SOLUTIONS MANUAL for Core Concepts version of Financial Analysis A User Approach 1e Gary Giroux
Chapter 1. What is Financial Analysis? Questions. 1. What is financial analysis and how can it be used for a recommendation for a company asking for a loan? An equity investment decision? 2. Give an example of an internal financial analysis decision. An external decision. 3. Assume you are asked to develop a financial analysis strategy for a 40 year old manager who is restructuring her 401K retirement portfolio. Identify the purpose of the analysis and key points needed. 4. You are asked to evaluate the chemical industry as part of a corporate overview of Dow Chemical. How would you go about this analysis? 5. What are quantitative financial analysis techniques important for both internal and external financial analysis projects? 6. Why is specific accounting knowledge important for external financial analysis? 7. What is comprehensive analysis and why is it a necessary step in the financial analysis process? 1
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Financial analysis is the use of financial and other information to make recommendations and decisions. It is a six step process: Purpose, Overview, Quantitative Financial Analysis, Detailed Accounting Analysis, Comprehensive Analysis, and Financial Analysis Decisions. Credit Decisions: determine line of credit, interest rate, and other terms. Equity Decisions: Buy/Sell based on earnings growth, and other ratios. Internal Analysis: What Managers do to operate and prepare statements. External Analysis: Six Step Approach by outsiders of a company, ratio analysis, etc. In making equity decisions for an older individual, dividend distribution and low-risk may be more desirable and should be analyzed. Her criteria differ from younger investors who may have a focus on long-term appreciation as opposed to dividends and may care less about dividends. Fortune 500 industries are broken into 62 categories. Using Standard Industrial Classification (SIC) codes. These should be used to designate Dow’s industry. Once accomplished, analysts should conduct a thorough analysis of competitors. Knowledge about Dow should help answer questions such as: What do the companies in this industry do? What is the specific industry? How concentrated is it (competition)? What factors are unique to the industry (legal)? How do US and global economic conditions affect the industry? 3 functions of Financial Analysis Techniques 1. Standardized Financial Info. a. Common-size analysis b. Return on Assets, etc. 2. Financial trends analyzed over time. a. ROA better or worse than last year. b. Are projected figures an improvement over current ones.
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3. Ratios and other measures can be compared with direct competitors. 6 Differences often arise as companies use different (legal) procedures to prepare financial data (FIFO, LIFO, Avg. Cost, etc.). For this reason and the complexity of corporate environment, SPECIFIC accounting knowledge becomes important. Notes to financial statement help present specific data to be analyzed. 7 The findings from the financial analysis steps are summarized in Comprehensive Analysis, which stresses the most relevant information for determining whether or not to invest. This includes discussion of Red Flags and Green Flags. Problems: Throughout the book most problems will focus on (1) the chemical industry using Du Pont, Dow and PPG, (2) the Hotel and Resort Industry, and (3) the automotive industry using Ford and General Motors. Problem 1.1. Du Pont’s Corporate Overview and Business Strategy. The following are excerpts from various sources. Industry: The chemical industry is global, with corporations producing both commodities and specialty products. A vast number of products are produced, with companies specializing in everything from bulk products with low margins to high-margin specialty products resulting from research and development. In the Fortune 1,000 34 chemical companies are listed (13 in the Fortune 500), with combined sales of $154 billion. Du Pont is the largest with revenues of $29 million. Economic conditions have a moderate effect on this industry, but have a differential impact on companies depending on specific products. Environmental regulations and other legal concerns have a major impact on this industry, again with differential effects by company. From Hoover’s Company Capsule (www.hoovers.com) E. I. du Pont de Nemours is the largest chemical company in the U.S. Developer of Lycra, Dacron, and Teflon, Du Pont has operations in about 65 countries. Its eight business units make products including coatings, nylon, specialty polymers, and pigments and chemicals. History: From Hoover’s Handbook (1993, p. 249): E. I. Du Pont fled the French Revolution … [and] founded E. I. Du Pont de Nemours [1802] and set up a gunpowder plant [in Delaware]. Within a decade the plant grew to be the largest of its kind in the U.S. … In 1902 Du Pont cousins Pierre, Alfred, and Coleman bought Du Pont and in 1903 instituted a centralized structure with functionally organized departments, an innovation that big business widely adopted. … In the 1920s Du Pont bought and improved French cellophane technology and began production of rayon. Du Pont’s of inventions includes neoprene synthetic rubber (1931), Orlon, Dacron, and many others. Du Pont’s Web page
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DuPont is a science company, delivering science-based solutions in markets such as food and nutrition, health care, apparel, home and construction, electronics and transportation. Two hundred years ago, DuPont was primarily an explosives company. One hundred years ago, our focus turned to global chemicals, materials and energy. Today, entering our third century, we deliver science-based solutions that make real differences in real lives. Look closely at the things around your home and, chances are, you'll find a DuPont imprint. Our ability to adapt to change and our foundation of unending scientific inquiry enabled this two-century journey to becoming one of the world's most innovative companies. But, in the face of constant change, innovation and discovery, our core values have remained constant: commitment to safety, health and the environment; integrity and high ethical standards; and treating people with fairness and respect. From 2001 10-K DuPont was founded in 1802 and was incorporated in Delaware in 1915. DuPont is a world leader in science and technology in a range of disciplines including high-performance materials, synthetic fibers, electronics, specialty chemicals, agriculture and biotechnology. The company operates globally through some 22 strategic business units. Within the strategic business units, a wide range of products are manufactured for distribution and sale to many different markets, including the transportation, textile, construction, motor vehicle, agricultural, home furnishings, medical, packaging, electronics and the nutrition and health markets. The company and its subsidiaries have operations in about 75 countries worldwide and, as a result, about 50 percent of consolidated sales are made to customers outside the United States. Subsidiaries and affiliates of DuPont conduct manufacturing, seed production, or selling activities, and some are distributors of products manufactured by the company. In February 2002, the company announced the realignment of its businesses into five market- and technology-focused growth platforms and its plans for the creation of a Textiles and Interiors subsidiary. The growth platforms are: DuPont Electronic & Communication Technologies; DuPont Performance Materials; DuPont Coatings & Color Technologies; DuPont Safety & Protection; and DuPont Agriculture & Nutrition. DuPont will consider a full range of options to separate DuPont Textiles & Interiors from the company by year-end 2003, market conditions permitting.
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Sales in 2001 were $24, 726, down from $28,268 in 2000. Net income in 2001 was $4,339 million, up from $2,314; however, $3,866 million was a gain on the sale of Du Pont Pharmeauticals. We faced the worst economic environment in two decades, unusually high energy prices and unfavorable currency exchange rates. … Overall misson is substantial growth— creating value for our shareholders. From MD&A (2000 Annual Report) Consolidated sales in 2000 were a record $28.3 billion, $1.4 billion or 5 percent above 1999. Specialty Fibers, Specialty Polymers and Pigments & Chemicals segments had the most positive impact on volume. Net income for the year 2000 was $2,314 million compared with $7,690 million in 1999. The decrease in net income principally reflects the absence of a $7,471 million after-tax gain recorded in 1999 of discontinued business … Income from continuing operations was $2,314 million or $2.19 per share in 2000, compared to $219 million of $.19 per share in 1999. Use this information (plus other internet searches) to write a one page Corporate Overview for Du Pont (one paragraph on industry and one paragraph on business strategy). Answers May Vary Industry [size & relative significance, geographic presence (e.g., U.S., global …), current performance (impact of business cycle, etc.), future potential] This paragraph may include: -Chemical Industry is global -produces commodities and specialty products -Total Sales of Industry $154 billion -Economic Conditions have moderate effect on the industry -Environmental Regulations have major impact on industry -DuPont operates globally through 22 strategic business units -Wide range of products -operations in 75 countries Business [historical, major focus & operations, segments, objectives, forecasts] Strategy This paragraph may include: -DuPont is science company, delivering science-based solutions in markets such as food and nutrition, health care, apparel, home and construction, electronics and transportation. -Market Saturation info (pgph. 2 from “DuPont’s Web Page”) -adaptable -In 2002, DuPont realigned its businesses into growth platforms
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Problem 1.2. Hilton’s Corporate Overview and Business Strategy. The following are excerpts from various sources. Industry: The hotel, casino and resort industry includes nine companies on Fortune’s 1000 list, with Hilton at #499 based on revenue. Total revenues for the group were $35 billion in 2001, with income down substantially to $791 million. Marriott is the largest of the group, at #189. These companies have global operations, although their primary focus usually is in the U.S. The corporations operate in somewhat different sectors, although all have major hotel operations. This is a capital intensive industry and depends on tourism for most of its revenue and growth. They were hard hit by the recession of 2001 and the September 11 attacks. From Hoover’s Company Capsule (www.hoovers.com): The company’s lodging empire includes some 2,000 hotels (about 80% are franchised), mostly located in the U.S. Hilton operates 21 vacation resorts [but] has completely cashed out of the gaming industry. History: From Hoover’s Handbook (1993, p. 326) Conrad Hilton got his start in hotel management by renting rooms in his family’s New Mexico home. [He bought] his first hotel in Cicso, Texas. He survived the Great Depression. He began buying hotels again. He founded Hilton International to manage his foreign business (1948) and realized his ambition to run New York’s Waldorf-Astoria (1949). The company began to franchise in 1965. Conrad’s son Baron became president in 1966. From company’s MD&A, 2001 10-K We are primarily engaged in the ownership, management and development of hotels, resorts and timeshare properties and the franchising of lodging properties. Our brands include Hilton, Hilton Garden Inn, Doubletree, Embassy Suites, Hampton, Homewood Suites by Hilton. In addition, we develop and operate timeshare resorts through Hilton Grand Vacations Company. Our operations consist of three reportable segments which are based on similar products or services: Hotel Ownership, Managing and Franchising, and Timeshare. The Hotel Ownership segment derives revenue primarily from the rental of rooms as well as food and beverage operations at our owned, majority owned and leased hotel properties and equity earnings from unconsolidated affiliates. The Management and Franchising segment provides services including hotel management and licensing of the Hilton family of brands. This segment generates its revenue from management and franchise fees charged to hotel owners. The Timeshare segment consists of multi-unit timeshare resorts. Development: We intend to grow our hotel brands primarily through franchising and the addition of management contracts, which require little or no capital investment. In addition, we will continue to invest in normal capital replacement and select major
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renovation projects at our owned hotels, and we may seek to acquire hotel properties on a strategic and selective basis. Fiscal 2001 compared with fiscal 2000 (in millions):
Revenue Operating Income Net Income EPS, Basic
2000 $3,451 830 272 0.73
2001 $3,050 632 166 0.45
% Change -12% -24 -39 -39
All operating numbers down, do to a combination of the recession and September 11 attacks. From Hilton’s webpage (www.hilton.com): Conrad Hilton purchased his first hotel in Cisco, Texas back in 1919. The first hotel to carry the Hilton name was built in Dallas in 1925. In 1943, Hilton became the first "coast-tocoast" hotel chain in the United States; and in 1949, open its first hotel outside the U.S. in San Juan, Puerto Rico. Hilton went on the New York Stock Exchange in 1946, and Conrad Hilton purchased the Waldorf Astoria in 1949. Hilton has several worldrenowned, marquee properties; some of which are: Beverly Hilton, Cavalieri Hilton in Rome, Hilton Athens, Hilton San Francisco, Hilton New York, Hilton Hawaiian Village, Hilton Waikoloa Village, Paris Hilton, and others.
Hilton Hotels Corporation is recognized around the world as a preeminent lodging hospitality company, offering guests and customers the finest accommodations, services, amenities and value for business or leisure. While the Hilton brand has, for more than 80 years, been synonymous with excellence in the hospitality industry, our acquisition in 1999 of Promus Hotel Corporation expanded our family of brands to include such wellknown and highly respected brand names as Hampton Inn®, Doubletree®, Embassy Suites Hotels®, and Homewood Suites® by Hilton. Through ownership of some of the most recognized hotels in the world and our newly enhanced brand portfolio, Hilton is now able to offer guests the widest possible variety of hotel experiences, including fourstar city center hotels, convention properties, all-suite hotels, extended stay, mid-priced focused service, destination resorts, vacation ownership, airport hotels and conference centers. Today's Hilton can be viewed as a major industry competitor in a number of areas: •
OWNING HOTELS. Hilton owns such unique, irreplaceable hotel assets as New York's Waldorf=Astoria, The Hilton Hawaiian Village® on Waikiki Beach, Chicago's Palmer House Hilton and the Hilton San Francisco on Union Square. These large-scale properties occupy the best locations in the nation's best markets.
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MANAGING/FRANCHISING HOTELS. The company is a prominent franchisor of hotels across its entire brand family, with income from management or franchise fees accounting for some 30 percent of Hilton's total cash flow. The company will open, through its franchisees, approximately 430 hotels and 63,000 rooms in 2000-01, consisting primarily of Hampton Inn, Homewood Suites by Hilton and Hilton Garden Inn hotels.
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VACATION OWNERSHIP. Hilton Grand Vacations Club, the company's vacation ownership business, operates properties across the country including such desirable locales as Las Vegas, Orlando, Miami and (in 2001) Honolulu.
INTERNATIONAL. A global strategic alliance with Hilton International, the London-based company which owns the rights to the Hilton brand outside of the U.S., brings to customers a single, seamless Hilton system of 2,000 hotels in more than 50 countries throughout the world. Additionally, Conrad International offers five-star luxury hotels in England, Ireland, Belgium, Hong Kong, Singapore, Turkey and Egypt.
Use this information (plus other internet searches) to write a one page Corporate Overview for Hilton (one paragraph on industry and one paragraph on business strategy). Answers May Vary Industry [size & relative significance, geographic presence (e.g., U.S., global …), current performance (impact of business cycle, etc.), future potential] This paragraph may include: -Total Revenues of industry were $35 billion -Industry has global operations, primary focus in US -Capital Investment Industry -Revenue depends on tourism Business Strategy
[historical, major focus & operations, segments, objectives, forecasts] -Mostly located in US -Primarily engaged in ownership, management and development of hotels, resorts, and timeshare properties and the franchising of lodging properties. -Operations consist of 3 segments: Hotel Ownership, Managing and Franchising, and Timeshare. -Development: Hotel growth through franchising and management, normal capital replacement. -acquired Promus Hotel Co. -Info from Webpage bullets describing how it is an industry competitor.
Problem 1.3. Ford’s Corporate Overview and Business Strategy. The following are excerpts from various sources. Industry: The 100 year old motor vehicle industry is global, with major North American, European and Asian markets. Auto manufacturing is among the largest and most complex of the heavy industrials in the world and companies compete in auto, truck, SUV and other markets. Competition is fierce with all companies attempting to gain market share in the major markets. These are durable goods, subject to business cycle conditions. When economic conditions are robust, these companies tend to be immensely profitable. But during recession, massive losses are the rule. Only Ford and General Motors are listed on the Fortune 1000 list. However, the Fortune Global 500 has 16 listed manufacturers, including DaimlerChrysler, Toyota, Volkswagen, Honda and Nissan. Globally, this is a trillion dollar industry (in sales). Individual companies have their own strengths and weakness by geographic area and product. The industry is subject to safety, fuel economy, and environmental regulations. Law suits also are common.
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From Hoover’s Company Capsule (www.hoovers.com) Ford Motor started a manufacturing revolution with its mass production assembly lines in the early 1900s. Now Ford is firmly entrenched in the status quo as the world’s largest truck maker and the #2 maker of cars and trucks, behind General Motors. It makes vehicles under the Aston Martin, Ford, Jaguar, Lincoln, Mercury, and Volvo brands. Two of its biggest successes are the Ford Taurus and the F-Series pickup. Ford also owns a controlling (33%) stake in Mazda and has purchased BMW’s Land Rover SUV operations. Ford’s finance subsidiary, Ford Motor Credit, is the US’s #1 auto finance company. Ford also owns 81% of Hertz, the #1 car rental firm in the world. The Ford family owns about 34% of the firm’s voting stock. History: From Hoover’s Handbook (1993, p. 280) Henry Ford began the Ford Motor Company in 1903 in Dearborn, Michigan, hoping to design a car he could mass-produce. In 1908 he introduced the Model T. …Ford perfected the moving assembly line. … By 1916 the cars cost $360; by 1920- 60% of all vehicles were Fords. … It was 1956 before the Ford allowed outside ownership. [During the Depression] market share slipped behind GM and Chrysler. … In 1950 Ford recaptured 2nd place from Chrysler. From Management Discussion and Analysis (2001 Annual Report) Our worldwide sales and revenues were $162.4 billion in 2001, down $7.7 billion from 2000, reflecting primarily lower vehicle sales in North America, offset partially by higher vehicle sales in Europe. We sold 6,991,000 cars and trucks in 2001, down 433,000 units … The Company lost $5,453 million in 2001 after a net income of $3,467 in 2000. Results summary: Automotive North America, return on sales of -2.3% Europe, return on sales of 0.8% Rest of world, earned $156 million Financial services: earnings declined 22% Stockholders’ equity was $7.8 billion 12/31/01, down $10.8 billion due to net losses, dividend payments, foreign currency translation, etc. Bond ratings were lowered by Moody’s in 2002 (from A3 to Baa1 on long-term debt), S&P (from A- to BBB) and Fitch (from A+ to A-). From Review of Major Operations (2000 Annual Report) 2000 Operating Highlights • Improved worldwide automotive sales of $170.1 billion in 2000, up $9.4 billion from 1999
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Record 7.4 million vehicles sold worldwide Income from operations for automotive $3.6 billion and $5,410 billion overall Competitive Strengths • Worldwide truck leadership • Total cost management • Global product development capability and distribution network • Global platforms/great brands • Strong union relations • Strong balance sheet • Highest U.S. customer loyalty Breakthrough Priorities • E-Business • Customer Satisfaction From CEO’s Letter (2000 Annual Report) At the start of last year we reconfirmed our commitment to being the leading consumer company for automotive products and services. This makes customers the foundation of everything we do and superior shareholder returns the ultimate measure of our success. Our two breakthrough strategic priorities—customer satisfaction and e-business—are aligned with the customer-driven vision. We made tremendous progress on both initiatives in 2000. Use this and other internet sources to write a one page Corporate Overview for Ford (one paragraph on industry and one paragraph on business strategy). Industry
Business Strategy
[size & relative significance, geographic presence (e.g., U.S., global …), current performance (impact of business cycle, etc.), future potential] This paragraph may include: -global industry, major North American, European and Asian markets. -largest and most complex industry -Fierce competition -durable goods subject to business cycle conditions -massive layoffs during recession -industry subject to safety, fuel economy, and environmental regulations. -Sales were 162.4 bilion -Return on Sales Data -Competitive Strengths [historical, major focus & operations, segments, objectives, forecasts] -Ford started manufacturing revolution, mass production -Controls 33% of Mazda and purchased BMW’s Land Rover SUV ops. Giroux • FINANCIAL STATEMENT ANALYSIS
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-#1 finance company -Owns Hertz -Operating Highlights -Breakthrough Priorities Cases: Case 1.1. Is IBM a direct competitor of Dell? IBM is the world’s largest provider of computer hardware, everything from notebooks to mainframes and network servers. It’s number two to Microsoft in software and also a major player in peripherals and computer services. About 60% of IBM’s sales are outside the U.S. IBM PC sales (part of IBM’s personal systems division) represent a 4% market share, up 1.1% from 1999. IBM is shifting to internet sales. An operating summary from IBM’s 2000 segment reporting note (in millions) is:
Revenue Pre-tax income Total assets
Personal Systems Segment $16,250 -148 2,442
Total Segments $96,370 10,891 69,263
Is IBM a direct competitor to Dell? Yes or no and explain. For more information see www.ibm.com and www.dell.com. The answer is yes & no. That is, either position can be supported. PCs are a small part of IBM’s operations (and not very successful), but still market share in this area. Dell must compete against IBM & all other manufacturers that have PCs as part of their operations. On the other hand, PCs are a minor consideration for IBM. [Note: particularly important numbers are in bold. Usually, these suggest “bad news”.] Ethics Considerations. Many industries are associated with specific public policy issues. Tobacco companies produce products that cause health problems and the companies have been sued by governments and individuals for billions. Chemical companies produce some dangerous chemicals, some that cause environmental damage. Perhaps the most significant problem is chemical dumping in water and land sites. Environmental Protection Agency damage assessments, lawsuits, and regulatory fines have cost the chemical industry hundreds of millions of dollars. Other industries have various public policy problems. Autos cause pollution and are subject to fuel mileage and safety issue, utilities are air polluters, pharmaceutical companies produce drugs with unexpected side effects. a. These are industry problems important to analysts. What should be the major focus? The specific public policy issues involved? Or should the focus be exclusively on the potential for damages that reduce earnings? b. Take the position of a specific user, either potential creditor or equity investor. Does this perspective change your answer from (a) above? a.
The importance of ethics & public policy issues is up to the analyst. Some
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b.
investors stay away from what they consider “unethical” industries or practices (supported on ethics or performance grounds), while others only look at the potential for returns. This answer will vary, but perhaps half will say that there is no difference.
Internet Projects Project 1.1. Pick a company for a Corporate Overview and Business Strategy. Use the company’s annual report, Hoover’s Company Capsule (www.hoovers.com), Fortune’s Fortune 500 industry (www.fortune.com) and other sources to write a one page Corporate Overview for this company (one paragraph on the industry & one paragraph on the business strategy).
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Chapter 2. The Financial Environment Questions 1. What is a capital market? What’s the difference between a primary and secondary market? 2. What is the mission of the SEC? The FASB? 3. Why would managers have different financial disclosure objectives than stockholders? 4. Finance theory has been important in evaluating capital markets, especially related to stock prices and investment strategies? Why? Consider portfolio theory, efficient markets and β analysis. 5. What is efficient contracting? What is its relationship to agency cost? 1 Capital Markets are the Source of long and short-term financing for companies, governments, and individuals. Commercial banks, investment banks, stock and bond market. Primary Markets carry first-issue stock (IPO) and bonds. Secondary Markets facilitate buying and selling of already issued bonds and stocks. 2 SEC Mission: “The primary mission…is to protect investors and maintain the integrity of the security markets.” The FASB was created to promulgate accounting standards. 3 Managers are expected to run a corporation in the best interest of its stockholders on the long-term. However, they may be focused on the short term. Managers may use “creative accounting” to accomplish “Earnings Management” which manipulates accounting figures to be more favorable from an operating perspective. 4 Financial Theory is an analysis of past realities to predict future market performance. It provides a guide to maximizing future long-term gains. Equity Capital markets, for example, are assumed to be efficient, which means that the current stock price relies on information which is quickly achieved by the public and is unbiased (managers and investors alike). Earnings Surprise is used to calculate the difference between future actual performance and future expected performance based on historical data. Portfolio Theory insists that investment portfolios should be diversified, so that if one industry busts, other industries will average out less of a loss. This is most effective for long term planning as large gains in an industry will also be averaged to a lower total portfolio gain. Nevertheless, it is conservative. Diversifying with a Beta greater than 1 (high risk) allows investors to limit the high risk between industries. Beta is derived from an equation of market risk. By definition, Beta of 1 is average market risk, Beta less than 1 is lower risk and Beta greater than 1 is higher-than-market risk. 5 Transaction costs are contracting costs and transactions are optimized through efficient contracting (writing contracts to accomplish something with minimum transaction and agency costs). Includes drafting, negotiating, safeguarding a contract, costs of governance structures, and agency costs. Agency Costs are:
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1. Information asymmetries (limited or misinformed information by one side) 2. Adverse Selection 3. Moral Hazard
Problems Problem 2.1. Where would the following information be found? MD&A Next Year’s Expected Operating Performance Business Strategy Retained Earnings Derivatives Gross Profit Projected Benefits Obligation Operating Leases Company’s ß Contingencies Stock Price Trends, Last 12 Months Other Comprehensive Income Analysts’ Forecasts Number of Common Shares Outstanding
Financial Statements
Notes
Market Analysis
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X X X X X
X X X X
X
X X
Problem 2.2. Earnings Expectations and Surprise (PC Companies). The following table relates to quarterly earnings for three companies: Quarterly
Quarterly
Quarterly
Change in
Earnings
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%
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Earnings, Last Period
Earnings, Earnings, Actual Current Current Quarterly Period Period Earnings (Analysts (Actual) ($) Forecasts) Dell $0.16 $0.17 $0.17 $.01 Gateway 0.02 -0.19 -0.20 $(.22) Apple 0.11 0.10 0.11 $0 Current quarter for Dell 1/02; 3/02 for all other companies
Surprise, in $ (Actual – Forecast) $0 $(.1) $.1
Earnings Surprise (Actual – Forecast) / Forecast 0% (5.3)% 10%
Complete this table. Are the stock prices likely to go up or down on the day of the earnings announcement? Explain. Problem 2.3. Earnings Expectations and Surprise (Chemical Companies). The following table relates to quarterly earnings for three companies: Quarterly Earnings, Last Period
Quarterly Quarterly Earnings, Earnings, Current Current Period Period (Analysts (Actual) Forecasts) Du Pont $0.12 $0.56 $0.55 Dow -0.01 0.07 0.07 PPG 0.49 0.52 0.58 Current quarter 3/02 for all companies
Change in Actual Quarterly Earnings ($)
Earnings Surprise, in $ (Actual – Forecast)
$.43 $.08 $.09
$.01 $0 $.06
% Earnings Surprise (Actual – Forecast) / Forecast (1.8)% 0% 11.5%
Complete this table. Are the stock prices likely to go up or down on the day of the earnings announcement? Explain. Problem 2.4. Earnings Expectations and Surprise (Hotel & Resort Companies). The following table relates to quarterly earnings for three companies: Quarterly Earnings, Last Period
Quarterly Quarterly Change in Earnings, Earnings, Actual Current Current Quarterly Period Period Earnings (Analysts (Actual) ($) Forecasts) Hilton $0.01 $0.05 $0.09 $.08 Marriott 0.25 0.27 0.32 $.07 Mandalay -0.10 0.68 0.71 $.81 Current quarter 3/02 for Hilton & Marriott, 40/02 for Mandalay
Earnings Surprise, in $ (Actual – Forecast) $.04 $.05 $.03
% Earnings Surprise (Actual – Forecast) / Forecast 80% 18.5% 4.4%
Complete this table. Are the stock prices likely to go up or down on the day of the earnings announcement? Explain. Giroux • FINANCIAL STATEMENT ANALYSIS
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Problem 2.5. Earnings Expectations and Surprise (Motor Vehicles Companies). The following table relates to quarterly earnings for Ford and GM: Quarterly Earnings, Last Period
Quarterly Quarterly Earnings, Earnings, Current Current Period Period (Analysts (Actual) Forecasts) Ford $-0.48 $-0.14 $-0.06 GM 0.60 1.09 1.29 Current quarter 3/02 for both companies.
Change in Actual Quarterly Earnings ($)
Earnings Surprise, in $ (Actual – Forecast)
$.42 $.69
$.08 $.2
% Earnings Surprise (Actual – Forecast) / Forecast 57.1% 18.3%
Complete this table. Are the stock prices likely to go up or down on the day of the earnings announcement? Explain. Problem 2.6. Beta and Growth Analysis for the Chemical Industry. Given below are the βs and five-year earnings growth forecasts:
Du Pont Dow PPG
β
β Portfolio
.73 .76 .83
Low Risk Low Risk Low Risk
5-Year Earnings Growth 11.0% 10.0 8.0
5-Year Growth Portfolio Average Low Low
Assume that the average risk portfolio has βs between .9 and 1.1 and earnings growth between 11%-14%. Low risk portfolios would be lower and high risk higher. Classify the companies in the correct portfolio for each indicator. Do the two measurements indicate the same portfolio for each company or are the signals mixed? Explain. Problem 2.7. Beta and Growth Analysis for the Hotel and Resort Industry. Given below are the βs and five-year earnings growth forecasts:
Hilton Marriott Mandalay
β
β Portfolio
.72 .93 .92
Low Average Average
5-Year Earnings Growth 13.9% 14.4 13.6
5-Year Growth Portfolio Average High Average
Assume that the average risk portfolio has βs between .9 and 1.1 and earnings growth between 11%-14%. Low risk portfolios would be lower and high risk higher. Classify the companies in the correct portfolio for each indicator. Do the two measurements indicate the same portfolio for each company or are the signals mixed? Explain.
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Problem 2.8. Beta and Growth Analysis. Given below are several Dow Jones Industrial companies, with industries, βs, and projected 5-year earnings growth (www.quicken.com). Assume that an average risk portfolio has companies with ßs between 0.9 and 1.1. Company 3M Johnson & Johnson Boeing Disney McDonalds Caterpillar AT&T IBM Walmart
Industry Conglomerate Pharmaceuticals Aerospace Entertainment Restaurant Machinery Long Distance Computers Discount
Β .59 .80 .83 .88 .92 .94 1.09 1.10 1.18
5 Year Growth 11.1 13.0 16.4 14.8 12.5 10.3 12.8 13.4 14.4
Classify these companies into an investment portfolio based on β: (1) low risk or low ß, (2) average (market) risk, and (3) high risk or high ß. Presumably risk levels should relate to industry and earnings growth rates. On average the S&P 500 companies are expected to grow 12.8% annually over the next five years (the “average” portfolio is expected to have securities with five year average growth rates of 11%-14%). Assuming this is true, which companies seem to be misclassified based on projected 5-year earnings growth rates. [Note: neither β nor projected earnings is necessarily very accurate.] Company
3M Johnson & Johnson Boeing Disney McDonalds Caterpillar AT&T IBM Walmart
Which Portfolio (based on ß)? Low Low
Misclassified (relative to 5 year growth rate)? Yes Yes
Low Low Average Average Average Average High
Yes Yes No Yes No No No
Explain 5-year growth is: Average Average High Average Low
Cases Case 2.1. Dell’s 10-K is attached. Where can Dell’s competitors Gateway and Apple financial statements be found? How can Dell’s accounting policies be compared with other PC companies? The annual reports can be found on the company web sites, the SEC’s EDGAR system Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 17
or other sources such as lexis/nexis. Policies can be analyzed from various sources that include MD&A, accounting policies (Note 1 in the 10-K), and other sources. Case 2.2. Are financial economists nuts? Peter Lynch makes the following statement in One Up on Wall Street (1989): “I also found it difficult to integrate the efficient-market hypothesis (that everything in the stock market is ‘known’ and prices are always ‘rational’) with the random-walk hypothesis (that the ups and downs of the market are irrational and entirely unpredictable).” What’s wrong with this statement? Lynch has no use for academic finance—after all he substantially outperformed the market for years with his Fidelity Magellan Fund. His definitions are not correctly stated (at least according to academics) and both random walk & efficient markets can both be correct. Note that the meaning of efficient markets is debated in the academic profession. Case 2.3. Stock price response to earnings announcement. NCR reported quarterly earnings on July 25, 2002 of $0.34 (up from $0.04 the previous quarter). Analysts expected $0.34 for the quarter. Is the “earnings surprise” good news or bad news? On July 26, NCR’s stock price dropped2.27 to 23.75. Was this expected? Why? The earnings surprise was 0; that is EPS was right on target based on analyst’s forecasts. Therefore, the price drop was unexpected. Ethic Considerations. Earnings management and earnings manipulation. Corporation are expected to use earnings management to promote their self interest. At some point, accounting and reporting adjustments severely misstate the financial position and performance of the firm. This is commonly called earnings manipulation. Can the distinction be made between earnings management and earnings manipulation in most cases? Explain. Earnings manipulation can be considered an extreme case of earnings manipulation. That is, earnings management is expected, but manipulation (which can be considered unethical) is not. Analyst’s try to “see through” earnings management, but this is even more difficult when earnings manipulation is present. Internet Projects Project 2.1. Go to Project Updates on the FASB web site and pick a project. Use the staff summary to analyze the project description, objectives, and issues in one page or less.
Giroux • FINANCIAL STATEMENT ANALYSIS
Chapter 3. The Financial Statements Questions 1. What are the ten financial statement elements and why are they integral to accounting analysis? 2. The balance sheet also is called the statement of financial position. Why are both terms correct? 3. Does the definition of assets by SFAS No. 5 fit for assets actually presented in the balance sheet? Explain. 4. What is the relationship between liabilities and equity? 5. What are the basic components of income? What is the bottom line? 6. How is the statement of cash flows useful for understanding both liquidity and performance? 7. How is comprehensive income presented on the financial statements? 1 Assets, Liabilities, Equity, Investments by Owners, Distribution to Owners, comprehensive Income, Revenues, Expenses, Gains, and Losses are all elements of the financial statement. These elements make up the basic structure of a company and are assumed to be accurate for financial analysis purposes. 2 The balance sheet shows the financial position of a company at a particular point in time. It demonstrates how Assets (what the company has) equals Liabilities (what the company borrowed) plus Equity (what the company earned). 3 Thee is a poor match between SFAS no. 5 Assets and the assets actually placed on the balance sheet. SFAS No. 5 states that assets should be recorded at current or market value. Many assets, however, such as Plant Property, and Equipment are recorded at Historical Value and reduced to current estimated value through an adjunct account “Accumulated Depreciation,” which is based on the company’s choice of depreciation method. Patents and Research & Development, which have “probable future economic benefit” are not even shown on the balance sheet. 4 Liabilities and Equity are the source of funding for the Assets of a company. Liabilities describe future economic sacrifices (or debt) and Equity represents the amount of the corporation’s Assets the owners are part of through earned income and stock. 5 Components of Net Income: Sales and Other Revenues Less: cost of goods sold. Less Service Costs Less Operating Expenses 6 Since Cash is the most liquid asset, the Statement of Cash Flow is used to track a company’s inflows and outflows of cash in Operating, Financing, and Investing activities. 7 Comprehensive Income is stated as a component of owner’s equity.
SOLUTIONS MANUAL • CHAPTER 3 19
Problems Problem 3.1. Assets of Du Pont. Below is the asset section of the balance sheet of Du Pont for fiscal year 2001. 7 December 31 2001 2000 ----------------ASSETS CURRENT ASSETS Cash and cash equivalents Marketable debt securities Accounts and notes receivable (Note 13) Inventories (Note 14) Prepaid expenses Deferred income taxes (Note 9) Total current assets PROPERTY, PLANT AND EQUIPMENT (Note 15) Less: Accumulated depreciation Net property, plant and equipment
$ 5,763 85 3,903 4,215 217 618 -------14,801 -------33,778 20,491 -------13,287 --------
$ 1,540 77 4,552 4,658 228 601 -------11,656 -------34,650 20,468 -------14,182 --------
GOODWILL AND OTHER INTANGIBLE ASSETS (Note 16) INVESTMENT IN AFFILIATES (Note 17) OTHER ASSETS (Notes 9 and 18)
6,897 8,365 2,045 2,206 3,289 3,017 --------------TOTAL $ 40,319 $ 39,426 ======== ======== This financial statement is much more complicated than that of Dell. Why? What additional items are here, but not on the Dell balance sheet? Various items refer to specific notes. What does this mean and why is it important? Is Du Pont a bigger company than Dell, based on assets? This financial statement discloses more details than the Dell financial sheet. Included are Prepaid and Deferred Income Tax disclosures. In addition, PPE is presented at its historical value and reduced on the balance sheet by Accumulated Depreciation. The references to notes identify that more details are available on the particular asset. Based on assets, Du Pont is a larger company. Problem 3.2. Preferred stock at Du Pont. The balance sheet of Du Pont includes the following: STOCKHOLDERS' EQUITY
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 3 20
Preferred stock, without par value - cumulative; 23,000,000 shares authorized; issued at December 31: $4.50 Series - 1,672,594 shares (callable at $120) $ 167 $ 167 $3.50 Series - 700,000 shares (callable at $102) 70 70 Common stock, $.30 par value; 1,800,000,000 shares authorized; Issued at December 31, 2001 - 1,088,994,789; 2000 - 1,129,973,354 327 339 Additional paid-in capital $ 7,371 $7,659 Du Pont has preferred stock. Is this different than common stock? Explain. Are the amounts of preferred stock material in terms of total paid-in capital. Explain. Preferred Stock is stock which receives preference on dividend distribution. A liability is created if yearly dividends are not paid on Preferred Stock, whereas Common Stock does not ensure yearly dividends to the holders. The amount of preferred stock are material in terms of Paid in Capital in that there is as much Preferred Stock in the corporation as there is Common Stock. Problem 3.3. Revenue and operating expenses for Hilton Hotels. Below is abbreviated information from Hilton’s income statement: 2001 Revenue Owned hotels $1,813 Leased hotels 26 Management & franchise fees 120 Other fees & income 191 2,150 Expenses Owned hotels 1,196 Leased hotels 26 Depreciation & amortization 187 Other operating expenses 173 Corporate expenses, net 73 1,655 Operating Income
$ 495
Hilton is a service company, not manufacturing. The format for revenue and operating expenses is much different than Dell. Why? What are the primary differences? Dell as a manufacturing company focuses on sales and cost of goods sold. Hilton as a service company focuses on major service categories such as revenues from owned hotels. Some expenses categories also are related to revenue categories.
Problem 3.4. Cash flows from operations for Du Pont. CFO from operations for 2001 is presented below. Unlike Dell, CFO is considerably less than net income. Why?
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 3 21
CASH PROVIDED BY CONTINUING OPERATIONS Net income $ 4,339 Adjustments to reconcile net income to cash provided by continuing operations: Cumulative effect of a change in accounting principle (Note 11) (11) Depreciation 1,320 Amortization of goodwill and other intangible assets 434 Gain on sale of DuPont Pharmaceuticals (Note 7) (6,136) Other noncash charges and credits – Accounts and notes receivable Inventories and other operating assets Increase (decrease) in operating liabilities: Accounts payable and other operating liabilities interest and income taxes (Notes 4 and 9) Cash provided by continuing operations
435 (362) (634)
Accrued
2,069 $ 2,419
Primarily, the sale of the Pharmaceuticals division created a large gain which leads to less Cash Flow represented by Net Income. This is a large reduction. Inventory and A/P maneuvers also affected the firm’s Cash Flow, making it lesser than Net Income. Cases Case 3.1. Income statement items for General Electric (GE). GE is a conglomerate and on some dimensions the largest company in the U.S. Below are 2001 income statement items: REVENUES Sales of goods Sales of services Other income (note 2) GECS revenues from services (note 3) Total revenues
$ 52,677 18,722 234 54,280 ----------125,913 ----------
COSTS AND EXPENSES (note 4) Cost of goods sold 35,678 Cost of services sold 13,419 Interest and other financial charges 11,062 Insurance losses and policyholder and annuity benefits 15,062 Provision for losses on financing receivables (note 13) 2,481 Other costs and expenses 28,162 ------------Total costs and expenses 106,212 EARNINGS BEFORE INCOME TAXES AND ACCOUNTING CHANGES
$ 19,701
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 3 22
GE has both manufacturing and service subsidiaries. In addition, much of its operations involve the large financing operation, General Electric Capital Services (GECS). How it this reflected on the income statement? Compare GE to Dell. GE is more complicated than Dell, since it is a conglomerate with manufacturing, service and finance operations. Each of these is represented on the Income Statement, with detailed information in the Notes. Since each category requires a somewhat different analysis, GE is relatively more difficult to analyze than Dell.
Ethics Considerations. So What Happened to Corporate Ethics? This was a question poised in a recent Business Week article (J. Byrne, “Restoring Trust in Corporate America,” June 24). Their analysis: The root of the deterioration dates back 20 years, to the start of an unprecedented Era of prosperity that transformed CEOs into cult heroes. From a time when many feared the U.S. would be overwhelmed by a super-efficient Japan, America’s business leaders helped to make the U.S. the world’s most productive economy. A return to business basics, along with a flowering of innovation and entrepreneurship, led to a celebration of corporate chieftains. Capital freely flowed into a financial system based on trust, stability, transparency, and the assurance that checks and balances made the stock exchanges a marketplace for every player. Nobody got fatter during the boom than the newly invincible CEOs, who were increasingly compensated with massive stock-option grants. That meant their success— and take-home pay—became directly related to how high they could nudge their stock price. Indeed, the great paradox of the so-called “shareholder revolution” of the past two decades is that CEOs gained exponentially in power, influence, and certainly pay. Pressures from institutional shareholders unwittingly led to massive transfers of wealth from investors to senior executives, all under the guise of lining up management’s interests with those of shareholders. a. Evaluate this perspective on corporate ethics. b. If this perspective is correct, it suggests that traditional management incentives are a major component of the problem. Do you agree? If so, what can be done about it? This analysis represents an interesting historical perspective on why current financial scandals exist. Scandals are recurring events, but scandals differ somewhat from period to period and this is a partial explanation to the current debacle. a. Opportunism is always a potential problem, but the incentives of managers and others and this analysis gives a useful perspective on current scandals. b. Yes [a not answer will differ]. Potential answers include new regulations such as the Sarbanes-Oxley Act, more scrutiny at the SEC, more prosecutions at the justice department, and perhaps reforms of auditing, investment banking, etc.
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 3 23
Internet Projects Internet Project 3.1. Company annual reports can be found at the company web sites and the 10-K at Lexis/Nexis. Download the financial statements of one company and evaluate the financial statements. How do they compare to Dell?
Giroux • FINANCIAL STATEMENT ANALYSIS
4. Quantitative Financial Analysis Using Financial Statement Information Questions 1. Why is a systematic quantitative perspective important for financial analysis? 2. How is standardization achieved in the quantitative process? Why is this important? 3. After a set of ratios is calculated for a company, how can they be analyzed? When is a ratio “good” or “bad”? 4. For each of these financial ratio categories (liquidity, leverage, activity, performance), describe the purpose of analysis and list at least three useful ratios. 5. What is the Du Pont Model and why is it important? 6. Give examples of ratio analysis limitations. 1 There is an immense amount of financial data on statements, in order to act on this data, synthesis is necessary as well as a breakdown of key components. Quantitative systematic processes make this job easier. 2 In the quantitative process, results are presented as ratios (percentages) in order to compensate for relative size differences in companies. 3 Once calculated, ratios should be analyzed for time-trends and in comparison to other companies within and without the industry. A ratio is “good” or “bad” based on the measurement. A good ratio indicates that items such as Net Income, revenues, assets, etc. are increasing due to proper management. 4 Liquidity-tests to see whether the company has the cash and other current assets to pay liabilities as they come due. 1. Current Ratio 2. Quick Ratio 3. Cash Ratio 4. Operating Cash Flow Ratio Leverage-considers the capital structure of the firm (debt/equity) and evaluates relative risks and returns on liability and equity. 1. Debt to Equity 2. Debt 3. Interest Coverage 4. Long Term Debt to Equity 5. Debt to Market Equity Activity-Measures efficiency. 1. Inventory Turnover 2. Receivables Turnover 3. Payables Turnover 4. Working Capital Turnover 5. Fixed Asset Turnover 6. Total Asset Turnover Performance-profitability 1. Gross Margin
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 4 25
2. Return on Sales 3. Return on Assets 4. Pretax Return on Assets 5. Return on Total Equity 6. Dividend Payout 5 The DuPont model breaks down Return on Equity into components such as Profitability, Activity, and Solvency which, when multiplied together, equal Return on Equity. This allows an in depth analysis as to what makes up ROE and what factors are contributing most to the high or low returns. 6 In ratio analysis, relative size is de-emphasized. Problems and advantages of being a larger or smaller company are not considered. Instead all companies are analyzed on a percentage basis. Also, ratios assume the financial data is correct and free from bias which is oftentimes untrue, since management may have manipulated the earnings. Problems Problems 4.1-4.6 Relate to the Chemical Industry. Problem 4.1. Common-size Analysis. Summary income statements and balance sheets are presented for the three largest companies in the chemical industry for fiscal year 2001 (in millions). For additional information, their web sites (ticker symbols) are www.dupont.com (DD); www.dow.com (DOW); and www.ppg.com (PPG).
Revenues COGS Gross Profit SG&A Expenses Net Income
Du Pont $24,726 16,727 7,999 4,513
Income Statement Dow $27,805 22,015 5,790 2,807
PPG $8,169 5,137 3,032 1,764
4,339
-385
387
Cash & MS Receivables, net Inventories Total Current Assets Fixed Assets, net Total Assets Total Current Liabilities Total Liabilities Total Equity
Balance Sheet Du Pont Dow $5,763 $220 3,903 5,098 4,215 4,440 14,801 10,308 13,287 13,579 40,319 35,515 8,067 8,125 25,867 25,522 14,452 9,993
Complete these tables using common-size analysis:
PPG $108 1,416 904 2,703 2,752 8,452 1,955 5,372 3,080
SOLUTIONS MANUAL • CHAPTER 4 26
Revenues COGS Gross Profit SG&A Expenses Net Income
Du Pont 100.00% 67.65% 32.35% 18.25%
Income Statement Dow 100.00% 79.18% 20.82% 10.10%
PPG 100.00% 62.88% 37.12% 21.59%
17.55%
-1.38%
4.74%
Cash & MS Receivables, net Inventories Total Current Assets Fixed Assets, net Total Assets Total Current Liabilities Total Liabilities Total Equity
Balance Sheet Du Pont Dow 14.29% 0.62% 9.68% 14.35% 10.45% 12.50% 36.71% 29.02% 32.95% 38.23% 100.00% 100.00% 20.01% 22.88% 64.16% 71.86% 35.84% 28.14%
PPG 1.28% 16.75% 10.70% 31.98% 32.56% 100.00% 23.13% 63.56% 36.44%
Summarize the highlights from common-size analysis for these companies and indicate possible red flags. Problem 4.2. Financial Ratios – Liquidity. Given the information from 3.1 above, calculate the liquidity ratios for the three chemical companies. Rate liquidity for each company from 1 (poor) to 10 (excellent). Du Pont Dow PPG Current 183.48% 126.87% 138.26% Quick 119.82% 65.45% 77.95% Cash 71.44% 2.71% 5.52% Operating Cash 29.99% 22.02% 54.22% Flow* Ratings 5-6 5-6 5-6 * Operating cash flows (in millions) are: Du Pont $2,419; Dow $1,789; PPG $1,060. Problem 4.3. Financial Ratios – Activity. The following additional information is provided for fiscal year 2000:
Inventory Receivables, net Working Capital
Du Pont $4,658 4,552 2,401
Dow $3,463 5,385 1,387
PPG $1,121 1,563 550
SOLUTIONS MANUAL • CHAPTER 4 27
Fixed Assets, net Total Assets Total Equity
13,287 39,426 13,299
13,579 27,645 9,686
2,752 9,125 3,097
Given the information above, calculate the activity ratios for the three chemical companies. Rate activity for these companies from 1 (poor) to 10 (excellent).
Inventory Turnover Receivables Turnover Working Capital Turnover Fixed Asset Turnover Total Asset Turnover Ratings
Average Days Inventory in Stock Average Days Receivables Outstanding Length of Operating Cycle Ratings
Du Pont 377.03% 584.88% 541.35% 186.09% 62.01% 3-4
Dow 557.13% 530.48% 1557.70% 204.76% 88.05% 4-5
PPG 507.36% 548.44% 1258.71% 296.84% 92.95% 4-5
Du Pont 96.81 62.41
Dow 65.51 68.81
PPG 71.94 66.55
159.21 3-4
134.32 4-5
138.49 4-5
Problem 4.4. Financial Ratios – Leverage. The following additional information is provided on stock price.
Stock Price, 5/1/2002 Shares Outstanding (millions)
Du Pont 44.63 1,002
Dow 31.49 905
PPG 52.22 168
Given the information above, calculate the leverage ratios for the three chemical companies. Rate leverage for these companies from 1 to 10.
Debt to Equity Debt Ratio Debt to Market Equity Ratings
Du Pont 178.99% 64.16% 57.84% 4-5
Dow 255.40% 71.86% 89.56% 4-5
PPG 174.42% 63.56% 61.23% 4-5
Problem 4.5. Financial Ratios – Profitability. Given the information above, calculate the profitability ratios for the three chemical companies. Rate profitability for these companies from 1 to 10.
SOLUTIONS MANUAL • CHAPTER 4 28
Du Pont Dow PPG Gross Margin 32.35% 20.82% 37.12% Return on Sales 17.55% -1.38% 4.74% Return on Assets 10.88% -1.22% 4.40% Return on Total Equity 31.27% -3.91% 12.53% Dividend Payout* 32.33% -314.99% 72.93% Ratings 7-8 1-2 RF 4-5 *Dividends per share for 2001: Du Pont $1.40; Dow $1.34; PPG $1.68 Problem 4.6. Du Pont Model. Given the information above, calculate the Du Pont Model for the three chemical companies. Rate Du Pont performance for these companies from 1 to 10. Du Pont Dow PPG Profitability 17.55% -1.38% 4.74% Activity 62.01% 88.05% 92.95% Return on Assets 10.88% -1.22% 4.40% Solvency* 289.83% 320.95% 284.56% Return on Equity* 31.54% -3.91% 12.53% Ratings 7-8 1-2 RF 4-5 * Only Du Pont has preferred stock, of $237; deduct this amount from total stockholders’ equity for total common equity; for other companies, common is the same as total. Problems 4.7-4.12 Relate to the Hotel and Resort Industry Problem 4.7. Common-size Analysis. Summary income statements and balance sheets are presented for three companies in the hotel and resort industry for fiscal year 2001 (in millions).
Revenues Cost of Sales Gross Profit SG&A Expenses Net Income * FYE Jan. 02
Hilton $2,632 1,946 686 71
Income Statement Marriott $10,152 9,234 918 187
Mandalay* $2,462 1,370 1,092 473
166
236
53
Cash & MS Receivables, net Inventories Total Current Assets Fixed Assets, net
Balance Sheet Hilton Marriott $35 $817 631 611 148 96 996 2,130 3,986 2,930
Mandalay $106 77 31 267 3,050
SOLUTIONS MANUAL • CHAPTER 4 29
Total Assets Total Current Liabilities Total Liabilities Total Equity
8,785 902 7,002 1,783
9,107 1,802 5,629 3,478
4,037 309 3097 941
Complete these tables using common-size analysis:
Revenues COGS Gross Profit SG&A Expenses Net Income
Hilton 100.00% 73.94% 26.06% 2.70%
Income Statement Marriott 100.00% 90.96% 9.04% 1.84%
Mandalay 100.00% 55.65% 44.35% 19.21%
6.31%
2.32%
2.15%
Cash & MS Receivables, net Inventories Total Current Assets Fixed Assets, net Total Assets Total Current Liabilities Total Liabilities Total Equity
Balance Sheet Hilton Marriott 0.40% 8.97% 7.18% 6.71% 1.68% 1.05% 11.34% 23.39% 45.37% 32.17% 100.00% 100.00% 10.27% 19.79% 79.70% 61.81% 20.30% 38.19%
Mandalay 2.63% 1.91% 0.77% 6.61% 75.55% 100.00% 7.65% 76.72% 23.31%
Summarize the highlights from common-size analysis for these companies and indicate possible red flags. Problem 4.8. Financial Ratios – Liquidity. Given the information from 4.7 above, calculate the liquidity ratios for the three hotel & resort companies. Rate liquidity for each company from 1 (poor) to 10 (excellent). Hilton 110.42% 73.84% 3.88% 29.93%
Marriott 118.20% 79.25% 45.34% 22.20%
Mandalay 86.41% 59.22% 34.30% 113.59%
Current Quick Cash Operating Cash Flow* Ratings 3-4 4-5 3-4 * Operating cash flows (in millions) are: Hilton $270; Marriott $400; Mandalay $351.
SOLUTIONS MANUAL • CHAPTER 4 30
Problem 4.9. Financial Ratios – Activity. The following additional information is provided for fiscal year 2000: Hilton $137 435 194 3,911 9,140 1,642
Inventory Receivables, net Working Capital Fixed Assets, net Total Assets Total Equity *FYE Jan. 02
Marriott $97 728 -502 3,011 8,237 3,267
Mandalay* $31 78 -10 3,237 4,248 1,069
Given the information above, calculate the activity ratios for the three chemical companies. Rate activity for these companies from 1 (poor) to 10 (excellent).
Inventory Turnover Receivables Turnover Working Capital Turnover Fixed Asset Turnover Total Asset Turnover Ratings
Hilton 1365.61% 493.81% 1827.78% 66.66% 29.37% 5-6
Average Days Inventory in Stock Average Days Receivables Outstanding Length of Operating Cycle Ratings
Marriott 9568.91% 1516.36% NM 341.76% 117.07% 5-6
Mandalay 4419.35% 3176.77% NM 78.32% 59.43% 5-6
Hilton 26.73 73.92
Marriott 3.81 24.07
Mandalay 8.26 11.49
100.64 5-6
27.89 6-7
19.75 6-7
Problem 4.10. Financial Ratios – Leverage. The following additional information is provided on stock price.
Stock Price, 5/1/2002 Shares Outstanding (millions)
Hilton 16.00 369
Marriott 44.03 245
Mandalay 7.13 68
Given the information above, calculate the leverage ratios for the three hotel & resort companies. Rate leverage for these companies from 1 to 10.
Debt to Equity Debt Ratio
Hilton 392.71% 79.70%
Marriott 161.85% 61.81%
Mandalay 329.12% 76.72%
SOLUTIONS MANUAL • CHAPTER 4 31
Debt to Market Equity Ratings
118.60% 3-4
52.18% 5-6
638.77% 5-6
Problem 4.11. Financial Ratios – Profitability. Given the information above, calculate the profitability ratios for the three hotel & resort companies. Rate profitability for these companies from 1 to 10. Hilton Marriott Mandalay Gross Margin 26.06% 9.04% 44.35% Return on Sales 6.31% 2.32% 2.15% Return on Assets 1.85% 2.72% 1.28% Return on Total Equity 9.69% 7.00% 5.27% Dividend Payout* 17.78% 29.07% 0.00% Ratings 3-4 3-4 3-4 *Dividends per share for 2001: Hilton $0.08; Marriott $0.28; Mandalay $0 Problem 4.12. Du Pont Model. Given the information above, calculate the Du Pont Model for the three Hotel & resort companies. Rate Du Pont performance for these companies from 1 to 10. Hilton Marriott Mandalay Profitability 6.31% 2.32% 2.15% Activity 29.37% 117.07% 59.43% Return on Assets 1.85% 2.72% 1.28% Solvency* 562.26% 257.14% 412.19% Return on Equity* 10.41% 7.00% 5.27% Ratings 3-4 3-4 3-4 * None of the companies has preferred stock; common is the same as total. Problems 4.13-4.18 Relate to the Automotive Industry Problem 4.13. Common-size Analysis. Summary income statements and balance sheets are presented for Ford and General Motors for fiscal year 2001 (in millions). For additional information, their web sites (ticker symbols) are www.ford.com (F) and www.gm.com (GM).
Fiscal year Revenue COGS Gross Profit SG&A Interest Exp Tax Expense
Ford 12/31/01 $162,412 125,706 36,706 13,602 10,848 -2,151
Income Statement (in millions) Ford GM 12/31/00 12/31/01 $170,064 $177,260 140,499 130,942 29,565 46,318 11,847 23,302 10,902 8,590 2,705 768
GM 12/31/00 $184,632 145,664 38,968 22,252 9,552 2,393
SOLUTIONS MANUAL • CHAPTER 4 32
Net Income
Fiscal year Cash & Mark Sec Receivables, Trade (net) Inventories Total Current Assets Total Fixed Assets Total Assets Total Current Liabilities Total Liabilities Total Equity
Fiscal year Cash Flows from Operations Cash Flows From Investing Cash Flows From Financing
-5,453 RF
Ford 12/31/01 $7,218
3,467
601
4,452
Balance Sheet (in millions) Ford GM 12/31/00 12/31/01 $4,851 $18,555
3,152
6,272
141,394
135,002
6,191 36,260
7,514 39,310
10,034 193,843
10,945 208,920
33,121
37,508
34,908
33,977
276,543 44,546
284,421 43,327
323,969 64,246
303,100 63,156
268,757
265,811
304,262
272,925
7,786
18,610
19,707
30,175
Cash Flow Statement (in millions) Ford Ford GM GM 12/31/01 12/31/00 12/31/01 12/31/00 $22,764 $33,764 $9,166 $10,871
-17,169
-9,867
-23,171
-11,313
-2,976
-8,521
22,372
-890
Common-size analysis—complete the following tables:
Fiscal year Revenue COGS Gross Profit
GM 12/31/00 $10,284
Ford 12/31/01
Income Statement – Common-size Ford GM GM 12/31/00 12/31/01 12/31/00
100% 77.4% 22.6%
100% 82.62% 17.38%
100% 73.87% 26.13%
100% 78.90% 21.11%
SOLUTIONS MANUAL • CHAPTER 4 33
SG&A Net Income
Fiscal year Cash & Mark Sec Receivables, net Inventories Total Current Assets Fixed Assets, net Total Assets Total Current Liabilities Total Liabilities Total Equity
8.37% (3.36)%
6.97% 2.04%
13.15% .34%
12.05% 2.41%
Ford 12/31/01 21.8%`
Balance Sheet –Common-size Ford GM GM 12/31/00 12/31/01 12/31/00 1.71$ 5.73% 3.4%
1.4%
2.21%
43.64%
44.54%
2.24% 13.11%
2.64% 13.82%
3.1% 59.83%
3.61% 68.93%
11.98%
13.19%
10.78%
10.85%
100% 16.11%
100% 15.23%
100% 19.83%
100% 20.84%
97.18%
93.46%
93.92%
90.04%
2.82%
6.54%
6.08%
9.96%
Problem 4.14. Financial Ratios—Liquidity. Given the information above, calculate the liquidity ratios for Ford and GM. Rate the liquidity from 1-10 for each company.
Year Current Quick Cash Operating Cash Flow Rating
Ford 2001 81.40% 23.38% 16.20% 51.10%
Liquidity GM 2001 3.02x 2.49x 28.89% 14.27%
3-4
6-7
Problem 4.15. Financial Ratios—Activity. Given the information above, calculate the activity ratios & rate their efficiency from 1-10
Year Inventory Turnover
Ford 2001 18.34
GM 2001 12.48
SOLUTIONS MANUAL • CHAPTER 4 34
Receivables Turnover Working Capital Turnover Fixed Asset Turnover Total Asset Turnover Average Days Inventory in Stock Average Days Receivables Outstanding Length of Operating Cycle Ratings
34.46 NM
1.28 1.29
4.60 57.9% 19.9
56.54% 56.54% 29.25
10.59
285.16
30.49
314.41
5-6
4-5
Problem 4.16. Financial Ratios—Leverage. Given the information above, calculate the leverage ratios & rate their solvency from 1-10. Ford 2001 14.28x 97.18% 29.90%
GM 2001 9.04x 93.92% 1.16x
Year Deb to Equity Debt Ratio Interest Coverage Debt to Market 8.62x 3.23x Equity* Ratings 3-4 3-4 * Market price (5/1/02) for Ford = 16.34; shares outstanding = 1,908 million; GM stock price = 65.51; shares outstanding = 1,437. Problem 4.17. Financial Ratios—Profitability. Given the information above, calculate the profitability ratios and rate their performance from 1-10. Ford 2001 22.6% (3.36)% (1.94)%
GM 2001 26.13% .34% .19%
Year Gross Margin Return on Sales Return on Assets Return on Total (41.32)% 2.41% Equity Dividend NM 20.91% Payout* Ratings 1-2 RF 3-4 *Dividends for Ford=$0.40, GM=$2.00
SOLUTIONS MANUAL • CHAPTER 4 35
Problem 4.18. Du Pont Model. Given the information above, calculate the Du Pont Model and ratings. Du Pont Model Ford GM Year 2001 2001 Profitability (3.36)% .34% Activity 57.9% 56.54% Return on (1.94)% .19% Assets Solvency 21.25x 12.57x Return on (41.32)% 24.1% Equity Ratings 1-2 RF 3-4 Cases Case 4.1. Overview of Chemical Industry Quantitative Analysis. A complete quantitative financial analysis for the current year has been conduction for the chemical industry. Write a short overview for each company, including an overall rating from 110.
Du Pont
Rating Written Summary 5-6 Good return on sales, somewhat high leverage, adequate liquidity, average activity, high profit & ROE
Dow
3-4
Net loss, low cash, somewhat high leverage, adequate liquidity. Average activity, negative profit
PPG
4-5
Somewhat high leverage, adequate liquidity, average activity, low to average profit
Case 4.2. Overview of Hotel and Resort Industry Quantitative Analysis. A complete quantitative financial analysis for the current year has been conduction for the hotel and resort industry. Write a short overview for each company, including an overall rating from 1-10.
Hilton
Rating Written Summary 3-4 Below average liquidity, average activity, below average leverage, below average profit
Marriott
3-4
Low average liquidity, average activity, average leverage, below average profit
SOLUTIONS MANUAL • CHAPTER 4 36
Mandalay
3-4
Below average liquidity, average activity, average leverage, below average profit
Case 4.3. Overview of Automotive Industry Quantitative Analysis. A complete quantitative financial analysis for the current year has been conduction for Ford and GM. Write a short overview for each company, including an overall rating from 1-10.
Ford
Rating Written Summary 2-3 Below average liquidity, average activity, below average leverage (note financing), net loss—RF on profit
GM
3-4
Above average liquidity, low average activity, below average leverage (note financing), below average profit
Case 4.4. Ford’s Industry Segments. Problems 4.13-4.18 included the total company. However, automotive and financial services are reported separately in their annual reports and have different characteristics. Consider the following abbreviated financial information for Ford for 2001. Automotive Sales/Revenue Cost & Expenses Operating Income Net Income (Loss) Cash & Marketable Securities Total Current Assets Total Assets Total Current Liabilities Total Liabilities Stockholders’ Equity
$131,528 139,096 (7,568)
Financial Services $30,884 29,432 1,452
Company-wide
$(5,453) 15,028
3,767
33,121 88,319 44,546 92,980
64,917 188,224 3,397 175,105 7,786
a. Calculate common-size information for the segments:
Sales/Revenue Cost & Expenses Operating Income
Automotive 100% 105.8 -5.8 RF
Financial Services 100% 95.3 4.7
SOLUTIONS MANUAL • CHAPTER 4 37
Cash & Marketable Securities Total Current Assets Total Assets Total Current Liabilities Total Liabilities
17.0
20.0
37.5 100% 50.4 105.3 RF
34.5 100% 1.8 93.0
b. Calculate the following ratios for the two segments:
Operating Income to Sales Operating Income to Total Assets Current Ratio Cash Ratio Debt Ratio
Automotive -5.8% RF -8.6% RF 74.4% RF 33.7% 105.3% RF
Financial Services 4.7% 0.7% 19.1x 110.9% 93.0%
c. Evaluate the financial information for the two business segments. How are they different? What are the obvious red flags? Are they differences expected? Explain. How does this analysis change your perspective on Ford as a potential equity investment? The auto segment shows major problems associated with losses, negative working capital and negative equity position. Financing Services has high leverage (as expected) & performs reasonably well. Internet Projects Project 4.1. Pick a company from the Fortune 500 list. Gather the financial information you need from the company’s annual report and other sources. Do a complete financial analysis, using the same format as above. Suggestions: Summary financial statements can be found at www.hoovers.com; complete financial statements can usually be found on company websites and the SEC’s Edgar system (available from several sources); considerable financial information can be found at various financial websites, such as Quicken (www.quicken.com) or Yahoo Financial (quote.yahoo.com).
5. Multi-period Quantitative Financial Analysis Questions 1. Why would a trend or growth analysis (both multi-period) be useful? 2. Assume that basic performance data for the last six years is somewhat erratic. What does the analyst do then? 3. How much is enough? Is limited annual performance data for the last six years enough or should a thorough financial analysis be conducted for the last 20 years (or something else)? Explain. 4. Is quarterly analysis useful? Explain. 5. Compare the results for the PC companies for both growth and trend analysis. They are based on the same numbers. Is the analysis the same? 1 Current financial data is insufficient alone to predict future performances. Therefore, decisions must be made based on past and the current year. 2 If the most recent data is erratic, then analysts must go further back in time to spot trends. 3 Depending on the erratic nature of the variables, 5 years should be generally sufficient. In more extreme cases, 10-20 would suffice. 4 Quarterly analysis is useful to spot the most recent trends. Since annual data is aggregated, it is hard to spot what the company does between annual reporting periods. Quarterly analysis provides more in-depth analysis with a shorter-term focus. 5 The results are generally the same. The growth analysis is more of a long-term focus whereas the trend is more short-sighted. They fit well together in analysis. Problems Problems 5.1-5.3 focus on the Chemical industry. Problem 5.1. Growth Analysis. Given are performance numbers for the last five years to the three chemical companies.
Revenue Gross Profit Net Income
Revenue Gross Profit Net Income
2001 $24,726 7,999 4,339
2001 $27,805 5,790 -385 RF
2000 $28,268 8,201 2,314
Du Pont 1999 $26,918 8,237 7,690
1998 $24,767 7,651 4,480
1997 $39,730 10,511 2,405
2000 $23,008 4,621 1,513
Dow 1999 $18,929 4,481 1,331
1998 $18,441 4,554 1,310
1997 $20,018 5,278 1,808
SOLUTIONS MANUAL • CHAPTER 5 39
2001 8,169 3,032 387
Revenue Gross Profit Net Income
2000 $8,629 2,848 620
PPG 1999 $7,757 2,623 568
1998 $7,510 2,680 801
1997 $7,379 2,634 714
Calculate the annual growth percentages for these chemical companies and rate from 1 to 10.
Revenue Gross Profit Net Income
1997-8 -37.66% 27.21% 86.28%
1998-9 8.68% -7.66% 71.65%
Du Pont 1999-2000 5.02% 0.44% -69.91%
2000-01 -12.53% 2.46% 87.51%
Total 97-01 -37.76% -23.90% 80.42%
Revenue Gross Profit Net Income
1997-8 -7.88% -13.72% -27.54%
1998-9 2.65% -1.60% 1.60%
Dow 1999-2000 21.55% 3.12% 13.67%
2000-01 20.85% 25.30% NM
Total 97-01 38.90% 9.70% NM
1998-9 3.29% -2.13% -29.09%
PPG 1999-2000 11.24% 8.58% 9.15%
2000-01 -5.33% 6.46% -37.58%
Total 97-01 10.71% 15.11% -45.80%
Revenue Gross Profit Net Income
1997-8 1.78% 1.75% 12.18%
Company Du Pont Dow PPG
Rating 2-3 2-3 2-3
Problem 5.2. Trend Analysis. An alternative to growth percentages is to set the earliest year as the base year = 100 and calculate the remaining years as percentage change. For Du Pont, 1997 is set to 100. Revenues for 1998 are calculated as 24,767 / 39,730 = .6234. 2001 revenues for Dow are 27,805 / 20,018 = 1.389.
. Revenues Gross Profit Net Income
1997 100.00% 100.00% 100.00%
1997
Du Pont 1998 1999 62.34% 67.75% 72.79% 78.37% 186.28% 319.75%
1998
Dow 1999
2000 71.15% 78.02% 96.22%
2001 62.24% 76.10% 180.42%
2000
2001
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 5 40
Revenues Gross Profit Net Income
100.00% 100.00% 100.00%
92.12% 86.28% 72.46%
94.56% 84.90% 73.62%
114.94% 87.55% 83.68%
138.90% 109.70% -21.29%
Revenues Gross Profit Net Income
1997 100.00% 100.00% 100.00%
1998 101.78% 101.75% 112.18%
PPG 1999 105.12% 99.58% 79.55%
2000 116.94% 108.12% 86.83%
2001 110.71% 115.11% 54.20%
Analyze the trend data and compare it to the growth analysis from 5.1. The underlying data is the same and the overall interpretation also. The difference is presentation and what seems the most meaningful. Thus, Du Pont’s long-term trend is obviously down for revenue and gross profit, but up (although erratic) for net income. The relations differ for Dow and PPG, since revenues and gross profit are generally up, but net income down for the period under analysis. Problem 5.3. Quarterly Analysis. The following performance information is available for the last five quarters for the three chemical companies (in millions).
Revenue COGS Gross Profit SG&A Net Income
Mar 2002 $6,142 3,984 2,158 932 479
Dec 2001 $5,229 3,668 1,561 956 3,915
Du Pont Sept 2001 $5,641 3,958 1,683 1,128 142
Revenue COGS Gross Profit SG&A Net Income
Mar 2002 $6,262 4,919 1,343 641 105
Dec 2001 $6,346 4,981 1,365 662 -37 RF
Dow Sept 2001 $6,729 5,236 1,493 694 57
Jun 2001 $7,344 5,743 1,601 727 280
Mar 2001 $7,386 6,055 1,331 724 -685 RF
Dec 2001 $1,907 875 1,032 420 83
PPG Sept 2001 $1,999 1,372 627 414 93
Jun 2001 $2,164 1,454 710 409 155
Mar 2001 $2,099 1,436 663 418 56
Revenue COGS Gross Profit SG&A Net Income
Mar 2002 $1,875 1,288 587 408 52
Jun 2001 $6,997 4,428 2,269 1,262 -213 RF
Mar 2001 $6,859 4,486 2,373 1,167 495
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 5 41
Complete the following common-size and percentage change table. Du Pont Common-size Common-size Common-size Period Revenue COGS Gross Profit SG&A Net Income
Mar 2002 100.00% 64.86% 35.14% 15.17% 7.80%
Dec 2001 100.00% 70.15% 29.85% 18.28% 74.87%
Mar 2001 100.00% 63.3% 32.4% 18.0% 7.2%
Dow Common-size Common-size Common-size Period Revenue COGS Gross Profit SG&A Net Income
Mar 2002 100.00% 78.55% 21.45% 10.24% 1.68%
Dec 2001 100.00% 78.49% 21.51% 10.43% -0.58% RF
Mar 2001 100.00% 82.0% 18.0% 9.8% -9.3% RF
PPG Common-size Common-size Common-size Period Revenue COGS Gross Profit SG&A Net Income
Mar 2002 100.00% 68.69% 31.31% 21.76% 2.77%
Dec 2001 100.00% 45.88% 54.12% 22.02% 4.35%
Mar 2001 100.00% 68.4% 31.6% 19.9% 2.7%
% Δ from % Δ same Qtr, 1 Previous Qtr year ago Dec 2001 Mar 2001 17.5% -10.5% 8.7% -11.2% 38.2% -9.1% -2.5% -20.1% -87.8% -3.2% % Δ from % Δ same Qtr, 1 Previous Qtr year ago Dec 2001 Mar 2001 -1.3% -15.2% -1.2% -18.8% -1.6% 0.9% -3.2% -11.5% NM NM % Δ from % Δ same Qtr, a Previous Qtr year ago Dec 2001 Mar 2001 -1.7% -10.7% 47.2% -10.3% -43.1% -11.5% 2.9% -2.4% -37.3% -7.1%
Does the quarterly analysis indicate any red flags? Explain On a quarterly basis, there are many negative numbers, which are potential red flags. Revenues and profits are down consistently from earlier quarters and Dow had net losses in March and December 2001.
Problems 5.4-5.6 focus on the Hotel and Resort Industry. Problem 5.4. Growth Analysis. Given are performance numbers for the last five years to the three chemical companies. Hilton
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 5 42
Revenue Gross Profit Net Income
2001 $2,632 686 166
2000 $3,177 1,008 272
Revenue Gross Profit Net Income
2001 $10,152 918 236
1999 $1,959 567 174 Marriott 2000 1999 $10,017 $8,739 1,117 992 479 400 Mandalay* 2000 1999 $2,524 $2,051 1,133 898 120 42
2001 $2,462 1,092 53
1998 $1,769 464 297
1997 $1,475 395 250
1998 $12,034 569 335
1997 $10,172 452 306
1998 $1,480 275 85
1997 $1,355 271 90
Revenue Gross Profit Net Income *FYE Jan. 02. Calculate the annual growth percentages for these chemical companies and rate from 1 to 10. Hilton 1997-8 1998-9 1999-2000 2000-01 Total 97-01 Revenue -19.93% -10.74% -62.17% 17.15% 78.44% Gross Profit -17.47% -22.20% -77.78% 31.94% 73.67% Net Income -18.80% 41.41% -56.32% 38.97% -33.60% Marriott 1997-8 1998-9 1999-2000 2000-01 Total 97-01 Revenue -18.31% 27.38% -14.62% -1.35% -0.20% Gross Profit -25.88% -74.34% -12.60% 17.82% 103.10% Net Income -9.48% -19.40% -19.75% 50.73% -22.88% Mandalay 1997-8 1998-9 1999-2000 2000-01 Total 97-01 Revenue -9.23% -38.58% -23.06% 2.46% 81.70% Gross Profit -1.48% -226.55% -26.17% 3.62% 302.95% Net Income 5.56% 50.59% -185.71% 55.83% -41.11% Company Hilton Marriott Mandalay
Rating 3-4 3-4 3-4
Comments Negative growth in income Negative growth in revenues & income Negative growth in income
Problem 5.5. Trend Analysis. An alternative to growth percentages is to set the earliest year as the base year = 100 and calculate the remaining years as percentage change. For Hilton, 1997 is set to 100. Revenues for 1998 are calculated as 1,769 / 1,475 = 1.1993. 2001 revenues for Marriott are 10,152 / 10,172 = .9980.
. Revenues
1997 100.00%
1998 119.93%
Hilton 1999 132.81%
2000 215.39%
Giroux • FINANCIAL STATEMENT ANALYSIS
2001 178.44%
SOLUTIONS MANUAL • CHAPTER 5 43
Gross Profit Net Income
Revenues Gross Profit Net Income
Revenues Gross Profit Net Income
100.00% 100.00%
117.47% 118.80%
143.54% 69.60%
255.19% 108.80%
173.67% 66.40%
1997 100.00% 100.00% 100.00%
Marriott 1998 1999 118.31% 85.91% 125.88% 219.47% 109.48% 130.72%
2000 98.48% 247.12% 156.54%
2001 99.80% 203.10% 77.12%
1997 100.00% 100.00% 100.00%
Mandalay 1998 1999 109.23% 151.37% 101.48% 331.37% 94.44% 46.67%
2000 186.27% 418.08% 133.33%
2001 181.70% 402.95% 58.89%
Analyze the trend data and compare it to the growth analysis from 4.1. Problem 5.6. Quarterly Analysis. The following performance information is available for the last five quarters for the three chemical companies (in millions).
Revenue COGS Gross Profit SG&A Net Income
Revenue COGS Gross Profit SG&A Net Income
Revenue COGS Gross Profit SG&A Net Income
Mar 2002 $822 680 142 17 34
Dec 2001 $579 460 119 23 4
Hilton Sept 2001 $610 466 144 16 21
Jun 2001 $744 489 255 16 86
Mar 2001 $699 531 168 16 55
Mar 2002 $2,364 2,178 186 29 82
Marriott Dec 2001 Sept 2001 $2,868 $2,373 2,740 2,144 128 229 115 13 -116 101
Jun 2001 $2,450 2,161 289 29 130
Mar 2001 $2,461 2,189 272 30 121
Mandalay Oct 2001 $581 337 244 117 23
Jul 2001 $644 355 290 123 31
Apr 2001 $669 365 305 112 47
Apr 2002 $638
49
Jan 2002 $629 324 305 112 -48
Complete the following common-size and percentage change table.
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 5 44
Hilton Common-size Common-size Common-size Period Revenue COGS Gross Profit SG&A Net Income
Mar 2002 100.00% 82.73% 17.27% 2.07% 4.14%
Dec 2001 100.00% 79.45% 20.55% 3.97% 0.69%
Mar 2001 100.00% 76.0% 24.0% 2.3% 7.9%
Marriott Common-size Common-size Common-size Period Revenue COGS Gross Profit SG&A Net Income
Mar 2002 100.00% 92.13% 7.87% 1.23% 3.47%
Dec 2001 100.00% 95.54% 4.46% 4.01% -4.04%
Mar 2001 100.00% 89.0% 11.1% 1.2% 4.9%
Mandalay Common-size Common-size Common-size Period Revenue COGS Gross Profit SG&A Net Income
Apr 2002 100.00%
7.68%
Jan 2002 100.00% 51.51% 48.49% 17.81% -7.63%
Apr 2001 100.00% 54.6% 45.6% 16.7% 7.0%
% Δ from % Δ same Qtr, 1 Previous Qtr year ago Dec 2001 Mar 2001 42.0% 17.6% 47.8% 28.1% 19.3% -15.5% -26.1% 6.3% 7.5x -38.2% % Δ from % Δ same Qtr, 1 Previous Qtr year ago Dec 2001 Mar 2001 -17.6% -3.9% -20.5% -0.5% 45.3% -31.6% -74.8% -3.3% NM -32.2% % Δ from % Δ same Qtr, a Previous Qtr year ago Jan 2002 Apr 2001 1.4% -4.6%
NM
4.3%
Does the quarterly analysis indicate any red flags? Explain Problems 5.7-5.9 focus on the Auto industry. Problem 5.7. Growth Analysis. Given are performance numbers for the last five years for Ford and GM.
Revenue Gross Profit Net Income
2001 $162,412 36,706 -5,453 RF
2000 $170,064 45,514 3,467
Ford 1999 $162,558 44,798 7,237
1998 $142,666 37,884 5,939
GM
Giroux • FINANCIAL STATEMENT ANALYSIS
1997 $145,348 36,441 6,088
SOLUTIONS MANUAL • CHAPTER 5 45
Revenue Gross Profit Net Income
2001 $177,260 46,318 601
2000 $184,632 52,379 4,452
1999 $167,369 35,115 6,002
1998 $155,445 40,903 2,956
1997 $172,580 44,355 6,698
Calculate the annual growth percentages for these companies and rate from 1 to 10.
Revenue Gross Profit Net Income
Revenue Gross Profit Net Income Rating
1997-8 1.85% -3.96% 2.45%
1997-8 9.93% 7.78% 55.87% Ford
1998-9 -13.94% -18.25% -21.86%
Ford 1999-2000 -4.62% -1.60% 52.09%
2000-01 4.50% 19.35% 257.28%
Total 97-01 11.74% 0.73% -189.57%
1998-9 -7.67% 14.15% -103.04%
GM 1999-2000 -10.31% -49.16% 25.82%
2000-01 3.99% 11.57% 86.50%
Total 97-01 2.71% 4.43% -91.03%
1-2 RF
GM
3-4
Problem 5.8. Trend Analysis. An alternative to growth percentages is to set the earliest year as the base year = 100 and calculate the remaining years as percentage change. For Ford, 1997 is set to 100. Revenues for 1998 are calculated as 142,666 / 145,348 = .9815. 2001 revenues for GM are 177,260 / 172,580 = 1.0271.
. Revenues Gross Profit Net Income
Revenues Gross Profit Net Income
1997 100.00% 100.00% 100.00%
1997 100.00% 100.00% 100.00%
1998 98.15% 103.96% 97.55%
Ford 1999 111.84% 122.93% 118.87%
2000 117.00% 124.90% 56.95%
2001 111.74% 100.73% -89.57%
1998 90.07% 92.22% 44.13%
GM 1999 96.98% 79.17% 89.61%
2000 106.98% 118.09% 66.47%
2001 102.71% 104.43% 8.97%
Analyze the trend data and compare it to the growth analysis from 4.4. Problem 5.9. Quarterly Analysis. The following performance information is available for the last five quarters for Ford and GM (in millions).
Mar 2002
Dec 2001
Ford Sept 2001
Jun 2001
Giroux • FINANCIAL STATEMENT ANALYSIS
Mar 2001
SOLUTIONS MANUAL • CHAPTER 5 46
Revenue COGS Gross Profit SG&A Net Income
$39,857 32,740 7,117 4,856 -800 RF
$41,150 26,074 15,076 26 -5,068 RF
$36,502 35,648 1,333 4,697 -692 RF
$42,314 33,648 8,666 4,250 -752 RF
$42,361 30,730 11,631 4,629 1,059
Revenue COGS Gross Profit SG&A Net Income
Mar 2002 $46,264 38,326 7,938 5,621 228
Dec 2001 $45,950 24,385 21,565 6,131 255
GM Sept 2001 $42,475 34,866 7,609 5,926 -368 RF
Jun 2001 $46,220 37,181 9,039 5,855 477
Mar 2001 $42,615 34,510 8,105 5,390 237
Complete the following common-size and percentage change table. Ford Common-size Common-size Common-size Period Revenue COGS Gross Profit SG&A Net Income
Mar 2002 100.00% 82.14% 17.86% 12.18% -2.01%
Dec 2001 100.00% 63.36% 36.64% 0.06% -12.32%
Mar 2001 100.00% 72.5% 27.5% 10.9% 2.5%
GM Common-size Common-size Common-size Period Revenue COGS Gross Profit SG&A
Mar 2002 100.00% 82.84% 17.16% 12.15%
Dec 2001 100.00% 53.07% 46.93% 13.34%
Mar 2001 100.00% 81.0% 19.0% 12.7%
Net Income
0.49%
0.55%
0.6%
% Δ from % Δ same Qtr, 1 Previous Qtr year ago Dec 2001 Mar 2001 -3.1% -5.9% 25.6% 6.5% -52.8% -38.8% 108.8x 4.9% NM -1.8x % Δ from % Δ same Qtr, 1 Previous Qtr year ago Dec 2001 Mar 2001 0.7% 8.6% 51.2% 11.1% -63.2% 2.1% -8.3% 4.3% -10.6%
-3.8%
Does the quarterly analysis indicate any red flags? Explain Cases Case 5.1. Quarterly Analysis for Dell Computer. Quarterly operating data for Dell is summarized for the last 16 quarters. Quarter Feb., 2002
Revenue $8,061
Gross Profit $1,470
Giroux • FINANCIAL STATEMENT ANALYSIS
Net Income $456
SOLUTIONS MANUAL • CHAPTER 5 47
10/01 7/01 5/01 1/01 10/00 7/00 4/00 1/00 10/99 7/99 4/99 1/99 10/98 7/98 4/98 1/98 10/97 7/97
7,468 7,611 8,028 8,674 8,264 7,670 7,280 6,801 6,784 6,142 5,537 5,173 4,818 4,331 3,920 3,737 3,188 4,331
1,373 1,390 1,448 1,559 1,758 1,634 1,492 1,304 1,370 1,788 1,190 1,161 1,086 985 873 822 717 985
429 -101 RF 462 375 674 603 525 436 483 507 434 425 384 346 305 285 248 346
A. Calculate gross profit and net income as a percent of revenue for each quarter Quarter 2/02 10/01 7/01 5/01 1/01 10/00 7/00 4/00 1/00 10/99 7/99 4/99 1/99 10/98 7/98 4/98 1/98 10/97 7/97
Gross Profit / Revenue 18.2% 18.4 18.3 18.0 18.0 21.3 21.3 20.5 19.2 20.2 29.1 21.5 22.4 22.5 22.7 22.3 22.0 22.5 22.7
Net Income / Revenue 5.7% 5.7 -1.3 5.8 40. 8.2 7.9 7.2 6.4 7.1 8.3 7.8 8.2 8.0 8.0 7.8 7.6 7.8 8.0
B. Calculate the percentage change for each quarter Quarter
% Δ, Revenue
% Δ, Gross Profit
% Δ, Net Income
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 5 48
10/01 to 2/02 7/01 to 10/01 5/01 to 7/01 1/01 to 5/01 10/00 to 1/01 7/00 to 10/00 4/00 to 7/00 1/00 to 4/00 10/99 to 1/00 7/99 to 10/99 4/99 to 7/99 1/99 to 4/99 10/98 to 1/99 7/98 to 10/98 4/98 to 7/98 1/98 to 4/98 10/97 to 1/98 7/97 to 10/97
7.9% -1.9 -5.2 -7.4 5.0 7.7 5.4 7.0 0.3 10.5 10.9 7.0 7.4 11.2 10.5 4.9 17.2 -26.4
7.1% -12.2 -4.0 -7.1 -11.3 7.6 9.5 14.4 -4.8 -22.8 50.3 2.5 6.9 10.3 12.8 6.2 14.6 -27.2
6.3% NM NM 23.2 -44.4 11.8 14.9 20.4 -9.7 -4.7 16.8 2.1 10.7 11.0 13.4 7.0 14.9 -28.3
C. Analyze the results, including any red flags. The obvious red flag is the net loss for the July 2001 quarter. The profit percentages show a general trend down, generally from over 22% to 18% for gross profit and from around 8% to 5% for net income. The percentages changes demonstrate more erratic positive and negative swings in all three measures. Particularly important are the negative %s around 2001. Overall, there a general downward performance trend. Case 5.2. Eleven-year Summary Data for PPG. The following summary data is given from PPG’s 2001 Annual Report (in millions, except for EPS). Year
Sales
Net Income
Basic EPS
$5,889 6,042 5,980 6,570 7,311 7,466 7,631 7,751 7,995 8,629 8,168
Income Before Tax $348 538 531 840 1,248 1,215 1,149 1,267 945 989 634
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
$276 319 22 515 768 744 714 801 568 620 387
$1.30 1.51 0.10 2.43 3.80 3.96 3.97 4.52 3.27 3.60 2.30
Year
Current Assets
Current
Total Assets
Stockholders’
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 5 49
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
$2,173 1,951 2,026 2,168 2,275 2,296 2,584 2,660 3,062 3,093 2,703
Liabilities $1,341 1,253 1,281 1,425 1,629 1,769 1,662 1,912 2,384 2,543 1,955
$6,056 5,662 5,652 5,894 6,194 6,441 6,868 7,387 8,914 9,125 8,452
Equity $2,655 2,699 2,473 2,557 2,569 2,483 2,509 2,880 3,106 3,097 3,080
a. Calculate common-size information for PPG: Year
Sales
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
100.0% 100 100 100 100 100 100 100 100 100 100
Year
Current Assets
1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
35.9% 34.5 35.8 36.8 36.7 35.6 37.6 36.0 34.4 33.9 32.0
Income Before Tax 5.9% 8.9 8.9 12.8 17.1 16.3 15.1 16.3 11.8 11.5 7.8
Net Income
Current Liabilities 22.1% 22.1 22.7 24.2 26.3 27.5 24.2 25.9 26.7 27.9 23.1
Total Assets
4.7% 5.3 0.4 7.8 10.5 10.0 9.4 10.3 7.1 7.1 4.7
100.0% 100 100 100 100 100 100 100 100 100 100
b. Calculate the following ratios for each year:
Giroux • FINANCIAL STATEMENT ANALYSIS
Stockholders’ Equity 43.9% 47.7 43.8 43.4 41.5 38.5 36.5 39.0 34.8 33.9 36.4
SOLUTIONS MANUAL • CHAPTER 5 50
Year 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Current Ratio Debt to EquityReturn on Sales Return on Assets 1.6x 1.3x 4.7% 4.6% 1.6 1.1 5.3 5.6 1.6 1.3 0.4 0.4 1.5 1.3 7.8 8.7 1.4 1.4 10.5 12.4 1.3 1.6 10.0 11.6 1.6 1.7 9.4 10.4 1.4 1.6 10.3 10.8 1.3 1.9 7.1 6.4 1.2 1.9 7.1 6.8 1.4 1.7 4.7 4.6
Return on Equity 10.4% 11.8 0.9 20.1 29.9 30.0 28.5 27.8 18.3 20.2 12.6
a. Calculate the following growth percentages for PPG: Year
Sales
1991-1992 1992-1993 1993-1994 1994-1995 1995-1996 1996-1997 1997-1998 1998-1999 1999-2000 2000-2001
2.6% -1.0 9.9 11.3 2.1 2.2 1.6 3.1 7.9 -5.3
Income Before Tax 54.6% -1.3 58.2 48.6 -2.6 -5.4 10.3 -25.4 4.7 -35.9
Net Income
Basic EPS
15.6% -93.1 22.4x 49.1 -3.1 -4.0 12.2 -29.1 9.2 -37.6
16.2% -93.4 23.3x 56.4 4.2 0.3 13.9 -27.7 10.1 -36.1
b. Evaluate the trends for PPG for the last 11 years. Are there any red flags? Although PPG was profitable over the entire period, performance was erratic—rising in the 1990s and declining from the late 1990s. There is a general trend for increasing leverage & falling equity. The return and growth ratios show a pattern of erratic performance over the period. Internet Projects Project 5.1. Use the same company selected in Project 4.1. Gather the financial information you need from the company’s annual report and other sources. Do a complete growth and trend financial analysis for the last six years, using the same format as above. Suggestions: Summary financial statements can be found at www.hoovers.com; complete financial statements can usually be found on company websites and the SEC’s Edgar system (available
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 5 51
from several sources); considerable financial information can be found at various financial websites, such as Quicken (www.quicken.com) or Yahoo Financial (quote.yahoo.com). Project 5.2. Use the same company selected in Project 4.1. Gather quarterly financial information for the last five quarters you need from the company’s 10-Q and other sources. Do a complete quarterly financial analysis for the last five quarters, using the same format as above. Suggestions: Limited quarterly data can be found at www.hoovers.com.
Giroux • FINANCIAL STATEMENT ANALYSIS
6. Quantitative Financial Analysis Techniques: Incorporating Market Information Questions 1. When is stock price information important? Is the major concern with current price or the price trend over a long period of time? Explain. 2. What is earnings per share? Should net income always be used as the measure of profitability? Explain. How important and how reliable are EPS forecasts? 3. Why are PE ratios important? Are they very general market premium indicators or precise measures that are reliable? 4. Why are investor goals important when evaluating dividends and dividend yields. 5. When is market-to-book extremely important to an analyst? Is “the higher the better” a good rule of thumb? Explain. 6. Is a company with a PEG of less than one always a good investment? Explain. 7. What does it mean if the dividend discount model and intrinsic value give mixed signals? 8. When would stock screening be a useful tool? 1 The current stock price is crucial when evaluating investment decisions. The current stock price portrays current and most up-to-date investor confidence. 2 EPS is Net Income divided by the number of common shares outstanding. Net Income is always involved in the numerator, but oftentimes analysts reduce it by Preferred Dividends (which are not included in bottom line Net Income yet, instead are reduced from Retained Earnings) or other variables to come at a better estimate of true “Earnings.” 3 PE ratios demonstrate the premium investors place on the stock, and therefore their confidence with the stock’s ability to generate future EPS. They are general indicators, however, and shouldn’t be over-analyzed. 4 Different investors have different goals when investing. Some (younger) care more about capital gains over the long run and prefer the companies they invest in to reinvest cash as opposed to distribute it as dividends. Other investors (geezers) expect annual dividend as a source of revenue and care less about long term capital gains. 5 Market to Book is most useful to inform analysts when companies are at a high premium and may need more analysis of raw financial data. The higher the ratio only indicates more information beyond the balance sheet is needed to analyze the company. 6 Companies with PEG of grater than 1 (or 1.5 recently) are good investments. This means that the premium of the stock (with its price) is expected to grow. 7 As long as Net Income is positive, intrinsic method should be used. 8 Stock screening is most useful for beginning investors who have general criteria about the stocks they wish to invest in. Problems Problems 6.1-6.6. Relate to the Chemical Industry
SOLUTIONS MANUAL • CHAPTER 6 53
Problem 6.1. Stock Price Charts. Stock prices for three chemical companies for one and five years are presented below [Du Pont (DD), Dow, and PPG] along with the Dow Jones Industrial Average (DJIA).
Provide a brief analysis of stock prices for these companies relative to the DJIA. Over the last 12 months, the chemical companies outperformed the Dow, although the return was still negative for all three companies. Over the last 5 years, the companies underperformed the Dow, negative for PPG and Du Pont.
Problem 6.2. Price Earnings & Dividend Ratios. Given are stock prices (May 1, 2002 closing); EPS 2001 actual, 2002 forecast, 2003 forecast, and 2001 dividend yield:
Du Pont Dow
Stock Price 44.63 31.49
EPS, Actual $4.15 -0.46 RF
EPS, 2002* $1.75 1.01
EPS 2003* $2.38 2.37
Giroux • FINANCIAL STATEMENT ANALYSIS
Dividend $1.40 1.34
SOLUTIONS MANUAL • CHAPTER 6 54
PPG 52.22 2.29 * Zacks analysts’ estimates from Quicken
2.73
3.50
1.68
Given the information above, calculate PE for the three definitions of EPS, dividend yield, and dividend payout:
Du Pont Dow PPG
Price / Actual EPS 10.75 NM 22.8
Price / 2002 EPS 25.5 31.2 19.1
Price / 2003 EPS 18.8 13.3 14.9
Dividend Yield 3.14% 4.26% 3.22%
Dividend Payout 33.7% NM 73.4%
Problem 6.3. PE to Annual Earnings Growth (PEG). Given are annual earnings growth rates, both historical and projected. 5 Year Historic Earnings Growth Rates* Du Pont -18.2% Dow -22.8 PPG -7.1 * www.quicken.com, Analysts Estimates
5 Year Projected Earnings Growth Rates* 11.0% 10.0 8.0
Calculate PE to earnings growth rates (PEG), using information above and calculated from Problem 6.2. Current PE /5 Year Historic Growth Du Pont Dow PPG
NM NM NM
1 Year Ahead PE Forecast /5 Year Projected Growth 2.31 3.12 2.39
2 Year Ahead PE Forecast /5 Year Projected Growth 1.70 1.33 1.86
Classify these companies by cell (1 to 9) based on the PEG matrix. Assume that average PE is 20 and average earnings growth is 12%. Problem 6.4. Market-to-Book & Sales Ratios. Given are stock price, net assets (total stockholders’ equity), shares outstanding, and annual revenues for 2001 of the chemical companies. a. Calculate book value per share and the market-to-book ratio for the chemical companies. Stock Price
Net Assets Shares (in Outstanding millions) (in millions)
Sales, 2001 (in millions)
Book Value per Share
Giroux • FINANCIAL STATEMENT ANALYSIS
Marketto-Book Ratio
SOLUTIONS MANUAL • CHAPTER 6 55
Du Pont Dow PPG
44.63 31.49 52.22
$14,452 9,993 3,080
1,002 905 169
$24,726 27,805 8,169
14.42 11.04 18.22
3.09 2.852 2.87
b. Calculate Market Value & the Sales-to-Net Assets & Sales-to Market Value ratios.
Du Pont Dow PPG
Market Value
Sales-to-Net Assets
44.7 billiom 28.5 billion 8.8 billion
1.71 2.78 2.65
Sales-to-Market Value .553 .975 .926
Problem 6.5. Earnings Growth (Dividend Discount) Model. Use the earnings growth model (P = kE / (r – g) to estimate projected stock price, assume the S&P 500 rate of return (r) is 12%. Stock Price
EPS
Du Pont 44.63 4.15 Dow 31.49 -0.46* PPG 52.22 2.29 * Estimate using forecast EPS of 1.01
Dividend Payout 33.7% 132.7 73.4
5 Yr Earning Growth 11.0% 10.0 8.0
Projected Price 139.85 NM 42.02
How do these compare to 5/1/02 stock price; that is, which are overvalued or undervalued? Problem 6.6. Intrinsic Value. Given the information below, calculate intrinsic value to stock price. Stock Price, 5/1/02
Annual Earnings (millions)*
5 Year Discount Intrinsic Earnings Rate Value per Growth Share** Rate Du Pont 44.63 $4,322 11.0% 11% $81.59 Dow 31.49 405 10.0 11 0 PPG 52.22 383 8.0 11 44.39 * Last four quarters, ending March 2002 ** www.quicken.com, Evaluator
Intrinsic Value to Stock Price 1.83 0 .850
Given the information and calculations above, are these stocks over- or under-valued? Explain. Problems 6.7-6.12. Relate to the Hotel and Resort Industry Problem 6.7. Stock Price Charts. Stock prices for three hotel and resort companies for one and five years are presented below [Hilton (HLT), Marriott (MAR), and Mandalay (MBG)], along with the Dow Jones Industrial Average (DJIA).
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 6 56
Provide a brief analysis of stock prices for these companies relative to the DJIA. Over the last 12 months, Hilton & Mandalay Bay outperformed the Dow, with a market return about 20%. Marriott had a negative return of about 15%, similar to the Dow. Over the last 5 years only Mandalay Bay performed on par with the Dow, with Hilton down about 20% and Marriott up about 10%. Problem 6.8. Price Earnings & Dividend Ratios. Given are stock prices (May 1, 2002 closing); EPS 2001 actual, 2002 forecast, 2003 forecast, and 2001 dividend yield: Stock Price EPS, Actual Hilton 16.00 $0.45 Marriott 44.03 0.92 Mandalay 7.13 0.71 * Zacks analysts’ estimates from Quicken
EPS, 2002* $0.63 1.68 1.87
EPS 2003* $0.81 2.07 2.20
Dividend 0.08 0.28 0
Given the information above, calculate PE for the three definitions of EPS, dividend yield, and dividend payout:
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 6 57
Price / Actual EPS 35.56 47.86 10.04
Hilton Marriott Mandalay
Price / 2002 EPS 25.4 26.2 3.8
Price / 2003 EPS 19.8 21.3 3.2
Dividend Yield .5% .6% 0
Dividend Payout .23 .26 0
Problem 6.9. PE to Annual Earnings Growth (PEG). Given are annual earnings growth rates, both historical and projected. 5 Year Historic Earnings Growth Rates* Hilton -15.8% Marriott 6.9 Mandalay -2.0 * www.quicken.com, Analysts Estimates
5 Year Projected Earnings Growth Rates* 13.9% 14.4 13.6
Calculate PE to earnings growth rates (PEG), using information above and calculated from Problem 6.8. Current PE /5 Year Historic Growth Hilton Marriott Mandalay
2.25 6.93 NM
1 Year Ahead PE Forecast /5 Year Projected Growth 1.83 1.82 .28
2 Year Ahead PE Forecast /5 Year Projected Growth 1.42 1.48 .24
Classify these companies by cell (1 to 9) based on the PEG matrix. Assume that average PE is 20 and average earnings growth is 12%. Problem 6.10. Market-to-Book & Sales Ratios. Given are stock price, net assets (total stockholders’ equity), shares outstanding, and annual revenues for 2001 of the Hotel & resort companies. a. Calculate book value per share and the market-to-book ratio for the chemical companies. Stock Price
Hilton Marriott Mandalay* *FYE 1-02
16.00 44.03 7.13
Net Assets Shares (in Outstanding millions) (in millions) $1,783 369 3,478 245 941 68
Sales, 2001 (in millions)
Book Value per Share
Marketto-Book Ratio
$2,632 10,152 2,462
4.83 14.20 13.84
3.31 3.10 .52
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 6 58
b. Calculate Market Value & the Sales-to-Net Assets & Sales-to Market Value ratios. Market Value
Sales-to-Net Assets
5904 10787.35 484.84
1.48 2.92 2.62
Hilton Marriott Mandalay
Sales-to-Market Value 44.58% 94.11% 5.07x
Problem 6.11. Earnings Growth (Dividend Discount) Model. Use the earnings growth model (P = kE / (r – g) to estimate projected stock price, assume the S&P 500 rate of return (r) is 15%.
Hilton Marriott Mandalay
Stock Price
EPS
16.00 44.03 7.13
$0.45 0.92 0.71
Dividend Payout 17.8% 30.4 0
5 Yr Earning Growth 13.9% 14.4 13.6
Projected Price $7.28 46.61 NM
How do these compare to 5/1/02 stock price; that is, which are overvalued or undervalued? Marriott is corrected priced (slightly undervalued), while Hilton is overvalued & Mandalay has no value according to the earnings growth model. Problem 6.12. Intrinsic Value. Given the information below, calculate intrinsic value to stock price. Stock Price, 5/1/02
Annual Earnings (millions)*
5 Year Discount Intrinsic Intrinsic Earnings Rate Value per Value to Growth Share** Stock Rate Price Hilton 16.00 $145 13.9% 11% $0.13 .8% Marriott 44.03 197 14.4 11% 8.40 19.08% Mandalay 7.13 55 13.6 11% 0 0% * Last four quarters, ending March 2002 (Apr. 2002 for Mandalay) ** www.quicken.com, Evaluator Given the information and calculations above, are these stocks over- or under-valued? Explain. All three companies are overvalued based on intrinsic value.
Problems 6.13-6.18. Relate to the Auto Industry Problem 6.13. Stock Price Charts. Stock prices for Ford and GM for one and five years are presented below along with the Dow Jones Industrial Average (DJIA).
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 6 59
Provide a brief analysis of stock prices for these companies relative to the DJIA. Over the last 12 months, Gm was up almost 20% while Ford was down over 40%. Over the last 5 years GM performed on par with the Dow, up almost 50%, while Ford was down about 30%. Problem 6.14. Price Earnings & Dividend Ratios. Given are stock prices (May 1, 2002 closing); EPS 2001 actual, 2002 forecast, 2003 forecast, and 2001 dividend yield: Stock Price EPS, Actual Ford 16.34 -3.02 RF GM 65.51 1.77 * Zacks analysts’ estimates from Quicken
EPS, 2002* 0.16 4.73
EPS 2003* 0.89 6.33
Dividend 0.40 2.00
Given the information above, calculate PE for the three definitions of EPS, dividend yield, and dividend payout: Price /
Price / 2002
Price / 2003
Dividend
Giroux • FINANCIAL STATEMENT ANALYSIS
Dividend
SOLUTIONS MANUAL • CHAPTER 6 60
Ford GM
Actual EPS NM 37.01
EPS 102.1 13.8
EPS 18.4 10.3
Yield 2.44% 3.05%
Payout NM 113.0%
Problem 6.15. Market-to-Book & Sales Ratios. Given are stock price, net assets (total stockholders’ equity), shares outstanding, and annual revenues for 2001 of the auto companies. a. Calculate book value per share and the market-to-book ratio for the chemical companies. Stock Price
Ford GM
16.34 65.51
Net Assets Shares (in Outstanding millions) (in millions) 7,786 1,908 19,707 1,437
Sales, 2001 (in millions)
Book Value per Share
Marketto-Book Ratio
162,412 177,260
4.08 13.71
4.00 4.77
b. Calculate Market Value & the Sales-to-Net Assets & Sales-to Market Value ratios.
Ford GM
Market Value
Sales-to-Net Assets
31176.72 94137.87
20.85 9
Sales-to-Market Value 5.21 1.88
Problem 6.16. PE to Annual Earnings Growth (PEG). Given are annual earnings growth rates, both historical and projected. 5 Year Historic Earnings Growth Rates* Ford -170.4 RF GM -14.8 * www.quicken.com, Analysts Estimates
5 Year Projected Earnings Growth Rates* 5.1 5.8
Calculate PE to earnings growth rates (PEG), using information above and calculated from Problem 6.14. Current PE /5 Year Historic Growth Ford GM
NM NM
1 Year Ahead PE Forecast /5 Year Projected Growth 20.0 2.4
2 Year Ahead PE Forecast /5 Year Projected Growth 3.6 1.8
Classify these companies by cell (1 to 9) based on the PEG matrix. Assume that average PE is 20 and average earnings growth is 12%.
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 6 61
Problem 6.17. Earnings Growth (Dividend Discount) Model. Use the earnings growth model (P = kE / (r – g) to estimate projected stock price, assume the S&P 500 rate of return (r) is 12%. Stock Price
EPS
Dividend Payout 250.0%* 113.0
Ford 16.34 -3.02* GM 65.51 1.77 * Estimate using forecast EPS of .16
5 Yr Earning Growth 5.1 5.8
Projected Price NM 32.26
How do these compare to 5/1/02 stock price; that is, are they overvalued or undervalued? GM is overvalued but Ford’s value cannot be calculated. Problem 6.18. Intrinsic Value. Given the information below, calculate intrinsic value to stock price. Stock Price, 5/1/02
Annual Earnings (millions)*
5 Year Earnings Growth Rate
Discount Rate
Intrinsic Value per Share**
Ford 16.34 Neg NA GM 65.51 592 5.8 11.0 0 * Last four quarters, ending March 2002 ** www.quicken.com, Evaluator
Intrinsic Value to Stock Price NA NA
Given the information and calculations above, are these stocks over- or under-valued? Explain. Cases Case 6.1. Market Analysis of the Chemical Industry. Conduct a comprehensive market analysis of the three chemical companies, based on the findings from Problems 6.1-6.6. Rate each category from 1 (poor) –10 (excellent) and the overall market analysis. The primary consideration overall for growth stocks is whether the stock is overvalued or undervalued. The primary consideration for income stocks is yield, followed by dividend payout and over- under-evaluation. Du Pont Stock Price Trends
Rating Analysis 4 Down last 5 years, but above DJIA last 12 months
PE Ratios
4
Moderate
Dividends
6
High yield & moderate payout
Market-to-book
5
Moderate
PEG
4
High PEG Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 6 62
Valuation: Dividend Discount Model Valuation: Intrinsic Value
8
Undervalued
7
Undervalued
Rating
Analysis
Dow Stock Price Trends
4
Down last 12 months, but up last 5 years
PE Ratios
3
Moderate only for 2 year ahead forecast
Dividends
5
High yield but loss in current year
Market-to-book
5
Moderate
PEG
4
High PEG
Valuation: Dividend Discount Model Valuation: Intrinsic Value
-
NM
1
0 intrinsic value
PPG
Rating
Analysis
Stock Price Trends
4
Down last 5 years & last 12 months
PE Ratios
6
Similar to overall market
Dividends
5
High yield & high payout
Market-to-book
5
Moderate
PEG
4
High PEG
Valuation: Dividend Discount Model Valuation: Intrinsic Value
4
Slightly overvalued
4
Slightly overvalued
Case 6.2. Market Analysis of the Hotel and Resort Industry. Conduct a comprehensive market analysis of the three hotel & resort companies, based on the findings from Problems 6.7-6.12. Rate each category from 1 (poor) –10 (excellent) and the overall market analysis. The primary consideration overall for growth
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 6 63
stocks is whether the stock is overvalued or undervalued. The primary consideration for income stocks is yield, followed by dividend payout and over- under-evaluation. Hilton Stock Price Trends
Rating Analysis 4 Up 20% last 12 months, down 20% last 5 years
PE Ratios
5
Moderate
Dividends
2
Low yield
Market-to-book
5
Moderate
PEG
4
Moderate to high
Valuation: Dividend Discount Model Valuation: Intrinsic Value
3
Overvalued
2
Overvalued
Marriott Stock Price Trends
Rating Analysis 4 Down last 12 months, up last 5 years
PE Ratios
4
Moderate
Dividends
2
Low yield
Market-to-book
5
Moderate
PEG
4
Moderate to high
Valuation: Dividend Discount Model Valuation: Intrinsic Value
6
Fairly priced
4
Overvalued
Mandalay Stock Price Trends
Rating Analysis 7 Up 20% last 12 months, up last 5 years
PE Ratios
6
Low PEs
Dividends
1
No dividend
Market-to-book
6
Market half of book value
PEG
7
Low PEG
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 6 64
Valuation: Dividend Discount Model Valuation: Intrinsic Value
-
NM
1
0 intrinsic value
Case 6.3. Market Analysis of the Auto Industry. Conduct a comprehensive market analysis of the auto companies, based on the findings from Problems 6.13-6.18. Rate each category from 1 (poor) –10 (excellent) and the overall market analysis. The primary consideration overall for growth stocks is whether the stock is overvalued or undervalued. The primary consideration for income stocks is yield, followed by dividend payout and over- under-evaluation. Ford Stock Price Trends
Rating Analysis 2 Down last 12 months & last 5 years
PE Ratios
2
High PEs
Dividends
5
Moderate yield, loss
Market-to-book
4
High given current problems
PEG
2
Very high
Valuation: Dividend Discount Model Valuation: Intrinsic Value
-
NM
1
NM
General Motors Stock Price Trends
Rating Analysis 6 Up last 12 months & last 5 years
PE Ratios
5
Low to moderate PEs
Dividends
6
Moderate yield, high payout
Market-to-book
4
Moderate
PEG
4
Relatively high
Valuation: Dividend Discount Model Valuation: Intrinsic Value
3
Overvalued
1
0 intrinsic value
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 6 65
Ethics Considerations. Corrupt corporate governance and Wall Street. The following excerpts from Fortune (“Global Crossing, Emperor of Greed” by J. Creswell) illustrates corrupt practices that led to corporate failure: Gary Winnick had never worked in the telecom industry before he founded Global Crossing in 1997. He had never run a public company before either. Yet in the late 1990s, Chairman Winnick was hailed as an industry giant, the creator of a telco that a year after going public in 1998 was valued at $38 billion--more than Ford. A little over two years later, Global Crossing is in bankruptcy and fighting to survive, part of an industry collapse that wiped out $2.5 trillion in market value. Investors and regulators are struggling to figure out what went so wrong so fast. The answer captures all of the insanity and money fever of the telecom and dot-com bubbles, which saw billions of dollars vanish in pursuit of business that never materialized. Like a lot of other overreaching companies, Winnick's Global Crossing rose swiftly and fell even faster. Its business plan changed with the phases of the moon. So did its CEOs (there were five in four years). It had a huge market value and a teeny cash flow. Global Crossing inflated its revenues by swapping capacity with other carriers, say analysts, and lured customers and investors by overstating the reach and capabilities of its network--a $12 billion "state-of-the-art" system that, several former employees told Fortune, simply doesn't work that well. It exploited its relationships with both Wall Street and its bankers on a scale unrivaled in the industry. What's inarguable, as our story will document, is that billions of dollars flowed out of this company and into the pockets of insiders. Gary Winnick and his cronies are arguably the biggest group of greedheads in an era of fabled excess. Not only did Winnick sell off stock at huge profits while investors who jumped in later watched their stakes burn to nothing, but he treated Global Crossing from the get-go as his personal cash cow, earning exorbitant fees from consulting and real estate deals between Global Crossing and his own private investment company. In all, Winnick cashed in $735 million of stock over four years--including $135 million Global Crossing issued to his private company--while receiving $10 million in salary and bonuses and other payments to the holding company. Enron's Kenneth Lay doesn't even come close. He sold only $108 million of stock. (The telecom boom's cash-out king may be Qwest Chairman Philip Anschutz, who dumped $1.9 billion in stock. But Qwest, at least for now, is afloat.) Wall Street partners fared well too. Canadian firm CIBC World Markets, which was an early investor in Global Crossing and at one time had five employees on its board, earned $56 million in banking fees even before Global Crossing's 1998 IPO. It turned a $41 million investment into a $1.7 billion windfall and exited the board just as the telecom bubble was bursting. Global Crossing paid more than $420 million in fees to Wall Street firms in three short years. As one investment banker recalls, "People wanted to do business with Winnick because he was the best game in town." Needless to say, most outside investors never saw that kind of payday. Global Crossing's market valuation, which peaked at $47 billion in February 2000, deflated to about $70 million when it filed for bankruptcy earlier this year. Investors and creditors have almost zero chance of
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 6 66
recouping any of the $20 billion that Global Crossing raised. The company is seeking a buyer, but a bid from two Asian partners fell through at the end of May. It is looking to restructure now. In all likelihood, though, Global Crossing will be broken up and stripped for parts. a. It seems that corrupt works, at least for a while for those at the top. Is the problem with the system or mainly a matter of better regulations and enforcement? b. Global Crossing went bankrupt. Part of the problems was earnings manipulation, especially aggressive revenue recognition (including transactions that seemed to have no economic basis except to book revenue). Is accounting practice the major problem or is it corporate governance? c. Wall Street firms benefited from Global Crossing. Are they part of the problem? a. b. c.
It would seem to be a matter of both. Corporate governance, regulation and other factors may reduce the level of corruption Both seem to be involved. Accounting was central to earnings manipulation, but adequate governance is an important check on manipulation Yes. Investment bankers and other have incentives to push these stocks and additional regulation and enforcement seems necessary
Internet Projects Project 6.1. Internet Overview. a. Go to the Fortune site (www.fortune.com). Find the Fortune 500 & browse. What is the largest company on the list? Why (what makes it the largest)? Go to the Fortune 500 industry list and pick Pharmaceuticals. Which company has the largest ROE and ROA? b. Go to Hoovers (www.hoovers.com) and search for Pfizer. Go to the Pfizer Capsule and read the profile. What is the ticker symbol? The web address? Go to the abbreviated financials. Write down 2000 revenues, gross profit, and net income and calculate common-size percentages. c. Go to Quicken (www.quicken.com). Enter Pfizer ticker. Use chart, year-to-date and compare to DJIA and Johnson & Johnson. How well has Pfizer done? Pull up 5-year chart. Ditto. Go to Analysts Ratings and look up EPS estimates for the next two years and earnings growth, estimated for next five years. Compare to Johnson & Johnson. d. Pull up Pfizer’s 2000 10-k. Use the company’s web page (www.pfizer.com), Lexis/Nexis (www.lexis.nexis.com/universe), or some other source. What is CFO and pension amount shown on the balance sheet? Project 6.2. Stock Screener. Go to Hoovers (www.hoovers.com)—money/stock screener. Do a series of searches. a. Large-cap, growth stocks, NYSE, all industries. List 5 companies from this list. b. Large-cap value stocks, all exchanges, all industries. Based on the information presented list 5 companies with a PE ratio below 10.
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SOLUTIONS MANUAL • CHAPTER 6 67
c. Use your own search to pick stocks. Explain the technique used and results. Project 6.3. Use the same company picked in Project 4.1. Gather the financial information you need from the company’s stock price, forecasts, annual report and other sources. Do a complete market analysis, using the same format as above.
Giroux • FINANCIAL STATEMENT ANALYSIS
7. An Accounting Analysis Perspective Questions 1. What is revenue recognition and why is aggressive revenue recognition a potential problem when evaluating earnings quality? 2. Explain how the matching principle works and its relationship to revenue recognition? 3. What are non-recurring items and why are they potential red flags? 4. There are alternative definitions of the “bottom line” including income from continuing operations, net income and comprehensive income? Is this complexity needed? Explain. Is S&Ps Core Earnings a useful addition to bottom line analysis? Explain. 5. What are pro forma statements? When they are part of the annual report of a company are they reliable? Why or why not? 6. Earnings management seems to be a major issue when evaluating accounting. Why? 7. How is the five-step detailed accounting analysis used to evaluate earnings management? 8. Assume that a financial is made four months after the end of the last fiscal year. How can the annual report information be updated to incorporate the most recent information available? 1 According to GAAP, revenues are recognized when 1. realized or realizable, or 2. earned. The timing of revenue is the primary concern, it is up to management to decide when it is truly “earned” or not. There may be a conflict since managers have incentive to maximize revenues in the current period. They can recognize revenue between the options of when sale was made, when product was received by buyer, or when cash is received. It is important to know what sales were associated with what period to make a decision about current performance. 2 Revenues recognized must be “matched” to related expenses. For example, sales of inventory include Cost of Goods Sold. However, not all expenses are as easy as sales to determine when to expense. 3 Non-recurring items are gains and losses that are unusual and expected to occur infrequently. These items are those that occur out of the realm of normal operations and may signify problems such as destroyed plants and property or a discontinuation of a part of the company. 4 This complexity is necessary. In order to view the complete nature of a company’s firm, analysts use Income from Continuing Ops. to analyze the company’s income derived from ordinary business. Bottom line Net Income includes the extraordinary items which occurred in the period, but most likely will not continue. Furthermore, Comprehensive Income provides a better view of Income by including items which bypass the Income Statement on the books, but nonetheless have an effect on earnings. Core Earnings increases the transparency of Net Income further by including expenses that may bypass the Income Statement and excluding items that are not a part of continuing operations. 5 Pro forma statements are restated earnings to emphasize a certain aspect of
SOLUTIONS MANUAL • CHAPTER 2 69
performance or future forecasts. They may be considered less reliable, however, since they are management’s forecasts and not always based on the entire financial position. They are somewhat subjective. 6 Despite the rigidity of GAAP, flexibility exists and there are many options a company has in such things as reporting revenues, expenses, and earnings, etc. Analysts must understand every way a company can blatantly and subtly doctor a financial statement for the best interest of the firm in order to best predict future performance. 7 1. Financial Accounting Overview-analyzes accounting policies of the company, revenue recognition, etc. 2. Evaluate reporting completeness-determines whether the company presents the information expected, in a useful and timely form. 3. Evaluate the potential for earnings management-determining if a company has policies that differ from industry may be a sign of earnings management. 4. Consider potential red flags-evaluates poor performance to determine if it is likely to continue. Also determine if non-recurring items were used to boost earnings. 5. Reevaluate or restate financial information-restate ratios and items in a way to do away with earnings management techniques. 8 Most recent information can be contained in earnings announcements, quarterly statements, proxy statements, and company announcements. Also quarterly statements are issued after first, second, and third quarter. Problems Problems 7.1-7.6 Relate to the Chemical Industry. Problem 7.1. Financial Accounting Overview. A review of Note 1 (Accounting Policies) of three chemical companies provides the following information:
Revenue Recognition
Marketable Securities
Du Pont Recognized when products are shipped & title & risk of loss transferred to customer Held-to-maturity
Inventory
LIFO & FIFO
Property, Plant & Equipment Environmental Liabilities
Recorded at cost, straight-line depreciation Recorded as operating expenses when liability
Dow When risk & title transferred to customer, generally at time of shipment
PPG When goods are shipped & title to inventory passes to customers
Trading, held-tomaturity, or available-for-sale LIFO, FIFO & Average Recorded at cost, straight-line depreciation Recorded as operating expenses when probable
Valued at cost
LIFO & FIFO Recorded at cost, straight-line depreciation Probable that a liability has been incurred & amount of
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 70
Hedging
incurred & can be reasonably estimated Forward exchange contracts, interest rate swaps, commodities futures contracts
Interest rate swaps, foreign currency swaps, commodities futures, options & swaps
liability reasonably estimated Commodity swaps and options, foreign currency and interest rates [swaps?]
Are there differences in accounting policies across these companies? Explain. Does this information suggest earnings management or the need for further analysis? Explain. Dow’s use of average cost depreciation in addition to LIFO and FIFO is different, this may indicate earnings management depending on the assets the depreciation method is applied to. DuPont expenses their Environmental Liabilities. This has a direct impact on current financials and will not affect future financials like creating liabilities as Dow and PPG do. Problem 7.2. EBIT and EBITDA. Given below are summary earnings numbers for the three chemical companies for 2001 (in millions):
Net Income Income from Continuing Operations Provision for Income Tax Interest Expense Depreciation and Amortization
Du Pont $4,339 4,328 2,467 590 1,754
Dow $-385 -417 -228 733 1,773
PPG $387 387 247 169 447
a. Based on this information, calculate EBIT and EBITDA and the percentage change over net income for EBIT ([Net Income – EBIT]/Net Income) and EBITDA ([Net Income – EBITDA]/Net Income).
EBIT EBIT % change from Net Income EBITDA EBITDA % change from Net Income
Du Pont $7,385 70.2% $9,139 110.6%
Dow $88 NM $1,861 NM
PPG $803 107.5% $1,250 223.0%
Supplementary information for the current year (in millions):
Sales Average Total Assets Average Equity
Du Pont $24,726 39,872.5 13,875.5
Dow $27,805 35,753 10,916.5
b. Calculate alternative profitability ratios. Giroux • FINANCIAL STATEMENT ANALYSIS
PPG $8,169 8,788.5 3,088.5
SOLUTIONS MANUAL • CHAPTER 2 71
Net Income Return on Sales Return on Total Assets Return on Equity
Du Pont 17.6% 10.9 31.3
Dow -1.38% RF -1.1 RF -3.5 RF
PPG 9.8% 4.4 12.5
EBIT Return on Sales Return on Total Assets Return on Equity
Du Pont 29.9% 18.5 53.2
Dow 0.32% 0.25 0.81
PPG 9.8% 9.19 26.0
EBITDA Return on Sales Return on total Assets Return on Equity
Du Pont 37.0% 22.9 65.9
Dow 6.7% 5.2 17.0
PPG 15.3% 14.2 40.5
c. Based on the information above, evaluate the useful of EBIT and EBITDA as alternative earnings numbers. Problem 7.3. Alternative Bottom Line Ratios for Du Pont. Given below is summary information from Du Pont’s income statement for the last three years (in millions).
Sales Income from Continuing Operations (ICO) Gain from Disposal of Discontinued Business (sale of Conoco) Net Income (NI) Translation Adjustment Minimum Pension Liability Adjustment Unrealized Gains on Marketable Securities Comprehensive Income (CI)
2001 $24,726 4,328
2000 $26,268 2,314
1999 $26,918 219 7,471
4,339 -19 -16
2,314 -38 4
7,690 172 76
-24
-21
51
4,254
2,259
$7,989
a. Calculate return on sales using (1) income from continuing operations (ICO / sales); (2) net income (NI / sales); and (3) comprehensive income (CI / sales).
ICO / Sales NI / Sales CI / Sales
2001 17.50% 17.55% 17.20%
2000 8.81% 8.81% 8.60%
Giroux • FINANCIAL STATEMENT ANALYSIS
1999 0.81% 28.57% 29.68%
SOLUTIONS MANUAL • CHAPTER 2 72
b. In 2001 Du Pont sold Du Pont Pharmaceuticals for a gain of $6,136 million ($3,866 net of tax). This was recorded as a separate line item as part of continuing operations. How does this affect the analysis (note: consider recalculating profit excluding this transaction)? Is this an example of earnings management? Explain. Theoretically, this item should not be a part of Income from Continuing Operations, instead should be reported net of tax after NI from Continuing Ops. before bottom-line. NI from Continuing Ops should be recalculated, but the bottom-line Net Income would remain unaffected. Problem 7.4. Comprehensive Income. Given are summaries of comprehensive income tables for three chemical companies for 2001 (in millions):
Net Income Unrealized Gains & LossesMarketable Securities Foreign Currency Translation Gains & Losses Pension Liability Adjustment Other Comprehensive Income Comprehensive Income / Net Income
Du Pont $4,339 -24
Dow $-385 27
PPG $387 10
-38
-148
-131
-16 6 $4,254 98.04%
-21 -45 -572 NM
-20 -51 238 61.50%
Calculate comprehensive income as a percent of net income (comprehensive income / net income) for these companies. Is this new information useful? Explain. Is it a better measure of the bottom line than net income? Explain. This new information is useful. Regardless of its placement on the Statement of Stockholders’ Equity, Comprehensive Income affects Earnings on the balance sheet. This ratio can calculate the affect the “dirty-surplus” has on asset growth of the company. Problem 7.5. Contingencies. Given are highlights from contingency footnotes of three chemical companies. Du Pont (Note 25, 2001 Annual Report): Lawsuits outstanding alleging property damage from Benlate fungicide. Approximately 110 cases pending, Du Pont denies claims. Environmental liability—company accrued $385 million in 2001, potential liability may be higher. Dow (Note P, 2001 Annual Report): Breast implant litigation settlement from 1994 (for subsidiary Dow Corning—now bankrupt). Company still defendant in 14,000 breast implant product liability cases. Company considers further liability remote. Pesticide lawsuits (dibromochoropropane) primarily for ground water contamination/ Company considers further liability remote. Environmental liability—company accrued a total $444 million through 2001
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 73
(including Superfund). Asbestos claims through Union Carbide subsidiary, litigation accruals of $233 million. PPG (Note 11, 2001 Annual Report): Lawsuits & claims on product liability, contract, patent, environmental, antitrust & other. Lawsuit for fixing prices on auto refinish & glass products; personal injury from exposure to asbestos (about 116,000 asbestos claims pending involving several companies). Company claims a successful defense and no responsibility. Trial court found PPG liable in 2002 in Texas, but PPG will appeal. Lost a lawsuit to Marvin Windows on breach of warranty. PPG will appeal. Environmental contingencies: PPG accrued $29 million in 2001 where liability probable as reserves (total reserves of $94 million). Possible environmental loss contingencies of $200-400 million considered reasonably possible (but unreserved). Do these disclosures change your viewpoint on these companies as potential investments? Explain. How do these disclosures fit into (1) evaluation of earnings management, (2) red flag potential, and (3) reevaluation or restatement of financial statements? Problem 7.6. Cash flow analysis. The following information is given below for fiscal year 2001 (millions): Du Pont Dow PPG Cash flow from operations (CFO) $2,419 $1,789 $1,060 Cash Flows from investments (CFI) 6,220* -2,674 -245 Cash flows from financing (CFF) -4,043 831 -816 Total Liabilities 23,443 25,522 5,250 Number of Shares Outstanding 1,089 981 168 Net Income 4,339 -385 387 Basic earnings per share (EPS) 4.18 -0.46 2.30 Stock Price, 5/01/02 44.63 31.49 52.22 * Includes proceeds from sale of Du Pont Pharmaceuticals for $7,798 a. Calculate the following:
Free Cash Flows (FCF) CFO / Total Liabilities CFO per Share Price/ CFO per Share PE
Du Pont $8,639 10.32% $2.22 $20.09 10.677
Dow $-885 7.01% $1.82 $17.27 NM
PPG $815 20.19% $6.31 $8.28 22.704
Dow $1,214 2,992 1,587
PPG $870 902 291
The following additional information is given:
CFO, 2000 CFO, 1999 Capital Expenditures, 2001
Du Pont $5,070 4,840 1,296
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 74
Capital Expenditures, 2000 1,925 Capital Expenditures, 1999 2,055 Inventory Additions, 2001 -362* Inventory Additions, 2000 727 Inventory Additions, 1999 384 Cash Dividends, 2001 1,501 Cash Dividends, 2000 1,465 Cash Dividends, 1999 1,511 * Indicates decrease in inventory for the year
156 115 34 -489* 79 1,162 783 771
561 490 -187* 92 7 276 276 264
b. Calculate cash flow adequacy ratios:
Cash Flow Adequacy
Du Pont 1.17
Dow 1.43
PPG 1.37
c. Analyze cash flows for Du Pont relative to Dow and PPG. Problems 7.7-7.12 Relate to the Hotel Industry. Problem 7.7. Financial Accounting Overview. A review of Note 1 (Accounting Policies) of three hotel and resort companies provides the following information:
Revenue Recognition
Hilton Recognized as services are performed; management fees & franchise fees based on contract
Marketable Securities
Held-to-maturity
Inventory
Time share properties Recorded at cost, straight-line depreciation Self insured Forward exchange contracts, interest rate swaps
Property, Plant & Equipment Insurance Hedging
Marriott Management fees based on contract; distribution services when shipped & title passes to customer; timeshare when 10% of sales price received Trading, held-tomaturity, or available-for-sale Not mentioned
Mandalay Casino revenues, cash basis less incentives; hotel services as performed, less complementary allowances
Recorded at cost, straight-line depreciation Not mentioned Not mentioned
Recorded at cost, straight-line depreciation No mentioned Interest rate swaps
Held-to-maturity
FIFO & Average
Are there differences in accounting policies across these companies? Explain. Does this information suggest earnings management or the need for further analysis? Explain. Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 75
The fact that Marriot does not disclose its Inventory Valuation method may cause a red flag. In addition to that, neither Marriot nor Mandalay discloses Insurance processes. Once again, based on Hedging, Marriot does not disclose its practices. Taken together, Marriot seems unreliable and a red flag appropriate. Problem 7.8. EBIT and EBITDA. Given below are summary earnings numbers for the three hotel and resort companies for 2001:
Net Income Income from Continuing Operations Provision for Income Tax Interest Expense Depreciation and Amortization
Hilton $174 176 130 237 187
Marriott $236 236 134 109 222
Mandalay $53 53 40 230 216
a. Based on this information, calculate EBIT and EBITDA and the percentage change over net income for EBIT ([Net Income – EBIT]/Net Income) and EBITDA ([Net Income – EBITDA]/Net Income).
EBIT EBIT % change from Net Income EBITDA EBITDA % change from Net Income
Hilton $543 2.1x $730 3.2x
Marriott $479 1.0x $701 2.0x
Mandalay $323 5.0x $539 9.2x
Marriott $10,152 8,672 3,372.5
Mandalay $2,639 4,142.5 1,005
Supplementary information for the current year:
Sales Average Total Assets Average Equity
Hilton $2,150 8,962.5 1,712.5
b. Calculate alternative profitability ratios. Net Income Return on Sales Return on Total Assets Return on Equity EBIT Return on Sales Return on Total Assets Return on Equity
Hilton 8.1% 2.0 10.2 Hilton 25.3% 6.1 31.7
Marriott 2.3% 2.7 7.0 Marriott 4.7% 5.5 14.2
Mandalay 2.0% 1.3 5.3 Mandalay 12.2% 7.8 32.1
EBITDA
Hilton
Marriott
Mandalay
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 76
Return on Sales Return on Total Assets Return on Equity
34.0% 8.1 42.6
6.9% 8.1 20.8
20.4% 13.0 53.6
c. Based on the information above, evaluate the useful of EBIT and EBITDA as alternative earnings numbers. Problem 7.9. Alternative Bottom Line Ratios for Hilton. Given below is summary information from Hilton’s income statement for the last three years (in millions).
Sales Income from Continuing Operations (ICO) Accounting Change Net Income (NI) Translation Adjustment Unrealized Gains on Marketable Securities Comprehensive Income (CI)
2001 $3,050 166
2000 $3,451 272
1999 $2,150 176
166 -2 -9
272 -1 -17
-2 174 -1 25
155
254
198
Calculate return on sales using (1) income from continuing operations (ICO / sales); (2) net income (NI / sales); and (3) comprehensive income (CI / sales).
ICO / Sales NI / Sales CI / Sales
2001 5.44% 5.44% 5.08%
2000 7.88% 7.88% 7.36%
1999 8.19% 8.09% 9.21%
Problem7.10. Comprehensive Income. Given are summaries of comprehensive income tables for three hotel and resort companies for 2001 (in millions):
Net Income Unrealized Gains & LossesMarketable Securities Foreign Currency Translation Gains & Losses Pension Liability Adjustment Other Comprehensive Income Comprehensive Income / Net Income *FYE Jan. 02
Hilton $166 -9
Marriott $236
Mandalay* $53
-84
1 -16 38 71.70%
-2
155 93.37%
152 64.41%
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 77
Calculate comprehensive income as a percent of net income (comprehensive income / net income) for these companies. Is this new information useful? Explain. Is it a better measure of the bottom line than net income? Explain Problem 7.11. Contingencies. Given are highlights from contingency footnotes of three hotel and resort companies. Hilton: Various lawsuits are pending against us, not expected to be material. Marriott: Lawsuit from partners using RICO claims for kick-backs, concealing transactions, etc., seeking $140 million, outcome unknown. Mandalay: Various lawsuits, including Detroit casino effort, outcome unknown. Do these disclosures change your viewpoint on these companies as potential investments? Explain. How do these disclosures fit into (1) evaluation of earnings management, (2) red flag potential, and (3) reevaluation or restatement of financial statements? Problem 7.12. Cash flow analysis. The following information is given below for fiscal year 2001 (millions):
Cash flow from operations (CFO) Cash Flows from investments (CFI) Cash flows from financing (CFF) Total Liabilities Number of Shares Outstanding Net Income Basic earnings per share (EPS) Stock Price, 5/01/02 a.
Hilton $585 -154 -443 7,002 369 166 0.45 16.00
Marriott $400 -481 564 5,629 245 166 0.97 44.03
Mandalay $358 -160 -198 3,097 76 53 0.73 7.13
Hilton $739 8.35% $1.59 10.09 35.56
Marriott $881 7.11% $1.63 26.97 45.39
Mandalay $518 11.56% $4.71 1.51 9.77
Marriott $850 711 560
Mandalay $436 225 156
Calculate the following:
Free Cash Flows (FCF) CFO / Total Liabilities CFO per Share Price/ CFO per Share PE
The following additional information is given:
CFO, 2000 CFO, 1999 Capital Expenditures, 2001
Hilton $589 279 370
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 78
Capital Expenditures, 2000 458 Capital Expenditures, 1999 254 Inventory Additions, 2001 -19 Inventory Additions, 2000 -26 Inventory Additions, 1999 -30 Cash Dividends, 2001 30 Cash Dividends, 2000 29 Cash Dividends, 1999 23 * Indicates decrease in inventory for the year
1,095 929 1 -4 -17 61 55 52
110 352 -20 5 0 0 0
b. Calculate cash flow adequacy ratios:
Cash Flow Adequacy
Hilton 1.33
Marriott 0.72
Mandalay 1.69
c. Analyze cash flows for Hilton relative to Marriott and Mandalay. Cases Case 7.1. Contingencies at Microsoft. Microsoft’s 1999 Annual Report reviewed contingencies in Note 17. Included is a discussion of the antitrust suit filed by the Justice Department and various state Attorneys General in 1998. This discussion is quite lengthy, but end with: “Management currently believes that resolving these matters will not have a material impact on the Company’s financial position or its results of operations” (p. 28). On April 3, 2000, U.S. District Judge Thomas P. Jackson found that Microsoft engaged in anticompetitive conduct in violation of antitrust laws. On June 7, he ordered the company split into two parts. On June 20, Jackson sent the Microsoft case directly to the Supreme Court, but delayed imposing restrictions on Microsoft business practices. Microsoft’s stock chart for the year (CNNFN) is:
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 79
Evaluate the adequacy of Microsoft’s contingency disclosure, given the court actions. How has the market reacted to these events? Microsoft’s contingency disclosure seemed to understate to potential for a negative antitrust outcome. This is reflected in the market reaction, which was quite negative after the announcement. Case 7.2. Revenue recognition associated with frequent flyer miles. Frequent flyer miles were discussed earlier as a potential expense and liability. Airlines also sell mileage to hotels, car rental agencies, and credit card companies. This is a revenue item. How should these be recognized? Revenue recognition policies for five airlines are given below: Airline Continental AMR (American) UAL (United) Delta US Air
Revenue Recognition Policy Revenue is deferred and recognized when transportation provided. Revenue is deferred and recognized over period approximating when mileage credits are used Revenue is recognized when the credits are sold (policy to change for future years) Revenue is recognized as operating revenue at time of sale Revenue is recognized as other operating revenue when credits are sold
Evaluate the revenue recognition policies or each airline given the revenue recognition criteria of the FASB. The airlines treated frequent flyer miles different, from aggressive (Delta) to conservative (Continental). Judgment and analysis of the circumstances can result in policy differences. Case 7.3. Restatement of Xerox Revenue. Xerox had the following press release on June 28, 2002: Xerox Corporation (NYSE: XRX) announced that it expects to file today the company's 2001 10-K, which includes a restatement for the years 1997 through 2000 as well as adjustments to previously announced 2001 results. The restatement, required under the company's previously announced settlement agreement with the Securities and Exchange Commission, primarily reflects changes to the company's lease accounting under Statement of Financial Accounting Standards No. 13. As a result, adjustments have been made to the timing and allocation of equipment, service, rental and finance revenue streams. Approximately $1.9 billion of revenue that was recognized over past years has been reversed and will be recognized in the company's future results, beginning in 2002. The monetary value of customers' contracts has not changed and there is no impact on the cash that has been received or is contractually due to be received.
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 80 For 1997 through 2001, the company reversed $6.4 billion of previously recorded equipment sale revenue offset by $5.1 billion of revenue that has been recognized and reported during the same period as service, rental, document outsourcing and financing revenues. Revenues for 1997-2001 have been reduced by 2 percent to $91 billion. The 2001 Revised 10-K had the following reconciliation of revenue: 2001 ---$ 16,502
2000 ---$ 18,701
1999 ---$ 19,567
1998 ---$ 19,593
1997 ---$ 18,225
522
45
(503)
(694)
(744)
Revenue, previously reported Application of SFAS No. 13: Revenue allocations in bundled arrangements 65 (78) (257) (284) (87) Latin America - operating lease accounting 187 (58) 57 (358) (461) Other transactions not qualifying as sales-type leases 73 57 (60) (119) (152) Sales of equipment subject to operating leases 197 124 (243) 67 (44) -------- ----------------------------Subtotal Other revenue restatement adjustments: Sales of receivables transactions South Africa deconsolidation Other revenue items, net Subtotal Increase (decrease) in total revenue Revenues, restated
42 61 (66) (72) 8 16 -------- -------(16) 5 506 50 -------- -------$ 17,008 18,751 ======= ======
(6) --(71) (60) -8 (62) (24) ---------------------(69) (122) (24) (572) (816) (768) ---------------------$ 18,995 $ 18,777 $ 17,457 ====== ====== ======
a. Calculate the percentage change in revenue for leases & total for each year ([revised – previous] / previous). 2001 2000 1999 1998 1997 Leases 3.2% 0.2% -2.6% -3.5% -4.1% Total 3.1 0.3 -2.9 4.2 4.3 Pre-tax earnings were restated as follows. 2001 2000 1999 1998 1997 Pre-tax (loss) income, previously reported $(137) $(384) $1,908 $579 $2,005 Pre-tax income (loss), restated $ 365 $ (367) $1,288 $ (13) $1,287 ====== ===== ===== ==== =====
b. Calculate the dollar amount and percentage change in pre-tax earnings:
Earning change % change
2001 $502
2000 $17
1999 $-620
1998 $-592
1997 $-718
-3.7%
-9.2%
-32.5%
-1.0x
-35.8%
The impact on the 2001 income statement was reported as: Year ended December 31, 2001 (millions) Total Revenues
Previously Reported
As Adjusted
$16,502
$17,008
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 81 Sales Service, outsourcing, financing and rentals Total Costs and Expenses Net Loss Diluted Loss per Share
8,028 8,474 16,639 (293) $ (0.43)
7,443 9,565 16,643 (71) $ (0.12)
c. Calculate the change and percentage change for these amounts:
Total Revenue Sales Services, etc. Total costs & expenses Net Loss
$ Change $-506 -585 1,091 4 222
% Change 3.0% 7.3 2.9 0 75.8
The stock chart year-to-date for Xerox compared to the Dow Jones average is:
d. Evaluate the impact of earnings management of revenue at Xerox in terms of performance and the evaluation of investors. Ethics Considerations. Operating Expenses Capitalized at World Com. On June 26, 2002 World Com announced that $3.8 billion in operating expenses had been misstated as capital items in the previous five quarters. Therefore, the $1.2 billion in earnings was wiped out and the company had a real loss of over $2 billion. It would have had to restate its earnings on the next 10-Q; however, the company filed for Chapter 11 bankruptcy instead on July 22. With assets listed at $107 billion, World Com became the largest firm ever to file for bankruptcy (beating out Enron, which had assets of $63.4 billion). At its peak, the company had a market capitalization of about $120 billion in 1999. This was earnings manipulation on a large scale, the only purpose of which was to camouflage real performance for as long as possible. Evaluate this use of manipulation from the perspective of the senior management, board of directors, investors, and the general public. Senior Earnings manipulation seems to work for short-term gain. However, it Management is short-sighted, especially since long-term credibility is negatively Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 82
Board of Directors Investors
General Public
affected; if violations are criminal the executives have the potential for both civil and criminal penalties The existence of manipulation violates the board’s corporate governance responsibilities and can lead to legal liabilities Investors will be misled by manipulation and may substantially misprice the security’s value. As in the case of WorldCom, the result is a 100% loss The question is trust. Without trust, this may affect not only investment decisions but also employment, purchase, credit and political decisions
Internet Projects Project 7.1. Report update using the internet. Using a company picked in earlier problems, do a search for the most recently available reports. Search the company web page for earnings or other media announcements. Check the SEC filings for both 10-K and 10-Q reports. Describe the most recent information available, based on information completeness versus timeliness.
Giroux • FINANCIAL STATEMENT ANALYSIS
8. Accounting Analysis: Specific Issues I Questions 1. Why are there three categories of marketable securities? How is each accounted for? 2. What are the alternative ways that inventory is accounted for? Why are alternatives allowed? What is lower of cost or market? 3. Straight line depreciation is usually used for accounting purposes and accelerated depreciation for tax. Why? 4. Why is the relative age of fixed assets important? How can age be estimated? 5. What is the statutory corporate tax rate? Why would the effective rate differ from the statutory rate? How can this be evaluated? 6. What is off-balance-sheet financing? Why is this related to earnings management? 1 1. Held to Maturity- recorded at historical cost. 2. Available for Sale-investor intends to sell, reported at fair value. When adjusted to fair value, Unrealized Gains and Losses may occur, this account belongs in Comprehensive Income. 3. Trading Securities-these are reported at fair value. However, Gains and Losses resulting from adjusting to market value are reported on the Income Statement. 2 LIFO, FIFO, and Avg. Cost. Alternatives are allowed to compromise with companies to adopt one of the three standards. Lower of Cost or Market is used for inventory valuation, required by GAAP, and states that inventory should be recorded at either the lesser of Original Cost or Current Market Value. 3 Straight-line depreciation smoothes the cost of fixed assets evenly over the useful life. In reality, this is not always so. More than likely, a company will derive more use in earlier periods than later periods. Therefore, the IRS requires the use of MACRS Accelerated Depreciation which recognizes more depreciation expense in earlier years than in later years. 4 Age can be estimated by dividing Accumulated Depreciation by Depreciation Expense (assuming straight-line depreciation). Determining the age of assets is important to investors since old fixed assets may have a greater likelihood of failure than newer ones. Shorter lives represent newer companies and/or newer investments. 5 The US statutory tax rate is 35%. Since Tax Expenses Can be Deferred as an Asset or Liability, companies do not always pay a straight-up 35%, instead may pay more or less. By dividing actual tax expense by Taxable Income, one can find the Effective rate. 6 Off Balance Sheet financing uses Leases to create revenue using equipment not in ownership. When equipment is leased to another company, the lessor no longer claims it as its own asset yet receives annual rents from the lessee. Upon the termination of the lease, the lessee can either buy it at a purchase
SOLUTIONS MANUAL • CHAPTER 8 84
option or return it to the lessor. The lessor can eradicate both the leased asset and the debt to finance the asset when a lease contract begins, thus leases can be used to doctor financial results. Problems Problems 8.1-8.5 Relate to the Chemical Industry Problem 8.1. Marketable Securities in the Chemical Industry. Given below are the marketable securities totals and other asset information for two chemical companies for 2001 (in millions) [Note: PPG reports financial instruments, but does not break out marketable securities]: Du Pont $85 Available-for-sale & held-to-maturity 14,801 40,319
Marketable Securities Policy Total Current Assets Total Assets
Dow $44 Available-for-sale and held-to-maturity 10,308 35,515
a. Calculate marketable securities as a percentage of current assets and total assets.
Marketable Securities / Total Current Assets Marketable Securities / Total Assets
Du Pont 0.57%
Dow 0.43%
0.21%
0.12%
b. Evaluate the use of marketable securities accounted for both companies. Problem 8.2. Inventory in the Chemical Industry. Given below are the 2001 inventory and related information for three chemical companies (in millions).
Inventory Finished Goods, Work in Progress Materials Policy Total Current Assets
Du Pont $4,681 3,837
Dow $4,440 3,569
PPG $904 622
844 LIFO, FIFO* 14,801
871 LIFO, FIFO, Avg. 10,308
166 LIFO 2,703
a. Calculate inventory as a percent of total current assets and finished goods and materials to total inventory percentages. Du Pont Dow PPG Inventory / Total 32% 43% 33% Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 8 85
Current Assets Finished Goods / Inventory Materials / Inventory
82%
80%
69%
18%
20%
18%
b. Analyze differences of ratios and policy based on business strategy and other financial analysis factors. Problem 8.3. Depreciation in the Chemical Industry. Given below are 2001 depreciationrelated numbers for three chemical companies (in millions).
Accumulated Depreciation Depreciation Expense Ending Gross Investment
Du Pont $20,491
Dow $22,311
PPG $4,101
1,320
1,595
375
33,778
35,890
7,153
a. Calculate the following fixed asset age and useful life ratios:
Average Age Average Age % Average Depreciable Life
Du Pont 15.52 61% 25.59
Dow 13.99 62% 22.50
PPG 10.94 57% 19.07
b. Analyze these ratios with particular focus on what they mean across the three companies in this industry. Problem 8.4. Income Tax Allocation in the Chemical Industry. Given below is 2001 income tax-related information for three companies in the chemical industry:
Pretax Income Income Tax Expense Taxes Payable
Du Pont $6,844 2,467
Dow $-613 -228
PPG $666 247
1,880
-
241
a. Calculate the reported effective tax rate and taxes payable rate for these companies.
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 8 86
Reported Effective Tax Rate Taxes Payable Rate b.
Du Pont 36.1%
Dow NA
PPG 37.1%
27.5%
0%
36.2%
Analyze these ratios for each company.
Problem 8.5. Operating Leases in the Chemical Industry. Given below is 2001 lease information. Calculate minimum lease payments / total assets.
Minimum Lease Payments (millions)
Total Assets (millions)
Du Pont
$905
$40,319
Dow
1,833
35,515
PPG
275
8,452
Minimum Lease Payments / Total Assets 2.2% 5.2% 3.3%
b. Do any of these ratios raise a concern (10% or above)? Problems 8.6-8.8 Relate to the Hotel and Resort Industry Problem 8.6. Depreciation in the Hotel & Resort Industry. Given below are 2001 depreciationrelated numbers for three chemical companies (in millions).
Accumulated Depreciation Depreciation Expense Ending Gross Investment
Hilton $1,154
Marriott $559
Mandalay $1,162
391
222
216
5,065
3,489
4,212
a. Calculate the following fixed asset age and useful life ratios:
Average Age Average Age % Average Depreciable Life
Hilton 2.95 23% 12.95
Marriott 2.52 16% 15.72
Giroux • FINANCIAL STATEMENT ANALYSIS
Mandalay 5.38 28% 19.50
SOLUTIONS MANUAL • CHAPTER 8 87
b. Analyze these ratios with particular focus on what they mean across the three companies in this industry. Problem 8.7. Income Tax Allocation in the Hotel & Resort Industry. Given below is 2001 income tax-related information for three companies in the chemical industry:
Pretax Income Income Tax Expense Taxes Payable
Hilton $250 77
Marriott $370 134
Mandalay $93 40
29
54
12
c. Calculate the reported effective tax rate and taxes payable rate for these companies.
Reported Effective Tax Rate Taxes Payable Rate b.
Hilton 31%
Marriott 36%
Mandalay 43%
12%
15%
13%
Analyze these ratios for each company.
Problem 8.8. Operating Leases in the Hotel & Resort Industry. Given below is 2001 lease information. Calculate minimum lease payments / total assets.
Minimum Lease Payments (millions)
Total Assets (millions)
Hilton
$233
$8,785
Marriott
2,190
9,107
Mandalay
124
4,037
Minimum Lease Payments / Total Assets 2.7% 24.1% 3.1%
b.
Do any of these ratios raise a concern (10% or above)?
c.
Calculate debt ratios and recalculate them adding operating leases for Marriott.
Total Liabilities Total Assets
Balance Sheet $5,629 9,107
Operating Leases $2,190 2,190
Giroux • FINANCIAL STATEMENT ANALYSIS
Adjusted 7189 11297
SOLUTIONS MANUAL • CHAPTER 8 88
Total Stockholders’ Equity Debt to Equity Debt Ratio
3,478
3478
1.62x 61.81%
2.07 63.64%
Cases Case 8.1. Investment income & loss at Microsoft. Microsoft reported the following Investment Income information in the 2001 10-K: The components of investment income/(loss) are as follows:
In Millions / Year Ended June 30 Dividends
1999 $ 118
2000 $ 363
Interest Net recognized gains/(losses) on investments
1,030 803 $1,951
1,231 1,732 $3,326
Investment income/(loss)
$
2001 377 1,808 (2,221) $ (36)
Microsoft went from a large gain of $3.3 billion to a $36 million loss. This had a dramatic effect on the income statement (selectively presented): Year Ended June 30 Revenue
1999 $19,747
2000 $22,956
Operating income Losses on equity investees and other Investment income/(loss) Income before income taxes Provision for income taxes Income before accounting change Cumulative effect of accounting change (net of income taxes of $185) Net income
$10,010 (70) 1,951 11,891 4,106 7,785
$11,006 (57) 3,326 14,275 4,854 9,421
2001 $25,29 6 $11,720 (159) (36) 11,525 3,804 7,721
— $ 7,785
— $ 9,421
(375) $ 7,346
a. The result of the investment loss in 2001 is that net income declined despite increasing operating income. Calculate common-size information below:
Revenue
1999
2000
2001
100.0%
100.0%
100.0%
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 8 89
Operating Income
50.7
47.9
46.3
Investment Income (loss)
-0.4
-14.5
-0.1
Net income
39.4
41.0
29.0
b. Evaluate the impact of Microsoft’s investment income (loss) on overall operating results? Note that Microsoft also reported a $1.2 billion unrealized holding loss(net of taxes of $351 million) as part of comprehensive income. How important is this in determining a buy or sell equity decision? Case 8.2. Leases in the Airline Industry. Given below are minimum operating lease payments and total assets for four airlines (in millions).
Minimum Lease Payments (millions)
Total Assets (millions)
Minimum Lease Payments / Total Assets
American (AMR)
$17,661
$32,841
53.8%
United (UAL)
24,538
25,197
97.3
Northwest
8,610
12,955
66.5%
a. Calculate the minimum lease payments / total assets. Are these a concern? Explain. b. Calculate the present value to total minimum payments for capital leases & using this percentage estimate the present value of operating lease payments:
AMR UAL Northwest
Capital Lease
Present Value of Capital Leases
$2,557 3,161 1,104
$1,740 2,180 586
PV to Total Minimum Capital Lease Operating % Lease Payments 68.1% 69.0 53.1
$17,661 24,538 8,610
Estimated PV of Operating Lease Payments $12,018 16,923 4,570
c. Given the information below, calculated the debt to equity and adjusted debt to equity ratios (assuming the present value of minimum lease payment for operating lease is the same as capital leases for each company). AMR
UAL
Giroux • FINANCIAL STATEMENT ANALYSIS
Northwest
SOLUTIONS MANUAL • CHAPTER 8 90
Total Liabilities, Balance Sheet Total Assets, Balance Sheet Operating Lease (at Estimated PV) Total Liabilities, Adjusted Total Assets, Adjusted Total Stockholders’ Equity Debt to Equity Ratio Debt to Equity, Adjusted
$27,690 32,841 12,018 60,531 44,859 5,373 5.2x 11.3x
$22,164 25,197 16,923 39,087 42,120 3,033 8.3x 12.9x
$13,386 12,955 4,570 17,956 17,525 -431 RF NM NM
d. Analyze the impact of operating leases on the debt to equity ratio. Does this suggest earnings management? Explain. Case 8.3. What happened at Enron? Enron was the seventh largest of the Fortune 500 early in 2001 and considered a successful energy-related company successfully using derivatives to buy and sell not only energy, but virtually anything including the weather. The stock chart indicates the market reaction to Enron in 2001:
From a high over 90 in August 2000 the stock continued down over the entire second half of the year, until declaring bankruptcy in early December when the price essentially went to zero. What happened? Until the 3rd Quarter 10-Q the financial statements weren’t much help. They showed a profitable company, although leverage was high. What was not obvious was earnings manipulation on a vast scale. The third quarter results were announced October 16 and the 10-Q released November 19. The SEC announced a formal investigation on October 31. Financial statements were restated from 1997, resulting in a decrease in stockholders’ equity over $1 billion. The company filed for Chapter 11 bankruptcy December 2. Note the large drop-off in price beginning around the October 16 announcement. Highlights of the 3rd quarter 10-K. First, the restated net income and stockholders’ equity since 1997 (in millions). Calculate the difference and percentage difference for each year.
Net Income, Reported
1997 $105
1998 $703
1999 $893
2000 $979
Giroux • FINANCIAL STATEMENT ANALYSIS
2001* $829
SOLUTIONS MANUAL • CHAPTER 8 91
Net Income, Restated Difference % Difference *First two quarters only
26 -79 -75.2%
564 -139 -19.8%
635 -258 -28.9%
842 -137 -14.0%
869 40 4.8%
1997 $5,618 5,309 -309 -55.0%
1998 $7,048 6,600 -448 -6.4%
1999 $9,570 8,724 -846 -8.8%
2000 $11,470 10,289 -1,181 10.3%
2001* $11,740 10,787 -953 8.1%
Equity, Reported Equity, Restated Difference % Difference *First two quarters only Third quarter earnings summary, compared to same quarter, 2000 (in millions, restated). Calculate common-size percentages. 3rd Qtr. 2001 Revenues Operating Income Net Income
3rd Qtr. 2000
$46,877 -917
3rd Qtr 2001, Common-size 100.0% -2.0% RF
$29,834 533
3rd Qtr 2000, Common-size 100.0% 1.7%
-644
-1.4% RF
282
1.0%
Third quarter balance sheet summary, compared to December 31, 2000 (in millions, restated). Calculate common-size percentages. 3rd Qtr. 2001 Cash Current Assets Total Assets Current Liabilities Total Liabilities Stockholders’ Equity
$1,001 24,847 61,783 27,003
3rd Qtr. 2001, Common-size 1.6% 40.2 100.0 43.7
17,407 9,598
28.2 15.5
12/31/2000 $1,240 30,027 64,926 28,741
12/31/2000, Common-size 1.9% 46.4 100.0 44.3
18,452 10,289
28.4 15.9
Calculate basic financial ratios, including cash, current, debt to equity, return on sales, and return on equity:
Cash Ratio Current Ratio Debt to Equity Return on Sales Return on Equity
3rd Qtr, 2001 3.7% 92.0% RF 1.8x -1.4% RF -6.7% RF
Earlier Period 6.7% 1.0x 1.8x 1.0% 2.7%
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 8 92
Rate Enron from 1-10 based on this abbreviated quantitative analysis. How useful are the financial numbers in predicting the potential for bankruptcy for Enron? Based on the information presented, what was the most useful indicator of severe financial problems? Ethics Considerations. What Happened at Enron: Corporate Governance and Accounting. The chief executives at Enron all resigned and testified before Congress (most took the fifth). The company’s bankruptcy represented a financial failure. Who was at fault? Chairman and CEO Kenneth Lay claimed that all accounting issues were accepted by auditor Arthur Andersen. Many of the special purpose entities that now seem deceptive were developed by Andersen as part of their consulting operation. How much of the blame should be placed on corporate executives versus Arthur Andersen? A major problem is the split responsibility for these manipulative and potentially illegal acts. The senior management would seem to be responsible, but claim that they were vetted by both auditors and lawyers. There seems to be plenty of blame to go around.
Internet Projects Project 8.1. Evaluating Enron. Access Enron’s 3rd quarter 10-Q and 2000 10-K and any other internet sources on Enron. Use the 10-Q to evaluate the three special purpose entities that were restated. Describe the use of earnings manipulation by Enron. Why was it effective? Can financial reporting be improved to better predict the presence of earnings manipulation? Explain.
Giroux • FINANCIAL STATEMENT ANALYSIS
9. Accounting Analysis: Specific Issues 2 Questions 1. What are stock options and why are they issued to managers and employees? 2. Why is segment reporting useful when evaluating large corporations? Are current requirements adequate? Explain. 3. How did the gold standard worked when it was the standard for all currency valuations? Compare that to the current system of fluctuating currencies. Is the present system superior or not? Explain. 4. How do fluctuating currencies impact foreign operations for domestic firms? What are the current accounting procedures for these activities? 5. What are the relative merits of defined benefit and defined contribution? pension plans? What are the major accounting requirements for defined benefit plans? 6. Are other post-employment benefits liabilities? Explain. Contrast OPEB accounting with pension accounting. 7. What is a derivative? How can derivates be used for hedging? How can derivatives be used for speculation? Can financial analysts effectively evaluate the risks associated with derivatives? 1 Stock Options are offered to managers and employees as incentive for corporate success. Employees and Managers are granted the options at a set price at an exercise date; this price remains constant. The holder of the option must usually wait until a stated amount of time (exercise period) until he can exercise the options. When done, the holder pays only the exercise price for stock which, ideally, has appreciated over time. 2 Segment reporting clarifies the distinct operations of large companies which may have several business lines, or client groups, for example. Currently, FAS allows companies to choose how they report segments (geographically, by clientele, product, etc.) therefore it is difficult to compare segments of different companies. 3 The Gold Standard tied currencies to an equivalent amount of gold, which resulted in little fluctuation. Presently, currencies fluctuate in relation to each other and foreign currencies are seen as how many are needed to buy $1, thus a commodity behavior. This new standard facilitates multinational business. 4 Fluctuating currencies cause foreign currency translation gains and losses. Balance sheet items (assets and liabilities) of foreign firms are translated at the exchange rate at the end of the period. Stock is translated at its historical exchange rate (or the rate the company acquires the operations of another country) and Income items are translated at an average exchange rate. Whatever is needed to balance the translated (now in USD) Balance sheet is the foreign currency translation gain/loss. 5 Defined Contribution Plans -no specific level of benefits is promised -Pension contributions by both parties are tax-exempt and earnings on invested assets are deferred until retirement -compensation plans such as this can increase loyalty
SOLUTIONS MANUAL • CHAPTER 9 94
Defined Benefit Plans -retirement benefits received are specified and guaranteed -considerable room for judgment, allowing earnings management -A company may keep their benefit plan over or under-funded. The cash contribution and funded states directly affects how much or LITTLE tax expense is recognized in a period. Companies must disclose extensive Benefit Plan status in the Notes to the financial statement. 6 Other Post Employment Benefits are required to be disclosed as liabilities. Costs of OPEB’s however, are not tax deductible. 7 A derivative is a financial contract derived from another contract. (options, futures, interest rates, foreign currencies, mortgage-backed securities, ex.) Hedging helps to reduce various market risk aspects. Companies can use hedging tools to set a price to buy stock (options for example) at a future date to avoid risk of fluctuating prices. It is difficult to evaluate the risks inherent in derivatives since the risk is, in effect, in the future. Problems Problems 9.1-9.5 Relate to the Chemical Industry Problem 9.1. Impact of Stock Options & Equity Dilution in the Chemical Industry. a. Chemical companies have the following stock options outstanding and total common shares outstanding. Calculate the options to shares outstanding percentage for fiscal year 2001 (in millions).
Du Pont Dow PPG
Stock Options Outstanding 73.2 67.5 14.5
Shares Outstanding 1,089 981 168
Options to Shares Outstanding 6.7% 6.9 8.7
b. Chemical companies have the following net income & pro forma income numbers. Calculate the difference & % difference as if stock options were treated as an expense.
Net Income—Reported Net Income—Pro forma Difference % Difference
Du Pont $4,339 4,249 90.00 2.07%
Dow $-385 -444 59.00 NM
PPG $387 24 363 93.8% RF
c. How significant is the potential dilution of stockholders’ equity for these three chemical companies? Explain Problem 9.2. Segment Reporting in the Chemical Industry.
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 9 95
a. Du Pont reports the following industry segment information for 2001 (in millions): Agricul. Nylon Perform Pharma- Pigments Polyester Specialty Specialty & Coating ceuticals & Fibers Polymers Nutrition & Poly. Chemicals Sales $4,316 $2,696 $5,754 $902 $3,554 $1,895 $4,418 $3,875 Operating 19 -75 319 3,924** 439 -349 356 372 Income* Net 8,998 1,838 3,927 102 1,732 2,042 4,213 2,513 Assets * After tax **Sold in 2001 for a gain Calculate (1) operating income / sales and (2) sales / net (identifiable) assets Agricul Nylon Perform & Coating Nutrition & Poly. Operating 0.44% -2.78% 5.54% Income / RF Sales Sales / 47.97% 146.68% 146.52% Net Assets
Pharmaceuticals
Pigments Polyester Specialty Specialty & Enter. Fibers Polymers Chemicals 435.03% 12.35% -18.42% 8.06% 9.60% RF 884.31%
205.20%
92.80%
104.87%
b. Du Pont has the following geographic segment information for 2001 (in millions). Calculate sales / net assets.
Sales Net Assets Sales / Net Assets
North America $13,613 8,952 152.07%
EMEA $6,431 2,732 235.40%
Asia Pacific $3,657 1,292 283.05%
South America $1,025 311 329.58%
c. Evaluate the segment reporting information for Du Pont. Problem 9.3. Foreign Currency in the Chemical Industry. a. Given are 2001 U.S. and foreign sales (in millions). Calculate foreign sales / total sales.
U.S. Sales Foreign Sales Foreign / Total Sales
Du Pont $12,054 12,672 51.25%
Dow $11,725 16,080 57.83%
Giroux • FINANCIAL STATEMENT ANALYSIS
PPG $5,469 2,700 33.05%
154.20%
SOLUTIONS MANUAL • CHAPTER 9 96
b. Calculate foreign currency translation as a percentage of net income and comprehensive income (stated in millions) for 2001.
Net Income Translation Adjustment Comprehensive Income Translation Adjustment / Net Income Translation Adjustment / Comprehensive Income
Du Pont $4,339 -19
Dow $-385 -148
PPG $387 -131
4,254
-982
238
-0.44%
NM
-33.85%
-0.45%
NM
-55.04%
c. Calculate cumulative foreign currency translations adjustment for the last three years and as a percent of 2001 comprehensive income (stated in millions).
Translation Adjustment, 2000 Translation Adjustment, 1999 Total Translation Adjustment, 99-01 Total Translation Adjustment / 2001 Comprehensive Income
Du Pont $-38
Dow $-188
PPG $-120
$172
$-121
-40
$115.00
-$457.00
-$291.00
2.70%
NM
-75.2%
d. Compare foreign operations and translation adjustments on the operations of these chemical companies. Problem 9.4. Defined benefit pension plans analysis for chemical companies. Given below is pension information for 2001 from pension footnotes and other sources (in millions). Benefit obligation at year-end is total pension liability based on PBO; pension expense is net periodic benefit cost; prepaid pension cost/obligation is net pension asset or liability position on the balance sheet (reported as part of other assets or other liabilities if negative).
Benefit Obligation at yearend Fair Value of Plan Assets Net Periodic Benefit Cost
Du Pont $18,769
Dow $11,341
PPG $2,414
17,923 -374
11,424 -95
2,423 -53
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 9 97
(Pension Expense) Prepaid Pension Cost (Liability) Total Assets Net Income
1,693
177
825
40,319 4,339
35,515 -385
8,452 387
a. Calculate funding status (Over- or Under-funded, based on Prepaid Pension Cost), pension obligation / total assets; prepaid pension cost (obligation) / total assets; and pension expense / net income. Note: Net Pension Benefit Cost is a negative expense for these companies (increases net income), because of positive expected return on plan assets.
Funding Status Benefit Obligation / Total Assets Prepaid Pension Cost / Total Assets Pension Expense / Net Income
Du Pont Over 46.55%
Dow Over 31.93%
PPG Over 28.56%
4.20%
0.50%
9.76%
-8.62%
NM
-13.70%
b. Compare the pension plans of the three chemical companies. Are there any concerns? Explain. Problem 9.5. Other Post-employment Benefits in the Chemical Industry. OPEB numbers are similar to defined benefit plans and usually included in the same footnote(s). The 2001 year-end OPEB balances are stated below (in millions):
OPEB Benefit Obligation Fair Value of Plan Assets Net Amount Recognized Net Benefit Cost (Pension Expense)
Du Pont $5,832
Dow $2,035
PPG $823
0
266
0
-5,633
-1,736
-586
347
214
64
a. Calculate fund status (over- or under-funded, based on Net Amount Recognized), OPEB obligation to total assets, net amount recognized to total assets, and OPEB expense (net benefit cost) to net income.
Funding Status OPEB Obligation / Total Assets
Du Pont Under 14.46%
Dow Under 5.73%
Giroux • FINANCIAL STATEMENT ANALYSIS
PPG Under 9.74%
SOLUTIONS MANUAL • CHAPTER 9 98
Net Amount Recognized / Total Assets OPEB Expense / Net Income
-13.97%
-4.89%
-6.93%
8.00%
NM
16.54%
c. Evaluate OPEB obligations for these chemical companies and the relationship to pension obligations. Are there any concerns? Explain. Problems 9.6-9.10 Relate to the Hotel & Resort Industry Problem 9.6. Impact of Stock Options & Equity Dilution in the Hotel & Resort Industry. a. Hotel & resort companies have the following stock options outstanding and total common shares outstanding. Calculate the options to shares outstanding percentage for fiscal year 2001 (in millions).
Hilton Marriott Mandalay
Stock Options Outstanding 33 20 10
Shares Outstanding 369 245 68
Options to Shares Outstanding 8.94% 8.16% 14.71%
d. Hotel & resort companies have the following net income & pro forma income numbers. Calculate the difference & % difference as if stock options were treated as an expense.
Net Income—Reported Net Income—Pro forma Difference % Difference
Hilton $166 150 -16.00 -9.64%
Marriott $236 187 -49.00 -20.76%
Mandalay $54 43 -11.00 -20.37%
e. How significant is the potential dilution of stockholders’ equity for these three hotel companies? Explain Problem 9.7. Segment Reporting in the Hotel & Resort Industry. a. Hilton reports the following industry segments information for 2001 (in millions).
Hotel Ownership Managing & Franchising Timeshare
Revenues $1,886 120
Operating Income $474 113
Assets $4,925 680
144
22
315
b. Calculate (1) operating income /revenues & (2) revenues / assets Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 9 99
Hotel Ownership Managing & Franchising Timeshare
Operating Income/Revenue Revenues / Assets 25.13% 94.17% 15.28%
38.29% 17.65% 45.71%
c. Evaluate the industry segment information for Hilton. Problem 9.8. Segment Reporting in the Hotel & Resort Industry a. Marriott reports the following industry segment information for 2001 (in millions):
Full-service Lodging Select-service Lodging Extended-service Lodging Time Share Senior Living Distribution Services
Revenues $5,238 864 635 1,049 729 1,637
Operating Income $294 145 55 147 -45 -6
Assets $3,394 931 366 2,107 690 216
b. Calculate (1) operating income / revenues & (2) revenues / assets. Operating Income/Revenues 5.61% 16.78% 8.66% 14.01% -6.17% -0.37%
Full-service Lodging Select-service Lodging Extended-service Lodging Time Share Senior Living Distribution Services
Revenues / Assets 154.33% 92.80% 173.50% 49.79% 105.65% 757.87%
c. Evaluate the industry segment information for Marriott. Problem 9.9. Foreign Currency in the Hotel & Resort Industry. a. Calculate foreign currency translation as a percentage of net income and comprehensive income (stated in millions) for 2001.
Net Income Translation Adjustment Comprehensive Income Translation
Hilton $166 0
Marriott $236 -14
Mandalay 53 0
155
230
38
0.00%
-5.93%
0.00%
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 9 100
Adjustment / Net Income Translation Adjustment / Comprehensive Income
0.00%
-6.09%
0.00%
c. Calculate cumulative foreign currency translations adjustment for the last three years and as a percent of 2001 comprehensive income (stated in millions).
Translation Adjustment, 2000 Translation Adjustment, 1999 Total Translation Adjustment, 99-01 Total Translation Adjustment / 2001 Comprehensive Income
Hilton -1
Marriott -10
Mandalay 0
-1
-18
0
-$2.00
-$42.00
$0.00
-1.29%
-18.26%
0.00%
e. Compare foreign operations and translation adjustments on the operations of these companies. Problem 9.10. Defined benefit pension plans analysis for hotel & resort companies. (None reported for Marriott.) Given below is pension information for 2001 from pension footnotes and other sources (in millions). Benefit obligation at year-end is total pension liability based on PBO; pension expense is net periodic benefit cost; prepaid pension cost/obligation is net pension asset or liability position on the balance sheet (reported as part of other assets or other liabilities if negative).
Benefit Obligation at year-end Fair Value of Plan Assets Net Periodic Benefit Cost (Pension Expense) Prepaid Pension Cost (Liability) Total Assets Net Income
Hilton $248 249 16
Mandalay $55 0 8
1 8,785 166
-15 4,037 53
d. Calculate funding status (Over- or Under-funded, based on Prepaid Pension Cost), pension obligation / total assets; prepaid pension cost (obligation) / total assets; and pension expense / net income. Note: Net Pension Benefit Cost is a negative expense for these companies (increases net income), because of positive expected return on plan assets. Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 9 101
Funding Status Benefit Obligation / Total Assets Prepaid Pension Cost / Total Assets Pension Expense / Net Income
Hilton Over 2.82%
Mandalay Under 1.36%
0.01%
-0.37%
9.64%
15.09%
e. Compare the pension plans of the two hotel & resort companies. Are there any concerns? Explain. Cases Case 9.1. Evaluating stock options and pensions at General Electric. Chapter 6 discusses S&Ps “Core Earning” and uses General Electric (GE) as an example for restating earning information. Two major items in S&Ps Core Earnings are stock options (to be added to net income) and net cost of pensions (to be deducted from net income). The following tables present GE’s stock options information for 2001. Calculate (1) the dilution percentage (options outstanding / total shares outstanding) and (2) pro forma difference percentage (net income difference / net income-reported): Options Outstanding 354 million Net IncomeReported $13,684
Common Stock Outstanding Dilution % 9,926 million 3.6% Net Income-Pro Difference Difference % Forma $13,388 $296 2.2%
GE had a net asset position for pension funding (i.e., the company is over-funded) of $12,415 million for 2001 (fair value of pension assets was $45,006 compared to PBO of $30,423). In addition, the income statement reported net cost reduction from pension of $1,480 million (primarily, expected return on plan assets was higher than pension expenses by this amount). Restate earnings using these two components of S&Ps core earnings: Net Income (reported) + Stock option expense - Pension cost reduction Core Earnings
$13,684 -296 -1,480 11,908
Evaluate net income versus Core Earnings (as identified) for GE. Earnings were reduced $1,776 million or 13.0%, based on core earnings
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 9 102
For 2002, GEs net income is up from $12.7 billion to $13.7 billion, although revenues dropped from $130 billion to $126 billion. GE’s stock price chart year-to-date shows the following:
Can the decline in stock price be best explained by revenues and sales for 2001 or by restatement such as S&P’s Core Earnings? Explain. Both are potential explanations. Both indicators suggest that investors were paying too high a premium for owning GE.
Case 9.2. Extensive Stock Option Reporting at Microsoft. Microsoft had the following disclosures in its 2001 10-K: The Company follows Accounting Principles Board Opinion 25, Accounting for Stock Issued to Employees, to account for stock option and employee stock purchase plans. An alternative method of accounting for stock options is SFAS 123, Accounting for Stock-Based Compensation. Under SFAS 123, employee stock options are valued at grant date using the Black-Scholes valuation model, and this compensation cost is recognized ratably over the vesting period. Had compensation cost for the Company’s stock option and employee stock purchase plans been determined as prescribed by SFAS 123, pro forma income statements for 1999, 2000, and 2001 would have been as follows: In Millions, Except Per Share Amounts Year Ended June 30
Revenue Operating expenses: Cost of revenue Research and development
1999 Reported
2000 2001 Pro Reported Pro Reporte Pro Forma Forma d Forma $19,747 $19,747 $22,956 $22,956 $25,296 $25,296 2,814 2,970
3,013 3,479
3,002 3,772
Giroux • FINANCIAL STATEMENT ANALYSIS
3,277 4,814
3,455 4,379
3,775 6,106
SOLUTIONS MANUAL • CHAPTER 9 103
Sales and marketing General and administrative
3,238 715
3,445 841
4,126 1,050
4,468 1,284
4,885 857
5,888 1,184
Total operating expenses
9,737
10,778
11,950
13,843
13,576
16,953
Operating income Losses on equity investees and other Investment income/(loss)
10,010 (70) 1,951
8,969 (70) 1,951
11,006 (57) 3,326
9,113 (57) 3,326
11,720 (159) (36)
8,343 (159) (36)
Income before income taxes Provision for income taxes
11,891 4,106
10,850 3,741
14,275 4,854
12,382 4,210
11,525 3,804
8,148 2,689
Income before accounting change Cumulative effect of accounting change
7,785 —
7,109 —
9,421 —
8,172 —
7,721 (375)
5,459 (375)
Net income
$ 7,785
$ 7,109
$ 9,421
$ 8,172
$ 7,346
$ 5,084
Basic earnings per share
$ 1.54
$ 1.41
$ 1.81
$ 1.57
$ 1.38
$ 0.95
Diluted earnings per share
$ 1.42
$ 1.30
$ 1.70
$ 1.48
$ 1.32
$ 0.91
Included in this extensive disclosure is the increase in major expense categories if stock options were recorded as expenses. Revenues remain unchanged, while net income declines from $7.4 billion to $5.1 billion. a. Use this table to selectively calculate common-size information for the last two years:
2000 Reported 100%
2000 Pro Forma 100%
2001 Reported 100%
2001 Pro Forma 100%
Cost of revenue
13.1
14.3
13.7
14.9
Research and development
16.4
21.0
17.3
24.1
Sales and marketing
18.0
19.5
19.3
23.3
General and administrative
4.5
5.6
3.4
4.7
52.1
60.3
53.7
67.0
Operating income
47.9
39.7
46.3
32.9
Income before income taxes
62.2
53.9
45.6
32.2
Net income
41.0
35.6
29.0
20.1
Revenue Operating expenses:
Total operating expenses
b. Evaluate the use of stock options by Microsoft. How much of an impact does it make on performance? The use of options increased operating expenses from 53.7% to 67.0%, with particular emphasis on R&D. The net effect was reducing return on sales from 29.0% to 20.1% Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 9 104
c. If all companies prepared this level of detailed information in the stock option footnote, would it be necessary (as several commentators have proposed) to treat stock options as an expense in the income statement? Explain. Either answer can be defended. It is reasonable to claim that this footnote disclosure provides more information than requiring expensing stock options. Case 9.3. Compensation at Disney. Considerable discussion is made on the employment compensation of senior management, especially in difficult periods. A typical argument is if shareholder value increases substantially (especially market value), managers should be richly compensated. Consider Michael Eisner, chairman and CEO of Disney. Under his initial employment contract in 1988, he was paid an annual salary of $750,000 plus a bonus based on performance, eight million stock option shares, and other compensation. Under the 1997 employment contract, base salary could be $1 million (the maximum allowed by IRS for tax deductibility), plus bonus, other compensation and 24 million stock option shares. During much of Eisner’s tenure, Disney has performed well. However, recent performance has suffered. Operating results for the last three years (in millions) are:
Revenues Gross Profit Net Income Total Assets Stockholders’ Equity
2001 $25,269 4,586 -158 43,699 22,672
2000 $25,402 7,512 920 45,027 24,100
1999 $23,402 7,010 1,300 43,679 20,975
a. Calculate return on sales, total assets and equity for the last two years:
Return on Sales Return on Assets Return on Equity
2001 -0.6% RF -0.5% RF -0.7% RF
2000 3.6% 2.1% 4.1%
Market performance for the last five years is summarized in this stock chart (relative to the Dow Jones Average:
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 9 105
b. Evaluate the relative performance of Disney over the last two years. Eisner’s compensation for the last three years is summarized as (from the 2002 Proxy Statement): Year 2001 2000 1999
Base Salary
Bonus
$1,000,000 813,462 750,000
$0 8,500,000 0
Stock Options $0 387,060 0
Other
Total
$4,020 3,004,020 3,820
$1,004,200 12,704,542 753,820
c. Calculate Eisner’s total compensation over the last three years. Compare his compensation to the relative performance of Disney over the same period. Is he appropriately compensated, based on the information presented? Explain. Case 9.4. Financial Risks and the Use of Derivatives at Microsoft. The following comes from Microsoft’s 2001 10-K: The Company is exposed to foreign currency, interest rate, and securities price risks. A portion of these risks is hedged, but fluctuations could impact the Company’s results of operations and financial position. The Company hedges the exposure of accounts receivable and a portion of anticipated revenue to foreign currency fluctuations, primarily with option contracts. The Company monitors its foreign currency exposures daily to maximize the overall effectiveness of its foreign currency hedge positions. Principal currencies hedged include the Euro, Japanese yen, British pound, and Canadian dollar. Fixed income securities are subject to interest rate risk. The portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. The Company routinely uses options to hedge its exposure to interest rate risk in the event of a catastrophic increase in interest rates. Many securities held in the Company’s equity and other investments portfolio are subject to price risk. The Company uses options to hedge its price risk on certain highly volatile equity securities. Foreign Currency Risk Certain forecasted transactions and assets are exposed to foreign currency risk. The Company monitors its foreign currency exposures daily to maximize the overall effectiveness of its foreign currency hedge positions. Principal currencies hedged include the Euro, Japanese yen, British pound, and Canadian dollar. Options used to hedge a portion of forecasted international revenue for up to three years in the future are designated as cash flow hedging instruments. Options and forwards not designated as hedging instruments under SFAS 133 are also used to hedge
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 9 106 the impact of the variability in exchange rates on accounts receivable and collections denominated in certain foreign currencies. Securities Price Risk Strategic equity investments are subject to market price risk. From time to time, the Company uses and designates options to hedge fair values and cash flows on certain equity securities. The security, or forecasted sale thereof, selected for hedging is determined by market conditions, up-front costs, and other relevant factors. Once established, the hedges are not dynamically managed or traded, and are generally not removed until maturity. Interest Rate Risk Fixed-income securities are subject to interest rate risk. The fixed-income portfolio is diversified and consists primarily of investment grade securities to minimize credit risk. The Company routinely uses options, not designated as hedging instruments, to hedge its exposure to interest rate risk in the event of a catastrophic increase in interest rates. Other Derivatives In addition, the Company may invest in warrants to purchase securities of other companies as a strategic investment. Warrants that can be net share settled are deemed derivative financial instruments and are not designated as hedging instruments. For the twelve months ended June 30, 2001, investment income included a net unrealized loss of $592 million, comprised of a $214 million gain for changes in the time value of options for fair value hedges, $211 million loss for changes in the time value of options for cash flow hedges, and $595 million loss for changes in the fair value of derivative instruments not designated as hedging instruments. Derivative gains and losses included in [other comprehensive income] OCI are reclassified into earnings at the time forecasted revenue or the sale of an equity investment is recognized. During the twelve months ended June 30, 2001, $214 million of derivative gains were reclassified to revenue and $416 million of derivative losses were reclassified to investment income/(loss). The derivative losses reclassified to investment income/(loss) were offset by gains on the item being hedged. The Company estimates that $144 million of net derivative gains included in other comprehensive income will be reclassified into earnings within the next twelve months.
For instruments designated as hedges, hedge ineffectiveness, determined in accordance with SFAS 133, had no impact on earnings for the twelve months ended June 30, 2001. No fair value hedges or cash flow hedges were derecognized or discontinued for the twelve months ended June 30, 2001. a. Evaluate the overall effectiveness of the financial risk strategy of using extensive derivative instruments. b. Microsoft recorded 2001 losses from using derivatives. Evaluate the extent of these losses, given the net income for 2001 was $7.3 billion. Does this suggest that Microsoft was effectively hedging or engages in speculative activity? Ethics Considerations. Stock Options and Ethics. A recent Business Week article (J. Byrne, “Restoring Trust in Corporate America,” June 24, 2002) indicates the problems with stock options: Behind the sins of Enron and other corporations was the corrupting effect of stock options. They led to massive CEO pay inflation in the 1990s. But the toxic effects of that rise became clear only as the bull market began to ebb. Even while shareholders were losing millions of dollars, executive after executive seemed to be cashing in on an unsupervised lottery. At now-bankrupt telecom provider Global Crossing Ltd., Chairman Gary Winnick sold $735 million in company stock from 1999 to last November. At Enron,
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 9 107
Chairman Lay sold more than $100 million in stock over the past three years—even while publicly insisting that he wasn’t cashing out. The same was true at Tyco, where CEO Kozlowski and his chief financial officer unloaded more than $500 million in stock, quietly selling it back to the company, a trick that allowed them to delay any public disclosure of their sales (p. 34). a. What is the major problem associated with stock options? Their existence? Their use by corrupt executives? Accounting issues, especially that compensation expenses are not recorded? Other. b. What is the solution to stock options? Should they be disallowed? Regulated more stringently? Subject to accounting reform, especially recording options as a compensation expense. a.
b.
There are a few contenders. First is the dilution of equity, followed by a “real expense” that is not recorded as an expense. Third is the incentive to management to insure that stock price goes up, no matter what manipulation tricks are required There are differences of opinion, from more disclosure to requiring the expensing of options, to government regulations on amount of options and under what circumstances they can be exercised Internet Projects Project 9.1. Derivatives. a. Review the financial statements and notes of Du Pont, Dow and PPG and check if they use any of the following categories of derivatives: Du Pont
Dow
PPG
Options Forward or Futures Contracts Currency Swaps Interest Rate Swaps b. Evaluate the use of derivatives for each company. Project 9.2. Derivatives. Using the company picked in earlier projects, review the 10-K of the company for use of derivatives and complete the following table. Evaluate the use of derivatives for this company. Check, if applicable
Analysis
Options Forward or Futures Contracts Currency Swaps
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 9 108
Interest Rate Swaps
Giroux • FINANCIAL STATEMENT ANALYSIS
10. Business Combinations Questions 1. Why were mergers common 100 years ago? What type of mergers were most common? 2. Why are mergers common today? Are the type(s) of mergers the same today as 100 years ago? Explain. 3. Why is the purchase method the only accounting procedure now allowed for mergers (SFAS No. 141)? 4. What is goodwill? How is it accounted for according to SFAS No. 142? 5. Under what circumstances is an acquisition desirable to the potential acquirer? Target firm? 6. What is the most typical market (stock price) response to the target firm in a merger announcement? Explain. 7. What should be in the executive summary associated with the detailed accounting analysis process? 1 The US economy experienced a boom after the Civil War. This allowed a few people with a high concentration of capital to buy out smaller companies. Mergers in manufacturing and production were most common. 2 There is still need to expand activities and reduce competition. There are more restrictions on current-day mergers (i.e. Microsoft) but the general purpose is the same. 3 Prior to 141 and 142, there was difficulty in comparing purchases by pooling and purchase method. The Purchase method, which adheres to historical cost principles, is now mandated. 4 Goodwill is the excess amount of Assets purchased over Liabilities when acquiring a company or division of a company. In essence, it is the Equity which the acquired division can claim. Currently, Goodwill is carried on the books of the purchaser at the value on the date of purchase and tested annually for impairment of the assets. When impairment occurs, Goodwill is written down. Otherwise, it remains on the book at its value. 5 Characteristics of target firm to be acquired 1. Generally acquire smaller companies 2. high liquidity 3. low leverage 4. over-funded defined benefit pension plans 5. financial difficulties can attract acquirers (IT carry-forwards) 6. Low PE 6 The stock price of the acquired firm generally reaches the target price of the Acquiring company. The price of the acquiring firm can go up or down depending on how confident investors are in the merger. 7 Findings of the detailed accounting analysis belong in the executive summary of corporations.
SOLUTIONS MANUAL • CHAPTER 10 110
Problems Problem 10.1. Goodwill in the Chemical Industry. Given is information on goodwill, amortization & relative size (in million) for 2001:
Du Pont Dow PPG
Goodwill $3,746 1,129 3,130
Amortization $357 29 178
Total Assets $42,319 8,452 35,515
Net Income $4,339 387 -385
a. Calculate amortization as a percent of goodwill & net income & goodwill as a percent of total assets.
Du Pont Dow PPG
Amortization / Amortization / Net Goodwill / Total Goodwill Income Assets 9.53% 8.23% 8.85% 2.57% 7.49% 13.36% 5.69% -46.23% 8.81%
b. Evaluate the impact of goodwill and amortization on the financial position of the industry. Problem 10.2. Goodwill in the Hotel & Resort Industry. Given is information on goodwill, amortization & relative size (in million) for 2001 (No goodwill reported by Marriott):
Hilton Mandalay
Goodwill $1,273 45
Amortization $77 12
Total Assets $8,785 4,037
Net Income $166 53
a. Calculate amortization as a percent of goodwill & net income & goodwill as a percent of total assets.
Hilton Mandalay
Amortization / Goodwill 6.05% 26.67%
Amortization / Net Income 46.39% 22.64%
Goodwill / Total Assets 14.49% 1.11%
b. Evaluate the impact of goodwill and amortization on the financial position of the industry. Cases Case 10.1. Merger announcement by UAL and the Market Reaction. On May 24, 2000 UAL (the parent of United Airlines) announced a merger with USAir, at about a 50% premium over USAir’s stock price of 40. According to Fortunes, UAL is the second largest airline (ARM, the parent of American Airline is bigger) and USAir is number 6. This is a horizontal merger, would Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 10 111
make UAL the largest airline, and would increase UAL’s market share in several key markets. How did the market react? A stock chart is presented below (USAir’s ticker is U):
a. Analyze the stock price reaction of USAir to the merger announcement. b. Analyze the stock price reaction of UAL to the merger announcement. a. b.
The stock price of US Air went up over 70% upon the announcement & then dropped back to reflect the actual agreement price of about 50% The stock price of UAL dropped slightly with the announcement and stayed down, suggesting that investors were not enthusiastic about the acquisition
Case 10.2. Industry Impact of Merger Announcements—the Airline Industry. The merger announcement (from Problem 8.1) may impact on the stock price of other airline companies. Both AMR and Delta (Fortune’s third largest airline) were rumored to be interested in acquiring Northwest (number four on Fortune’s list). a. Without considering actual stock price reaction, predict what stock prices should do for these three companies. Given below is the stock chart for these companies:
b. Analyze the stock price reaction for these airlines.
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 10 112
c. Was the actual reaction the same as predicted? Explain. a. b.
c.
There would seem to be no reason for a market reaction based on rumor The stock price of the potential target, Northwest, went up, while the rumored acquirers went down by fairly substantial margins. The rationale would seem to be the same as (a) above Apparently, the investors reacted to rumor in this case, rather than any actual information
Case 10.3. Du Pont’s acquisition & divestment strategy. MD&A (2000 annual report) states: “As part of its strategy for growth, the company has made and may continue to make acquisitions and divestitures and form strategic alliances.” Since 1999 the following activities took place: Acquisitions: 1999 acquisition of 80% of Pioneer Hi-brands International not previously owned (price $7,684 million--$3,419 million cash plus $4,154 million in stock); Herberts Coating Business (cash of $1,588 million). Divestitures: 1999 Conoco spin-off trading Conoco shares for Du Pont (a $7,471 million gain net-of-tax recognized as a discontinued operations); 2001 sales of Du Pont Pharmaceutical to Bristol-Myers Squibb for $7,798 million (net assets sold of $1,411 million, resulting in a pre-tax operating gain of $6,136 million). Consider basic financial statement numbers for 1999-2001:
Sales Income from Continuing Operations Net Income Total Assets Stockholders’ Equity
2001 $25,370 4,328
2000 $29,202 2,314
1999 $27,892 219
4,339 40,319 14,452
2,314 39,426 13,299
7,690 40,777 12,875
Sales declined in 2001; income from continuing operations for 1999 was very low, but net income for 1999 much higher than later years; total assets decline in 2000, but up in 2001 to almost the 1999 level. a. Analyze how much of these differences in performance and size is associated with these acquisitions and divestitures. Analyzing companies that make frequent acquisitions and divestitures is particularly difficult. After the consolidation, it is difficult to determine the relative success of the parent given these large business trades. b. To what extent can large swings in performance and size be specifically identified as caused by acquisitions and divestitures? How can this be determined?
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 10 113
Du Pont seems to acquire and sell off companies frequently. Given the impact of the sales of Conoco and Du Pont Pharmaceuticals on the income statement, this can be a concern to analysts trying to evaluate the operations of Du Pont Ethics Considerations. When should acquisition be made? Strategic acquisitions can be an important component of a corporation’s business strategy. However, there has been a merger frenzy with catastrophic results. Consider excerpts from a recent Fortune article (R. Charan & J. Useem, “Why Companies Fail: Acquisition Lust:” WorldCom founder Bernard Ebbers liked to eat. He ate MCI. He ate MFS and its UUNet subsidiary. He tried to eat Sprint. Wall Street helped him wash it all down with cheap capital and a buoyant stock price. Pretty soon WorldCom was tipping the scales at $39 billion in revenues. But there was a problem: Ebbers didn't know how to digest the things he ate. A born dealmaker, he seemed to care more about snaring new acquisitions than about making the existing ones--all 75 of them--work together. At least Ebbers was up front about it: "Our goal is not to capture market share or be global," he told a reporter in 1997. "Our goal is to be the No. 1 stock on Wall Street." a. Are there fundamental principles on when acquisitions make sense? Take a position and defend it. b. WorldCom went bankrupt after Bernard Ebbers resigned (the stock price had dropped substantially). Why are some acquisitions successful and other a failure? a.
b.
Acquisitions should be based on business strategy in the context of industry conditions. [specific answers are expected to differ substantially and include considerations of opportunism, earnings manipulation and so on] The telecom companies all had problems, associated with specific technology, over-capacity, etc. WorldCom seemed to acquire too many companies at the wrong time, while also using earnings manipulation. Determining the right acquisition timing and targets is difficult to evaluate
Internet Projects Project 10.1. Using the company picked in earlier chapters, complete an accounting analysis and prepare a summary table and executive summary.
Giroux • FINANCIAL STATEMENT ANALYSIS
11. Capital Structure and Credit Risk Questions 1. What are the major categories of debt and how do these relate to credit risk? 2. What is the relationship of default risk to bankruptcy risk when evaluating overall credit risk? 3. How is the financial analysis process used for evaluating credit risk? What measures are particularly important for this analysis? 4. What is Chapter 11 bankruptcy and how does it fit in the financial failure process? 5. What is Altman’s Z-score and how can it be used in the credit analysis process? 6. What is a bond rating? Is this important in the credit analysis process? Explain. 7. What’s the difference between an investment grade rating and a non-investment grade rating? 1 Short Term debt, loans, leases are types of debt. Establishing long term relationship with creditors allows reduced credit risk. 2 Bankruptcy risk may indicate default risk. Therefore, the higher the probability of bankruptcy, the greater the credit risk. 3 Various ratios can determine credit risk. For example, current ratio, EBIT/Total Assets, RE/Total Assets, Debt Ratio, leverage analysis, ROA, ROE, etc. FLI, FSLR, Debt to Equity, Interest Coverage are also important in deciding credit risk. 4 Chapter 11 indicates corporate financial failure and legally protects a debtor from its creditors while it reorganizes. It is a last ditch process. 5 Altman’s Z-score is a predictor of bankruptcy. Above 2.6 is healthy and below 1.1 indicates bankruptcy. 6 Bond Ratings, such as Moody’s and S&P, indicate credit worthiness of a firm. Bonds with high risk will most likely have a high return, but also high risk of default. Bonds with low risk will most likely be safer but have less of a return based on bond ratings. 7 Investment Grade Ratings (AAA-BBB) are low risk bonds. Non investment grade bonds are higher risk. Problems Problems 11.1-11.2 Relate to the Chemical Industry. Problem 11.1. Financial leverage and solvency ratios in the Chemical Industry. Below are financial numbers for the three chemical companies.
Net Income, 2001 Total Equity, 2001 Total Equity, 2000 Total Assets, 2001 Total Assets, 2000
Du Pont $4,339 14,452 13,299 40,319 39,426
Dow $-385 9,993 9,686 10,308 27,645
PPG $387 3,080 3,080 8,452 9,125
SOLUTIONS MANUAL • CHAPTER 11 115
Common Equity, 2001 Common Equity, 2000 Total Liabilities, 2001 Long-term Debt, 2001
14,215 13,062 25,867 5,350
9,993 9,686 25,522 9,266
3,080 3,097 5,372 1,699
a. Calculate the following ratios for 2001:
Financial Leverage Index Financial Structure Leverage Ratio Debt / Equity Long-term Debt / Equity
Formula ROE / ROA
Du Pont 287.359%
Dow 192.860%
PPG 285.341%
Average Total Assets / Average Common Equity Total Liabilities / Total Equity Long-term Debt / Total Equity
292.353%
192.860%
284.556%
178.986%
255.399%
174.416%
37.019%
92.725%
55.162%
b. Evaluate the financial leverage and credit risk of these companies, including a rating from 1-10.
Financial Leverage Credit Risk
Du Pont 3-5 3-5
Dow 3-5 3-5
PPG 3-5 3-5
Problem 11.2. Calculating Z-scores in the Chemical Industry. Below are the financial numbers for three chemical companies needed to calculate Altman’s Z-score (1983) for 2001 (in millions):
Total current assets Total current liabilities Total assets Retained earnings Earnings before tax Interest expense Total stockholders’ equity Total liabilities
Du Pont $14,801 8,067 40,319 13,517 6,844 590 14,452 23,443
Dow $10,308 8,125 35,515 11,112 35 733 9,993 25,522
PPG $2,703 1,955 8,452 6,551 666 180 3,080 5,250
a. Calculate Altman’s Z-score for each company and rate each company as failing, healthy or indeterminate.
6.56 x working capital / total assets 3.26 x retained earnings / total assets
Du Pont 1.10 1.09
Dow 0.40 1.02
Giroux • FINANCIAL STATEMENT ANALYSIS
PPG 0.58 2.53
SOLUTIONS MANUAL • CHAPTER 11 116
6.72 x EBIT / total assets 1.05 x BV of equity / BV of debt = Z-score Category
1.24 0.65 4.07 healthy
0.15 0.41 1.98 gray area
0.67 0.62 4.40 healthy
Bond ratings for the chemical companies are: Moody’s Standard & Poor’s
Du Pont AA3 AA
Dow A1 A
PPG A1 A
b. Evaluate the credit worthiness of these companies, using Altman’s Z-score, bond ratings and previous financial analysis and rate the companies on a 1-10 scale.
Du Pont Dow PPG
Rating 8 6 7
Explanation Healthy, investment grade bonds Gray area for Altman’s, but investment grade bonds Healthy, investment grade bonds
c. Are the signals from Altman’s Z-score and bond ratings consistent or not? Explain. Problems 11.3-11.4 Relate to the Hotel & Resort Industry. Problem 11.3. Financial leverage and solvency ratios in the Hotel & Resort Industry. Below are financial numbers for the three chemical companies.
Net Income, 2001 Total Equity, 2001 Total Equity, 2000 Total Assets, 2001 Total Assets, 2000 Common Equity, 2001 Common Equity, 2000 Total Liabilities, 2001 Long-term Debt, 2001
Hilton $166 1,783 1,642 8,785 9,140 1,783 1,642 7,002 4,950
Marriott $236 3,478 3,267 9,107 8,237 3,478 3,267 5,629 2,815
Mandalay $53 941 1,069 4,037 4,248 941 1,069 3,097 2,482
c. Calculate the following ratios for 2001:
Financial Leverage Index Financial Structure Leverage Ratio
Formula ROE / ROA
Hilton 523.358%
Marriott 257.139%
Mandalay 412.189%
Average Total Assets / Average Common Equity
523.358%
257.139%
412.189%
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 11 117
Debt / Equity Long-term Debt / Equity
Total Liabilities / Total Equity Long-term Debt / Total Equity
392.709%
161.846%
329.118%
277.622%
80.937%
263.762%
d. Evaluate the financial leverage and credit risk of these companies, including a rating from 1-10.
Financial Leverage Credit Risk
Hilton 2-4 2-4
Marriott 4-6 4-6
Mandalay 3-5 3-5
Problem 11.4. Calculating Z-scores in the Hotel & Resort Industry. Below are the financial numbers for three companies needed to calculate Altman’s Z-score (1983) for 2001 (in millions):
Total current assets Total current liabilities Total assets Retained earnings Earnings before tax Interest expense Total stockholders’ equity Total liabilities
Hilton $996 902 8,785 168 250 385 1,783 7,002
Marriott $2,130 1,802 9,107 941 370 109 3,478 5,629
Mandalay $267 309 4,037 1,374 93 221 941 3,097
d. Calculate Altman’s Z-score for each company and rate each company as failing, healthy or indeterminate.
6.56 x working capital / total assets 3.26 x retained earnings / total assets 6.72 x EBIT / total assets 1.05 x BV of equity / BV of debt = Z-score Category
Hilton 0.07 0.06 0.49 0.27 0.89 bankrupt
Marriott 0.24 0.34 0.35 0.65 1.58 gray area
Mandalay -0.07 1.11 0.52 0.32 1.88 gray area
Bond ratings for the companies are: Hilton
Marriott
Mandalay
Moody’s Standard & Poor’s e. Evaluate the credit worthiness of these companies, using Altman’s Z-score, bond ratings and previous financial analysis and rate the companies on a 1-10 scale.
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 11 118
Hilton Marriott Mandalay
Rating 2-4 3-5 3-5
Explanation Bankrupt Gray Gary
f. Are the signals from Altman’s Z-score and bond ratings consistent or not? Explain. Problem 11.5. Calculate Z-scores for Ford and GM. Below are the financial data needed to calculate Altman’s Z-score (1983) for 2001 (millions): Ford $37,833 43,327 284,421 17,884 8,234 9,519 18,610 265,138
Total current assets Total current liabilities Total assets Retained earnings Earnings before tax Interest expense Total stockholders’ equity Total liabilities
GM $208,920 63,156 303,100 10,119 7,164 9,552 30,175 272,925
a. Calculate Z-scores and rate each company as failing, healthy or indeterminate. Ford -0.13 0.20 0.42 0.07 0.57 bankrupt
6.56 x working capital / total assets 3.26 x retained earnings / total assets 6.72 x EBIT / total assets 1.05 x BV of equity / BV of debt = Z-score Category
GM 3.15 0.11 0.37 0.12 3.75 healthy
The bond ratings for Ford and GM are: Moody’s Standard & Poor’s
Ford A1 A
GM A2 A
b. Evaluate the credit worthiness of these companies, using Altman’s Z-score, bond ratings and previous financial analysis and rate the companies on a 1-10 scale.
Ford GM
Rating 3-5 7-8
Explanation Bankrupt, Investment grade bond rating Healthy, investment grade bond rating
Cases
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 11 119
Case 11.1. Debt levels at General Electric (GE). GE reported the following balance sheet information for the last two fiscal years (in millions). Calculate common-size information. 2001 Total Assets Short-term Borrowing Current Liabilities Long-term Borrowing Total Liabilities Stockholders’ Equity
$495,023 153,076
2001Common-size 100% 30.1
2000 $437,006 119,180
2000Common-size 100% 27.3
198,904 79,806
40.2 16.1
156,112 82,132
35.7 18.8
434,984 54,824
87.9 11.1
381,578 50,492
87.3 11.6
Does the level of debt seem excessive? A Major part of GE is General Electric Capital Services (GECS), which is one of the largest financial services companies in the U.S. Consequently, this subsidiary is funded primarily by debt. GE’s balance sheet separates GE (manufacturing) from GECS. The same information as above for 2001 is presented for the two components. Calculate common-size information. GE
GE –Commonsize 100.0% 1.6
GECS
GECSCommon-size 100.0% 37.8
Total Assets $109,733 $425,484 Short-term 1,722 160,844 Borrowing Current 36,072 32.9 174,549 41.0 Liabilities Long-term 787 0.7 79,091 18.6 Borrowing Total Liabilities 53,961 49.2 392,627 92.3 Stockholders’ 54,824* 50.0 28,590* 6.7 Equity * GECS equity is recorded as “Investment in GECS” in GE balance sheet Under GESC short-term borrowing is primarily commercial paper ($117,459 million); long-term borrowing is primarily senior notes due 2003-2055 ($78,347). GECS has committed lines of credit of $28.6 billion. Part of the debt is non-U.S. and the company uses interest rate and foreign currency swaps, currency forwards and currency swaps. Now evaluate the liabilities of the two components of GE. Case 11.2. Classifying debt for Ford Motor Co. The 2001 annual report for Ford reports the following liabilities on the balance sheet (in millions):
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 11 120 LIABILITIES Automotive Trade payables Other payables Accrued liabilities (Note 10) Income taxes payable Debt payable within one year (Note 11)
2001 $ 15,677 4,577 23,990 302 -------44,546
Total current liabilities Long-term debt (Note 11) Other liabilities (Note 10) Deferred income taxes Payable to Financial Services (Note 1) Total Automotive liabilities Financial Services Payables Debt (Note 11) Deferred income taxes Other liabilities and deferred income Payable to Automotive (Note 1) Total Financial Services liabilities
2000
$ 15,075 4,011 23,369 449 277 -------43,181
13,492 30,868 362 3,712 -------92,980
11,769 29,610 353 2,637 -------87,550
3,095 153,543 9,703 7,826 938 -------175,105
5,297 153,510 8,677 7,486 1,587 -------176,557
Company-obligated mandatorily redeemable preferred securities of a subsidiary T trust holding solely junior subordinated debentures of the Company (Note 1) 672 673
a. Total liabilities were $268,757 in 2001 and $264,780 in 2000. A key question is what number to use when evaluating credit risk. The financial services sector has considerably more debt than automotive, expected for this type of activity. Calculate the percentage of liabilities for each sector.
2001 Liabilities 2000 Liabilities
Automotive % 34.6% 33.1%
Financial Services % 65.2% 66.7%
b. Given the following information calculate debt to equity ratios and debt ratios for the two sectors and overall.
Total Assets Stockholders’ Equity Debt to Equity Ratio Debt Ratio
Automotive $276,543 7,786 34.5x 97.2%
Financial Services $283,390 18,610 14.2x 93.4%
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 11 121
c. Also, some liabilities can be excluded such as deferred income taxes. Note 10 has the following information on other liabilities from the automotive sector. Which of these should be excluded from leverage analysis? NOTE 10. Liabilities - Automotive Sector (in millions) Accrued Liabilities (Current) ----------------------------Dealer and customer allowances and claims
2001 2000 ------------- -------------$13,412 $11,660
Deferred revenue Employee benefit plans Postretirement benefits other than pensions Other Total accrued liabilities
Other Liabilities (Non-current) -----------------------------Postretirement benefits other than pensions Dealer and customer allowances and claims Employee benefit plans Unfunded pension obligation Other Total other liabilities
2,460 1,790 1,230 5,098 ------$23,990 =======
2,209 2,029 1,076 6,395 ------$23,369 =======
$5,451 6,805 3,853 1,143 3,616 ------$30,868 =======
$14,093 6,202 4,145 1,188 3,982 ------$29,610 =======
The automotive sector has current liabilities separated from long-term, but financial services does not. Note 11 has the following (interest-paying) debt information (summarized): Current Liab. Commercial Paper Other Current L-T Notes & Bank Debt Subordinated Debt (L-T)
Auto – 2001
Auto – 2000
Financial-2001 $16,683
Financial-2000 $44,596
$302 13,492
$52 11,769
29,594 106,173
21,796 85,626
1,093
1,492
d. Calculate current and long-term (interest-paying) debt, total (interest-paying) debt & relative percentages to total debt.
Current Debt ($) Current Debt/ Total Debt
Auto – 2001 $302
Auto – 2000 $52
Financial-2001 $46,227
Financial-2000 $66,392
0.1%
0.02%
17.2%
25.1%
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 11 122
Long-term Debt ($) Long-term Debt/ Total Debt
$13,492
$11,769
$107,266
$87,118
5.0%
4.4%
39.9%
32.9%
What numbers should be used to calculate leverage ratios? Should the other liabilities from Note 10 be excluded? Should current liabilities be excluded? Should only interest-paying debt be included? How do the alternative definitions of debt or liabilities affect the credit risk of Ford? Ethics Considerations. How much risk? In a recent Fortune article (R. Charan & J. Useem, “Why Companies Fail: Overdosing on Risk”) incredible risk is assumed by CEOs: Some companies simply live too close to the edge. Global Crossing, Qwest, 360networks--these telecom flameouts chose paths that were not just risky but wildly imprudent. Their key mistake: loading up on two kinds of risk at once. The first might be called "execution risk." In their race to band the earth in optical fiber, the telco upstarts ignored some key questions: Namely, would anyone need all of this fiber? Weren't there too many companies doing the same thing? On top of execution risk was another kind, which we'll call liquidity risk. Global Crossing--run by Gary Winnick, formerly of the junk-bond house Drexel Burnham Lambert--loaded up on $12 billion of high-yield debt. This essentially limited Winnick to a cannonball strategy: one shot, and if you miss, it's bankruptcy. Bankruptcy it was. Given the utter violence of the telecom shakeout, you might say it was inevitable. But other telcos did manage to escape the carnage. BellSouth, dismissed as hopelessly conservative during the Wild West years, emerged with a pristine balance sheet and a strong competitive position. Its gentlemanly CEO, Duane Ackerman, was guided by a radical idea: "being good stewards of our shareholders' money." a. There seems to be a relationship between corporate governance and bankruptcy risk. Is this reasonable? Are CEOs of these high-risk companies unethical? b. What is the relationship of corporate governance and stewardship?
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 11 123
a.
b.
Corporate governance is a significant part of a company’s business strategy and playing by the rules. When governance is weak, the change of earnings manipulation and other legal and ethical violations increases Close. Stewardship is one of the primary roles of the board of directors
Internet Projects Project 11.1. Using the same company as in previous chapters, look up the bond rating and calculate Altman’s Z-score and compare it with one or more companies in the same industry. Go to Moody’s webpage (www.moody’s.com) and evaluate the bond rating history for this company.
Giroux • FINANCIAL STATEMENT ANALYSIS
12. Credit Analysis Questions 1. Review the six-step process for a credit decision. Does it differ from other purposes (e.g., an equity investment decision)? Explain. 2. To evaluate credit risk, what are the main objectives of the credit analysis? How are these evaluated? 3. What credit-worthiness characteristics are associated with a commercial loan at the prime rate? 4. Give some examples of red flags that would cause a loan to be rejected. 5. Why are collateral and debt covenants often required for a bank loan? 1
2
3 4
5
1. Loan Purpose- reason for borrowing. 2. Corporate Overview- analysis of industry and company’s business strategy. 3. Quantitative Financial Analysis- credit risk focus, Z-score and bond rating, default, bankruptcy risk. 4. Accounting Analysis and Forecast- confidence in financial analysis, forecasts cash flow, sales , and profitability. 5. Comprehensive Analysis- summary and consider loan options. 6. Loan decision. Generally, this is the same decision process as an Equity Decision. The Loan Purpose has its separate step, but this is similar to equity decisions based on the requirements of the investor. Also, the main difference between two processes would be the ratios calculated. Credit ratios focus more on bankruptcy and default risk whereas Equity decisions are based on Return. Credit analysts should know all aspects of the business being analyzed, ratios and other circumstances of business combined. How much credit risk the bank will assume in addition to collateral are important in deciding whether or not to offer credit. Prime Rates can be obtained by Blue Chip borrowers without collateral and few debt covenants. These borrowers have low credit risk. Red flags include declining profitability, activity ratios, liquidity ratios. Oftentimes, even rising AR and Inventory may cause red flags to creditors, since these reduce Cash Flow. Collateral and debt covenants protect the creditor. If default, collateral can be assumed. In addition, having the borrowing party agree to limit their other debt helps the creditor look out for their own best interest.
Problems Problem 12.1. Du Pont Credit Analysis. Assume that Du Pont’s Chief Financial Officer comes to your bank for a $2 billion revolving line of credit for 2 years at the prime rate. Complete the following credit analysis summary based on the calculations made from previous chapters. 1. Purpose of Loan
$2 billion revolving ling of credit for 2 years
SOLUTIONS MANUAL • CHAPTER 2 125
2. Corporate Overview
3. Financial Analysis
4. Accounting Analysis 5. Comprehensive Analysis 6. Loan Decision
Industry: chemical industry, global, large industry with over a dozen Fortune 500 companies, environmental & other legal problems Business strategy: importance of R&D for new product development & high markups; also several commodities Liquidity-average; activity-average; average-average; profitgood; Du Pont-good; growth/trend-poor for revenue, average for net income; quarterly-slightly below average; Altman’shealthy (4.1) Problems with contingencies Major company with a 200 year history; reasonable business strategy; high profit, but poor trends; AA bond rating Accept at prime rate; no collateral or debt covenants required
Problem 12.2. Hilton Credit Analysis. Assume that Hilton’s Chief Financial Officer comes to your bank for a $1 billion note for 2 years at the prime rate. This note will provide interim credit for the construction of new hotel facilities. Long-term financing will come later through longterm bonds or leases. Complete the following credit analysis summary based on the calculations made from previous chapters. 1. Purpose of Loan 2. Corporate Overview
3. Financial Analysis 4. Accounting Analysis 5. Comprehensive Analysis 6. Loan Decision
$1 billion note for 2 years—construction of new hotel facilities Industry—hotel & resorts, major industry with $35 billion in revenues; global but with primary focus in the US; capital intensive; revenue depends on tourism Business Strategy—Hotel ownership, managing & developing properties & franchising; also timeshares Liquidity-average; activity-average; leverage-low average; profit-low average; Du Pont-low average; trend-low; quarterlyaverage Operating losses in some segments Major company in a stable industry; reasonable financial position, no major financial or accounting problems Accept at prime rate, with new construction lien (i.e., serving as collateral), no debt covenants
Problem 12.3. Ford Credit Analysis. Assume that Ford’s Financial Services Sector Director comes to your bank for a $5 billion unsecured 90-day loan at the prime rate to cover a record temporary demand for Ford Credit loans. Complete the following credit analysis summary based on the calculations made in previous chapters. 1. Purpose of Loan 2. Corporate Overview
Unsecured 90 day $5 billion loan for Ford Credit Industry—Motor vehicle manufacture; large, capital intensive, global; highly cyclical; contingencies related to safety, fuel economy & environment Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 126
3. Financial Analysis 4. Accounting Analysis 5. Comprehensive Analysis 6. Loan Decision
Business Strategy—Many operations in the US & Europe, owns several other manf., including Jaguar, Land Rover, & part of Mazda Liquidity-low average; activity-average; leverage-low anerage; profit-poor (RF); Du Pont-poor (RF); trend-low for revenues, poor for net income (RF); quarterly-poor (RF) Problems with legal & regulatory contingencies; high leverage & commitments Significant financial & accounting problems, especially contingencies Accept at prime rate, but use Ford Credit notes as collateral; limit dividends as debt covenants
Cases Case 12.1. Financial Analysis for Amazon.com. Using the information from above, calculate the following for Amazon and its competitors: a. Common-size statements.
Sales Cost of Goods Sold Gross Profit SG&A Net Income
Cash Inventory Total Current Assets Total Assets Total Current Liabilities
Amazon 2001 - $
Amason 2001 - %
Amazon 2000 - %
Amazon 1999
Amazon 1998 100% 78.0
Barnes & Noble 2001 100% 73.1
$3,122 2,324
100% 74.4
100% 87.9
100% 95.4
799
25.6
12.1
848 -567
27.2 -18.2 RF
100% 10.9
4.6
22.0
26.9
89.1
36.1 -51.1 RF
39.2 -43.9 RF
32.1 -20.5 RF
18.7 1.3
58.3 12.0
Amazon 2001 - $
Amazon Amazon 2001 - % 2000 - %
Amazon 1999
Amazon 1998
ebay 2000
$997 144 1,208
60.9% 8.8 73.7
38.5% 8.2 63.7
4.7% 8.9 40.9
4.0% 4.6 65.3
Barnes & Noble 2000 4.1% 49.0 60.7
31.2% 0 52.7
$1,638
100%
100%
100%
100%
100%
100%
921
56.2
45.7
29.9
25.0
43.5
10.7
Giroux • FINANCIAL STATEMENT ANALYSIS
eBay 2001
SOLUTIONS MANUAL • CHAPTER 2 127
Total Liabilities Total Equity
3,078
187.9
145.3
89.2
78.6
66.1
14.8
-1,440
-87.9 RF
-45.3 RF
10.8
21.4
33.9
85.1
b. Calculated these ratios (additional information below table*):
Current Cash Inventory Turnover Total Asset Turnover Debt to Equity Debt Debt to Market Equity Gross Margin Return on Sales Return on Total Equity Return on Assets
Amazon 2001 1.3x 1.1x 14.6x
Amazon 2000 1.4x 84.3% 12.3x
Barnes & Noble 2001 1.4x 9.5% 2.8x
eBay 2001 4.9x 2.9x 0
1.7x
1.2x
1.9x
52.4%
NM
NM
2.0x
17.4%
1.9x RF 50.0%
1.5x RF -
66.1% 83.5%
14.8% 1.7%
25.6% -18.2%RF
12.1% -51.1% RF
26.9% 1.3%
89.1% 12.0%
NM
NM
7.7%
7.4%
-30.1%RF
-61.3% RF
2.5%
6.3%
c. Analyze the financial calculations for a commercial loan decision for Amazon. Internet Projects Project 12.1. Go to the Standard & Poor’s website (www.standardand poors.com/Forum/Ratings Analysis/CorporateFinance). Using the company analyzed in previous chapters, check if they have been recently analyzed by S&P. If yes, give a brief analysis. Project 12.2. Using the company picked in earlier chapters and using the completed analyses done, do a credit analysis. Assume the company wants a $1 billion revolving line of credit (or develop another scenario that fits your company and complete the credit analysis table below. 1. Purpose of Loan 2. Corporate Overview 3. Financial Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 2 128
Analysis 4. Accounting Analysis 5. Comprehensive Analysis 6. Loan Decision
Giroux • FINANCIAL STATEMENT ANALYSIS
13. Equity Investment Analysis Questions 1. Why would an investor determine that maximizing long-term portfolio growth is the appropriate investment purpose? 2. Why would an investor rely on mutual funds rather picking individual securities? What are the problems associated with mutual funds? 3. Review the PE, PEG and yield of the Dow Jones Industrial Companies. Which companies are likely fits to a growth portfolio? An income portfolio? Explain. 4. Why is an executive summary important to summarize the six-step process? 5. Ultimately, a specific buy or sell decision must be made. How is a comprehensive financial analysis useful for the actual decision? 1 Long Term capital gains portfolios are characteristics of young investors who may not need the dividend income at the present time to live on. Older investors would prefer, most likely, to earn dividend returns, however, as opposed to long term capital gains. These two are tradeoffs as investors who are younger would prefer cash paid in dividends to be reinvested by the company into capital assets which can improve business and therefore the stock price. 2 Mutual funds are professionally managed and help reduce risk by using professional advice in addition to proper diversification and liquidity advantages. However, since risk is lowered, so is potential return. Also, fees are involved to manage these funds which investors have no control over. 3 Firms with large PE and PEG indicate fits for a growth portfolio. Their sock price is expected to increase. A stock with a higher dividend yield, however, would be preferred for an income portfolio. These stocks provide the investor with more Dividend Revenue on a regular basis. 4 The executive summary states the findings of the six step process and highlights the important aspects. 5 Buy/Sell recommendations should be based on earnings potential ratios and be weighted by ratios which define the potential risk of investing in the company. Problems Problem 13.1. Financial Analysis for Du Pont, based on analysis throughout the book. a. Convert the financial analysis ratios to ratings from 1 (poor) to 10 (excellent), using the following table: Category Common-size, Income Statement Common-size, Balance Sheet Liquidity Ratios
Rating 6
Discussion Good profit
4
High leverage
5
Average
SOLUTIONS MANUAL • CHAPTER 12 130
Leverage Activity Profitability Du Pont Model Growth, Historical Growth, Projected Quarterly Analysis
4 4 7 7 3
Somewhat high leverage Low average Good profit Good profit Negative for revenue, reasonable for NI
4
Average, but erratic
b. Convert the market analysis ratios to ratings from 1 to 10, using the following table: Category Stock Price Growth, 5 Years Stock Price Growth, 1 Year EPS Growth, Last 2 Years EPS Growth, 2 Year Projections Quarterly Earnings PE, Actual PE, 2 Year-ahead Projections Yield Market-to-Book Intrinsic Value (CNNFN) PEG
Rating 3
Discussion Negative 15%
5 5 3
Negative, but above Dow Jones Average Negative
5 3
Average Somewhat high
7 5 7 3
Good at 3.1% Average at 3.1 Undervalued High PEG at 2.3
c. Convert the accounting analysis to ratings from 1 to 10, using the following table: Issue Revenue Recognition Expensing vs. Capitalizing Costs Unusual Accounting Policies Stock Options Nonrecurring Items Business Combination Abuse Operating Leases, Offbalance-sheet Reporting Commitments Contingencies Retirement
Rating 7 7
Conservative Conservative
Discussion
5
Divestitures
6 3
Low level None Divestitures (Du Pont Pharm.)
7
Low level
5 3 5
Segment Reporting
3
Moderate Significant potential liabilities Overfunded pension, underfunded OPEB Mixed returns, negative for nylon &
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 12 131
Other
polyester None
-
d. Prepare an executive summary for Du Pont, using the same format as Dell (Appendix 1): Investment Purpose Corporate Overview Financial Analysis Detailed Accounting Analysis Comprehensive Analysis Investment Decision
Which Gotrocks Fund is most likely? Why? Summarize from Chapter 1 Summarize the analysis from Chapter 3, 4 and other sources. What are the major concerns associated with Du Pont? Explain.
Summarize all available information relative to the investment purpose Buy, sell or hold? Why? Other considerations.
Problem 13.2. Financial Analysis for Hilton, based on analysis throughout the book. a. Convert the financial analysis ratios to ratings from 1 (poor) to 10 (excellent), using the following table: Category Common-size, Income Statement Common-size, Balance Sheet Liquidity Ratios Leverage Activity Profitability Du Pont Model Growth, Historical Growth, Projected Quarterly Analysis
Rating 6
Discussion Average
4
High leverage
3 4 5 4 4 4
Low liquidity, especially cash High Average Low average Low average Average for revenue, negative NI
4
Low average, erratic
b. Convert the market analysis ratios to ratings from 1 to 10, using the following table: Category Stock Price Growth, 5 Years Stock Price Growth, 1 Year EPS Growth, Last 2 Years EPS Growth, 2 Year Projections
Rating 3
Discussion Negative, lowest in industry
6
Good, above Dow Jones
7
Good trend
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 12 132
Quarterly Earnings PE, Actual PE, 2 Year-ahead Projections Yield Market-to-Book Intrinsic Value (CNNFN) PEG
3 5
High PE Average range
3 5 3 4
Low at 0.5% Average at 3.3 Overvalued High at 1.8
c. Convert the accounting analysis to ratings from 1 to 10, using the following table: Issue Revenue Recognition Expensing vs. Capitalizing Costs Unusual Accounting Policies Stock Options Nonrecurring Items Business Combination Abuse Operating Leases, Offbalance-sheet Reporting Commitments Contingencies Retirement Segment Reporting Other
Rating 7 7
Discussion Conservative Conservative
-
None
5 7
Moderate levels None None detected
7
Low
6 5 7 5 -
Moderate Lawsuits, immaterial Overfunded Most perform well
d. Prepare an executive summary for Hilton, using the same format as Dell (Appendix 1): Investment Purpose Corporate Overview Financial Analysis Detailed Accounting Analysis Comprehensive Analysis Investment Decision
Which Gotrocks Fund is most likely? Why? Summarize from Chapter 1 Summarize the analysis from Chapter 3, 4 and other sources. What are the major concerns associated with Du Pont? Explain.
Summarize all available information relative to the investment purpose Buy, sell or hold? Why? Other considerations.
Cases
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 12 133
Case 13.1. Gotrocks has recently established a Value Fund, to invest in securities of companies that are undervalued. These could be undervalued for a variety of reasons, but most are companies that have had recent financial and performance problems and a substantial decline in market price. There should be evidence of a successful restructuring in progress and, therefore, potential for stock price appreciation. a. Review the list of the DJIA. Are there any stocks that seem to meet the criteria of the Value Fund? Use various Internet sites to assist the analysis. List these and explain the rationale. b. Pick one company from (a) above an prepare an abbreviated executive summary: Investment Purpose Corporate Overview Financial Analysis Detailed Accounting Analysis Comprehensive Analysis Investment Decision Ethics Considerations. Investing in Ethics. In the face of corporate corruption, the failure of auditors and other third-party reviews to limit excesses, and the lack of substantial new regulations, individual and institutions can fight back. Investors can avoid companies that have a record of poor corporate governance or problematic financial reports or dump them when new revelations indicate problems. Institutional investors are targeting the S&P 500 index on corporate governance and compensation issues. The New York Stock Exchange is tightening its listing requirements, emphasizing minimum standards of corporate governance and financial reporting. Following the lead of Merrill Lynch (following a $100 million settlement with the Attorney General of New York, investment bankers are making reforms for a more unbiased focus on financial analysis (e.g., increasing the number of “sell” recommendations). a. Are these actions by various users enough to make a difference? b. Are there other actions you would suggest? a.
b.
Hopefully, these actions are at least modestly effective. Avoiding potential problem companies would seem to be a reasonable part of financial analysis This could be a long list, including new government regulations, institutional requirements, auditor rules, and so on
Internet Projects Project 13.1. Use the company picked in earlier chapters and convert financial analysis to ratings similar to Du Pont above. Prepare an executive Summary for this company.
Giroux • FINANCIAL STATEMENT ANALYSIS
SOLUTIONS MANUAL • CHAPTER 12 134
Investment Purpose Corporate Overview Financial Analysis Detailed Accounting Analysis Comprehensive Analysis Investment Decision
Giroux • FINANCIAL STATEMENT ANALYSIS