Chapter 10

PART FOUR
Financial Accounting
Analysis Wrap-Up
4
Chapter 10 provides analysis relevant to preparing and using finan-
cial accounting information: financial statement analysis (focusing
on the illustrative case of Canadian Pacific Railway Limited, made
familiar by various examples in earlier chapters and so brought
together in this chapter), “present value” analysis of the time value
of money, and “what if” or “effects” analysis used to help managers
understand the effects of accounting changes or various financial
and other business deals.
C10 Financial Accounting Analysis Wrap-Up
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CHAPTER TEN
10
Financial
Accounting Analysis
Wrap-Up
TO THE READER: This chapter is written to be used flexibly. Its three parts (Sections 10.2–10.6, Section 10.7, and
Sections 10.8–10.9) may be studied in any order, any time after Chapter 4 is covered.
10.1 Chapter Introduction: Analysis of Financial Accounting

Information
Lydia and Serge are successful professionals: Lydia is in architec- transferring them into the house down payment. We had to
ture and Serge is in engineering. They are beginning to accumu- balance the loss of investment income from our savings and the
late significant savings and have started to think about building an new cost of mortgage interest against the benefits of being house-
investment portfolio. In preparation for a meeting with an owners. Companies have to do the same sort of calculations: we
investment advisor, they are talking over cups of frothy coffee at a need to see how they do that and if they do it well.”
local muffin and doughnut shop. Lydia: “We’ve both talked about companies doing things well.
Lydia: “I believe in business fundamentals. A company that I’m more than a little spooked by all the upset in stock markets
performs well should be appreciated by the stock market in the and companies’ accounting, and am not sure how to tell who
long run. In my practice, I certainly see some client companies really is doing well. Look at this newspaper: one article claims that
that seem to be well-run and others that don’t seem to have it cash flow is the best measure of performance, and beside it is an
together. But those are impressions from meeting the clients’ article talking about net income as a good prediction of future
people and seeing their offices. I’d like to do a more rigorous performance, and at the bottom of the page there is an analysis of
evaluation than that.” future cash flows discounted to the present to show the invest-
Serge: “Remember when we were deciding to buy a house? ment value of those cash flows. There seem to be many versions of
We worried about whether we were taking on an appropriate debt what ‘doing well’ means.”
load, and if we were getting enough benefit out of our savings by
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640 PART FOUR FINANCIAL ACCOUNTING ANALYSIS WRAP -UP
Learning Objectives
This final chapter provides useful tools for analyzing and evalu- • How to do leverage analysis to determine how a company’s
ating financial position and performance. For those of you who borrowing is contributing to the earnings it makes for the
will not become accountants, this chapter will help you develop owners/shareholders (Section 10.6);
essential analytical skills. No matter where your career takes • How to do basic present value analysis of future cash flows to
you, or what business-oriented courses you take from here, the evaluate projects, bonds, and other financial matters
ability to analyze a company’s financial statements and deter- (Section 10.7);
mine how well the company is performing is highly valuable. If • How to do “what if” (effects) analysis, including using a
you do become an accountant, this chapter helps you develop framework for understanding how events and accounting
the kind of analytical ability that the world expects accountants policies can affect the financial statements.
to have. In this chapter you will learn: Future accountant or not, you’ll be pleased at how much
• How to calculate and interpret a full set of financial ratios you know about corporate performance by the time you have
(Sections 10.2–10.5). Various earlier chapters have worked through the chapter’s extensive examples and
presented some ratio analysis and interpretations: here explanations.
they will be brought together using the continuing
example of CPR;
Serge: “Yes, one of my clients is doing a major re-evaluation of a proposed project we were
bidding on because they said that changes in expected rates of returns were making the project
less advantageous and more risky. They said they wanted to reconsider their financing mix before
deciding to go ahead. It would be useful for me to be able to incorporate relevant analysis into my
project proposals so that I don’t get surprised when I talk to a client. My personal investment
objectives and ability to provide good professional services may overlap here.”
Lydia: “You’ve got that right! Just yesterday, our senior partner said we should consider a
change in the way our firm calculates its own profit and asked us to look at an analysis that showed
what our firm’s profit would be if various alternatives were used. That sort of analysis would be
useful for you and me when comparing companies as investments because often they use different
accounting methods and have different options for the future.”
10.2 Investment and Relative Return

Investment and Relative Return
A fundamental economic assumption is that wealth, or capital, has value because it can
An investment forgoes
current consumption be used for consumption, to get “all the ... things your little heart pines for,” as Fats
in order to provide Waller sang. If our wealth is used up on current consumption, there’ll be no consump-
future consumption. tion next period, so generally we are willing to forgo some current consumption by
investing some of our wealth in order to obtain consumption in the future. We hope
that the investment will earn a return that we can consume in the future.
This takes us to the business concept that an investment is made to earn a return.
How much of a return? Whether the return is satisfactory depends on the size of the
investment required to earn it. For example, you might be pleased with a $1,000 annual
return if you had invested $2,000, but horrified if you had invested $2,000,000. One way
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CHAPTER 10 F INANCIAL ACCOUNTING ANALYSIS WRAP -UP 641
to relate the two components is via return on investment (ROI), in which the return is the
numerator and the initial investment is the denominator:
Return
Relative return (return on investment) =
Investment
Later, we will examine relative returns, like return on investment, in more depth. For
The concept of ROI
requires attention to now, note that we have to have some way of measuring both return and investment if we
both the return and are to be able to calculate (and evaluate) relative return:
the investment. • Is the return in the numerator valid? Earlier chapters commented about earnings
management and other manipulations, and about earnings and cash flow as differ-
ent ways of measuring return. The word “return” in ROI could be represented by
several possible quantities, including net income, cash generated by operations, or
interest. The appropriate quantity for the numerator depends on the context of the
analysis, as we will see. Also, the roles of GAAP and other rules in making figures
such as net income meaningful are very important to the conclusions that may be
drawn from ratio analysis.
• Is the investment in the denominator valid? The same point about choosing the
relevant quantity applies to the denominator. Also, earlier chapters commented
about various alternative ways of measuring assets, about unclear distinctions
between liabilities and equity, and about distortions that may result from
off-balance-sheet liabilities and assets.
• Additionally, sometimes a doubtful or ambiguous accounting method can create a
problem in both the numerator and denominator, bringing the whole ratio into
question. An example here is that if a company chooses a revenue recognition
method that makes the validity of net income doubtful, that will also make the
retained earnings and equity figures doubtful, throwing into question one of the
most widely used ROI-type ratios, called return on equity (ROE), which is a ratio of
income to equity.
• The purpose of a ratio is to produce a scale-free, relative measure of a company that
Ratios allow
comparisons of can be used to compare to other companies, or to other years for the company.
different sized Such a measure is scale-free because both numerator and denominator are meas-
companies or the ured in the same units (dollars) and both are dependent on the size of the
same company over company. A large company will have a larger investment than a small one and
time. should be expected to have a larger return as well, but a ratio like ROI cancels out
some of the effects of size and so allows the large and small companies to be
compared.
“Net-of-Tax” Analysis
Way back in Section 1.12, net-of-tax analysis was introduced. Please take a moment and
review the Kamble Manufacturing example in that section.
Net-of-tax analysis is a way of quickly estimating the effect on net income, and on
ratios that use net income, of changes in revenues, expenses, gains, or losses. If you
assume income tax is paid or refunded quickly, you can use it also to estimate effects on
operating cash flows. The whole idea is to focus on income statement items that change,
take out the income tax effect, and so get the effect on net income directly without
having to include all the items that do not change. The analysis illustrated by the
Kamble Manufacturing example follows this formula:
Net income (1 Tax rate) Income before income tax
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Net-of-Tax Example
Here’s another example. Suppose Alcatraz Fencing Inc. has one revenue, one expense,
and an income tax rate of 35%. You can look at net income as the residual after the
income tax has been deducted. But this works just as well for the revenues and expenses.
Let’s recast the income statement as if the revenues and expenses were taxed directly, so
that they are shown net of tax and the income tax effect is, therefore, included in them
rather than being a separate expense:
Income Net-of-Tax
Statement Version
Revenue (net $1,000 (1 0.35)) $1,000 $650
Expense (net $700 (1 0.35)) 700 455
Income before income tax $ 300
Income tax expense (35%) 105
Net income $ 195 $195
Suppose the president of Alcatraz has a plan to increase revenue by $200 without any
The effect of a
revenue or expense increase in the $700 expense. What would that do to net income?
change on net • Using the above formula, the new net income would be higher by $200 × (1 – 0.35)
income is the change = $130.
× (1 – Tax rate). • Therefore the new net income would be $325 ($195 + $130). There is no need to
recalculate the whole income statement.
• If you are doubtful, you can always do the analysis the longer way by recalculating
the income statement, as was illustrated in Section 1.12’s Kamble example.
• The new revenue is $1,200, the expenses are still $700, so income before income tax
is now $500. New income tax expense at 35% is $175, and so new net income is
$325. Same answer, but longer, particularly for real companies that have many
revenues and expenses.
Another Net-of-Tax Example, Using Interest Expense

Another net-of-tax example, which will be important for some of the ratio analyses in
Interest and other
expenses cost less this chapter, concerns interest expense. Suppose $60 of Alcatraz’s expense was interest
than they seem and we wanted to know what the company’s net income would be prior to considering
because they reduce the interest (as if it had no debt).
income tax. • The answer is that if the interest expense were not present, the net income would
go up, but not by $60, because deducting the interest expense saves income tax.
• The net income would rise by $60 × (1 – 0.35) = $39. Same formula again. Interest
really costs the company only $39, because it brings a tax saving, as does any tax
deductible expense.
• Again, we can calculate the net income effect the long way. Revenue is still $1,000,
expense is now $640 ($700 – $60 interest), so new income before income tax is
$360, new income tax expense is $126, and new net income is $234, which is $39
higher than the original $195.
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how’s your understanding?

Here are two questions you should be able to answer based 2. A Canadian transportation company had revenues of
on what you have just read. If you can’t answer them, it $10.5 billion in a recent year. Its income tax rate was
would be best to reread the material. 37%. If its revenues increased by 2%, with no effect on
expenses other than income tax, what would be the effect
1. The president of a company is thinking about changing
on net income for that year?
the company’s method of accounting for insurance
expense, and wants to know what the effect of the policy
will be on net income. Explain why all you need to know Revenue effect = 2% × $10.5 billion = $210.0 million more
to estimate the effect is the amount of the expense under revenue.
the present and proposed methods and the company’s
income tax rate. Net income effect = $210 (1 – 0.37) = $132.3 million higher.
10.3 Introduction
Analysis
to Financial Statement
Financial Evaluation Is Not Just Calculation

The purpose of financial statement analysis is to use the statements to evaluate an enter-
Financial statement
prise’s financial performance and position. Therefore, the value of the analysis depends
analysis is knowledge-
based judgment, not on the contents of the financial statements. When you have completed Sections 10.2–10.6,
just calculation. you will be able to take a set of financial statements of pretty well any company and
make an evaluation of its performance and prospects. Such an evaluation is not just a
calculation, it is a judgment based on the calculations that make sense for that company
and based on substantial knowledge of the company. The more you know about a
company, its business, its management, and its accounting, the more useful and credible
your analysis will be.
You may have noticed that the preceding paragraph
There are many Financial evaluation
used the word “company.” Analytical techniques for
sources and kinds of • Calculations based on
financial statement governments and not-for-profit organizations are more
informed judgment.
analysis. specialized than those illustrated for this book’s examples,
• Techniques often
though many of the ratios and other techniques are specialized to suit
useful there too. Some companies, such as banks and particular companies,
insurance companies, also have sufficiently specialized industries, or decisions.
financial statements and business operations that they • Financial statements
require particular analytical techniques in addition to or are only part of a vast
instead of those illustrated in this book. Other methods of array of information.
analysis can always be developed in order to make the
analysis fit the decision-making (use) objective of the user. Therefore, this chapter is illus-
trative: other techniques exist, and new ones are being invented all the time. Banks, on-
line investment services, and various brokerages offer some analysis on their Web pages;
the financial pages of newspapers like The Globe and Mail, National Post, and The Wall
Street Journal contain analyses of companies pretty well daily, and magazines like
Canadian Business, Fortune, and Business Week publish frequent comparisons of compa-
nies’ performance, often of hundreds of companies at a time, using various financial
statement numbers and ratios. When you use any of these, pay attention to how various
The financial numbers and ratios are defined, because these can vary significantly.
statements should be Financial accounting information is not used in a vacuum, but is part of a vast array
analyzed given all the
of information available to investors, creditors, managers, and others. The use of this
other available
information depends on its quality, such as whether the financial statements have been
information.
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carefully prepared and are comparable to other companies’ statements. Use is also
affected by the availability of other sources of information that may contain all or part of
what is in the financial statements. As is noted in the coverage of stock markets in
Chapter 5, it is difficult to “beat the market” using financial statement information,
because the statements reflect business events people already know something about
and because there are many other people, all with their own sources of information,
also trying to analyze what is going on and taking action on the basis of their analyses.
Financial accounting information is part of a network of information; it doesn’t stand
alone. Consistent with this, various analytical techniques, though explained and illus-
trated separately in this chapter, work best together to tell an overall story. This is
illustrated also.
Doing Intelligent Analysis

Much of financial analysis involves ratios, which are boiled-down summaries of the financial
Ratios are indicators,
statements. Ratios have little meaning on their own: they are merely indicators, which can
given meaning by
the analyst’s be interpreted and used meaningfully only with a good understanding of the company
understanding of and the accounting policies used in preparing the financial statements. The scale-free
the company. nature of a ratio means that it allows comparisons over certain periods of time, among
companies of different sizes, and with other indicators such as interest rates or share
prices. But it also can be tempting to think that when you have calculated a ratio, you
have something meaningful in itself. While there is some fundamental meaning in each
ratio, as we will see, what the comparisons mean to the analyst’s decision must be added
by the analyst, using knowledge and information beyond the ratios.
To do an intelligent and useful financial statement analysis, you should do the
following:
The analysis depends a. Get a clear understanding of the decision or evaluation to which the analysis will
on the decision or contribute, who the decision maker is, and what assistance he or she requires.
evaluation to be made Helping an investor decide whether to make a long-term investment in shares
from it. requires a different set of evaluations than helping a bank manager decide whether
to make a short-term secured loan. The two analyses share an interest in the enter-
prise’s viability, economic prospects, and management quality, but the first implies
an orientation to earnings performance, stock market behaviour, and investing
activity by the enterprise, whereas the second is more concerned with ability to pay,
quality of assets, and debt structure.
b. Learn about the enterprise, its circumstances, and its plans. This is essential in any
real analysis: don’t be misled by the more limited information given for the exam-
ples in this book. The annual report’s Management Discussion and Analysis (MD&A)
section and the notes to the financial statements will help you learn about the enter-
prise. Circumstances may make a big difference: for example, good performance
for a new company in a troubled industry may be unsatisfactory for an established
company in a prosperous industry.
c. Calculate the ratios, trends, and other figures that apply to your specific problem. Don’t
calculate indiscriminately. The examples in this chapter show you how to calculate
many ratios and other comparisons, but not all are relevant to every situation.
d. Find whatever comparative information you can to provide a frame of reference for
your analysis. Industry data, reports by other analysts, results for similar companies
or the same company in other years, and other such information is often plentiful.
e. Use the MD&A and other explanatory sections of the annual report to deepen the
A useful analysis is insight into performance and strategy that your analysis provides.
focused, selective, f. Focus on the analytical results that are most significant to the decision maker’s
informed, and circumstances and integrate and organize the analysis so that it will be of most help
organized. to the decision maker.
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There are many sources of information about companies to help you become
knowledgeable about them and be able to place your analysis in context. As you might
expect, there is more information about large companies than small ones and more
about public companies (those whose shares and other securities are listed on stock
exchanges) than about private ones (those that are closely held by a few owners).
Companies usually post their complete annual reports, including financial statements,
on their Web pages and will often send you additional information, such as securities
commissions filings. Many libraries have extensive sources of company, industry, and
other economic information, much of it on computer-readable databases. Consult your
university or public library, because new databases and other information products are
coming out continuously.
The Web is increasingly important as a source of financial information: many
Many sources of
helpful financial companies have informative Web sites, and there are numerous services that point you
information exist, to financial information. Just one example is the U.S. Securities and Exchange
including the Web. Commission’s site (www.sec.gov), which links to the SEC’s EDGAR database that
contains all of the thousands of information filings to the SEC, many by Canadian and
other non-U.S. companies. The corresponding site in Canada, maintained by the
Canadian Securities Administrators (the provincial securities commissions) in both
English and French, is www.sedar.com. With SEDAR, you can select the name of any
public company in Canada and get access to its publicly available information. Another
example is the research and analysis service offered by on-line brokers—while some of
this is offered only to the brokers’ customers, much is available to anyone who accesses
the brokers’ sites. Similarly, business magazines such as Canadian Business, Business Week,
The Economist, Forbes, and Fortune offer on-line information, sometimes for subscribers
only. If you are analyzing a company, type the company’s name into your Web search
engine and you might be surprised at the variety of articles, news releases, analyses, and
commentaries that are out there.
As you know, the preparer of financial statements has a choice from among a
Analysis often involves
recasting the financial number of accounting policies on which to base the financial information. You, as the
statements on analyst of these statements, may wish to recast them using other policies that you prefer
different bases. before computing any of the ratios. For example, some analysts deduct intangible assets,
such as goodwill, from assets and owners’ equity before computing ratios. They reason
that because these assets are not physical in nature, some people may doubt their value;
deleting them, therefore, may improve comparability with companies that don’t have
such assets. Sections 10.8–10.9 illustrate how to do “what if” analysis that considers
possible changes, including changes to the way the company does its accounting.
The validity of financial analysis based on accounting ratios has been challenged.
Use ratios with care
and intelligence. Among the criticisms are that:
(1) future plans and expected results, not historical numbers, should be used in
computing ratios, especially liquidity ratios;
(2) current market values, not historical numbers, should be used for assets, debts, and
shareholders’ equity in computing performance ratios; and
(3) cash flow, not accounting income, should be used in computing performance ratios.
Another objection is that because, at least for public companies, stock markets and
other capital markets adjust prices of companies’ securities as information comes out,
ratios based on publicly available information cannot tell you anything the markets have
not already incorporated into security prices. While these criticisms are controversial,
they are reminders to use ratios with care and intelligence. Useful additional ideas on
the issues raised in this section can be found in many accounting and finance texts. Be
careful when reading such material: ratio analysis may be made to appear more cut-and-
dried than it is, and some nonaccounting authors do not appear to know much about
the nature of the accounting information used in the analysis.
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Financial Statements and Managers’ Performance

It can be hard to determine how much of a company’s performance is really due to
Identifying managers’
contribution to a management and how much depends on other factors, such as economic trends, prod-
company’s uct price changes, union pressure, and even pure good or bad luck. Also, in most
performance can be companies, management is a group, so it is difficult to set one manager’s performance
difficult. apart from the group’s. The result is that evaluating a manager’s performance (even the
president’s) with financial statements requires great care and knowledge of the
company and its industry—and is always somewhat arbitrary.
The ratios and other computations used in financial statement analysis can easily
compound the problem of evaluating the manager. Let’s take the example of return on
assets. Consider the case of two companies, “A” and “B.”
• Company A has assets of $100,000 and net income plus after-tax interest of $20,000,
for a 20% return on assets (ROA is a ratio to be explained in Section 10.4). Looks
great. But the manager is not looking into the future much and so is not keeping
the company’s assets or maintenance up to date.
• Company B is exactly the same, except that the manager is very aware of the need to
stay competitive and look after the assets, and so has spent $10,000 on new assets
and $2,000 (after tax) on an improved maintenance program. B’s assets are, there-
fore, $110,000 and its net income plus after-tax interest is $18,000, for a 16% ROA.
Consequently, A looks better than B: ROA is reduced for B by both a smaller numerator
A ratio like ROA can
make a good manager and a larger denominator than A has. You can see that unless the person doing the
look worse than a financial analysis really understands the situation, the prudent and responsible manager
poor manager. of B will look worse than the neglectful manager of A!

Here are two questions you should be able to answer based 1. How should a person prepare before beginning to analyze
on what you have just read. If you can’t answer them, it a set of financial statements?
would be best to reread the material. 2. What are some limitations of financial statement analysis?
10.4 Financial Statement Ratio Analysis

Canadian Pacific Railway Limited: An Example
Company
The analyses in this and the next two sections use the December 31, 2004, financial
information of CPR, the company you will have become familiar with through use of its
financial statements as illustrations in Chapters 2, 3, 4, and elsewhere. CPR is used in
this chapter because it is familiar, so you will have some of the knowledge you need to
interpret the ratios, and because this chapter’s analysis will be able to pull together the
various bits of knowledge scattered throughout the earlier chapters’ examples. For more
information about CPR, and to find out how it has been doing since the year 2004,
consult its Web site, www.cpr.ca, which has lots of financial, strategic, managerial, prod-
uct, and market information, or go to the SEDAR site (www. sedar.com) and select
Canadian Pacific Railway Limited. You can also use your search engine to find news
reports and other information about the company.
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To save you having to dig around in earlier chapters, here are the year 2004 finan-
cial statements of CPR. The four statements you used before are included, plus three
notes (Notes 6, 10, and 12) that provide supplementary information useful in the
analysis to come. Please review these statements before you go on.
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10•1
Canadian Pacific Railway Limited
Consolidated Balance Sheet
2004 2003
(Restated –
Year ended December 31 (in millions) see Note 2)
Assets
Current assets
Cash and short-term investments $ 353.0 $ 134.7
Accounts receivable (Note 9) 434.7 395.7
Materials and supplies 134.1 106.4
Future income taxes (Note 7) 70.2 87.4
992.0 724.2
Investments (Note 11) 96.0 105.6
Net properties (Note 12) 8,393.5 8,219.6
Other assets and deferred charges (Note 13) 1,018.3 907.3
Total assets $ 10,499.8 $ 9,956.7
Liabilities and shareholders’ equity
Current liabilities
Accounts payable and accrued liabilities $ 975.3 $ 907.0
Income and other taxes payable 16.2 13.5
Dividends payable 21.0 20.2
Long-term debt maturing within one year (Note 14) 275.7 13.9
1,288.2 954.6
Deferred liabilities (Note 16) 767.8 702.8
Long-term debt (Note 14) 3,075.3 3,348.9
Future income taxes (Note 7) 1,386.1 1,295.8
Shareholders’ equity (Note 19)
Share capital 1,120.6 1,118.1
Contributed surplus 300.4 294.6
Foreign currency translation adjustments 77.0 88.0
Retained income 2,484.4 2,153.9
3,982.4 3,654.6
Total liabilities and shareholders’ equity $ 10,499.8 $ 9,956.7
Commitments and contingencies (Note 22)

See Notes to Consolidated Financial Statements
Approved on behalf of the Board:
J.E. Newall, Director R. Phillips, Director

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IB I
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Statement of Consolidated Income
2004 2003 2002

(Restated – (Restated –
Year ended December 31 (in millions, except per share data) see Note 2) see Note 2)
Revenues
Freight $ 3,728.8 $ 3,479.3 $ 3,471.9
Other 174.1 181.4 193.7
3,902.9 3,660.7 3,665.6
Operating expenses
Compensation and benefits 1,259.6 1,163.9 1,143.4
Fuel 440.0 393.6 358.3
Materials 178.5 179.2 168.7
Equipment rents 218.5 238.5 255.4
Depreciation and amortization 407.1 372.3 340.2
Purchased services and other 610.7 583.6 555.6
3,114.4 2,931.1 2,821.6
Operating income, before the following: 788.5 729.6 844.0

Special charge for environmental remediation
(Note 3) 90.9 – –
Special charge for labour restructuring and asset
impairment (Note 4) (19.0) 215.1 –
Loss on transfer of assets to outsourcing firm
(Note 12) – 28.9 –
Operating income 716.6 485.6 844.0

Other charges (Note 5) 36.1 33.5 21.8
Foreign exchange gain on long-term debt (94.4) (209.5) (13.4)
Interest expense (Note 6) 218.6 218.7 242.2
Income tax expense (Note 7) 143.3 41.6 105.9
Net income $ 413.0 $ 401.3 $ 487.5
Basic earnings per share (Note 8) $ 2.60 $ 2.53 $ 3.08
Diluted earnings per share (Note 8) $ 2.60 $ 2.52 $ 3.06
See Notes to Consolidated Financial Statements.
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IB I
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10•3
Statement of Consolidated Cash Flows
2004 2003 2002
(Restated – (Restated –
Year ended December 31 (in millions) see Note 2) see Note 2)
Operating activities
Net income $ 413.0 $ 401.3 $ 487.5
Add (deduct) items not affecting cash
Depreciation and amortization 407.1 372.3 340.2
Future income taxes (Note 7) 131.5 31.8 95.0
Environmental remediation charge (Note 3) 90.9 – –
Restructuring and impairment charge (Note 4) (19.0) 215.1 –
Foreign exchange gain on long-term debt (94.4) (209.5) (13.4)
Amortization of deferred charges 24.7 20.3 19.3
Other – – (0.8)
Restructuring payments (88.8) (107.0) (119.3)
Other operating activities, net (Note 20) (112.2) (365.0) (45.0)
Change in noncash working capital balances
related to operations (Note 10) 33.2 (53.6) –
Cash provided by operating activities 786.0 305.7 763.5
Investing activities
Additions to properties (Note 12) (673.8) (686.6) (558.5)
Other investments (2.5) (21.9) 4.0
Net proceeds from disposal of transportation properties 10.2 8.2 3.5
Cash used in investing activities (666.1) (700.3) (551.0)
Financing activities
Dividends paid (81.7) (80.8) (80.8)
Issuance of shares 2.5 2.0 2.0
Issuance of long-term debt 193.7 699.8 –
Repayment of long-term debt (16.1) (376.6) (405.7)
Cash provided by (used in) financing activities 98.4 244.4 (484.5)
Cash position
Increase (decrease) in net cash 218.3 (150.2) (272.0)
Net cash at beginning of year 134.7 284.9 556.9
Net cash at end of year $ 353.0 $ 134.7 $ 284.9
Net cash is defined as:

Cash and short-term investments $ 353.0 $ 134.7 $ 284.9
See Notes to Consolidated Financial Statements.
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Canadian Pacific Railway Ltd.
6. Interest expense
(in millions) 2004 2003 2002
Interest expense $ 223.9 $ 226.4 $ 254.2

Interest income (5.3) (7.7) (12.0)
Total interest expense $ 218.6 $ 218.7 $ 242.2

Gross cash interest payments $ 219.0 $ 228.7 $ 245.5
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10. Change in noncash working capital balances related to operations

(in millions) 2004 2003 2002
(Use) source of cash:

Accounts receivable $ (39.0) $ 45.2 $ 21.1
Materials and supplies (35.5) 2.5 (6.6)
Accounts payable and accrued liabilities 112.3 (76.3) (17.4)
Income and other taxes payable (4.6) (25.0) 2.9
Change in noncash working capital $ 33.2 $ (53.6) $ –
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12. Net properties
(in millions) Cost Accumulated Net book
depreciation value
2004
Track and roadway $ 7,667.1 $ 2,482.7 $ 5,184.4
Buildings 319.7 128.4 191.3
Rolling stock 3,323.2 1,319.8 2,003.4
Other 1,566.1 551.7 1,014.4
Total net properties $ 12,876.1 $ 4,482.6 $ 8,393.5
2003 (Restated – see Note 2)

Track and roadway $ 7,325.7 $ 2,321.0 $ 5,004.7
Buildings 314.6 108.1 206.5
Rolling stock 3,270.4 1,277.5 1,992.9
Other 1,535.9 520.4 1,015.5
Total net properties $ 12,446.6 $ 4,227.0 $ 8,219.6
Exhibit 10.6 continues on the next page

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Included in the “Other” category at December 31, 2004, are software development
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10•6
costs of $596.5 million (2003 – $582.9 million) and accumulated depreciation of
$202.8 million (2003 – $164.7 million). Additions during 2004 were $30.3 million
(continued) (2003 – $31.7 million) and depreciation expense was $53.6 million (2003 –
$55.3 million).
At December 31, 2004, net properties included $396.9 million (2003 – $387.9 million)
of assets held under capital lease at cost and related accumulated depreciation of
$83.5 million (2003 – $70.1 million).
During the year, capital assets were acquired under the Company’s capital program
at an aggregate cost of $686.3 million (2003 – $699.0 million), none of which were
acquired by means of capital leases (2003 – $nil). At April 1, 2003, the Company
consolidated $193.5 million in net properties of a VIE for which it is the primary bene-
ficiary (see Note 2). Cash payments related to capital purchases were $673.8 million
(2003 – $686.6 million). At December 31, 2004, $0.2 million (2003 – $12.4 million)
remained in accounts payable related to the above purchases.
Included in the special charge recorded in the second quarter of 2003 was a
$102.7-million write-down to fair market value of the assets of the D&H, including
a $21.8-million (US$16.0 million) accrual for the impact of labour restructuring (see
Note 4).
In the fourth quarter of 2003, CPR and IBM Canada Ltd. (“IBM”) entered into a
seven-year agreement for IBM to operate and enhance the Company’s computing
infrastructure. CPR incurred a loss of $28.9 million on the transfer of computer assets
to IBM at the start of the arrangement.
To make sure you are familiar with the CPR financial statements and so are ready to start
Continue this section
only after familiarizing the analysis, answer the following questions:
yourself with the CPR • What were the company’s total assets at December 31, 2004? Was that more or less
financial statements. than 2003?
• What was the total equity of the company at December 31, 2004?
• What was the company’s net income for the year ended December 31, 2004? What
were the main revenues and expenses that led to this income?
• How much cash was generated by operations for the year ended December 31,
2004? Did the company end up with more or less cash at the end of the year than at
the beginning?
• What was accumulated amortization (depreciation) at the end of 2004? At the end
of 2003?
• How much did accounts receivable changes contribute to the increases and
decreases in noncash working capital used in calculating cash from operations in
2004?
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Twenty kinds of ratios that could be used to analyze a company’s financial performance
This section focuses
on extracting financial and position are outlined in the following pages. Each ratio is illustrated by showing
statement information how it is calculated from the CPR statements. Some interpretive and comparative
and calculating ratios. comments are made as illustrations, but the main purpose of this section is to show you
how to extract the needed information from the statements and figure out the ratios.
Most figures below are given in millions of dollars, as they are in CPR’s statements.
Ratios are only
indicators, so precision Ratios are calculated arbitrarily to three decimal places. They could be done to more
to several decimal decimals, but that would be false accuracy, because the ratios depend on all sorts of
places is unnecessary. judgments and estimates made in assembling the financial statements and, therefore,
should not be thought of as precise quantities, but rather as indicators.
This section’s 20 ratios are summarized in Exhibit 10.8, near the end of the section.
They all should be used in combination with each other, because each has only part of the
story to tell, but to help you see their main uses, they are grouped into four categories:
• Performance ratios: ratios 1–11.
• Activity (turnover) ratios: ratios 12–14.
• Financing ratios: ratios 15–17.
• Liquidity and solvency warning ratios: ratios 18–20.
Performance Ratios
1. Return on equity (sometimes called return on shareholders’ investment or return on
net worth): calculated as Net income / Owners’
ROE = Net income / ROE: What return is the owners’
Owners’ equity. equity. ROE, a very frequently used ratio, indi-
historical investment earning?
cates how much return the company is generat-
ing on the historically accumulated owners’
investment (contributed share capital and other capital items plus retained earn-
ings). Owners’ equity can be taken straight from the balance sheet or can be
computed from the balance sheet equation as total assets minus total liabilities. The
denominator can be year-end equity or average equity over the year; for a growing
company, you’d expect a slightly larger ROE figure for the latter.
CPR’s ROE (based on year-end equity) for the last two years was:
• 2004: $413.0 / $3,982.4 = 0.104
• 2003: $401.3 / $3,654.6 = 0.110
The income return relative to equity was in the range of many companies’ ROEs.
The 2004 return was a little lower than 2003: Both income and equity were higher at
CPR’s 2004 ROE at
10.4% was down a the end of 2004 than at the end of 2003 but equity grew proportionally more at
little from 2003’s 9.0% (($3,982.4 – $3,654.6)/$3,654.6) than income at 2.9% (($413.0 –
11%. $401.3)/401.3). The analyses to come will tell us more about how the ROE came
about and how it relates to other indicators.
2. Return on assets (often also called return on
ROA = (Income + ROA : What return are the
Interest expense) / investment or ROI): usually calculated as (Net
assets earning, before
Total assets. income + Interest expense) / Total assets. Income considering the interest
before income tax may be used instead of net cost of financing them?
income. As with the equity denominator in
ROE, the total assets figure can be the year-end figure or the average over the year.
ROA indicates the company’s ability to generate a return on its assets before consider-
ing the cost of financing those assets (interest). It helps in judging whether borrowing is
worthwhile: presumably if it costs x% to borrow money, the company should expect
to earn at least x% on the assets acquired with the money. (The relationship
between ROA and borrowing cost is explored further in Section 10.6.) Some finan-
cial databases calculate ROA just as income divided by total assets, but we will
remove the financing cost because that provides more information.
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We will use a slightly refined version of

ROA(ATI): Calculating ROA
ROA: we’ll calculate the interest expense after using after-tax interest.
income tax, because if interest is just added back
to income, the impact of the tax saving it brings
is lost. Net income is after tax, so it makes sense to use an after-tax version of interest
expense too.
For our refined ROA, which will be designated ROA(ATI) as a reminder that it uses
Refined ROA(ATI) =
(Net income + After- after-tax interest (ATI), we first have to calculate the after-tax interest cost. You will
tax interest expense) / recall from Section 10.2 that After-tax interest cost = Interest expense × (1 – Tax rate):
Total assets. • We first have to estimate CPR’s effective income tax rate. Its income statement
shows net income but not income before income tax: we have to calculate that by
adding the income tax expense back to net income. Doing this results in income
before income tax in 2004 of $556.3 ($413.0 + $143.3) and $422.9 in 2003
($401.3 + $41.6).
• With that information, we can estimate CPR’s income tax rate: 2004 = 25.8%
($143.3 / $556.3) and 2003 = 9.4% ($41.6 / $442.9). (One of CPR’s notes, not
included in this book, sets out the tax rate reductions and other factors that led
these rates to be lower than expected Canadian statutory rates.)
• Now we need to know CPR’s interest
expense. Note 6, presented earlier in this ROA: To calculate the numera-
tor, add after-tax interest
section, shows that the interest expense
expense to net income.
figure on the income statement is a net after
deducting interest revenue. According to the
note, the interest expense was $223.9 in 2004 and $226.4 in 2003.
• We can now calculate the company’s interest cost on an after-tax basis: 2004 =
$166.1 ($223.9 × (1 – 0.258)) and 2003 = $205.1 ($226.4 × (1 – 0.094)). Note: the
rounded figures for CPR’s tax rates in 2004 and 2003 are used in this calculation
and all future calculations.
CPR’s refined ROA(ATI) based on year-end assets was:
• 2004: ($413.0 + $166.1) / $10,499.8 = 0.055
• 2003: ($401.3 + $205.1) / $9,956.7 = 0.061
These ROAs were moderate: in 2004 and 2003, it was hard to get more than 5%
CPR’s 2004 ROA(ATI)
or so on guaranteed investment certificates at the bank, on Canada Savings Bonds
of 5.5% was down
from 2003’s 6.1% and (CSBs), and on similar investments. CPR has earned more than that on its assets, but
about half its ROE. it is taking more risk to earn its returns than you’d take on bank certificates or CSBs,
so it should be able to do better. Many companies have ROAs in this range. The
calculation above also shows some interesting results along the way. First, the interest
really only cost the company $166.1 million in 2004 ($205.1 million in 2003) because
it was a tax-deductible expense and so saved income tax. Second, if the company had
not had any interest at all, its net income, after tax, would have been $579.1 million
in 2004 ($413.0 + $166.1) and $606.4 million in 2003 ($401.3 + $205.1).
These two “relative return” ratios may be
CPR has positive CPR’s ROE and ROA
compared, as is done in the little table here.
leverage: ROE greater ROE ROA Extra
than ROA(ATI). Whenever the ROE exceeds the ROA, that
means the company is making extra money for 2004 0.104 0.055 0.049
the owners by borrowing to make the assets 2003 0.110 0.061 0.052
greater than they would be with just equity
funding. In 2003, leverage (the “extra” in the table) more than doubled the ROA,
and in 2004 nearly doubled it. Leverage is a main topic in Section 10.6; some other
ratios that reflect leverage effects are shown later in this section.
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3. Sales return (or profit margin): usually calculated as Net income / Revenue. Sales return
Sales return = Net
income / Revenue. indicates the percentage of sales revenue that ends up as income, so it is the average
“bottom line” profit on each dollar of sales. For example, a 0.10 sales return would
mean that 10 cents in net income are generated from each dollar of sales, on aver-
age. It is a useful measure of performance and gives some indication of pricing strat-
egy or competition intensity. You might expect a discount retailer in a competitive
market to have a low sales return, and an upscale jeweller to have a high return, for
example.
In Section 10.6, we will use an alternative version of the sales return ratio, calcu-
lated analogously to that of the refined ROA(ATI), by adding interest expense after
tax back to net income in order to determine the operating return before the cost
of financing that return. Here the more usual simpler version will be illustrated.
CPR’s sales return for 2004 was 0.106 ($413.0 / $3,902.9) and for 2003 was 0.110
Sales return was down
($401.3 / $3,660.7). CPR earned 10.6 cents per dollar of revenue in 2004 and 11
in 2004 compared to
2003, as were ROE cents in 2003.
and ROA(ATI). • 2004: ($413.0 / $3,902.9) = 0.106
• 2003: ($401.3 / $3,660.7) = 0.110
The combination of revenue growth of 7.2% (($3,728.8 – $3,479.3)/$3,479.3)

while controlling operating expenses which increased only 6.2% (($3,114.4 –
$2,931.1)/$2,931.1) would lead to an increase in the sales return. The positive
outcome was offset by increases in nonoperating costs and lower foreign exchange
gains on long-term debt.
4. Common size financial statements: by calculating all balance sheet figures as percent-
Common size analysis
ages (ratios) of total assets and/or all income statement figures as percentages of
converts the
statements to total revenue, the size of the company can be approximately factored out. This
percentages of procedure assists in comparing companies of different sizes and in spotting trends
revenue or assets. over time for a single company. You can think of it as turning the whole financial
statement into ratios.
Common size comparisons can be done using a variety of assumptions. To illus-
trate the analysis, here are common size percentages for the three years included in
CPR’s income statement. Freight revenue could have been used as the baseline,
because freight is CPR’s main business, but to connect with other analyses being
illustrated, total revenue is used here. This is a judgment, of the sort the analyst always
has to make. To further illustrate judgment, some income statement items were
grouped and others were not—different groupings may lead to different
conclusions. All percentages were rounded to one decimal.
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CPR Common Size Income Statements
2004 2003 2002

Revenues:
Freight 95.5% 95.0% 94.7%
Other 4.5 5.0 5.3
Total 100.0% 100.0% 100.0%
Operating expenses:
Compensation 32.3 31.8 31.2
Fuel 11.3 10.8 9.8
Other 38.1 44.2 36.0
Operating income 18.3 13.2 23.0
Foreign exchange gain (2.4) (5.7) (0.4)
Interest and other 6.5 6.9 7.2
Income tax 3.7 1.1 2.9
Net income (Ratio 3 percentages) 10.5% 10.9% 13.2%
The common size Two interesting trends are immediately apparent: operating expenses as a
income statement percentage of sales have increased each year, and interest and other charges have
shows the been falling. The reduction in interest and other charges has been insufficient to
components of sales offset the rising operating costs.
return.
• Sales growth ($3728.8 – $3479.3)/$3479.3 = 7.2%
• Operating expense growth (($3,114.4 – $2,931.1)/$2931.1) = 6.2%
A similar analysis may be done of the balance sheet, dividing all assets, liabilities,
and equity items by total assets. You might try that yourself as an exercise and see
what is revealed by it.
5. Gross margin (or gross profit ratio): calculated as (Revenue – Cost of goods sold expense) /
Gross margin =
Revenue. This provides a further indication of a company’s product pricing and
(Revenue – COGS) /
Revenue. product mix beyond the business line analysis done above. For example, a gross
margin of 33% indicates that a company’s average markup on cost is 50% (revenue
equals 150% of cost, so cost is 67% of revenue and gross margin is 33%). This is a
rough indicator only, especially for companies with a variety of products or unstable
markets.
As we saw in Section 3.4, gross margin cannot be calculated for CPR. The
Gross margin cannot
be calculated from company sells services, not products, so it has no “cost of goods sold” to report.
CPR’s financial Perhaps its expense categories could be grouped into a “cost of services provided”
statements. category, but the company doesn’t do that. In Section 3.4, we tried other ways of
relating CPR’s revenues and expenses. Using the common size income statement
shown above as Ratio 4, the various categories of expenses can be related to
revenue, and that is about all that can be done.
It is a reminder that financial statement analysis is dependent on the contents of
the financial statements. We cannot analyze information we do not have, or that
would be irrelevant or inapplicable to the particular company we are analyzing.
6. Average interest rate : calculated as Interest expense / Liabilities. This ratio shows what the
Average interest rate =
company pays for interest relative to its borrowing. There are various versions of this
Interest expense /
Liabilities. ratio:
• Interest expense can be calculated before or after income tax.
• Related expenses such as amortization of debt issue costs could be included or not.
• All liabilities may be included or just interest-bearing ones, such as bonds and
mortgages.
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If the ratio is calculated on an after-tax basis and applied to all liabilities, it is

likely to be quite low: interest is tax-deductible, so income tax savings amount to a
significant part of it, and many liabilities, such as future income tax, dividends
payable, deposits on contracts, and most accounts payable, carry no interest.
Interest rate calculations are discussed further in Section 10.6, where the rate is
calculated on an after-tax basis.
On a before-tax basis, Note 6 reports interest expense of $223.9 million in 2004
and $226.4 million in 2003. We can calculate total liabilities two ways:
• Add up all the liabilities: 2004: $1,288.2 + $767.8 + $3,075.3 + $1,386.1 = $6,517.4;
2003: $954.6 + $702.8 + $3,348.9 + $1,295.8 = $6,302.1.
• Just subtract equity from the total of liabilities and equity: 2004: $10,499.8 –
$3,982.4 = $6,517.4; 2003: $9,956.7 – $3,654.6 = $6,302.1.
• It’s sometimes useful to use both methods just to check!
Therefore, the average pre-tax interest rate on all year-end liabilities was:
• 2004: $223.9 / $6,517.4 = 0.034
• 2003: $226.4 / $6,302.1 = 0.036
The two years had almost the same average interest rate. As some of the liabili-
Average interest rate
ties included in the ratio’s denominator did not carry interest, it is a predictably low
is low and has not
changed much in the rate. The impact of interest on measuring leverage will be examined in Section 10.6.
two years. The very long Note 14 about long-term debt (not included in this book) indicates
that the long-term debt carries interest at average rates from 6% to 9% (and that
there is some “perpetual” debt created by an act of parliament in 1889—a left-over
of the railway’s original financing to link the country with steel). Assuming that only
the long-term debt (including its current portion) bears interest, we can calculate
the average long-term interest rate:
• 2004: $223.9 / ($275.7 + $3,075.3) = 0.067
• 2003: $226.4 / ($13.9 + $3,348.9) = 0.067
This calculation suggests that the company’s interest rates have fallen. The
unchanged overall average above was partly a function of a change in the mix of
interest-bearing and non-interest-bearing liabilities.
7. Cash flow to total assets : calculated as Cash generated by operations / Total assets. Cash
Cash flow to total
generated by operations is found in the cash flow statement, and total assets may be
assets = Cash from
operations / Total taken from the year-end balance sheet figure or calculated as an average of the
assets. beginning and ending figures. This ratio relates the company’s ability to generate
cash resources to its assets, which approximately factors out size. It provides an alter-
native return measure to ROA, focusing on cash return rather than on accrual
income return as used in ROA.
CPR’s cash flow to assets ratios were:
Cash flow to total
assets in 2004 was • 2004: $786.0 / $10,499.8 = 0.075
more than double • 2003: $305.7 / $9,956.7 = 0.031
that of 2003.
Cash flow to total assets in 2004 was more than double that of 2003. A review of
the statement of cash flows reveals the major cause of this change as the reduction
of cash used up by “other operating activities.” The cash provided by operations in
2003 appears unusually low, with 2004 being a return to a more normal level. Cash
flow to total assets is also higher than ROA, which is what we should expect since
operating cash flows should provide funds for new assets to replace those that are
wearing out and for which amortization was deducted in calculating net income.
Section 10.5 has more about this.
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8. Earnings per share: conceptually, this ratio is calculated as (Net income – Dividends on
EPS = (Net income –
Preferred dividends) / preferred shares) / Average number of common shares outstanding. EPS relates earnings
Average number of attributable to common shares (the numerator) to the number of common shares
common shares issued, thereby providing a sort of down-to-earth performance measure. It is also
outstanding. another way of factoring out the company’s size. If you have only 100 shares of a
large company, it is not easy to understand what the company’s multimillion-dollar
income means to you. But if you are told that the EPS = $2.10, you know that your
100 shares earned $210 for the year and can then relate the company’s returns to
your own circumstances.
Calculating EPS is a little complicated, so GAAP require that publicly traded
EPS is provided in the
audited financial companies provide it in their financial statements. (See price-earnings ratio below.)
statements of public Because it is part of the financial statements, it is (for public companies) the only
companies. ratio routinely covered by the auditor’s report. For small, closely held companies,
EPS is not meaningful, and not required by GAAP, because the owners usually
cannot trade their shares readily and are likely to be interested in the value of the
overall company more than in that of individual shares.
There are different More than one version of EPS can appear in the same set of statements. If a
versions of EPS, company has extraordinary items, discontinued operations, or other anomalies, EPS
depending on is calculated both before and after such items, so that the effect of such items may
circumstances. readily be seen. Also, if the company has potential commitments to issue further
shares, such as in stock-option plans to motivate senior management or preferred
shares convertible to common shares at the option of the holder of the preferred
shares, the potential effect of the exercise of such commitments is calculated by
showing both ordinary EPS and “fully diluted” EPS. (“Dilution” refers to the poten-
tial lowering of return to present shareholders resulting from other people’s exercis-
ing rights arising from commitments already made by the company.) Adding to the
variety, EPS can be calculated a little differently in the U.S. than in Canada (though
country differences like that are being reduced or eliminated, as noted in the
discussion of international standards harmonization in Section 5.5).
CPR had no discontinued operations, nor any extraordinary items. But it did
have commitments potentially requiring it to issue more shares (stock options).
Therefore, the income statement shown at the beginning of this section shows two
EPS figures for each year:
• 2004: Basic EPS = $2.60, diluted EPS = $2.60
• 2003: Basic EPS = $2.53; diluted EPS = $2.52
The weighted average number of common shares outstanding during 2004 was
158.7 million (158.5 million for 2003). The dilutive effect of the outstanding share
options is quite small: less than $0.01 in 2004 and only $0.01 in 2003. This indicates
CPR has granted only a relatively small number of stock options to its employees in
recent years.
9. Book value per share : calculated as (Shareholders’ equity – Preferred shares) / Number of
Book value per share
common shares issued and outstanding. Similar to EPS, this ratio relates the portion of
= (Shareholders’
equity – Preferred the shareholders’ equity attributable to the residual common shareholders to the
shares) / Common number of shares outstanding, and so brings the company balance sheet down to
shares issued. the level of the individual shareholder. It is not really a performance ratio, but
shareholders’ equity does include retained earnings, so it incorporates accumulated
performance. Because the balance sheet’s figures do not reflect the current market
value of most assets or of the company as a whole, many people feel that book value
per share is a largely meaningless ratio. Other people feel that as an accumulation,
it is less subject to manipulation than annual earnings, and some accounting
research uses book value per share as a preferred measure to EPS. In any case, you
will see it mentioned in many financial publications.
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Using the same 158.7 million shares outstanding at the end of 2004, and the
Book value per share
increased from 2003 158.5 million shares outstanding at the end of December 2003 (a small number
to 2004. having been issued under stock option plans) for 2004, CPR’s book value per
common share was:
• 2004: $3,982.4 / 158.7 = $25.09
• 2003: $3,654.6 / 158.5 = $23.06
Normally, book value per share increases as retained earnings accumulate and
new shares are issued. Indeed, the increase in book value per share of $2.03 ($25.09
– $23.06) is very close to the increase in retained earnings per share, $2.08
(($2,484.4 – $2,153.9)/158.7).
In Section 2.10, a comparison of market value per share to book value per share
CPR’s market
was made. The company’s closing share price on December 31, 2004, was $41.10, so
capitalization was
64% higher than its its price to book ratio was 1.64 ($41.10 / $25.09 from above). Thus the company’s
book value at the end market capitalization was 64% higher than book value. With 158.7 million shares
of 2004. outstanding, the stock market valued CPR at about $6.5 billion, compared to its
equity book value of $4 billion. This is not a great premium, but then, numerous
companies that had much higher premiums due to stratospheric share prices and
not much book value to back them up have crashed to earth (Enron, WorldCom,
Global Crossing, Nortel, and on and on). CPR is being valued as a stable, not excit-
ing company—which fits with the stability in earnings and cash flows we have seen
in earlier ratios.
10. Price-earnings ratio : calculated as Current market price per share / EPS. The PE ratio
PE ratio = Current
relates the accounting earnings and market price of the shares, but, since the rela-
market price per
share / EPS. tionship between such earnings and changes in stock market prices is not straight-
forward (as discussed in Chapter 5 especially), the interpretation of PE is
controversial. Nevertheless, it is a widely used ratio, appearing in many publications
and analyses of companies. Many newspapers include PE (or its inverse, the
earnings-price ratio) in their daily summaries of each company’s stock market trades
and prices.
The idea is that because market price should reflect the market’s expectation of
The PE ratio varies
future performance, PE compares the present performance with those expectations,
because of general
stock market changes as did the price to book ratio mentioned under Ratio 9. A company with a high PE
unrelated to the is expected to show greater future performance than its present level, while one
company. with a low PE is not expected to do much better in the future. High-PE companies
are those that are popular and have good share prices, while low-PE companies are
not so popular, having low share prices relative to their present earnings. PE is
highly subject to general increases and decreases in market prices, so it is difficult to
interpret over time and is more useful when comparing similar companies listed in
the same stock market at the same time. It is especially difficult to interpret, maybe
largely meaningless, when the stock market is going through a sudden change, as
happened when the dot-com bust began the long disruption in share prices in 2000
and continued throughout the early years of the decade.
CPR’s stock price has fluctuated somewhat throughout 2003 and 2004 but the
CPR’s PE is consistent
trend has been to fairly steady growth. Using the year-end closing prices, which are
with a stable
investment of low risk. close to the highs for the year, gives a conservative view of the price-earnings ratio:
• 2004: PE = $41.10 / $2.60 = 15.8
• 2003: PE = $36.58 / $2.53 = 14.5
This is a solid PE, a little on the low side but again indicating that the market
sees CPR as a good, fairly safe investment. No high flyer, but not likely to go bust
suddenly, either. Many PE ratios in recent years were ridiculously high, and some
observers think they are still on the high side. You can get an idea of whether the PE
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is too high by inverting it to get the earnings-price ratio. CPR’s earnings-price ratio
would be about 7%: this is the earnings return implied for an investor who bought
in at $41.10. Such a return is better than bond interest rates, and CPR is probably
not a risky investment, unless the stock market has a complete meltdown.
11. Dividend payout ratio: calculated as Annual common dividends declared per share / EPS, or
Dividend payout ratio
if dividends per share are not disclosed, just Dividends declared / Net income. This is a
= Dividends declared /
Earnings (or Dividends measure of the portion of earnings paid to shareholders. For example, if the divi-
per share / EPS). dend payout ratio is 0.40, 40% of income was distributed to shareholders and the
remaining 60% was kept in the company (retained earnings) to finance assets or
reduce debts. A stable ratio would suggest that the company has a policy of paying
dividends based on earnings, and a variable ratio would suggest that other factors
than earnings are important in the board of directors’ decisions to declare
dividends.
Though it cannot be illustrated using CPR, a wrinkle in calculating the dividend
payout ratio should be mentioned. It can be calculated in various ways:
• Dividends declared per share / EPS, or
• Dividends declared per share / Continuing earnings per share, or
• Total dividends declared (on statement of retained earnings) / Net income, or
• Total dividends declared / Continuing earnings (on income statement).
The total and per-share methods should produce similar results, depending on
whether, as for CPR, there have been major changes in shares issued during the year
or lumpy dividends. The total method is always available, but the per-share versions
depend on knowing the dividends per share figure, which is not always disclosed.
Basing the ratio on continuing earnings (or continuing EPS) instead of net income
or EPS is useful if the company has been divesting itself of big chunks of its business.
The payout ratio would then be a better estimate of what might be expected in the
future.
CPR has only a short history of dividend payouts since the reorganization in
2001. We can learn the total dividends amount each year from the statement of
retained earnings. Using this information and the average number of shares
outstanding, an estimate of annual dividends can be calculated.
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10•7 2004 2003 2002
Dividends declared ($ millions) $ 82.5 $ 80.8 $ 80.8

Net income ($ millions) $ 413.0 $ 401.3 $ 487.5
Weighted average number of 158.7 158.5 158.5

shares outstanding (millions)
Basic EPS $ 2.60 $ 2.53 $ 3.08

Dividend per share (calculated) $ 0.52 $ 0.51 $ 0.51
Dividend payout ratio 0.200 0.201 0.165
From the information in Exhibit 10.7, we can infer that CPR appears to be
conservative and stable. It appears that the board of directors has chosen to follow a
policy of conservative stable dividends in the amount of about $0.13 per share quar-
terly or 20% of total net income.
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The dividend payout ratio is usually consistent with the company’s PE ratio. Fast-
growing companies are often strapped for cash and so pay little or no dividends,
plowing earnings back into more growth. People hold the shares of such companies
because they expect growth in share price, not dividends, and because of such
expectations of future growth, the PE ratios of such companies are usually high. In
contrast, people invest in some more dull, but safer, companies not because they
expect high share price growth but because they expect regular dividends, almost
like Canada Savings Bonds. CPR pays more than zero dividends, but with its supply
of cash could have paid a higher percentage of earnings than it did. This reinforces
the growing conclusion from these ratios that CPR is a solid, moderate company,
not a high-growth one. Just what we would expect from a railway that is more than
100 years old.
Activity (Turnover) Ratios

12. Total asset turnover: calculated as Revenue / Total assets. Total assets can be the year-end
Total asset turnover =
figure, which is used in this book, or an average of beginning and ending assets,
Revenue / Total assets.
which relates the revenue over a period to the average assets over the same period,
and may be more relevant if a company is growing or shrinking rapidly in assets.
This and similar turnover ratios relate the company’s dollar sales volume to its size,
thereby answering the question: How much revenue is associated with a dollar of
assets?
• Turnover and profit-margin ratios are often useful together because they tend to
move in opposite directions.
• Companies with high turnover tend to have low margins.
• Companies with low turnover tend to have (or hope to have) high margins.
• Those extremes represent contrary marketing strategies or competitive pressures:
pricing low and trying for high volume versus pricing high and making more on
each unit sold.
There is more about using profit margin and turnover together in Section 10.6.
Using year-end assets, CPR’s total asset turnovers were:
Total asset turnover
was low but slightly • 2004: $3,902.9 / $10,499.8 = 0.372
improved in 2004 as • 2003: $3,660.7 / $9,956.7 = 0.368
revenue grew faster
than assets. Two observations are indicated.
(1) These turnover ratios are very low. They are much below those that most
companies have: CPR takes nearly three years to earn a dollar of revenue on
each dollar of assets. By comparison, Canadian Tire had a total asset turnover
for the same 2004 period of 1.371 (more than three times CPR’s) and Wal-Mart’s
turnover for the year ended March 31, 2004, was 2.472 (seven times CPR’s).
Well, what would we expect? CPR has miles of railroad track, thousands of
engines and railcars, maintenance shops and so on. Canadian Tire owns few of
its stores, letting franchisees build most of them, and Wal-Mart is a discount
retailer, depending on high sales volume. It is a reminder to consider the kind
of company being analyzed, and a reminder that there are no absolute ratios, only
relative comparisons. One comparison could be to Canadian National Railway.
In 2004, CN’s asset turnover was 0.34,3 less than CPR’s. So this comparison puts
CPR in a better relative light.
(2) CPR’s asset turnover improved slightly from 2003 to 2004. This improvement is
the result of higher growth in revenues, 6.6% (($3.902.9 – $3,660.7)/$3,660.7),
than in assets, 5.5% (($10,499.8 – $9,956.7)/$9,956.7). While the change is
small, it is another indication of the stability of CPR.
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13. Inventory turnover : calculated as Cost of goods sold expense / Average inventory assets (or
Inventory turnover =
COGS / Average by year-end inventory, for convenience). If cost of goods sold is not disclosed, it is
inventories. often replaced by sales revenue in calculating the ratio, which is alright for compar-
ing one year to others for one company, as long as markups and product mixes do
not change substantially. This ratio relates the level of inventories to the volume of
activity: a company with low turnover may be risking obsolescence or deterioration
in its inventory and/or may be incurring excessive storage and insurance costs. In
recent years, many companies have attempted to pare inventories to the bone, keep-
ing just enough on hand to meet customer demand or even ordering inventory as it
is demanded by customers (as in the “just in time” method of minimizing invento-
ries without running out of stock and irritating customers).
As we have already seen, CPR doesn’t have a cost of goods sold, and its balance
sheet indicates its inventories are just supplies for running the railroad, not goods
for sale. So we cannot calculate a meaningful inventory turnover ratio. Using CPR as
the example company has this shortcoming, but it doesn’t mean the inventory
turnover ratio is not important or useful. It is very important for evaluating retailers
and other sellers of goods.
14. Collection ratio (receivables turnover, often called days’ sales in receivables): calculated
Collection ratio =
as Accounts receivable / (Revenue / 365). As for the other turnover ratios, the balance
Accounts receivable /
(Revenue / 365). sheet amount, accounts receivable, can be the year-end figure or an average over
the year. This ratio indicates how many days it takes, on average, to collect a day’s
sales revenue. It becomes large when accounts receivable become larger relative to
sales, so its interpretation is the opposite of those of the previous two turnover ratios:
a large collection ratio is a negative signal, raising questions about the company’s
policies of granting credit and the vigour of its collection attempts. The ratio is
subject to significant seasonal changes for many companies, usually rising during
heavy selling periods, such as just before Christmas for a retailer, and falling during
slow times. (It would be preferable to use only revenue from credit sales in the
denominator, since cash sales are collected immediately, but few companies break
their revenue figures down to separate cash revenue.)
CPR’s collection ratios were:
It takes CPR a month
and one-third, on • 2004: $434.7 / ($3,902.9 / 365) = 40.6 days
average, to collect • 2003: $395.7 / ($3,660.7 / 365) = 39.5 days
from its customers.
It takes the company about a month and one-third, on average, to collect from its
customers. This is reasonable time: most customers pay monthly, and CPR has
government agencies and other relatively slow payers among its customers. Its collec-
tion pattern is similar to CN Rail’s: CN’s collection ratio for 2004 was 44.3 days.4
Financing Ratios
15. Debt-equity ratio : calculated as Total liabilities / Total equity, or sometimes as Total exter-
Debt-equity ratio =
nal debt / Total equity, to exclude deferred revenue, future income tax, and other
Total liabilities / Total
equity. liabilities that are consequences of accrual accounting’s revenue and expense
matching more than they are real debt. This ratio, which we saw back in Section 2.10,
measures the proportion of borrowing to owners’ investment (including retained
earnings) and thus indicates the company’s policy of financing its assets.
A ratio greater than 1 indicates the assets are financed mostly with debt, while a
ratio less than 1 indicates the assets are financed mostly with equity. A high ratio,
well above 1, is a warning about risk: the company is heavily in debt relative to its
equity and may be vulnerable to interest rate increases, general tightening of credit,
or creditor nervousness. (A high ratio also indicates that the company is leveraged,
which means it has borrowed to increase its assets over the amount that could be
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acquired with owners’ funds only, and it hopes thereby to increase returns and
benefit the owners. See the comments on leverage at the end of the discussion of
ROA earlier in this section and in Section 10.6.)
CPR’s debt-equity ratios, as calculated in Section 2.10 and using the same liability
totals as were calculated for Ratio 6 above, were:
The debt-equity ratio
has trended • 2004: $6,517.4 / $3,982.4 = 1.64
downward since • 2003: $6,302.1 / $3,654.6 = 1.72
2001.
CPR’s debt-equity ratio was 2.14 in 2001, a significant increase from the 2000
level of 1.42. It now seems probable that this increase was brought about by financial
needs arising from the reorganization of Canadian Pacific in 2001. The trend
appears to be downward towards earlier levels, again evidencing the stability of CPR.
However, the debt-equity ratio certainly shows that CPR is leveraged, relying more
on debt than on equity, but that its relative reliance on debt is decreasing.
16. Long-term debt-equity ratio: calculated as (Long-term loans + Mortgages + Bonds + Similar
Long-term debt-
long-term debts) / Total equity. This ratio has many versions, depending on which
equity ratio = Long-
term debts / Equity. specific items the analyst decides to include as debt. It is frequently referred to as the
debt/equity ratio under the apparent assumption that longer-term debt is more
relevant to evaluating risk and financing strategy than are the accrual and non-
interest-bearing components of Ratio 15.
For CPR, this ratio involves just the one long-term debt figure on the balance
sheet. Not including the debt’s tiny current portion, the resulting ratios were:
CPR’s reliance on
long-term debt is • 2004: $3,075.3 / $3,982.4 = 0.772
decreasing. • 2003: $3,348.9 / $3,654.6 = 0.916
Again we see the downward trend in CPR’s reliance on debt since 2001, when
this ratio was at 1.18.
17. Debt to assets ratio : if calculated as Total liabilities / Total assets, this ratio is the comple-
Debt to assets ratio =
ment of the debt-equity ratio discussed above (Ratio 15) and indicates the propor-
total liabilities / Total
assets. tion of assets financed by borrowing. It may also be calculated by just comparing
long-term debt or external debt to assets (complement of Ratio 16).
Using total liabilities, the ratios for CPR were:
Over 60% of CPR’s • 2004: $6,517.4 / $10,498.8 = 0.62
assets were financed • 2003: $6,302.1 / $9,956.7 = 0.63
by liabilities in 2004.
The same pattern as in Ratios 15 and 16 is here. Assets were financed more than
50% by liabilities and the reliance on liabilities has decreased since 2001 when the
company financed its assets over two-thirds by liabilities, which is what we also
learned from the debt-equity ratio being over 2.
Liquidity and Solvency Warning Ratios

18. Working capital (current) ratio : calculated as Current assets / Current liabilities. This ratio
Working capital ratio
has already been scrutinized (Section 2.10). It indicates whether the company has
= Current assets /
Current liabilities. enough short-term assets to cover its short-term debts. A ratio above 1 indicates that
working capital is positive (current assets exceed current liabilities), and a ratio
below 1 indicates that working capital is negative. Generally, the higher the ratio,
the greater is the financial stability and the lower is the risk for both creditors and
owners. However, the ratio should not be too high because that may indicate the
company is not reinvesting in long-term assets to maintain future productivity. Also,
a high working capital ratio can actually indicate problems if inventories are getting
larger than they should or collections of receivables are slowing down.
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The working capital ratio is a very commonly used indicator. Some analysts use a
The working capital
ratio’s meaning rough rule that says the working capital ratio should be around 2 (twice as much in
depends on the current assets as current liabilities), but this is simplistic. Many large companies
company’s specific regularly operate with a working capital ratio closer to 1 than 2. The ratio’s interpre-
circumstances. tation depends on the specific circumstances of each company, as does the interpre-
tation of any ratio. Interpretation of it is also complex because it is static, measuring
financial position at a point in time and not considering any future cash flows the
company may be able to generate to pay its debts.
This ratio is most useful for companies having cash flows that are relatively
smooth during the year and hardest to interpret for those that have unusual assets
or liabilities or that depend on future cash flows to pay current debts. An example
of the latter would be a company that owns a rented building: there may be few
current assets and large current liabilities for mortgage payments, but, as long as the
building is mostly rented and rental income is steady, the company is not in diffi-
culty even though its working capital ratio is low. However, it is more at risk than a
similar company with a higher working capital ratio, because that company could
more easily weather a loss of tenants due to recession or the opening of a competing
building.
As we saw in Section 2.10, CPR’s working capital ratio changed only slightly in 2004:
CPR has a negative
working capital • 2004: $992.0 / $1,288.2 = 0.77
position. • 2003: $724.2 / $954.6 = 0.76
This ratio shows CPR’s working capital position to be negative; that is, there are
insufficient current assets on hand to repay all current liabilities. We have noted
throughout that CPR is a very stable company. It is also the case that CPR generates
its revenue using its long-term assets to provide service rather than selling its current
assets as in the case with Wal-Mart. Thus by using its current revenues as earned and
collected, CPR is able to meet the required payments of expenses and current liabil-
ities despite the working capital deficit.
19. Acid test (quick) ratio : calculated as (Cash + Temporary investments + Accounts receivable) /
Acid test ratio =
Current liabilities. This is a more demanding version of the working capital ratio and
(Cash + Temporary
investments + indicates whether current liabilities could be paid without having to sell the inven-
Accounts receivable) / tory (in other words, without having to convince more customers to buy what the
Current liabilities. company has for sale). There is an even harsher version of this ratio, called the
“extreme acid test,” which uses only cash and equivalents in the numerator. A
complementary ratio, Inventory / Working capital, is often used to indicate what
percentage of working capital is tied up in inventory. These ratios are all used to
signal lower levels of liquidity, and so greater degrees of risk, than may be revealed
by the working capital ratio alone, and so tend to be used when that ratio is deterio-
rating or is worrisome for some other reason. We saw that the working capital ratio
for CPR may have risen only to adequacy, so the acid test ratio may tell us something
further about the company’s liquidity.
Using the acid test ratio is likely to be informative if a company’s working capital
includes large amounts of inventories that would have to be sold to pay bills, or
large prepaid expenses that have drained cash. CPR doesn’t have either of these, so
the quick ratio will not tell us much more than the working capital ratio does, but
let’s calculate it anyway. The ratio was presented in Section 2.10:
CPR’s acid test ratio is • 2004: ($353.0 + $434.7) / $1,288.2 = 0.61
less than 1, indicating • 2003: ($134.7 + $395.7) / $954.6 = 0.56
weak liquidity.
This shows CPR to have liquid assets equal to only 60% of its current liabilities.
This is low but is likely adequate, assuming CPR could match its payments to at least
some of its suppliers roughly to the time it takes to collect from its own customers.
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20. Interest coverage ratio: usually calculated as (Income before interest expense and income tax) /
Interest coverage ratio
= (Income before Interest expense. This and similar coverage ratios that are based on cash flow figures
interest expense and from the cash flow statement indicate the degree to which financial commitments
income tax) / Interest (in this case, those to pay interest on debts) are covered by the company’s ability to
expense. generate income or cash flow. A low coverage ratio indicates that the company is not
operating at a sufficiently profitable level to cover the interest obligation comfort-
ably and may also be a warning of solvency problems (difficulty in meeting
obligations over the long haul).
CPR’s interest coverage ratios, using the interest expense from Note 6 used in
earlier ratios, were:
CPR’s interest
coverage was • 2004: ($413.0 + $143.3 + $223.9) / $223.9 = 3.49
comfortable in 2004, • 2003: ($401.3 + $41.6 + $226.4) / $226.4 = 2.96
and improving.
The result here is what we would expect from the other debt-related ratios.
CPR’s interest coverage is comfortable, though with its increased borrowing and the
increased interest that goes with it, it is less comfortable than it was in 2003.
Concluding Comments About the Twenty Ratios

The twenty ratios are summarized in Exhibit 10.8. Each one focuses on a different
aspect of performance, and the comparison of each with the previous or other years tells
us something and also invites us to learn more about the company so we can understand
what each ratio is indicating. Comments integrating the story told by all the ratios will be
made in Section 10.6 on page 668.
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10•8
Summary of the Twenty Ratios for Canadian Pacific Railway
Ratio 2004 2003

1. ROE 0.104 0.110
2. ROA(ATI) 0.055 0.061
3. Sales return (based on net income) 0.106 0.110
4. Common size see details see details
5. Gross margin not available not available
6. Average interest rate (no tax correction) 0.034 0.036
7. Cash flow to total assets 0.075 0.031
8. EPS (reported audited figure) $2.60 $2.53
9. Book value per share $25.09 $23.06
10. PE (approximate) 15.8 14.5
11. Dividend payout 0.200 0.201
12. Total assets turnover 0.372 0.368
13. Inventory turnover not available not available
14. Collection 40.6 days 39.5 days
15. Debt-equity 1.64 1.72
16. Long-term debt-equity 0.772 0.916
17. Debt to assets 0.62 0.63
18. Working capital 0.77 0.76
19. Acid test 0.61 0.56
20. Interest coverage 3.49 2.96
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By the time you read this, CPR will have gone through at least one more fiscal year.
To improve your understanding of the company and the ratios above, visit the company
Web site (www.cpr.ca) and look for the year 2005 or subsequent annual reports, or its
regular quarterly reports. The company’s explanations of performance in the letter to
shareholders, the Management Discussion and Analysis (MD&A), the notes to the finan-
cial statements, and elsewhere in the annual report, plus other items such as press
releases, and speeches contained in CPR’s Web site, or elsewhere such as the SEDAR site
(www.sedar.com) are likely to be informative. Compare it to competitors such as CN Rail
(www.cn.ca).
FYI
statement data, do help to predict companies’ future
H
ere are some accounting research results relevant to
the value of the kind of financial analysis included in earnings performance. The analysts can often anticipate
this chapter: significant changes in earnings because they are follow-
ing companies closely, so market prices regularly change
1. Ratios computed from financial statements have some
before the new financial statements are released.
value in predicting bankruptcy or other financial prob-
Sometimes financial statement analysis does turn up
lems. For some companies, but not all, financial problems
new information, allowing people to fine-tune their
can be predicted several years in advance using
expectations about future performance.
accounting ratios.
5. Financial statement analysis helps to assess risk, and thus
2. Even though annual reports come out rather a long time
helps investors choose the shares that seem appropriate
after the fiscal year-end, there is enough reaction by
for their risk preferences.
stock markets to them to indicate that analysis of the
6. Financial statement analysis is useful to corroborate what
reports still has something to say to market traders.
people already believe about a company’s performance,
3. People cannot cope with masses of disaggregated data: it
position, or risk. Even if such analysis turns up little that is
takes too long and requires too much special expertise.
“new,” it acts as a check on the other flows of informa-
So, summarizing techniques, such as financial analysis,
tion about companies, because the validity of that infor-
play a major role in users’ decision making.
mation can be verified later when the financial
4. Analysts’ forecasts of earnings, based partly on financial
statements come out.

Here are two questions you should be able to answer based 1. How well did CPR perform in 2004 as compared to 2003?
on what you have just read. If you can’t answer them, it 2. How was CPR’s liquidity at the end of 2004? Is that an
would be best to reread the material. improvement over 2003?
10.5 Interpretation of Cash Flow Information

Both in the theory of economics and finance and in the practical relationships between
The cash flow
statement businesses and their owners and creditors, cash flow is an important measure of return.
supplements the Income for the company is all very well, but owners sooner or later want to receive some
analysis of the other of it in cash dividends, and lenders want cash payments to cover interest and principal
statements. due, and so on. Income is revenue minus expenses, but the revenue may be tied up in
uncollected receivables and the expenses may either not have been paid yet or have
been paid in advance. In financial statement analysis, the cash flow statement’s focus on
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cash provides important supplementary information about how the company was
managed and how it performed.
To refresh your memory of the cash flow statement and help you think about using
it for analysis, Exhibit 10.9 contains a summary of the kinds of effects on cash that the
statement can indicate.
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10•9 Increase Decrease

Cash Cash
Net income:
Positive net incomes X
Negative net incomes (net losses) X
Noncash expenses (such as amortization of
long-term assets and the deferred portion
of income tax expense) are added back to
net income and so appear to X
Noncash revenues (such as a gain on sale of
a noncurrent asset) are deducted from net
income and so appear to X
Changes in noncash working capital accounts:
Increases in noncash current assets X
Decreases in such assets X
Increases in noncash current liabilities X
Decreases in such liabilities X
Changes in noncurrent assets:
Increases in cost of (investment in) such assets X
Proceeds from disposal of such assets X
Changes in noncurrent debts and capital:
Financing obtained from owners and creditors X
Repayments, redemptions, dividend payments X
Here are some points about the cash flow statement, based on the above summary.
• The operations section of the statement converts income from the complex accrual
basis used in preparing the income statement to a simpler cash flow basis.
• Cash from operations thus is an alternative measure of return. We saw this in
Ratio 7, cash flow to total assets, in Section 10.4.
• The conversion from accrual to cash basis reveals something about how the
company has managed its current assets and liabilities over the period; for example,
have receivables gone up, delaying the inflow of cash from revenue?
• The investing and financing sections of the statement show what the company did
with the cash it generated from day-to-day operations, and how much nonoperating
cash it raised during the period.
The cash flow statement, in combination with the income statement and balance sheet, can be
The cash flow 5
used in at least the following ways. Each point is illustrated by reference to CPR’s cash
statement helps to
evaluate earnings flow statement, given at the beginning of Section 9.4 and already examined in Section 4.7.
quality, investment a. Evaluate the relative significance of the cash flow figures by relating them to the size of
and financing policies, the company’s assets, liabilities, equity, and income. For CPR, we saw in Section 10.4
and risks. that the ratio of operating cash flow to total assets was larger than the return on
assets in 2004 but only about half the ROA in 2003. This would seem to be the
result of lower-than-normal cash flows from operations in 2003 when less than half
the 2002 or 2004 cash flows were generated. The lower-than-usual cash flows from
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operations were offset by increased borrowings, as seen in the cash provided by

financing activities.
b. Evaluate the company’s relative dependence on internally generated cash (from operations)
versus cash generated from external financing activities. Operating cash flow was
the main source of cash in all three years shown in Exhibit 10.3. However, in both
2003 and 2004, CPR required long-term borrowings in excess of repayments to
finance the significant additions to properties seen as cash uses in investing.
c. Evaluate solvency (ability to pay debts when
due) and liquidity (having adequate Nine evaluations using
reserves of cash and near-cash assets). We cash flow information
saw from Section 10.4 that solvency does a. Significance of cash flow
not seem to be a problem: CPR can cover b. Dependence on internal versus
its interest payments and, based on the external financing
2004 experience, can borrow long-term c. Solvency and liquidity
and repay it when due. Liquidity is a little d. Spending on asset acquisitions
strained, but the company took major e. Debt versus equity strategy
f. Dividend policy
action in 2004 to borrow long-term and
g. Quality of earnings
shore up its liquidity. The cash flow state-
h. Possible cash flow manipulation
ment shows that even in 2003 when the i. Hazards of success or benefits of
inflows from operations were unusually decline
low, they still provided a significant portion
of the funds needed for investing activities.
d. Evaluate the level of spending on long-term asset acquisitions in relation to the size of the
company’s assets and the amount of annual amortization, in order to help judge
whether the company appears to be keeping its plant and equipment up to date.
CPR stayed ahead of the game in 2004 as it had in 2003 by spending 60% to 80%
more on new assets than was charged as the amortization on existing assets
($673.8 million spent compared to $407.1 million amortized in 2004).
Considering that there is some inflation and that the assets are expected to last
a long time (amortization is only 3% of the $12,876 million property and plant
costs the company had at the beginning of 2004 according to Note 12 shown in
Exhibit 10.6), the spending was probably not much more than enough to replace
what was wearing out. New spending totaled just 5% of the $12,876 million prop-
erty and plant cost at the beginning of the year, leaving 2% to cover inflation and
expansion. The company appears to be holding its own but not expanding.
e. Evaluate the company’s debt versus equity financing strategy. We saw in Section 10.4 that
CPR is leveraged, having almost twice as much in liabilities as equity at the end of
2004. Accounts payable represents 15% of the total debt at the end of 2004, but the
long-term debt-equity ratio is still almost 1 but declining over time. Looking at the
cash flow statement, we can infer that the financing strategy is clearly to borrow
long-term to supplement operating cash flows, not to raise more equity. The
marginal growth in share capital resulted entirely from employees exercising stock
options. The cash flow statement reveals that equity has not been part of the financ-
ing strategy, except through letting retained earnings grow.
f. Evaluate the company’s dividend policy by comparing dividends with both income and
cash flow, and reviewing the pattern over time. The newly independent CPR is
essentially a new company in financial terms, even though in operating terms it is
over 100 years old. The dividend policy is probably still evolving but, as mentioned
earlier, it appears that CPR is attempting to maintain a constant dividend per share.
This is often done by companies to provide shareholders with a dependable cash
flow in the expectation that this will encourage some stability in the share price.
g. Determine the relationship between income and cash flow to evaluate the “quality” of
earnings (income): income should be reasonably consistent with cash flow, after
adjusting for normal corrections such as amortization, and should not be so far out
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of line with cash flow that there’s some question about its validity. Here CPR’s cash
flow to earnings has generally been healthy since it became independent of the
parent group in 2001. Although low enough to be of possible concern in 2003, cash
flow from operating activities returned to earlier levels of about twice the earnings
in 2004. Note 10, at the beginning of Section 10.4, indicates that there was little net
change in noncash working capital between 2003 and 2004. Reductions in accounts
receivable and inventories were offset by the increase in accounts payable and
accrued liabilities. The reduction in accounts receivable brought the collection ratio
down during the year. This decrease supports the lack of other indications of prob-
lems with recognizing revenue prematurely. There are no indications of earnings
management or other threats to earnings quality.
h. Identify possible manipulation of the cash flow figures, such as failing to replace invento-
ries or delaying payment of current or noncurrent debts, by comparisons to the way
cash flows were generated in past years. CPR’s operating cash flows are very stable.
There is no indication of anything untoward in the cash flow figures.
i. Identify either the hazards of success, such as drains on cash flow due to the buildup of
inventories or accounts receivable, or the benefits of decline, such as cash increases due
to shrinking inventories or receivables. There don’t seem to be hazards in CPR’s
cash flow information. The company is emerging from the former corporate
umbrella and has had to take some steps to upgrade liquidity, but its operating cash
flows indicate robust performance and ability to generate enough cash flow inter-
nally to keep property and plant assets up to date.

Here are two questions you should be able to answer based 1. What were the main components of CPR’s 2004 cash
on what you have just read. If you can’t answer them, it flow?
would be best to reread the material. 2. How does cash flow information contribute to financial
statement analysis?
10.6 Integrative Ratio Analysis

The previous two sections contained a lot of ratios and comments. To pull all the details
Pulling all the
together to form some conclusions about performance, risk, earnings quality, and other
analytical results
together is more art factors is more an art than a science, because the conclusions depend on the decisions
than science. made or information used to craft the analysis, as well as on the degree of knowledge or
detail the analyst brings to bear. They also depend on what is found among the various
ratios and cash flow data. If the analysis reveals a serious liquidity problem, for example,
that may well colour all the conclusions. Similarly, if the company’s accounting methods
were suspect for some reason, the conclusions would likely be particularly cautious or
skeptical.
To help you think about how to pull your analysis together, this section contains two
illustrations:
1. An overall summary of what the previous two sections’ analyses have shown about
CPR.
2. An example of an integrated numerical analysis: leverage analysis.
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Overall Conclusions From the CPR Analysis in

Sections 10.4 and 10.5
Here are some conclusions to connect the various analyses in the preceding sections
together into an overall portrayal of CPR’s financial performance and position. The
categories of Section 10.4 plus Section 10.5 are used to make some integrative
comments; then a summary follows.
Performance
CPR’s story is steady, stable performance showing a mixture of small improvements and
small declines from 2003 to 2004. Return on equity and return on assets declined
slightly, while earnings per share rose and cash provided by operations more than
doubled. It should be noted, however, that this doubling of cash flow from operations
really only provided a return to the 2002 level. The reasons are contained in the similar
decline in sales return, and small growth in both revenues and operating expenses,
resulting in little growth in net income. CPR’s price-earnings ratio and price to book
ratio indicate that the stock market sees the company as a solid investment, not a high
flyer. Dividends will be important if share price growth is low.
Activity (Turnover)
The company’s asset turnover was relatively slow: it is a large-asset railway, so that is to be
expected. The bulk of its assets are noncurrent. The company’s revenues grew slightly
faster than its assets, providing a small improvement in the asset turnover from 2003 to
2004. The asset turnover improved, indicating that the pace of growth in income was
slightly higher than that of assets. Receivables collections improved, which also improves
the asset turnover, but it is still not fast. Taken together, the activity ratios are further indi-
cations that CPR is a mature company, stable and not rapidly expanding or changing.
Financing
CPR was leveraged with 60% more debt than equity. This means that about two-thirds of
its assets were provided by creditors and only one-third by owners. The debt-equity ratio
has been declining since CPR became independent, mainly through the growth of
retained earnings. Most of its financing was long-term, like its assets: the company was
following common principles of matching the financing term to the assets being
financed.
Liquidity/Solvency/Warning
The company had negative working capital (ratio less than 1) in both 2004 and 2003.
Despite this situation, CPR is able to meet its current liability obligations by generating
cash from operations and by maintaining a balance among cash, accounts receivable,
and accounts payable. Inventories were not a major part of CPR’s working capital, so the
quick ratio was only a little weaker than the working capital ratio. Interest coverage was
comfortable, both compared to income and, as cash from operations was larger than
income, compared to cash flow.
Cash Flow
Operating cash flows were stable and significant, providing enough cash to finance
property and plant acquisitions without external financing in 2004. This left the exter-
nal financing to provide a base increase in cash, to help liquidity. Spending on new
property and plant appeared to be about enough to keep the assets up to date and to
replace those wearing out, but not enough for real growth.
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Overall Summary
CPR in 2004 was a stable company, putting its affairs in order and maintaining a
healthy cash flow and slightly improved earnings and returns to shareholders. Long-
term debt, and therefore risk, were reduced, helping improve liquidity and so reducing
short-term risk. The various ratios and stock market price performance agreed in
portraying the company as not extreme on any dimension, positively or negatively, and
so being an attractive investment though not a high-flyer. Its market capitalization and
price-earnings ratio indicated that investors expect similar performance and moderate
growth in the future. Have a look at www.cpr.ca and www.sedar.com and see how CPR
has performed since this evaluation!
Leverage Analysis
Leverage, also called “trading on the equity,” “financial leverage,” and, in Britain
and some other countries, “gearing,” is an important objective and consequence of
borrowing money and then using it to generate returns. It works like this:
• Professor Grunion wants to invest $15,000 in a real estate project.
• Grunion has $5,000 available in personal funds.
• So, Grunion borrows $10,000 from the bank at 11% interest.
• Grunion invests the total $15,000 in the project and receives an annual return of
$2,100.
• The project’s return is 14% before tax ($2,100 / $15,000).
• Out of that, Grunion pays the bank interest (11% of $10,000 = $1,100).
• Grunion keeps the rest ($2,100 – $1,100 = $1,000).
• Grunion’s before-tax return on the equity invested is 20% ($1,000 / $5,000).
Not bad! The project returns 14%, but Grunion gets 20% on the equity invested. The
Grunion has made
extra money by reason is that Grunion borrowed at 11% but used the borrowed funds to earn 14%. The
borrowing at a rate extra 3% return on the borrowed funds is Grunion’s to keep in return for taking the risk
less than the project of investing in the project:
earns. • Overall return = 14% on $15,000 = $2,100.
• Paid to the bank = 11% on $10,000 = $1,100 (3% less than the return).
• Kept by Grunion: 14% on $5,000 own funds + 3% on $10,000 borrowed funds.
• Grunion’s return = the 14% ($700) + the 3% ($300) = $1,000, which is 20% of the
$5,000, so Grunion has benefited from leverage: borrowing money to earn money.
Leverage is a good way to increase your return, as long as you can ensure that the
project’s total rate of return is greater than your borrowing cost. It’s a double-edged
sword, though, because leverage can hit you hard if returns are low or negative. Suppose
Grunion’s real estate project returns only 7%. Then look what happens:
• Overall return = 7% on $15,000 = $1,050.
• Paid to the bank = 11% on $10,000 = $1,100.
• Kept by Grunion: 7% on own funds minus 4% on $10,000 borrowed funds.
• Grunion’s return = the 7% ($350) – the 4% ($400) = –$50, which is –1% of $5,000.
Grunion has been hurt by leverage. The project earned a return, but not enough of
a return to cover the cost of borrowing money to invest in the project.
So, Grunion in this case loses on every dollar borrowed, because the project returns less
Borrowing hurts if its
interest rate is higher than the cost of borrowing. It’s not such a great deal anymore! Grunion is losing 1% on
than the rate the the equity invested, but if just that equity had been invested, with no borrowing,
project earns. Grunion would have made 7%, the project’s return. Leverage is now hurting, not
helping.
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Leverage is therefore the difference between what the project earns before any
return to the lenders and the investor and what the investor earns, after paying the
lenders the cost of the borrowing. Keeping the Grunion example in mind, we have the
following:
• The investor’s return is after all costs of borrowing, so it is the project income minus
interest that is the project net income. That is related to the amount of investment
the investor made, the investor’s equity. Net income divided by equity is return on
equity. ROE is Ratio 1, Section 10.4.
• The project return before interest is what Ratio 2, Section 10.4, was getting at:
return on assets, the refined ROA(ATI) version that is calculated prior to the
after-tax cost of interest.
• Any difference between ROE and ROA(ATI) is leverage. In the two Grunion
ROE – ROA =
examples above:
Leverage, either
positive or negative. a. ROE = 0.20; ROA(ATI) = 0.14; leverage therefore = 0.06, so Grunion has bene-
fited by 6% from favourable borrowing;
b. ROE = –0.01; ROA(ATI) = 0.07; leverage therefore = –0.08; so Grunion has
suffered by 8% from unfavourable borrowing.
Based on the above discussion, leverage can be defined by the following equation, in
which any of the terms can be positive or negative:
ROE = ROA + Leverage
After-Tax Leverage
Before we can apply the leverage idea to CPR or any company, it is useful to consider
the effects of income tax. They were included in the ROE and ROA(ATI) calculated in
Section 10.4, but were not included in the Grunion example above. It’s easy to do. Let’s
assume Grunion’s income tax rate is 40%.
• In the first example, the project net income would now be $1,000 × (1 – 0.4) = $600.
• This is 12% of Grunion’s $5,000 investment, so ROE = 12%. (We could calculate the
after-tax ROE directly as the before-tax 20% × (1 – 0.4) = 12%.)
• In the first example, the project’s return before interest would be $600 + ($1,100 ×
(1 – 0.4)) = $1,260, calculated the way the numerator in ROA(ATI), Ratio 2, does it.
This is also the $2,100 before-interest return × (1 – 0.4).
• So ROA(ATI) = $1,260 / $15,000 = 8.4%. (As for ROE, we could calculate the after-
tax ROA directly, as the before-tax 14% × (1 – 0.4) = 8.4%.)
• Following the same reasoning, the second project’s ROE would be –1% × (1 – 0.4) =
–0.6%, and its ROA(ATI) would be 7% × (1 – 0.4) = 4.2%. (The latter, calculated as
Ratio 2 does it, is also (–$50 × (1 – 0.4) + $1,100 × (1 – 0.4)) / $15,000 = $630 /
$15,000 = 4.2%.)
• Any difference between ROE and ROA(ATI) is leverage. In the two after-tax
examples:
a. ROE = 0.12; ROA(ATI) = 0.084; leverage therefore = 0.036, so Grunion has
benefited by 3.6% from favourable borrowing (this is 60% of the before-tax
leverage, which is what we would expect: original 6% × (1 – 0.4));
b. ROE = –0.006; ROA(ATI) = 0.042; leverage therefore = –0.048; so Grunion has
suffered by 4.8% from unfavourable borrowing (which is (1 – 0.4) × the original
negative 8%).
The four Grunion versions are summarized in Exhibit 10.10, showing how in each case
an adequate or inadequate ROA leads to positive or negative leverage, before or after
income tax.
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B IT
HI
EX
10•10
Summary of Grunion Examples
Positive Leverage Negative Leverage
Before After Before After
Tax 40% Tax Tax 40% Tax
Start with ROA 0.14 0.084 0.07 0.042
– Interest rate 0.11 0.066 0.11 0.066
= Leverage potential 0.03 0.018 (0.04) (0.024)
× Debt-equity ratio 2 2 2 2
= Leverage obtained 0.06 0.036 (0.08) (0.048)
+ ROA 0.14 0.084 0.07 0.042
= ROE (leveraged) 0.20 0.12 (0.01) (0.006)
So after-tax leverage is just like after-tax anything else: take the before-tax calculation
Income tax reduces
the impact of positive and multiply it by (1 – Tax rate). Because of income tax, positive leverage is smaller as
or negative leverage. some of the gain is paid in income tax, and negative leverage is also smaller as some of
the loss reduces income tax (assuming that the tax rate also applies to negative income,
which is that there is other income against which the loss can be deducted). Leverage
can be analyzed using either before- or after-tax figures. The earlier equation defining
leverage can be rewritten this way, in which all terms are after-tax:
ROE = ROA(ATI) + Leverage
Expanded Leverage Analysis: The Scott Formula

What was CPR’s leverage?
• According to Section 10.4, its ROE in 2004 was 0.104, and its ROA(ATI) was 0.055.
• Therefore, its leverage was 0.049 in 2004 (0.104 – 0.055).
• It was 0.049 (0.11 – 0.061) in 2003.
This is substantial: leverage made about 50% of the contribution to ROE in both years.
If CPR had not borrowed, its ROE would have been halved. How did this happen?
To incorporate more of the ratios in Section 10.4, and thus both integrate the ratio
The Scott formula is
analyses and expand the story about leverage, Professor W. R. Scott, most recently at the
an example of
integrative use of ratio University of Waterloo, developed the “Scott formula.” This formula is a version of a
analysis. group of integrative analyses (another, the “DuPont formula,” has been used for nearly a
century). It is based on combining ratios into a larger story. There are other approaches
to numerical integrative analysis, such as using various ratios together in a “multiple
regression” statistical analysis to try to predict bankruptcy or other problems, and you
will probably see other ways of combining ratios because many analysts seek ways to
combine them. The Scott formula is used to illustrate such expanded analysis, because it
is an example of taking advantage of the double-entry nature of financial statements to
increase analytical power.
This expanded analysis uses the after-tax version of leverage above, plus relies on
the basic cause of leverage illustrated in the Grunion examples: leverage happens when
there is borrowing and the rate of return earned on the project is different from the
cost of borrowing. The impact of leverage depends on the extent of borrowing: if
Grunion had positive leverage, the more borrowed, the better ROE resulted, and if
leverage was negative, the more borrowed, the worse the ROE. You’ll see that the Scott
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formula uses the same leverage logic as shown in the four Grunion examples
summarized in Exhibit 10.10. Using these ideas, four definitions are important:
1. Overall return ROE is the same as Ratio 1 in Section 10.4;
2. Project return is ROA(ATI), which was Ratio 2;
3. Borrowing cost (interest rate after tax) is IN(ATI), the after-tax version of average
interest rate Ratio 6, calculated as (Interest expense × (1 – Tax rate)) / Borrowing;
4. Extent of borrowing is L/E, the debt-equity ratio (Ratio 15).
As illustrated in Exhibit 10.10, leverage equals the difference between project return
and borrowing cost, times the extent of borrowing:
Leverage = (ROA(ATI) – IN(ATI)) × L/E

The two terms inside the brackets on the right show the potential for leverage (illustrated
in Exhibit 10.10), and determine whether the leverage is positive or negative. Let’s call
the part inside the brackets leverage potential. Therefore, we can write the leverage
formula as:
Leverage = Leverage potential × Extent of borrowing

The expanded analysis in Exhibit 10.10 uses these ideas to show why the leverage was as
it was. If the project return was greater than the borrowing cost, borrowing helped. If
the return was less than the borrowing cost, borrowing hurt.
So we have the following expanded analysis:
ROE = ROA(ATI) + (ROA(ATI) – IN(ATI)) × L/E

The Scott formula incorporates two more ratios by breaking the first term on the right,
ROA(ATI) into two ratios:
• SR(ATI), an after-tax version of sales return (Ratio 3), which uses the ROA(ATI)
numerator and revenue as the denominator, and
• AT, the total assets turnover (Ratio 12), which uses revenue as the numerator and
has the same denominator as ROA(ATI).
Thus the full Scott formula analysis is:
ROE = ROA(ATI) + (ROA(ATI) – IN(ATI)) × L/E

ROE = SR(ATI) × AT + (ROA(ATI) – IN(ATI)) × L/E
The analysis integrates six different ratios and also shows leverage potential:
The Scott formula
integrates six ratios • ROE, the return on equity (Ratio 1)
into its analysis of • SR(ATI), an after-tax-interest version of the sales return (Ratio 3)
leverage. • AT, the total assets turnover ratio (Ratio 12)
• ROA(ATI), the “refined” return on assets (Ratio 2)
• IN(ATI), an after-tax version of the average interest rate (Ratio 6)
• ROA(ATI) – IN(ATI), the leverage potential
• L/E, the extent of borrowing, or the debt-equity ratio (Ratio 15)
The Scott formula uses after-tax interest to bring in the effects of income tax systemati-
cally, but it can be done without the tax adjustment as long as it is left out of all three of
the ratios mentioning ATI above. Let’s see how this formula is calculated from the finan-
cial statements and then, how to use it. A brief arithmetic proof of the formula is
6
included in the endnotes, if you’re interested.
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Scott Formula for CPR

To illustrate how to apply the Scott formula to a real company, let’s use CPR’s figures.
The formula can be applied to any set of balanced financial statement figures: it works because
the balance sheet balances, as long as SR, ROA, and IN are either all before tax or all
after tax. (We’ll do them all after tax.) To test your knowledge of the financial state-
ments, put a piece of paper over the 2004 figures below and find them yourself in the
financial statements at the beginning of Section 10.4. (You should recognize the ratios
as the same ones calculated in Section 10.4, including ROA(ATI), but with SR(ATI) and
IN(ATI) now adjusted for after-tax interest.)
IB I
XH
T
E
10•11
2004
Figures Symbols
Total assets, end of 2004 $10,499.8 A
Total liabilities, end of 2004 6,517.4 L
Total equity, end of 2004 3,982.4 E
Total revenue for 2004 3,902.9 REV
Net income for 2004 413.0 NI
Interest expense for 2004 223.9 INT
Income tax rate for 2004
($143.3 / ($413.0 + $143.3)) 0.257 TR
After-tax 2004 interest expense
(Expense × (1 – Tax rate)) 166.4 ATI = INT × (1 – TR)
ROE (return on equity) 0.104 NI / E
SR(ATI) (sales return before interest) 0.149 (NI + ATI) / REV
AT (assets turnover) 0.372 REV / A
ROA(ATI) (return on assets) 0.055 (NI + ATI) / A
IN(ATI) (average interest rate after tax) 0.026 ATI / L
L/E (debt-equity ratio) 1.64 L/E
Result:
0.104 = 0.149 × 0.372 + (0.055 – 0.026) × 1.64
0.104 = 0.149 + 0.029 × 1.64
0.104 = 0.055 + 0.048 off by 0.01 due to rounding
For comparison, here is the result for CPR for 2003. If you are not sure how it all works,
check the amounts below by calculating them from the 2003 figures.
0.110 = 0.166 × 0.368 + (0.061 – 0.032) × 1.72
0.110 = 0.061 + 0.029 × 1.72
0.110 = 0.061 + 0.050
(A good way to check your work as you’re going is to make sure that the result of multi-
plying the first two terms after the equal sign is the same as the third term on the right,
after the plus sign. Both terms are ROA(ATI).)
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Summary Comments on Integrative and Leverage

Analyses for CPR
The Scott formula result for CPR shows that the company’s 10.4% return on equity in
ROE is explained
exactly by the five 2004 and 11% in 2003 were made up of:
other ratios.
2004 2003
• A 14.9% return on sales (adding back after-tax interest) 16.6%

• An asset turnover of 0.372 0.368
• Return on assets of 5.5% (adding back after-tax interest) 6.1%
• Average interest rate of 2.6% (after tax) 3.2%
• Leverage potential of 2.9% (5.5% – 2.6%) after tax 2.9%
• A debt-equity ratio of 1.64 1.72
This provides several points of comparison with other companies or other years. Those
comparisons could have been made using the individual ratios listed earlier, but now the
ratios are tied to one another so that you can see how each affects return on equity. The
terms on the right of the equal sign can be collected together to summarize the two
basic components of the return on equity:
• The first is the operating return, which indicates the company’s ability to make a
return on its assets before interest costs (2004: 0.149 × 0.372 = 0.055, the return on
assets).
• The second is the leverage return (2004: (0.055 – 0.026) × 1.64 = 0.029 × 1.64 = 0.048,
or 0.049 without the rounding error), which starts with the return on assets (0.055)
and then subtracts the interest cost to get the leverage potential and adjusts for the
degree of borrowing. The Scott formula’s second term tells us about how the lever-
age return arose.
So, we have for CPR:
ROE = Operating
return + Leverage Return on equity = Operating return + Leverage return
return.
2004: 10.4% = 5.5% + 4.9%
2003: 11.0% = 6.1% + 5.0%
Thus, the Scott formula analysis indicates that CPR’s ROE went down because the
improvement in asset turnover was offset by the decline in sales return. The lower ROE
is also the result of the decreased leverage component. This indicates a little less risk but
these factors are not large.

Here are two questions you should be able to answer based return on equity was 12%, the return on assets was 7%,
on what you have just read. If you can’t answer them, it and the leverage return was 5%. Explain this result to the
would be best to reread the material. company’s president.
2. Write a paragraph summarizing CPR’s financial perform-
1. You have prepared a leverage analysis for Pembina
ance for 2004 compared with 2003. Use information from
Manufacturing Ltd. for 2006 and determined that the
Sections 10.4, 10.5 and 10.6.
NEL
10.7 Future Cash Flows: Present Value Analysis

Cash flow is important to a company, and assessing cash flow is a significant part of the
Management decision
making must look to analysis of a company’s financial performance and position. Sorting out the impact of
the future. interest rates on the company’s returns is important to understanding how it has
performed. Stock markets and other capital markets are concerned with the company’s
expected ability to generate returns in the future, especially cash returns that can be
used to pay dividends or reinvest in the company. Many financial contracts, such as
those for management compensation and supply or service arrangements, focus on
future financial performance. Generally, management should be looking forward to the
future and trying to combine its asset acquisition, borrowing, and income-generation
strategies to produce a good future return for the owners.
An important way of thinking about future performance, especially future cash
flows, is present value (PV ) or discounted cash flow (DCF ) analysis. Future cash flows are
not the same as present ones, because you have to wait for them. Because you have to wait,
you lose interest or other returns you could have earned if you had had the cash sooner.
Detailed PV or DCF techniques are examined in management accounting and
finance courses, and you may well have seen them already in economics or business
mathematics courses. In this section, basic ideas will be outlined to help you think about
how managers can assess projects that promise future cash flows and how traders in capi-
tal markets may use expectations of future cash flows and future interest rates when
deciding on prices of securities. (Such traders would rarely do explicit PV or DCF calcu-
lations, but research shows that capital market prices behave as if they were doing
something like that.)
Interest and the Time Value of Money

In Western society, it is permissible—even expected—that the owner of capital should
The existence of
interest gives money charge a person who wants to use that capital a fee for that use. That fee is called interest
(cash flow) a time and is computed by applying a specified percentage rate to the amount lent, which can
value. be referred to as either the investment or the principal. For example, an 8% interest rate
on a $200 loan would produce annual interest of $16 ($200 × 0.08). The existence of
interest, which builds up as time passes, gives money a time value. The time value of money
is the principle behind all the calculations in this section.
Here are some interest formulas you probably already know (P = principal or
investment, i = interest rate):
Annual interest = P × i
Amount due at the end of one year = P × (1 + i)
Amount due after n years, with annual compounding,
if no payments are made = P × (1 + i)n
The amount due is the total future cash flow, consisting of repaying the principal plus
Interest is added to
the principal to paying the accumulated interest.
compute the total Suppose a loan provides for repayment of the principal plus interest after several
future cash flow. years, with no payments in the meantime. Two examples of this are Canada Savings
Bonds (when you buy them you are lending the government your money) and whole
life insurance (some of the premiums you pay are invested on your behalf and you are
entitled to the accumulated value if you don’t die first). If the interest is compounded,
which is normally the case, that means interest builds up on the unpaid interest as well as on
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the unpaid principal. In order to know how this works, you need to know how frequently
Interest’s impact
depends on how interest compounds. Do you get interest on the interest:
frequently it is • as soon as any interest arises (“continuous compounding”)? or
compounded. • after a day’s interest has been added (“daily compounding”)? or
• after a month’s interest has been added (“monthly compounding”)? or
• only after a year’s interest has been added (“annual compounding”)?
Here’s an example of annual compounding. We have the same $200, 8% loan as above,
which is to be repaid in five years with annual compounding. We can then calculate the
amount that the loan has built up to at the end of each year (its “future value,” FV below)
as follows:
IB I
XH
T
E
10•12
FV at Beginning Annual Interest FV at End
Year of Year at 8% of Year
1 $200.00 $16.00 $216.00
2 216.00 17.28 233.28
3 233.28 18.66 251.94
4 251.94 20.16 272.10
5 272.10 21.77 293.87
You can see that the FV increases every year. Using the third interest formula above, we
can calculate the FV at the end of any year:
End of year 3: FV = P × (1 + i)n
= $200 × (1 + 0.08)3
= $251.94
End of year 5: FV = $200 × (1 + 0.08)5
= $293.87
Interest and Present Value

The concept of interest can be “turned on its head” by considering what you lose by wait-
If you wait for your
ing some period of time for your money, or, putting it another way, what a future
money, you lose the
interest you could payment is worth in present terms if you assume your money should earn interest
have earned if you between now and when you get it back.
had it now. Suppose someone promises to give you $100 a year from now. If you had the money
now, instead, you’d be earning 9% interest on it.
• If you’d had some amount P now and earned 9% on it, you’d be in the same
position as you will be after waiting the year for $100.
• Using the second interest formula above, $100 = P × (1 + 0.09), where P is the
amount on which you could have earned interest.
• Solving for P, we get P = $100/(1.09) = $91.74.
• If you had $91.74, you could have invested it at 9% and ended up with $100 at the
end of the year ($91.74 + 0.09 × $91.74 = $100).
The $91.74 is the present value of $100 received after waiting one year, “discounted at
Present value is the
9%.” Present value is another way of thinking of the time value of money: it reminds us
future cash flow minus
the interest that could that as long as we wait for cash that could have earned interest starting now, we lose that
have been earned. interest. As long as the interest rate is greater than zero, present value is less than the
actual future amount of cash that will be received because the interest included in that
future cash flow has been deducted.
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The following present value formulas are analogous to the above interest formulas
(here C = future cash flow and i = interest rate):
= C
Present value waiting one year
1+i
Present value waiting n years with no payments C
in the meantime, interest compounded annually =
(1 + i)n
Combining these two, present value of a constant cash C 1
payment over n years, interest compounded annually = 1 – n
i
(1 + i)
7
(A comment on the derivation of the third formula is at the end of this chapter. )
Therefore the present value of $1,000 received three years from now, discounted at
Lost interest is the
an opportunity cost interest rate of 12%, would be $711.78 (this is $1,000 divided by
opportunity cost of
waiting for the cash. (1.12)3). The phrase “opportunity cost” is often used, because by waiting three years for
the $1,000, the opportunity is lost to invest at 12% in the meantime.
The concepts of future value and present value are illustrated in Figure 10.1. The
charts in the figure illustrate the difference between the future values of an investment
made now and the present values of future cash flows. Interest gets larger each period. In the
future values case, it becomes a larger component of the total value; in the present
values case, it becomes a larger component of the cash flow.
figure 10.1 Future values of a Present values of a

principal invested at periodic cash flow, at
a fixed rate, with a fixed opportunity
interest compounded cost interest rate
each period
Cash flows
FVs
$ $
Interest
Interest
P
Principal PVs
(looking back to
now from future)
Now Now
Time Time
Future value > principal Present value < cash

because interest builds flows because interest
up over time. is lost by waiting.
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Here’s a present value example. A company is considering an investment that will

cost $10,000 now and will return $2,400 at the end of each year for five years. This looks
good: 24% of the investment cost received each year, a total of $12,000 back on the
$10,000 invested. To make the investment, the company will have to borrow at an
interest rate of 7%. Should it go ahead?
Before we do the calculations, note three things about problems like this:
1. We are trying to determine if the money coming in is equivalent to a cost of capital of
A project should earn
7%. If the company has to raise its money at 7%, it will want the investments it
a return that is at least
equal to the rate paid makes to return at least that. A greater rate of return would be desirable, otherwise
to finance the project. there would be little point in investing, but 7% is the minimum acceptable return.
2. The idea of present value analysis is to take the future returns and subtract the 7%
that the company has to pay on its borrowing, to determine if, after considering the
Present value has
future interest borrowing cost, the returns equal the $10,000 that has to be invested. Is the present
removed and so can value of the future cash flows equal to the present cost outlay that has to be made in order to get
be compared to the those flows?
project’s cost. 3. The 24% quoted above is irrelevant to the analysis. It compares the annual return to
the investment cost, alright, but it does not consider the interest cost of waiting
several years for some of that return. The whole idea of present value analysis is to
build that interest cost, the time value of money, into the analysis.
Here’s the present value analysis:
• Using the second present value formula above:
1
PV of first year’s return is $2,400/(1.07) $2,242.99
2
PV of second year’s return is $2,400/(1.07) 2,096.25
3
PV of third year’s return is $2,400/(1.07) 1,959.11
4
PV of fourth year’s return is $2,400/(1.07) 1,830.95
5
PV of fifth year’s return is $2,400/(1.07) 1,711.17
Total PV $9,840.47
• Since the annual flows are constant, the third present value formula above could
have been used instead:
5
PV = ($2,400/0.07)(1 – 1/(1.07) ) = $9,840.48
This is the same answer except for a minor rounding difference.
We can draw the needed conclusion from this and also see the effects of waiting for
returns:
• The conclusion is that the investment is not
Present value is less Decision using present value:
a good idea. It will cost $10,000, but after
than cost, which if PV > investment cost, project is
means the return is calculating the interest cost of waiting for
attractive; if PV < investment cost,
less than the financing the money to be returned, the present value
project is not attractive.
rate. of the $12,000 returned is only $9,840.
Therefore, the investment is returning less
than the 7% rate the company has to pay to finance it. It’s close, but still not attrac-
tive.
• You can estimate the “internal rate of return” (IRR) of the project by equating the
cost of $10,000 to the third formula above and solving for i:
5
$10,000 = ($2,400 / i)(1 – 1 / (1 + i) )
This calculation produces an i of 6.4%.
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So the return from the project is less than

A higher interest rate Decision using rate of return: if
means more interest is 7%. The lower interest rate of 6.4% project rate of return > cost of
lost by waiting, so the produced a higher PV ($10,000) than the capital rate, project is attractive;
present value is lower. higher required interest rate of 7% if it is < than cost of capital rate,
($9,840). (Don’t worry about having to solve it is not attractive.
for the nth root of a denominator as above:
there are theoretical problems with calculat-
ing the IRR, mainly that it assumes the returns are reinvested at the IRR rate, 6.4%
above, so we will not use it further. But you can see the idea that if the IRR is not at
least equal to the borrowing cost, the project is not attractive.)
• From the annual calculations above, you
The farther into the Time value of money: the longer
can see that the present value of the $2,400
future the cash flow is, you wait for the money, the lower
the lower the present is smaller the longer we wait for it. The
its present value and the less
value is. $2,400 received after one year has a PV of
attractive it is.
$2,243, but the $2,400 received after four
years has a PV of $1,831. This is a necessary
result: the longer the wait, the lower the PV because the greater is the amount of
interest assumed included in the cash flow and, therefore, the lower is the residual
PV. In the right-hand chart of Figure 10.1, you can see the PVs getting smaller as
they go out further into the future.
Some Present Value Examples

As we have seen with the example above, the concept of present value is very useful in
Present value at 11%
evaluating investment possibilities ahead of time. Here are some more examples.
exceeds cost, so the
project is attractive 1. Suppose you are offered the chance to invest $2,000 in a project that will pay you
(it earns more than back $4,500 after six years. Is it a good deal? Suppose, alternatively, you could invest
11%). 6
your $2,000 at 11%. The present value of the $4,500 is $4,500/(1 + 0.11) , or $2,406.
Therefore, the present value of what you’ll get ($2,406) exceeds your cost ($2,000),
and it does seem to be a good deal.
2. Gazplatz Ltd. issues bonds paying interest at 7% having a total face value of
$100,000 that will pay interest every year in cash plus pay the principal back in 10
years. What would you pay for such a set of bonds if you could get 9% on your
money elsewhere?
a. Present value of annual interest
10
= ($7,000 / 0.09) (1 – 1 /(1 + 0.09) ) = $44,924
b. Present value of principal payment
10
= $100,000 / (1 + 0.09) = 42,241
Total present value = $87,165
(Note that the interest rate in the formula is the opportunity rate or required rate of
9%, the cost of raising the capital to make the investment or the returns forgone
from other uses of the investment cost. The company’s 7% rate just determines how
much interest is paid each year—it does not represent the investor’s interest
expectations.)
As a rational investor, you’d be willing to pay $87,165 for the bonds. If the
If the bonds were
priced to yield 9%, bonds sold for $87,165, they’d be “priced to yield” 9%. They’d sell at a discount below
they’d sell for $100,000 to make them sufficiently attractive to investors who want a better return
$87,165. than the stated 7% rate. By paying $87,165, you’d actually earn the 9% you want
(the bonds’ yield), as we can show by constructing a table of each year’s return:
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Cash Paid Return on Residual Effective
Each Investment (Growth Principal
Date Year Demanded (9%) in Debt) Balance
Purchase date $87,165
1 year later $ 7,000 $ 7,845* $ (845) 88,010
2 years later 7,000 7,921 (921) 88,931
3 years later 7,000 8,004 (1,004) 89,935
4 years later 7,000 8,094 (1,094) 91,029
5 years later 7,000 8,193 (1,193) 92,222
6 years later 7,000 8,299 (1,299) 93,521
7 years later 7,000 8,417 (1,417) 94,938
8 years later 7,000 8,544 (1,544) 96,482
9 years later 7,000 8,683 (1,683) 98,165
10 years later 107,000 8,835 98,165 0
$170,000 $82,835 $87,165
* $7,845 = $87,165 × 0.09; $7,921 = $88,010 × 0.09; and so on.
3. Usually, in modern financial arrangements, “blended” payments are made to cover

the specified interest plus some payment on the principal. House mortgages and car
loans are two common examples. In such cases, to understand what is going on, we
have to separate the return on investment (the interest) from the return of invest-
ment (repayment of the principal). Here is an example: a loan of $7,998 carrying an
interest rate of 10% is being repaid by a blended annual payment of $2,110, made at
the end of each year, which will cover all interest and pay off the principal as well in
five years. In such a case, the interest amount gets smaller every year because the
principal balance is falling, but the rate of return on investment is a constant 10%.
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Total Return on Residual
Blended Investment Paid on Principal
Date Payment (Interest) Principal Balance
Loan date $ 7,998
1 year later $ 2,110 $ 800* $1,310 6,688
2 years later 2,110 669 1,441 5,247
3 years later 2,110 525 1,585 3,662
4 years later 2,110 366 1,744 1,918
5 years later 2,110 192 1,918 0
$10,550 $2,552 $7,998
* $800 = $7,998 × 0.10; $669 = $6,688 × 0.10; and so on.
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Using this example, the present value of $2,110 paid every year for five years, discounted
The present value of
the blended payments at 10%, compounded annually, is $7,998, the loan principal. This is ($2,110/0.10) × (1 –
equals the principal 1/(1.10)5): check it and see.
amount of the loan.

Here are two questions you should be able to answer based 2. Wildwood Inc. issued a set of $1,000 face-value bonds
on what you have just read. If you can’t answer them, it carrying an interest rate of 10% and payable in eight
would be best to reread the material. years. The bonds were priced to yield 12%, which is what
the capital market demanded for bonds of that risk and
1. What is the present value of $300 you will receive after
life. Did the bonds sell for more, or less, than $1,000
two years if your opportunity cost of waiting is 11%?
each?
PV = $243.49, which is $300/(1 + (0.11)2)

Less: the market wanted more return than 10% and so would
offer a lower price than $1,000 so that the price would be the
bond’s present value at 12% instead of 10%.
10.8 “What If” (Effects) Analysis

Suppose you are a financial analyst trying to determine what a recently released set of
You may want to see
financial statements tells you about the company’s performance. You can do various
what difference an
accounting method standard analyses, but before you do that you find that the company’s accounting isn’t
you prefer would quite comparable to that of another company you want to compare it to, or that the
make. company has used an accounting method you don’t agree with. You therefore want to
alter the numbers to show “what if” the company used the other company’s accounting
method, or a method you do agree with.
Doing this has been necessary rather too often in recent years, as company after
company reported that its earnings or other financial statement quantities had been
improperly stated when the financial statements first came out. Press releases that give
the company’s explanation of what happened can be given a “reasonableness check” by
using the sorts of analyses shown here.
“What if” questions are very common in business. Answering them requires analysis
Analysis of the effects
of the accounting information: we’ll call this “what if ” (effects) analysis. The ability to
of a method choice
helps in making the analyze accounting information to tell managers, bankers, and others what difference
choice. various changes in accounting policy choices or detailed methods, correction of errors in
the financial statements, or business events in general would make to the financial state-
ments is very important to accountants. If you are going to be an accountant, you have
to develop this skill. If you are not going to be an accountant, you should have some
idea of what the accountants are doing in such analyses, so that you can evaluate the
results they give you. You may even want to do some basic analysis yourself. Computer
spreadsheets are particularly good for this sort of analysis, but you have to know what to
tell the spreadsheet to do.
Examples of “What If” Effects Analysis

Effects analysis can One way to think about what would result if one method were used instead of another,
often be done using or one event happened instead of another, is to figure out the accounting numbers both
shortcuts, once you ways and compare them. Another way is to use shortcuts, like the “net of tax” approach
understand the idea.
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illustrated in Sections 1.12 and 10.2 or other forms of marginal analysis. If you see a
shortcut in a given problem, including the examples below, go ahead and use it!
a. Cash Versus Accrual

Here’s an example we’ve seen since Chapter 1. Suppose a company’s president said, “I
know we use accrual accounting, but what difference would it make to this year’s income
if we used the cash basis instead?”
We find that this year’s accrual income is $11,800 (income statement), and this
year’s cash from operations is $13,400 (cash flow statement). Therefore, the answer to
the president’s question is that income would be $1,600 higher this year on a cash basis.
No analysis is needed, because the financial statements provide the answer, if you know
how to read them.
b. Revenue Recognition: During or After Production

Section 6.7 gives the example of Greenway Construction, which uses percentage of
Effects analysis can
completion to recognize its construction revenues and expenses. Suppose the
often be done from
overall effects without company’s banker, more used to revenue recognition at completion of production
knowing details. (completion of the contract), wanted to know what difference there would be to income
if the completion of production method were used instead. You can answer this without
knowing the details of the accounting methods, as long as you know what the methods
do to income. (If you have not yet studied Section 6.7, the necessary data are given
below.)
The percentage of completion project income (totalling $600,000 over three years)
was:
• $120,000 for Year 1;
• $270,000 for Year 2; and
• $210,000 for Year 3.
If revenue and expenses were recognized only at completion of the project, the project
income would be:
• $0 in Year 1;
• $0 in Year 2; and
• $600,000 in Year 3.
So the answer to the banker’s question would be that income would be:
• $120,000 lower in Year 1 ($0 – $120,000);
• $270,000 lower in Year 2 ($0 – $270,000); and
• $390,000 higher in Year 3 ($600,000 – $210,000).
There has been no change in the three-year total, but the yearly figures are rearranged
if the completion of production method is used.
c. Franchise Revenue Recognition

Similarly, Section 6.8 compares the accrual and cash basis ways of recognizing income
from WonderBurgers Ltd.’s franchising operations. Again, all we need to know is the
effect of each method on income. If you have not yet studied Section 6.8, here are that
section’s results for the accrual versus the cash basis of recognizing income.
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Accrual Basis Income Cash Basis Income
(a) (b) (c) (d) (e) (f)
Year Revenue Expense Income Received Spent Income
1 $10,000 $3,200 $ 6,800 $15,000 $4,000 $11,000
2 7,500 2,400 5,100 5,000 3,000 2,000
3 7,500 2,400 5,100 5,000 1,000 4,000
$25,000 $8,000 $17,000 $25,000 $8,000 $17,000
Difference
Year (a)–(d) (b)–(e) (c)–(f)
1 $(5,000) $ (800) $(4,200)
2 2,500 (600) 3,100
3 2,500 1,400 1,100
0 0 0
If the cash basis were used instead of the accrual basis, the following income effects
would result over the three years of the WonderBurgers example (see the (c) – (f)
column under Difference):
• Year 1 income would be $4,200 higher;
• Year 2 income would be $3,100 lower; and
• Year 3 income would be $1,100 lower.
Examples of Income Tax Effects In This Analysis

d. Income Tax Effects on Examples (b) and (c)
Suppose Greenway Construction pays income tax at a rate of 35% and WonderBurgers
pays at a rate of 30%. What effect would that have on the figures above? Income tax
reduces all the effects by the tax rate, because that proportion goes to the government.
As shown elsewhere in this book (and below), a useful rule is just to multiply the before-
tax effect by (1 – Tax rate), in this case (1 – 0.35) = 0.65 for Greenway and (1 – 0.30) =
0.70 for WonderBurgers.
Here is a table of the effects, before and after income tax (for presentation
purposes, Greenway’s figures are in thousands of dollars):
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Greenway WonderBurgers
Gross Tax After-tax Gross Tax After-tax

Effect Effect Effect Effect Effect Effect
Year 100% 35% 65% 100% 30% 70%
1 $(120) $(42) $ (78) $ 4,200 $1,260 $ 2,940
2 (270) (94.5) (175.5) (3,100) (930) (2,170)
3 390 136.5 253.5 (1,100) (330) (770)
Total $ 0 $ 0 $ 0 $ 0 $ 0 $ 0
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Income tax reduces both positive and negative differences:

• The assumption here is that an increased income is taxed, and
• A decreased income produces tax savings (by reducing tax payable on other income
or creating tax credits that can be used to get refunds on past years’ taxes or reduce
future taxes).
Without knowing the details of the income tax law (which are beyond the scope of this
book), we cannot say for sure how much of the income tax effect is current and how
much is future. We know the effect on total income tax expense, as indicated above, but
not how to allocate that effect between the current and future portions of the expense.
We know the other side of the overall effect, the increase or decrease in total income tax
liability, but not how to allocate that effect between the income tax payable liability and
the future income tax liability.
e. “Net-of-Tax” Analysis and Interest Expense Net of Tax

Income tax tends to Please review the net-of-tax material in Section 1.12 and, if you have not studied
reduce both positive Section 10.2 yet, please read the latter part of it now. Those sections’ analyses are exam-
and negative effects ples of “what if” analysis, and net-of-tax analysis can be used to build tax effects into
on income. many evaluations.

Here are two questions you should be able to answer based
on what you have just read. If you can’t answer them, it (a) Up $180,000 ($500,000 – $320,000).
would be best to reread the material. (b) Down $85,000 ($(300,000) – $(215,000)).
1. A company is thinking of changing its accounting policies (c) Up $95,000 ($(85,000) + $180,000).
in a way that will increase revenue by $500,000 this year,
with $300,000 of that coming from a reduction in last (d) No change. By that point, sum of revenue changes = 0,
year’s revenue and $200,000 coming from a reduction in sum of expense changes = 0, so effect on retained earnings
next year’s revenue. Expenses would change too, with last also = 0.
year’s expenses going down $215,000, this year’s 2. Answer part 1 assuming the company’s income tax rate is
expenses going up $320,000, and next year’s expenses 40%.
going down $105,000. Ignoring income tax, what would
this change do to (a) net income this year, (b) retained
earnings at the beginning of this year, (c) retained earn- Just multiply each answer above by (1 – 0.40), with the results:
ings at the end of this year, and (d) retained earnings at (a) up $108,000; (b) down $51,000; (c) up $57,000; (d) still
the end of next year? no effect.
10.9 Multi-Year “What If” (Effects) Analysis

The analysis approach outlined in Section 10.8 can be extended to as many years as you
need. Some of this was illustrated above in the Greenway and WonderBurgers examples,
but now let’s develop a framework for a complete multi-year analysis.
An Example
Earth Fabrics Inc. manufactures several lines of environmentally friendly dress fabrics,
hiking clothes, and other cloth goods. It has been in business three years. There have
been more returns of fabrics by retail stores in the current year than in the first two, and
because of this, the president is considering a suggestion by the external auditor to
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recognize revenue from shipments to retailers a little more conservatively. The

company’s income tax rate is 34%, and revenue and accounts receivable data for the
company’s first three years, presented in the usual financial statement presentation
order of having the most recent year to the left, are:
Year 3 Year 2 Year 1
Revenue for the year $1,432,312 $943,678 $575,904

Year-end accounts receivable 194,587 148,429 98,346
The auditor suggests that a more appropriate revenue recognition policy would reduce
revenues by reducing year-end accounts receivable by 10% at the end of Year 1, 15% at
the end of Year 2, and 25% at the end of Year 3. (Recognizing revenue includes a debit
to accounts receivable and a credit to revenue, so reducing receivables implies reducing
revenue, and vice versa.)
What effect would this have on:
1. Accounts receivable at the end of each year?
2. Revenue in each year?
3. Net income for the year?
4. Income tax liability at the end of each year?
5. Shareholders’ equity at the end of each year?
1. Effects on accounts receivable:

Year 1 Receivables down 10% = $ 9,835 New balance = $ 88,511
Year 2 Receivables down 15% = $22,264 New balance = $126,165
Year 3 Receivables down 25% = $48,647 New balance = $145,940
It’s important to realize what these receivables changes do. By reducing the receiv-
ables at the end of any year, all revenue recognized up to that point is reduced—you
might say that the recognition of some of it is being postponed to the next year. So,
for example, the Year 1 revenue is reduced $9,835, but because that revenue is post-
poned to Year 2, that year’s revenue is increased by $9,835. By the end of Year 3, all
the prior revenues are reduced by $48,647. Let’s see how that divides up into the
three years.
2. Effects on revenue:
Year 1 Revenue down $ 9,835
Year 2 Revenue down $22,264 and up $9,835, net down 12,429
Year 3 Revenue down $48,647 and up $22,264, net down 26,383
Total decrease in revenue over the three years $48,647
3. Effects on net income:

Year 1 Net income down $9,835 × (1 – 0.34) $ 6,491
Year 2 Net income down $12,429 × (1 – 0.34) 8,203
Year 3 Net income down $26,383 × (1 – 0.34) 17,413
Total decrease in net income over the three years $32,107
We can check this. If accounts receivable are reduced by an accumulated amount of

$48,647, then the accumulated net income must have gone down by this amount ×
(1 – 0.34). So, $48,647 × (1 – 0.34) = $32,107. The rest ($48,647 – $32,107 =
$16,540) is the effect on income tax itself, which we will calculate directly next.
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4. Effects on income tax liability:

Income tax is saved on the lower incomes. The amount of the accumulated tax
saving is just the tax rate (0.34) times the accumulated change in accounts
receivable at the same time*:
Year 1 Year-end tax liability down $9,835 × (0.34) $ 3,344
Year 2 Year-end tax liability down $22,264 × (0.34) $ 7,570
Year 3 Year-end tax liability down $48,647 × (0.34) $16,540**
* Or calculate the reduced revenue each year and multiply the revenue effect by 0.34.
** Check: this is the same as “the rest” of the receivable effect identified in answer 3.
5. Effects on shareholders’ equity:

Shareholders’ equity is reduced by the reductions in net income, which
reduce retained earnings. Therefore, the effects on shareholders’ equity are the
accumulations of those listed for income in part 3:
Year 1 Ending equity down $ 6,491
Year 2 Ending equity down ($6,491 + $8,203) $14,694
Year 3 Ending equity down ($6,491 + $8,203 + $17,413) $32,107
An Analytical Framework
It may help you to keep multiple-year analyses straight if you use the analytical
framework below. The framework relies on two important things:
• Because accounting is a double-entry system, all the effects at any point in time must
balance out, so that the balance sheet stays in balance. This might help if, for exam-
ple, you can’t remember which way one effect goes; you know that it has to work so
that everything stays in balance.
• Because each balance sheet is the accumulation of everything that has gone before,
each balance sheet’s effects are the sum of whatever the effects were on the previous
balance sheet plus the effects on the income statement between the two balance
sheets.
Figure 10.2 provides the framework, in blank. We’ll fill it in shortly.
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figure 10.2 “What If” Effects Analytical Framework
Balance Sheet Income Statement Balance Sheet

End Last Year + This Year = End This Year
Assets Revenue Assets
Liabilities Expenses Liabilities

Other than tax Other than tax Other than tax
Income tax Income tax Income tax
Equity Equity
Retained earnings Net Retained earnings
Inc.
Notes
1. Without knowledge of the tax law, it may be impossible to separate the tax
effects into current and future portions.
2. For there to be a cash effect, some cash or cash equivalent account must be
affected. For accounting policy changes, error corrections, and most other effects
analyses, this will not happen.
Now let’s fill the framework in three times, once for each of the three years of the
Earth Fabrics example. Remember that the company has only existed for three years, so
the “end of last year” figures for Year 1 are all zero.
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Year 1
Rec. down $ 0 Down $ 9,835 Rec. down $ 9,835
No effect No effect No effect
Down $ 0 Down $ 3,344 Down $ 3,344
Equity Equity
Retained earn. Net income Retained earn.
Down $ 0 Down $ 6,491 Down $ 6,491
Year 2
Rec. down $ 9,835 Down $12,429 Rec. down $22,264
Down $ 3,344 Down $ 4,226 Down $ 7,570
Equity Equity
Down $ 6,491 Down $ 8,203 Down $14,694
Year 3
Rec. down $22,264 Down $26,383 Rec. down $48,647
Down $ 7,570 Down $ 8,970 Down $16,540
Equity Equity
Down $14,694 Down $17,413 Down $32,107
You should note the following two points about the analytical framework:
The analysis can start
from any point but • Each year’s effects add vertically and horizontally. That is, vertically, the beginning
has to add and cross- and ending balance sheet effects and income statement effects work out exactly, and
add in all directions. horizontally, the ending balance sheet effects are the sum of the beginning ones
and the income statement ones.
• You can do the analysis at any point, working forward or backward from there.
Probably, the most important analysis would be Year 3, because it accumulates
everything from the beginning to now.
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The analytical framework will help you think about effects analysis, but you have to
consider the specific circumstances of each situation rather than hope for a general
solution you can memorize. You have to exercise the knowledge and judgment you’ve
acquired in your studies and experience! We’ll do a further effects analysis example
below to help you develop your analytical ability.
Journal Entry
You may be interested to know how the revenue recognition change would be entered
in the accounts. It is quite straightforward, and uses the figures for the Year 3 analysis,
because the company is just finishing Year 3 (let’s assume the accounts for Year 3 have
not yet been closed). Here is the entry, in the order of the accounts in the analytical
framework:
CR Accounts receivable 48,647
DR Income tax liability (we don’t know if this is
current or future tax) 16,540
DR Retained earnings (prior years’ effects, aggregated) 14,694
DR Revenue (Year 3) 26,383
CR Income tax expense (Year 3) 8,970
Cash Effects
You’ll note that the analysis above and the journal entry to implement the change said
Cash is unlikely to
be affected by nothing about cash. An important point to remember is that analysis of accounting method
accounting method changes almost never involves cash. Accrual accounting, after all, is intended to go beyond
changes. cash flow, so accrual figures don’t affect cash, before or after the change. If we are
changing revenue, receivables, inventories, depreciation, etc., we will change net
income, working capital, income tax liability, and/or owners’ equity (retained earnings),
but unless cash is being spent or received as part of the change, there is no cash effect.
There will eventually be a cash effect through increased income tax or a tax refund, but
at the time the accounting change is implemented, there is no tax effect.
It’s pretty easy to see that if no cash (or cash equivalent) account is affected in the
change, there is no cash effect. Remembering that may be enough for you! But you can
also show, via examining effects on the cash flow statement’s operations section, that
even if there appears to be a cash effect because net income is affected, that effect is
cancelled out by effects on other account changes used to determine cash from
operations. Let’s use the Earth Fabrics example to show you how this works.
NEL
IB I
XH
T
E
10•18
Year 1 Year 2 Year 3

Accounts receivable:
Total reduction at the end of the year $9,835 $22,264 $48,647
Total reduction at the beginning of the year 0 9,835 22,264
Asset reduction over the year $9,835 $12,429 $26,383
Income tax liability:
Total reduction at the end of the year $3,344 $ 7,570 $16,540
Liability reduction over the year $3,344 $ 4,226 $ 8,970
Retained earnings:
Total reduction at the end of the year $6,491 $14,694 $32,107
Income reduction over the year $6,491 $ 8,203 $17,413
Cash flow statement’s operations section changes:
Income reduction appears to hurt cash –$6,491 –$ 8,203 –$17,413
Receivables reduction appears to help cash 9,835 12,429 26,383
Liability reduction appears to hurt cash –3,344 –4,226 –8,970
Net effect on cash from operations $ 0 $ 0 $ 0
A Further Example
Rexdon Interiors Ltd. sells decorating supplies and does contract home and office deco-
rating work. The company accounts for revenue at the point of delivery for ordinary
sales and on the completed contract basis for contract work. Resulting accounts for 2004
and 2003 are:
2004 2003
Revenue for 2004 $1,234,530
Accounts receivable at the end of the year 114,593 $93,438
Bad debts expense for 2004 11,240
Allowance for doubtful accounts at the end of the year 13,925 6,560
The president, Rex, is thinking of changing the revenue recognition method for
contract work to the percentage of completion method. (You don’t have to know the
details of the method to do this analysis.) If this were done,
• accounts receivable would rise to $190,540 at the end of 2003 and $132,768 at the
end of 2004;
• the controller advises that revenue/expense matching would also require raising
the allowance for doubtful accounts to $14,260 at the end of 2003 and to $16,450 at
the end of 2004. No other expense recognition changes would be anticipated.
• Rexdon’s income tax rate is 32%.
Using the analytical framework described above, here is a summary of the effects of
the policy change. (“ADA” is the allowance for doubtful accounts.) Explanations for the
figures follow.
NEL
IB I
XH
T
E
10•19

Rec. up $97,102 Down $78,927 Rec. up $18,175
ADA up $(7,700) ADA up $(2,525)
No effect BDs down $ 5,175 No effect
Up $28,609 Down $23,601 Up $ 5,008
Equity Equity
Up $60,793 Down $50,151 Up $10,642
The effects are much larger at the end of 2003 than at the end of 2004, resulting in
effects on the 2004 income statement that might be opposite to what you expected. This
is a warning to corporate executives contemplating earnings management: if a company
does try to manipulate its net income through accounting policy changes, it can easily
have such unexpected results. Financial statement manipulation is not for the faint of
heart: unexpected effects are just one reason such manipulation is not a good idea.
President Rex should only change revenue recognition policies if he believes the new
policy is really better, more appropriate, and fairer, and if he is therefore willing to stick
with the new policy even when it produces awkward results, as it does in 2004.
Here are details behind the above framework summary:
a. Retained earnings at the end of 2003 would rise by the increase in receivables minus
the increase in income tax expense:
($190,540 – $93,438 – $14,260 – $6,560) × (1 – 0.32)
= $89,402 × (1 – 0.32)
= $60,793 increase.
b. The 2003 income tax liability would increase by
$89,402 × 0.32 = $28,609.
c. Revenue for 2004 would decrease because more revenue that is now in 2004 would
be pushed back to 2003 than would revenue now in 2005 be pushed back to 2004.
• The increase in 2003 accounts receivable ($190,540 – $93,438 = $97,102) would
be transferred out of 2004 revenue;
• The increase in 2004 accounts receivable ($132,768 – $114,593 = $18,175)
would be transferred into 2004 revenue;
• For a net decrease in 2004 revenue of $78,927 ($97,102 – $18,175).
d. Bad debts expense for 2004 would also decrease because of the corresponding
revision in the timing of recognition of the expense.
• The increase in 2003 allowance ($14,260 – $6,560 = $7,700) would be
transferred out of 2004 expense to 2003;
• The increase in 2004 allowance ($16,450 – $13,925 = $2,525) would be
transferred into 2004 expense;
• For a net decrease in 2004 expense of $5,175.
NEL
e. Net income for 2004 would decrease due to the combined effect of the revenue
decrease and the bad debts expense decrease, minus the tax effect:
($78,927 – $5,175) × (1 – 0.32) = $73,752 × (1 – 0.32) = $50,151 decrease.
f. The 2004 income tax expense would decrease by $73,752 × 0.32 = $23,601.
g. Income tax liability at the end of 2004 would increase $5,008 ($28,609 increase from
2003, minus $23,601 decrease from 2004).
h. There would be no immediate effect on cash or on 2004 cash flow, but eventually
the $5,008 increased income tax liability would have to be paid.
Following the above framework summary, the journal entry to record the policy change
as at the end of 2004 would be:
DR Accounts receivable 18,175
CR Allowance for doubtful accounts 2,525
CR Income tax liability (payable or future) 5,008
CR Retained earnings (prior period
policy change effect) 60,793
DR Revenue for 2004 78,927
CR Bad debts expense for 2004 5,175
CR Income tax expense for 2004 23,601
Note that these examples assume that policy changes and error corrections affecting
prior years are entered directly into retained earnings and would be shown on the state-
ment of retained earnings. That is consistent with present Canadian GAAP, as explained
in Section 3.5. However, GAAP in the U.S. would require that most of these be adjusted
to the current year’s income statement instead. This means that in the U.S., the current
year’s income would include the prior years’ effects also. The net effect on the balance
sheet at the end of the current year would be the same under either country’s GAAP.

Here are two questions you should be able to answer based 2. Granby Industrial Inc. decided to change its accounting
on what you have just read. If you can’t answer them, it for warranties, to accrue warranty expense sooner than
would be best to reread the material. had been done. The effect on warranty liability as at the
end of 2002 was to increase it by $121,000. By the end of
1. Hinton Inc. has found an error in its revenue account: an
2003, the liability would go up $134,000. The company’s
invoice for $1,400 was recorded as revenue in 2002 when
income tax rate is 30%. What would be the effect of the
it should have been recorded in 2003. The company’s
change on: (a) 2003 net income; (b) 2003 cash from
income tax rate is 35% and there was no corresponding
operations; (c) retained earnings at the end of 2003;
error in cost of goods sold. What is the effect of the error
(d) income tax liability at the end of 2003?
on: (a) 2002 net income; (b) 2002 cash from operations;
(c) 2003 net income; (d) retained earnings at the end of
2002; (e) retained earnings at the end of 2003? (a) ($134,000 – $121,000) × (1 – 0.30) = $9,100 lower;
(b) no cash effect;

(a) $1,400 × (1 – 0.35) = $910 too high;
(c) $134,000 × (1 – 0.30) = $93,800 lower;
(b) no cash effect;
(d) $134,000 × (0.30) = $40,200 lower.
(c) $910 too low;
(d) $910 too high;
(e) no effect as the sum of 2002’s and 2003’s incomes is
unaffected
NEL
10.10 Terms to Be Sure You Understand

Here is this chapter’s list of terms introduced or emphasized. Make sure you know what they mean in accounting, and
if any are unclear to you, check the chapter again or refer to the glossary of terms at the back of the book.
Accounting policy choices Gross profit ratio Principal

Acid test ratio IN(ATI) Profit margin
AT Interest PV
Average interest rate Interest coverage ratio Quick ratio
Book value per share Inventory turnover Ratio analysis
Cash flow to total assets L/E Ratios
Collection ratio Leverage Refined ROA
Common size financial statements Leverage analysis Return on assets
Compounded(ing) Leverage potential Return on equity
Cost of capital Leverage return Return on investment
Current ratio Long-term debt-equity ratio ROA
Days’ sales in receivables Management discussion and analysis ROA(ATI)
DCF Market capitalization ROE
Debt to assets ratio MD&A ROI
Debt-equity ratio Net-of-tax analysis Sales return
Discounted cash flow Notes to the financial statements Scott formula
Dividend payout ratio Operating return SR(ATI)
Earnings per share Opportunity cost Time value of money
Earnings-price ratio PE Total assets turnover
EPS Present value “What if” (effects) analysis
Financial statement analysis Present value analysis Working capital
Future value Price to book ratio Working capital ratio
FV Priced to yield Yield
Gross margin Price-earnings ratio
NEL
695 PART ONE INTRODUCTION TO FINANCIAL ACCOUNTING
10.11 CONTINUING DEMONSTRATION CASE
Installment 10 D ATA F O R I N S TA L L M E N T 10
In Installment 9, three financial statements for Mato Inc. were prepared: a statement of
income and deficit for the year ended February 28, 2007 (which might have been called
the statement of loss and deficit, because the company had a $54,066 loss); balance
sheets at February 28, 2007, and March 1, 2006; and cash flow statement for the year
ended February 28, 2007.
These statements are the data for this installment, which will illustrate the calcula-
tion of various financial ratios and the Scott formula. The illustration will not always be
straightforward, because the company lost money and is not in a strong financial posi-
tion. Unfortunately, you may well encounter such less-than-successful companies. So,
seeing how to apply the analyses to them should increase your understanding of the
analyses.
R E S U LT S FOR I N S TA L L M E N T 10
To begin with, here are the ratios set out in Section 10.4, in the order given there. Refer
to the statements in Installment 9 (Section 9.9), and make sure you know where the
figures for the ratios below came from. Note that the company has made no provision
for an income tax recovery on its first-year loss—such a recovery would depend on
having future taxable income to deduct the loss against, and that is not likely enough to
warrant creating an income tax recovery asset in the present circumstances.
Other versions of some of the ratios calculated below are quite possible. Dollar signs
have been omitted and most ratios are rounded to three decimals.
Performance ratios:
1. Return on year-end equity: (54,066) / 70,934 = (0.762), negative.
Return on beginning equity: (54,066) / 125,000 = (0.433), negative.
2. Return on ending assets: ((54,066) + 6,469) / 160,742 = (0.296), negative.
3. Sales return before interest: ((54,066) + 6,469) / 229,387 = (0.207), negative.
Sales return after interest: (54,066) / 229,387 = (0.236), negative.
4. Common size financial statements: not illustrated here.
5. Gross margin: 90,620 / 229,387 = 0.395. Cost of goods sold is 0.605 of sales revenue,
so the average markup is 0.395 / 0.605 = 65% of cost.
6. Average interest rate: 6,469 / 89,808 = 0.072.
7. Cash flow to total ending assets: (40,028) / 160,742 = (0.249), negative.
8. Earnings per share: number of shares not known, and EPS is not as meaningful for a
private company as for a publicly traded one.
9. Book value per share: number of shares not known; however, the owners’ original
equity of $125,000 is now down to $70,934, which means the book value of the
shares is only 56.7% of the amounts the owners contributed.
10. Price-earnings ratio: not determinable because the shares of a private company like
this are not traded and their price, therefore, is not known.
11. Dividend payout ratio: no dividends declared since there was a loss.
Activity (turnover) ratios:
12. Total asset turnover: 229,387 / 160,742 = 1.427 times.
13. Inventory turnover: 138,767 / 33,612 = 4.128 times.
14. Collection ratio: 14,129 / (229,387/365) = 22.5 days.
NEL 695
Financing ratios:
15. Debt-equity ratio: 89,808 / 70,934 = 1.266.
Beginning debt-equity ratio was: 16,100 / 125,000 = 0.129.
16. Long-term debt-equity ratio: zero (no long-term debt).
17. Debt to assets ratio: 89,808 / 160,742 = 0.559.
Liquidity and solvency warning ratios:
18. Working capital ratio: 54,684 / 89,808 = 0.609.
Beginning working capital ratio was: 130,000 / 16,100 = 8.075.
19. Acid test ratio: (6,418 + 14,129) / 89,808 = 0.229.
20. Interest coverage ratio: not calculated because with this large a loss there is no
coverage!
The ratios tell a grim story:
• The company has lost 43.3% of its beginning equity;
• Its working capital ratio is considerably less than 1 (its working capital is negative);
• Its acid test ratio is less than 25%; and
• Its cash and receivables would carry its operations for less than a month.
But, there are some positive signs:
• The collection ratio is low (only 22.5 days);
• The debt-equity ratio is not high, even though equity has been reduced by losses;
and
• With a fairly low debt to assets ratio and no long-term debt, there may be room for
some long-term borrowing, should that be necessary to improve the current
position.
What does the Scott formula tell us? Using the year-end figures from the above ratios, we
have (no tax adjustments to any ratios are necessary):
ROE = SR × AT + (ROA – IN) × L/E
(0.762) = (0.207) × 1.427 + ((0.296) – 0.072) × 1.266
(0.762) = (0.295) + (0.368) × 1.266
(0.762) = (0.295) + (0.466)
The formula works out to within a 0.001 rounding error. It indicates that the company’s
woeful ROE is due to the negative effects of leverage compounding poor operating
performance: the company was already losing money, and by borrowing, made things
worse. Normally, a high asset turnover indicates good performance. But here, as the
company was losing on every sale, getting more sales also made things worse. Perhaps
Mavis and Tomas tried to do too much in their first year.
This example illustrates that most ratios and such aggregations as the Scott formula
can be calculated for losing companies. Financial statement analysis is not limited to
profitable, financially solid companies. However, the interpretation of the statements
must be made carefully, because negative relationships may exist where they’re not
expected, as we saw with the effects of asset turnover above.
We should wish Mavis and Tomas well in their second year. If they don’t do better,
there won’t be a third year!
696 NEL
10.12 Homework and Discussion to Develop Understanding
The problems roughly follow the outline of the chapter. Three main categories of
questions are presented.
• Asterisked problems (*) have an informal solution provided in the Student Solutions
Manual.
• EXTENDED TIME problems grant a thorough examination of the material and
may take longer to complete.
• CHALLENGING problems are more difficult.
For further explanation, please refer to Section 1.15.
Financial Statement Analysis and Interpretation • Sections 10.3–10.6

Discussing Financial Analysis Issues
* PROBLEM 10.1 List advantages and disadvantages of ratio analysis
List the advantages and disadvantages you see of using ratio analysis of financial state-
ments (including leverage analysis) as a way of evaluating management’s performance.
For the disadvantages, try to think of a way around each problem you identify.
PROBLEM 10.2 Comment on a complaint about financial statement analysis
A senior member of a large public company’s management complained:

Accountants’ financial analyses don’t seem very useful to me. The analyses
don’t reveal the business management factors that are important to my
company’s success. They are biased toward the past rather than the future.
And, anyway, the stock market is way ahead of the accountants in judging the
company’s performance.
Comment on the manager’s complaint.
PROBLEM 10.3 Ratios to measure different kinds of performance
1. Many financial performance measures are ratios of some return over some
investment base. Why is such a concept of performance important in business?
2. With your answer to part 1 in mind, how might you measure the performance of
each of the following investments owned by I. Investor?
a. Her $1,200 in a savings account at Banker’s Trust.
b. Her investment of $15,000 in a little consulting business she runs in her spare
time.
c. Her Slapdash 210 ragtop sports car.
d. Her investment of $300,000 in a stock-indexed mutual fund.
PROBLEM 10.4 How does financial statement analysis help users?
Many external parties rely on statements such as the balance sheet, the income state-
ment, and the cash flow statement produced by a company. Identify two different types
of major users of financial information and briefly explain how analysis of the three
financial statements will help them. (This is a similar question to some asked about the
value of financial statements in earlier chapters, but now you should be able to relate
financial statement analysis to user value.)
NEL
E xtended time PROBLEM 10.5 Draft a speech on analysis and the use of financial statements
Write the rough notes for a speech you have been asked to give to a local investment
club. The members of the club are all experienced stock market investors and want a
better understanding of companies’ accounting information. The topic of your speech
is “Analysis and Use of Financial Accounting Information.”
Performing Ratio Analysis
* PROBLEM 10.6 Use statement analysis to evaluate a president’s claims
The president of a medium-sized manufacturing company wants to renew the company’s

operating loan. In discussions with the bank’s lending officer, the president says, “As the
accompanying financial statements show, our working capital position has increased
during the past year, and we have managed to reduce operating expenses significantly.”
The partial financial statements showed the following:
Titan Manufacturing Ltd.

Partial Balance Sheet
as at December 31, 2006 and 2005
2006 2005
Current Assets
Cash $ 50,000 $200,000
Accounts receivable 250,000 100,000
Inventories 500,000 400,000
Total current assets $800,000 $700,000
Current Liabilities
Accounts payable $250,000 $200,000
Operating loan 100,000 100,000
Total current liabilities $350,000 $300,000
Titan Manufacturing Ltd.

Income Statement
for the Years Ended December 31, 2006 and 2005
2006 2005
Sales $1,200,000 $1,500,000
Less cost of goods sold 780,000 900,000
Gross profit $ 420,000 $ 600,000
Operating expenses 350,000 400,000
Income before taxes $ 70,000 $ 200,000
Income taxes 14,000 40,000
Net income $ 56,000 $ 160,000
1. Evaluate the president’s comments. Incorporate appropriate ratio analysis into your
discussion.
2. What additional financial information (if any) would you request of the president?
Why?
NEL
C hallenging PROBLEM 10.7 Use ratios to evaluate relative performance
Your friend, Inna, has asked you to evaluate information about two companies in the
same industry. Inna wants to invest in one or the other, but not both. Both companies
are publicly traded, started with $10,000 of cash, have been in operation exactly one
year, have paid the interest owing on their long-term debts to date, and have declared
dividends of $1 per share.
The beginning balance sheets for the two companies at January 1, 2006, were as
follows:
Alpha Company Omega Company

Total assets $10,000 Total assets $10,000
Long-term debt $ 1,000 Long-term debt $ 9,000
Shareholders’ equity Shareholders’ equity
(900 common shares issued) 9,000 (100 common shares issued) 1,000
Total $10,000 Total $10,000
In 2006, Alpha Company had a net income of $2,400, while Omega Company’s net
income was $1,600. Your friend says, “Alpha Company seems the better investment. Its
return on investment is 24%, and Omega’s is only 16%.”
Comment on Inna’s observation and on the relative performance of the companies,
and give her some investment advice.
C hallenging and PROBLEM 10.8 Performance evaluation using ratios

E xtended time International Business Computers (IBC) has enjoyed modest success in penetrating the
personal computer market since it began operations a few years ago. A new computer
line introduced recently has been received well by the general public. However, the
president, who is well versed in electronics but not in accounting, is worried about the
future of the company.
The company’s operating loan is at its limit and more cash is needed to continue
operations. The bank wants more information before it extends the company’s credit
limit.
The president has asked you, as vice-president of finance, to do a preliminary evalu-
ation of the company’s performance, using appropriate financial statement analysis, and
to recommend possible courses of action for the company. The president particularly
wants to know how the company can obtain additional cash. Use the following summary
financial information to do your evaluation and make your recommendations.
NEL
International Business Computers

Balance Sheets as at December 31 (in 000s)
2004 2003 2002

Current assets:
Cash $ 19 $ 24 $ 50
Marketable securities 37 37 37
Accounts receivable—trade 544 420 257
Inventory 833 503 361
Total current assets $1,433 $ 984 $ 705
Fixed assets:
Land $ 200 $ 200 $ 100
Buildings 350 350 200
Equipment 950 950 700
$1,500 $1,500 $1,000
Less: Accumulated amortization,
buildings and equipment (447) (372) (288)
Net fixed assets 1,053 1,128 712
Total assets $2,486 $2,112 $1,417
Current liabilities:
Bank loan $ 825 $ 570 —
Accounts payable—trade 300 215 $ 144
Other liabilities 82 80 75
Income tax payable 48 52 50
Total current liabilities $1,255 $ 917 $ 269
Shareholders’ equity:
Common stock $1,000 $1,000 $1,000
Retained earnings 231 195 148
Total shareholders’ equity $1,231 $1,195 $1,148
Total liabilities and shareholders’ equity $2,486 $2,112 $1,417
International Business Computers

Combined Statements of Income and Retained Earnings
for the Years Ended December 31
2004 2003 2002

Sales $3,200 $2,800 $2,340
Cost of goods sold 2,500 2,150 1,800
Gross profit $ 700 $ 650 $ 540
Expenses 584 533 428
Net income $ 116 $ 117 $ 112
Opening retained earnings 195 148 96
$ 311 $ 265 $ 208
Less: Dividends 80 70 60
Closing retained earnings $ 231 $ 195 $ 148
Other related information included in total expenses:
Interest expense $ 89 $ 61 —
Income tax expense $ 95 $ 102 $ 97
NEL
Performing Integrative Ratio Analysis
* PROBLEM 10.9 Comments on leverage, risk, and Scott formula’s analysis
Use nontechnical language to answer the following:

1. What is financial leverage?
2. Why is such leverage risky?
3. How does the Scott formula incorporate leverage?
4. Which is more risky, a company whose Scott formula leverage component is
(0.10 – 0.08) × 2, or one whose component is (0.09 – 0.08) × 1? Explain.
PROBLEM 10.10 Answer various questions using ratio analysis
Company A is owned 100% by Mr. A. A summary of Company A’s financial statement

information is as follows:
Balance Sheet as at September 30, 2006:

Total assets $115,000
Total liabilities $ 50,000
Total shareholder’s equity 65,000
Total liabilities and shareholder’s equity $115,000
Income Statement for the year ending September 30, 2006:

Revenue $ 45,000
Expenses
Interest $ 3,000
General and operating expenses 27,000
Income tax (331/3%) 5,000 35,000
Net income for the year $ 10,000
Statement of Retained Earnings for the year

ending September 30, 2006:
Balance at beginning of year $ 25,000
Net income for year 10,000
Balance at end of year $ 35,000
1. Calculate Company A’s return on equity for 2006.

2. What contributes more to return on equity: managerial performance (operating
return) or leverage return (financial leverage)? Show all calculations.
3. Company A is considering borrowing $50,000 for additional assets that would earn
the company the same return on assets it has historically earned, according to the
financial statement information above. The cost of borrowing this money is 8%.
Should the company borrow the money? (Assume there are no alternative sources
of funding.) Show all calculations. Hint: this is not a present value question.
4. Place yourself in the role of the local bank manager. Mr. A has approached you to
lend the company the required $50,000 mentioned above. Detailed financial
statement information has already been presented to you.
a. What additional information would you require, if any?
b. What financial statement ratios, in addition to those calculated in previous parts
of this problem, would be useful in aiding your decision? Do not calculate the
ratios, just mention or describe them.
NEL
PROBLEM 10.11 Calculate and explain return on equity and effect of debt
A neighbour of yours finds out that you are taking business courses and engages you in a
conversation to get some cheap investment advice. She was raised during the Depression
and is very averse to debt, believing that solid companies should be debt-free and raise
all their capital by issuing shares or by retaining earnings. You have handy a set of finan-
cial statements for a company she knows about, which you use to discuss the matter with
her.
Use the financial information below, extracted from those financial statements, to
calculate the company’s return on equity. Explain to your neighbour the effect debt has
on the company’s return on equity, and, specifically, whether this return is helped or
hindered by the company’s debt.
Total assets $410,090
Total liabilities 161,340
Interest-bearing long-term debt 69,400
Share capital 142,050
Income tax rate 43%
Retained earnings $106,700
Total revenues 510,900
Interest expense 8,270
Income before-tax and unusual item 58,850
Net income 54,300
E xtended time PROBLEM 10.12 Use the Scott formula to explain change in performance
The president of General Products Ltd. is curious about why—in spite of growth in
revenue, assets, and net income since last year—the company’s return on equity has
gone down. Last year’s ROE was 9.3%, but this year it is 9.0%.
This year’s financial statement information shows the following:
• As at September 30, 2006: total assets, $7,500,000; total liabilities, $3,000,000; total
owners’ equity, $4,500,000.
• For the year ended September 30, 2006: revenue, $2,700,000; interest expense,
$300,000; other expenses except income tax, $1,725,000; income tax expense
(40%), $270,000; net income, $405,000; dividends declared, $75,000.
1. Prepare a Scott-formula analysis for the year ended September 30, 2006.
2. Explain to the president what the results you derived in part 1 indicate about the
company’s 2006 performance.
3. The president wants to know what the limitations of the Scott formula for assessing
managerial performance are. Remembering that the formula is based on account-
ing figures, answer the president.
4. Last year’s Scott formula for General Products Ltd. (rounded to three decimals)
was: 0.093 = (0.164) (0.491) + (0.080 – 0.025) (0.240). Use this and your answer to
part 1 to explain to the president why return on equity changed from last year to
this year.
PROBLEM 10.13 Analysis of effects of events on Scott formula leverage analysis
You are the chief accountant for Yummy Cookies Inc. and have just calculated the
following Scott-formula leverage analysis for the company:
0.095 = 0.04 × 2.00 + (0.08 – 0.07) × 1.5
The president is not happy with a return on equity of 9.5% and has asked you to
estimate the effects of each of the following changes and events separately:
NEL
1. Raising selling prices to increase after-tax sales return by half and asset turnover by 5%.
2. Refinancing the company’s debt to reduce the after-tax cost of borrowing to 6%.
3. Reducing operating costs to increase after-tax sales return to 5%.
4. Increasing long-term borrowing and reducing equity to increase the debt-equity
ratio to 1.8.
Future Cash Flows: Present Value Analysis • Section 10.7

Understanding Present Value
PROBLEM 10.14 Basic present value analysis
You have just won a large lottery prize and must choose how you wish to receive your
winnings. Which of the following will you choose?
1. An immediate payment of $25,000,000.
2. An initial payment of $1,000,000 now and a further 24 annual payments of
$1,000,000 at the end of each year.
3. A monthly payment of $80,000 for 25 years. The first payment will be received one
month from now.
PROBLEM 10.15 Basic ideas of present value analysis
1. Explain what the “time value of money” or “present value” concept is all about. Why
would businesspeople be sensitive to it?
2. Calculate the present value of each of the following:
a. $1,000 to be received a year from now. If it were on hand now, it would be
invested at 10% interest.
b. $1,000 to be received at the end of each of the next three years. The opportu-
nity cost of interest or cost of capital in this case is 12%.
c. Answer (b) again but assume a rate of 10%. Why is the present value higher
when the rate is lower?
PROBLEM 10.16 Explain effects of some changes on present values
You are working on some project evaluations for your company’s president, and have
just completed present value calculations. The president asks you to consider some
possible changes in the project plans. Explain the effect of each on the present values
you have just calculated.
a. One project’s time line is shortened by two years, with the total cash flow from the
project being the same as originally predicted.
b. The required rate of return on another project is increased from 9% to 11%.
c. Some cash inflows on a third project are expected to be postponed so that they
come in during the 5th to 8th years instead of the 3rd to 6th years, though the total
cash inflow will remain the same and will still take place over the originally planned
15 years.
d. The company’s cost of capital increases by 0.5% as a result of increases in market
interest rates.
C hallenging PROBLEM 10.17 Retirement planning
As a newly qualified chartered accountant, you feel it is time you started planning for
your retirement. Now aged 25, you plan to retire after working for an additional 30 years.
You expect to enjoy 35 years of retirement. After reviewing your desired retirement
lifestyle, you feel you will need a pre-tax income of $100,000 per year during retirement.
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Required:
1. How much must you save each year to achieve your goal if you achieve an after-tax
return on your savings of 8%?
2. Assume you save the same amount as calculated above but achieve a 10% after-tax
return. What pre-tax income would this provide for your retirement?
3. How much would you have to save annually to achieve your goal if you only achieve
a 5% after-tax return?
Present Value Analysis in Making Decisions
PROBLEM 10.18 Present value analysis—how to finance your car?
Feeling the need for speed, you decide to purchase a Honda Civic Si with all the options
as a graduation present to yourself. Your research on the Honda Canada Web site shows
that the full price including taxes totals $41,874.29. You estimate that with your current
funds and some cash presents from family, you will have to finance $35,000 at 5%.
1. What will your monthly payment be if you finance the vehicle over 48 months?
2. What will your monthly payment be if you finance the vehicle over 60 months?
PROBLEM 10.19 Present value analysis—proposed investment in shares
Surprising Sleepwear Ltd. is considering making an investment in shares of a company

that makes fibreglass underwear. The investment will cost $175,000 and will return
$8,000 cash per year for four years. At the end of four years, Surprising expects to be
able to sell the shares for $200,000. Surprising pays 8% to raise financing for such
ventures. Based just on this data, should Surprising buy the shares?
PROBLEM 10.20 Present value analysis—buy or lease a truck?
Speedy Trucking is trying to decide whether it should buy a new truck for its business or
lease the truck from another company. If Speedy decides to buy the truck, it must pay
$140,000 cash immediately, and the truck is expected to last for five years. At the end of
the five years, the truck will have no remaining value and will be disposed of. If Speedy
decides to lease the truck, it must pay $30,000 at the end of each year for five years, at
which point the truck must be returned to the leasing company.
1. If the current market interest rate (which Speedy has to pay to borrow) is 8%,
should Speedy lease or buy the truck?
2. Suppose Speedy discovers that if the truck were bought, it could be sold at the end
of the five years for $25,000. Would your answer to part 1 change?
3. Identify one or two important assumptions made in your analyses and explain why
those assumptions are important.
PROBLEM 10.21 Buy a kitchenette unit or not?
Harriett is thinking of buying a kitchenette unit for her “handmade goods” store, so that
she may sell coffee, cappuccino, cookies, and other such things to browsing customers.
She thinks the unit would be a great success, bringing in net cash of $4,500 per year
(sales from the unit, less expenses, plus increased sales of handcrafts, less expenses).
The unit would cost $20,000 and Harriett would plan to sell it in four years for about
$6,500 and buy a bigger one if the idea is a success. Harriett’s company would pay about
12% interest on a bank loan to cover the cost of the unit.
Should Harriett’s company buy the kitchenette unit? Support your answer with
relevant calculations.
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PROBLEM 10.22 Answer questions about a blended payments mortgage
You are the accountant for Red River Jeans, which has just obtained a mortgage on its
factory. The mortgage carries interest at 5% and requires 10 annual payments of
$15,000 beginning a year from when the cash was provided. Answer the following
questions:
1. How much cash did Red River receive for the mortgage?
2. What will be the interest expense on the mortgage for the first year?
3. What will be owing on the mortgage at the end of the sixth year?
4. You have to do a balance sheet on the day the mortgage was obtained. In that
balance sheet, what will be the current portion of the mortgage, and what will be
the noncurrent portion?
C hallenging PROBLEM 10.23 Evaluate business disposition alternatives
A company has decided to discontinue one of its lines of business. It has put the busi-
ness up for sale and has received three offers. The first is for $750,000 cash. The second
is for $250,000 cash now and $75,000 for each of the next 10 years. The third is for a 10-
year schedule of payments equalling $75,000 for each of the next five years and
$125,000 for each of the remaining five years. The company has studied interest rates
and believes it could earn 5% on the money for the next five years and 6% for the five
years after that. Which offer is the best one?
Bond and Stock Price Analysis
* PROBLEM 10.24 Bond pricing
Wescania Inc. plans to issue 100,000 $100 bonds, intending to use the bonds to invest in
various business opportunities that are expected to earn an overall 10% return over the
10 years the bonds are outstanding. Bond markets are rather volatile right now, so the
company is trying to set the interest rate on the bonds so that they will bring in the
needed $10,000,000 without costing more interest than necessary. Right now, the bond
market seems to price $100 bonds for companies like Wescania at $100 if they carry
interest of 8%, so the company plans to pay 8% interest on the bonds.
1. What would the 8% bonds sell for if Wescania priced them to yield
a. 8%?
b. 7%?
c. 9%?
2. If the company could sell the bonds priced to yield 7%, it would obtain about
$700,000 more than the $10,000,000 needed. Does that mean the company would
make a greater net income on the projects than it planned, or would it make less?
PROBLEM 10.25 Evaluate a possible investment
Rosie has been saving money for years and has it invested in bank investment certificates
that earn 5%. She feels the rate of return is too low and has been looking around for
other investment opportunities. She has been considering investing in Natural Body
Oils Inc. (NBO), which has been doing very well in recent years. NBO’s shares are sell-
ing for $15 right now on the Toronto Stock Exchange. Her investigation indicates that a
share of NBO may be expected to pay an annual dividend of $1.00 per year and should
sell for somewhere between $12 and $20 in five years, at which time Rosie plans to cash
all her investments in and buy a condo in a warm place.
What advice would you give Rosie about investing in NBO?
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C hallenging PROBLEM 10.26 Present value analysis—investment choices
You are a rational investor facing a choice of two investment opportunities on

December 31, 2004. Your required rate of return is 9%, the current market yield.
1. The first investment is in corporate bonds issued by Big Conglomerate, Inc. (an old
and established firm), which have a face value of $100 and pay 8% annual interest
on December 31 of each of the next four years, and repay the $100 principal on
December 31 of the fourth year.
What is the value of the $100 Big Conglomerate bond to you?
2. The second alternative is an investment in shares of a small gold mining company
recently formed by your uncle. He is quite confident that the company will be able
to pay cash dividends according to the following schedule:
Dec. 31/2005 Dec. 31/2006 Dec. 31/2007 Dec. 31/2008
$32 per share $32 per share $32 per share $32 per share
Based on this schedule, at what price per share would it not matter to you
whether you invested some of your money in Big Conglomerate bonds or bought
shares in your uncle’s mining company?
3. What other factors might you want to consider before you make a decision?
What If Effects Analysis • Sections 10.8 and 10.9

Understanding What If Analysis
* PROBLEM 10.27 Some effects analysis concepts
1. Why do changes in accounting methods usually have no effect on cash or cash flow?
2. Since the cash flow statement begins with net income, any method change that
changes net income will appear to change cash flow. How can this happen when the
cash flow statement’s total cash flow is unaffected by the change?
3. Can you suggest a situation where an accounting method change would affect cash
flow as reported on the cash flow statement?
4. Why is it important to take income tax into account when doing “what if” effects
analysis?
5. If a company decides to recognize revenue earlier than had been its practice, its
accounts receivable will increase. Does this mean that revenue and net income will
increase for every year affected by the policy change?
PROBLEM 10.28 General effects analysis
Suppose that on December 31, the last day of its fiscal year, a large company sold bonds
by which it borrowed $75,000,000 cash, to be paid back in six years. The money was used
on the same day to reduce the company’s short-term bank loans by $25,000,000 and buy
additional equipment for $50,000,000.
Calculate the changes to the following that would result from the above:
a. Total current assets.
b. Total assets.
c. Total current liabilities.
d. Working capital ratio.
e. Total shareholders’ equity.
f. Net earnings for the year ended on the day of the borrowing.
g. Cash and cash equivalents.
h. Cash used for investments.
i. Cash provided from financing.
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Describe how predictions of the effects on the following could be made:

j. Return on equity for the period after the loan.
k. Leverage return.
PROBLEM 10.29 Effects on debt and equity changes
Suppose that a company decided to make a common share offering for $45,000,000.
$15,000,000 would be used to expand and renovate an existing factory while the remain-
der would be used to pay down long-term debt. Calculate the change this would have
upon the company’s
a. Total assets
b. Total liabilities
c. Total shareholders’ equity
d. Debt-equity ratio
e. Cash provided from financing activities
f. Cash provided from investing activities
g. Cash on hand
Performing What If Analysis
* PROBLEM 10.30 Effects of changing doubtful accounts allowance, with tax
“Karl, we have a problem in our accounts receivable. We’ve provided an allowance for
doubtful accounts of 2% of the gross receivables, but during this recession more
customers are running into trouble. The allowance should be raised to 5%.”
“Tanya, we can’t do that. It would wipe out our profitability and ruin our cash flow.”
Given the data below, prepare an analysis for Karl and Tanya. (If you have not yet
studied the allowance for doubtful accounts, Tanya’s proposal would reduce income by
the indicated increase in the allowance.)
Data: Gross accounts receivable at year-end $8,649,000
Net income for the year at present $223,650
Income tax rate 30%
PROBLEM 10.31 Effects of ending a policy of capitalizing advertising costs, with income tax
Checkup Auto Services Inc., which has been in business one year, has a chain of heavily
advertised automobile service centres. The company’s income tax rate is 35%. The
company makes it a practice to capitalize a portion of its advertising costs as a “deferred
asset.” The amount of advertising cost capitalized this year was $100,000 and the new
company’s policy is to amortize the capitalized amount to expense at 20% per year. An
accountant suggested to the company’s vice-president of finance that the policy of capi-
talizing advertising should be ended because the future economic benefit from the
expenditures is not clearly determinable. The vice-president wants to know what effect
such policy changes would have.
PROBLEM 10.32 Effects of proposed policy of capitalizing improvement costs,

with income tax
Senior management of Telemark Skiing Ltd. wishes to capitalize $2,650,000 in ski hill
improvement costs expended this year and amortize the capitalized costs over 10 years,
rather than just expensing them all as is now done. The company’s income tax rate is
30%, and the company would plan to continue deducting the costs as expenses in
computing income tax payable for this year, assuming the tax authorities would permit
that. What would be the effect on this year’s net income and cash flow from operations
if the company capitalized those costs?
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Performing What If Analysis with Income and Ratio Effects
* PROBLEM 10.33 Effects analysis of truck fleet purchase and financing
Suppose that on May 1, 2006, Large Corporation decides to purchase a new fleet of
delivery trucks at a total cost of $5,800,000. The trucks will be paid for in cash, which
Large Corporation will raise by using $2,200,000 cash on hand, issuing shares for
$2,000,000, and borrowing $1,600,000 over 20 years from the bank.
1. Using the preceding information, fill in the blanks below, indicating the magnitude
and direction of the change in each category the truck purchase will cause.
Large Corporation
Changes in Balance Sheet at May 1, 2006
Cash equivalent assets $_________ Cash equivalent liabilities $_________
Other current assets $_________ Other current liabilities $_________
Noncurrent assets $_________ Noncurrent liabilities $_________
Share capital $_________
Retained earnings $_________
Total liabilities
Total assets $_________
_________ & owners’ equity $_________
_________
2. What effect (if any) will this event have on the financing activities section of the cash
flow statement for the year?
3. What effect (if any) will this event have on the income statement for the year?
4. Which important financial statement ratios would you expect this event to affect?
5. Record the above event as a journal entry.
PROBLEM 10.34 Loan and policy change effects analyses
1. Strapped Ltd., which has $210,000 in current assets and $180,000 in current liabili-
ties, borrows $50,000 from the bank as a long-term loan, repayable in four years.
What is the effect of this loan on working capital? On the working capital ratio? On
current net income?
2. Slipshod Inc. has discovered that it has not estimated enough warranty expenses
because more customers are returning products for repair than had been expected.
The company decides to recognize an additional $210,000 in noncurrent warranty
liability, and therefore in corresponding expenses: $145,000 in respect to sales recog-
nized in the current year and $65,000 in respect to prior years’ sales. The company’s
income tax rate is 40%. What will this do to the current year’s net income? To
retained earnings? To cash from operations? To the working capital ratio?
C hallenging PROBLEM 10.35 Multiple-issue effects analysis, with tax
Cranberry Costumes Ltd. has been operating for several years now. So far the income
for the current year is $75,000, before income tax at 30%. (The preceding year’s income
before tax was $62,000, and the tax rate then was also 30%.) Owner Jan Berry is consid-
ering a few changes and has asked your advice. The possible changes are:
• Change the revenue recognition policy to recognize revenue earlier in the process.
This would increase accounts receivable by $26,000 immediately and $28,000 at the
end of the previous year.
• Make a monthly accrual of the bonuses paid to employees at the end of each fiscal
year. This would increase accounts payable by $11,000 immediately and $7,000 at
the end of the preceding year.
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• Postpone for five years repayment of a $19,000 loan (by Jan to the company), which
has up to now been classified as a current liability.
• Capitalize as a trademark asset $14,000 of advertising supplies and wages expense
recorded in the preceding year.
1. Calculate the net income after income tax for the current year that will result if all
of the changes are adopted, and discuss the economic reasons for considering each
change.
2. Calculate the effect on the amount of cash in the bank account of Cranberry
Costumes Ltd. that these changes will have.
3. Explain any difference between results calculated for part 1 and part 2 above.
C hallenging PROBLEM 10.36 Effects analysis, with ratios
Funtime Toys Inc. invents, manufactures, and sells toys and children’s board games. In
2006, financial executives at Funtime decided to change two accounting methods.
• First, they decided to capitalize certain costs related to the development of new
educational games, which had previously been expensed as incurred. It was thought
that market demand for the games had been strong for several years, and that
development costs were sure to provide future benefits.
• Second, the amortization method used on one class of equipment was changed to
produce an annual amortization expense that was thought to better match the
company’s revenue generation process.
The effects of these changes on development and amortization expenses for the fiscal
years 2005 and 2006 are shown below. The company’s income tax rate is 30% and the
method changes would affect future, not current, income tax.
Development Expense 2005 2006

Old method $ 70,000 $ 90,000
New method 60,000 81,000
Amortization Expense 2005 2006

Old method $160,000 $180,000
New method 175,000 170,000
Determine the combined impact the two method changes have on each of the following
items for 2005 and 2006. Decide whether each item increases, decreases, or is not
affected. (Check each ratio carefully to determine the impact on both the numerator
and the denominator.)
a. Net income.
b. Working capital at the end of the year.
c. Total assets at the end of the year.
d. Debt-equity ratio at the end of the year.
e. Return on year-end equity.
f. Total asset turnover.
Multi-Year What-If Analysis
* PROBLEM 10.37 Basic multi-year effects analysis, with income tax
Mistaya Ltd. has decided to change its revenue recognition policy to increase revenue
$10,000 in the current year and by a total of $8,000 in prior years (accounts receivable
are increased correspondingly). Matched expenses increase $4,000 in the current year
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and $3,000 in prior years (so accounts payable go up as well). The company’s income
tax rate is 35%.
Determine all effects of the change on the company’s income statement and cash
flow statement for the current year and balance sheet as at the end of the current year.
Show your calculations and demonstrate that all the effects balance.
PROBLEM 10.38 Multi-year effects analysis without considering income tax
Record Sales Inc. has the following history for its first three years of existence:
2006 2005 2004

Revenue:
Credit sales $1,100,000 $700,000 $500,000
Cash sales 100,000 90,000 40,000
Cash collected from customers* 1,050,000 740,000 420,000
Accounts receivable that became:
Doubtful during the year 50,000 25,000 10,000
Worthless during the year 20,000 40,000 5,000
* Including cash sales
The president, John Record, is wondering what difference to the company’s work-
ing capital and income before income tax it would make if the company used one of the
following accounts receivable valuation methods:
a. Make no allowance for doubtful or bad debts and just keep trying to collect.
b. Write off worthless accounts, but make no allowance for doubtful ones.
c. Allow for doubtful and worthless accounts when they become known.
Provide an analysis for the president.
PROBLEM 10.39 Effects of recognizing supplies inventory, with tax
Magnic Manufacturing Co. has large amounts of manufacturing supplies that have been
recorded as an expense when purchased. Now the company is considering recognizing
the supplies on hand as an asset. If this were done, a new supplies inventory account
would appear in the current assets. Its balance would be $148,650 at the end of last year
and $123,860 at the end of this year. The company’s income tax rate is 30%.
Calculate the effect on each of the following that would result if the company
changed its accounting to recognize the supplies inventory:
1. Retained earnings at the end of last year.
2. Income tax liability at the end of last year.
3. Supplies expense for this year.
4. Net income for this year.
5. Current assets at the end of this year.
6. Income tax liability at the end of this year.
7. Retained earnings at the end of this year.
8. Cash flow for this year.
9. Cash flow for next year.
C hallenging and PROBLEM 10.40 Multi-year effects analysis, with tax

E xtended time Kennedy Controls Inc. is considering a change in its accounting for maintenance costs.
The chief financial officer proposes that the company capitalize 20% of its maintenance
expenses, on the grounds that some of that expenditure has created additional plant
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assets. The company, the income tax rate for which is 40%, has existed for four years
and amortizes its plant assets at 10% of year-end cost.
Here are some relevant account balances for the last four years, before considering
the above proposal:
Year 1 Year 2 Year 3 Year 4

Expenditures on plant assets $1,243,610 $ 114,950 $ 34,770 $ 111,240
Balance in the plant assets
account 1,243,610 1,358,560 1,393,330 1,504,570
Amortization expense 124,361 135,856 139,333 150,457
Accumulated amortization 124,361 260,217 399,550 550,007
Maintenance expense 43,860 64,940 73,355 95,440
Determine the effects of the proposed change on the Year 4 income statement, cash flow
statement, and balance sheet at the end of Year 4.
C hallenging and PROBLEM 10.41 Effects of an inventory error, with tax

E xtended time On December 20, 2004, Profit Company Ltd. received merchandise amounting to
$1,000, half of which was counted in its December 31 listing of all inventory items on
hand. The invoice was not received until January 4, 2005, at which time the acquisition
was recorded as of that date. The acquisition should have been recorded in 2004.
Assume that the periodic inventory method is used (that is, the inventory asset is based
on what was counted as being on hand, and the cost of goods sold expense is deduced
as “beginning inventory + purchases – ending inventory” and that the company’s
income tax rate is 40%. Indicate the effect (overstatement, understatement, none) and
the amount of the effect, if any, on each of the following:
1. Inventory as at December 31, 2004.
2. Inventory as at December 31, 2005.
3. Cost of goods sold expense, 2004.
4. Cost of goods sold expense, 2005.
5. Net income for 2004.
6. Net income for 2005.
7. Accounts payable as at December 31, 2004.
8. Accounts payable as at December 31, 2005.
9. Retained earnings as at December 31, 2004.
10. Retained earnings as at December 31, 2005.
Integrated Problems
Analyze Petro-Canada’s Financial Statements
Information for Problems 10.42*, 10.43*, and 10.44*: Petro-Canada
Petro-Canada, headquartered in Calgary, is a national oil company with operations

across Canada, including oil from the Grand Banks of Atlantic Canada and from the
Syncrude project in Alberta, natural gas in various parts of Western Canada, and gas
stations in most parts of the country. Below are its 2004 financial statements (without
notes or accounting policies). Use those statements to answer the following three
problems.
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Petro-Canada
Consolidated Balance Sheet
(stated in millions of Canadian dollars)
As at December 31, 2004 2003
(Note 2)
Assets
Current assets
Cash and cash equivalents (Note 13) $ 170 $ 635
Accounts receivable (Note 11) 1,254 1,503
Inventories (Note 14) 549 551
Prepaid expenses 13 16
1,986 2,705
Property, plant and equipment, net (Note 15) 14,783 10,943

Goodwill (Note 12) 986 810
Deferred charges and other assets (Note 16) 345 316
$ 18,100 $ 14,774
Liabilities and shareholders’ equity

Current liabilities
Accounts payable and accrued liabilities $ 2,223 $ 1,822
Income taxes payable 370 300
Short-term notes payable 299 –
Current portion of long-term debt (Note 17) 6 6
2,898 2,128
Long-term debt (Note 17) 2,275 2,223

Other liabilities (Note 18) 646 306
Asset retirement obligations (Note 19) 834 773
Future income taxes (Note 7) 2,708 1,756
Commitments and contingent liabilities (Note 25)
Shareholders’ equity (Note 20) 8,739 7,588

$ 18,100 $ 14,774
Approved on behalf of the Board of Directors
Ron A. Brenneman, Director Brian F. MacNeill, Director
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Petro-Canada
Consolidated Statement of Earnings
For the years ended December 31, 2004 2003 2002

(Note 2) (Note 2)
Revenue
Operating $14,687 $12,887 $10,374
Investment and other income (Note 4) (310) 12 –
14,377 12,899 10,374
Expenses
Crude oil and product purchases 6,740 5,620 4,837
Operating, marketing and general (Note 5) 2,690 2,557 2,222
Exploration (Note 15) 235 271 301
Depreciation, depletion and amortization
(Notes 5 and 15) 1,402 1,560 977
Foreign currency translation (Note 6) (77) (251) 52
Interest 142 182 187
11,132 9,939 8,576
Earnings before income taxes 3,245 2,960 1,798
Provision for income taxes (Note 7)
Current 1,461 1,247 959
Future 27 63 (116)
1,488 1,310 843
Net earnings $ 1,757 $ 1,650 $ 955
Earnings per share (Note 8)

Basic $ 6.64 $ 6.23 $ 3.63
Diluted $ 6.55 $ 6.16 $ 3.59
Petro-Canada
Consolidated Statement of Retained Earnings

(Note 2) (Note 2)
Retained earnings at beginning of year,

as previously reported $3,943 $2,380 $1,511
Retroactive application of change in accounting
for asset retirement obligations (Note 2) (133) (114) (95)
Retained earnings at beginning of year,
as restated $3,810 $2,266 $1,416
Net earnings 1,757 1,650 955
Dividends on common shares (159) (106) (105)
Retained earnings at end of year $5,408 $3,810 $2,266
NEL
Petro-Canada
Consolidated Statement of Cash Flows

(Note 2) (Note 2)
Operating activities
Net earnings $ 1,757 $ 1,650 $ 955
Items not affecting cash flow from operating
activities before changes in noncash working
capital (Note 9) 1,755 1,451 1,020
Exploration expenses (Note 15) 235 271 301
Cash flow from operating activities before changes
in noncash working capital 3,747 3,372 2,276
Proceeds from sale of accounts receivable (Note 11) 399 – –
Increase (decrease) in other noncash working capital
related to operating activities (Note 10) 133 (164) (226)
Cash flow from operating activities 4,279 3,208 2,050
Investing activities
Expenditures on property, plant and equipment
and exploration (Note 15) (4,073) (2,315) (1,861)
Proceeds from sales of assets 44 165 26
Increase in deferred charges and other assets (36) (147) (72)
Acquisition of Prima Energy Corporation (Note 12) (644) – –
Acquisition of oil and gas operations of
Veba Oil and Gas GmbH (Note 12) – – (2,234)
(Increase) decrease in noncash working capital
related to investing activities (Note 10) 10 94 (16)
(4,699) (2,203) (4,157)
Financing activities
Increase in short-term notes payable 314 – –
Proceeds from issue of long-term debt 533 804 2,100
Repayment of long-term debt (299) (1,352) (465)
Proceeds from issue of common shares 39 50 30
Purchase of common shares (Note 20) (447) – –
Dividends on common shares (159) (106) (105)
Increase in noncash working capital related
to financing activities (Note 10) (26) – –
(45) (604) 1,560
Increase (decrease) in cash and

cash equivalents (465) 401 (547)
Cash and cash equivalents at
beginning of year 635 234 781
Cash and cash equivalents at
end of year (Note 13) $ 170 $ 635 $ 234
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E xtended time * PROBLEM 10.42 Interpret Petro-Canada’s cash flow statement
Use the above Petro-Canada cash flow statement, and other statements where relevant,
to answer the following questions:
1. Why is the company’s cash from operating activities ($4,279 million in 2004, for
example) so much greater than its earnings ($1,757 million in 2004, for example)?
2. The notes to the financial statements are not included above. What kinds of
accounts are likely to be mentioned in Notes 9 and 10?
3. Write a paragraph identifying the major components of the company’s cash flows
over the three years.
4. Interpret the company’s cash flow and financial strategy, particularly for 2004, using
for reference the points a–i set out in Section 10.5 and used there to comment on
CPR.
E xtended time * PROBLEM 10.43 Analyze Petro-Canada’s financial position
Prepare an analysis of and commentary on Petro-Canada’s financial position at the

end of 2004, as compared to 2003, using the balance sheet above and any relevant
information from the other financial statements above.
E xtended time * PROBLEM 10.44 Do a performance analysis of Petro-Canada
1. Using the Petro-Canada financial statements above, prepare a few ratios relevant to
analyzing the company’s financial performance for 2004 as compared to 2003, and
comment on what those ratios show.
2. Did Petro-Canada benefit from financial leverage in 2004? How did that compare to
2003? Answer these questions simply, without use of the Scott formula.
3. Answer the questions in part 2 using the Scott formula, and comment on the
relative sizes of operating and leverage returns in 2004 and 2003.
Analyze Sleeman Breweries Ltd.’s Financial Statements
Information for Problems 10.45, 10.46 and 10.47: Sleeman Breweries Ltd.
Sleeman Breweries Ltd. is headquartered in Guelph, Ontario. According to Note 1 in

the 2004 Annual Report, Sleeman “develops, produces, imports, markets and distributes
beer for sale to provincial liquor distribution organizations and entities engaged in the
food and beverage industries within Canada.” Below are its financial statements (without
notes or accounting policies) for the year ended January 1, 2005. Use those statements
to answer the following three problems. (Note that Sleeman had 16,259,645 common
shares outstanding at January 1, 2005, and 15,971,050 at December 27, 2003.)
NEL
Sleeman Breweries Ltd.

Consolidated Balance Sheets
(in thousands of dollars)
January 1, December 27,
2005 2003
ASSETS
Current
Accounts receivable –Trade $ 34,529 $ 30,322
–Other (Note 5) 9,196 6,363
Income taxes recoverable 697 –
Inventories (Note 6) 39,147 31,054
Prepaid expenses 6,589 5,379
90,158 73,118
Note receivable (Note 5) 1,083 2,166

Property, plant and equipment (Note 7) 100,748 74,691
Long-term investment and executive loans (Note 8) 3,311 6,337
Intangible assets (Note 9) 104,852 86,443
$ 300,152 $ 242,755
LIABILITIES
Current
Bank indebtedness (Note 10) $ 9,634 $ 555
Accounts payable and accrued liabilities 39,146 39,299
Income taxes payable – 2,284
Current portion of long-term debt (Note 11) 12,043 13,374
60,823 55,512
Long-term debt (Note 11) 103,616 71,916

Future income taxes (Note 12) 13,929 11,527
178,368 138,955
SHAREHOLDERS’ EQUITY
Share capital (Note 13) 48,353 45,075
Contributed surplus 308 28
Retained earnings 73,123 58,697
121,784 103,800
$ 300,152 $ 242,755
Approved by the Board
Pierre Des Marais II, Director Ken Hallat, Director
NEL

Consolidated Statements of Earnings and Retained Earnings
(in thousands of dollars except per share amounts)
Fiscal Year Ended
2005 2003
Net revenue $ 213,354 $ 185,036
Cost of goods sold 106,207 96,703

Gross margin 107,147 88,333
Gain on settlement of obligation (Note 4) – 591

Selling, general and administrative 71,204 55,523
Earnings before the undernoted 35,943 33,401
Depreciation and amortization 7,172 6,301

Interest expense—net 6,643 6,097
Earnings before income taxes 22,128 21,003
Income taxes (Note 12) 7,702 8,750

Net earnings 14,426 12,253
Retained earnings, beginning of year 58,697 46,444

Retained earnings, end of year $ 73,123 $ 58,697
Earnings per share (Note 15)

Basic $ 0.89 $ 0.77
Diluted $ 0.87 $ 0.76
NEL

Consolidated Statements of Cash Flow
(in thousands of dollars except per share amounts)
Fiscal Year Ended
2005 2003
Net inflow (outflow) of cash related to

the following activities:
Operating
Net earnings $ 14,426 $ 12,253
Items not affecting cash
Depreciation and amortization 7,172 6,301
Future income taxes 2,184 3,221
Gain on settlement of obligation (Note 4) – (591)
Noncash interest charges in income (314) (90)
Stock-based compensation expense 280 28
Loss (gain) on disposal of equipment (5) 4
23,743 21,126
Changes in noncash operating working
capital items (Note 16) (10,544) (7,533)
13,199 13,593
Investing
Business acquisitions (net) (Note 3) (40,265) –
Proceeds from sale of agency agreement 1,176 980
Additions to property, plant and equipment (15,735) (8,652)
Additions to intangible assets (859) (2,105)
Proceeds from executive loans 1,499 249
Proceeds from disposal of equipment 630 19
(53,554) (9,509)
Financing
Net increase in bank operating loans 8,388 (9,906)
Stock options exercised 3,274 1,322
Long-term debt—proceeds 41,193 90,000
Long-term debt—principal repayments (12,500) (85,500)
40,355 (4,084)
Change in cash and cash balance, end of year $ – $ –

Supplemental disclosures of cash flows:
Interest paid $ 7,433 $ 6,121
Income taxes paid, net of cash refunds of $885
(2002 –$221) $ 7,439 $ 3,332
NEL
E xtended time PROBLEM 10.45 Analyze Sleeman’s financial performance
Using the above financial statements, prepare an analysis and interpretation of Sleeman
Breweries Ltd.’s 2004 financial performance in comparison to 2003. Use relevant
performance-related ratios from Section 10.4 plus the company’s cash flow information.
E xtended time PROBLEM 10.46 Analyze Sleeman’s financial position
Using the above financial statements, prepare an analysis and interpretation of Sleeman
Breweries Ltd.’s financial position as at January 1, 2005 (2004 fiscal year), in comparison
to 2003. Use any relevant ratios and cash flow information.
E xtended time PROBLEM 10.47 Analyze Sleeman’s leverage
Using the above financial statements, prepare an analysis, using the Scott formula, of
whether, and to what extent, Sleeman benefited from leverage in 2004 as compared to
2003.
Analyze Canadian National Railway Company’s Financial Statements
Information for Problems 10.48, 10.49, and 10.50: Canadian National Railway Company.
The Canadian National Railway Company (CN) is Canada’s largest railway company and
one of CPR’s largest competitors. In order to answer the following questions, you will
need to find CN’s financial statements available on its Web site at www.cn.ca. Look for a
link titled About CN and navigate to find the annual report section. If you are using the
2004 annual report as this question does, there are two complete sets of financial state-
ments. Use only the Canadian GAAP statements of the 2004 annual report. You should
be able to answer the same kinds of questions for years after 2004, depending on what
information CN posts to its Web site in later years.
E xtended time PROBLEM 10.48 Examine CN’s cash flow and financial performance
Examine CN’s financial statements.

1. Write a paragraph identifying the major components of the company’s cash flows
over the three years.
2. What caused financing activities to switch from a cash outflow in 2003 to a cash
inflow in 2004? Why might this change have been necessary?
3. Using CN’s financial statements, prepare an analysis of the company’s financial
performance in 2004 compared to 2003. Use any relevant ratios and information.
E xtended time PROBLEM 10.49 Analyze CN’s leverage
Using the above financial statements, prepare an analysis, using the Scott formula, of
whether, and to what extent, CN benefited from leverage in 2004 as compared to 2003.
E xtended time PROBLEM 10.50 Compare CN to CPR
The Canadian National Railway Company is one of the main competitors to the
Canadian Pacific Railway Company. Compare the analysis you have just completed on
CN in Problems 10.48 and 10.49 to the analysis of CPR presented in the chapter. Does
each company display the same trends in terms of financial performance between 2004
and 2003? Do the companies’ strategies of financing or growth seem to be similar?
Discuss these issues and any other relevant information.
NEL
CASE 10A
USING ANALYSIS TO CATCH PROBLEMS
• How might the ratio and leverage analysis
R
ead the article “Hide and Seek” below and
then discuss its list of ten “red flags” that covered in this chapter be used to identify
investors should beware of in evaluating the problems such as those identified in the article?
story told by the financial statements. Here are just • Does the existence of such problems indicate
some ideas to get you started: weaknesses in financial accounting that should
be addressed?
• How has what you have learned about account-
• Can you suggest other red flags in addition to
ing helped you to recognize or avoid the red
the article’s ten?
flags?
HIDE AND SEEK

Accounting tricks make it difficult for investors to get a true picture of a
company’s finances. Here are 10 red flags to watch out for.
By John Gray
accounting schemes. But the slowing economy and the
S
o you thought it was safe to go back into the invest-
ing waters. For years, some companies have played end of the bull market last year made it more difficult for
fast and loose with their reported earnings. Analysts, companies to hide their financial sins; as a result, share-
shareholders and the media embraced the farce of pro holders have become hungry for more critical analysis of
forma earnings that often have only a casual relationship the companies in which they have invested. (In a recent
to standard accounting practices—and uncritical investors study of 150 randomly chosen companies, the Ontario
rewarded those companies with soaring share prices and Securities Commission found fault with the interim finan-
huge management compensation packages. But that’s all cial reporting of 77.) The collapse of Enron—with its
changed now, right? The collapse of Enron Corp., the bogus financial statements given the seal of approval by
Houston-based energy trading giant that used invisible ink auditor Arthur Andersen LLP (which has been indicted by
to write its financial statements; the bankruptcy of Global a federal grand jury in Houston)—has shown that share-
Crossing, the Bermuda-based telecom giant; criticism over holders themselves must cast the first critical eye on a
accounting practices at Tyco International and even IBM— company’s financials. As Wall Street giant Goldman Sachs
it’s put a stop to all those accounting shenanigans, hasn’t stated in a recent report: “There is a need now, more than
it? ever, for financial statements users to delve into company
Wrong, warns Al Rosen, forensic accountant, chair- reports to ferret out accounting’s ‘smoke and mirrors.’”
man of Toronto-based Veritas Investment Research Corp. It is a daunting task, but something shareholders now
and one of Canada’s staunchest critics of accounting must do to protect themselves from the financial land-
monkey business. “That’s a bunch of bull,” he says. “There mines planted in some company financial statements, says
are still plenty of companies out there playing accounting Robin Schwill, an insolvency lawyer with the Toronto-based
dirty tricks, and they can’t afford to stop.” As we enter yet law firm of Osler, Hoskin & Harcourt LLP, who also
another earnings season, and gear up for the release of teaches an MBA course on financial statement interpreta-
dozens of annual reports, Rosen and other independent tion at York University’s Schulich School of Business. “This
financial analysts are predicting just as much accounting is hard work,” Schwill concedes. “But if you don’t do it, you
tomfoolery as in the past. are not an investor—you are a gambler who is taking a roll
Rosen has often been a lone voice in the wilderness, of the dice.”
accusing companies of misleading shareholders through a Not that an amateur analyst would have been able to
variety of ingenious—and, unfortunately, perfectly legal— uncover Enron’s complex web of financial indiscretions.
NEL
Indeed, in the wake of the scandal, US President George 2 Everything-but-the-Bad-Stuff Accounting

W. Bush has proposed a 10-point corporate responsibility A more common practice is for companies to highlight
plan, which, among other things, would force CEOs to “everything but the bad stuff” in their quarterly earnings
vouch for the veracity of information in their financial press releases, says Rosen. Companies in the tech sector
statements. In the meanwhile, there are plenty of red flags perfected the practice, but it has spread well beyond
that investors should look for to ensure that earnings Silicon Valley. Take the Toronto-Dominion Bank, which in
statements reflect the company’s bottom line. February announced quarterly earnings of $526 million.
That figure was based on what the bank describes as “oper-
1 The Big Bath ating cash basis,” which excludes “items it doesn’t consider
Canadian investors have become all too familiar with the to be part of its normal operations” such as acquisition
strategy known as “Big Bath Accounting.” In the wake of funding costs associated with its purchase of Canada Trust
the tech-stock meltdown, once-stellar companies such as in 2000. However, TD does not exclude the revenue that
Nortel Networks Corp. and JDS Uniphase Corp. broke has flowed into the bank from the Canada Trust merger.
records with the size of their writedowns. Last year, Nortel The result is a distorted picture of the bank’s performance.
announced a staggering six-month net loss of more than Lower down in the filing the bank reports that under stan-
US$19 billion; not to be outdone, JDS reported an annual dard accounting rules, net earnings are $355 million—a
loss of US$50.6 billion. Investors should prepare for more 32.5% drop.
big baths this year, as companies try to account for the loss Claude Lamoureux, president and CEO of the
of revenue as a result of recession and the Sept. 11 terrorist Ontario Teachers’ Pension Plan (OTPP) Board, decries the
attacks—and as they grapple with changes to the Canadian practice of trumpeting pro forma earnings in press releases
Institute of Chartered Accountants standards, which and public discussions with shareholders. He has called on
shorten the length of time in which firms can write down Canadian firms to base all their press releases on financial
such charges as goodwill. “A lot of companies are going to statements that comply with generally accepted accounting
take a vacuum cleaner to the books and take as big a hit as principles (GAAP) and are approved by both the
they can to get these charges off their books,” says Rosen. company’s auditor and the audit committee of the board of
It has already started. In February, Montreal-based directors.
Quebecor Inc. warned investors that it might have to write
off between $1.5 billion and $2 billion in goodwill related 3 Moving Debt off the Balance Sheet
to their purchase of Le Groupe Vidéotron Ltée. The accounting technique made infamous by Enron was its
Quebecor’s $5.4-billion purchase of the cable company in use of special purpose entities (SPE) to move debt off its
late 2000 pushed its depreciation and amortization costs up balance sheet. Use of off-balance-sheet financing has
by $174.1 million and increased its financial expenses to become increasingly popular in recent years, according to
$214.2 million. That helped force the company to post a a recent Goldman Sachs report. This is perhaps the most
net loss of $241.7 million, or a whopping $3.74 per share, dangerous accounting gimmick, because it is very difficult
last year. to determine from financial filings exactly when a company
Now, taking a huge loss is not as bad as tweaking the has entered into these agreements. As the Goldman Sachs
numbers to boost profits. But it makes it just as difficult for report notes, “Accounting sleuths must delve through the
investors to properly evaluate the company and compare it investing company’s audited financial statements in search
to its peers who have not taken a loss. After all, once a of footnotes that may list financing-related associates, affili-
company has taken a multibillion-dollar charge, just about ates, or partnerships.” The lack of disclosure makes it
anything looks good. Taking a large writeoff in the wake of impossible for investors to determine how much the
a bad transaction is appropriate, says Larry Woods, an inde- company must pay to fully service its debt or to fulfill other
pendent financial analyst based in Hamilton, Ont. contractual obligations, says Woods. “Companies have been
However, many companies write down every conceivable piling on debt for years now, and these off-balance-sheet
charge—even inventories on which they will eventually see entities can be the straw that breaks the camel’s back.”
some return. “The money they eventually earn from those
transactions then seeps into the companies’ operational 4 Pension Plan Makeover
earnings,” Woods says, “making it impossible to determine Pension plan accounting is complicated, esoteric and not
if the revenue is from core businesses or from stuff they entirely logical. But what every shareholder needs to
previously wrote off.” understand is that most companies have obligations to
fund their pension plan to a certain level. Any shortfall
NEL
must eventually be made up by contributions from the Corp., which reported more than 90% of a calculated
company’s coffers. During the bull market of the past few US$46-million tax effect in 2000, helping reduce its net
years, companies were able to cut back on contributions, as loss for the year. Such credits also have a nasty habit of
gains in the stock market helped keep pension plans disappearing as the company reassesses its finances. This
healthy. But even as stock prices stumbled, or fell dramati- was the case with Consumers Packaging Inc. The Toronto-
cally, many firms kept on predicting robust growth of their based glass manufacturer, whose stock has been suspended
pension investments to help boost their bottom line. from trading since December, recorded a $20-million tax
Take Toronto-based Imperial Oil Ltd., which in its asset in 1999, only to cancel it the next year.
most recent annual report noted that expected gains in its
pension plan were calculated at about 10%, allowing it to 7 Adding Water to the Wine
book a $259-million reduction in pension expense. At the Few accounting subjects are as controversial as the issue of
same time, however, the company reported that the actual how companies account for stock-based compensation.
gains on its pension plan were more along the lines of Most stock option plans are not considered an expense
$157 million. and do not need to be accounted for on the books at all.
Fiddling with the pension fund is a common account- But they can have a significant effect on the value of share-
ing trick. With all markets down substantially from the holders’ investments. A recent survey by Canadian Business
previous years, most mutual funds showing negative found company after company that would have seen
returns, and a growing number of baby boomers poised to reported earnings slashed by as much as 200% had they
start collecting their pensions, shareholders have to ask been forced to expense stock option plans.
themselves how long it will be before companies have to Shareholders must constantly monitor the use of
start dipping into revenue to top up those plans. shares to compensate management or to acquire rival
companies, or they run the risk of seeing their investment
5 Turning Expenses into Assets watered down as the profit pie gets cut into more and
You have to spend money to make money, right? Well, not smaller pieces. As OTPP head Lamoureux points out,
in the world of creative accounting. With a little sleight of between 1998 and 2001 Nortel reported 14% sales growth;
hand you can easily turn costs (which your peers are listing however, on a per-share basis, that translated into a decline
as expenses) into assets. Laval, Que.-based BioChem of 26% over the same period. JDS Uniphase reported a
Pharma Inc. (which merged with UK drug maker Shire staggering 586% increase in sales during that period.
Pharmaceuticals in May, 2001) used this audacious strategy However, if calculated on a per-share basis, it dwindles to a
in 1998 when it established CliniChem, a sister company, relatively small 81% increase over the same four years.
to handle all its research and development. By funnelling
BioChem’s R&D work through CliniChem, which then 8 Channel Stuffing
promptly hired BioChem to actually do the work, the Nothing will destroy a company’s ability to meet analysts’
company magically changed one of the most expensive earnings expectations more than having a warehouse full
costs for a biotech into revenue. (When Rosen publicly of unsold goods. Rather than come clean and tell share-
criticized the company in this magazine, he didn’t get holders they have not met sales expectations, some compa-
letters from shareholders thanking him for his analysis. nies are tempted to move their merchandise to the market
Rather, he got inquiries from other companies looking for knowing that much of it is going to come back unsold or
advice on how to set up similar schemes.) will have to be sold at a massive discount. Investors looking
for evidence of channel stuffing should look for large
6 Not All Earnings Are Created Equally changes to stated inventory levels, or an increase in the
From what source does a company derive its income? Are contingencies set aside for bad accounts.
earnings coming from core operations, or are they supple- The most powerful example of the practice was the
mented with a host of other sales from affiliated fall from grace of “Chainsaw” Al Dunlap, the former head
operations, tax credits, sale of assets or investing profits? of Sunbeam Corp., the US appliance maker. He allegedly
With the economy dragging and sales lagging, many moved millions of dollars in merchandise onto the backs
companies are likely to post a loss this year. As a result, of distributors and retailers using discounts and other
they will qualify for tax credits that can be manipulated to inducements. That, along with the use of cash reserves to
manage the bottom line. These credits can give a false pump up the company’s operating earnings, resulted in a
impression of how successful a company is in selling its record-breaking US$189 million in reported earnings in
goods or services. Such is the case for Toronto-based Imax fiscal 1997. But when the scheme was uncovered, Sunbeam
NEL
was forced to restate its earnings from the fourth quarter of Just ask investors in Toronto-based e-commerce
1996 to the first quarter of 1998; the US Securities and company Microforum Inc. On Sept. 21, 2000, the company
Exchange Commission (SEC) alleges that US$60 million of announced the resignation of its CFO to pursue “an entre-
that record-breaking profit was the result of accounting preneurial start-up opportunity.” One week later,
fraud. An SEC lawsuit against Dunlap, other Sunbeam Microforum announced an unexpected $3-million to $5-
executives and a former partner of Arthur Andersen, its million loss, and said that it was investigating allegations
auditor, is still ongoing. Dunlap and a group of former levied by its former CFO against CEO Howard Pearl. Pearl
Sunbeam executives recently settled a class action lawsuit, stepped down amid reports he used company funds to take
agreeing to pay more than US$15 million to shareholders. his family to Disney World and put his children’s nanny on
the company payroll. Microforum said it has investigated
9 Changing Horses the allegations and found no evidence of wrongdoing by
As the Canadian and US economies continue to grow Pearl. Microforum is now under bankruptcy protection,
closer, the stocks of many companies trade on both and investors are left with a stock worth less than 10¢ per
Canadian and US exchanges. These companies may make share, a far cry from the more than $14 it was trading at
their primary financial reporting in accordance with either two years ago.
Canadian or US accounting principles, which allows them
to shop around and see which set of standards provides the There are still many mini-Enrons waiting to be discovered,
rosiest picture. “If a company suddenly changes which says Woods. “A lot of the profits companies have been
accounting standards it is reporting under,” Rosen says, reporting recently are bull,” he says. An indication of this
“you had better look pretty closely at the books to see why.” can be seen when you compare the value of the S&P 500
Depending on the industry, or the transaction, a index to US corporate income tax. The two indicators
switch from Canadian GAAP to US GAAP can subtract usually move in tandem, but a few years ago they began to
millions from the bottom line. “Much of Canadian GAAP diverge, meaning that corporations were reporting higher
income is not income at all under US GAAP,” says Rosen. profits to shareholders than they were to the tax man.
The bottom line for shareholders: look well beyond
10 Words to Live or Die by the bottom line to fully understand the companies you are
There are certain words used by companies that are a investing in. “The footnotes to the financial statements are
major red flag for accounting sleuths. For instance, if you a treasure trove of information,” says Rosen. “Read the
find a “going concern” note in the company’s financial footnotes first. After seeing all the ways a company has
statements, pay close attention. This means the company bent, spindled and mutilated its earnings, you may have an
may discuss some fundamental assumptions that could entirely different outlook on the company.” Words to the
mean the difference between it staying in business or going wise.
out of business. Shareholders should also be concerned if
the company changes auditors in the middle of an audit or
announces the sudden resignation of its CEO or chief Canadian Business, April 1, 2002, pp. 28, 30–32.
financial officer to “pursue other interests.”
NEL
Case 10B
ANALYSIS OF A COMPANY’S FAILURE
The company’s share price fell dramatically
T
his case is about a company that went under
30 years ago. It’s an “oldie but goodie”: the between January 31, 1973, and January 31, 1974. In
insight it provides into using financial infor- 1974, the company lost its credit rating, and after
mation to spot trouble is still valuable! rescue attempts by 143 banks, the company was
W.T. Grant Company was a large U.S. retailer that declared bankrupt shortly after the end of its 1975
enjoyed considerable success but then went bankrupt fiscal year. Within another year, all the company’s
in the mid-1970s. The company had grown rapidly in assets had been liquidated and the company ceased
the ten years up to 1973, establishing over 600 new to exist.
stores in that period. A Canadian subsidiary was Summary financial statements, several ratios, and
Zellers, now owned by the Hudson’s Bay Company. It the Scott formula calculations for W.T. Grant over
8
made some strategy changes during this time; for the period 1970–75 are shown below. Use those to
example, moving “upscale” from low-priced soft identify some reasons for the company’s share price
goods to higher-priced goods in competition with crash in 1973–74 and its ultimate failure.
several department store chains. Its strategy was also
to lease store space rather than to buy the property.
W.T. GRANT COMPANY

Some Balance Sheet Items as of January 31 (in millions $)
1970 1971 1972 1973 1974 1975
Cash and marketable securities 33 34 50 31 46 80
Accounts receivable 368 420 477 543 599 431
Inventory 222 260 299 400 451 407
Total current assets 628 720 831 980 1103 925
Total assets 707 808 945 1111 1253 1082
Total current liabilities 367 459 476 633 690 750
Total liabilities 416 506 619 776 929 968
Equity 291 302 326 335 324 114
Some Income, Cash Flow, and Dividend Numbers (in millions $)

Year Ended January 31
1970 1971 1972 1973 1974 1975

Revenue 1220 1265 1384 1655 1861 1772
Cost of goods sold 818 843 931 1125 1283 1303
Income before interest and tax 85 92 76 85 60 (87)
Interest expense 15 19 16 21 51 199
Tax expense 28 33 26 26 1 (119)
Net income 42 40 35 38 8 (177)
Tax rate 0.40 0.45 0.43 0.41 0.11 0.40
Dividends declared 20 21 21 21 21 5
Cash flow from operations (3) (15) (27) (114) (93) (85)
Financing activities 25 33 76 121 138 140
Investment activities (14) (17) (32) (28) (29) (21)
NEL
W.T. GRANT COMPANY

Some Summary Numbers (Year Ended January 31)
1970 1971 1972 1973 1974 1975

Return on equity 0.144 0.132 0.107 0.113 0.025 1.553
Return on assets 0.072 0.062 0.047 0.045 0.042 0.057
Sales return 0.042 0.040 0.032 0.030 0.028 0.035
Total asset turnover 1.73 1.57 1.46 1.49 1.49 1.64
Cash flow to total assets 0.004 0.019 0.029 0.103 0.074 0.079
Average interest rate 0.022 0.038 0.026 0.027 0.055 0.205
Debt/equity ratio 1.43 1.68 1.90 2.32 2.87 8.49
Inventory turnover 3.68 3.24 3.21 2.81 2.84 3.20
Collection ratio 110.1 121.2 125.8 119.8 117.5 88.8
Working capital ratio 1.71 1.57 1.75 1.55 1.60 1.23
Acid test ratio 1.09 0.99 1.11 0.91 0.93 0.67
Gross margin 0.32 0.33 0.33 0.32 0.31 0.26
Interest coverage ratio 5.67 4.84 4.75 4.05 1.33 negative
Earnings per share in $ 2.94 2.67 2.50 2.71 0.57 negative
Dividends per share in $ 1.40 1.40 1.50 1.50 1.50 zero
January 31 closing share price in $ 47.0 47.1 47.8 43.9 10.9 1.1
Scott Formula Components*
ROE SR AT (ROA IN) (D/E)

1970 0.144 0.042 1.73 (0.072 0.022) 1.43
1971 0.132 0.040 1.57 (0.062 0.021) 1.68
1972 0.107 0.030 1.46 (0.047 0.015) 1.90
1973 0.113 0.030 1.49 (0.045 0.016) 2.32
1974 0.025 0.028 1.49 (0.042 0.049) 2.87
1975 1.553 0.035 1.64 (0.057 0.119) 8.49
*Because of rounding, the numbers don’t all satisfy the relationship precisely.
NOTES
1. Canadian Tire Corporation, 2004 annual report, 42, 6. Proof of the Scott formula (A = Assets, L = Liabilities,
43. E = Equity, and the “ATI” notation for ROA, SR, and
2. Wal-Mart Inc., 2004 annual report summary, IN is left out to avoid clutter):
www.walmartstores.com, summary p. 16. a. Define ROE = Net income / E
3. Canadian National Railway, 2004 annual report, b. Define ROA = (Net income + After-tax interest
Canadian GAAP version, 81–82. expense) / A
c. Define IN = After-tax interest expense / L
4. Ibid., 81–82.
d. By double-entry accounting, A = L + E
5. The booklet Reporting Cash Flows: A Guide to the Revised e. From (a), Net income = ROE × E
Statement of Changes in Financial Position (Toronto: f. From (b), Net income = (ROA × A) – After-tax
Deloitte, Haskins & Sells now Deloitte & Touche, interest expense
1986) was helpful in developing points about g. Equate right sides of (e) and (f):
interpreting cash flow information. ROE × E = (ROA × A) – After-tax interest expense
h. From (d) and (c):
ROE × E = (ROA × L + E) – (IN × L)
NEL
ROE × E = ROA × L + ROA × E – IN × L 7. The formula for the present value of a constant cash
ROE × E = ROA × E + (ROA – IN) × L payment comes from the sum of the following
i. Dividing the last through by E produces: geometric series:
ROE = ROA + (ROA – IN) × L / E
C C C C
j. Break up the first term to the right of the equal 1 + 2 + 3 + ... + n
sign into two terms by multiplying it by REV / (l + i) (l + i) (l + i) (l + i)
REV: See an algebra textbook for proof of how this series
ROA = (Net income + After-tax interest expense) sums to the formula given.
/A
8. For more information on this case and some interest-
ROA = (Net income + After-tax interest expense)
ing charts of various ratios’ performance over time,
/ REV × REV / A
see J.A. Largey, III, and C.P. Stickney, “Cash Flows,
k. Define the first new term as sales return SR and
Ratio Analysis and the W.T. Grant Company
the second as asset turnover AT
Bankruptcy,” Financial Analysts Journal (July–August
l. This produces the final version of the formula:
1980): 51–54.
ROE = SR × AT + (ROA – IN) × L / E
Putting in the ATI notation produces:
ROE = SR(ATI) × AT + (ROA(ATI) – IN(ATI)) ×
L/E
NEL

Chapter 10

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Chapter 10

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PART FOUR

C10 Financial Accounting Analysis Wrap-Up

10.1 Chapter Introduction: Analysis of Financial Accounting

10.2 Investment and Relative Return

Another Net-of-Tax Example, Using Interest Expense

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Financial Evaluation Is Not Just Calculation

Doing Intelligent Analysis

Financial Statements and Managers’ Performance

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10.4 Financial Statement Ratio Analysis

Commitments and contingencies (Note 22)

J.E. Newall, Director R. Phillips, Director

Statement of Consolidated Income

2004 2003 2002

Operating income, before the following: 788.5 729.6 844.0

Operating income 716.6 485.6 844.0

Net income $ 413.0 $ 401.3 $ 487.5

Basic earnings per share (Note 8) $ 2.60 $ 2.53 $ 3.08

Diluted earnings per share (Note 8) $ 2.60 $ 2.52 $ 3.06

See Notes to Consolidated Financial Statements.

Net cash is defined as:

See Notes to Consolidated Financial Statements.

Interest expense $ 223.9 $ 226.4 $ 254.2

Total interest expense $ 218.6 $ 218.7 $ 242.2

10. Change in noncash working capital balances related to operations

(Use) source of cash:

Change in noncash working capital $ 33.2 $ (53.6) $ –

2003 (Restated – see Note 2)

Exhibit 10.6 continues on the next page

We will use a slightly refined version of

The combination of revenue growth of 7.2% (($3,728.8 – $3,479.3)/$3,479.3)

CPR Common Size Income Statements

2004 2003 2002

If the ratio is calculated on an after-tax basis and applied to all liabilities, it is

10•7 2004 2003 2002

Dividends declared ($ millions) $ 82.5 $ 80.8 $ 80.8

Weighted average number of 158.7 158.5 158.5

Basic EPS $ 2.60 $ 2.53 $ 3.08

Activity (Turnover) Ratios

Liquidity and Solvency Warning Ratios

Concluding Comments About the Twenty Ratios

Ratio 2004 2003

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10.5 Interpretation of Cash Flow Information

10•9 Increase Decrease

operations were offset by increased borrowings, as seen in the cash provided by

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10.6 Integrative Ratio Analysis

Overall Conclusions From the CPR Analysis in

ROE = ROA + Leverage

ROE = ROA(ATI) + Leverage

Expanded Leverage Analysis: The Scott Formula

Leverage = (ROA(ATI) – IN(ATI)) × L/E

Leverage = Leverage potential × Extent of borrowing

ROE = ROA(ATI) + (ROA(ATI) – IN(ATI)) × L/E

ROE = ROA(ATI) + (ROA(ATI) – IN(ATI)) × L/E

Scott Formula for CPR

Summary Comments on Integrative and Leverage

• A 14.9% return on sales (adding back after-tax interest) 16.6%

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10.7 Future Cash Flows: Present Value Analysis

Interest and the Time Value of Money