annual reports where the ratio was included.

Seven ratios appeared more than 50% of the time in one section or another. These ratios and thenumber of times found were earnings per share (100), dividends per share (98), book value per share(84), working capital (81), return on equity (62), profit margin (58), and effective tax rate (50). Thecurrent ratio was found 47 times, and the next ratio in order of disclosure, the debt/capital ratio,appeared 23 times. From this listing, we can conclude that profitability ratios and ratios related toinvesting were the most popular. Exhibit 11-8 excludes ratios not disclosed at least five times.

Logically, profitability ratios and ratios related to investing were the most popular for inclusion inthe annual report. Including ratios related to investing in the annual report makes sense because oneof the annual report’s major objectives is to inform stockholders.

A review of the methodology used indicated that wide differences of opinion exist on how someof the ratios should be computed. This is especially true of the debt ratios. The two debt ratios mostfrequently disclosed were the debt/capital ratio and the debt/equity ratio. This book does not coverthe debt/capital ratio. It is similar to the debt/equity ratio, except that the denominator includes sour-ces of capital, in addition to stockholders’ equity.

The annual reports disclosed the debt/capital ratio 23 times and used 11 different formulas. Onefirm used average balance sheet amounts between the beginning and the end of the year, while 22firms used ending balance sheet figures. The debt/equity ratio was disclosed 19 times, and 6 differentformulas were used. All firms used the ending balance sheet accounts to compute the debt/equity ratio.

In general, no major effort is being made to explain financial results by the disclosure of financialratios in annual reports. Several financial ratios that could be interpreted as important were not dis-closed or were disclosed very infrequently. This is particularly important for ratios that cannot be rea-sonably computed by outsiders because of a lack of data such as accounts receivable turnover.

At present, no regulatory agency such as the SEC or the FASB accepts responsibility for deter-mining either the content of financial ratios or the format of presentation for annual reports, exceptfor the ratio earnings per share. Many practical and theoretical issues relate to the computation of fi-nancial ratios. As long as each firm can exercise its opinion as to the practical and theoretical issues,there will be a great divergence of opinion on how a particular ratio should be computed.

Degree of Conservatism and Quality of EarningsA review of financial statements, including the notes, indicates their conservatism with regard toaccounting policies. Accounting policies that result in the slowest reporting of income are the mostconservative. When a firm has conservative accounting policies, it is said that its earnings are of highquality. This section reviews a number of areas that often indicate a firm’s degree of conservatism inreporting income.

INVENTORYUnder inflationary conditions, the matching of current cost against the current revenue results in thelowest income for a period of time. The LIFO inventory method follows this procedure. FIFO, theleast conservative method, uses the oldest costs and matches them against revenue. Other inventorymethods fall somewhere between the results of LIFO and FIFO.

For a construction firm that has long-term contracts, the two principal accounting methods thatrelate to inventory are the completed-contract method and the percentage-of-completion method. Theconservative completed-contract method recognizes all of the income when the contract is com-pleted; the percentage-of-completion method recognizes income as work progresses on the contract.

FIXED ASSETSTwo accounting decisions related to fixed assets can have a significant influence on income: themethod of depreciation and the period of time selected to depreciate an asset.

The conservative methods, sum-of-the-years’-digits and declining-balance, recognize a largeamount of depreciation in the early years of the asset’s life. The straight-line method, the least con-servative method, recognizes depreciation in equal amounts over each year of the asset’s life.



Sometimes a material difference in the asset’s life used for depreciation occurs between firms.Comparing the lives used for depreciation for similar firms can be a clue as to how conservative thefirms are in computing depreciation. The shorter the period of time used, the lower the income.

INTANGIBLE ASSETSIntangible assets include goodwill, patents, and copyrights. Research and development (R&D) costsare a type of intangible asset, but they are expensed as incurred. The shorter the period of time usedto recognize the cost of the intangible asset, the more conservative the accounting. (Goodwill is notamortized.)

Some firms spend very large sums on R&D, and others spend little or nothing. Because of therequirement that R&D costs be expensed in the period incurred, the income of a firm that does con-siderable research is reduced substantially in the period that the cost is incurred. This results in moreconservative earnings.

PENSIONSTwo points relating to pensions should be examined when the firm has a defined benefit plan. One isthe assumed discount rate used to compute the actuarial present value of the accumulated benefit obli-gation and the projected benefit obligation. The higher the interest rate used, the lower the presentvalue of the liability and the lower the immediate pension cost. The other item is the rate of compen-sation increase used in computing the projected benefit obligations. If the rate is too low, the pro-jected benefit obligation is too low. If the rate is too high, the projected benefit obligation is too high.

Forecasting Financial FailureThere have been many academic studies on the use of financial ratios to forecast financial failure.Basically, these studies try to isolate individual ratios or combinations of ratios that can be observedas trends that may forecast failure.

A reliable model that can be used to forecast financial failure can also be used by management totake preventive measures. Such a model can aid investors in selecting and disposing of stocks. Bankscan use it to aid in lending decisions and in monitoring loans. Firms can use it in making credit deci-sions and in monitoring accounts receivable. In general, many sources can use such a model toimprove the allocation and control of resources. A model that forecasts financial failure can also bevaluable to an auditor. It can aid in the determination of audit procedures and in making a decision asto whether the firm will remain as a going concern.

Financial failure can be described in many ways. It can mean liquidation, deferment of paymentsto short-term creditors, deferment of payments of interest on bonds, deferment of payments of princi-pal on bonds, or the omission of a preferred dividend. One of the problems in examining the litera-ture on forecasting financial failure is that different authors use different criteria to indicate failure.When reviewing the literature, always determine the criteria used to define financial failure.

This book reviews two of the studies that deal with predicting financial failure. Based on the num-ber of references to these two studies in the literature, they appear to be particularly significant on thesubject of forecasting financial failure.

UNIVARIATE MODELWilliam Beaver reported his univariate model in a study published in The Accounting Review in Jan-uary 1968.7 A univariate model uses a single variable. Such a model would use individual financialratios to forecast financial failure. The Beaver study classified a firm as failed when any one of thefollowing events occurred in the 1954–1964 period: bankruptcy, bond default, an overdrawn bankaccount, or nonpayment of a preferred stock dividend.

Beaver paired 79 failed firms with a similar number of successful firms drawn from Moody’sIndustrial Manuals. For each failed firm in the sample, a successful one was selected from the sameindustry. The Beaver study indicated that the following ratios were the best for forecasting financialfailure (in the order of their predictive power):

1. Cash flow/total debt

2. Net income/total assets (return on assets)

3. Total debt/total assets (debt ratio)



Beaver speculated as to the reason for these results:

My interpretation of the finding is that the cash flow, net income, and debt positions cannot be alteredand represent permanent aspects of the firm. Because failure is too costly to all involved, the perma-nent, rather than the short-term, factors largely determine whether or not a firm will declare bank-ruptcy or default on a bond payment.8

Assuming that the ratios identified by Beaver are valid in forecasting financial failure, it would bewise to pay particular attention to trends in these ratios when following a firm. Beaver’s reasoningfor seeing these ratios as valid in forecasting financial failure appears to be very sound.

These three ratios for Nike for 2009 have been computed earlier. Cash flow/total debt was38.10%, which appears to be very good. Net income/total assets (return on assets) was 11.57%,which appears to be very good. The debt ratio was 34.39%, which again is very good. Thus, Nikeappears to have minimal risk of financial failure.

The Beaver study also computed the mean values of 13 financial statement items for each yearbefore failure. Several important relationships were indicated among the liquid asset items.9

1. Failed firms have less cash but more accounts receivable.

2. When cash and receivables are added together, as they are in quick assets and current assets,the difference between failed and successful firms is obscured because the cash and receivablesdifferences are working in opposite directions.

3. Failed firms tend to have less inventory.

These results indicate that particular attention should be paid to three current assets when forecast-ing financial failure: cash, accounts receivable, and inventory. The analyst should be alert for lowcash and inventory and high accounts receivable.

MULTIVARIATE MODELEdward I. Altman and Thomas P. McGough developed a multivariate model to predict bankruptcy.10

His model uses five financial ratios weighted in order to maximize the predictive power of the model.The model produces an overall discriminant score, called a Z score. The Altman model is as follows:

Z ¼ :012 X1 þ :014 X2 þ :033 X3 þ :006 X4 þ :010 X5

X1 ¼ Working Capital/Total Assets

This computation is a measure of the net liquid assets of the firm relative to the total capitalization.

X2 ¼ Retained Earnings (balance sheet)/Total Assets

This variable measures cumulative profitability over time.

X3 ¼ Earnings Before Interest and Taxes/Total Assets

This variable measures the productivity of the firm’s assets, abstracting any tax or leverage factors.

X4 ¼Market Value of Equity/Book Value of Total Debt

This variable measures how much the firm’s assets can decline in value before the liabilitiesexceed the assets and the firm becomes insolvent. Equity is measured by the combined market valueof all shares of stock, preferred and common, while debt includes both current and long-term debts.

X5 ¼ Sales/Total Assets

This variable measures the sales-generating ability of the firm’s assets.When computing the Z score, the ratios are expressed in absolute percentage terms. Thus, X1

(working capital/total assets) of 25% is noted as 25.The Altman model was developed using manufacturing companies whose asset size was between

$1 million and $25 million. The original sample by Altman and the test samples used the period1946–1965. The model’s accuracy in predicting bankruptcies in more recent years (1970–1973) wasreported in a 1974 article.11 Not all of the companies included in the test were manufacturing compa-nies, although the model was initially developed by using only manufacturing companies.

With the Altman model, the lower the Z score, the more likely that the firm will go bankrupt. Bycomputing the Z score for a firm over several years, it can be determined whether the firm is movingtoward a more likely or less likely position with regard to bankruptcy. In a later study that coveredthe period 1970–1973, a Z score of 2.675 was established as a practical cutoff point. Firms that



scored below 2.675 are assumed to have characteristics similar to those of past failures.12 CurrentGAAP recognize more liabilities than the GAAP used at the time of this study. Thus, we wouldexpect firms to score somewhat less than in the time period 1970–1973. The Altman model is sub-stantially less significant if there is no firm market value for the stock (preferred and common),because variable X4 in the model requires that the market value of the stock be determined.

NIKE Z SCOREThe Z Score for Nike for 2009 follows:

Z ¼ :012 ðworking capital=total assetsÞþ :014 ðretained earnings ½balance sheet�=total assetsÞþ :033 ðearnings before interest and taxes=total assetsÞþ :006 ðmarket value of equity=book value of total debtÞþ :010 ðsales=total assetsÞ

Z ¼ :012ð$6;457;000;000=$13;249;600;000Þþ :014ð$5;451;400;000=$13;249;600;000Þþ :033ð$1;996;800;000=$13;249;600;000Þþ :006ðð485;500;000 3 $57:05Þ=$4;556;500;000Þþ :010ð$19;176;100;000=$13;249;600;000Þ

Z ¼ :012ð48:73Þþ :014ð41:14Þþ :033ð15:07Þþ :006ð607:87Þþ :010ð144:73Þ

Z ¼ 6:76

The Z score for Nike for 2009 was 6.76. Considering that higher scores are better and that compa-nies with scores below 2.675 are assumed to have characteristics similar to those of past failures,Nike is a very healthy company.

There are many academic studies on the use of ratios to forecast financial failure. These studieshelp substantiate that firms with weak ratios are more likely to go bankrupt than firms with strongratios. Since no conclusive model has yet been developed, the best approach is probably an inte-grated one. As a supplemental measure, it may also be helpful to compute some of the ratios thatappear useful in forecasting financial failure.

Analytical Review ProceduresStatement of Auditing Standards No. 23, ‘‘Analytical Review Procedures,’’ provides guidance for theuse of such procedures in audits. The objective of analytical review procedures is to isolate signifi-cant fluctuations and unusual items in operating statistics.

Analytical review procedures may be performed at various times, including the planning stage,during the audit itself, and near the completion of the audit. Some examples of analytical review pro-cedures that may lead to special audit procedures follow:

1. Horizontal common-size analysis of the income statement may indicate that an item, such asselling expenses, is abnormally high for the period. This could lead to a close examination of theselling expenses.

2. Vertical common-size analysis of the income statement may indicate that the cost of goods soldis out of line in relation to sales, in comparison with prior periods.

3. A comparison of accounts receivable turnover with the industry data may indicate that receiv-ables are turning over much slower than is typical for the industry. This may indicate that receiv-ables should be analyzed closely.

4. Cash flow in relation to debt may have declined significantly, indicating a materially reducedability to cover debt from internal cash flow.



5. The acid-test ratio may have declined significantly, indicating a materially reduced ability topay current liabilities with current assets less inventories.

When the auditor spots a significant trend in a statement or ratio, follow-up procedures should beperformed to determine the reason. Such an investigation can lead to significant findings.

Management’s Use of AnalysisManagement can use financial ratios and common-size analysis as aids in many ways. Analysis canindicate the relative liquidity, debt, and profitability of a firm. Analysis can also indicate how invest-ors perceive the firm and can help detect emerging problems and strengths in a firm. As indicatedpreviously, financial ratios can also be used as part of the firm’s corporate objectives. Using financialratios in conjunction with the budgeting process can be particularly helpful. An objective of thebudgeting process is to determine the firm’s game plan. The budget can consist of an overall compre-hensive budget and many separate budgets, such as a production budget.

The comprehensive budget relating to financial statements indicates how a firm plans to get fromone financial position (balance sheet) to another. The income statement details how the firm changedinternally from one balance sheet position to another in terms of revenue and expenses. The state-ment of cash flows indicates how the firm’s cash changed from one balance sheet to another.

A proposed comprehensive budget should be compared with financial ratios that have been agreedupon as part of the firm’s corporate objectives. For example, if corporate objectives include a currentratio of 2:1, a debt equity of 40%, and a return on equity of 15%, then the proposed comprehensivebudget should be compared with these corporate objectives before the budget is accepted as thefirm’s overall game plan. If the proposed comprehensive budget will not result in the firm achievingits objectives, management should attempt to change the game plan in order to achieve its objectives.If management cannot change the proposed comprehensive budget satisfactorily to achieve the cor-porate objectives, they should know this when the comprehensive budget is accepted.

Use of LIFO ReservesA firm that uses LIFO usually discloses a LIFO reserve account in a note on the face of the balancesheet. If a LIFO reserve account is not disclosed, there is usually some indication of an amount thatapproximates current cost. Nike uses first-in, first-out or moving average; therefore, it does not havea LIFO reserve. Thus, Sherwin-Williams Company was selected to illustrate LIFO reserve analysis.

In its 2008 annual report, Sherwin-Williams Company disclosed that the excess of FIFO overLIFO was $321,280,000 and $241,579,000 for 2008 and 2007, respectively.

This information can be used for supplemental analysis of inventory and (in general) the analysisof liquidity, debt, and profitability. Supplemental analysis using this additional inventory informationcan be particularly significant when there is a substantial LIFO reserve and/or a substantial change inthe reserve.

For Sherwin-Williams, an approximation of the increase or decrease in income if inventory is atapproximate current acquisition costs could be computed by comparing the change in inventory, netof any tax effect. For 2008, compute the approximation of the income if the inventory were atapproximate current acquisitions costs as follows:

In thousands

2008 Net Income $ 476,876Net increase in inventory reserve:

2008 $ 321,2802007 241,579

(a) 79,701(b) Effective tax rate � 33.3 %(c) Change in taxes [a � b] $ 26,540(d) Net increase in income [a � c] 53,161

Estimated income if the inventory were presentedat approximate current acquisitions cost $530,037

Specific liquidity and debt ratios can be recomputed, taking into consideration the adjusted inventoryfigure. To make these computations, add the gross inventory reserve to the inventory disclosed incurrent assets. Add the approximate additional taxes to the current liabilities.



Estimate the additional tax figure by multiplying the gross LIFO reserve by the effective tax rate.This tax figure relates to the additional income that would have been reported in the current year andall prior years if the higher inventory amounts had been reported. The additional tax amount is adeferred tax amount that is added to current liabilities, to be conservative. The difference betweenthe additional inventory amount and the additional tax amount is added to retained earnings becauseit represents the total prior influence on net income. The adjusted figures for Sherwin-WilliamsCompany at the end of 2008 follow:

Inventory:As disclosed on the balance sheet $ 864,200,000Increase in inventory 321,280,000

$1,185,480,000

Deferred current tax liability:Effective tax rate [33.3% � increase in inventory ($321,280,000)] $ 106,986,240

Retained earnings:As disclosed on the balance sheet $4,245,141,000Increase in retained earnings ($321,280,000 � $106,986,240) 214,293,760

$4,459,434,760

An adjusted cost of goods sold can also be estimated using the change in the inventory reserve. Anet increase in the inventory reserve would reduce the cost of goods sold. A net decrease in inventoryreserve would increase the cost of goods sold.

The adjusted liquidity, debt, and profitability ratios could possibly be considered to be morerealistic than the unadjusted prior computations because of the use of current acquisition costs forinventory.

For many of the ratios, we cannot generalize about whether the ratio will improve or decline whenthe LIFO reserve is used. For example, if the current ratio is above 2.00, then it may not improvewhen the LIFO reserve is considered, especially if the firm has a high tax rate. When the current ratioand/or tax rate is low, then the current ratio will likely improve.

The Sherwin-Williams inventory disclosure on its December 31, 2008, annual report follows:

Consolidated Balance Sheets (in Part)(thousands of dollars) December 31, 2008Inventories:Finished goods $749,405Work in process and raw materials 114,795

$864,200

NOTE 4—INVENTORIESInventories were stated at the lower of cost or market, with cost determined principally on the last-in,first-out (LIFO) method. The following presents the effect on inventories, net income, and netincome per common share had the company used the first-in, first-out (FIFO) inventory valuationmethod adjusted for income taxes at the statutory rate and assuming no other adjustments. Manage-ment believes that the use of LIFO results in a better matching of costs and revenues. This informa-tion is presented to enable the reader to make comparisons with companies using the FIFO methodof inventory valuation.

2008 2007 2006

Percentage of total inventories on LIFO 86% 83% 88%Excess of FIFO over LIFO $321,280 $241,579 $226,818Decrease in net income due to LIFO (49,184) (7,844) (24,033)Decrease in net income per common share due to LIFO (0.41) (0.06) (0.17)

Notice that Note 4 discloses a decrease in net income due to LIFO of $49,184 (in thousands),while our prior estimate was $53,161 (in thousands).

Graphing Financial InformationIt has become popular to use graphs in annual reports to present financial information. Graphs makeit easier to grasp key financial information. They can be a better communication device than a written



report or a tabular presentation because they communicate by means of pictures and, thus, createmore immediate mental images.

There are many forms of graphs. Some popular forms used by accountants are line, column, bar,and pie graphs. These forms will be briefly described here, but a detailed description of those andother forms can be found in reference books and articles.13

The line graph uses a set of points connected by a line to show change over time. It is importantfor the vertical axis to start at zero and that it not be broken. Not starting the vertical axis at zero and/or breaking the vertical axis can result in a very misleading presentation. Exhibit 11-9 illustrates aline graph.

A column graph has vertical columns. As a line graph, it is important that the vertical axis start atzero and that it not be broken. A column graph is often the best form of graph for presenting account-ing data. Exhibit 11-10 presents a column graph.

A bar graph is similar to a column graph, except that the bars are horizontal. Exhibit 11-11 onpage 476 illustrates a bar graph.

A pie graph is divided into segments. This type of graph makes a comparison of the segments,which must add up to 100%. A pie graph can mislead if it creates an optical illusion. Also, someaccounting data do not fit on a pie graph. Exhibit 11-12 on page 477 illustrates a pie graph.

Management of EarningsChapter 1 describes cash basis as recognizing revenue when cash is received and recognizingexpenses when cash is paid. It was indicated that the cash basis usually does not provide reasonableinformation about the entity’s earnings capability in the short run. Because of the shortcomings ofthe cash basis, the accrual basis has been adopted for income reporting for most firms.

With the accrual basis, revenue is recognized when realized (realization concept) and expensesare recognized when incurred (matching concept). As indicated in Chapter 1, use of the accrual basiscomplicates the accounting process, but the end result is more representative than the cash basis ofan entity’s financial condition. Without the accrual basis, accountants would not usually be able tomake the time period assumption—that the entity can be accounted for with reasonable accuracy fora particular period of time.

Nike includes the following comment in its Management Discussion and Analysis of FinancialCondition and Results of Operation in its 2009 annual report.

E X H I B I T

11-9EXXON MOBIL*

Line Graph—Upstream Return on Average Capital Employed 2008 Annual Report

*‘‘Their principal business is energy, involving exploration for, and production of, crude oil and natural gas, manufacture of petroleum

products and transportation and sale of crude oil, natural gas and petroleum products.’’ 10-K



Critical Accounting PoliciesOur previous discussion and analysis of our financial condition and results of operations are basedupon our consolidated financial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States of America. The preparation of these financial state-ments requires us to make estimates and judgments that affect the reported amounts of assets, liabil-ities, revenues and expenses, and related disclosure of contingent assets and liabilities.

We believe that the estimates, assumptions and judgments involved in the accounting policies describedbelow have the greatest potential impact on our financial statements, so we consider these to be our

E X H I B I T

11-10SHERWIN-WILLIAMS*

Column Graph—Dividends Paid 2008 Annual Report

*‘‘The Sherwin-Williams Company, founded in 1866 and incorporated in Ohio in 1884, is engaged in the development, manufacture, dis-

tribution and sale of paint, coatings and related products to professional, industrial, commercial and retail customers primarily in North

and South America with additional operations in the Caribbean region, Europe and Asia.’’ 10-K

E X H I B I T

11-11MOLEX*

Bar Graph—Revenues 2008 Annual Report

*‘‘Our core business is the manufacture and sale of electronic components.’’ 10-K

Source: Used by permission of Molex.



critical accounting policies. Because of the uncertainty inherent in these matters, actual results coulddiffer from the estimates we use in applying the critical accounting policies. Certain of these criticalaccounting policies affect working capital account balances, including the policies for revenue recogni-tion, the allowance for uncollectible accounts receivable, inventory reserves, and contingent paymentsunder endorsements contracts. These policies require that we make estimates in the preparation of ourfinancial statements as of a given date. However, since our business cycle is relatively short, actualresults related to these estimates are generally known within the six-month period following the finan-cial statement date. Thus, these policies generally affect only the timing of reported amounts acrosstwo to three fiscal quarters.

Within the context of these critical accounting policies, we are not currently aware of any reasonablylikely events or circumstances that would result in materially different amounts being reported.

The accounting policies described in detail were the following:

� Revenue recognition� Allowance for uncollectible accounts receivable� Inventory reserves� Contingent payments under endorsement contracts� Property, plant and equipment� Goodwill and other intangible assets� Hedge accounting for derivatives� Stock-based compensation� Taxes� Other contingencies

Thus, Nike describes the proper use of estimates and judgments to prepare its financial statementsunder generally accepted accounting principles.

Some firms have used estimates and judgments to improperly manipulate their financial state-ments. Other firms have deliberately made errors to manipulate their financial statements. Thisresults in financial statements that are not a proper representation of financial condition and resultsof operations, creating a substantial problem during the 1990s. The former chairman of the Secur-ities and Exchange Commission, Arthur Levitt, had this to say as part of his address entitled the‘‘Numbers Game,’’ at the New York University Center for Law and Business on September 28,1998:

Increasingly, I have become concerned that the motivation to meet Wall Street earnings expectationsmay be overriding common sense business practices. Too many corporate managers, auditors, andanalysts are participants in a game of nods and winks. In the zeal to satisfy consensus earnings

E X H I B I T

11-12THE MARCUS CORPORATION*

Pie Graph—Revenues 2008 Annual Report

*‘‘We are engaged primarily in two business segments: movie theatres and hotels and resorts.’’ 10-K

Source: Used by permission of The Marcus Corporation.



estimates and project a smooth earnings path, wishful thinking may be winning the day over faithfulrepresentation.

As a result, I fear that we are witnessing an erosion in the quality of earnings, and therefore, the qual-ity of financial reporting. Managing may be giving way to manipulations; integrity may be losing out toillusion.

Many in corporate America are just as frustrated and concerned about this trend as we, at the SEC,are. They know how difficult it is to hold the line on good practices when their competitors operate inthe gray area between legitimacy and outright fraud.

A gray area where the Accounting is being perverted; where managers are cutting corners; and, whereearnings reports reflect the desires of management rather than the underlying financial performance ofthe company.14

Thus, both the former chairman of the Securities and Exchange Commission and the financialcommunity were concerned about the apparent increase in the inappropriate management of earningsduring the 1990s. We can speculate on why there was an increase in the improper management ofearnings during the 1990s. Some of the likely reasons are as follows: (1) conviction that the capitalmarkets would pay more for a stock that represented smooth earnings rather than peaks and valleysof earnings, (2) increase in the awarding of stock options as a means of compensation as opposed tocash, (3) substantial negative market reaction when a company would not meet its numbers, and (4)possibly an all-time high in greed.

The general public did not appear to be overly concerned about the increase in the improper man-agement of earnings until the Enron situation developed in 2001. A possible reason for this lack ofconcern was the substantial increase in stock prices during the 1990s. Starting in 2000, stock pricesexperienced substantial declines. These declines in stock prices likely influenced the general publicto be concerned about the improper management of earnings.

There are many ways to manage earnings improperly. We don’t know of all the possibilities, butthe ways that we do know would require us to write a separate book. We do know that revenue rec-ognition is often involved in the manipulation of financial reports. The General Accounting Office,Congress’s investigative arm, reported in an October 2002 report to the Senate Banking Committeethat earnings restatements cost investors $100 billion in the prior five years. Earnings restatementsrose by about 145% from 1997 through June 2002. Revenue-recognition issues arose in 38% of thecases studied.15

Revenue recognition often also involves inventory, accounts receivable, and cash flow. For exam-ple, early recognition of revenue could involve moving inventory from the balance sheet to cost ofgoods sold on the income statement, the booking of accounts receivable, and lack of cash flow. Anunderstanding of financial reporting and analysis would help in detecting the problem.

Enron and WorldCom substantially influenced financial reporting in the United States. Thesecases crystallized views of the U.S. House and Senate that resulted in the Sarbanes-Oxley Actof 2002. Hopefully, the Sarbanes-Oxley Act will lead to constructive improvement in financialreporting.

Enron was one of the largest corporations in the world. In October 2001 it announced that it wasreducing after-tax net income by approximately $500 million and shareholders’ equity by $1.2 bil-lion. In November, it announced that it was restating reported net income for the years 1997–2000.In December 2001, Enron filed for bankruptcy.

The Enron situation involved many financial reporting issues that were poorly disclosed or notdisclosed at all. Some of the issues were accounting for investments in subsidiaries and special-purpose entities, sales of investments to special-purpose entities, revenue for fees, and fair value ofinvestments.16 The Enron financial statements, including the notes, were complicated and difficult tocomprehend. The lesson here is that if a reasonable understanding of financial reporting and analysisis not adequate to understand the financial report, then consider this when investing.

In June 2002 WorldCom announced that it had inflated profits by $3.8 billion over the previousfive quarters. WorldCom was the largest corporate accounting fraud in history. Soon after thisannouncement, WorldCom declared bankruptcy.17 In November 2002, a special bankruptcy court ex-aminer reported that the improper accounting would exceed $7.2 billion.18

The WorldCom fraud was uncovered by three accountants working in the internal auditing depart-ment. Their findings were communicated to the audit committee of the board, and later the entireboard was informed. The internal discovery and reporting of the fraud represents a positive aspect ofthe WorldCom fraud.19



The WorldCom problem apparently started in 2000 when business declined. Initially, WorldCommoved dollars from reserve accounts to hold up profits. When this was no longer sufficient, it thenturned to shifting operating costs to capital accounts. Shifting operating costs (expenses on theincome statement) to capital accounts (assets on the balance sheet) would make the company lookmore profitable in the short run. As capital expenditures, these costs would be depreciated in subse-quent years. Apparently, WorldCom had planned a write-down. This would remove these accountsfrom the balance sheet. Hopefully, Wall Street would overlook the write-down when looking to thefuture.20

Although the WorldCom fraud was discovered by internal auditors, the Securities and ExchangeCommission sent a ‘‘Request for Information’’ to WorldCom on March 7, 2002. The SEC apparentlythought that the WorldCom profit figures were suspicious, considering that WorldCom’s closestcompetitors, including AT&T Corp., were losing money throughout 2001. A lesson from WorldComis that if the numbers look too good, that may be because they are too good.21

Following Enron and WorldCom, many cases have been brought against companies and individu-als for improper management of earnings. As of 2005, the largest company subsequent to Enron andWorldCom charged with improper management of earnings has been American International Group,Inc. (AIG). AIG is the world’s biggest publicly traded seller of property-casualty insurance to busi-nesses and the largest life insurer in the United States in terms of premiums.22

The SEC, the Justice Department, and the U.S. Attorney’s Office in New York City were allinvestigating AIG’s accounting issues. New York’s attorney general and insurance commissionersued AIG and two former top executives, accusing them of manipulating AIG’s financial results.23

The New York prosecutor’s office presented evidence to a grand jury weighing criminal chargesagainst individuals during the summer of 2005.24

On May 31, 2005, AIG restated its financial results for a five-year period. ‘‘The accountingadjustments tallied in the document slashed AIG’s previously reported net income for 2004 by 12%,or $1.32 billion, to $9.73 billion, and reduced AIG’s book value by $2.26 billion to $80.61 billion.Overall, the restatement reduced AIG’s net income from 2000 through 2004 by $3.9 billion, or10%.’’25

A U.S. Government Accountability Office (GAO) study dated July 2006 disclosed that ‘‘over theperiod of January 1, 2002 through September 30, 2005, the total number of restating companies(1,084) represents 16 percent of the average number of listed companies from 2002 to 2005, as com-pared to almost 8 percent during the 1997–2001 period.’’26

This study concluded that ‘‘a variety of factors appear to have contributed to the increased trendin restatements, including increased accountability requirements on the part of company executives;increased auditor and regulatory scrutiny … and a general unwillingness on the part of public compa-nies to risk failing to restate regardless of the significance of the event.’’27

In an August 2006 correspondence, the GAO made this comment related to its July 2006 study:‘‘Although there are many reasons for restatements, most restatements involve more routine reportingissues … and are not symptomatic of financial reporting fraud and/or accounting errors.’’28

It was noted in Chapter 4 that a FASB standard issued in May 2005 requires retrospective applica-tion to prior periods’ financial statements of a voluntary change in accounting principle unless it isimpracticable. This standard will contribute to additional retrospective application to prior periods.

The SEC issued Staff Bulletin No. 108 in September 2006 that requires retroactive revision ofprior-period numbers presented in financial reporting. This relates to accounting for immaterialadjustments waived over time that become cumulatively material at a point in time. This bulletin willalso contribute to additional retrospective application to prior periods.

Restatements have become a substantial problem in analysis of financial statements. It is impor-tant to review companies that are being analyzed for restatements during the period of time that isbeing analyzed. A similar review should be made for companies with which the company is beingcompared. It is impossible to guard against some unreliable industry data.

The Housing BustThe housing bust led to a worldwide recession or possibly depression, depending on how it finallyplays out. A few comments are in order to explain its origins and implications.

The Federal National Mortgage Association (Fannie Mae) and Federal Home Mortgage Corpora-tion (Freddie Mac) control a substantial portion of the mortgage market in the United States. Fannie



Mae was created in 1938 to raise levels of home ownership. It was in effect a U.S. governmentorganization.

In 1968, Fannie Mae was privatized, removing it from the national budget. It began operating as agovernment-sponsored enterprise with the implied protection of the federal government. As a gov-ernment-sponsored enterprise, it does not pay taxes or report to the SEC. It is subject to congres-sional oversight, which has proven to be ineffective. The federal government created a secondgovernment-sponsored enterprise in 1970, the Freddie Mac.

Because of the implied protection of the federal government, the rating agencies (Standard &Poor’s, Moody’s, Fitch) gave their mortgage securities a AAA rating. With this rating, the securitieswere sold to banks, mutual funds, governments, and individuals throughout the world.

In 1977, Congress passed the Community Reinvestment Act, which required banks to meet thecredit needs of the local communities. The objective of this Act was to reduce discriminatory creditpractices against low-income neighborhoods. Banks sold many of their mortgages to either FannieMae or Freddie Mac.

Fannie Mae and Freddie Mac controlled trillions of dollars of mortgages either by holding themortgages or selling the mortgages. Many individuals warned of the dangers of Fannie Mae andFreddie Mac to the world economy because of their size, their securities given a AAA rating, and theway they operated with loose government oversight that was often political.

Both Fannie Mae and Freddie Mac contributed substantial sums to politicians that took manyforms, including sponsored travel for congressional staff. They have paid millions in fines for violat-ing federal election laws. Individual executives at both Fannie Mae and Freddie Mac were paid mil-lions annually.

Government auditors in 2003 and 2004 found that both Fannie Mae and Freddie Mac manipulatedaccounting rules to look more profitable and help ensure that executives would receive substantialbonuses.

By the time that the mortgage market blew up in 2007 and 2008, Fannie Mae and Freddie Machad polluted the world with high-risk mortgages. As housing prices declined in the United States, insome cities by over 50%, mortgages that were high quality became troubled mortgages because theoutstanding mortgage on many homes became substantially more than the value of the home.

Financial institutions such as Lehman Brothers, Merrill Lynch, American International Group,Goldman Sachs, J. P. Morgan Chase, and Bear Stearns had taken substantial financial risk (these areonly example firms as the list would be very long). In some cases, financial institutions had taken onobligations that were 30 or 40 times their equity. Hundreds of banks failed.

The collapse of the housing market and of many financial institutions led to a worldwide stockmarket collapse. An analysis of a company that was done only a few weeks earlier was of little use.

This points out the importance of keeping track of investments and being ready to revise the analy-sis. Companies such as Nike, which had a very good analysis, did experience declines in market value,but they did survive.

ValuationValuation is a process of estimating the value of a firm or some component of a firm. There aremany approaches to valuation. Those approaches can be summarized as fundamental analysis andmultiperiod discounted valuation approaches. In practice, a wide variety of valuation approaches areemployed.

With fundamental analysis, the basic accounting measures are used to assess the firm’s futureoperating cash flows or earnings. Fundamental analysis makes use of the financial statements. Thisapproach considers items such as reported earnings, cash flow, and book value.

The multiperiod discounted valuation approach projects either earnings or cash flow and discountsthese numbers to the present value (intrinsic value).

MULTIPLESFundamental valuation typically uses one or more multiples. Multiples frequently used are price-to-earnings (PE), price-to-book, price-to-operating cash flow, and price-to-sales. Perceived risk willreduce a multiple, while perceived growth will increase a multiple. When using a multiple approach,it is important to compare results with similar firms.



Multiples use conventional financial statements. For example, PE uses earnings, price-to-bookuses the book value, and price-to-operating cash flow uses operating cash flow, while price-to-salesuses sales. Often, the analysis will use several multiples.

The use of multiples and conventional financial reports is not well accepted by the traditional fi-nancial literature or many valuation books. However, there is ample evidence proving that securityanalysts and fund managers prefer the use of multiples.

MULTIPERIOD DISCOUNTED VALUATION MODELSThe financial literature and valuation books strongly support use of the multiperiod discounted valua-tion model in terms of either earnings or cash flow. Discounted cash flow is preferred.

Multiperiod Discounted Earnings ModelsThere are many multiperiod discounted earnings models. These models rely on accrual accounting toproduce results that are closer to the firm’s underlying economic performance in the short run thanare cash flows.

The two most popular discounted earnings models appear to be discounted abnormal earnings(DAE) and residual income (RI).

Discounted Abnormal Earnings

With this approach, the value of the firm’s equity is the sum of its book value and discounted fore-casts of abnormal earnings.

Residual Income

This approach discounts future expected earnings. The focus is on earnings as a periodic measure ofshareholder wealth creation.

Multiperiod Discounted Cash Flow ModelsThere are many multiperiod discounted cash flow models. The three most popular seem to be freecash flow (FCF), dividend discount model (DDM), and discounted cash flow (DCF).

Free Cash Flow

The free cash flow model states that the intrinsic value (discounted free cash flow) equals the sum ofthe stream of expected free cash flows discounted to the present.

There are different definitions of free cash flow, but they are along these lines for common stock:operating cash flows minus interest, minus cash outlays for operating capacity (buildings, equipment,etc.), minus repayments, minus preferred dividends.

Dividend Discount Model (DDM)

The dividend discount model discounts the projected dividend stream to present value. It considersonly the dividend stream to common shareholders.

Discounted Cash Flow (DCF)

The discounted cash flow model involves a multiple-year forecast of cash flows. The forecasts arediscounted at the firm’s estimated cost of capital to arrive at an estimated present value.

WHAT THEY USE‘‘Three recent studies have dealt with the issue of what models are actually used by analysts: Barker(1999), Demirakos et al. (2004), and Asquith et al. (2005). All these studies agree that multiperioddiscounted valuation models do not seem to play a significant role in analysts’ normal valuation ac-tivity. Simple price-earnings multiples seem to be the predominant technique. Hence, any cost of eq-uity capital discounted valuation model may not be an adequate representation of the reality ofvaluation.’’29

Let’s review the three studies sited: Barker, Demirakos et al., and Asquith et al.



BarkerThe Barker study states that the value of a share is given by the dividend discount model, but theactual determination of the share value is rarely based on the direct estimation of the futuredividends.30

Barker references prior studies of valuation models used by market participants, which indicatedthat the strongest and most consistent finding in the behavioral literature is that the price-to-earningsis of primary importance.31 A further finding was that discounted cash flow models are of little prac-tical importance to investment decisions.32

The Barker study itself dealt with analysts and fund managers in the United Kingdom. The valua-tion models selected for study were price-earnings, dividend yield, price-cash flow (PCF), net assetvalue (NAV), sales/market capitalization, discounted cash flow, and dividend discount.33 Analystsand fund managers were asked to rate the importance of these valuation models. Both groups pickedthe PE method as the preferred method of valuation. The PE, dividend yield, and price-cash flowwere significantly more important than all other valuation models. (The discounted cash flow modeland the dividend discount model were both of little practical importance.)34

The analysts were asked to rank the importance of selected financial ratios: the profit and lossaccount (ratios) were perceived to be of greater relevance than the balance sheet (ratios).35

For both the analysts and fund managers, ‘‘a consistent finding from these interviews was that val-uation models are perceived to be important in the context of one another, and not just in isola-tion.’’36 This also applied to financial ratios.

It was found that analysts anchor their process in accounting information combined with othersources that are considered relevant to the reliably foreseeable future.37 This indicates the importanceof financial reports.

Analysts and fund managers consider almost all information received directly from companies tobe very important.38 They both ‘‘perceive their own assessment of company management to be at theheart of investment decision-making.’’39 If management makes the correct decisions, the firm willgenerate future cash flow streams.

Demirakos et al.The Demirakos et al. study examined the valuation practices of financial analysts at internationalinvestment banks. The firms consisted of 26 large U.K.-listed companies drawn from the beverages,electronics, and pharmaceuticals sectors.

Descriptive analysis ‘‘shows that almost all the sampled reports contain some form of valuationby reference to a multiple of earnings.40 The attention given to PE models varies systematicallyacross sectors in understandable ways.’’41

The main message to emerge from this content analysis of financial analysts’ reports is that analystsappear to tailor their valuation methodologies to the circumstances of the industry. PE models remainthe mainstay of valuation practice, but other forms of analysis complement those as circumstancesdemand. In some cases, discounted cash flow (DCF) models are used and in others, more detailedanalysis of price-to-sales multiples, growth options, or profitability analysis are used. Another finding isthat use of the residual income valuation (RIV) model is extremely limited, but analysts frequently useaccounting data in single-period comparative and hybrid models.42

Asquith et al.The Asquith et al. study catalogued the complete contents of Institutional Investor All-American ana-lyst reports and examined the market reactions to their release. This study found that analysts usemarket-to-book value as their asset multiple.43 No information reported in this study indicated thatdiscounted cash flow was used.

INTERNATIONAL ASPECTSThe Barker study dealt with analysts and fund managers in the United Kingdom. The Demirakosstudy examined the valuation practices of financial analysts at international investment banks.Twenty-six large U.K. firms were examined. The Asquith study examined the contents of Institu-tional Investor All-American analyst reports. Did the varied international aspects of these studiesinfluence the results?



Marco Trombetta in his paper ‘‘Discussion of Implied Cost of Equity Capital in Earnings-BasedValuation: International Evidence’’ commented as follows:

The kind of training that financial analysts are likely to receive around the world is probably fairly sim-ilar, especially if we focus on those countries with a significant important stock market. Moreover theglobalization of capital markets and investment strategies calls into question the assumption thatfinancial analysis is a national activity.44

VALUATION AS SEEN BY MANAGEMENT CONSULTANTSThis section comments on a book, Valuation, Measuring, and Managing the Value of Companies,that now is in its fourth edition. Because the three authors (Tom Copeland, Tim Koller, and JackMurrin) are all current or former partners of McKinsey & Company, Inc., and co-leaders of its corpo-rate finance practice, it reflects practice as viewed by consultants. Individuals interested in valuationfrom a firm’s perspective would benefit from a review of this book.

FROM PAGE VMcKinsey & Company, Inc., is an international top management consulting firm. Founded in 1926,McKinsey advises leading companies around the world.

This book is written from the perspective of creating value for the firm. The firm should be man-aged to increase its value. Its ‘‘premise is that the value of a company derives from its ability to gen-erate cash flows and cash-flow-based returns on investment.’’45

The authors’ position follows closely the theory of valuation. Discounted cash flows provide amore reliable picture of a company’s value than an earnings-multiple approach.46 Discounted cashflows drive the value of a company.

The firm should focus on long-term rather than short-term cash flows. Short-term cash flows areeasy to manipulate, such as delaying research.47

Copeland et al. examine mergers and acquisitions (M&A) and observe that the market is oftenunimpressed with the acquirers’ deals. Reviewing the results of academic studies of transactionsinvolving public companies in mergers and acquisitions showed that ‘‘shareholders of acquiringcompanies, on average, earned small returns that are not even statistically different from zero.’’48 Onthe other hand, shareholders of acquired companies are often big winners ‘‘receiving on average a 20percent premium in a friendly merger and a 35 percent premium in a hostile takeover.’’49 Manyacquisitions turn out badly because the purchaser paid too much.50

The authors observed that the acquirers overpaid for the following reasons:51

1. Overoptimistic appraisal of market potential

2. Overestimation of synergies

3. Poor due diligence

4. Overbidding

DOT.COMSThe authors maintain that the correct way to value dot.coms is to use the classic discounted cash flowapproach to valuating, reinforcing the continued importance of basic economics and finance.52

E-commerce firms have investments in customer acquisition, which is expensed in the incomestatement. Thus, as more customers are acquired, the values balloon as the losses balloon.53

Amazon.com built a customer base and expanded its offerings. Amazon.com started with privateequity financing and sold convertible preferred in 1996, which was converted to common in 1997.

Some data from the Amazon.com financial statements are given in Exhibit 11-13. Amazon.comhad a market capitalization in the billions by the end of 2000, yet it had never made a profit.

According to the Copeland et al. approach to discounted cash flow for ‘‘high-growth companieslike Amazon.com, don’t be constrained by current performance. Instead of starting from thepresent—the usual practice in DCF valuations—start by thinking about what the industry and thecompany could look like when they evolve from today’s very high-growth, unstable condition to asubstantial, moderate growth rate in the future, and then extrapolate back to current performance.’’54

Copeland et al. also recommend a customer value analysis when valuing very high-growthcompanies. Five factors that drive the customer-value analysis of a retailer like Amazon.com are asfollows:55



1. The average revenue per customer per year from purchases by its customers as well as revenuesfrom advertisements on its site and from retailers that rent space on it to sell their own products

2. The total number of customers

3. The contribution margin per customer (before the cost of acquiring customers)

4. The average cost of acquiring a customer

5. The customer churn rate (that is, the proportion of customers lost each year)

Any analysis should consider a company’s ability to survive long enough for the projections totake place. Amazon.com was able to raise substantial capital prior to the dot.com crash in 2000.Apparently, Amazon.com raised more capital than needed in 1999 and 2000, which allowed it to op-erate on plan without making major adjustments because of inadequate capital. Note the proceedsfrom long-term debt: 1997 ($75,000,000), 1998 ($326,000,000), 1999 ($1,264,000,000), and 2000($681,000,000).

E X H I B I T

11-13SELECTED DATA FROM THE AMAZON.COM FINANCIAL STATEMENTS, 1997–2000

$millions 1997 1998 1999 2000

Income statements:Sales 148 610 1,640 2,762Operating loss (33) (109) (606) (864)Net loss (31) (125) (720) (1,411)

Balance sheets:Current liabilities 44 162 739 975Long-term debt 77 348 1,466 2,127

Stockholders’ equity:Common stock 66 300 1,148 1,326Accumulated deficit (38) (162) (882) (2,293)

Total 28 138 266 (967)Total liabilities & stockholders’ equity 149 648 2,471 2,135

Cash flow statements:Net cash provided (used) in operating activities 1 31 (91) (130)Proceeds from long-term debt 75 326 1,264 681Proceeds of capital stock and exercise of stock options 53 14 64 45

Selected Data from the Amazon.com financial statements 1997–2000

SummaryThis chapter reviewed special areas related to financialstatements. It was noted that commercial loan departmentsgive a high significance rating to selected ratios that primar-ily measure liquidity or debt. The debt/equity ratio receivedthe highest significance rating, and the current ratio wasthe second highest rated by the commercial loan officers. Acommercial bank may elect to include a ratio as part of aloan agreement. The two ratios most likely to be included ina loan agreement are the debt/equity and the current ratio.

Financial executives give the profitability ratios the high-est significance ratings. They rate earnings per share andreturn on investment the highest. Many firms have selectedkey financial ratios, such as profitability ratios, to beincluded as part of their corporate objectives.

Certified public accountants give the highest significancerating to two liquidity ratios: the current ratio and theaccounts receivable turnover in days. The highest ratedprofitability ratio was the after-tax net profit margin, whilethe highest rated debt ratio was debt/equity.

A firm could use its annual report to relate financial dataeffectively by the use of financial ratios. In general, no majoreffort is being made to explain financial results by the disclo-sure of financial ratios in annual reports. A review of themethodology used to compute the ratios disclosed in annualreports indicated that wide differences of opinion exist onhow many of the ratios should be computed.

A review of the financial statements, including the notes,indicates the conservatism of the statements in terms ofaccounting policies. When a firm has conservative account-ing policies, it is said that its earnings are of high quality.

There have been many academic studies on the use offinancial ratios to forecast financial failure. No conclusivemodel has yet been developed to forecast financial failure.

Auditors use financial analysis as part of their analyticalreview procedures. By using financial analysis, they candetect significant fluctuations and unusual items in operatingstatistics. This can result in a more efficient and effectiveaudit.



Management can use financial analysis in many ways tomanage a firm more effectively. A particularly effective use offinancial analysis is to integrate ratios that have been acceptedas corporate objectives into comprehensive budgeting.

It has become popular to use graphs in annual reports topresent financial information. Graphs make it easier to graspkey financial information. Graphs can communicate betterthan a written report or a tabular presentation.

Many companies are restating their financial statements.This represents a substantial problem when analyzing finan-cial statements.

The improper management of earnings has become avery hot topic. Hopefully, this improper manipulation ofearnings is under control.

The collapse of the housing market and of many financialinstitutions led to a worldwide stock market collapse. Anal-ysis of a company that was done only a few years earlierwas of little use.

The objective with valuation is to determine a value forthe firm’s equity. In theory, the value of a company derivesfrom its ability to generate cash flows and cash-flow-basedreturns on investment. Research indicates that multiperioddiscounted valuation models do not seem to play a signifi-cant role in analysts’ or fund managers’ normal valuationactivity. A simple price-earnings multiple seems to be pre-dominant. The multiperiod discounted valuation modelsappear to play a significant role for a management consultingfirm reviewed.

To The Net

1. Go to the SEC Web site (http://www.sec.gov). Under‘‘Filings & Forms (EDGAR),’’ click on ‘‘Search for CompanyFilings.’’ Click on ‘‘Company or Fund, etc.’’ Under CompanyName, enter ‘‘Baldor Electric Company’’ (or under TickerSymbol, enter ‘‘BEZ’’). Select the 10-K filed March 4, 2009.Determine:a. Item 1 Business. Copy the first sentence.b.

January 3,2009

December29, 2007

Inventory balanceInventory valuation

adjustment

c. 2008 net income.d. 2008 effective tax rate.e. The approximate income for 2008 if inventory had been

valued at approximate current cost.

2. Go to the SEC Web site (http://www.sec.gov). Under‘‘Filings & Forms (EDGAR),’’ click on ‘‘Search for CompanyFilings.’’ Click on ‘‘Company or Fund, etc.’’ Under CompanyName, enter ‘‘Omnova Solutions’’ (or under Ticker Symbol,enter ‘‘OMN’’). Select the 10-K filed January 30, 2009.a. Determine the business description. Copy the second

paragraph under introduction.b. What was the income (loss) from continuing operations

for the years ended November 30, 2008 and 2007?c. During 2008, LIFO inventory quantities were increased.

Address the following:

1. Inventories valued using the LIFO method representedapproximately what percentage of inventories atNovember 30, 2008?

2. Estimate inventories for 2008 if the inventory werepresented at approximate current acquisitions cost.

3. The effect of the LIFO liquidation in 2008 decreased costof products by how much in 2008?

QuestionsQ 11-1 Commercial loan officers regard profitability finan-cial ratios as very significant. Comment.

Q 11-2 Which two financial ratios do commercial loanofficers regard as the most significant? Which two financialratios appear most frequently in loan agreements?

Q 11-3 The commercial loan officers did not list the divi-dend payout ratio as a highly significant ratio, but they didindicate that the dividend payout ratio appeared frequentlyin loan agreements. Speculate on the reason for this appa-rent inconsistency.

Q 11-4 Corporate controllers regard profitability financialratios as very significant. Comment.

Q 11-5 List the top five financial ratios included in cor-porate objectives according to the study reviewed in thisbook. Indicate what each of these ratios primarily measures.

Q 11-6 CPAs regard which two financial ratios as themost significant? The highest rated profitability ratio? Thehighest debt ratio?

Q 11-7 Financial ratios are used extensively in annualreports to interpret and explain financial statements.Comment.

Q 11-8 List the sections of annual reports where ratiosare most frequently located, in order of use.

Q 11-9 According to a study of annual reports reviewed inthis chapter, what type or types of financial ratios are mostlikely to be included in annual reports? Speculate on theprobable reason for these ratios appearing in annual reports.

Q 11-10 The study of annual reports reviewed in thischapter showed that earnings per share was disclosed inevery annual report. Why?

Q 11-11 The study of annual reports reviewed in thischapter indicated that wide differences of opinion exist onhow many ratios should be computed. Comment.

Q 11-12 What types of accounting policies are describedas conservative?



http://www.sec.gov

http://www.sec.gov

Q 11-13 Indicate which of the following accounting poli-cies are conservative by placing an X under Yes or No.Assume inflationary conditions exist.

Conservative

Yes No

a. LIFO inventory ________ ________b. FIFO inventory ________ ________c. Completed-contract

method________ ________

d. Percentage-of-completionmethod

________ ________

e. Accelerated depreciationmethod

________ ________

f. Straight-line depreciationmethod

________ ________

g. A relatively short estimatedlife for a fixed asset

________ ________

h. Short period for expensingintangibles

________ ________

i. Amortization of patentover five years

________ ________

j. High interest rate used tocompute the present valueof accumulated benefitobligation

________ ________

k. High rate of compensationincrease used in computingthe projected benefitobligation

________ ________

Q 11-14 All firms are required to expense R&D costsincurred each period. Some firms spend very large sums onR&D, while others spend little or nothing on this area. Whyis it important to observe whether a firm has substantial orimmaterial R&D expenses?

Q 11-15 Indicate some possible uses of a reliable modelthat can be used to forecast financial failure.

Q 11-16 Describe what is meant by a firm’s financial failure.

Q 11-17 According to the Beaver study, which ratios shouldbe watched most closely, in order of their predictive power?

Q 11-18 According to the Beaver study, three currentasset accounts should be given particular attention in orderto forecast financial failure. List each of these accounts andindicate whether they should be abnormally high or low.

Q 11-19 What does a Z score below 2.675 indicate,according to the Altman model?

Q 11-20 Indicate a practical problem with computing a Zscore for a closely held firm.

Q 11-21 No conclusive model has been developed toforecast financial failure. This indicates that financial ratiosare not helpful in forecasting financial failure. Comment.

Q 11-22 You are the auditor of Piedmore Corporation.You determine that the accounts receivable turnover hasbeen much slower this period than in prior periods and thatit is also materially lower than the industry average. Howmight this situation affect your audit plan?

Q 11-23 You are in charge of preparing a comprehensivebudget for your firm. Indicate how financial ratios can helpdetermine an acceptable comprehensive budget.

Q 11-24 List four popular forms of graphs used byaccountants.

Q 11-25 List two things that can make a line graphmisleading.

Q 11-26 Indicate two possible problems with a pie graphfor accounting data.

Q 11-27 The surveyed CFAs gave the highest significancerating to which type of financial ratio?

Q 11-28 CFAs gave liquidity ratios a high significance rat-ing. Comment.

Q 11-29 Describe a proper management of earnings.Describe an improper management of earnings.

Q 11-30 In valuation of stock equity, fundamental analysismakes extensive use of multiperiod discounted cash flow.Comment.

Q 11-31 The use of multiples and conventional financialreports is not well accepted by the traditional financial liter-ature or many valuation books. Comment.

Q 11-32 Multiperiod discounted valuation models do notseem to play a significant role in analysts’ normal valuationactivity. Comment.

Q 11-33 Comment on the importance of an assessmentof company management when valuing a company from theperspective of analysts and fund managers.

Q 11-34 We are interested in the future when valuing thestock equity of a company. Therefore, traditional financialstatements are of little use in this endeavor. Comment.

Q 11-35 It appears that most restatements are sympto-matic of financial reporting fraud. Comment.

ProblemsP 11-1

Required Answer the following multiple-choice questions:

a. Notes to financial statements are beneficial in meeting the disclosure requirements of financialreporting. The notes should not be used to

1. Describe significant accounting policies.

2. Describe depreciation methods employed by the company.



3. Describe principles and methods peculiar to the industry in which the company operateswhen these principles and methods are predominately followed in that industry.

4. Disclose the basis of consolidation for consolidated statements.

5. Correct an improper presentation in the financial statements.

b. Which one of the following would be a source of funds under a cash concept of funds but wouldnot be listed as a source under the working capital concept?

1. Sale of stock

2. Sale of machinery

3. Sale of treasury stock

4. Collection of accounts receivable

5. Proceeds from long-term bank borrowing

c. The concept of conservatism is often considered important in accounting. The application of thisconcept means that in the event some doubt occurs as to how a transaction should be recorded,it should be recorded so as to

1. Understate income and overstate assets.

2. Overstate income and overstate assets.

3. Understate income and understate assets.

4. Overstate income and understate assets.

5. Overstate cash and overstate assets.

d. Early in a period in which sales were increasing at a modest rate and plant expansion and start-up costs were occurring at a rapid rate, a successful business would likely experience

1. Increased profits and increased financing requirements because of an increasing cashshortage.

2. Increased profits and decreased financing requirements because of an increasing cash surplus.

3. Increased profits and no change in financing requirements.

4. Decreased profits and increased financing requirements because of an increasing cash shortage.

5. Decreased profits and decreased financing requirements because of an increasing cash surplus.

e. Which of the following ratios would best disclose effective management of working capital by agiven firm relative to other firms in the same industry?

1. A high rate of financial leverage relative to the industry average

2. A high number of days’ sales uncollected relative to the industry average

3. A high turnover of net working capital relative to the industry average

4. A high number of days’ sales in inventory relative to the industry average

5. A high proportion of fixed assets relative to the industry average

P 11-2


a. If business conditions are stable, a decline in the number of days’ sales outstanding from oneyear to the next (based on a company’s accounts receivable at year-end) might indicate

1. A stiffening of the company’s credit policies.

2. That the second year’s sales were made at lower prices than the first year’s sales.

3. That a longer discount period and a more distant due date were extended to customers in thesecond year.

4. A significant decrease in the volume of sales of the second year.

b. Trading on equity (financial leverage) is likely to be a good financial strategy for stockholdersof companies having

1. Cyclical high and low amounts of reported earnings.

2. Steady amounts of reported earnings.

3. Volatile fluctuation in reported earnings over short periods of time.

4. Steadily declining amounts of reported earnings.c. The ratio of total cash, trade receivables, and marketable securities to current liabilities is

1. The acid-test ratio.

2. The current ratio.



3. Significant if the result is 2-to-1 or below.

4. Meaningless.

d. The times interest earned ratio is a primary measure of

1. Liquidity.

2. Long-term debt-paying ability.

3. Activity.

4. Profitability.

e. The calculation of the number of times bond interest is earned involves dividing

1. Net income by annual bond interest expense.

2. Net income plus income taxes by annual bond interest expense.

3. Net income plus income taxes and bond interest expense by annual bond interest expense.

4. Sinking fund earnings by annual bond interest expense.

P 11-3


a. Which of the following would not be an example of the use of a multiple when valuing commonequity?

1. Multiperiod discounted earnings models

2. Price-to-earnings (PE)

3. Price-to-book

4. Price-to-operating cash flow

b. The two most popular discounted earnings models appear to be

1. Discounted abnormal earnings and residual income.

2. Free cash flow and dividend discount model.

3. Sales/market capitalization and price-earnings.

4. Price-cash flow and dividend discount.

c. Shareholders of acquired companies are often big winners, receiving on average a premium ofwhat in a friendly merger?

1. 10%

2. 20%

3. 30%

4. 35%

d. Which of the following was not given as a reason for acquirers paying too much in anacquisition?

1. Overuse of conventional financial statements

2. Overbidding

3. Overoptimistic appraisal of market potential

4. Overestimation of synergies

e. Which of the following would likely be very useful when valuing a dot.com?

1. Discounted cash flow

2. Price-earnings

3. Net asset value

4. Dividend yield

P 11-4 Thorpe Company is a wholesale distributor of professional equipment and supplies. Thecompany’s sales have averaged about $900,000 annually for the three-year period 2007–2009. Thefirm’s total assets at the end of 2009 amounted to $850,000.

The president of Thorpe Company has asked the controller to prepare a report that summarizesthe financial aspects of the company’s operations for the past three years. This report will be pre-sented to the board of directors at its next meeting.

In addition to comparative financial statements, the controller has decided to present a number ofrelevant financial ratios that can assist in the identification and interpretation of trends. At the requestof the controller, the accounting staff has calculated the following ratios for the three-year period2007–2009:



Ratio 2007 2008 2009

Current ratio 2.00 2.13 2.18Acid-test (quick) ratio 1.20 1.10 0.97Accounts receivable turnover 9.72 8.57 7.13Inventory turnover 5.25 4.80 3.80Percent of total debt to total assets 44.00% 41.00% 38.00%Percent of long-term debt to total assets 25.00% 22.00% 19.00%Sales to fixed assets (fixed asset turnover) 1.75 1.88 1.99Sales as a percent of 2007 sales 100.00% 103.00% 106.00%Gross profit percentage 40.0% 33.6% 38.5%Net income to sales 7.8% 7.8% 8.0%Return on total assets 8.5% 8.6% 8.7%Return on stockholders’ equity 15.1% 14.6% 14.1%

In preparing his report, the controller has decided first to examine the financial ratios independentlyof any other data to determine whether the ratios themselves reveal any significant trends over thefirst three-year period.

Required

a. The current ratio is increasing, while the acid-test (quick) ratio is decreasing. Using the ratiosprovided, identify and explain the contributing factor(s) for this apparently divergent trend.

b. In terms of the ratios provided, what conclusion(s) can be drawn regarding the company’s useof financial leverage during the 2007–2009 period?

c. Using the ratios provided, what conclusion(s) can be drawn regarding the company’s net invest-ment in plant and equipment?

Source: Materials identified as CFA Examination I, June 4, 1988, June 6, 1987 and June 6, 1988 are reproducedwith permission from the Association for Investment Management and Research and the Institute of CharteredFinancial Analysts.

(CMA Adapted)

P 11-5 L. Konrath Company is considering extending credit to D. Hawk Company. L. KonrathCompany estimated that sales to D. Hawk Company would amount to $2 million each year. L. Kon-rath Company, a wholesaler, sells throughout the Midwest. D. Hawk Company, a retail chain opera-tion, has a number of stores in the Midwest. L. Konrath Company has had a gross profit ofapproximately 60% in recent years and expects to have a similar gross profit on the D. Hawk Com-pany order. The D. Hawk Company order is approximately 15% of L. Konrath Company’s presentsales. Data from recent statements of D. Hawk Company follow:

(In millions) 2007 2008 2009

AssetsCurrent assets:

Cash $ 2.6 $ 1.8 $ 1.6Government securities (cost) 0.4 0.2 —Accounts and notes receivable (net) 8.0 8.5 8.5Inventories 2.8 3.2 2.8Prepaid assets 0.7 0.6 0.6

Total current assets 14.5 14.3 13.5Property, plant, and equipment (net) 4.3 5.4 5.9

Total assets $18.8 $19.7 $19.4

Liabilities and EquitiesCurrent liabilities $ 6.9 $ 8.5 $ 9.3Long-term debt, 6% 3.0 2.0 1.0

Total liabilities 9.9 10.5 10.3Shareholders’ equity 8.9 9.2 9.1Total liabilities and equities $18.8 $19.7 $19.4

IncomeNet sales $24.2 $24.5 $24.9Cost of goods sold 16.9 17.2 18.0Gross margin 7.3 7.3 6.9Selling and administrative expenses 6.6 6.8 7.3Earnings (loss) before taxes 0.7 0.5 (0.4)Income taxes 0.3 0.2 (0.2)Net income $ 0.4 $ 0.3 $ (0.2)



Required

a. Calculate the following for D. Hawk Company for 2009:

1. Rate of return on total assets

2. Acid-test ratio

3. Return on sales

4. Current ratio

5. Inventory turnover

b. As part of the analysis to determine whether L. Konrath Company should extend credit to D.Hawk Company, assume the ratios were calculated from D. Hawk Company statements. Foreach ratio, indicate whether it is a favorable, an unfavorable, or a neutral statistic in the decisionto grant D. Hawk Company credit. Briefly explain your choice in each case.

Ratio 2007 2008 2009

Rate of return on total assets 1.96% 1.12% (.87)%Return on sales 1.69% .99% (.69)%Acid-test ratio 1.73 1.36 1.19Current ratio 2.39 1.92 1.67Inventory turnover (times per year) 4.41 4.32 4.52Equity relationships:

Current liabilities 36.0% 43.0% 48.0%Long-term liabilities 16.0 10.5 5.0Shareholders’ equity 48.0 46.5 47.0

100.0% 100.0% 100.0%

Asset relationships:Current assets 77.0% 72.5% 69.5%Property, plant, and equipment 23.0 27.5 30.5

100.0% 100.0% 100.0%

c. Would you grant credit to D. Hawk Company? Support your answer with facts given in theproblem.

d. What additional information, if any, would you want before making a final decision?


(CMA Adapted)

P 11-6 Your company is considering the possible acquisition of Growth, Inc. The financial state-ments of Growth, Inc., follow:

GROWTH, INC.Balance Sheet

December 31, 2009 and 20082009 2008


Cash $ 64,346 $ 11,964Accounts receivable, less allowance of

$750 for doubtful accounts99,021 83,575

Inventories, FIFO 63,414 74,890Prepaid expenses 834 1,170

Total current assets 227,615 171,599Investments and other assets 379 175Property, plant, and equipment:

Land and land improvements 6,990 6,400Buildings 63,280 59,259Machinery and equipment 182,000 156,000

252,270 221,659Less: Accumulated depreciation 110,000 98,000Net property, plant, and equipment 142,270 123,659

Total assets $370,264 $295,433



2009 2008

Liabilities and Stockholders’ EquityCurrent liabilities:

Accounts payable $ 32,730 $ 26,850Federal income taxes 5,300 4,800Accrued liabilities 30,200 24,500Current portion of long-term debt 5,500 5,500

Total current liabilities 73,730 61,650Long-term debt 76,750 41,900Other long-term liabilities 5,700 4,300

Deferred federal income taxes 16,000 12,000Total liabilities 172,180 119,850

Stockholders’ equity:Capital stock 44,000 43,500Retained earnings 154,084 132,083

Total stockholders’ equity 198,084 175,583Total liabilities and stockholders’ equity $370,264 $295,433

GROWTH, INC.Statement of Income

Years Ended December 31, 2009, 2008, and 2007

2009 2008 2007

Revenues $578,530 $523,249 $556,549Costs and expenses:

Cost of products sold 495,651 457,527 482,358Selling, general, and administrative 35,433 30,619 29,582Interest and debt expense 4,308 3,951 2,630

535,392 492,097 514,570Income before income taxes 43,138 31,152 41,979Provision for income taxes 20,120 12,680 17,400Net income $ 23,018 $ 18,472 $ 24,579

Net income per share $ 2.27 $ 1.85 $ 2.43

Partial notes: Under the LIFO method, inventories have been reduced by approximately $35,300and $41,100 at December 31, 2009 and 2008, respectively, from current cost, which would bereported under the first-in, first-out method.

The effective tax rates were 36.6%, 30.7%, and 31.4%, respectively, for the years ended Decem-ber 31, 2009, 2008, and 2007.

Required

a. Compute the following for 2009, without considering the LIFO reserve:

Liquidity

1. Days’ sales in inventory

2. Merchandise inventory turnover

3. Inventory turnover in days

4. Operating cycle

5. Working capital

6. Current ratio

7. Acid-test ratio

8. Cash ratio

Debt

1. Debt ratio

2. Debt/equity ratio

3. Times interest earned



Profitability

1. Net profit margin

2. Total asset turnover

3. Return on assets

4. Return on total equity

b. Compute the ratios in part (a), considering the LIFO reserve.

c. Comment on the apparent liquidity, debt, and profitability, considering both sets of ratios.

P 11-7

Required For each of the following numbered items, you are to select the lettered item(s) that indi-cate(s) its effect(s) on the corporation’s statements. If more than one effect is applicable to a particu-lar item, be sure to indicate all applicable letters. (Assume that the state statutes do not permitdeclaration of nonliquidating dividends except from earnings.)

Item Effect

1. Declaration of a cash dividend due in onemonth on noncumulative preferred stock

2. Declaration and payment of an ordinarystock dividend

3. Receipt of a cash dividend, not previouslyrecorded, on stock of another corporation

4. Passing of a dividend on cumulative preferredstocks

5. Receipt of preferred shares as a dividend onstock held as a temporary investment. Thiswas not a regularly recurring dividend.

6. Payment of dividend mentioned in (1)

7. Issue of new common shares in a5-for-1 stock split

a. Reduces working capital

b. Increases working capital

c. Reduces current ratio

d. Increases current ratio

e. Reduces the dollar amount of total capital stock

f. Increases the dollar amount of total capital stock

g. Reduces total retained earnings

h. Increases total retained earnings

i. Reduces equity per share of common stock

j. Reduces equity of each common stockholder

P 11-8 Argo Sales Corporation has in recent years maintained the following relationships among the data onits financial statements:

Gross profit rate on net sales 40%Net profit rate on net sales 10%Rate of selling expenses to net sales 20%Accounts receivable turnover 8 per yearInventory turnover 6 per yearAcid-test ratio 2-to-1Current ratio 3-to-1Quick-asset composition: 8% cash, 32% marketable securities,

60% accounts receivableAsset turnover 2 per yearRatio of total assets to intangible assets 20-to-1Ratio of accumulated depreciation to cost of fixed assets 1-to-3Ratio of accounts receivable to accounts payable 1.5-to-1Ratio of working capital to stockholders’ equity 1-to-1.6Ratio of total debt to stockholders’ equity 1-to-2

The corporation had a net income of $120,000 for 2009, which resulted in earnings of $5.20 pershare of common stock. Additional information includes the following:

Capital stock authorized, issued (all in 2000), and outstanding:Common, $10 per share par value, issued at 10% premiumPreferred, 6% nonparticipating, $100 per share par value, issued at a 10% premium



Market value per share of common at December 31, 2009: $78Preferred dividends paid in 2009: $3,000Times interest earned in 2009: 33The amounts of the following were the same at December 31, 2009 as at January 1, 2009:inventory, accounts receivable, 5% bonds payable—due 2017, and total stockholders’ equity.All purchases and sales were on account.

Required

a. Prepare in good form the condensed balance sheet and income statement for the year endingDecember 31, 2009, presenting the amounts you would expect to appear on Argo’s financialstatements (ignoring income taxes). Major captions appearing on Argo’s balance sheet are cur-rent assets, fixed assets, intangible assets, current liabilities, long-term liabilities, and stockhold-ers’ equity. In addition to the accounts divulged in the problem, you should include accounts forprepaid expenses, accrued expenses, and administrative expenses. Supporting computationsshould be in good form.

b. Compute the following for 2009. (Show your computations.)

1. Rate of return on stockholders’ equity

2. Price/earnings ratio for common stock

3. Dividends paid per share of common stock

4. Dividends paid per share of preferred stock

5. Yield on common stock


(CMA Adapted)

P 11-9 Warford Corporation was formed five years ago through a public subscription of commonstock. Lucinda Street, who owns 15% of the common stock, was one of the organizers of Warfordand is its current president. The company has been successful but currently is experiencing a shortageof funds. On June 10, Street approached Bell National Bank, asking for a 24-month extension on two$30,000 notes, which are due on June 30, 2009 and September 30, 2009. Another note of $7,000 isdue on December 31, 2009, but Street expects no difficulty in paying this note on its due date. Streetexplained that Warford’s cash flow problems are due primarily to the company’s desire to finance a$300,000 plant expansion over the next two fiscal years through internally generated funds.

The commercial loan officer of Bell National Bank requested financial reports for the last two fis-cal years. These reports follow:

WARFORD CORPORATIONStatement of Financial Position

March 31, 2008 and 2009

2008 2009

Assets:Cash $ 12,500 $ 16,400Notes receivable 104,000 112,000Accounts receivable (net) 68,500 81,600Inventories (at cost) 50,000 80,000Plant and equipment (net of depreciation) 646,000 680,000

Total assets $881,000 $970,000

Liabilities and Owners’ Equity:Accounts payable $ 72,000 $ 69,000Notes payable 54,500 67,000Accrued liabilities 6,000 9,000Common stock (60,000 shares, $10 par) 600,000 600,000Retained earnings* 148,500 225,000

Total liabilities and owners’ equity $881,000 $970,000

*Cash dividends were paid at the rate of $1.00 per share in fiscal year 2008 and $1.25 per share in fiscal year 2009.



WARFORD CORPORATIONIncome Statement

For the Fiscal Years Ended March 31, 2008 and 20092008 2009

Sales $2,700,000 $3,000,000Cost of goods sold* 1,720,000 1,902,500Gross profit 980,000 1,097,500Operating expenses 780,000 845,000Net income before taxes 200,000 252,500Income taxes (40%) 80,000 101,000Income after taxes $ 120,000 $ 151,500

*Depreciation charges on the plant and equipment of $100,000 and $102,500 for fiscal years ended March 31, 2008 and 2009, respectively, are

included in cost of goods sold.

Required

a. Calculate the following items for Warford Corporation:

1. Current ratio for fiscal years 2008 and 2009

2. Acid-test (quick) ratio for fiscal years 2008 and 2009

3. Inventory turnover for fiscal year 2009

4. Return on assets for fiscal years 2008 and 2009

5. Percentage change in sales, cost of goods sold, gross profit, and net income after taxes fromfiscal year 2008 to 2009

b. Identify and explain what other financial reports and/or financial analyses might be helpful tothe commercial loan officer of Bell National Bank in evaluating Street’s request for a timeextension on Warford’s notes.

c. Assume that the percentage changes experienced in fiscal year 2009, as compared with fiscalyear 2008, for sales, cost of goods sold, gross profit, and net income after taxes, will be repeatedin each of the next two years. Is Warford’s desire to finance the plant expansion from internallygenerated funds realistic? Explain.

d. Should Bell National Bank grant the extension on Warford’s notes, considering Street’s state-ment about financing the plant expansion through internally generated funds? Explain.

Source: Materials identified as CFA Examination I, June 4, 1988, June 6, 1987 and June 6, 1988 are reproduced withpermission from the Association for investment Management and Research and the Institute of Chartered FinancialAnalysts.

(CMA Adapted)P 11-10 The following data apply to items (a) through (g):

JOHANSON COMPANYStatement of Financial Position

December 31, 2008 and 2009

(In thousands) 2008 2009


Cash and temporary investments $ 380 $ 400Accounts receivable (net) 1,500 1,700Inventories 2,120 2,200

Total current assets 4,000 4,300Long-term assets:

Land 500 500Building and equipment (net) 4,000 4,700

Total long-term assets 4,500 5,200Total assets $8,500 $9,500

Liabilities and EquitiesCurrent liabilities:

Accounts payable $ 700 $1,400Current portion of long-term debt 500 1,000

Total current liabilities 1,200 2,400Long-term debt 4,000 3,000

Total liabilities 5,200 5,400



(In thousands) 2008 2009

Stockholders’ equity:Common stock 3,000 3,000Retained earnings 300 1,100

Total stockholders’ equity 3,300 4,100Total liabilities and equities $8,500 $9,500

JOHANSON COMPANYStatement of Income and Retained Earnings

For the Year Ended December 31, 2009

(In thousands)

Net sales $28,800Less: Cost of goods sold $15,120

Selling expenses 7,180Administrative expenses 4,100Interest 400Income taxes 800 27,600

Net income 1,200Retained earnings, January 1 300

Subtotal 1,500Cash dividends declared and paid 400Retained earnings, December 31 $ 1,100


a. The acid-test ratio for 2009 is

1. 1.1-to-1.

2. 0.9-to-1.

3. 1.8-to-1.

4. 0.2-to-1.

5. 0.17-to-1.

b. The average number of days’ sales outstanding in 2009 is

1. 18 days.

2. 360 days.

3. 20 days.

4. 4.4 days.

5. 80 days.

c. The times interest earned ratio for 2009 is

1. 3.0 times.

2. 1.0 time.

3. 72.0 times.

4. 2.0 times.

5. 6.0 times.

d. The asset turnover in 2009 is

1. 3.2 times.

2. 1.7 times.

3. 0.4 time.

4. 1.1 times.

5. 0.13 time.

e. The inventory turnover in 2009 is

1. 13.6 times.

2. 12.5 times.

3. 0.9 time.

4. 7.0 times.

5. 51.4 times.



f. The operating income margin in 2009 is

1. 2.7%.

2. 91.7%.

3. 52.5%.

4. 95.8%.

5. 8.3%.

g. The dividend payout ratio in 2009 is

1. 100%.

2. 36%.

3. 20%.

4. 8.8%.

5. 33.3%.


(CMA Adapted)

P 11-11 The statement of financial position for Paragon Corporation at November 30, 2009, theend of its current fiscal year, follows. The market price of the company’s common stock was $4 pershare on November 30, 2009.

(In thousands)


Cash $ 6,000Accounts receivable $ 7,000Less: Allowance for doubtful accounts 400 6,600Merchandise inventory 16,000Supplies on hand 400Prepaid expenses 1,000

Total current assets $30,000Property, plant, and equipment:

Land 27,500Building $36,000Less: Accumulated depreciation 13,500 22,500

Total property, plant, and equipment 50,000Total assets $80,000


Accounts payable $ 6,400Accrued interest payable 800Accrued income taxes payable 2,200Accrued wages payable 600Deposits received from customers 2,000

Total current liabilities $12,000Long-term debt:

Bonds payable—20-year, 8% convertible debentures dueDecember 1, 2014 (Note 7)

20,000

Less: Unamortized discount 200 19,800Total liabilities 31,800

Stockholders’ equity:Common stock—authorized 40,000,000 shares of $1 par

value; 20,000,000 shares issued and outstanding 20,000Paid-in capital in excess of par value 12,200Total paid-in capital 32,200Retained earnings 16,000

Total stockholders’ equity 48,200Total liabilities and stockholders’ equity $80,000

All items are to be considered independent of one another, and any transactions given in the itemsare to be considered the only transactions to affect Paragon Corporation during the just-completedcurrent or coming fiscal year. Average balance sheet account balances are used in computing ratios



involving income statement accounts. Ending balance sheet account balances are used in computingratios involving only balance sheet items.

Required Answer the following multiple-choice questions:a. If Paragon paid back all of the deposits received from customers, its current ratio would be

1. 2.50-to-1.00.

2. 2.80-to-1.00.

3. 2.33-to-1.00.

4. 3.00-to-1.00.

5. 2.29-to-1.00.

b. If Paragon paid back all of the deposits received from customers, its quick (acid-test) ratio would be

1. 1.06-to-1.00.

2. 1.00-to-1.00.

3. 0.88-to-1.00.

4. 1.26-to-1.00.

5. 1.20-to-1.00.

c. A 2-for-1 common stock split by Paragon would

1. Result in each $1,000 bond being convertible into 600 new shares of Paragon common stock.

2. Decrease the retained earnings due to the capitalization of retained earnings.

3. Not affect the number of common shares outstanding.

4. Increase the total paid-in capital.

5. Increase the total stockholders’ equity.

d. Paragon Corporation’s building is being depreciated using the straight-line method, salvagevalue of $6,000,000, and life of 20 years. The number of years the building has been depreciatedby Paragon as of November 30, 2009 is

1. 7.5 years.

2. 12.5 years.

3. 9.0 years.

4. 15.0 years.

5. None of these.

e. Paragon’s book value per share of common stock as of November 30, 2009 is

1. $4.00.

2. $1.61.

3. $1.00.

4. $2.41.

5. None of these.

f. If, during the current fiscal year ending November 30, 2009, Paragon had sales of $90,000,000with a gross profit of 20% and an inventory turnover of five times per year, the merchandiseinventory balance on December 1, 2008 was

1. $14,400,000.

2. $12,800,000.

3. $18,000,000.

4. $20,000,000.

5. $16,000,000.

g. If Paragon has a payout ratio of 80% and declared and paid $4,000,000 of cash dividends during thecurrent fiscal year ended November 30, 2009, the retained earnings balance on December 1, 2008 was

1. $20,000,000.

2. $17,000,000.

3. $15,000,000.

4. $11,000,000.

5. None of these.

Source: Materials identified as CFA Examination I, June 4, 1988, June 6, 1987 and June 6, 1988 are reproducedwith permission from the Association for investment Management and Research and the Institute of CharteredFinancial Analysts. (CMA Adapted)



P 11-12 Calcor Company has been a wholesale distributor of automobile parts for domestic auto-makers for 20 years. Calcor has suffered through the recent slump in the domestic auto industry, andits performance has not rebounded to the levels of the industry as a whole.

Calcor’s single-step income statement for the year ended November 30, 2009, follows:

CALCOR COMPANYIncome Statement

For the Year Ended November 30, 2009 (thousands omitted)

Net sales $8,400Expenses:

Cost of goods sold 6,300Selling expense 780Administrative expense 900Interest expense 140

Total 8,120Income before income taxes 280Income taxes 112Net income $ 168

Calcor’s return on sales before interest and taxes was 5% in fiscal 2009 compared with the industryaverage of 9%. Calcor’s turnover of average assets of four times per year and return on averageassets before interest and taxes of 20% are both well below the industry average.

Joe Kuhn, president of Calcor, wishes to improve these ratios and raise them nearer to the industryaverages. He established the following goals for Calcor Company for fiscal 2010:

Return on sales before interest and taxes 8%Turnover of average assets 5 times per yearReturn on average assets before interest and taxes 30%

For fiscal 2010, Kuhn and the rest of Calcor’s management team are considering the followingactions, which they expect will improve profitability and result in a 5% increase in unit sales:

1. Increase selling prices 10%.

2. Increase advertising by $420,000 and hold all other selling and administrative expenses at fiscal2009 levels.

3. Improve customer service by increasing average current assets (inventory and accounts receiva-ble) by a total of $300,000, and hold all other assets at fiscal 2009 levels.

4. Finance the additional assets at an annual interest rate of 10% and hold all other interest expenseat fiscal 2009 levels.

5. Improve the quality of products carried; this will increase the units of goods sold by 4%.

6. Calcor’s 2010 effective income tax rate is expected to be 40%—the same as in fiscal 2009.

Required

a. Prepare a single-step pro forma income statement for Calcor Company for the year endedNovember 30, 2010, assuming that Calcor’s planned actions would be carried out and that the5% increase in unit sales would be realized.

b. Calculate the following ratios for Calcor Company for the 2009–2010 fiscal year and statewhether Kuhn’s goal would be achieved:

1. Return on sales before interest and taxes

2. Turnover of average assets

3. Return on average assets before interest and taxes

c. Would it be possible for Calcor Company to achieve the first two of Kuhn’s goals withoutachieving his third goal of a 30% return on average assets before interest and taxes? Explainyour answer.

Source: Materials identified as CFA Examination I, June 4, 1988, June 6, 1987 and June 6, 1988 are reproducedwith permission from the Association for investment Management and Research and the Institute of CharteredFinancial Analysts.

(CMA Adapted)



P 11-13 The following data are for the A, B, and C Companies:

Company

Variables A B C

Current assets $150,000 $170,000 $180,000Current liabilities $ 60,000 $ 50,000 $ 30,000Total assets $300,000 $280,000 $250,000Retained earnings $ 80,000 $ 90,000 $ 60,000Earnings before interest and taxes $ 70,000 $ 60,000 $ 50,000Market price per share $ 20.00 $ 18.75 $ 16.50Number of shares outstanding 9,000 9,000 9,000Book value of total debt $ 30,000 $ 50,000 $ 80,000Sales $430,000 $400,000 $200,000

Required

a. Compute the Z score for each company.

b. According to the Altman model, which of these firms is most likely to experience financialfailure?

P 11-14 General Company’s financial statements for 2009 follow here and on the following pages:

GENERAL COMPANYStatement of Income


2009 2008 2007

Net sales $860,000 $770,000 $690,000Cost and expenses:

Cost of products sold 730,000 630,000 580,000Selling, general, and administrative 46,000 40,000 38,000Interest and debt expense 4,000 3,900 6,500

780,000 673,900 624,500Income before income taxes 80,000 96,100 65,500Provision for income taxes 33,000 24,000 21,000Net income $ 47,000 $ 72,100 $ 44,500

Net income per share $ 2.67 $ 4.10 $ 2.54

GENERAL COMPANYStatement of Cash Flows


2009 2008 2007

Operating activities:Net income $ 47,000 $ 72,100 $ 44,500Adjustments to reconcile net income to net cash

provided by operating activities:Depreciation and amortization 21,000 20,000 19,000Deferred taxes 3,800 2,500 2,000Increase in accounts receivable (4,000) (3,000) (3,000)Decrease (increase) in inventories (3,000) (2,500) 1,000Decrease (increase) in prepaid expenses (300) (200) 100Increase (decrease) in accounts payable 6,000 5,000 (1,000)Increase (decrease) in income taxes 100 300 (100)Increase (decrease) in accrued liabilities 6,000 3,000 (1,000)

Net cash provided by operating activities 76,600 97,200 61,500Investing activities:

Additions to property, plant, and equipment (66,500) $(84,400) (52,500)



2009 2008 2007

Financing activities:Payment on long-term debt (1,000) (2,000) (1,500)Issuance of other long-term liabilities 9,200 1,000 (1,000)Issuance of capital stock 1,000 — —Dividend paid (10,300) (9,800) (9,500)

Net cash used in financing activities (1,100) (10,800) (12,000)Increase (decrease) in cash 9,000 2,000 (3,000)Cash at beginning of year 39,000 37,000 40,000Cash at end of year $ 48,000 $ 39,000 $ 37,000

GENERAL COMPANYBalance Sheet December 31, 2009

2009 2008


Cash $ 48,000 $ 39,000Accounts receivable, less allowance for doubtful accounts of

$2,000 in 2009 and $1,400 in 2010 125,000 121,000Inventories 71,000 68,000Prepaid expenses 2,500 2,200

Total current assets 246,500 230,200Property, plant, and equipment:

Land and land improvements 12,000 10,500Buildings 98,000 89,000Machinery and equipment 303,000 247,000

413,000 346,500Less: Accumulated depreciation 165,000 144,000

Net property, plant, and equipment 248,000 202,500Total assets $494,500 $432,700


Accounts payable $ 56,000 $ 50,000Income taxes 3,700 3,600Accrued liabilities 34,000 28,000

Total current liabilities 93,700 81,600Long-term debt 63,000 64,000Other long-term liabilities 16,000 6,800Deferred federal income taxes 27,800 24,000

Total liabilities 200,500 176,400Stockholders’ equity:

Capital stock 46,000 45,000Retained earnings 248,000 211,300

Total stockholders’ equity 294,000 256,300Total liabilities and stockholders’ equity $494,500 $432,700

Note: The market price of the stock at the end of 2009 was $30.00 per share. There were 23,000 common shares outstandingat December 31, 2009.

Required

a. Compute the Z score of General Company at the end of 2009.

b. According to the Altman model, does the Z score of General Company indicate a high probabil-ity of financial failure?

P 11-15LIFO reserves: Rhodes CompanyReported year for analysis, 2009

2009 Net income as reported $ 90,200,0002009 Inventory reserve 50,000,0002008 Inventory reserve 46,000,0002009 Income taxes 55,000,0002009 Income before income taxes 145,200,000



Required Compute the approximate income if inventory had been valued at approximate current cost.

P 11-16LIFO reserves: Lion Company

Reported year for analysis, 2008

2008 Net income as reported $45,000,0002008 Inventory reserve 20,000,0002007 Inventory reserve 28,000,0002008 Income taxes 14,000,0002008 Income before income taxes 59,000,000

Required Compute the approximate income if inventory had been valued at approximate current cost.

P 11-17 An airline presented this graph with its annual report.

Required Indicate the misleading feature in this graph.

CasesCASE 11-1 UP IN SMOKE

REYNOLDS AMERICAN, INC.*CONSOLIDATED STATEMENTS OF INCOME(Dollars in Millions, Except Per Share Amounts)

For the Years Ended December 31,

2008 2007 2006

Net sales1 $8,377 $8,516 $8,010Net sales, related party 468 507 500Net sales 8,845 9,023 8,510Costs and expenses:

Cost of products sold1,2,3 4,863 4,960 4,803Selling, general, and administrative expenses 1,500 1,687 1,658Amortization expense 22 23 28Restructuring charge 90 1Trademark impairment charge 318 65 90

Operating income 2,052 2,288 1,930

*‘‘Reynolds American, Inc., referred to as RAI, is a holding company for the second largest cigarette manufacturer in theUnited States, R. J. Reynolds Tobacco Company, and the second largest smokeless tobacco products manufacturer in theUnited States, Conwood Company, LLC.’’1Excludes excise taxes of $1,890 million, $2,026 million, and $2,124 million for the years ended December 31, 2008, 2007,and 2006, respectively.2Includes Master Settlement Agreement and other state settlement agreements, collectively referred to as the MSA, expense of$2,073 million, $2,821 million, and $2,611 million for the years ended December 31, 2008, 2007, and 2006, respectively.3Includes federal tobacco quote buyout expenses of $249 million, $225 million, and $256 million for the years ended Decem-ber 31, 2008, 2007, and 2006, respectively.




2008 2007 2006

Interest and debt expense 275 338 270Interest income (60) (134) (136)Gain on termination of joint venture (328)Other (income) expense, net 37 11 (13)

Income from continuing operations beforeincome taxes and extraordinary items

2,128 2,073 1,809

Provision for income taxes 790 766 673Income from continuing operations before

extraordinary item 1,338 1,307 1,136Extraordinary item—gain on acquisition 1 74

Net income $1,338 $1,308 $1,210Basic income per share:

Income from continuing operations beforeextraordinary item $4.58 $4.44 $3.85

Extraordinary item 0.25Net income $ 4.58 $ 4.44 $ 4.10

Diluted income per share:Income from continuing operations before

extraordinary item $4.57 $4.43 $3.85Extraordinary item 0.25

Net income $ 4.57 $ 4.43 $ 4.10Dividends declared per share $ 3.40 $ 3.20 $ 2.75

REYNOLDS AMERICAN, INC.CONSOLIDATED BALANCE SHEETS

(Dollars in Millions)

December 31,

2008 2007


Cash and cash equivalents $ 2,578 $ 2,215Short-term investments 23 377Accounts receivable, net of allowance (2008 - $1; 2007 - $1) 84 73Accounts receivable, related party 91 80Notes receivable 35 1Other receivables 37 25Inventories 1,170 1,196Deferred income taxes, net 838 845Prepaid expenses and other 163 180

Total current assets 5,019 4,992Property, plant, and equipment, at cost:

Land and land improvements 95 96Buildings and leasehold improvements 692 682Machinery and equipment 1,756 1,738Construction-in-process 37 74Total property, plant, and equipment 2,580 2,590

Less accumulated depreciation 1,549 1,517Property, plant, and equipment, net 1,031 1,073

Trademarks and other intangible assets, net of accumulated amortization(2008 - $619; 2007 - $597)

3,270 3,609

Goodwill 8,174 8,174Other assets and deferred charges 660 781

$18,154 $18,629

Liabilities and Shareholders’ EquityCurrent liabilities:

Accounts payable $ 206 $ 218Tobacco settlement accruals 2,321 2,449Due to related party 3 7



December 31,

2008 2007

Deferred revenue, related party 50 35Current maturities of long-term debt 200Other current liabilities 1,143 1,194

Total current liabilities 3,923 3,903Long-term debt (less current maturities) 4,486 4,515Deferred income taxes, net 282 1,184Long-term retirement benefits (less current portion) 2,836 1,167Other noncurrent liabilities 390 394Commitments and contingencies:Shareholders’ equity:

Common stock (shares issued: 2008 – 291,450,762; 2007 – 295,007,327)Paid-in capital 8,463 8,653Accumulated deficit (531) (873)Accumulated other comprehensive loss – (Defined benefit pension and

post-retirement plans: 2008 – $(1,643) and 2007 – $(306), net of tax) (1,695) (314)Total shareholders’ equity 6,237 7,466

$18,154 $18,629

Notes to Consoldiated Financial Statements (in Part)

Note 10—InventoriesThe major components of inventories at December 31 were as follows:

2008 2007

Leaf tobacco $ 993 $ 967Other raw materials 60 45Work in progress 58 48Finished products 145 163Other 26 24Total 1,282 1,247Less LIFO allowance 112 51

$1,170 $1,196

Inventories valued under the LIFO method were $765 million and $889 million at December 31,2008 and 2007, respectively, net of the LIFO allowance. The LIFO allowance reflects the excess ofthe current cost of LIFO inventories at December 31, 2008 and 2007, over the amount at which theseinventories were carried on the consolidated balance sheets. RAI recorded expense of $61 million,income of $12 million and expense of $2 million from LIFO inventory liquidations during 2008,2007, and 2006, respectively.

Note 12 Income Taxes (In Part)


2008 2007 2006

Effective Tax Rate 37.1% 37.0% 37.2%

Required

a. Determine the change in net income for 2008 in comparison with the reported net income ifFIFO had been used for all inventory.

b. Compute the following for 2008 with no adjustments for LIFO reserve:


2. Working capital

3. Current ratio

4. Acid-test ratio

5. Debt ratio



c. Compute the measures in (b) considering the LIFO reserve (eliminate the LIFO reserve)


2. Working capital

3. Current ratio

4. Acid-test ratio

5. Debt ratio

d. Comment on the different results of the ratios computed in (b) and (c).

CASE 11-2 ACCOUNTING HOCUS-POCUS

This case is an excerpt from a presentation given by former Chairman Arthur Levitt, Securities andExchange Commission, the ‘‘Numbers Game,’’ to New York University Center for Law and Busi-ness, September 28, 1998.

Accounting Hocus-PocusOur accounting principles weren’t meant to be a straitjacket. Accountants are wise enough to knowthey cannot anticipate every business structure or every new and innovative transaction, so they de-velop principles that allow for flexibility to adapt to changing circumstances. That’s why the higheststandards of objectivity, integrity and judgment can’t be the exception. They must be the rule.

Flexibility in accounting allows it to keep pace with business innovations. Abuses such as earn-ings management occur when people exploit this pliancy. Trickery is employed to obscure actual fi-nancial volatility. This, in turn, masks the true consequences of management’s decisions. Thesepractices aren’t limited to smaller companies struggling to gain investor interest. It’s also happeningin companies whose products we know and admire.

So what are these illusions? Five of the more popular ones I want to discuss today are ‘‘big bath’’restructuring charges, creative acquisition accounting, ‘‘cookie jar reserves,’’ ‘‘immaterial’’ misappli-cations of accounting principles and the premature recognition of revenue.

‘‘Big-Bath’’ ChargesLet me first deal with ‘‘Big Bath’’ restructuring charges.

Companies remain competitive by regularly assessing the efficiency and profitability of their oper-ations. Problems arise, however, when we see large charges associated with companies restructuring.These charges help companies ‘‘clean up’’ their balance sheet—giving them a so-called ‘‘big bath.’’

Why are companies tempted to overstate these charges? When earnings take a major hit, thetheory goes Wall Street will look beyond a one-time loss and focus only on future earnings.

And if these charges are conservatively estimated with a little extra cushioning, that so-called con-servative estimate is miraculously reborn as income when estimates change or future earnings fallshort.

When a company decides to restructure, management and employees, investors and creditors, cus-tomers and suppliers all want to understand the expected effects. We need, of course, to ensure thatfinancial reporting provides this information. But this should not lead to flushing all the associatedcosts—and maybe a little extra—through the financial statements.

Creative Acquisition AccountingLet me turn now to the second gimmick.

In recent years, whole industries have been remade through consolidations, acquisitions and spin-offs. Some acquirers, particularly those using stock as an acquisition currency, have used this environ-ment as an opportunity to engage in another form of ‘‘creative accounting.’’ I call it ‘‘merger magic.’’

I am not talking tonight about the pooling versus purchase problem. Some companies have nochoice but to use purchase accounting—which can result in lower future earnings. But that’s a resultsome companies are unwilling to tolerate.

So what do they do? They classify an ever-growing portion of the acquisition price as ‘‘in-process’’Research and Development, so—you guessed it—the amount can be written off in a ‘‘one-time’’charge—removing any future earnings drag. Equally troubling is the creation of large liabilities forfuture operating expenses to protect future earnings—all under the mask of an acquisition.



Miscellaneous ‘‘Cookie Jar Reserves’’A third illusion played by some companies is using unrealistic assumptions to estimate liabilities forsuch items as sales returns, loan losses or warranty costs. In doing so, they stash accruals in cookiejars during the good times and reach into them when needed in the bad times.

I’m reminded of one U.S. company who took a large one-time loss to earnings to reimburse fran-chisees for equipment. That equipment, however, which included literally the kitchen sink, had yetto be bought. And, at the same time, they announced that future earnings would grow an impressive15 percent per year.

‘‘Materiality’’Let me turn now to the fourth gimmick—the abuse of materiality—a word that captures the attentionof both attorneys and accountants. Materiality is another way we build flexibility into financialreporting. Using the logic of diminishing returns, some items may be so insignificant that they arenot worth measuring and reporting with exact precision.

But some companies misuse the concept of materiality. They intentionally record errors within adefined percentage ceiling. They then try to excuse that fib by arguing that the effect on the bottomline is too small to matter. If that’s the case, why do they work so hard to create these errors? Maybebecause the effect can matter, especially if it picks up that last penny of the consensus estimate.When either management or the outside auditors are questioned about these clear violations ofGAAP, they answer sheepishly.…‘‘It doesn’t matter. It’s immaterial.’’

In markets where missing an earnings projection by a penny can result in a loss of millions of dol-lars in market capitalization, I have a hard time accepting that some of these so-called non-eventssimply don’t matter.

Revenue RecognitionLastly, companies try to boost earnings by manipulating the recognition of revenue. Think about abottle of fine wine. You wouldn’t pop the cork on that bottle before it was ready. But some compa-nies are doing this with their revenue—recognizing it before a sale is complete, before the product isdelivered to a customer, or at a time when the customer still has options to terminate, void or delaythe sale.

Required

a. ‘‘Big Bath’’—Comment on how a ‘‘Big Bath’’ would have enabled WorldCom to cover up itsfraud.

b. Why would writing off ‘‘in-process’’ Research and Development be similar to a ‘‘Big Bath’’?

c. How could a company use ‘‘allowance for doubtful accounts’’ as ‘‘Cookie Jar Reserves’’?

d. Speculate on how a company could use ‘‘Materiality’’ or disregard or partially disregard a spe-cific accounting standard.

CASE 11-3 TURN A CHEEK

June 1996, New York Times columnist Bob Herbert wrote a pair of opinion editorials accusing NikeCorp. of cruelly exploiting cheap Asian labor. Nike CEO Philip Knight replied in a letter to the edi-tor, which the Times published. Some of the information in the Knight letter included that Nike has,on average, paid double the minimum wage as defined in countries where its products are producedunder contract.56

In 1998, Marc Kasky, a resident of California, sued Nike, alleging that the Knight letter violatedCalifornia’s consumer protection laws against deceptive advertising and unfair business practices.57

In effect, the position was that the New York Times editorials were under the First Amendment, butthat the Nike reply was under the Fifth Amendment. The First Amendment covers freedom ofspeech, while the Fifth Amendment covers commercial speech.

The California Supreme Court ruled in May 2002 that the Nike reply had to be viewed under theFifth Amendment. The Supreme Court stated it was ‘‘commercial speech because it is both morereadily verifiable by its speaker and more hardy than noncommercial speech, can be effectively regu-lated to suppress false and actually or inherently misleading messages without undue risk of chillingpublic debate.’’58



Nike appealed the decision to the U.S. Supreme Court. The Supreme Court agreed to hear thecase. In June 2003, the Supreme Court changed its mind and dismissed the matter on proceduralgrounds.59 Usually, the justices consider cases only after the state courts render a final decision;here, the state court had only said the speech was a commercial speech and sent the case backdown for further proceedings—likely including a trial on whether the statements were indeed mis-leading.60

A trial did not take place, as Nike settled on September 2003, agreeing to pay $1.5 million over athree-year period to the Fair Labor Association, a Washington worker-rights group.61

Required

a. Write a position paper on why the Nike reply should be viewed under the First Amendment.

b. Write a position paper on why the Nike reply should be viewed under the Fifth Amendment.

Note: Good reference materials for this case are:Note: Roger Parloff, ‘‘Can We Talk,’’ Fortune (September 2, 2002), pp. 102–104, 106, 108, 110.Note: Kasky v. Nike, Inc. Cite as 45 p. 3d 243 (Cal 2002).Note: Nike Web site http://www.Nike.com.

CASE 11-4 BOOKS UNLIMITED*

Borders Group, Inc., presented this information in its 10-K’s:

CONSOLIDATED STATEMENTS OF OPERATIONS(Dollars in millions except per share data)

Jan. 31, 2009 Feb. 2, 2008 Feb. 3, 2007

Sales $3,242.1 $3,555.1 $3,532.3Other revenue 33.3 42.3 37.1

Total revenue $3,275.4 $3,597.4 $3,569.4Cost of merchandise sold (includes occupancy) 2,484.8 2,668.3 2,615.7

Gross margin 790.6 929.1 953.7Selling, general, and administrative expenses 839.6 907.0 879.8Pre-opening expense 2.8 5.0 8.1Goodwill impairment 40.3 — —Asset impairments and other write-downs 57.1 13.0 60.6

Operating income (loss) (149.2) 4.1 5.2Interest expense, net 5.3 43.1 29.9

Loss before income tax (154.5) (39.0) (24.7)Income tax provision (benefit) 30.2 (19.1) (2.8)

Loss from continuing operations $ (184.7) $ (19.9) $ (21.9)Loss from operations of discontinued operations

(net of income tax benefit of $0.9, $2.9 and $15.2) (1.7) (8.7) (129.4)Loss from disposal of discontinued operations

(net of income tax benefit of $3.1, $7.6 and $0.0) (0.3) (128.8) —Loss from discontinued operations (net of tax) (2.0) (137.5) (129.4)Net loss $ (186.7) $ (157.4) $ (151.3)

Loss per common share data (Note 2)Basic:

Loss from continuing operations per commonshare $ (3.07) $ (0.34) $ (0.35)

Loss from discontinued operations per commonshare $ (0.03) $ (2.34) $ (2.09)

Net loss per common share $ (3.10) $ (2.68) $ (2.44)Weighted-average common shares outstanding 60.2 58.7 61.9

*‘‘Borders Group, Inc., through our subsidiaries, Borders, Inc. (‘‘Borders’’), Walden Book Company, Inc. (‘‘Waldenbooks’’),and others (individually and collectively, ‘‘we,’’ ‘‘our’’ or the ‘‘Company’’), is an operator of book, music and movie super-stores and mall-based bookstores.’’ 10-K



http://www.Nike.com

CONSOLIDATED BALANCE SHEETS(Dollars in millions except share amounts)

Fiscal Year Ended

Jan. 31, 2009 Feb. 2, 2008


Cash and cash equivalents $ 53.6 $ 58.5Merchandise inventories 915.2 1,242.0Accounts receivable and other current assets 102.4 103.5Current assets of discontinued operations — 102.0

Total current assets 1,071.2 1,506.0Property and equipment, net 494.2 592.8Other assets 39.4 64.9Deferred income taxes 4.0 44.9Goodwill 0.2 40.5Noncurrent assets of discontinued operations — 53.6

Total assets $1,609.0 $2,302.7

Liabilities, Minority Interest and Stockholders’ EquityCurrent liabilities:

Short-term borrowings and current portion of long-term debt $ 329.8 $ 548.6Trade accounts payable 350.0 511.9Accrued payroll and other liabilities 279.8 321.6Taxes, including income taxes 30.1 18.3Deferred income taxes 4.0 9.9Current liabilities of discontinued operations — 57.5

Total current liabilities 993.7 1,467.8Long-term debt 6.4 5.4Other long-term liabilities 345.8 325.0Noncurrent liabilities of discontinued operations — 25.4Contingencies (Note 8) — —

Total liabilities 1,345.9 1,823.6Minority interest 0.5 2.2

Total liabilities and minority interest 1,346.4 1,825.8Stockholders’ equity:

Common stock, 300,000,000 shares authorized; 59,903,232 and58,794,224 shares issued and outstanding at January 31, 2009and February 2, 2008, respectively 186.9 184.0

Accumulated other comprehensive income 11.9 42.4Retained earnings 63.8 250.5

Total stockholders’ equity 262.6 476.9Total liabilities, minority interest and stockholders’ equity $1,609.0 $2,302.7

CONSOLIDATED STATEMENTS OF CASH FLOWS(Dollars in millions)

Fiscal Year Ended,

Jan. 31, 2009 Feb. 2, 2008 Feb. 3, 2007

Cash provided by (used for):Net loss $(186.7) $(157.4) $(151.3)Net loss from discontinued operations (2.0) (137.5) (129.4)Net loss from continuing operations (184.7) (19.9) (21.9)

OperationsAdjustments to reconcile net loss from continuing operations to operating cash flows:

Depreciation 107.1 103.7 111.2Gain on sale of investments — — (5.0)Loss on disposal of assets 1.9 0.5 2.0Stock-based compensation cost 3.0 5.1 4.1Decrease in minority interest — 0.4 0.6Decrease (increase) in deferred income taxes 34.5 (3.7) (24.7)



Fiscal Year Ended,

Jan. 31, 2009 Feb. 2, 2008 Feb. 3, 2007

Decrease (increase) in other long-term assets 23.6 0.3 (1.3)(Decrease) increase in other long-term liabilities (14.9) 4.5 8.8Goodwill impairment 40.3 — —Asset impairments and other write-downs 57.1 13.0 60.6

Cash provided by (used for) current assets and current liabilities:Decrease (increase) in inventories 321.4 52.2 (23.3)Decrease (increase) in accounts receivable 10.2 13.3 (7.5)Decrease (increase) in prepaid expenses 9.8 (1.0) 10.4Decrease in accounts payable (160.2) (59.2) (55.7)Increase (decrease) in taxes payable 13.7 (36.4) (70.0)(Decrease) increase in accrued payroll and other

liabilities (29.2) 32.2 50.8Net cash provided by operating activities of

continuing operations 233.6 105.0 39.1Investing

Capital expenditures (79.9) (131.3) (165.6)Investment in Paperchase (3.6) (0.8) —Proceeds from the sale of discontinued operations 97.3 20.4 —Proceeds from sale of investments — — 21.6

Net cash provided by (used for) investing activities ofcontinuing operations 13.8 (111.7) (144.0)

FinancingProceeds from the excess tax benefit of options exercised 0.5 0.9 4.3Net (repayment of) funding from credit facility (261.7) 43.4 303.4Funding from short-term note financing 42.5 — —Issuance of long-term debt 1.2 0.4 —Repayment of long-term debt (1.4) — —Repayment of long-term capital lease obligations (0.4) (0.4) (0.1)Issuance of common stock (0.4) 3.1 21.9Repurchase of common stock (0.2) (0.6) (148.7)Payment of cash dividends (6.5) (19.4) (25.2)

Net cash (used for) provided by financing activities ofcontinuing operations (226.4) 27.4 155.6

Effect of exchange rates on cash and cash equivalents ofcontinuing operations (0.9) 0.8 (0.6)

Net cash (used for) provided by operating activities ofdiscontinued operations (21.3) (0.7) 16.2

Net cash used for investing activities of discontinuedoperations (6.5) (17.8) (41.9)

Net cash (used for) provided by financing activities ofdiscontinued operations

—(41.9) 13.9

Effect of exchange rates on cash and cash equivalents ofdiscontinued operations 2.8 (0.2) 0.5

Net cash used for discontinued operations (25.0) (60.6) (11.3)Net increase (decrease) in cash and cash equivalents (4.9) (39.1) 38.8Cash and cash equivalents at beginning of year 58.5 97.6 58.8Cash and cash equivalents at end of year $ 53.6 $ 58.5 $ 97.6Supplemental cash flow disclosures:

Interest paid $ 36.3 $ 43.8 $ 32.8Income taxes (received) paid $ (34.6) $ 12.4 $ 63.5

Required

a. Compute the following liquidity ratios for 2009 and 2008:


2. Inventory turnover (use ending inventory)

3. Working capital

4. Current ratio

5. Cash ratio



6. Sales to working capital (use ending working capital)

7. Operating cash flow/current maturities of long-term debt and current notes payable

b. Compute the following long-term debt-paying ability for 2009 and 2008:

1. Debt ratio

2. Operating cash flow / total debt

c. Compute the following profitability ratios for 2009 and 2008:

1. Net profit margin

2. Return on assets (use end of year total assets)

3. Return on total equity (use end of year total equity)

4. Gross profit margin

d. Compute or obtain the following investor analysis:

1. Earnings per common share

2. Operating cash flow/cash dividends

e. Comment on the results in (a), (b), (c) and (d)

f. Comment on the trend in net income (loss)

g. Comment on significant trends (items) in the Consolidated Statement of Cash Flows

h. Using these ratios for 2009 and 2008, comment using the Beaver Study on possible financialfailure:

1. Cash flow/total debt

2. Net income/total assets (return on assets)

3. Total debt/Total assets (debt ratio)

CASE 11-5 VALUE—NIKE, INC.

Selected data from Nike’s financial statements for the period 2005–2009 follow:

Item 6 Selected Financial Data (In Part)

Year Ended May 31, 2009 2008 2007 2006 2005

(In millions, except per share data and financial ratios)1

Revenues $19,176.1 $18,627.0 $16,325.9 $14,954.9 $13,739.7Gross margin 8,604.4 8,387.4 7,160.5 6,587.9 6,115.4Gross margin % 44.9% 45.0% 43.9% 44.0% 44.5%Restructuring charges 195.0 — — — —Goodwill impairment 199.3 — — — —Intangible and other asset

impairment 202.0 — — — —Net income 1,486.7 1,883.4 1,491,5 1,392.0 1,211.6Basic earnings per common share 3.07 3.80 2.96 2.69 2.31Diluted earnings per common share 3.03 3.74 2.93 2.64 2.24Weighted average common shares

outstanding 484.9 495.6 503.8 518.0 525.2Diluted weighted average common

shares outstanding 490.7 504.1 509.9 527.6 540.6Cash dividends declared per

common share 0.98 0.875 0.71 0.59 0.475Cash flow from operations 1,736.1 1,936.3 1,878.7 1,667.9 1,570.7Price range of common stock

High 70.28 70.60 57.12 45.77 46.22Low 38.24 51.50 37.76 38.27 34.31

At May 31,Cash and equivalents $ 2,291.1 $ 2,133.9 $ 1,856.7 $ 954.2 $ 1,388.1Short-term investments 1,164.0 642.2 990.3 1,348.8 436.6Inventories 2,357.0 2,438.4 2,121.9 2,076.7 1,811.1Working capital 6,457.0 5,517.8 5,492.5 4,733.6 4,339.7Total assets 13,249.6 12,442.7 10,688.3 9,869.6 8,793.6



Year Ended May 31, 2009 2008 2007 2006 2005

(In millions, except per share data and financial ratios)1

Long-term debt 437.2 441.1 409.9 410.7 687.3Redeemable Preferred Stock 0.3 0.3 0.3 0.3 0.3Shareholders’ equity 8,693.1 7,825.3 7,025.4 6,285.2 5,644.2Year-end stock price 57.05 68.37 56.75 40.16 41.10Market capitalization 27,697.8 33,576.5 28,472.3 20,564.5 21,462.3Financial Ratios:Return on equity 18.0% 25.4% 22.4% 23.3% 23.2%Return on assets 11.6% 16.3% 14.5% 14.9% 14.5%Inventory turns 4.4 4.5 4.4 4.3 4.4Current ratio at May 31 3.0 2.7 3.1 2.8 3.2Price/Earnings ratio at May 31 18.8 18.3 19.4 15.2 18.3

1All share and per share information has been restated to reflect a two-for-one stock split affected in the form of a 100% com-mon stock dividend distributed on April 2, 2007.

Note: There are many approaches to valuing a company. The analysts would likely review a com-pany using several approaches.

Required

a. Liquidity

1. Review the summary analysis for Nike, Inc., from 2007–2009. Give your opinion of theliquidity position (refer back to Exhibit 3, Summary Analysis).

2. Review the current ratio in this case (2005–2009). Give your opinion of the liquidityposition.

3. Review cash provided by operations (2005–2009). Give your opinion as to the trend.

b. Long-term debt-paying ability

1. Review the summary analysis for Nike, Inc., from 2007–2009. Give your opinion of the debtposition (refer back to Exhibit 3, Summary Analysis).

2. Review the trend of long-term debt in relation to total assets (2007–2009). Give your opinionof the debt trend.

c. Profitability

1. Review the summary analysis for Nike, Inc. from 2007–2009. Give your opinion of the prof-itability (refer back to Exhibit 3, Summary Analysis).

2. Review the trend in revenues (2005–2009). Comment on the trend.

3. Review the trend in gross margin (2005–2009). Comment on the trend.

d. Investor Analysis

1. Review the absolute amount and trend in the price/earnings. Considering liquidity, debt, andprofitability, is there a reasonable probability that the price/earnings may increase?

2. Comment on the trend in market capitalization (2005–2009) (share price � number of out-standing shares).

3. Review cash dividends declared per common share (2005–2009). Is there a likely chance thatdividends will be increased during the year ended May 31, 2010?

4. Give your opinion of the stock price of Nike, Inc., on May 31, 2011. In practice, many thingswould be considered that are not presented in this case. Base your opinion on the summaryanalysis (2007–2009) and the data provided with this case.

e. Other

1. This case has used a fundamental financial statement approach to valuing Nike. In your opin-ion, would an analyst likely use this type of approach for valuing Nike? Comment.

WEB CASE THOMSON ONE Business School Edition

Please complete the Web case that covers material discussed in this chapter at www.cengage.com/accounting/Gibson. You’ll be using Thomson ONE Business School Edition, a powerful tool thatcombines a full range of fundamental financial information, earnings estimates, market data, andsource documents for 500 publicly traded companies.



http://www.cengage

Endnotes1. C. H. Gibson, ‘‘Financial Ratios as Perceived by Commercial Loan Officers,’’ Akron Business and Eco-

nomic Review (Summer 1983), pp. 23–27.

2. The basis of the comments in this section is a study by Dr. Charles Gibson in 1981. The research was doneunder a grant from the Deloitte Haskins & Sells Foundation.

3. C. H. Gibson, ‘‘Ohio CPA’s Perceptions of Financial Ratios,’’ The Ohio CPA Journal (Autumn 1985),pp. 25–30. ª 1985. Reprinted with permission of The Ohio CPA Journal.

4. C. H. Gibson, ‘‘How Chartered Financial Analysts View Financial Ratios,’’ Financial Analysts Journal(May–June 1987), pp. 74–76.

5. Ibid.

6. C. H. Gibson, ‘‘Financial Ratios in Annual Reports,’’ The CPA Journal (September 1982), pp.18–29.

7. W. H. Beaver, ‘‘Alternative Accounting Measures as Predictors of Failure,’’ The Accounting Review(January 1968), pp. 113–122.

8. Ibid., p. 117.

9. Ibid., p. 119.

10. E. I. Altman, ‘‘Financial Ratios, Discriminant Analysis and the Prediction of Corporate Bankruptcy,’’ Jour-nal of Finance (September 1968), pp. 589–609.

11. Edward I. Altman and Thomas P. McGough, ‘‘Evaluation of a Company as a Going Concern,’’ The Jour-nal of Accountancy (December 1974), pp. 50–57.

12. Ibid., p. 52.

13. Suggested reference sources: Anker V. Andersen, ‘‘Graphing Financial Information: How AccountantsCan Use Graphs to Communicate,’’ National Association of Accountants (1983), p. 50; Edward Bloches,Robert P. Moffie, and Robert W. Smud, ‘‘How Best to Communicate Numerical Data,’’ The Internal Audi-tor (February 1985), pp. 38–42; Deanna Qxender Burgess, ‘‘Graphical Sleight of Hand: How Can AuditorsSpot Altered Exhibits That Appear in Annual Reports?’’ Journal of Accountancy (February 2002), pp. 45–50; Charles H. Gibson and Nicholas Schroeder, ‘‘Improving Your Practice—Graphically,’’ The CPA Jour-nal (August 1990), pp. 28–37; Johnny R. Johnson, Richard R. Rice, and Roger A. Roemmich, ‘‘PicturesThat Lie: The Abuse of Graphs in Annual Reports,’’ Management Accounting (October 1980), pp. 50–56;Robert Lefferts, How to Prepare Charts and Graphs for Effective Reports (New York: Barnes & NobleBooks, 1982), p. 166; David Lynch and Steven Galen, ‘‘Got the Picture? CPAs Can Use Some SimplePrinciples to Create Effective Charts and Graphs for Financial Reports and Presentations,’’ Journal of Ac-countancy (May 2002), pp. 183–187; Calvin F. Schmid and Stanton E. Schmid, Handbook of Graphic Pre-sentation, 2nd ed. (New York: Ronald Press, 1979), p. 308.

14. www.sec.gov.

15. ‘‘Restatements of Profits Prove Costly to Investors,’’ The Wall Street Journal (October 24, 2002), p. D2.

16. George J. Benoton and Al L. Hartgraves, ‘‘Enron: What Happened and What We Can Learn from It,’’Journal of Accounting and Public Policy (August 2002), pp. 105–127.

17. Susan Pulliam and Deborah Solomon, ‘‘How Three Unlikely Sleuths Discovered Fraud at WorldCom,’’The Wall Street Journal (October 30, 2002), p. A6.

18. Jared Sandberg and Susan Pulliam, ‘‘Report by WorldCom Examiner Finds New Fraudulent Activities,’’The Wall Street Journal (November 5, 2002), p. 1.

19. Pulliam and Solomon, ‘‘How Three Unlikely Sleuths Discovered Fraud at WorldCom.’’

20. Ibid.

21. Ibid.

22. Theo Francis, ‘‘AIG Issues Report, and Caution,’’ The Wall Street Journal (June 1, 2005), p. C1.

23. Ibid., p. C3.

24. Ibid.

25. Ibid.

26. Financial Restatements, July 2006, GAO-06-678, P4.

27. Ibid., p. 48.

28. United States Government Accountability Office, Washington, DC, Letter addressed to the Honorable PaulS. Sarbanes, Ranking Minority Member, Committee on Banking, Housing, and Urban Affairs, UnitedStates Senate, August 31, 2006. Enclosure I, pg. 5, GAO-06-1053a Financial Restatement Database.



http://www.sec.gov

29. Marco Trombetta, ‘‘Discussion of Implied Cost of Equity Capital in Earnings-Based Valuation: Interna-tional Evidence,’’ Accounting and Business Research (2004, 34:4), p. 345.

30. Richard G. Barker, ‘‘The Role of Dividends in Valuation Models Used by Analysts and Fund Managers,’’The European Accounting Review (1999, 8:2), p. 195.

31. Ibid., p. 197.

32. Ibid.

33. Ibid., pp. 200–201.

34. Ibid., p. 200.

35. Ibid., p. 202.

36. Ibid.

37. Ibid., p. 204.

38. Ibid., p. 205.

39. Ibid., p. 214.

40. Efthimios G. Demirakos, Norman C. Strong, and Martin Walker, ‘‘What Valuation Models Do AnalystsUse?,’’ Accounting Horizons (December 2004, 18:4), p. 229.

41. Ibid.

42. Ibid., p. 237.

43. Paul Asquith, Michael B. Mikhail, and Andrea S. Au, ‘‘Information Content of Equity Analyst Reports,’’Journal of Financial Economics (2005, 75), p. 278.

44. Trombetta, ‘‘Discussion of Implied Cost of Equity Capital,’’ p. 345.

45. Tom Copeland, Tim Koller, and Jack Murrin, Valuation, Measuring, and Managing the Value of Compa-nies, 3rd ed. (New York: John Wiley & Sons, 2000), p. preface 1x.

46. Ibid., p. 62.

47. Ibid., p. 67.

48. Ibid., p. 113.

49. Ibid.

50. Ibid., p. 115.

51. Ibid., p. 116.

52. Ibid., p. 315.

53. Ibid.

54. Ibid., p. 317.

55. Ibid., p. 321.

56. Roger Parloff, ‘‘Can We Talk,’’ Fortune (September 2, 2002), pp. 102–103.

57. Ibid., p. 103.

58. Kasky v. Nike, Inc. Cite as 45 p. 3d 243 (Cal 2002).

59. Eugene Valokh, ‘‘Nike and the Free-Speech Knot,’’ The Wall Street Journal (June 30, 2003), p. A16.

60. Ibid.

61. Stephanie Kang, ‘‘Nike Settles Case with an Activist for $1.5 Million,’’ The Wall Street Journal (Septem-ber 15, 2003), p. 10.



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