own Thread and post a response to the following:
a. Choose one of the 3 main types of ratios (liquidity, solvency, or profitability) and give the
definition. (see Illustration 2-9)
b. Give an example of how it is measured and calculated (ratio or formula).
c. Explain why a bank would utilize this ratio when deciding whether they should loan
money to a business. Give an example.
Chapter 2 Discussion Post Rubric
Categories:
Chooses a MAIN
type of ratio
Gives the proper
definition
0 Points
Does not list any of
the 3 main types of
ratios
Does not give a
definition
1-2 points
Lists a ratio, but not
one of the main 3
types
N/A
Gives example
of how it is
measured and
calculated
Explains why a
bank would
utilize this ratio
Grammar
Spelling
Complete
Sentences
Does not give an
example of how it is
measured and
calculated
Does not explain
why a bank would
utilize this ratio
multiple errors, and
no complete
sentences
Only shows how it
is measured, or
how it is calculated
Explanation is
unclear or repetitive
of definition
N/A
3 points
Lists one of the 3
main types
Gives the proper
definition of the
ratio
Gives example of
how it is measured
and calculated
Clearly explains
why a bank would
utilize this ratio
Uses complete
sentences and has
little to no grammar
or spelling errors
*A quality post is at least 4-5 complete sentences and addresses what is required. Uses
non-offensive language.
RATIO ANALYSIS
Ratio analysis expresses the relationship among selected items of financial statement data.
A ratio expresses the mathematical relationship between one quantity and another. For
analysis of the primary financial statements, we classify ratios as shown in Illustration 2-9.
ILLUSTRATION 2-9 Financial ratio classifications
A single ratio by itself is not very meaningful. Accordingly, in this and the following
chapters, we will use various comparisons to shed light on company performance:
• 1.Intracompany comparisons covering two years for the same company.
• 2.Industry-average comparisons based on average ratios for particular industries.
• 3.Intercompany comparisons based on comparisons with a competitor in the same
industry.
Next, we use some ratios and comparisons to analyze the financial statements of Best Buy.
USING THE INCOME STATEMENT
Best Buy generates profits for its stockholders by selling electronics. The income statement
reveals how successful the company is at generating a profit from its sales. The income
statement reports the amount earned during the period (revenues) and the costs incurred
during the period (expenses). Illustration 2-10 shows a simplified income statement for
Income Statements
For the 12 Months Ended February 1, 2014,
and 11 Months Ended February 2, 2013 (in millions)
2014
Revenues
2013
Income Statements
For the 12 Months Ended February 1, 2014,
and 11 Months Ended February 2, 2013 (in millions)
Net sales and other revenue
\$42,410
\$39,827
32,720
30,528
8,760
9,471
398
269
41,878
40,268
Expenses
Cost of goods sold
Selling, general, and administrative expenses and other
Income tax expense
Total expenses
Net income/(loss)
\$
532 \$ (441)
ILLUSTRATION 2-10 Best Buy’s income statement
From this income statement, we can see that Best Buy’s sales and net income increased
during the period. Net income increased from a \$441 million loss to a positive \$532 million.
One extremely unusual aspect of Best Buy’s income statement is that the 2013 comparative
column only covers 11 months. This occurred because Best Buy changed its year-end from
“the Saturday nearest the end of February to the Saturday nearest the end of January.” Such
a change is very uncommon and complicates efforts to compare performance across years.
A much smaller competitor of Best Buy is hhgregg. hhgregg operates 228 stores in 20 states
and is headquartered in Indianapolis, Indiana. It reported net income of \$228,000 for the
year ended March 31, 2014.
To evaluate the profitability of Best Buy, we will use ratio analysis. Profitability ratios, such
as earnings per share, measure the operating success of a company for a given period of
time.
Earnings per Share
Earnings per share (EPS) measures the net income earned on each share of common stock.
Stockholders usually think in terms of the number of shares they own or plan to buy or sell,
so stating net income earned as a per share amount provides a useful perspective for
determining the investment return. Advanced accounting courses present more refined
techniques for calculating earnings per share.
For now, a basic approach for calculating earnings per share is to divide earnings available
to common stockholders by weighted-average common shares outstanding during the year.
What is “earnings available to common stockholders”? It is an earnings amount calculated
as net income less dividends paid on another type of stock, called preferred stock (Net
income − Preferred dividends).
By comparing earnings per share of a single company over time, we can evaluate its
relative earnings performance from the perspective of a stockholder—that is, on a per
share basis. It is very important to note that comparisons of earnings per share across
companies are not meaningful because of the wide variations in the numbers of shares of
outstanding stock among companies.
Illustration 2-11 shows the earnings per share calculation for Best Buy in 2014 and 2013,
based on the information presented below. Recall that Best Buy’s 2013 income is based on
11 months of results. Further, to simplify our calculations, we assumed that any change in
the number of shares for Best Buy occurred in the middle of the year.
(in millions)
2014 2013
Net income (loss)
\$532 \$(441)
Preferred dividends
-0-
-0-
Shares outstanding at beginning of year
338
341
Shares outstanding at end of year
347
338
Earnings per Share=Net Income−Preferred DividendsWeighted-Average Common
Shares Outstanding
(\$ and shares
in millions)
2014
2013
Earnings per
\$532−\$0(347+338)/2=\$1.55 −\$441−\$0(338+341)/2=−\$1.30
share
ILLUSTRATION 2-11 Best Buy’s earnings per share
DECISION TOOLS
Earnings per share helps users compare a company’s performance with that of previous
years.
USING A CLASSIFIED BALANCE SHEET
You can learn a lot about a company’s financial health by also evaluating the relationship
between its various assets and liabilities. Illustration 2-12 provides a simplified balance
Balance Sheets
(in millions)
Assets
February 1, 2014 February 2, 2013
Current assets
Cash and cash equivalents
Short-term investments
Receivables
\$ 2,678
\$ 1,826
223
0
1,308
2,704
Balance Sheets
(in millions)
Merchandise inventories
5,376
6,571
900
946
Total current assets
10,485
12,047
Property and equipment
7,575
8,375
Less: Accumulated depreciation
4,977
5,105
2,598
3,270
Other assets
930
1,470
Total assets
\$14,013
\$16,787
Accounts payable
\$ 5,122
\$ 6,951
Accrued liabilities
873
1,188
Accrued income taxes
147
129
Accrued compensation payable
444
520
Other current liabilities
850
2,022
7,436
10,810
976
1,109
1,612
1,153
2,588
2,262
10,024
13,072
335
88
3,654
3,627
3,989
3,715
\$14,013
\$16,787
Other current assets
Net property and equipment
Liabilities and Stockholders’ Equity
Current liabilities
Total current liabilities
Long-term liabilities
Long-term debt
Other long-term liabilities
Total long-term liabilities
Total liabilities
Stockholders’ equity
Common stock
Retained earnings and other
Total stockholders’ equity
Total liabilities and stockholders’ equity
ILLUSTRATION 2-12 Best Buy’s balance sheet
Liquidity
Suppose you are a banker at CitiGroup considering lending money to Best Buy, or you are a
sales manager at Hewlett-Packard interested in selling computers to Best Buy on credit.
You would be concerned about Best Buy’s liquidity—its ability to pay obligations expected
to become due within the next year or operating cycle. You would look closely at the
relationship of its current assets to current liabilities.
WORKING CAPITAL
One measure of liquidity is working capital, which is the difference between the amounts of
current assets and current liabilities:
Working Capital=Current Assets−Current Liabilities
ILLUSTRATION 2-13 Working capital
When current assets exceed current liabilities, working capital is positive. When this
occurs, there is a greater likelihood that the company will pay its liabilities. When working
capital is negative, a company might not be able to pay short-term creditors, and the
company might ultimately be forced into bankruptcy. Best Buy had working capital in 2014
of \$3,049 million (\$10,485 million−\$7,436 million).
CURRENT RATIO
Liquidity ratios measure the short-term ability of the company to pay its maturing
obligations and to meet unexpected needs for cash. One liquidity ratio is the current ratio,
computed as current assets divided by current liabilities.
The current ratio is a more dependable indicator of liquidity than working capital. Two
companies with the same amount of working capital may have significantly different
current ratios. Illustration 2-14 shows the 2014 and 2013 current ratios for Best Buy and
for hhgregg, along with the 2014 industry average.
Current Ratio=Current AssetsCurrent Liabilities
(\$ in millions)
hhgregg
Industry
Average
2014
2014
\$10,485\$7,436=1.41:1 1.11:1 1.68:1
.88:1
2014
2013
ILLUSTRATION 2-14 Current ratio
What does the ratio actually mean? Best Buy’s 2014 current ratio of 1.41:1 means that for
every dollar of current liabilities, Best Buy has \$1.41 of current assets. Best Buy’s current
ratio increased in 2014. When compared to the industry average of .88:1, Best Buy’s
liquidity seems strong. It is lower than hhgregg’s but not significantly so.
One potential weakness of the current ratio is that it does not take into account
the composition of the current assets. For example, a satisfactory current ratio does not
disclose whether a portion of the current assets is tied up in slow-moving inventory. The
composition of the current assets matters because a dollar of cash is more readily available
to pay the bills than is a dollar of inventory. For example, suppose a company’s cash
balance declined while its merchandise inventory increased substantially. If inventory
increased because the company is having difficulty selling its products, then the current
ratio might not fully reflect the reduction in the company’s liquidity.
ACCOUNTING ACROSS THE
ORGANIZATIONREL Consultancy GroupCan a Company Be
Too Liquid?
There actually is a point where a company can be
too liquid—that is, it can have too much working capital. While it is important to be liquid
enough to be able to pay short-term bills as they come due, a company does not want to tie
up its cash in extra inventory or receivables that are not earning the company money.
By one estimate from the REL Consultancy Group, the thousand largest U.S. companies had
cumulative excess working capital of \$1.017 trillion in a recent year. This was an 18%
increase, which REL said represented a “deterioration in the management of operations.”
Given that managers throughout a company are interested in improving profitability, it is
clear that they should have an eye toward managing working capital. They need to aim for
a “Goldilocks solution”—not too much, not too little, but just right.
Source: Maxwell Murphy, “The Big Number,” Wall Street Journal (November 9, 2011).
What can various company managers do to ensure that working capital is managed
efficiently to maximize net income?
DECISION TOOLS
The current ratio helps users determine if a company can meet its near-term obligations.
ETHICS NOTE
A company that has more current assets than current liabilities can increase the ratio of
current assets to current liabilities by using cash to pay off some current liabilities. This
gives the appearance of being more liquid. Do you think this move is ethical?
Solvency
Now suppose that instead of being a short-term creditor, you are interested in either
buying Best Buy’s stock or extending the company a long-term loan. Long-term creditors
and stockholders are interested in a company’s solvency—its ability to pay interest as it
comes due and to repay the balance of a debt due at its maturity. Solvency ratios measure
the ability of the company to survive over a long period of time.
DEBT TO ASSETS RATIO
Some users evaluate solvency using a ratio of liabilities divided by stockholders’ equity.
The higher this “debt to equity” ratio, the lower is a company’s solvency.
The debt to assets ratio is one measure of solvency. It is calculated by dividing total
liabilities (both current and long-term) by total assets. It measures the percentage of total
financing provided by creditors rather than stockholders. Debt financing is more risky than
equity financing because debt must be repaid at specific points in time, whether the
company is performing well or not. Thus, the higher the percentage of debt financing, the
riskier the company.
The higher the percentage of total liabilities (debt) to total assets, the greater the risk that
the company may be unable to pay its debts as they come due. Illustration 2-15 shows the
debt to assets ratios for Best Buy and hhgregg, along with the industry average.
Debt to Assets Ratio=Total LiabilitiesTotal Assets
(\$ in millions)
hhgregg
Industry
Average
2013
2014
2014
\$10,024\$14,013=72% 78%
51%
88%
2014
ILLUSTRATION 2-15 Debt to assets ratio
The 2014 ratio of 72% means that every dollar of assets was financed by 72 cents of debt.
Best Buy’s ratio is less than the industry average of 88% and is significantly higher than
hhgregg’s ratio of 51%. The higher the ratio, the more reliant the company is on debt
financing. This means that Best Buy has a lower equity “buffer” available to creditors if the
company becomes insolvent when compared to hhgregg. Thus, from the creditors’ point of
view, a high ratio of debt to assets is undesirable. Best Buy’s solvency appears lower than
hhgregg’s and higher than the average company in the industry.
The adequacy of this ratio is often judged in light of the company’s earnings. Generally,
companies with relatively stable earnings, such as public utilities, can support higher debt
to assets ratios than can cyclical companies with widely fluctuating earnings, such as many
high-tech companies. In later chapters, you will learn additional ways to evaluate solvency.
INVESTOR INSIGHTWhen Debt Is Good
Debt financing differs greatly across industries and
companies. Here are some debt to assets ratios for selected companies in a recent year:
Debt to Assets Ratio
23%
Nike
41%
Microsoft
48%
ExxonMobil
48%
General Motors
74%
Discuss the difference in the debt to assets ratio of Microsoft and General Motors.
DECISION TOOLS
The debt to assets ratio helps users determine if a company can meet its long-term
obligations.
USING THE STATEMENT OF CASH FLOWS
In the statement of cash flows, net cash provided by operating activities is intended to
indicate the cash-generating capability of the company. Analysts have noted, however,
that net cash provided by operating activities fails to take into account that a
company must invest in new property, plant, and equipment (capital expenditures)
just to maintain its current level of operations. Companies also must at least maintain
dividends at current levels to satisfy investors. A measurement to provide additional
insight regarding a company’s cash-generating ability is free cash flow. Free cash
flowdescribes the net cash provided by operating activities after adjusting for capital
expenditures and dividends paid.
Consider the following example. Suppose that MPC produced and sold 10,000 personal
computers this year. It reported \$100,000 net cash provided by operating activities. In
order to maintain production at 10,000 computers, MPC invested \$15,000 in equipment. It
chose to pay \$5,000 in dividends. Its free cash flow
was \$80,000 (\$100,000−\$15,000−\$5,000). The company could use this \$80,000 to
purchase new assets to expand the business, pay off debts, or increase its dividend
distribution. In practice, analysts often calculate free cash flow with the formula shown in
Illustration 2-16. (Alternative definitions also exist.)
Free CashFlow=Net Cash Providedby Operating
Activities−CapitalExpenditures−CashDividends
ILLUSTRATION 2-16 Free cash flow
We can calculate Best Buy’s 2014 free cash flow as shown in Illustration 2-17 (dollars in
millions).
DECISION TOOLS
Free cash flow helps users determine the amount of cash a company generated to expand
operations, pay off debts, or increase dividends.
Net cash provided by operating activities
\$1,094
Less: Expenditures on property, plant, and equipment
547
Dividends paid
233
Free cash flow
\$
314
ILLUSTRATION 2-17 Best Buy’s free cash flow
Best Buy generated free cash flow of \$314 million, which is available for the acquisition of
new assets, the retirement of stock or debt, or the payment of additional dividends. Longterm creditors consider a high free cash flow amount an indication of solvency. hhgregg’s
free cash flow for 2014 is \$60 million. Given that hhgregg is considerably smaller than Best
Buy, we would expect its free cash flow to be much lower.
DO IT!2Ratio Analysis
The following information is available for Ozone Inc.
2017
Current assets
Total assets
2016
\$ 88,000 \$ 60,800
400,000
341,000
40,000
38,000
Total liabilities
120,000
150,000
Net income
100,000
50,000
Net cash provided by operating activities
110,000
70,000
Preferred dividends
10,000
10,000
Common dividends
5,000
2,500
Current liabilities
2017
2016
Expenditures on property, plant, and equipment
45,000
20,000
Shares outstanding at beginning of year
60,000
40,000
120,000
60,000
Shares outstanding at end of year
(a)Compute earnings per share for 2017 and 2016 for Ozone, and comment on the
change. Ozone’s primary competitor, Frost Corporation, had earnings per share of \$2 in
2017. Comment on the difference in the ratios of the two companies.
• (b)Compute the current ratio and debt to assets ratio for each year, and comment on
the changes.
• (c)Compute free cash flow for each year, and comment on the changes.
Action Plan
• ✓Use the formula for earnings per share (EPS): (Net income−Preferred
dividends)÷Weighted-average common shares outstanding.
• ✓Use the formula for the current ratio: Current assets÷Current liabilities.
• ✓Use the formula for the debt to assets ratio: Total liabilities÷Total assets.
• ✓Use the formula for free cash flow: Net cash provided by operating activities – Capital
expenditures – Cash dividends.

Related exercise material: BE2-3, BE2-4, BE2-5, DO IT! 2-2, E2-7, E2-9, E2-10, and E2-11.