Reading 42: Financial Statement Analysis: Applications-LOS e 2011, comparison, statements, another, company

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Session 10: Financial Reporting and Analysis: Applications and International Standards Convergence
Reading 42: Financial Statement Analysis: Applications

LOS e: Determine and justify appropriate analyst adjustments to a company’s financial statements to facilitate comparison with another company.

 

 

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?

Inventory method

Depreciation method

A) First-in, First-out Accelerated

B) Last-in, First-out Accelerated

C) First-in, First-out Straight-line

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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.

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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.

Operational efficiency

Adjusted measure

A) EBITDA margin 25.0%

B) EBITDA margin 17.4%

C) EBITDA / Interest expense 3.1 times

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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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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:

in millions, except per-share data	Company A	Company B
Current assets	$3,000	$5,500
Fixed assets	$5,700	$5,500
Total debt	$2,700	$3,500
Common equity	$6,000	$7,500
Outstanding shares	500	750
Market price per share	$26.00	$22.50

The firms’ financial statement footnotes contain the following:

• Company A values its inventory using the first in, first out (FIFO) method.
• Company B’s inventory is based on the last in, first out (LIFO) method. Had Company B used FIFO, its inventory would have been $700 million higher.
• Company A leases its manufacturing plant. The remaining operating lease payments total $1,600 million. Discounted at 10%, the present value of the remaining payments is $1,000 million.
• Company B owns its manufacturing plant.

To make the firms financials ratios comparable, calculate the adjusted price-to-book ratios for Company A and Company B.

Company A

Company B

A) $2.17 $2.06

B) $2.17 $2.81

C) $1.63 $2.06

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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].

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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.

FIFO Inventory

FIFO COGS

A) $36 million $54 million

B) $26 million $54 million

C) $36 million $74 million

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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).