Chapter 2

2.16

(a)FIFO is probably used for the rest of Kennametal's inventories. Companies using LIFO must disclose the value of those inventories as if FIFO had been used, which Kennametal has done in this case.

(b)Finished goods refers to those inventories that are complete and ready for sale. Work in process and powder blends are inventories currently in the manufacturing process, but not yet complete. Raw materials and supplies have not been put in the manufacturing process. The amount closest to current cost would be the FIFO inventory value. Under FIFO, the first goods purchased are assumed sold, so the last goods purchased would be included in the inventory valuation and would have been purchased at amounts closest to current costs. The LIFO valuation reduction is a result of the impact of inflation on inventory values. Since the first goods purchased using LIFO remain in inventory, LIFO inventories would be valued at a lower amount than FIFO inventories during an inflationary period. Kennametal's inventories are lower in 2007, ($403,613) than they would have been if reported using FIFO ($469,584).

2.17(a)per year

(b) Year 1$60,000 x 2/5 = $24,000

Year 2($60,000 - $24,000) x 2/5 = $14,400

2.18Using the equation from Chapter 2, the calculations to determine dividends are as follows:

Beginning retained earnings

+

net income

-

dividends

=

Ending retained earnings

2008

700

+

250

-

60

=

890

2009

890

+

225

-

70

=

1,045

2010

1,045

+

40

-

75

=

1,010

2.25

1.

Del Monte Foods

Common Size Balance Sheet

April 29 and 30,

ASSETS

2007

2006

Current Assets

Cash and cash equivalents

--

%

13

%

Restricted cash

--

1

Trade accounts receivable, net of allowance

6

7

Inventories

18

21

Prepaid expenses and other current assets

3

3

Total Current Assets

27

%

45

%

Property, plant and equipment, net

16

17

Goodwill

30

21

Intangible assets, net

26

16

Other assets, net

1

1

Total Assets

100

%

100

%

LIABILITIES AND STOCKHOLDERS' EQUITY

Current Liabilities

Accounts payable and accrued expenses

11

%

12

%

Short-term borrowings

--

--

Current portion of long-term debt

1

2

Total Current Liabilities

12

%

14

%

Long-term debt

43

35

Deferred tax liabilities

8

6

Other non-current liabilities

5

9

Total Liabilities

68

%

64

%

Stockholders' Equity

Common stock

--

--

Additional paid-in capital

22

27

Treasury stock, at cost

(3

)

(4

)

Accumulated other comprehensive income (loss)

1

--

Retained earnings

12

12

13

13

Total Stockholders' Equity

32

%

36

%

Total Liabilities and Stockholders' Equity

100

%

100

%

2.The asset structure of Del Monte Foods has changed from 2006 to 2007. Current assets have decreased from 45% to 27% of total assets. Most of the decline is a result of the cash account decreasing, although inventories have declined by 3%, also. It is probable that the cash was used to purchase Meow Mix and Milk-Bone. A significant part of the purchase price was for goodwill and intangible assets and as can be seen on the common size balance sheet, these two accounts are the most significant to Del Monte in 2007, making up 56% of total assets, an increase of 19% from 2006.

Changes in the debt and equity structure of Del Monte Foods are not as drastic. Current liabilities are stable and only make up 12% of total assets in 2007. The main change in the liability structure is the increase in long-term debt, most likely attributable to the purchase of meow Mix and Milk-Bone. Because of the change in liabilities the additional paid-in capital and retained earnings percentages have declined relative to assets in 2007 compared to 2006, even though the dollar amounts have increased.

The debt structure of Del Monte is somewhat risky. Large amounts of money have been paid to acquire two companies. If the acquisitions deliver above average profits for Del Monte, there should not be a problem, however, if the acquisitions turn out to be a poor strategic decision, Del Monte could have trouble paying back amounts borrowed. Most of the assets purchased are intangible, not tangible.

3.Investors and creditors would be concerned about the ability of the firm to generate enough cash to pay the large amounts of debt that will ultimately come due. Most resources are tied up in goodwill and intangible assets, items not immediately saleable if cash is needed.

4.Investors and creditors would want to look at all other financial statements, the notes to the financial statements, the management discussion and analysis, the auditor's report and stock price information. SEC documents, Form 10-K, Form 10-Q and Form 8-K reports, would be a good source of both financial and nonfinancial information. Financial information of competitors would be useful for comparison purposes. Nonfinancial information from newspapers and periodicals would also be useful. In particular, investors and creditors would want to determine the prospects of Del Monte Foods for the future by researching the food industry.

CHAPTER 3

3.11

2009 to 2010

2008 to 2009

Sales growth

21.0%

62.5%

Operating expense growth

22.2%

63.6%

2010

2009

2008

Cost of goods sold

78.8

%

76.9

%

70.8

%

Gross profit margin

21.2

23.1

29.2

Operating profit margin

11.9

13.8

20.0

Average tax rate

42.9

42.6

43.8

Net profit margin

6.8

7.9

11.3

Sales growth over the three-year period is strong, but the rate of increase decreased 2009-2010 relative to 2008-2009. Sales growth could be the result of price increases, volume increases, or both. The reduction in the gross profit margin indicates problems with inventory cost controls, the pricing of products, or a combination of these factors. The decrease in the operating profit margin is partly a flow-through from the gross profit margin and the result of increasing operating expenses; operating expenses are increasing at a slightly faster rate than sales. Finally, the combination of problems with inventory management, pricing, and control of operating expenses has produced a deteriorating net profit margin. Tax expense has not been a contributing factor because the average tax rate decreased between 2008 and 2010.

3.12

Jackrabbit, Inc.

Income Statement for the Year

Net sales

$1,840,000

Cost of goods sold

1,072,000

Gross profit

768,000

Selling expenses

270,000

General and administrative expenses

155,000

Depreciation expense

24,000

Operating profit

319,000

Other Income (expense)

Gain on sale of equipment

15,000

Equity losses

(9,000)

Interest income

13,000

Interest expense

(16,000)

Pre-tax income

322,000

Income tax expense

96,000

Net income

$226,000

3.13

Yarrick Company

Common Size Income Statement (in percent

For the Years Ended December 31, 2010, 2009, and 2008

2010

2009

2008

Net sales

100.0

100.0

100.0

Cost of goods sold

58.2

54.2

53.7

Gross profit margin

41.8

45.8

46.3

Selling, gen. & admin.

17.7

20.0

29.1

Research & develop.

16.0

21.3

40.3

Operating profit margin

8.1

4.5

(23.1)

Income tax expense

3.0

1.3

(8.2)

Net profit margin

5.1

3.2

(14.9)

Sales have increased 15.7 percent from 2008 to 2009 and 52.9 percent from 2009 to 2010 for Yarrick Company. This increase is the result of volume or price increases. The gross profit margin has declined each year. Yarrick has either lowered selling prices or costs of goods sold have risen and the company has not passed on those increases to their customers.

Operating profit margin has surprisingly increased despite the decline in gross profit margin. This has been achieved by significant reductions in selling, general, and administrative and research and development expenses in 2009. In dollars these expenses increased in 2010, but from a percentage standpoint decreased due to the large sales growth. The reduction in these expenses is concerning. To stay on the cutting edge of their industry it is important for Yarrick to spend enough in research and development. Cuts in this area may be detrimental to sales growth in the long-run. If advertising is being reduced or key productive, personnel are being laid off to achieve the cost reductions in selling, general and administrative expenses, this, too, can negatively impact the company's sales and profits. If Yarrick has been able to reduce costs through the elimination of waste, this would be a quality change.

Net profit has increased from a loss of $20 to a profit of $12 from 2008 to 2010 due to the above mentioned changes in operating expenses. Tax expense has not had a significant impact on the net profit of the firm.

3.14(a)

Gross profit margin:

2010

2009

2008

Tickets

45.1%

48.0%

51.0%

Concessions

91.2%

90.0%

88.3%

Total

59.5%

60.4%

61.0%

(b)The overall gross profit margin of LA Theaters is declining. The cause of this decline is the result of tickets rather than concessions. If the cost of acquiring films is increasing, then ticket prices have not been raised proportionately, otherwise ticket prices have been reduced without a corresponding decrease in cost of films. Concessions gross profit margin is increasing each year which has mitigated the decline in overall gross profit margin. Concessions prices have been raised without corresponding increases in costs or the costs of concessions have been declining without a change in prices.

LA Theaters should focus on selling as many concessions as possible since the profit margin is quite high on these items. If ticket prices cannot be raised to compensate for increased costs, the management should be sure that the theaters are filled to capacity as volume increases in ticket revenues will result in higher gross profit margins. The cost of acquiring films is fixed, but does not change proportionately with the volume of ticket sales

3.20

1.The format of the income statement is similar to a single-step format. Revenues and expenses are not separated by operating or nonoperating activities and intermediate profit figures are not shown. This format does not allow the analyst to assess the core operations of the firm separate from the investing and financing activities of the firm. By using a multiple-step format, the analyst can assess the core operations and also identify strengths and weaknesses of the company by analyzing the intermediate profit numbers--gross profit, operating profit and income before taxes, as well as net profit.

2.

Sara Lee

Common Size Income Statement

(Percent)

2007

2006

2005

Net Sales

100.0

100.0

100.0

Cost of sales

61.5

61.3

59.9

Gross profit

38.5

38.7

40.1

Selling, general and administrative expenses

32.8

33.6

32.4

Net charges for exit activities, asst and business dispositions

0.8

0.8

0.4

Impairment charges

1.4

1.7

0.0

Contingent sale proceeds

(1.0)

(1.0)

(1.0)

Operating profit

4.5

3.6

8.3

Interest expense

(2.2)

(2.7)

(2.5)

Interest income

1.0

0.7

0.7

Income from continuing operations before income taxes

3.3

1.6

6.5

Income tax (benefit) expense

(0.1)

1.4

1.1

Income from continuing operations

3.4

0.2

5.4

Net income from discontinued operations, net of tax

0.5

1.1

0.9

Gain on sale of discontinued operations, net of tax

0.2

3.5

0.0

Net Income

4.1

4.8

6.3

(b)

2006-2007

2005-2006

Sales growth

7.1%

1.0%

Operating cost growth*

6.2%

6.1%

*Includes Cost of goods sold.

2007

2006

2005

Effective tax rate

(1.6%)

83.5%

17.6%

The analyst must decide which items on the income statement to include in the calculation of operating profit and which items are nonoperating. There are many choices that could be made in reformatting the income statement. Interest expense and interest income are financing and investing activities, respectively and should definitely not be included in operating profit. Net charges for exit activities, asset and business dispositions and impairment charges could be included as operating or nonoperating, depending on how these items are viewed by the analyst. If these items appear to be items that occur annually as part of the business operations then they should be part of operating profit. If, however, it is believed these items are not reoccurring as part of daily operations, then it could be argued that they should be included on the income statement after the operating profit calculation. The contingent sale proceeds are an offset to expenses caused by a business transaction and therefore, have been included as part of operating profit. The effective tax rates were copied from Note 23.

3.Sara Lee's sales and operating cost growth have increased in both 2006 and 2007, but not proportionately. Costs grew at about the same rate, but sales increased less than costs in 2006 causing operating profit to drop. In 2007, sales increased faster than costs causing operating profit to increase compared to 2006. Increases in sales could have been caused by either volume increases or price increases.

Gross profit margin declined in all years. Possible causes of the decrease are a reduction in prices, an increase in costs or a decrease in volume if there are significant fixed costs within cost of goods sold.

Other operating expenses are stable. Selling, general and administrative expenses increased slightly in 2006, but decreased in 2007. The contingent sales proceeds have also been stable year to year.

Interest expense increased in 2006, but decreased in 2007. These changes are the result of either changes in the levels of debt and/or changes in interest rates.

The income tax rate is volatile. Sara Lee generates taxable losses in the United States, but profits in foreign countries. When Sara Lee moves monies from foreign countries to the United States, tax is incurred on the repatriation of earnings. Additional taxes were paid as a result of repatriation, especially in 2006, which is the main explanation for the tax rate of 83.5%. Foreign taxes are lower than United States taxes so this has reduced the effective tax rate all years. The favorable outcome of tax reviews and audits in foreign countries also reduced taxes significantly all three years. In addition, in 2007, the tax benefit is explained not only by lower foreign tax rates and benefits from audits, but also by deductions related to the sale of capital assets.

Net income and a gain from the sale of discontinued operations added positively to the bottom line. This is a one-time item which will not appear in future years. Net income from continuing operations followed the same pattern as operating profit, decreasing in 2006 and then increasing in 2007.

Sara Lee operates in a highly competitive environment. The transformation plan the firm has undertaken to improve operational efficiency, if successful, should help in controlling costs and maintaining or slightly improving profit margins in future years. The increase in oil prices and ultimately food prices will be a factor

CHAPTER 4

4.11

Little Bit, Inc.

Statement of Cash Flows

For Year Ended December 31, 2009

Cash flow from operating activities

Net income

$ 5,500

Non-cash expenses included in net income:

Depreciation

18,000

Deferred income taxes

500

Cash provided by (used for) current assets and liabilities

Accounts receivable

(6,500

)

Inventory

(8,500

)

Prepaid expenses

(4,000

)

Accounts payable

2,000

Accrued liabilities

(16,000

)

Net cash used by operating activities

(

$ 9,000

)

Cash flows from investing activities

Purchase of plant and equipment

(6,000

)

Purchase of long-term investments

(1,000

)

Net cash used by investing activities

(

$ 7,000

)

Cash flows from financing activities

Additions to long-term debt

17,000

Sale of common stock

15,000

Net cash provided by financing activities

$ 32,000

Increase in cash

$ 16,000

Analysis

Inflows

$

%

Long-term debt

17,000

53

Sale of common stock

15,000

47

Total

32,000

100

Outflows

Operating activities

9,000

56

Purchase of property and equipment

6,000

38

Purchase of long-term investments

1,000

6

Total

16,000

100

Little Bit, Inc. failed to generate cash from operating activities due primarily to growth in inventories, receivables and prepaid expenses, combined with the payment of accrued liabilities. The firm may be expanding as evidenced by the increase in capital assets.

The expansion is being supported primarily by long-term debt and the sale of common stock. It would appear that Little Bit is using long-term debt only for the acquisition of plant and equipment, but also to cover the negative cash flow from operations. This is generally not good to match long-term debt maturities with the financing of current assets.

It is essential that Little Bit generate cash flow in the future to lessen the

need for debt, perhaps by controlling the growth of inventories and receivables.

4.12

(a)Cash provided by operations in 2009 is considerably less than net income. The major reason is the $288.2 million increase in accounts receivable. Inventory also increased substantially ($159.4 million) but the growth in inventory was comparable to what the firm experienced in 2008. Additions to plant and equipment were about the same in 2009 as 2008, so the increase in receivables appears out of line with overall expansion. Techno may be loosening credit to customers in order to stimulate sales and income (note increase in net income between 2008 and 2009), but the result of the receivables management is a sharp reduction in operating cash flow. If the firm continues to build receivables at the same pace, Techno will likely experience negative operating cash flow in 2010.

(b)

2009

2008

Inflows

$

%

$

%

Operations

24,525

8.2

177,387

78.1

Investment activities

14,408

4.8

0

0

Short-term borrowings

125,248

41.8

45,067

19.9

Add. to long-term borrowings

135,249

45.2

4,610

2.0

299,430

100.0

227,064

100.0

Outflows

Add. to plant and equipment

94,176

49.8

93,136

21.2

Investment activities

0

0

34,771

7.9

Purchase of treasury stock

45,854

24.2

39,267

8.9

Dividends

49,290

26.0

22,523

5.1

Repay long-term borrowings

0

0

250,564

56.9

189,320

100.0

440,261

100.0

Change in cash

110,110

(213,197)

In 2008 Techno generated most of its cash (78%) internally through operations. About 20% came from short-term borrowings, apparently to finance working capital. As the result of a strong operating cash flow and a large cash account balance ($291 million) Techno was able to expand plant and equipment while reducing by $250.5 million its long-term borrowings and to add long-term investments. A sharply reduced cash flow from operations in 2009 (see discussion in "a" above) resulted in the need for heavy long-term and short-term borrowings to support growth in receivables, inventory, and plant and equipment. The apparent use of some long-term borrowing for working capital needs could be a problem in the future. Techno also more than doubled its payment of dividends in spite of the decrease in operating cash flow. Given, however, that Techno ended the year with a cash balance of $188.2 million, the firm does not appear to have any immediate liquidity problems. The analyst would want to explore the cause of the buildup in receivables in 2009.

4.18

1.

Avnet, Inc.

Statement of Cash Flows Summary Analysis

For the Years Ended June 30, July 1, and July 2,

(dollars in thousands)

2007

%

2006

%

2005

%

Inflows:

Cash from operations

724,639

52

0

0

461,836

98

Issuance of notes in public offerings

593,169

42

246,483

62

0

0

Proceeds from bank debt

0

0

89,511

22

0

0

Other financing, net

69,512

5

30,991

8

2,274

0

Cash proceeds from sales of PPE

2,774

0

4,368

1

7,271

2

Cash proceeds from divestitures

3,445

0

22,779

6

0

0

Effect of exchange rate

7,925

1

3,353

1

0

0

Total Inflows

1,401,464

100.0

397,485

100.0

471,381

100.0

Outflows:

Cash from operations

0

0

19,114

2

0

0

Repayment of notes

505,035

45

369,965

49

89,589

61

Repayment of bank debt

122,999

11

0

0

10,789

7

Payment of other debt

780

0

643

0

86

0

Purchases of PPE

58,782

5

51,803

7

31,338

22

Acquisitions and investments, net

433,231

39

317,114

42

3,563

3

Effect of exchange rate

0

0

0

0

10,816

7

Total Outflows

1,120,827

100.0

758,639

100.0

146,181

100.0

Change in cash

280,637

(361,154)

325,200

Avnet has generated an increasing and positive dollar amount of net income from 2005 to 2007. Cash from operations (CFO) was greater than net income in 2005 and 2007, but in 2006 the firm generated a negative CFO. Increasing accounts receivable and decreasing accrued expenses caused CFO to be lower, especially in 2006. Accounts payable increased significantly each year and inventories decreased in 2005 and 2007 which helped increase the CFO amount. Inventories, however, increased in 2006 negatively impacting CFO that year. If sales growth is particularly high each year this could explain the increasing accounts receivable and accounts payable.

Avnet generated 98 percent of cash from operations in 2005, but in 2006 negative CFO caused the firm to rely on issuance of notes and bank debt to generate cash. The firm also received cash from divestitures. CFO supplied over half the cash in 2007, with the balance mainly from issuance of notes and other financing.

Much of the firm's excess cash is used to pay down the notes and bank debt which is a good sign that Avnet is able to quickly reduce this debt. Purchases of property, plant and equipment are relatively minor, as Avnet has been making acquisitions and investments in 2006 and 2007. These two items explain the large amount of borrowings in the same years.

The acquisitions may also explain the increases in accounts receivable, inventories and accounts payable that occurred. Overall it appears that Avnet will not have trouble generating cash in the future and paying off debt. CFO was positive all years, except 2006, which is likely to be an aberration.

2. Avnet is successful in generating positive CFO and has so far been able to make payments on debt. They would be a good credit risk.

3.Balance sheet information that would be useful includes:

· the proportion of short-term versus long-term debt,

· detail of types of debt outstanding (from notes),

· amounts of debt due in the next five years (from notes), and

· operating lease and other commitments the firm may have (from notes).

4.19

1.

Agilysys, Inc.

Statement of Cash Flows Summary Analysis

For the Years Ended March 31,

(dollars in thousands)

2007

%

2006

%

2005

%

Inflows:

Cash from operations

152,648

23

0

0

25,692

26

Proceeds-sale of invest.

0

0

788

1

0

0

Proceeds from marketable securities

1,147

0

0

0

0

0

Proceeds from sale of business

485,000

75

0

0

0

0

Proceeds from escrow settlement

423

0

0

0

0

0

Issuance of common shares

10,107

2

5,442

7

4,007

4

Excess tax benefit

1,854

0

0

0

0

0

Effect of exchange rate

0

0

367

0

810

1

Operating cash flows- discontinued operations

0

0

74,767

92

67,128

69

Total Inflows

651,179

100.0

81,364

100.0

97,637

100.0

Outflows:

Cash from operations

0

0

25,902

15

0

0

Purchase of marketable securities

0

0

6,822

4

0

0

Acquisition of business

10,613

5

27,964

16

0

0

Purchase of PPE

6,250

3

3,252

2

1,213

21

Redemption of Prf. Sec.

0

0

107,536

61

0

0

Principal payment

59,567

31

286

0

375

7

Dividends paid

3,675

2

3,608

2

3,330

59

Effect of exchange rate

97

0

0

0

0

0

Operating cash flows-discontinued operations

114,087

59

0

0

0

0

Investing cash flows-investing operations

73

0

24

0

742

13

Total Outflows

194,362

100.0

175,394

100.0

5,660

100.0

Change in cash

456,817

(94,030)

91,977

Agilysys, Inc. has volatile cash flow from operating activities (CFO) over the three years from 2005 to 2007. The firm experienced net losses from continuing operations all three years, although income was positive when discontinued operations are included. Cash from operating and investing activities has been separated between continuing and discontinued operations on the statement of cash flows. CFO was positive in 2005 and 2007 despite the net losses; however, CFO in 2006 was negative.

In 2005, accounts receivable decreased and accounts payable increased causing CFO to be positive. Just the opposite occurred in 2006. The increase in accounts receivable and decrease in accounts payable contributed to the negative CFO being larger than the net loss. In 2007, the large increases in accounts payable and accrued liabilities caused CFO to be positive, however, the firm will have to pay down those balances in the near future.

Agilysys generated 95% of cash inflows in 2005, from operations if both continuing and discontinued operations are included. The other 5% of cash was generated from the issuance of common stock and changes in the foreign exchange rate. While no CFO was generated from continuing operations in 2006, discontinued operations contributed 92% to cash inflows with 7% coming from the issuance of stock. In 2007, only 23% of cash came from CFO from continuing operations because 75% was cash received from selling the firm's distribution-related business.

Cash outflows vary significantly each year. In 2005, a relatively small dollar amount of cash was used. Dividends were the main use followed by purchases of property and equipment, investing related to the now discontinued operations and repayment of long-term obligations. Redemption of mandatorily redeemable preferred securities was the key use of cash in 2006. The firm made significant acquisitions in 2006 and had negative CFO which contributed to the overall outflows of cash. In 2007, the discontinued operations generated negative CFO. Agilysys was able to use cash from the sale of their business to pay down a large portion of long-term debt and continued to acquire other businesses for cash.

As noted in the excerpts the company has completed its transformation from its distribution business to its computer systems business through acquisitions and divestitures. If this new strategy is successful, Agilysys will hopefully begin to generate positive CFO. In the meantime, the firm has extra cash to use from the sale of the business in 2007. Capital expenditures should be insignificant in the future and the firm retired its long-term debt in 2007, so cash outflows will most likely consist of acquisitions and dividends. If good acquisitions are made, the firm should be able to position itself well with respect to cash.

2.The statement of cash flows is extremely useful in making credit decisions. Although the statement of cash flows is prepared from the balance sheet and income statement, it presents information in a way that reveals how the firm is generating cash and how the cash is being used, over a period of time. The volatility of CFO for Agilysys cannot be observed by looking at only the income statement or the balance sheet. The reasons for this volatility can be determined fairly quickly by looking at the statement of cash flows.

Chapter 5

5.1Six items should be considered when assessing the area of revenue:

· premature revenue recognition,

· use of the gross versus the net basis of recording revenue,

· vendor financing,

· charges to the allowance for doubtful accounts,

· price versus volume changes, and

· real versus nominal growth of sales.

5.2Depending on which inventory valuation method a firm uses, determines the value of cost of goods sold on the income statement and ending inventory balances on the balance sheet. If there is inflation or deflation of the products being valued, then cost of goods sold and ending inventory using FIFO or LIFO will be higher or lower depending on the direction of price changes. This in turn will impact whether net income is higher or lower.

If a firm uses the LIFO method of inventory valuation during inflationary times, it is possible to record paper profits if more inventory is sold than is purchased or manufactured. Understanding the inventory valuation methods, will allow the user of financial statements to understand what changes in these numbers are real versus which changes have occurred only on paper as a result of the choice of a particular method.

5.3While writing down an asset's value results in lower net income in the period of the write-down, relative to the next accounting period, net income will be higher. Companies that purposely write-down assets or write-down more than is necessary may be trying to show positive earnings growth in the following accounting period in hopes of impressing investors.

5.4Restructuring charges could be either an operating or a nonoperating expense, depending on the circumstances. If the restructuring charge is truly a one-time item that is not expected to recur, then it could be viewed as nonoperating. Firms, who record restructuring charges often, are more than likely recording items that are ordinary operating expenses in the course of their business.

5.5Purchasing treasury stock for investment purposes would be appropriate for firms that believe the market has undervalued their stock price. Some firms also purchase their own common stock in order to reissue it for employee stock programs. This is appropriate for preventing the dilution of the stock price for current investors. It would be a poor decision to purchase treasury stock for the sole purpose of trying to boost earnings per share, especially if the firm does not have enough cash to cover daily operating needs and long-term needs such as purchasing property, plant and equipment and repaying debt.

5.6Rather than viewing this as a one-time event, analysts should consider the implications of such a charge. DMR should have been writing off accounts of customers who were unlikely to pay on a yearly basis. The one-time charge in such a large amount should be a red flag that either the firm's accounting department is not competent, or that there is the possibility of manipulation of the reserve account, allowance for doubtful accounts.

5.7The gross profit margin could increase as a result of selling price increases or decreases in the costs of obtaining inventories. A third reason could be due to high fixed costs in the firm which do not increase or decrease with demand, such as depreciation of plant and equipment. With a 20 percent sales growth rate, excess capacity could be used without a corresponding increase in cost of goods sold. These would all be plausible reasons for the higher gross profit margin.

If a firm had written down a significant amount of inventory in the prior year, the following year, there would not be a corresponding write-down of inventory and gross profit margin would look higher relative to the prior year's number. This would be a quality issue that the analyst would want to take into consideration when analyzing a firm's financial statements.

5.8Salaries and wages are generally not considered to be discretionary expenses, however, paying higher salaries than is the norm, could be considered as partly discretionary. It appears that Costco is choosing to pay higher salaries and offer better benefits to their employees than Wal-Mart. By doing this, Costco appears to be operating more efficiently and effectively than Wal-Mart. Employee turnover is quite a bit lower at Costco and sales per square foot, profits per employee, and operating income growth are better at Costco.

5.9Students will have a variety of answers to this question, but an example of a possible response follows:

Conflicts of interest can arise between what management wants investors and creditors to see and the economic reality of transactions even when the accounting rules are followed. For example, firms may legally record leases as operating leases, whereby information about the obligations are revealed only in the notes, instead of directly on the balance sheet. By negotiating lease agreements that meet the criteria for operating leases as prescribed by the FASB, management can make sure the obligation is not shown as a liability, similar to a capital lease.

The timing of revenues and expenses can be planned so that the recording of the item occurs in one year as opposed to another year. In a year in which net income is lower than expected, management could choose to sell assets in order to report gains on sale. While there is nothing wrong with completing the sales transaction per se, the intent of selling the asset when it can mask an otherwise poor year would be considered poor quality of financial reporting.

5.10There is no response presented here as a variety of firms could be chosen.

5.11Since the SEC homepage changes as updates are made, students may find different items available each semester.

5.12The quality of financial reporting for Intel is good. Intel has explained items well in their management discussion and analysis and the notes to the financial statements. One questionable area that was discussed in Chapter 2 is whether the allowance for doubtful accounts may have been overestimated. Intel does use off-balance sheet financing and has a few potential liabilities, but these items are discussed as they should be and given Intel's solid financial position, the firm has no reason to purposely try to hide information.

5.13(a) I.Sales

1.Premature revenue recognition

According to Note 1, "Significant Accounting Policies", Kodak records revenue correctly. Detailed explanations are given by Kodak with regard to how all different types of revenue are recorded. (Note 1 of Form 10-K)

2.Gross vs. net basis

This item does not affect Kodak.

3.Allowance for doubtful accounts

The following is an analysis of the relationship between sales, accounts receivable and the allowance for doubtful accounts for Kodak.

(in millions)

2007

2006

% change

Sales

$10,301

$10,568

(2.5)

Accounts receivable, gross

2,053

2,206

(6.9)

Less: allowance for doubtful accounts

(114)

(134)

(14.9)

Accounts receivable, net

$1,939

$2,072

The relationship between sales, accounts receivable and the allowance for doubtful accounts is normal. As the percentage of sales has decreased, accounts receivable and the allowance account have also decreased. The percentage of the allowance account relative to total accounts receivable seems reasonable at 5.6 percent and 6.1 percent, respectively, for 2007 and 2006. Amounts actually written off have declined in 2007 compared to prior years, so a lower allowance for doubtful accounts balance makes sense.

4.Price vs. volume changes

Sales decreased 2.5 percent from 2006 to 2007. The overall decrease was a result lower volume of sales in traditional businesses. The Graphic Communications Group is the only segment that experienced increasing sales due to volume and favorable foreign exchange.

5.Real vs. nominal growth

Sales (in millions)

2007

2006

% change

As reported (nominal)

$10,301

$10,568

(2.5)

Adjusted (real)

10,301

10,867

(5.2)

Using base period CPI (1982-1984 = 100)

(2007 CPI/2006 CPI)

x

2006 sales

=

Adjusted sales

(207.3/201.6)

x

10,568

=

10,867

Adjusting for inflation indicates that sales decreased more than the nominal decrease in sales.

II.Cost of goods sold

6.Cost-flow assumption for inventory

Kodak uses FIFO or average cost for all of its inventories. FIFO produces lower quality earnings, but an inventory value on the balance sheet closest to current cost.

7.Base LIFO layer liquidation

This item does not affect Kodak.

8.Loss recognition on write-down of inventories

Kodak indicates in Note 1 that the firm provides reserves for obsolete inventories. The amount of any write-downs in 2007 has been combined with asset impairments in Note 17.

III.Operating Expense

9.Discretionary expenses

Kodak has the following discretionary expenses:

(in millions)

2007

2006

2005

Advertising expense (from Note 1)

$394

$366

$460

Research and development

535

578

739

Kodak decreased advertising expenses in 2006. There is no specific explanation provided in the management discussion and analysis for the decline in advertising, but it could be a result of elimination of traditional products. In 2007 Kodak has increased advertising for new products. If the reduction was in the film area only this is probably a good place to cut costs, but if advertising is not being maintained or increasing for digital products, this could negatively impact future sales.

Research and development (R&D) costs have declined each year. According to management, the reductions in 2007 are a result of realignment of resources and the timing of development projects. In 2006, the decrease was attributed to significant spending reductions related to traditional product lines and integration synergies within the GCG segment. Also contributing to the decline in 2006 is that purchased in-process R&D was written off in 2005 as part of the R&D amount, instead of as a separate line item, causing 2005 R&D to be higher than normal. It is poor quality reporting to combine purchased in-process R&D with actual ongoing research and development.

10.Depreciation

Kodak uses the straight-line method of depreciation which is generally of lower quality.

11.Asset impairment

Kodak reports $282 million of asset impairments in Note 17 but has combined the number with inventory write-downs. Other intangible asset impairments are recorded in Note 14 in the amount of $46 million for 2007.

12.Reserves

Kodak has reserve accounts for the allowance for doubtful accounts, restructuring charges, warranty costs and environmental liabilities (See Notes 2, 10, 11 and 12.)

13.In-process research and development

As noted in 9 above, Kodak has not reported this item separately, but as part of the R&D expense overall. This is poor quality of financial reporting.

14.Pension accounting-interest rate assumption

Kodak recorded net pension income of $181 million for U.S. pension plans and net pension expense of $50 million for non-U.S. pension plans in 2007. Kodak's U.S. pension plans are currently overfunded by $2,135 million, but the non-U.S. pension plans are underfunded by $595 million. Kodak has maintained an assumed long-term rate of return on plan assets of 8.99% on U.S. plans, but has increased the rate on non-U.S. plans from 7.99% to 8.10%. Since the actual returns on plan assets have been higher than the expected returns, the assumed rate is reasonable. Of concern is the underfunded non-U.S. pension plans combined with the large amounts accrued for other postretirement benefits of $2,524 million.

IV.Non-operating Revenue and Expense

15.Gains (losses) from sale of assets

Gains from sales of assets were recorded in 2007, 2006, and 2005, in the amounts of $139, $70, and $65 million, respectively, according to Note 14. There is also a gain from a sale of a business in 2007 in the amount of $19 million.

16.Interest income

Amounts for interest income are included in Note 15 and the amounts have increased each year from $24 million in 2005 to $59 and $95 million in 2006 and 2007.

17.Equity income

Equity income is included in Note 15, however, Kodak has sold their equity investments. The $5 million amount shown in Note 15 related to one of the equity investments is actually an impairment charge on the investment.

18.Income taxes

Kodak's effective tax rate has been volatile (benefit of 20 percent in 2007 and a provision of approximately 37 percent in 2006 and 2007) due largely to the effects of the valuation allowance account.

Net deferred tax assets are shown for both 2007 and 2006, however the valuation allowance is large which indicates that Kodak is not currently expecting to be able to use all the deferred benefits. Pensions and postretirement obligations, foreign tax credits and tax loss carryforwards have caused the largest amount of deferred tax assets.

19.Unusual items

Kodak does not have this category on their income statement.

20.Discontinued operations

Kodak has earnings from discontinued operations of $881 million in 2007. Note 23 shows the details of the amounts shown on the income statement.

21.Extraordinary items

Kodak does not have these items.

V.Other issues

22.Material changes in number of shares outstanding

The number of common shares outstanding has been relatively stable.

23.Operating earnings, a.k.a. core earnings, pro forma earnings or EBITDA

Kodak shows pro-forma financial information in Note 22 to show the effects of acquisitions as if they had occurred at the beginning of the periods presented.

Quality of Financial Reporting -- The Balance Sheet

Kodak has included "Commitments and Contingencies" (Note 11) on the face of their balance sheet, but also has guarantees that should be considered when assessing the potential obligations of the firm. These items are discussed in Note 12. According to Notes 11 and 12, Kodak has commitments and potential obligations totaling $1,659 million not reported directly on the balance sheet. These items are as follows (in millions):

· Operational commitments - $1,130

· Operating leases - $412

· Guarantees - $117

Quality of Financial Reporting -- The Statement of Cash Flows

There are no apparent problems of quality of financial reporting revealed on the statement of cash flows.

(b)A variety of answers is possible depending on the overall objective in adjusting net earnings. The following is one possible solution:

(in millions)

Net earnings as reported in 2007

$676

Adjustments

c. add back loss recognized on write-down of assets

328

h. deduct gain from sale of assets

(158

)

j. add back impairment charge on equity investment

5

m. deduct gain from discontinued operations

(881

)

($30)

Chapter 6

6.1The credit analyst is concerned with the ability of the borrower to repay interest and principal on loans. Questions raised in a credit analysis would focus on the borrowing cause, the firm's capital structure, and the source of the debt repayment. The investment analyst attempts to estimate the future earnings stream in order to attach a value to the securities being considered. Questions raised in an investment analysis would focus on the company's performance record, future expectations and the firm's competitive position, risk in the capital structure and the expected returns.

6.2Financial ratios can serve as screening devices, indicate areas of potential strength or weakness, and reveal matters that need further investigation. But financial ratios do not provide answers in and of themselves, and they are not predictive. Financial ratios should be used with caution and common sense, and they should be used in combination with other elements of financial analysis. It should also be noted that there is no one definitive set of key financial ratios, there is no uniform definition for all ratios, and there is no standard that should be met for each ratio. Finally, there are no “rules of thumb” that apply to the interpretation of financial ratios. Each situation should be evaluated within the context of the particular firm, industry, and economic environment.

6.3Liquidity ratios measure a firm’s ability to meet cash needs as they arise. Activity ratios measure the liquidity of specific assets and the efficiency of managing assets. Leverage ratios measure the extent of a firm’s financing with debt relative to equity and its ability to cover interest and other fixed charges. Profitability ratios measure the overall performance of a firm and its efficiency in managing assets, liabilities, and equity. Market ratios measure returns to stockholders and the value the marketplace puts on a company’s stock.

6.4The Du Pont System helps the analyst see how the firm's decisions and activities over the course of an accounting period interact to produce an overall return to the firm's shareholders.

By reviewing the relationships of a series of financial ratios, the analyst can identify strengths and weaknesses as well as trace potential causes of any problems in the overall financial condition and performance of the firm.

The ratios which are looked at include the return on investment (profit generated from the overall investment in assets) which is a product of the net profit margin (profit generated from sales) and the total asset turnover (the firm’s ability to produce sales from its assets). Extending the analysis the return on equity (overall return to shareholders, the firm’s owners) is derived from the product of return on investment and financial leverage (proportion of debt in the capital structure). Using this system, the analyst can evaluate changes in the firm’s condition and performance, whether they are indicative of improvement or deterioration or some combination. The evaluation can then focus on specific areas contributing to the changes.

6.5

Current Ratio

725,000

475,000

1.53 times

Quick Ratio

400,000

475,000

0.84 times

Average Collection Period

275,000

1,500,000/365

67 days

Inventory Turnover

1,200,000

325,000

3.69 times

Fixed Asset Turnover

1,500,000

420,000

3.57 times

Total Asset Turnover

1,500,000

1,145,000

1.31 times

Debt Ratio

875,000

1,145,000

76.4 %

Times Interest Earned

200,000

72,000

2.78 times

Gross Profit Margin

300,000

1,500,000

20.0 %

Operating Profit Margin

200,000

1,500,000

13.3 %

Net Profit Margin

76,800

1,500,000

5.1 %

Return on Total Assets

76,800

1,145,000

6.7 %

Return on Equity

76,800

270,000

28.4 %

The current position is deteriorating, as measured by the current and quick ratios, and is below the industry average. The average collection period has increased and is slightly longer than the industry average, indicating potential weakness in credit and/or collection policies. The inventory turnover has slowed and is well below competitors' levels. Eleanor's Computers is apparently overstocked with inventory due to inventory management problems and/or sluggish sales.

Capital asset efficiency is in good shape, as evidenced by an improving and above average fixed asset turnover. The efficient management of fixed assets approximately offsets the poor inventory turnover, and the total asset turnover is only slightly weaker than the industry.

The inventory has apparently been financed with debt, resulting in an increasing debt ratio, which is well above industry standards. A combination of too much debt and low profit is producing difficulty in covering interest payments, shown by times interest earned.

The gross profit margin has slipped due either to lack of cost controls for products sold, the need to sell products at discounts, or both. The operating profit margin, however, reflects good control of operating expense. The overall return, as measured by the net profit margin, has fallen because of the combination of cost/pricing policies and high interest charges.

The return on investment, which has declined and is below the industry average, reflects decreasing profitability and the overstocking of inventory. Return on equity is above the industry average and is trending upward. Although the high debt ratio improves the return on equity, it also increases risk. The increased use of financial leverage has more than offset the decrease in profitability:

Net Profit

Margin

x

Total Asset

Turnover

=

Return on

Investment

5.12

x

1.31

=

6.71

Return on

Investment

x

Financial

Leverage

=

Return on

Equity

6.71

x

4.24

=

28.44

6.6Luna's current ratio has increased and is above the industry average, the average collection period has shortened and is less than the industry average, and the inventory turnover ratio has improved; the ratios indicate that Luna has no obvious problems with liquidity or the management of inventory and receivables. Both the total asset turnover and fixed asset turnover ratios have declined, however, and are below the industry. Problems with asset utilization are apparently caused by the management of capital assets. Luna's expansion of capital assets has been more rapid than sales growth, given the declining ratio; the firm may be underutilizing its plant and equipment or may not yet be benefiting from asset growth. Luna's debt ratio is stable and below the industry, while interest coverage is above industry; the declining fixed charge coverage implies that lease payments for Luna are excessive. The decreasing net profit margin is apparently attributable to escalating operating costs rather than cost of goods sold, and the operating expenses are traceable to costs associated with the capital asset expansion and lease payments. These problems have adversely affected the overall returns.

6.7

(a) FIFO

(b) LIFO

Gross profit margin

53.3

3

%

25.8

3

%

Operating profit margin

33.3

3

%

5.8

3

%

Net profit margin

19.9

3

%

2.0

6

%

Current ratio

1.6

1

1.1

0

Quick ratio

0.7

7

0.7

7

(c)The ratios calculated using FIFO give the appearance that Rare Metals, Inc. is doing well, while the ratios calculated using LIFO give the opposite effect. Based on the cost of goods sold (COGS) and ending inventory amounts, prices of the metal have been increasing. The first goods purchased, which are the lower priced items, are included in COGS under FIFO. Using LIFO, however, a better match is made with current cost and revenues and a more realistic picture of profitability is illustrated. The company will most likely have to replace goods sold at the higher price in the future. The difference in profit margins has resulted from a “paper” profit recorded under the FIFO method.

Ending inventory is undervalued when LIFO is used during inflation. The FIFO valuation is a better reflection of the current market price of Rare Metals, Inc.’s inventory. As a result the current ratio of 1.61 is a more accurate representation than 1.10. The quick ratios are identical because inventory has been eliminated from the calculation, and inventory is the only difference in the numbers being compared.

(d)Yes, cash flow from operating activities will differ due to the difference in taxes paid. Assuming that the inventory method is the only cause of differences in amounts on the income statement, the amount of tax expense is greater when FIFO rather than LIFO is used. Although tax expense may not be identical to cash paid for taxes, if in this case it is assumed that taxable income and earnings before taxes are the same, Rare Metals Inc. would have paid $289 million more in taxes if they chose the FIFO method instead of the LIFO method. While profit margins would be higher using FIFO, cash flow from operations would be higher using LIFO. It is important to note that it is cash, not profit or earnings, which must be used to pay the bills!

6.8

(a)XYZ is more liquid than ABC. XYZ’s current and quick ratios are both above one and the cash-flow liquidity ratio is close to one, indicating the company should be able to pay current liabilities as they come due. ABC’s liquidity ratios are all below one. It appears that ABC must find external funding in the short-term to be able to pay current liabilities. XYZ generated more than 2.5 times the cash from operations in compared to ABC.

Total asset turnover is the same for both firms with ABC showing better inventory efficiency than XYZ, but XYZ is managing accounts receivable and fixed assets better than ABC.

ABC is highly leveraged compared to XYZ. This is not surprising given the differences seen in the liquidity area between the two firms. The cash flow adequacy ratio is over one for XYZ, which means the firm has no trouble covering capital expenditures, debt repayment and dividends with cash from operations. ABC is only covering $0.43 on every dollar of these same items with cash generated from their operations.

ABC generates higher operating and net profits than XYZ, and therefore has higher return on assets and equity ratios. The return on equity ratio is extremely high due to the fact that ABC uses a significant amount of debt (76%) and is generating sufficient returns to cover the cost of the debt. XYZ, while not as profitable, is translating their profits into cash much better than ABC.

(b)

ABCXYZ

Stock Price

EPS

$41

$4.59

$35

$1.19

PE Ratio

8.9

29.4

The PE ratio indicates the value being placed by the stock market on a company’s earnings. A higher value is being placed on XYZ compared to the value placed on ABC. Investors may be placing a higher value on XYZ, because they understand the importance of cash flow from operations and view it as a better measure than accrual-based profits.

6.9

Current

Quick

Net Wk. Capital

Debt

(a)

D

N

N

I

(b)

N

N

N

N

(c)

I

I

I

D

(d)

D

D

D

N

(e)

D

N

D

I

(f)

N

N

N

N

(g)

I

I

I

I

(h)

I

I

I

D

(i)

N

N

N

D

(j)

N

D

N

N

(k)

D

D

N

I

(l)

I

N

N

D

The instructor might want to discuss why a firm would make a specific transaction at the end of the period to affect certain ratios. For example, consider item (l). If the objective is to increase the current ratio and decrease the debt ratio, perhaps to meet requirements in a loan covenant, the firm could pay cash to a supplier to reduce payables at the end of the accounting period.

6.10

(a)

Debt

Equity

Debt Ratio*

40+10

90+10

= 50%

40

90+10

= 40%

Times Interest Earned*

18

4.8+1.5

= 2.86 x

18

4.8

= 3.75x

Operating Profit

18,000,000

18,000,000

Interest Expense

6,300,000

4,800,000

Earnings before tax

11,700,000

13,200,000

Income tax exp. (40%)

4,680,000

5,280,000

Net Income

7,020,000

7,920,000

Shares Outstanding

800,000

1,000,000

Earnings per share

$8.78

$7.92

Return on Equity

7,020

50,000

= 14.04%

7,920

60,000

= 13.20%

Return on Assets (adjusted)

7,020+6,300(1-0.4)

100,000

= 10.80

7,920+4,800(1-0.4)

100,000

= 10.80

Financial Leverage Index

14.04

10.80

= 1.3

13.20

10.80

= 1.2

*Numbers are in millions

(b)Use of debt would increase the debt ratios from 44% to 50%, while equity financing would reduce the debt ratio to 40%. Interest coverage would decline from 3.1 times to 2.86 times if debt is employed; times interest earned would increase to 3.75 times with stock financing. Earnings per share would be higher with the debt financing. The financial leverage index is greater than 1, indicating the successful use of financial leverage under either alternative, but is higher with debt financing.

The Board would want to consider each of these ratios and other factors as well. The additional risk resulting from adding debt would likely exert downward pressure on the price to earning ratio and thus could result in a decreased share price. The Board would want to review the reasonableness of the projection for operating profit, including the stability and predictability of the firm's earnings stream in the past. Other factors would include the marketability of stock relative to the current and future availability of credit; interest rate expectations; the effect of each alternative on the cost of capital; and the amount and timing of planned future expansions.

6.11At first glance, it appears that Wal-Mart has poor short-term liquidity. The current, quick and cash flow liquidity ratios are all below 1.0 and decreasing from 2007 to 2008. This means the firm does not have as many current assets or liquid items to cover current liabilities. The cash conversion cycle, however, offers a much better picture of the firm. The average collection period is insignificant at 4 days which makes sense. Wal-Mart takes bank credit cards such as MasterCard and Visa and is, therefore, not at risk if customers default. Days inventory held has improved by two days and is currently at 45 days which does not seem too large for a giant retailer. The days payable outstanding is stable at 39 days which indicates that Wal-Mart pays suppliers in a timely manner. The cash conversion cycle has dropped one day to ten days in 2008 which is a relatively short conversion period. The fact that Wal-Mart is able to convert sales into cash so quickly may explain why they are successful with a current ratio below one. Further evidence that Wal-Mart does not have liquidity problems is the positive and increasing cash from operations number.

Operating efficiency is good as evidenced not only by the cash conversion cycle, but also by the fixed and total asset turnover ratios which are stable.

6.12AMC had a risky capital structure in 2006, with over 70 percent debt, most of which was long-term. It is good, however, that AMC has been able to reduce their risk by reducing debt in 2007. The debt ratio of 66.1% is high, but not nearly as risky. The interest (accrual-based and cash-based) and fixed charge coverage ratios are low, but have improved from 2006 to 2007. An increase in operating profit appears to have also contributed to an increase in cash flow from operations. In addition, the lower debt most likely caused interest expense to be smaller in 2007. Cash flow adequacy is also low and below one, indicating that AMC cannot cover capital expenditures, debt repayments and dividends with cash generated from operations. The ratio has improved in 2007 which is a positive sign.

The profitability of AMC is improving. The gross profit margin has improved due to better cost control or an increase in prices. Operating profit has benefited from the improved gross profit margin, but also from reduction of other operating costs as well. Net profit is higher than operating profit in 2007 and has improved from a loss in 2006 to a profit in 2007. This may be a result of the reduction in debt causing lower interest expense. Return on assets and return on equity were negative in 2006 and because of the improved profitability in 2007, are now positive. Return on equity is almost three times greater than return on assets due to the high leverage of AMC. The cash return on assets has improved significantly over the past year.

AMC has clearly made the appropriate strategic moves to improve the capital structure and the profitability of the firm from 2006 to 2007. Long-term solvency at this point is not a concern.

6.13Writers of the 2010 annual report will probably want to emphasize rebounding in 2010 from an abnormal year in 2009. They will want to point out reasons for the improvement in 2010, showing how the company is building for continued success. The "Summary of Analysis" section at the end of Chapter 5 provides an overview of the positive aspects of R.E.C., Inc.'s performance and outlook. The annual report will focus on strengths: sales growth, well-managed expansion, increased profit, positive cash flow, effective cost controls, improvement in receivables and inventory management, overall favorable outlook for economy, industry and geographic location. There will be some need to explain the identified problems, such as the negative cash flow in 2009 and how the firm has recovered, which is actually a major plus.

6.14There is no solution presented for this problem since students will choose different industries. Having students share what they have learned from their research can lead to interesting discussions.

6.15 There is no solution presented for this problem since students will choose different industries. Having students share what they have learned from their research can lead to interesting discussions.

6.16

(a) and (b)

2007

2006

2005

Ind.

Avg.*

Short-term liquidity

Current ratio

2.79

2.15

2.2

Quick ratio

2.39

1.64

1.1

Cash flow liquidity ratio*

3.27

2.42

Average collection period

25 days

28 days

53 days

Days inventory held

67 days

92 days

81 days

Days payable outstanding

47 days

48 days

38 days

Cash conversion cycle

45 days

72 days

96 days

Operating efficiency

Accounts receivable turnover

14.88

13.06

7.0

Inventory turnover

5.46

3.98

4.5

Accounts payable turnover

7.81

7.61

9.5

Fixed asset turnover

2.27

2.01

9.1

Total asset turnover

.69

.73

1.1

Leverage

Debt ratio

23.16%

24.02%

53.9%

Long-term debt to total capitalization

4.43%

4.79%

Debt to equity

0.30

0.32

0.8

Financial leverage index

1.30

1.31

Times interest earned

548 times

236 times

636 times

6.1 times

Cash interest coverage

1,027 times

523 times

669 times

Fixed charge coverage

50 times

32 times

72 times

Cash flow adequacy**

1.65 times

1.20 times

1.89 times

Profitability

Gross profit margin

51.92%

51.49%

59.36%

34.2%

Operating profit margin

21.43%

15.97%

31.14%

4.6%

Net profit margin

18.20%

14.26%

22.31%

Cash flow margin

32.93%

30.02%

38.18%

Return on total assets

12.54%

10.43%

Return on equity

16.31%

13.72%

Cash return on assets

22.69%

21.96%

*includes trading assets

**includes short-term debt

41

2007

2006

2005

Ind.

Avg.

Market measures

Earnings per share

$1.20

$0.87

$1.42

PE ratio

Based on closing price

22.30

23.28

Dividend payout rate

37.50%

45.98%

Dividend yield

Based on closing price

26.76%

20.25%

* Industry average is from The Risk Management Association, Annual Statement Studies, 2007; SIC #3674

(c)As requested, an evaluation of Intel has been completed. The following report includes an evaluation of short-term liquidity, capital structure and long-term solvency, operating efficiency and profitability, market measures and quality of financial reporting issues. Strengths and weaknesses are identified and the investment potential and creditworthiness of the firm are assessed.

Short-term Liquidity

Intel's short-term liquidity is impressive. The current and quick ratios are both increasing due to the increase in cash, short-term investments and trading assets, while current liabilities are stable. The current and quick ratios in 2007 are above the industry average. The cash-flow liquidity ratio increased as well due to the increases in liquid assets and increasing cash from operations. Intel has a significant amount of cash and short-term investments and therefore, should not have problems paying debt as it comes due. In fact, cash and short-term investments are 28% of total assets. This company has no problem generating cash from operations as evidenced by the statement of cash flows.

Accounts receivable are decreasing despite an increase in sales which is positive for Intel since this means the firm is probably collecting cash efficiently from its credit customers. The collection period has improved by three days and is less than half the industry average. One concern is that two customers account for 35% of accounts receivable and sales and a default by either customer would be significant to the company. The two customers are Dell and Hewlett-Packard so the risk of default is probably small. It appears that in 2005 the firm may have overestimated the allowance for doubtful accounts. The account balance at the end of 2005 was much larger than it needed to be and Intel has reversed the charges in 2006 and 2007, thus increasing net income in those two years. Intel actually had net recoveries of bad debts in 2007 in the amount of $1 million indicating that the firm does a superb job collecting on accounts receivable. At the end of 2007 the allowance account seems to be in line with what it should be given the low rate of defaults that Intel experiences.

Days inventory held has decreased significantly and is now below the industry average. This is good because of the rapid obsolescence of products in the high technology industry. According to the management discussion and analysis (MDA) the reduction of inventories was a result of lower product costs and reclassification of inventories associated with an anticipated divestiture.

Days payable outstanding has decreased by one day indicating Intel is paying suppliers faster, however, Intel takes longer to pay than the competition. At 47 days this is probably not a concern. It is possible that Intel, due to its excellent short-term liquidity, is better able than its competitors to obtain more favorable credit terms from its suppliers.

The cash conversion cycle has improved by 27 days due to the large decrease in days inventory held and the better collection period.

Overall the short-term liquidity of Intel is excellent. Compared to the industry Intel operates within, their ratios and account balances are better than their competitors. Intel has higher amounts of cash and investments than the competition.

Operating Efficiency

As discussed under short-term liquidity, Intel has improved the turnover of accounts receivable and inventory and is also paying accounts payable faster.

The fixed and total asset turnover ratios for Intel are low compared to the competition. Intel invests heavily in fixed assets to increase capacity, while keeping inventory levels low, a strategy opposite their competition. The fixed asset turnover increased due to increasing sales and decreasing net property, plant and equipment. The total asset turnover declined. This is not a result of the poor utilization of working capital or fixed assets, but rather a result of the large increase in cash and investments.

Capital structure and long-term solvency

Intel has little debt, especially when compared to their competition. Most of the company's debt is short-term and all debt can be covered with the current levels of cash and short-term investments. Liabilities make up approximately 23 percent of total assets, making Intel's capital structure low risk.

Intel is generating profits and a large amount of cash from operations, allowing the company to cover interest and lease payments easily. Cash flow adequacy is over one meaning Intel generates a lot of excess cash each year. The financial leverage index indicates Intel is using debt successfully in both 2007 and 2006. Should Intel need to borrow in the future, the large equity cushion will allow them to obtain financing readily.

Profitability

Revenues for Intel increased in 2007 after a decline in 2006. Operating costs increased in 2006 causing a significant decline in profitability, however, in 2007 operating costs did not increase proportionately with revenue, therefore, profitability increased. Digital Enterprise Group revenues increased due to higher volume and higher average selling prices. The Mobility Group revenues increased due to volume, as selling prices decreased.

The gross profit margin decreased significantly over the three year period, although it increased slightly from 2006 to 2007. The MDA explains that the drop in gross margin was largely a result of the implementation of the FASB rule requiring the firm to record share-based compensation. The numbers are not comparable to 2005 as share-based compensation was not reported prior to 2006. Intel is projecting that their gross profit margin will return to higher levels (around 57%) in 2008 due to lower costs and the elimination of lower margin businesses.

Operating profit decreased significantly from 2005 to 2006, as a result of the implementation of the FASB rule requiring share-based compensation be recorded. From 2006 to 2007 operating profit increased as a result of changes in the operating expenses other than cost of goods sold. Research and development costs (R&D) declined in 2007 due to lower development process costs as Intel transitioned from R&D to manufacturing using the 45nm process technology. Marketing, general and administrative expenses also declined in 2007 as a result of lower headcount, lower share-based compensation and lower advertising expenses. The lower costs are attributed to the restructuring program Intel has undertaken to increase efficiency and improve cost structure. The firm is beginning to see these results in 2007 as evidenced by the increased profit numbers. Amortization expense has declined in 2007 as a result of fully amortized intangible assets.

Intel has net overall gains from equity investments in 2006 and 2007 although the amount is insignificant. Interest income and other, net, is a combination of gains from divestitures and interest income. Divestiture gains were less in 2007 compared to 2006; however, interest income was higher due to higher investment balances and higher interest rates.

Intel's effective tax rate is relatively low compared to the statutory rate of 35 percent. The firm has benefited from lower foreign tax rates, export sales benefits, domestic manufacturing benefits and research and development credits. The exceptionally low rate in 2007 was a result of settlements which will probably not occur in future years, therefore, one could expect future effective tax rates to be around 28%.

Net profits are healthy and increasing. The return on assets (both accrual-based and cash-based) and return on equity have improved in 2007 as a result of the increasing profits without a proportional increase in assets and equity. If costs are managed well, profits should continue to trend upward. To continue to be successful, Intel must maintain good control of expenses, while continuing to develop cutting edge products.

Market Measures

Earnings per share decreased in 2006, but has increased in 2007. The increasing sales and profits have not caused the PE ratio to increase which is surprising. The PE ratio dropped slightly in 2007 indicating that the marketplace is not placing as high a value on Intel despite the excellent year Intel had in 2007. This could be due to the riskiness of the high technology industry combined with the concerns about the general economy, in particular rising oil prices and the housing and mortgage crisis.

The dividend yield offers a good return for investors. Intel has chosen to increase their dividends every year while also repurchasing their common stock. The amount of common stock being repurchased each year has declined from 2005 to 2007.

Quality of Financial Reporting

Intel has disclosed key information as required in their annual report and Form 10-K. The only questionable item is whether Intel in prior years had overstated their allowance for doubtful accounts, a reserve account that can be manipulated. This account appears appropriate in 2007. Overall, the quality of financial reporting is good.

Strengths

Strong cash flow from operations

Solid short-term liquidity

Better receivables, inventory and fixed asset management

Low debt levels

Increasing sales and profits

Increasing dividends

Weaknesses

Reliance on two customers

Riskiness and competitiveness of high technology industry

Investment potential

Intel's stock prices have dropped due to the overall economic downturn. Since revenues and profits are increasing and Intel's financial position is excellent, Intel's stock may be a good value at this time. Investors may have to be patient and willing to wait for a turnaround in both the general economy and the technology industry, so the investment would not be recommended for those investors wanting a quick profit.

Creditworthiness

Intel's solid short-term and long-term solvency combined with strong cash flow from operations and a low debt ratio make this company a good credit risk.

6.17

Analysis of Eastman Kodak - 2007

Eastman Kodak (Kodak) has just completed a major restructuring to move out of its traditional area of business, film, and into the digital area and high technology industry. The competition in the technology industry is probably far greater than Kodak has ever experienced in the film industry. In recent years the firm has not had impressive financial results although they are improving. A discussion of the financial well-being of Kodak follows, as well as recommendations for investors and creditors.

Short-term liquidity

Kodak's short-term liquidity is improving. The current and quick ratios are above one and have improved from 2006 to 2007. This is a result of an increase in cash and cash equivalents while current liabilities have been stable. The cash flow liquidity ratio is increasing for the same reason.

The average collection period has decreased three days but is still fairly long at 69 days. This should be monitored. Inventory days held is stable and an acceptable amount at 45 days. Kodak is taking significantly longer to pay suppliers. At 58 days this is probably not a problem yet, but the firm needs to be sure that bills continue to be paid on time. The lengthening of the days payable outstanding is the main reason that the cash conversion cycle declined 20 days. This has allowed Kodak to be more efficient which is good.

The decreasing cash from operating activities is mainly the result of discontinued operations and the payment on liabilities. These items should not have as a great an impact in future years, so it can be expected that Kodak's cash from operations will increase.

Operating efficiency

The accounts receivable, inventory and payables turnovers were discussed under short-term liquidity. Fixed and total asset turnovers have increased which is good. This is a result of the large reduction in fixed assets due to downsizing. Total asset turnover only increased slightly which has to do with the large increase in cash and cash equivalents.

Capital Structure

Kodak's debt structure is risky, but improving. The firm now has 78 percent debt in 2007, compared to 90 percent debt in 2006. Long-term debt has declined the most as Kodak used cash from discontinued operations to help pay down debt.

The times interest earned and fixed charge coverage ratios are negative due to the operating losses Kodak has generated. Because these are accrual-based ratios, it is important to assess the cash situation of Kodak. In 2004, Kodak generated an operating loss. The cash interest coverage ratio is positive and increasing so it appears that Kodak can certainly make their contractual payments of interest and leases. Interest expense dropped in 2007 due to the reduction in debt which is good for the firm and has improved the coverage ratios.

Cash flow adequacy is low and below one. This is a result of both the relatively low cash from operations amount and the large debt repayments the firm must make. Kodak has been reducing capital expenditures, but still continues to pay dividends each year. Continuing to focus on reducing debt will help improve this ratio.

Profitability

Eastman Kodak (Kodak) has experienced decreasing sales from 2005 to 2007 mainly due to volume declines in traditional businesses. The Graphic Communications Group is the only segment that increased sales over the three year period. Kodak's operating costs declined more than sales which positively impacted operating profit by reducing the amount of Kodak's operating loss each year.

Overall gross profit margin has increased as a result of cost reduction initiatives and favorable foreign exchange rates. The Consumer Digital Imaging Group (CDG) had declining sales as a result of traditional products, but newer digital product lines increased 7%. Gross profit margin for CDG increased as a result of cost reductions and favorable foreign exchange. The Film Products Group (FPG) sales were expected to decline given the movement away from film. Increasing costs related to manufacturing, changes in depreciation, and silver costs caused the gross profit margin of FPG to decline from 43.5% to 36.9% in 2006, however, gross profit margin was stable in 2007 compared to 2006. The Graphic Communications Group (GCG) positively contributed to revenues, however, gross profit margin which increased in 2006, decreased in 2007. The increase in 2006 was a result of reduced costs and favorable price/mix as a result of acquisitions. In 2007, increased aluminum costs for manufacturing and an unfavorable price/mix of products caused the drop in gross profit margin.

Kodak has generated operating losses in all three years; however, the loss is diminishing in size each year. Kodak has successfully decreased selling, general and administrative costs through their restructuring efforts and cost reduction initiatives. Advertising costs were cut in 2006, but have been partially restored in 2007. This is a positive sign as Kodak needs to advertise new product lines and maintain its positive brand recognition.

Research and development (R&D) costs have declined each year. According to management, the reductions in 2007 are a result of realignment of resources and the timing of development projects. In 2006, the decrease was attributed to significant spending reductions related to traditional product lines and integration synergies within the GCG segment. Also contributing to the decline in 2006 is that purchased in-process R&D was written off in 2005 as part of the R&D amount, instead of as a separate line item, causing 2005 R&D to be higher than normal. While the cuts made in R&D appear to be appropriate, it will be important for Kodak to commit an appropriate amount of funds to R&D in the future to remain innovative.

Restructuring costs have been significant each year as Kodak transitions from film to digital products. The company has laid off large numbers of employees and sold plant and equipment. As of the end of 2007, most of the restructuring is complete and as Kodak moves into 2008, the firm should begin to realize more significant cost savings. According to management only modest charges in this area should occur in 2008 and beyond. Kodak should realize an operating profit in 2008 as a result of their restructuring efforts.

Other income and expenses include gains and losses on sales of capital assets, as well as impairments to assets. These amounts should be minimal in the future as a result of the completion of the restructuring program. Lower interest expense in 2007 is a result of Kodak paying down debt.

In 2007, Kodak realized a tax benefit as a result of losses and settlements with tax authorities that resulted in benefits. The firm's tax rate will most likely be higher in the future assuming Kodak becomes more profitable and stable after the many years of restructuring.

Net profit margin improved all three years. The positive net profit margin in 2007 is a result of a one-time gain from discontinued operations of the Health Group segment. Without this gain Kodak would have reported a net loss. Kodak has worked to overcome challenges related to their transition to a high technology area. Their strategy appears to be beneficial in terms of profitability. Future cost savings should allow Kodak to generate profits in 2008.

Market Measures

Due to the net losses from continuing operations the PE ratio is not meaningful. In 2006 Kodak's closing stock price was higher than at the end of 2005, but by the end of 2007, the stock had dropped below 2005 year-end's price. Much of this decline could be attributed to general economic conditions. With both the sharp spike in oil prices and the subprime mortgage crisis, sales of luxury items would most likely decline as consumers tend to delay purchases of items such as digital cameras and the types of products that Kodak sells. Kodak has improved its financial position immensely, even though the firm still has a risky capital structure.

Quality of financial reporting

Overall Kodak has delivered the required financial information. Mixing in-process R&D with the recurring amounts of R&D is misleading, however, that appears to be the most significant example of poor quality reporting found in the report.

Strengths

Improving short-term liquidity

Fixed asset turnover increasing

Long-term debt decreasing

Restructuring and transition from film to digital area near completion

Improving profit margins

Weaknesses

Long average collection period

Risky debt structure

Operating and net losses from continuing operations

Competitive industry

Negative economic conditions

Investment Potential

Kodak's stock price has declined since 2005, but appears to be partly the result of weak general economic conditions. The firm has made significant improvements in their financial structure as a result of their restructuring. Management is looking to rebuild the firm by finding high return products to replace the loss of the formerly profitable film market. Investing in Kodak in the short-term is not recommended. There is potential stock price growth in the long-term, however, if management succeeds. This stock is not for risk averse investors.

Creditworthiness

Kodak's already high debt ratio combined with its off-balance sheet commitments does not make it a good credit risk. Kodak needs to increase profits and CFO before taking on more debt.

53

6.18

1.

Please note that the year-end for Target is at the end of January each year. The years ended in 2008, 2007 and 2006 are referred to in the analysis as 2007, 2006 and 2005 since most months of the fiscal year fall within those actual years.

Short-term liquidity

Target's current, quick and cash flow liquidity ratios are all increasing. Cash and cash equivalents and accounts receivable both increased while accounts payable and accrued liabilities decreased. The cash flow liquidity ratio did not increase nearly as much as the current and quick ratio as a result of cash from operations (CFO) decreasing from 2006 to 2007. The drop was a result in increasing current assets.

The cash conversion cycle has increased 12 days. This is a result of the average collection period increasing eight days, the inventory days held increasing two days and days payable outstanding decreasing two days. The increase in the collection period is not a good trend. As mentioned in the management's discussion and analysis, the industry has experienced a decline in payment rates. This may result in much larger bad debts if customers are having trouble paying their bills.

Target's sales,