Question

Balance Sheet Ratios for 2004 and 2005

1. Look closely at the Consolidated Condensed Statement of Cash Flows from 2005 and comment on what Financing Activity occurred to cause the negative Book Equity.
2. Is the Book Debt to Equity Ratio meaningful in 2005?
3. Would the Market to Book Ratio be meaningful in 2005?
4.   Does the Negative Book Equity mean the company is worthless to its shareholders in 2005? Explain your answer.

Yours ended June 30 (dollars in milions, except per share amounts) 2005 2004 2003 $ Net sales Cost of products sold 4,388 2.493 4,162 2,331 3.986 2.171 1,895 1,831 543 1,815 523 Gross profit Soling and administrative exponses Advertising costs Research and development costs Restructuring and asset impairment costs Interest expense Other (incomo) cxponse: Equity carnings and gain on exchange of Honkal borica, S.A. Other, net Earnings from continuing operations before income taxes Income taxes on continuing operations Reversal of deferred taxes from equity investment in Henkel Iberica, S.A Earnings from continuing operations Discontinued operations: Gain on exchange Earnings from exchanged businesses Reversal of deferred taxes from exchanged businesses Losses from Brazil operations Income tax expense on discontinued operations Earnings from discontinued operations 579 Not carnings $ 1,096 $ 549 $ 493 Earnings per common share Basic Continuing operations Discontinued operations Basic not carnings por common sharo $ 2.31 $ 2.92 3.28 6.20 028 2.11 0.15 226 2.50 $ $ $ Diluted Continuing operations Discontinued operations Diluted not carnings por common sharo 2.88 3.23 6.11 2.28 0.28 2.56 2.08 0.15 223 $ $ $ Weighted average common shares outstanding (in thousands) Basic Diluted 176,586 179,176 211,683 214,371 218,174 220,692

Answer 1

Ans (a). The financing activity causing negative Book Equity are: (i) Increase in long-term debts   (ii) Reduction in other assets (iii) Increase in interest expenses    (iv) Purchasing Treasury Shares

Ans (b). The book debt to equity of 2005 is not adequate. A company must have a debt-equity ratio of 2:1. However, in the given scenario the equity itself is negative thereby causing the entire ratio to be absurd.

Ans (c). Even the market to book ratio can give absurd results. However, in the given scenario the market value of equity can be arrived at by getting market info and book value can be arrived at by taking into consideration the assets and liabilities of the company. Therefore, it can give meaningful information.

Ans (d). Negative shareholder's equity can be caused due to many exceptional circumstances. The same does not always mean that the company is worthless to the shareholders.