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I do need it today by 9pm EST, if not, I have to find someone else. Thanks,,,For this Distingiushed Scholar Project, your assignment is to research Starbucks. Once you have found the financial statements, you will calculate the past three year’s worth of financial ratios found on page 119 of the textbook. You will need to calculate all of the Liquidity and Asset Management ratios, Total debt to total assets ratio, all of the Profitability ratios, the P/E and M/B ratio.,,The assignment to research is Starbucks.,,Go to bottom of page to Table 4-2 which is Allied Food Products: Summary of Financial Ratios (Millions of Dollars) this will give you a idea for the question that is ask above.,,,,CHA P TER4 ,CHA P TER4 ,ANALYSIS OF FINANCIAL ,STATEMENTS1 ,,,Enron, WorldCom ,Lessons Learned from Enron and WorldCom ,,In early 2001, Enron appeared to be on top of the world. The high-flying energy ,firm had a market capitalization of $60 billion, and its stock was trading at $80 a ,share. Wall Street analysts were touting its innovations and management success ,and strongly recommending the stock. Less than a year later, Enron had ,declared bankruptcy, its stock was basically worthless, and investors had lost billions ,of dollars. This dramatic and sudden collapse left many wondering how so ,much value could be destroyed in such a short period of time. ,,While Enron’s stock fell steadily throughout the first part of 2001, most ,analysts voiced no concerns. The general consensus was that it was simply ,caught up in a sell-off that was affecting the entire stock market and that its ,long-run prospects remained strong. However, a hint of trouble came when ,Enron’s CEO, Jeffrey Skilling, unexpectedly resigned in August 2001; he was ,replaced by its chairman and previous CEO, Ken Lay. By the end of August, its ,stock had fallen to $35 a share. Two months later, Enron stunned the financial ,markets by announcing a $638 million loss, along with a $1.2 billion write-down ,in its book value equity. The write-down, which turned out to be grossly inadequate, ,stemmed primarily from losses realized on a series of partnerships set up ,by its CFO, Andrew Fastow. Shortly thereafter, it was revealed that Enron had ,,1 We have covered this chapter both early in the course and toward the end. Early coverage gives ,students an overview of how financial decisions affect financial statements and results, and thus of ,what financial management is all about. If it is covered later, after coverage of bond and stock valuation, ,risk analysis, capital budgeting, capital structure, and working capital management, students ,can better understand the logic of the ratios and see how they are used for different purposes. ,Depending on students’ backgrounds, instructors may want to cover the chapter early or late. ,,© AP PHOTO/RON EDMONDS ,,,Chapter 4 Analysis of Financial Statements ,,guaranteed the partnerships’ debt, so its true liabilities were far higher than the ,financial statements indicated. These revelations destroyed Enron’s credibility, ,caused its customers to flee, and led directly to its bankruptcy. ,,Not surprisingly, Enron’s investors and employees were enraged to learn ,that its senior executives had received $750 million in salaries, bonuses, and ,profits from stock options for good performance in the same year before the ,company went bankrupt. During that year, senior executives were bailing out of ,the stock as fast as they could, even as they put out misleading statements ,touting the stock to their employees and outside investors. Fastow has since ,pleaded guilty to fraud and is cooperating with authorities in the cases against ,his former bosses, Lay and Skilling, who have been indicted for their roles in ,Enron’s collapse and await trial. ,,After Enron declared bankruptcy, critics turned their attention to the company’s ,auditor, Arthur Andersen, and to certain Wall Street analysts who had ,blindly recommended the stock over the years. Critics contended that the auditors ,and analysts neglected their responsibilities because of conflicts of interest. ,Andersen partners looked the other way because they didn’t want to compromise ,their lucrative consulting contracts with Enron, and the analysts kept recommending ,the stock because they wanted to help the investment banking ,side of their firms get more Enron business. ,,As if the Enron debacle was not enough, in June 2002 it was learned that ,WorldCom, an even larger company, had “cooked its books” and inflated its ,profits and cash flows by more than $11 billion. Shortly thereafter, WorldCom ,collapsed, with many more billions of investor losses and thousands unemployed. ,Enron had set up complicated partnerships to deceive investors, but ,WorldCom simply lied, reporting normal operating costs as capital expenditures ,and thus boosting its reported profits. Interestingly, Enron and WorldCom used ,the same auditing firm, Arthur Andersen, which was itself put out of business, ,causing about 70,000 employees to lose their jobs. It is also interesting to note ,that Citigroup’s investment banking subsidiary, Salomon Smith Barney, earned ,many millions in fees from WorldCom, and that Salomon’s lead telecom analyst, ,Jack Grubman, who helped bring in this business, did not downgrade World-,Com to a sell until the very day the fraud was announced. At that point the ,stock was selling for less than a dollar, down from a high of $64.50. ,,The Enron and WorldCom collapses caused investors throughout the world ,to wonder if these companies’ misdeeds were isolated situations or were symptomatic ,of undiscovered problems lurking in many other companies. Those ,fears led to a broad decline in stock prices, and President Bush expressed ,outrage at executives whose actions were imperiling our financial markets and ,economic system. In response to these and other abuses, Congress passed the ,Sarbanes-Oxley Act of 2002. One of its provisions requires the CEO and the ,CFO to sign a statement certifying that the “financial statements and disclosures ,fairly represent, in all material respects, the operations and financial condition” ,of the company. This will make it easier to haul off in handcuffs a CEO or ,CFO who has misled investors. ,,Financial statements have undoubtedly improved in the last few years, and ,they now provide a wealth of good information that can be used by managers, ,investors, lenders, customers, suppliers, and regulators. As you will see in this ,chapter, a careful analysis of a company’s statements can highlight its strengths ,and shortcomings. Also, as you will see, financial analysis can be used to predict ,how such strategic decisions as the sale of a division, a change in credit or ,inventory policy, or a plant expansion will affect a firm’s future performance. ,,,102 ,,Part 2 Fundamental Concepts in Financial Management ,,Putting Things In PerspectivePutting Things In Perspective ,The primary goal of financial management is to maximize shareholders’ ,wealth over the long run, not to maximize accounting measures such as net ,income or EPS. However, accounting data influence stock prices, and these ,data can be used to understand why a company is performing the way it is ,and to forecast where it is heading. Chapter 3 described the key financial ,statements and showed how they change as a firm’s operations undergo ,change. Now, in Chapter 4, we show how the statements are used by managers ,to improve performance; by lenders to evaluate the likelihood of collecting ,on loans; and by stockholders to forecast earnings, dividends, and ,stock prices. ,,If management is to maximize a firm’s value, it must take advantage of ,the firm’s strengths and correct its weaknesses. Financial analysis involves ,,(1) comparing the firm’s performance to other firms, especially those in the ,same industry, and (2) evaluating trends in the firm’s financial position over ,time. These studies help management identify deficiencies and then take ,corrective actions. We focus here on how financial managers and investors ,evaluate firms’ financial positions. Then, in later chapters, we examine the ,types of actions management can take to improve future performance and ,thus increase the firm’s stock price. ,The most important ratio is the ROE, or return on equity, which is net ,income to common stockholders divided by total stockholders’ equity. ,Stockholders obviously want to earn a high rate of return on their invested ,capital, and the ROE tells them the rate they are earning. If the ROE is ,high, then the stock price will also tend to be high, and actions that ,increase ROE are likely to increase the stock price. The other ratios provide ,information about how well such assets as inventory, accounts receivable, ,and fixed assets are managed, and about how the firm is financed. As we ,will see, these factors all affect the ROE, and management uses the other ,ratios primarily to help develop plans to improve the average ROE over the ,long run. ,,4.1 RATIO ANALYSIS ,Financial statements report both a firm’s position at a point in time and its operations ,over some past period. However, their real value lies in the fact that they ,can be used to help predict future earnings and dividends. From an investor’s ,standpoint, predicting the future is what financial statement analysis is all about, ,while from management’s standpoint, financial statement analysis is useful both to ,help anticipate future conditions and, more important, as a starting point for planning ,actions that will improve future performance. ,,,Chapter 4 Analysis of Financial Statements ,,Financial ratios are designed to help one evaluate a financial statement. For ,example, Firm A might have debt of $5,248,760 and interest charges of $419,900, ,while Firm B might have debt of $52,647,980 and interest charges of $3,948,600. ,Which company is stronger? The burden of these debts, and the companies’ ability ,to repay them, can best be evaluated (1) by comparing each firm’s debt to its ,assets and (2) by comparing the interest it must pay to the income it has available ,for payment of interest. Such comparisons involve ratio analysis. ,,In the paragraphs that follow, we will calculate Allied Food Products’ financial ,ratios for 2005, using data from the balance sheets and income statements ,given in Tables 3-1 and 3-2. We will also evaluate the ratios relative to the industry ,averages.2 Note that the dollar amounts in the ratio calculations are generally ,in millions. ,,4.2 LIQUIDITY RATIOS ,A liquid asset is one that trades in an active market and hence can be quickly ,converted to cash at the going market price, and a firm’s “liquidity position” ,deals with this question: Will the firm be able to pay off its debts as they come ,due in the coming year? As shown in Table 3-1 in Chapter 3, Allied has $310 million ,of debt that must be paid off within the coming year. Will it have trouble ,meeting those obligations? A full liquidity analysis requires the use of cash ,budgets, but by relating cash and other current assets to current liabilities, ratio ,analysis provides a quick, easy-to-use measure of liquidity. Two of the most ,commonly used liquidity ratios are discussed here. ,,Current Ratio ,,The primary liquidity ratio is the current ratio, which is calculated by dividing ,current assets by current liabilities: ,,Current assets,,Current ratio ,,Current liabilities ,,$1,000,, 3.2,,$310 ,Industry average 4.2 ,,Current assets include cash, marketable securities, accounts receivable, and ,inventories. Allied’s current liabilities consist of accounts payable, short-term ,notes payable, current maturities of long-term debt, accrued taxes, and accrued ,wages. ,,If a company is getting into financial difficulty, it begins paying its bills ,(accounts payable) more slowly, borrowing from its bank, and so on, all of which ,increase current liabilities. If current liabilities are rising faster than current ,assets, the current ratio will fall, and this is a sign of possible trouble. Allied’s ,current ratio of 3.2 is well below the industry average, 4.2, so its liquidity position ,is rather weak. Still, since its current assets are supposed to be converted to ,,2 In addition to the ratios discussed in this section, financial analysts sometimes employ a tool ,known as common size analysis. To form a common size balance sheet, simply divide each asset and ,liability item by total assets and then express the results as percentages. The resultant percentage ,statement can be compared with statements of larger or smaller firms, or with those of the same ,firm over time. To form a common size income statement, divide each income statement item by ,sales. With a spreadsheet, which most analysts use, this is trivially easy. ,,Liquid Asset ,,An asset that can be ,converted to cash ,quickly without having ,to reduce the asset’s ,price very much. ,,Liquidity Ratios ,,Ratios that show the ,relationship of a firm’s ,cash and other current ,assets to its current ,liabilities. ,,Current Ratio ,,This ratio is calculated ,by dividing current ,assets by current ,liabilities. It indicates ,the extent to which ,current liabilities are ,covered by those ,assets expected to be ,converted to cash in ,the near future. ,,,Part 2 Fundamental Concepts in Financial Management ,,Quick (Acid Test) ,Ratio ,,This ratio is calculated ,by deducting inventories ,from current assets ,and then dividing the ,remainder by current ,liabilities. ,,Asset Management ,Ratios ,,A set of ratios that ,measure how ,effectively a firm is ,managing its assets. ,,cash within a year, it is likely that they could be liquidated at close to their ,stated value. With a current ratio of 3.2, Allied could liquidate current assets at ,only 31 percent of book value and still pay off current creditors in full.3 ,,Although industry average figures are discussed later in some detail, note ,that an industry average is not a magic number that all firms should strive to ,maintain—in fact, some very well-managed firms may be above the average ,while other good firms are below it. However, if a firm’s ratios are far removed ,from the averages for its industry, an analyst should be concerned about why ,this variance occurs. Thus, a deviation from the industry average should signal ,the analyst (or management) to check further. ,,Quick, or Acid Test, Ratio ,,The second most used liquidity ratio is the quick, or acid test, ratio, which is ,calculated by deducting inventories from current assets and then dividing the ,remainder by current liabilities: ,,Current assets Inventories,,Quick, or acid test, ratio ,,Current liabilities ,,$385 ,, 1.2,,$310 ,Industry average 2.2 ,,Inventories are typically the least liquid of a firm’s current assets, hence they are ,the assets on which losses are most likely to occur in the event of liquidation. ,Therefore, this measure of a firm’s ability to pay off short-term obligations without ,relying on the sale of inventories is important. ,,The industry average quick ratio is 2.2, so Allied’s 1.2 ratio is quite low in ,comparison with other firms in its industry. Still, if the accounts receivable can ,be collected, the company can pay off its current liabilities without having to liquidate ,its inventories. ,,,What are some characteristics of a liquid asset? Give some examples. ,,What two ratios are used to analyze a firm’s liquidity position? ,Write out their equations. ,,Why is the current ratio the most commonly used measure of short-,term solvency? ,,Which current asset is typically the least liquid? ,,A company has current liabilities of $500 million, and its current ratio ,is 2.0. What is its level of current assets? ($1,000 million) If this firm’s ,quick ratio is 1.6, how much inventory does it have? ($200 million) ,,4.3 ASSET MANAGEMENT RATIOS ,A second group of ratios, the asset management ratios, measures how effectively ,the firm is managing its assets. These ratios answer this question: Does the ,amount of each type of asset seem reasonable, too high, or too low in view of ,,3 1/3.2 0.31, or 31%. Note also that 0.31($1,000) $310, the current liabilities balance. ,,,Chapter 4 Analysis of Financial Statements ,,current and projected sales? When they acquire assets, Allied and other companies ,must obtain capital from banks or other sources. If a firm has too many ,assets, its cost of capital will be too high and its profits will be depressed. On the ,other hand, if assets are too low, profitable sales will be lost. The asset management ,ratios described in this section are important. ,,Inventory Turnover Ratio ,,“Turnover ratios” are ratios where sales are divided by some asset, and as ,the name implies, they show how many times the item is “turned over” during ,the year. Thus, the inventory turnover ratio is defined as sales divided by ,inventories: ,,Sales,,Inventory turnover ratio ,,Inventories ,,$3,000,, 4.9,,$615 ,Industry average 10.9 ,,As a rough approximation, each item of Allied’s inventory is sold out and ,restocked, or “turned over,” 4.9 times per year. “Turnover” is a term that originated ,many years ago with the old Yankee peddler, who would load up his ,wagon with goods, then go off on his route to peddle his wares. The merchandise ,was called “working capital” because it was what he actually sold, or ,“turned over,” to produce his profits, whereas his “turnover” was the number of ,trips he took each year. Annual sales divided by inventory equaled turnover, or ,trips per year. If he made 10 trips per year, stocked 100 pans, and made a gross ,profit of $5 per pan, his annual gross profit would be (100)($5)(10) $5,000. If ,he went faster and made 20 trips per year, his gross profit would double, other ,things held constant. So, his turnover directly affected his profits. ,,Allied’s turnover of 4.9 is much lower than the industry average of 10.9. ,This suggests that it is holding too much inventory. Excess inventory is, of ,course, unproductive and represents an investment with a low or zero rate of ,return. Allied’s low inventory turnover ratio also makes us question the current ,ratio. With such a low turnover, the firm may be holding obsolete goods not ,worth their stated value.4 ,,Note that sales occur over the entire year, whereas the inventory figure is for ,one point in time. For this reason, it might be better to use an average inventory ,measure.5 If the business is highly seasonal, or if there has been a strong upward ,or downward sales trend during the year, it is especially useful to make an ,adjustment. To maintain comparability with industry averages, however, we did ,not use the average inventory figure.,,4 A problem arises when calculating and analyzing the inventory turnover ratio. Sales are stated at ,market prices, so if inventories are carried at cost, as they generally are, the calculated turnover ,overstates the true turnover ratio. Therefore, it might be more appropriate to use cost of goods sold ,in place of sales in the formula’s numerator. However, some established compilers of financial ratio ,statistics such as Dun & Bradstreet use the ratio of sales to inventories carried at cost. To have a figure ,that can be compared with those published by Dun & Bradstreet and similar organizations, it is ,necessary to measure inventory turnover with sales in the numerator, as we do here. ,5 Preferably, the average inventory value should be calculated by summing the monthly figures during ,the year and dividing by 12. If monthly data are not available, the beginning and ending figures ,can be added and then divided by 2. Both methods adjust for growth but not for seasonal effects. ,,Inventory Turnover ,Ratio ,,This ratio is calculated ,by dividing sales by ,inventories. ,,,Part 2 Fundamental Concepts in Financial Management ,,Days Sales ,Outstanding (DSO) ,,This ratio is calculated ,by dividing accounts ,receivable by average ,sales per day; it indicates ,the average ,length of time the ,firm must wait after ,making a sale before ,it receives cash. ,,Fixed Assets Turnover ,Ratio ,,The ratio of sales to ,net fixed assets. ,,Days Sales Outstanding ,,Days sales outstanding (DSO), also called the “average collection period” ,(ACP), is used to appraise accounts receivable, and it is calculated by dividing ,accounts receivable by average daily sales to find how many days’ sales are tied ,up in receivables. Thus, the DSO represents the average length of time that the ,firm must wait after making a sale before receiving cash. Allied has 46 days sales ,outstanding, well above the 36-day industry average: ,,Days ,,Receivables Receivables,,DSO sales ,,Average sales per day Annual sales> ,365,,outstanding ,,$375 $375 ,, 45.625 days ˜ ,46 days,,$3,000> ,365 $8.2192 ,,Industry average 36 days ,,Note that in this calculation we used a 365-day year. Some analysts use a 360day ,year; on this basis Allied’s DSO would have been slightly lower, 45 days.6 ,,The DSO can also be evaluated by comparing it with the terms on which the ,firm sells its goods. For example, Allied’s sales terms call for payment within 30 ,days, so the fact that 46 days’ sales, not 30 days’, are outstanding indicates that ,customers, on the average, are not paying their bills on time. This deprives the ,company of funds that could be used to reduce bank loans or some other type of ,costly capital. Moreover, with a high average DSO, it is likely that a number of ,customers are paying very late, and those customers may well be in financial ,trouble, in which case Allied may never be able to collect the receivable.7 Therefore, ,if the trend in DSO over the past few years has been rising, but the credit ,policy has not been changed, this would be strong evidence that steps should be ,taken to expedite the collection of accounts receivable. ,,Fixed Assets Turnover Ratio ,,The fixed assets turnover ratio measures how effectively the firm uses its plant ,and equipment. It is the ratio of sales to net fixed assets: ,,Sales,,Fixed assets turnover ratio ,,Net fixed assets ,,$3,000,, 3.0,,$1,000 ,Industry average 2.8 ,,6 It would be somewhat better to use average receivables, either an average of the monthly figures or ,(Beginning receivables Ending receivables)/2 ($315 $375)/2 $345 in the formula. Had ,average annual receivables been used, Allied’s DSO on a 365-day basis would have been ,$345/$8.2192 41.975 days, or approximately 42 days. The 42-day figure is a more accurate one, ,but our interest is in comparisons, and because the industry average was based on year-end receivables, ,the 46-day number is better for our purposes. The DSO is discussed further in Part 6. ,7 For example, if further analysis along the lines suggested in Part 6 indicated that 85 percent of the ,customers pay in 30 days, then for the DSO to average 46 days, the remaining 15 percent must be ,paying on average in 136.67 days. Paying that late suggests financial difficulties. In Part 6 we also ,discuss refinements into this analysis, but a DSO of 46 days would alert a good analyst of the need ,to dig deeper. ,,,Chapter 4 Analysis of Financial Statements ,,Allied’s ratio of 3.0 times is slightly above the 2.8 industry average, indicating ,that it is using its fixed assets at least as intensively as other firms in the industry. ,Therefore, Allied seems to have about the right amount of fixed assets relative ,to its sales. ,,Potential problems may arise when interpreting the fixed assets turnover ,ratio. Recall that fixed assets are shown on the balance sheet at their historical ,costs, less depreciation. Inflation has caused the value of many assets that were ,purchased in the past to be seriously understated. Therefore, if we compared an ,old firm that had acquired many of its fixed assets years ago at low prices with a ,new company with similar operations that had acquired its fixed assets only ,recently, we would probably find that the old firm had the higher fixed assets ,turnover ratio. However, this would be more reflective of when the assets were ,acquired than of inefficiency on the part of the new firm. The accounting profession ,is trying to develop procedures for making financial statements reflect ,current values rather than historical values, which would help us make better ,comparisons. However, at the moment the problem still exists, so financial analysts ,must recognize that a problem exists and deal with it judgmentally. In ,Allied’s case, the issue is not serious because all firms in the industry have been ,expanding at about the same rate, hence the balance sheets of the comparison ,firms are reasonably comparable.8 ,,Total Assets Turnover Ratio ,,The final asset management ratio, the total assets turnover ratio, measures the ,turnover of all the firm’s assets, and it is calculated by dividing sales by total assets: ,,Sales,,Total assets turnover ratio ,,Total assets ,,$3,000,, 1.5,,$2,000 ,Industry average 1.8 ,,Allied’s ratio is somewhat below the industry average, indicating that it is not ,generating enough sales given its total assets. Sales should be increased, some ,assets should be disposed of, or a combination of these steps should be taken. ,,,Identify four ratios that are used to measure how effectively a firm ,manages its assets, and write out their equations. ,,If one firm is growing rapidly and another is not, how might this ,distort a comparison of their inventory turnover ratios? ,,If you wanted to evaluate a firm’s DSO, with what would you compare ,it? ,,What potential problem might arise when comparing different firms’ ,fixed assets turnover ratios? ,,A firm has annual sales of $100 million, $20 million of inventory, ,and $30 million of accounts receivable. What is its inventory ,turnover ratio? (5) What is its DSO based on a 365-day year? ,,(109.5 days) ,Total Assets Turnover ,Ratio ,,This ratio is calculated ,by dividing sales by ,total assets. ,,8 See FASB #89, Financial Reporting and Changing Prices (December 1986), for a discussion of the ,effects of inflation on financial statements. The report’s age indicates how difficult the problem is. ,,,Part 2 Fundamental Concepts in Financial Management ,,4.4 DEBT MANAGEMENT RATIOS ,Financial Leverage ,,The use of debt ,financing. ,,The extent to which a firm uses debt financing, or financial leverage, has three ,important implications: (1) By raising funds through debt, stockholders can control ,a firm with a limited amount of equity investment. (2) Creditors look to the ,equity, or owner-supplied funds, to provide a margin of safety, so the higher the ,proportion of the total capital provided by stockholders, the less the risk faced ,by creditors. (3) If the firm earns more on its assets than the interest rate it pays ,on debt, then using debt “leverages,” or magnifies, the return on equity, ROE. ,,Table 4-1 illustrates both the potential benefits and risks resulting from the ,use of debt.9 Here we analyze two companies that are identical except for how ,they are financed. Firm U (for “Unleveraged”) has no debt and thus 100 percent ,common equity, whereas Firm L (for “Leveraged”) is financed with half debt at a ,10 percent interest rate and half equity. Both companies have $100 of assets. ,Their sales will range from $150 down to $75, depending on business conditions, ,with an expected level of $100. Some of their operating costs (rent, the president’s ,salary, and so on) are fixed and will be there regardless of the level of ,sales, while other costs (some labor costs, materials, and so forth) will vary with ,sales.10 When we deduct total operating costs from sales revenues, we are left ,with operating income, or earnings before interest and taxes (EBIT). ,,Notice in the table that everything is the same for the leveraged and ,unleveraged firms down through operating income—thus, they have the same ,EBIT under the three states of the economy. However, things then begin to differ. ,Firm U has no debt so it pays no interest, and its taxable income is the same as ,its operating income, and it then pays a 40 percent state and federal tax to get to ,its net income, which is $27 under good conditions and $0 under bad conditions. ,When net income is divided by common equity, we get the ROE, which ranges ,from 27 percent to 0 percent for Firm U. ,,Firm L has the same EBIT under each condition, but it uses $50 of debt with ,a 10 percent interest rate, so it has $5 of interest charges regardless of business ,conditions. This amount is deducted from EBIT to get to taxable income, taxes ,are then taken out, and the result is net income, which ranges from $24 to $5, ,depending on conditions.11 At first blush it looks like Firm U is better off under ,all conditions, but this is not correct—we need to consider how much the two ,firms’ stockholders have invested. Firm L’s stockholders have put up only $50, ,so when that investment is divided into net income, we see that their ROE under ,good conditions is a whopping 48 percent (versus 27 percent for U) and is 12 ,percent (versus 9 percent for U) under expected conditions. However, L’s ROE ,falls to 10 percent under bad conditions, which means that it would go bankrupt ,if those conditions last for several years. ,,There are two reasons for the leveraging effect: (1) Because interest is ,deductible, the use of debt lowers the tax bill and leaves more of the firm’s operating ,income available to its investors. (2) If operating income as a percentage of ,,9 We discuss ROE in more depth later in the chapter, and we examine the effects of leverage in ,detail in the chapter on capital structure. ,10 The financial statements do not show the breakdown between fixed and variable operating costs, ,but companies can and do make this breakdown for internal purposes. Of course, the distinction is ,not always clear, because what’s a fixed cost in the very short run can become a variable cost over a ,longer time horizon. It’s interesting to note that companies are moving toward making more of their ,costs variable, using such techniques as increasing bonuses rather than base salaries, switching to ,profit-sharing plans rather than fixed-pension plans, and outsourcing various parts and materials. ,11 As we discussed in the last chapter, firms can carry losses back or forward for several years. ,Therefore, if Firm L had profits and thus paid taxes in recent prior years, it could carry its loss ,under bad conditions back and receive a credit (a check from the government). In Table 4-1 we ,assume that the firm cannot use the carry-back/carry-forward provision. ,,,Chapter 4 Analysis of Financial Statements ,,TABLE 4-1 Effects of Financial Leverage on Stockholder Returns ,,FIRM U [UNLEVERAGED (NO DEBT)] ,,Current assets $ 50 Debt $ 0 ,Fixed assets 50 Common equity 100 ,Total assets $100 Total liabilities and equity $100 ,BUSINESS CONDITIONS ,Good Expected Bad ,,Sales revenues $150.0 $100.0 $75.0 ,Operating costs Fixed 45.0 45.0 45.0 ,Variable 60.0 40.0 30.0 ,Total operating costs 105.0 85.0 75.0 ,Operating income (EBIT) $ 45.0 $ 15.0 $ 0.0 ,Interest (Rate = 10%) 0.0 0.0 0.0 ,Earnings before taxes (EBT) $ 45.0 $ 15.0 $ 0.0 ,Taxes (Rate = 40%) 18.0 6.0 0.0 ,Net income (NI) $ 27.0 $ 9.0 $ 0.0 ,,ROEU 27.0% 9.0% 0.0% ,,FIRM L [LEVERAGED (SOME DEBT)] ,,Current assets $ 50 Debt $ 50 ,Fixed assets 50 Common equity 50 ,Total assets $100 Total liabilities and equity $100 ,BUSINESS CONDITIONS ,Good Expected Bad ,,Sales revenues $150.0 $100.0 $75.0 ,Operating costs Fixed 45.0 45.0 45.0 ,Variable 60.0 40.0 30.0 ,Total operating costs 105.0 85.0 75.0 ,Operating income (EBIT) $ 45.0 $ 15.0 $ 0.0 ,Interest (Rate = 10%) 5.0 5.0 5.0 ,Earnings before taxes (EBT) $ 40.0 $ 10.0 $ 5.0 ,,Taxes (Rate = 40%) 16.0 4.0 0.0 ,Net income (NI) $ 24.0 $ 6.0 $ 5.0 ,ROEL 48.0% 12.0% 10.0% ,,assets exceeds the interest rate on debt, as it generally is expected to do, then a ,company can use debt to acquire assets, pay the interest on the debt, and have ,something left over as a “bonus” for its stockholders. Under the expected conditions, ,our hypothetical firms ex