Comet Corporation is a capital intensive, growing firm. Comet operates in an inflationary environment and its inventory quantities are stable. Which of the following accounting methods will cause Comet to report a lower price-to-book ratio, all else equal?
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Inventory method |
Depreciation method |
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FIFO results in higher assets and higher equity in an inflationary environment as compared to LIFO. Equity is higher because COGS is lower (and inventory higher) under FIFO. Straight-line depreciation will result in greater assets and equity compared to accelerated depreciation for a stable or growing firm. Equity is greater because depreciation expense is less with straight-line depreciation. Greater equity will result in greater book value per common share, the denominator of the price-to-book ratio. Greater book value per share will result in a lower price-to-book ratio.
Falcon Financial Group is considering the purchase of Company A or Company B based on a low price-to-book investment strategy that also considers differences in solvency. Selected financial data for both firms, as of December 31, 20X7, follows:
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in millions, except per-share data |
Company A |
Company B |
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Current assets |
$3,000 |
$5,500 |
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Fixed assets |
$5,700 |
$5,500 |
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Total debt |
$2,700 |
$3,500 |
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Common equity |
$6,000 |
$7,500 |
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Outstanding shares |
500 |
750 |
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Market price per share |
$26.00 |
$22.50 |
The firms’ financial statement footnotes contain the following:
To make the firms financials ratios comparable, calculate the adjusted price-to-book ratios for Company A and Company B.
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Company A |
Company B |
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Company A should be adjusted for the operating lease liability and the related assets; however, adding the present value of the lease payments to both assets and liabilities does not change equity (book value). Thus, Company A’s adjusted P/B ratio is 2.17 = [$26 price / ($6,000 million equity / $500 million shares)]. Company B’s inventory should be adjusted back to FIFO by adding the LIFO reserve to both assets and equity. Thus, Company B’s P/B ratio is 2.06 = $22.50 / [($7,500 million equity + $700 million LIFO reserve) / 750 million shares].
At the end of 2007, Decatur Corporation reported last-in, first-out (LIFO) inventory of $20 million, cost of goods sold (COGS) of $64 million, and inventory purchases of $58 million. If the LIFO reserve was $6 million at the end of 2006 and $16 million at the end of 2007, compute first-in, first-out (FIFO) inventory at the end of 2007 and FIFO COGS for the year ended 2007.
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FIFO Inventory |
FIFO COGS |
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2007 FIFO inventory was $36 million ($20 million LIFO inventory + $16 million reserve). 2007 FIFO COGS was $54 million ($64 million LIFO COGS – $10 million increase in LIFO reserve).
Craig Loomis, a credit analyst with Shawnee Financial Group, has been asked to assess the operational efficiency of Lenexa Company. Loomis calculates the following ratios from data gathered from Lenexa’s annual report:
Total debt
$14,500,000
Revenues
$35,200,000
Earnings before interest and taxes
$6,125,000
Depreciation and amortization
$1,675,000
Interest expense
$2,200,000
According to the financial footnotes, Lenexa is a lessee in an operating lease arrangement for manufacturing equipment. The discounted present value of the lease payments is $6,000,000 using an interest rate of 10%. The annual payment is $1,000,000. Only considering the above data, determine which ratio best measures operational efficiency and calculate the adjusted measure for the appropriate analytical treatment of the lease.
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Operational efficiency |
Adjusted measure |
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EBITDA margin is a measure of operational efficiency. EBITDA / Interest expense is a measure of the tolerance for leverage. The adjustment involves capitalizing the operating lease. As a result, the lease payment is added back to EBITDA. Adjusted EBITDA margin is 25.0% [($6,125,000 EBIT + $1,675,000 deprecation and amortization + $1,000,000 lease payment) / $35,200,000 revenues].
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