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CHAPTER 13

Financial Statement Analysis

OVERVIEW OF EXERCISES, PROBLEMS, AND CASESEstimated

Time inLearning Objective Exercises Minutes Level

1. Explain the various limitations and considerations in financial statement analysis.

2. Use comparative financial statements to analyze a company 12* 45 Modover time (horizontal analysis). 13* 30 Mod

3. Use common-size financial statements to compare various 12* 45 Modfinancial statement items (vertical analysis). 13* 30 Mod

4. Compute and use various ratios to assess liquidity. 1 15 Mod2 15 Mod3 30 Mod4 20 Mod5 30 Mod

5. Compute and use various ratios to assess solvency. 6 20 Mod7 20 Mod

6. Compute and use various ratios to assess profitability. 8 20 Mod9 20 Mod

10 15 Mod11 10 Mod

7. Explain how to report on and analyze other income statement items (Appendix)

*Exercise, problem, or case covers two or more learning objectivesLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

13-2 FINANCIAL ACCOUNTING SOLUTIONS MANUAL

Problems Estimatedand Time in

Learning Objective Alternates Minutes Level


2. Use comparative financial statements to analyze a company over time (horizontal analysis).

3. Use common-size financial statements to compare various financial statement items (vertical analysis).

4. Compute and use various ratios to assess liquidity. 1 40 Mod2 40 Mod5* 30 Mod7* 40 Mod

5. Compute and use various ratios to assess solvency. 1# 30 Mod2# 30 Mod5* 30 Mod6* 40 Diff7* 40 Mod

6. Compute and use various ratios to assess profitability. 3 20 Mod4 60 Diff5* 30 Mod6* 40 Diff7* 40 Mod

7. Explain how to report on and analyze other income statement items (Appendix).

*Exercise, problem, or case covers two or more learning objectives#Alternate problem onlyLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)

CHAPTER 13 FINANCIAL STATEMENT ANALYSIS 13-3

EstimatedTime in

Learning Objective Cases Minutes Level


2. Use comparative financial statements to analyze a company over 1 45 Modtime (horizontal analysis).

3. Use common-size financial statements to compare various 2 45 Mod financial statement items (vertical analysis). 3 45 Mod

6 45 Mod

4. Compute and use various ratios to assess liquidity. 4* 45 Mod5* 45 Mod7* 45 Diff8 30 Med

5. Compute and use various ratios to assess solvency. 4* 45 Mod5* 45 Mod7* 45 Diff

6. Compute and use various ratios to assess profitability. 4* 45 Mod5* 45 Mod

7. Explain how to report on and analyze other income statement items (Appendix)

*Exercise, problem, or case covers two or more learning objectivesLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)


Q U E S T I O N S

1. The inventory valuation method used by a company will have a significant effect on many ratios. Depending on the relative movement of prices, the choice between LIFO and FIFO will result in significantly different amounts reported for inventory. For example, in a period of rising prices, the use of LIFO will reduce inventory (relative to what it would have been under FIFO) and thus reduce the current ratio and the acid-test ratio. The inventory turnover ratio will differ as well, because LIFO will result in more cost of goods sold expense. Thus, all other things being equal, in a period of rising prices, a LIFO company will report a higher turnover of inventory than a FIFO company. The LIFO company’s cash flow will be better because it will pay less in taxes. Thus, the various ratios that involve cash from operations will be affected. Finally, the profitability ratios will be affected by the choice of an inventory method. For example, the LIFO company will report lower profits and thus have a lower profit margin.

2. One of the difficulties in comparing a company’s ratios with industry standards is that the standards are an average for all companies surveyed. First, your company may be much larger or smaller than the average company in the survey. Second, many large companies today are conglomerates, and their operations cross over the traditional boundaries of any one industry. This makes comparison with industry standards difficult. Finally, your company may use different accounting methods than most others in the survey. If your company uses straight-line depreciation but a majority of the sample companies use accelerated depreciation, comparisons can be difficult.

3. Published financial statements, as well as those often used by management, are based on historical costs and have not been adjusted for inflation. Trend analysis is one type of analysis that must be performed with particular caution if inflation is significant. An increase in sales, for example, may be due to an increase in prices, rather than to an increase in the number of units sold. Inflation affects the various financial statements differently. Some period expenses, such as advertising, are usually not seriously misstated in historical cost terms. However, depreciation based on costs paid for assets that are fifty years old will be much different from depreciation adjusted for the effects of inflation.

4. The analysis of financial statements over a series of years is called horizontal analysis. For example, by looking for trends in certain costs over a series of years (thus the name trend analysis), the analyst is able to more accurately predict future costs. Common-size financial statements are statements in which all amounts are stated as a percentage of one selected item on the statement, such as net sales. Thus, vertical analysis of a single year’s income statement will help the analyst discern the relative amounts incurred for various costs.


5. Rising costs to either manufacture or purchase inventory could be responsible for a decline in gross profit in the face of an increase in sales. Assume that 1,000 units of a product are sold with a unit cost of $80 and a selling price of $100. Sales total $100,000, and gross profit is $20,000. Assume that in the following year, the company raises the selling price to $115 because of rising costs. If the cost to make a unit goes up to $96 and the company sells another 1,000 units, sales will increase by 15% to $115,000, but gross profit will decrease to 1,000 X ($115 – $96), or $19,000—a decrease in gross profit of 5%.

6. The composition of current assets indicates the relative size of cash, accounts receivable, inventory, and other short-term assets. A relatively large balance in inventory may indicate that a company is not turning over its products quickly enough. Similarly, a large accounts receivable balance could signal a problem in the collection department. Finally, a large cash balance may be a sign that the company is not taking advantage of short-term investment opportunities.

7. Ratios can be categorized according to their use in performing three types of analysis: (1) liquidity analysis, (2) solvency analysis, and (3) profitability analysis.

8. The first stage in the operating cycle for a manufacturer is the purchase of raw material and its transformation into a final product. The second step is the sale of the product, and the third is the collection of any receivable from credit granted to the customer. The operating cycle differs for a retailer in that a finished product is purchased from a wholesaler and there is not the time involved in production.

9. Current assets are reported on a balance sheet in the order of their nearness to cash, or liquidity. Cash is obviously presented first, followed by short-term investments. Accounts receivable, one step removed from cash, are shown next, and then inventory. Because prepaid assets, such as supplies or insurance paid for in advance, will not be converted into cash, they are normally reported last in the current asset section of the balance sheet.

10. A relatively low acid-test or quick ratio compared with the current ratio probably indicates a large inventory balance. Large amounts of inventory may be normal for a company, but on the other hand they could signal problems in moving obsolete items. The inventory turnover ratio for the most recent period should be compared with those of prior periods to determine whether there has been a decrease in the number of turns per year. A less likely explanation for a low quick ratio compared with the current ratio would be large balances in various prepayments, such as supplies and insurance.


11. All turnover ratios are a measure of the activity for a period compared with the investment necessary to carry on that activity. For example, the inventory turnover ratio measures the relationship between inventory sold, on a cost basis, and the average amount of inventory on hand during that time period. The base is the average inventory because it is divided into an activity measure for the entire period—that is, cost of goods sold.

12. An accounts receivable turnover of nine times translates to an average number of days in receivables of 40 (360/9). If the credit department extends terms of 2/10, net 30, investigation of the company’s actual credit policies is warranted. For example, the department may routinely give customers up to 40 or 50 days to pay. If this policy does not create any cash flow problems, why have terms of 2/10, net 30? Alternatively, the average time to collect may be an indication that the credit department is extending credit to customers who are not good credit risks.

13. One possible explanation for a decrease in inventory turnover is slow-moving items. Caution must be used, however, because a low inventory turnover may simply be a seasonal phenomenon. For example, the ratio for the third quarter of the year should be compared with that of the third quarter of the prior year. Problems in the sales department may also partially explain a low turnover of inventory. Or, the company may be pricing itself out of the market and need to consider lowering its prices to meet the competition.

14. A manufacturer’s operating cycle runs from the purchase of raw materials, to the transformation of the materials into a final product, to sale, to the collection of any receivable. This differs from the operating cycle of a service business because the latter does not technically sell a product. Service businesses must look for alternative measures of efficiency. For example, an airline would be interested in the average amount of time elapsed between the sale of a ticket and collection from the passenger. A public accounting firm might want to know the average length of time that passes after an audit is finished before the client pays the bill.

15. Liquidity analysis is concerned with the ability of the company to pay its debts as they are due and thus focuses on the current assets and liabilities. Solvency is the ability to stay in business over the long run. The debt-to-equity ratio and the debt service coverage ratio are two measures of the firm’s solvency.

16. The debt service coverage ratio is superior to the times interest earned ratio as a measure of solvency for two reasons. First, the ratio considers the need to pay both interest and principal, whereas the times interest earned ratio deals only with interest. Second, the necessary payments to service debt are compared with the cash available to pay the debt, while the times interest earned ratio uses an accrual income number in its numerator.


17. Both are right. Many different ratios are used to assess the relative mix of a company’s capital structure. The debt-to-equity ratio measures the amount of outstanding debt relative to the amount of stockholders’ equity. An alternative measure is to divide the same debt by the total assets of the company. A different ratio will obviously result, but as long as the same measure is used consistently, either ratio is an indicator of solvency.

18. The debt service coverage ratio measures the amount of cash generated from operating activities that is available to repay the interest and any maturing debt. A loan officer is primarily concerned with the company’s ability to meet interest and principal payments on time and, therefore, would be very interested in this ratio.

19. Dividends are not a legal obligation, but they often become an expectation on the part of stockholders. Therefore, when computing the cash available to make capital acquisitions, it is helpful to take into account the normal dividend requirements.

20. The numerator in any rate of return ratio must match the investment or base in the denominator. If total assets is the base, the numerator must be a measure of the income available to all providers of capital. Interest expense, net of tax, is added back to net income because the creditors are one of the sources of capital, and we want to consider the income available before any of the sources of funds are given a distribution. Interest must be on a net or after-tax basis to be consistent with net income, which is on an after-tax basis.

21. A return on stockholders’ equity that is lower than the return on assets means that the company is not successfully using borrowed funds. Return on assets measures the return to all providers of capital, whereas return on equity is concerned only with common stockholders. The company has not been able to earn an overall return that is as high as what is being paid to creditors and preferred stockholders. Leverage deals with the use of someone else’s money to earn a favorable return. Presently, this company is not successfully employing financial leverage.

22. The price/earnings ratio is sometimes used as an indicator of the quality of a company’s earnings because it combines a measure of the company’s performance, based on its earnings, and the company’s worth as measured by the market price of its stock. The ratio of price to earnings is an indication of the market’s assessment of the company’s performance. For example, the use of different accounting methods can cause the market to value the price of one company’s stock higher than another company’s stock, even though they report similar earnings. This could be the case if one defers taxes by using LIFO whereas the other uses FIFO. This differing treatment of the two stocks is a statement by the market about the “quality” of the two company’s earnings.


23. Most of the liquidity ratios are primarily suited to use by management. For example, the investor would not normally place major emphasis on the turnover of either inventory or receivables. On the other hand, turnover ratios must be constantly monitored by management. The stockholder will be very interested in both the dividend payout ratio and the dividend yield. A banker would rely partially on a company’s debt service coverage in the past as an indication of its ability to repay a potential loan in the future.

24. The inventory turnover ratio is meaningless to a service business such as a law firm or a public accounting firm. These firms do not sell a tangible product; instead, they sell their professional expertise and thus must rely on alternative measures of their efficiency in marketing their services. An accounting firm, for example, might keep detailed records on the number of clients served, the average annual billings to each client, and the ratio of these billings to the average costs incurred on each audit.

25. Separate reporting of discontinued operations, extraordinary items and the cumulative effect of a change in accounting principle assists the reader of the statements in making predictions about the future profitability of the business. For example, users of the income statement may want to ignore these items when assessing the future prospects for the company because these items by their nature are not likely to reoccur in the future.

E X E R C I S E S

LO 4 EXERCISE 13-1 ACCOUNTS RECEIVABLE ANALYSIS

1. Accounts receivable turnover:

Net credit sales/Average accounts receivable:2004: $600,000/[($150,000 + $100,000)/2] = $600,000/$125,000 = 4.8 times2003: $540,000/[($100,000 + $80,000)/2] = $540,000/$90,000 = 6 times

2. Number of days sales in receivables:2004: 360/4.8 = 75 days2003: 360/6 = 60 days

3. The average age of a receivable in 2003 was the same number of days as the maximum credit period of 60 days. The average age in 2004 of 75 days, however, is significantly in excess of the credit period. The company needs to investigate this increase and decide whether efforts are needed to speed up the collection process. The company may decide that allowing customers more liberal payment terms has had a positive effect on sales, as evidenced by the increase in sales, and not want to press its customers for earlier payment. Conversely, the company may find that allowing an extra 15 days for payment causes cash flow problems.


LO 4 EXERCISE 13-2 INVENTORY ANALYSIS

1. Inventory turnover:

Cost of goods sold/Average inventory:2004: $7,100,000/[($200,000 + $150,000)/2] = $7,100,000/$175,000

= 40.57 times2003: $8,100,000/[($150,000 + $120,000)/2] = $8,100,000/$135,000

= 60 times

2. Number of days sales in inventory:2004: 360/40.57 = 8.9 days2003: 360/60 = 6 days

3. Inventory turnover has declined dramatically from the prior year. Many different explanations are possible for this decline, such as problems in the sales effort, over-pricing of the products relative to the competition, or inferior produce. Management needs to investigate the problem and decide who should be held responsible for the slow movement. The company may find that no one department or individual is totally responsible and that many different parts of the business need to work together to improve the turnover of inventory.

LO 4 EXERCISE 13-3 ACCOUNTS RECEIVABLE AND INVENTORY ANALYSES FOR COCA-COLA AND PEPSI

1. Calculations (all dollar amounts in millions):

a. Accounts Receivable Turnover Ratio:Coca-Cola Company$19,564/[($2,097 + $1,882)/2] = $19,564/$1,989.5 = 9.83 times

PepsiCo, Inc.$25,112/[($2,531 + $2,142)/2] = $25,112/$2,336.5 = 10.75 times

b. Days Sales in Receivables:Coca-Cola Company360/9.83 = 36.6 days

PepsiCo, Inc.360/10.75 = 33.5 days

c. Inventory Turnover Ratio:Coca-Cola Company$7,105/[($1,294 + $1,055)/2] = $7,105/$1,174.5 = 6.0 times

PepsiCo, Inc.$11,497/[($1,342 + $1,310/2] = $11,497/$1,326 = 8.7 times


d. Days’ Sales in Inventory:Coca-Cola Company360/6.0 = 60 days

PepsiCo, Inc.360/8.7 = 41.4 days

e. Cash to Cash Operating Cycle:Coca-Cola Company36.6 + 60 = 96.6 days

PepsiCo, Inc.33.5 + 41.4 = 74.9 days

2. PepsiCo, Inc. has a higher accounts receivable turnover ratio and, accordingly, a lower number of days’ sales in receivables than Coca-Cola. PepsiCo, Inc. also a higher inventory turnover ratio and, accordingly, a lower number of days’ sales in inventory. PepsiCo, Inc. also has a lower cash to cash operating cycle.

LO 4 EXERCISE 13-4 LIQUIDITY ANALYSES FOR COCA-COLA AND PEPSICO

1. Calculations (all dollar amounts in millions):

Coca Cola Company PepsiCo, Inc.a. Current ratio $7,352/$7,341 = 1.00 to 1 $6,413/$6,052 = 1.06 to 1

b. Quick assets $2,126 + $219 + $2,097 $1,638 + 207 + $2,531 = $4,442 $4,376

Acid-test or $4,442/$7,341 = .61 to 1 $4,376/$6,052 = .72 to 1Quick ratio

2. PepsiCo’s current and acid-test (or quick) ratios are higher than Coca Cola’s. Based on these measures, PepsiCo appears to be more liquid than Coca Cola.

3. Other ratios that can be used to more fully assess the liquidity of these two companies are these: cash flow from operations to current liabilities ratio, accounts receivable turnover ratio, number of days’ sales in receivables, inventory turnover ratio, number of days’ sales in inventory, and cash to cash operating cycle.


LO 4 EXERCISE 13-5 LIQUIDITY ANALYSES FOR MCDONALD’S AND WENDY’S

1. Calculations:

McDonald’s Wendy’s (In millions) (In thousands)

a. Working capital $1,715.4 – $2,422.3 $330,819 – $360,075= $(706.9) = $(29,256)

b. Current ratio $1,715.4/$2,422.3 $330,819/$360,075= .71 =.92

c. Quick assets $330.4+$855.3 $171,944+$86,416+11,204 = $1,185.7 = $ 269,564

Acid-test or $1,185.7/$2,422.3 $269,564/$360,075Quick ratio = .49 = .75

2. Both McDonald’s and Wendy’s have negative working capital. Wendy’s current and acid-test (or quick) ratios are both higher than McDonald’s. Based on these measures, Wendy’s appears to be somewhat more liquid than McDonald’s.

3. Calculations of cash flow from operations to current liabilities ratios:

McDonald’s (in millions)$2,890.1/[($2,422.3 + $2,248.3)/2] = $2,890.1/$2,335.3 = 123.8%

Wendy’s (in thousands)$444,256/[($360,075 + $296,687)/2] = $444,256/$328,381 = 135.3%

This ratio overcomes the two limitations of the current and the quick ratios, because it focuses on cash and cash flows. McDonald’s cash flow from operations to current liabilities ratio is slightly lower than Wendy’s. Together with the current and quick ratios, Wendy’s appears to be more liquid overall than is McDonald’s.

4. McDonald’s has negative working capital but a strong cash flow from operations to current liabilities ratio. As such, McDonald’s might be able to cover its short-term cash requirements through short-term borrowings.


LO 5 EXERCISE 13-6 SOLVENCY ANALYSES FOR TOMMY HILFIGER

1. 2003 2002a. Debt-to-equity $984,776/$1,043,375 $1,096,989/1,497,462

ratio = .94 to 1 = .73 to 1

b. Times interest [($513,605)+ $46,976 + ($134,545+ $41,177 +earned $14,144]/$46,976 = $20,069)/$41,177 =

($452,485)/$46,976 $195,791/$41,177= (9.6) to 1 = 4.8 to 1

c. Debt service ($230,105 + $46,976 + ($353,100 + $41,177 + coverage $14,144)/($46,976 + $20,069)/($41,177+ ratio* $74,234) = $291,225/ $155,538)= $414,346/

$121,210 = 2.4 times $196,715 = 2.1 times

*The amounts for interest and taxes represent interest expense and income tax expense rather than the amounts paid.

d. Cash flow from ($230,105 – $0)/$71,903operations to ($353,100–0)/$96,923to capital = 320.0% = 364.3%capital expen-ditures ratio

2. The company’s debt to equity ratio increased during 2003, due in large part to the significantly lower stockholders’ equity, the result of the net loss recorded for the year. The net loss results in a times interest earned ratio that is a negative number for 2003. Interestingly, the company continued to generate positive cash flow from operating activities, and even though the ratio of this number to capital expenditures decreased slightly, the debt service coverage ratio actually increased in 2003.

LO 5 EXERCISE 13-7 SOLVENCY ANALYSIS

1. a. Debt-to-equity ratio: Total liabilities/Total stockholders’ equity

At 12/31/04: ($350,000 + $600,000)/$1,650,000= $950,000/$1,650,000 = .58 to 1

At 12/31/03: ($405,000 + $800,000)/$1,500,000= $1,205,000/$1,500,000 = .80 to 1

b. Times interest earned for 2004 (Net income + Interest expense +Income tax expense)/Interest expense:

($150,000 + $89,000 + $111,000)/$89,000 = $350,000/$89,000 = 3.93 to 1


c. Debt service coverage for 2004 (Cash flows from operations before interest and tax payments)/Interest and principal payments:

($185,000 + $89,000+ $96,000*)/($89,000 + $275,000**) = $370,000/$364,000 = 1.02 times

*Taxes payable, 12/31/03 $ 45,000Add: Tax expense 111,000Less: Taxes payable 12/31/04 65,000 Taxes paid during 2004 $ 96,000

**Principal payments:a. Short-term notes payable $ 75,000b. Serial bonds 200,000

Total $ 275,000

2. The company’s debt-to-equity ratio has decreased because of the repayment of the short-term notes and the installment payment on the serial bonds. The ratio at the end of 2004 of almost .6 to 1 indicates a relatively conservative balance of debt to stockholders’ equity. The times interest earned ratio indicates that Impact’s profits before interest and taxes were almost four times the amount of interest expense.

Two problems arise, however, in using the times interest earned ratio as the sole measure of solvency. First, it considers the payment of only interest, not principal. Second, principal and interest payments must be made with cash, not profits. The debt service coverage ratio is a much better indication of the company’s ability to meet its obligations. A ratio of 1.02 times indicates that Impact generated just enough cash from operations to meet its principal and interest payments in 2004.

LO 6 EXERCISE 13-8 RETURN RATIOS AND LEVERAGE

1. Ratios:

a. Return on sales = (Net income + Interest expense, net of tax)/Net sales[($60,000 + ($50,000 X 60%)]/$650,000 = $90,000/$650,000 = 13.85%

b. Asset turnover = Net sales/Average total assets$650,000/[($1,600,000 + $2,000,000*)/2]= $650,000/$1,800,000 = .36 times

*Total assets at end of year are the same as total liabilities and stockholders’ equity (given).

c. Return on assets = (Net income + Interest expense, net of tax)/Average total assets

$90,000 (from Part a.)/$1,800,000 (from Part b.) = 5%


d. Return on common stockholders’ equity = (Net income – Preferred dividends)/Average common stockholders’ equity

($60,000 – $25,000*)/[($950,000 + $915,000**)/2]= $35,000/$932,500 = 3.75%

*Preferred dividends: $250,000 par value X 10%**Stockholders’ equity at beginning of year:

Common stock $ 600,000Retained earnings $350,000 at end of

year less $60,000 net income plus $25,000 dividends 315,000

Stockholders’ equity at beginning of year $ 915,000

2. Evergreen has not been successful in using outside funds because the return on stockholders’ equity of 3.75% is less than the return to all providers of capital, as measured by the return on assets of 5%.

Evidence that Evergreen has not successfully employed leverage is found by looking closer at the cost of outside funds. The average cost of borrowed funds is $50,000 in interest expense divided by $650,000 in short-term loans payable and long-term bonds. This cost of 7.7% times 1 minus the tax rate, or 60%, translates to an after-tax borrowing rate of 4.62%. The return paid to the preferred stockholders is 10%. Both of these rates exceed the return to the common stockholder of 3.75% and indicate that Evergreen is not successfully employing leverage.

LO 6 EXERCISE 13-9 RELATIONSHIPS AMONG RETURN ON ASSETS, RETURN ON SALES, AND ASSET TURNOVER

Case 1. Return on assets = Net income (assuming no interest expense)/Average total assets = $10,000/$60,000 = 16.67%.

Case 2. Return on sales = Net income/Net sales2% = $25,000/XNet sales = $1,250,000

Case 3. Return on assets = Return on sales X Asset turnover X = 6% X 1.5 Return on assets = 9%

Case 4. Asset turnover = Net sales/Average total assets.1.25 = $50,000/XAverage total assets = $40,000

Return on assets = Net income (assuming no interest expense)/Average total assets

10% = X/$40,000Net income = $4,000


Case 5. Return on assets = Net income (assuming no interest expense)/Average total assets

15% = $20,000/XAverage total assets = $133,333

LO 6 EXERCISE 13-10 EPS, P/E RATIO, AND DIVIDEND RATIOS

1. Ratios:a. Earnings per common share = (Net income less preferred

dividends)/Number of common shares outstanding:[$1,300,000 – 8%($5,000,000)]/400,000 shares= ($1,300,000 – $400,000)/400,000 = $900,000/400,000 = $2.25 per share

b. Price earnings ratio = Current market price/EPS= $24.75/$2.25 = 11 to 1

c. Dividend payout ratio = Common dividends per share/EPS= ($.40 X 4 quarters)/$2.25= $1.60/$2.25 = 71.11%

d. Dividend yield ratio = Common dividends per share/Market price= $1.60 (from Part c.)/$24.75 = 6.46%

2. An investment advisor needs to be aware of industry trends, the general economic environment, the historical performance of the company, the investor’s attitudes about risk, and any other relevant data needed to make an informed decision.

LO 6 EXERCISE 13-11 EARNINGS PER SHARE AND EXTRAORDINARY ITEMS (APPENDIX)

1. Earnings per share before extraordinary items = (Net income before extraordinary loss less preferred dividends)/Number of common shares outstanding:

[$5,850,000 – (9%)($2,000,000)]/1,500,000 shares= ($5,850,000 – $180,000)/1,500,000 shares= $5,670,000/1,500,000 shares = $3.78 per share

2. Earnings per share (after the extraordinary loss) = (Net income – preferred dividends)/Number of common shares outstanding:

($2,130,000 – $180,000)/1,500,000 shares = $1,950,000/1,500,000 = $1.30 per share

3. Management is accountable for the overall operation of the company and thus, to some extent, must be evaluated on the basis of the “bottom line” as measured by the earnings per share after the extraordinary loss from the flood. In attempting to forecast future profits, however, both management and a potential stockholder would be much more concerned with EPS


exclusive of any extraordinary items, because these gains and losses are unusual in nature and infrequently occurring.

MULTI-CONCEPT EXERCISES

LO 2,3 EXERCISE 13-12 COMMON-SIZE BALANCE SHEETS AND HORIZONTAL ANALYSIS

1. FARINET COMPANYCOMMON-SIZE COMPARATIVE BALANCE SHEETS

DECEMBER 31, 2004 AND 2003

12/31/04 12/31/03Dollars Percent Dollars Percent

Cash $ 16,000 1.7%* $ 20,000 2.5%*Accounts receivable 40,000 4.3 30,000 3.8Inventory 30,000 3.3 50,000 6.2Prepaid rent 18,000 2 .0 12,000 1 .5

Total current assets $ 104,000 11 .3 % $ 112,000 14 .0 %Land$ 150,000 16.2% 150,000 18.7%Plant and equipment 800,000 86.6 600,000 74.8Accumulated

depreciation (130,000 ) (14 .1 ) (60,000 ) (7 .5 )Total long-term

assets $ 820,000 88 .7 $ 690,000 86 .0 Total assets $ 924,000 100 .0 % $ 802,000 100 .0 %

Accounts payable $ 24,000 2.6% $ 20,000 2.5%Income taxes payable 6,000 .6 10,000 1.3Short-term notes

payable 70,000 7 .6 50,000 6 .2 Total current

liabilities $ 100,000 10 .8 % $ 80,000 10 .0 %Bonds payable $ 150,000 16 .2 % $ 200,000 24 .9 %Common stock $ 400,000 43.3% $ 300,000 37.4%Retained earnings 274,000 29 .7 222,000 27 .7

Total stockholders’equity $ 674,000 73 .0 %* $ 522,000 65 .1 %

Total liabilities andstockholders’ equity $ 924,000 100 .0 % $ 802,000 100 .0 %

*Rounded to total.

2. Observations from Farinet’s common-size balance sheets:


a. Current assets as a percentage of total assets has decreased. At the same time, current liabilities has accounted for about the same percentage of total equities in the two years.

b. The relative mix of current assets has changed from one year to the next. Cash now accounts for a smaller share of total assets, as does inventory, whereas accounts receivable accounts for a slightly higher percentage of total assets.

c. Major investments in plant and equipment have been made in 2004. At the end of 2003, plant and equipment accounted for three-fourths of the total assets, and now it accounts for over 86% of the total.

d. Bonds payable now make up a smaller share of the capital structure with the retirement of $50,000 during 2004.

e. Short-term borrowings increased and now represent a larger share of the current liabilities (from $50,000/$80,000, or 62.5%, to $70,000/$100,000, or 70%).


3. FARINET COMPANYCOMPARATIVE BALANCE SHEETS

DECEMBER 31, 2004 AND 2003

December 31 Increase (Decrease)2004 2003 Dollars Percent

Cash $ 16,000 $ 20,000 $ (4,000) (20)%Accounts receivable 40,000 30,000 10,000 33Inventory 30,000 50,000 (20,000) (40)Prepaid rent 18,000 12,000 6,000 50

Total current assets $ 104,000 $ 112,000 $ (8,000 ) (7 )%Land $ 150,000 $ 150,000 $ 0 0%Plant and equipment 800,000 600,000 200,000 33Accumulated

depreciation (130,000 ) (60,000 ) (70,000 ) (117)Total long-term

assets $ 820,000 $ 690,000 $ 130,000 19 %Total assets $ 924,000 $ 802,000 $ 122,000 15 %

Accounts payable $ 24,000 $ 20,000 $ 4,000 20%Income tax payable 6,000 10,000 (4,000) (40)Short-term notes

payable 70,000 50,000 20,000 40 Total current

liabilities $ 100,000 $ 80,000 $ 20,000 25 %Bonds payable $ 150,000 $ 200,000 $ (50,000 ) (25 )%Common stock $ 400,000 $ 300,000 $ 100,000 33%Retained earnings 274,000 222,000 52,000 23

Total stockholders’ equity $ 674,000 $ 522,000 $ 152,000 29 %

Total liabilities and stockholders’ equity $ 924,000 $ 802,000 $ 122,000 15 %


4. Largest changes Refer toa. Accumulated depreciation Fixed asset records, showing

additions to plant and equipment and depreciation calculations

b. Prepaid rent Rental agreementsc. Inventory Purchase orders, sales recordsd. Income tax payable Income tax return and

supporting recordse. Short-term notes payable Loan agreements

LO 2,3 EXERCISE 13-13 COMMON-SIZE INCOME STATEMENTS AND HORIZONTAL ANALYSIS

1. MARINERS CORP.COMMON-SIZE COMPARATIVE INCOME STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003(IN THOUSANDS OF DOLLARS)

2004 2003Dollars Percent Dollars Percent

Sales revenue $ 60,000 100.0% $50,000 100.0%Cost of goods sold 42,000 70 .0 30,000 60 .0

Gross profit $ 18,000 30.0% 20,000 40.0%Selling and adminis-

trative expense 9,000 15 .0 5,000 10 .0 Operating income $ 9,000 15.0% $15,000 30.0%

Interest expense 2,000 3 .3 2,000 4 .0 Income before tax $ 7,000 11.7% $13,000 26.0%

Income tax expense 2,000 3 .3 4,000 8 .0 Net income $ 5,000 8 .4 %* $ 9,000 18.0%

*Rounded to total.

2. Observations from Mariners’ common-size statements:

a. Although sales increased in absolute dollars, the gross profit percentage has decreased significantly because of a higher ratio of cost of goods sold to sales: from 60% to 70%.

b. Selling and administrative expenses have increased both in absolute dollars and as a percentage of sales. An increase from 10% to 15% of sales is a drastic increase in the importance of this cost relative to sales.

c. Interest expense remained the same in absolute dollars, but because sales increased, it decreased slightly from 4% to 3.3% of sales.

d. The bottom line net income decreased both in absolute dollars and as a percentage of sales. The solid increase in sales is more than offset by the large increases in both product costs and selling and administrative expenses.


3. MARINERS CORP.COMPARATIVE STATEMENTS OF INCOME

FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003

December 31 Increase (Decrease)2004 2003 Dollars Percent

Sales revenue $60,000 $ 50,000 $10,000 20%Cost of goods sold 42,000 30,000 12,000 40

Gross profit $18,000 $ 20,000 $ (2,000) (10)%Selling and adminis-

trative expense 9,000 5,000 $ 4,000 80 Operating income $ 9,000 $ 15,000 $ (6,000) (40)%

Interest expense 2,000 2,000 0 0 Income before tax $ 7,000 $ 13,000 $ (6,000) (46)%

Income tax expense 2,000 4,000 (2,000 ) (50 ) Net income $ 5,000 $ 9,000 $ (4,000 ) (44)%

4. Largest changes Refer toSelling and administrative Individual records, for the

expenses various expensesIncome tax expense Income tax return and supporting

records

P R O B L E M S

LO 4 PROBLEM 13-1 EFFECT OF TRANSACTIONS ON WORKING CAPITAL, CURRENT RATIO, AND QUICK RATIO

1. Calculation of working capital, current ratio, and quick ratio (dollar amounts in thousands):

Working capital($70 + $60 + $80 + $100 + $10) – ($75 + $25 + $40 + $60) = $320 – $200 = $120

Current ratio$320/$200 = 1.60 to 1

Quick ratio($70 + $60 + $80)/$200 = $210/$200 = 1.05 to 1

2. Effect of transactions on working capital, current ratio, and quick ratio:


Working Effect Effect EffectCapital of of of

(in Thou- Trans- Current Trans- Quick Trans-Transaction sands) action Ratio action Ratio action

a. Purchased inventory on account, $20,000 $120 none 1.545 decrease .955 decrease

b. Purchased inventory for cash, $15,000 $120 none 1.60 none .975 decrease

c. Paid suppliers on account, $30,000 $120 none 1.706 increase 1.059 increase

d. Received cash on account, $40,000 $120 none 1.60 none 1.05 none

e. Paid insurance for next year, $20,000 $120 none 1.60 none .95 decrease

f. Made sales on account, $60,000 $180 increase 1.90 increase 1.35 increase

g. Repaid short-term loans at bank, $25,000 $120 none 1.686 increase 1.057 increase

h. Borrowed $40,000 at bank for 90 days $120 none 1.50 decrease 1.042 decrease

i. Declared and paid $45,000 cash dividend $ 75 decrease 1.375 decrease .825 decrease

j. Purchased $20,000 of trading securities $120 none 1.60 none 1.05 none

k. Paid $30,000 in salaries $ 90 decrease 1.45 decrease .90 decreasel. Accrued additional

$15,000 in taxes $105 decrease 1.488 decrease .977 decrease

LO 4 PROBLEM 13-2 EFFECT OF TRANSACTIONS ON WORKING CAPITAL, CURRENT RATIO, AND QUICK RATIO

1. Calculation of working capital, current ratio and quick ratio (dollar amounts in thousands):

Working capital($70 + $60 + $80 + $100 + $10) – ($75 + $25 + $40 + $210)= $320 – $350 = $(30)

Current ratio$320/$350 = .91 to 1

Quick ratio($70 + $60 + $80)/$350 = $210/$350 = .60 to 1

2. Effect of transactions on working capital, current ratio, and quick ratio:

Working Effect Effect Effect


Capital of of of(in Thou- Trans- Current Trans- Quick Trans-

Transaction sands) action Ratio action Ratio action

a. Purchased inventory on account, $20,000 $(30) none .919 increase .568 decrease

b. Purchased inventory for cash, $15,000 $(30) none .91 none .557 decrease

c. Paid suppliers on account, $30,000 $(30) none .906 decrease .563 decrease

d. Received cash on account, $40,000 $(30) none .91 none .60 none

e. Paid insurance for next year, $20,000 $(30) none .91 none .543 decrease

f. Made sales on account, $60,000 $ 30 increase 1.086 increase .771 increase

g. Repaid short-term loans at bank, $25,000 $(30) none .908 decrease .564 decrease

h. Borrowed $40,000 at bank for 90 days $(30) none .923 increase .641 increase

i. Declared and paid $45,000 cash dividend $(75) decrease .786 decrease .471 decrease

j. Purchased $20,000 of trading securities $(30) none .91 none .60 none

k. Paid $30,000 in salaries $(60) decrease .829 decrease .514 decreasel. Accrued additional

$15,000 in taxes $(45) decrease .887 decrease .575 decrease

LO 6 PROBLEM 13-3 GOALS FOR SALES AND RETURN ON ASSETS

1. a. Return on sales = net income after adding back interest expense, net of tax/net sales

= $5,000,000/$60,000,000 = 8.33%

b. Asset turnover = net sales/average total assets= $60,000,000/$40,000,000 = 1.5 times

c. Return on assets = return on sales X asset turnover= 8.33% X 1.5 = 12.5%

2. Asset turnover = ($60,000,000 X 120%)/($40,000,000 X 112.5%)= $72,000,000/$45,000,000 = 1.6 times

3. If average total assets are $45,000,000 and the goal is a 15% return on assets, net income will need to be 15% of $45,000,000, or $6,750,000.

4. Income will have to increase by 35%, ($6,750,000 – $5,000,000)/$5,000,000, to achieve the goal of a 15% return on assets. The president has set a goal for an increase in sales of only 20%. To increase income by a larger percentage than the increase in sales will require cost-cutting in the various departments of the business. The company may want to look for cheaper sources of supply for its materials, as long as the quality


of the product is maintained. Efforts will need to be made to cut selling, general, and administrative expenses as well.

LO 6 PROBLEM 13-4 GOALS FOR SALES AND INCOME GROWTH

1. Selected financial data (in millions of dollars):

2007 2006 20051. Sales* 266.2 242.0 220.02. Net income(sales X 3%)* 7.986 7.26 6.63. Dividends declared and paid

(greater of $3,000,000or 50% of net income) 3.993 3.63 3.3

4. Owners’ equity, December 31balance (prior years’ balance + net income less dividends) 80.923 76.93 73.3

5. Debt, Dec. 31 balance** 52.177 44.07 36.7Selected ratios:

6. Return on owners’ equity (Item 2/Item 4) 9.9% 9.4% 9.0%

Note: The return on owners’ equity ratios in the problem for 2002-2004 are based on year-end owners’ equity rather than the average for each year. Therefore, to be consistent, year-end balances are used for 2005-2007.

7. Debt to total assets [Item 5/(Item 4 + Item 5)] 39.2% 36.4% 33.4%

*Sales and net income increase at the rate of 10% per year.

**Calculation of total debt balance:Total assets (sales/asset

turnover rate of 2) $ 133.100 $121.00 $ 110.0Less: Owners’ equity

(Item 4) 80.923 76.93 73.3 Debt $ 52.177 $ 44.07 $ 36.7

2. No, the CEO will not be able to meet all her requirements if a 10% per year growth in income and sales is achieved. If under the stated assumptions that the net income to sales ratio be maintained at 3% with annual sales growth of 10%, and the asset turnover ratio be maintained at 2, the goal of holding debt to 35% of total assets will be met only in 2005. The debt will increase to 36.4% of total assets in 2006 and to 39.2% of total assets in 2007 under the proposed plan. The calculations assume that all other factors remain constant. Because some of the factors that affect stock prices are outside the company’s control, it cannot be determined whether the main requirement of improving the stock price can be met if the expected performance is accomplished.


3. Alternative actions to be considered to improve the return on equity and support the increased dividend payments:

a. Improve the return on assets by

• reducing the asset base through better asset management.

• improving asset quality to generate higher returns per dollar invested, including the acquisition of a subsidiary or a more profitable line of business.

b. Improve profits by

• concentrating production and sales on high profit-producing lines.

• cost control efforts to maintain and reduce both variable and fixed costs.

4. The CEO is probably concerned with the potential impact that greater debt would have on the company’s cost of capital. Increasing debt relative to owners’ equity creates added risk, which translates to higher returns required by investors in the company’s stocks and bonds. If investors perceive that the company’s financial risks have increased, the market prices for its long-term debt issues will fall (interest rates will rise), and greater dividend payments will be necessary to maintain the market price of the stock.

MULTI-CONCEPT PROBLEMS

LO 4,5,6 PROBLEM 13-5 BASIC FINANCIAL RATIOS

1. Financial ratios for 2004 for CCB Enterprises (thousands omitted):

a. Times interest earned = (Net income + Income tax expense + Interest expense)/Interest expense

= ($72,000 + $48,000 + $20,000)/$20,000= $140,000/$20,000 = 7 to 1

b. Return on total assets = (Net income + Interest expense, net of tax)/Average total assets

= {$72,000 + [$20,000 X (1 – 40%*)]}/[($540,000 + $510,000)/2] = $84,000/$525,000 = 16%

*Tax rate = Income taxes/Income before tax = $48,000/$120,000 = 40%.

c. Return on common stockholders’ equity = (Net income – Preferred dividends)/Average common stockholders’ equity

= $72,000/[($260,000 + $217,000)/2]= $72,000/$238,500 = 30.19%

d. Debt/equity ratio = Total liabilities/Total stockholders’ equity = $280,000/$260,000 = 1.08 to 1


e. Current ratio = Current assets/Current liabilities= $144,000/$120,000 = 1.2 to 1

f. Quick (acid-test) ratio = (Cash + Marketable securities + Short-term receivables)/Current liabilities

= ($26,000 + $48,000)/$120,000= $74,000/$120,000 = .62 to 1

g. Accounts receivable turnover ratio = Net credit sales/Average accounts receivable

= $800,000/[($48,000 + $50,000)/2]= $800,000/$49,000 = 16.3 times

h. Number of days’ sales in receivables = Number of days in period/Accounts receivable turnover

= 360 days/16.3 times = 22 days

i. Inventory turnover ratio = Cost of goods sold/Average inventory= $540,000/[($65,000 + $62,000)/2]= $540,000/$63,500 = 8.5 times

j. Number of days’ sales in inventory = Number of days in period/Inventory turnover


k. Number of days in cash operating cycle = Days sales in inventory + Days sales in receivables

= 42 days + 22 days = 64 days

2. Comments on the overall financial health of CCB Enterprises:

The current ratio indicates a fairly strong liquidity position, although the significantly smaller quick ratio may signal a problem with excess inventory. Whether or not the quick ratio is indicative of a liquidity problem could be determined more accurately by comparing this ratio with prior years, as well as with an industry average.

Inventory turnover of 8.5 times may not be a problem area (see discussion of quick ratio above), but it should be compared with those of prior years and with an industry average—turning over inventory every 42 days may be normal for the industry.

The length of time that receivables are outstanding, 22 days, appears to be relatively short. It may indicate that the credit department is doing a good job in screening customers for credit. On the other hand, if the credit terms are too stringent, the company may be losing good customers. Comparison of this statistic with those of other companies in the same line of business would help to determine whether there is a problem in the credit department.

The company appears to be successfully using outside capital, as is evidenced by a return on assets of 16%, but a return on stockholders’ equity of almost double this—30.2%. Further evidence of the company’s use of leverage could be found by examining the exact cost of each individual source of capital. For example, what are the terms of the instruments that make up long-term debt, and what is the effective interest cost of each?


The times interest earned ratio indicates that earnings are seven times the amount of interest expense—what appears to be excellent coverage. However, how much cash is generated from operations? Is this cash sufficient to cover not only interest payments but also maturing principal amounts? Calculation of the debt service coverage ratio, with information found on a cash flows statement, would provide further evidence of the company’s solvency.

Finally, to fully evaluate the company’s financial health, it would be necessary to know more about its plans for the long run. Does it plan to expand plant and equipment? Are there any plans to take on additional products or acquire another company? Are any additional debt issues being contemplated?

LO 5,6 PROBLEM 13-6 PROJECTED RESULTS TO MEET CORPORATE OBJECTIVES

1. Projected results for the four objectives for Tablon, Inc. (in thousands of dollars):

• Sales growth of 20% will be achieved:

Sales increase for the year = $30,000 - $25,000 = 20% Sales for 2004 $25,000

• Return on stockholders’ equity of 15% will not be met:

Net income – preferred dividends = $1,200 - $0*_ Average stockholders’ equity ($9,300 + $8,700)/2

= $1,200/$9,000

= 13.3%

*No preferred stock

• Long-term debt-to-equity ratio of not more than 1 will not be achieved:

Long-term debt at 5/31/05 = $10,000____Stockholders’ equity at 5/31/05 $5,000 + $4,300)

= $10,000/$9,300

= 1.08 to 1

• A cash dividend of 50% of net income, with a minimum payment of at least $400,000 will be met:

50% X 2005 net income = .50 X $1,200 = $600($600 is the forecasted dividend payment)


2. Contributing factors to Tablon’s failure to meet all its objectives include the following:

• Each of the three expenses, cost of goods sold, selling expenses, and administrative expenses and interest, as a percentage of sales, are expected to increase in 2005 from 2004:

2004 2005Cost of goods sold 52% 53.33%Selling expenses 20% 23.33%Administrative expenses and interest 16% 16.67%

• Accounts receivable will increase by $3,000,000 during the year—a 73% increase, compared with an increase in sales of only 20%. This could cause a cash flow problem and possibly an increase in bad debts.

• Production will exceed sales needs, as is evidenced by the 23% expected increase in the amount of inventory. This will result in additional carrying costs for the year.

• Long-term borrowing increased by 50% in the first six months of 2004, and for the full year it is expected to be up by 66.67% from the beginning of the year.

3. Possible actions that the controller could recommend to the president in response to the problems cited above include the following:

• Review the accounts receivable collection process to determine ways to speed up collection and to determine whether credit is being extended to high-risk customers.

• Slow down the production during the remainder of the year.

• Examine the reasons for an increase in the ratio of cost of goods sold to sales.

• Review the selling and administrative expenses to determine whether certain areas can be cut back and still provide necessary services.

• Review the continuing increases in long-term debt and decide whether they are necessary. Consider the issuance of preferred stock as an alternative form of financing.

LO 4,5,6 PROBLEM 13-7 COMPARISON WITH INDUSTRY AVERAGES

1. IndustryRatio Average Heartland, Inc.

Current ratio 1.23 .92


Acid-test (quick) ratio .75 .53Accounts receivable turnover 33 times 39 timesInventory turnover 29 times 31 timesDebt-to-equity ratio .53 .69Times interest earned 8.65 times 4.43 timesReturn on sales 6.57% 4.54%Asset turnover 1.95 times 1.98 timesReturn on assets 12.81% 8.97%Return on common

stockholders’ equity 17.67% 11.78%

Calculations for Heartland’s ratios (thousands omitted):

Current ratio = Current assets/Current liabilities$31,100/$33,945 = .92 to 1

Acid-test ratio = (Cash + Marketable securities + Accounts receivable)/Current liabilities

($1,135 + $1,250 + $15,650)/$33,945 = $18,035/$33,945 = .53 to 1

Accounts receivable turnover ratio = Sales/Average accounts receivable$542,750/[($15,650 + $12,380/2] = $542,750/$14,015 = 39 times

Inventory turnover ratio = Cost of goods sold/Average inventory$435,650/[($12,680 + $15,870)/2] = $435,650/$14,275 = 31 times

Debt-to-equity ratio = Total liabilities/Total stockholders’ equity($33,945 + $80,000)/$165,580 = $113,945/$165,580 = .69 to 1

Times interest earned = (Net income + Interest expense + Income tax expense)/Interest expense

$19,095 + $9,275 + $12,730)/$9,275 = $41,100/$9,275 = 4.43 times

Return on sales = (Net income + Interest expense, net of tax)/Net sales[$19,095 + $9,275(1 –.40*)]/$542,750 = ($19,095 + $5,565)/$542,750 = $24,660/$542,750 = 4.54%

*Tax rate is $12,730/$31,825 = 40%.

Asset turnover = Net sales/Average total assets$542,750/[($279,525 + $270,095)/2] = $542,750/$274,810 = 1.98 times

Return on assets = (Net income + Interest expense, net of tax)/Average total assets

$24,660 (above)/$274,810 (above) = 8.97%

Return on common stockholders’ equity = (Net income – Preferred dividends)/Average common stockholders’ equity

$19,095/[($165,580 + $158,485)/2] = $19,095/$162,032.5 = 11.78%

2. Heartland is not as liquid as the average company in the industry, as is evidenced by its lower current and quick ratios. The inventory turnover ratio is very close to the industry average, whereas the accounts receivable turnover is significantly better. Note, however, that the industry has a very


high turnover—in fact, the average number of days in receivables for the industry is 360/33, or 11 days. Heartland’s accounts payable has increased significantly during a year in which inventory has actually decreased.

The company is not as solvent as the rest of the industry, either, as is indicated by its higher debt-to-equity ratio and lower times interest earned ratio. The heavy reliance on outside funds is also reflected in the profitability of the company. Even though Heartland’s return on equity is higher than its return on assets, both ratios are significantly lower than the comparable industry averages. Its asset turnover is slightly higher than the industry norm.

3. If the bank’s primary consideration in making the loan decision is the company’s relative performance compared with that of the competition, it probably will not approve the loan. Heartland is already more highly leveraged than the average company in the industry, and it is not nearly as profitable. However, the loan decision will depend on other factors in addition to the company’s relative standing in its industry. For example, the bank will look at how Heartland’s ratios this year compare with those of prior years. Maybe the company is smaller than others in the industry and has always performed at its current level. If the bank approves the loan, it will probably require a higher interest rate to compensate for any perceived additional risk.

A L T E R N A T E P R O B L E M S

LO 5 PROBLEM 13-1A EFFECT OF TRANSACTIONS ON


DEBT-TO-EQUITY RATIO

1. Calculation of debt-to-equity ratio (ooo’s omitted):($150 + $375)/$400 = $525/$400 = 1.31 to 1

2. Effect of transactions on debt-to-equity ratio:

Debt-to-Equity Effect ofTransaction Ratio Transaction

a. Purchased inventory on account, $20,000 1.363 increase

b. Purchased inventory for cash, $15,000 1.31 none

c. Paid suppliers on account, $30,000 1.238 decrease

d. Received cash on account, $40,000 1.31 none

e. Paid insurance for next year, $20,000 1.31 none

f. Made sales on account, $60,000 1.141 decrease

g. Repaid short-term loans at bank, $25,000 1.25 decrease

h. Borrowed $40,000 at bank for 90 days 1.413 increase

i. Declared and paid $45,000 cash dividend 1.479 increase

j. Purchased $20,000 of trading securities 1.31 none

k. Paid $30,000 in salaries 1.419 increasel. Accrued additional

$15,000 in taxes 1.403 increase

LO 5 PROBLEM 13-2A EFFECT OF TRANSACTIONS ON DEBT-TO-EQUITY RATIO

1. Calculation of debt-to-equity ratio (ooo’s omitted):


($25 + $125)/$400 = $150/$400 = .38 to 1

2. Effect of transactions on debt-to-equity ratio:

Debt-to-Equity Effect ofTransaction Ratio Transaction

a. Purchased inventory on account, $20,000 .425 increase

b. Purchased inventory for cash, $15,000 .38 none

c. Paid suppliers on account, $30,000 .30 decrease

d. Received cash on account, $40,000 .38 none

e. Paid insurance for next year, $20,000 .38 none

f. Made sales on account, $60,000 .326 decrease

g. Repaid short-term loans at bank, $25,000 .313 decrease

h. Borrowed $40,000 at bank for 90 days .475 increase

i. Declared and paid $45,000 cash dividend .423 increase

j. Purchased $20,000 of trading securities .38 none

k. Paid $30,000 in salaries .405 increasel. Accrued additional

$15,000 in taxes .429 increase

LO 6 PROBLEM 13-3A GOALS FOR SALES AND RETURN ON ASSETS

1. a. Return on sales = net income after adding back interest expense, net of tax/net sales

= $60,000/$750,000 = 8%

b. Asset turnover = net sales/average total assets= $750,000/$400,000 = 1.88 times

c. Return on assets = return on sales X asset turnover= 8% X 1.88 = 15.04%

2. Asset turnover = ($750,000 X 115%)/($400,000 X 110%)= $862,500/$440,000 = 1.96 times

3. If average total assets are $440,000 and the goal is a 20% return on assets, net income will need to be 20% of $440,000, or $88,000.


4. Income will have to increase by 47%, ($88,000 – $60,000)/$60,000, to achieve the goal of a 20% return on assets. The president has set a goal for an increase in sales of only 15%. To increase income by a larger percentage than the increase in sales will require cost-cutting in the various departments of the business. The company may want to look for cheaper sources of supply for its materials as long as the quality of the product is maintained. Efforts will need to be made to cut selling, general, and administrative expenses as well.

LO 6 PROBLEM 13-4A GOALS FOR SALES AND INCOME GROWTH

1. Selected financial data (in millions of dollars):

2007 2006 20051. Sales* 133.1000 121.000 110.02. Net income(sales X 3%)* 3.9930 3.630 3.33. Dividends declared and paid

(greater of $2,000,000 or 60% of net income) 2.3958 2.178 2.0

4. Owners’ equity, December 31 balance (prior years’ balance + net income less dividends) 44.3492 42.752 41.3

5. Debt, Dec. 31 balance** 22.2008 17.748 13.7Selected ratios:

6. Return on owners’ equity (Item 2/Item 4) 9.0% 8.5% 8.0%

Note: The return on owners’ equity ratios in the problem for 2002-2004 are based on year-end owners’ equity rather than the average for each year. Therefore, to be consistent, year-end balances are used for 2005-2007.

7. Debt to total assets [Item 5/(Item 4 + Item 5)] 33.36% 29.3% 24.9%

*Sales and net income increase at the rate of 10% per year.

**Calculation of total debt balance:Total assets (sales/asset

turnover rate of 2) $ 66.5500 $60.500 $ 55.0Less: Owners’ equity

(Item 4) 44.3492 42.752 41.3 Debt $22.2008 $17.748 $13.7

2. No, the CEO will not be able to meet all his requirements if a 10% per year growth in income and sales is achieved. If under the stated assumptions that the net income to sales ratio be maintained at 3% with annual sales growth of 10%, and the asset turnover ratio be maintained at 2, the goal of holding debt to 25% of total assets will only be met in 2005. The debt will


increase to 29.3% of total assets in 2006 and to 33.36% of total assets in 2007 under the proposed plan. The calculations assume that all other factors remain constant. Because some of the factors that affect stock prices are outside the company’s control, it cannot be determined whether the main requirement of improving the stock price can be met if the expected performance is accomplished.

3. Alternative actions to be considered to improve the return on equity and support the increased dividend payments:

a. Improve the return on assets by• reducing the asset base through better asset management.• improving asset quality to generate higher returns per

dollar invested, including the acquisition of a subsidiary or a more profitable line of business.

b. Improve profits by• concentrating production and sales on high profit-producing lines.• cost control efforts to maintain and reduce both variable and fixed

costs.

ALTERNATE MULTI-CONCEPT PROBLEMS

LO 4,5,6 PROBLEM 13-5A BASIC FINANCIAL RATIOS

1. Financial ratios for 2004 for SST Enterprises (thousands omitted):

a. Times interest earned = (Net income + Income tax expense + Interest expense)/Interest expense

= ($60,000 + $27,000 + $15,000)/$15,000= $102,000/$15,000 = 6.8 times

b. Return on total assets = (Net income + Interest expense, net of tax)/Average total assets

= {$60,000 + [$15,000 X (1 – 31%*)]}/[($300,000 + $295,000)/2]= $70,350/$297,500 = 23.65%

*Tax rate = Income taxes/Income before tax = $27,000/$87,000 = 31%.

c. Return on common stockholders’ equity = (Net income – Preferred dividends)/Average common stockholders’ equity

= $60,000/[($180,000 + $165,000)/2]= $60,000/$172,500 = 34.78%

d. Debt/equity ratio = Total liabilities/Total stockholders’ equity = $120,000/$180,000 = .67 to 1

e. Current ratio = Current assets/Current liabilities


= $100,000/$105,000 = .95 to 1

f. Quick (acid-test) ratio = (Cash + Marketable securities + Short-term receivables)/Current liabilities

= ($27,000 + $36,000)/$105,000= $63,000/$105,000 = .6 to 1

g. Accounts receivable turnover ratio = Net credit sales/Average accounts receivable

= $600,000/[($36,000 + $37,000)/2]= $600,000/$36,500 = 16.4 times

h. Number of days’ sales in receivables = Number of days in period/Accounts receivable turnover


i. Inventory turnover ratio = Cost of goods sold/Average inventory= $405,000/[($35,000 + $42,000)/2]= $405,000/$38,500 = 10.52 times

j. Number of days’ sales in inventory = Number of days in period/Inventory turnover


k. Number of days in cash operating cycle = Days sales in inventory + Days sales in receivables

= 34 days + 22 days = 56 days

2. Comments on the overall financial health of SST Enterprises:

The current ratio is slightly less than 1 to 1, and the significantly smaller quick ratio may signal a problem with excess inventory. Whether or not the quick ratio is indicative of a liquidity problem could be determined more accurately by comparing this ratio with those of prior years, as well as with an industry average.

Inventory turnover of 10.52 times may not be a problem area (see discussion of quick ratio above), but it should be compared with those of prior years and with an industry average—turning over inventory every 34 days may be normal for the industry.

The length of time that receivables are outstanding, 22 days, appears to be relatively short. It may be an indication that the credit department is doing a good job in screening customers for credit. On the other hand, if the credit terms are too stringent, the company may be losing good customers. Comparison of this statistic with other companies in the same line of business would help to determine whether there is a problem in the credit department.

The company appears to be successfully using outside capital, as is evidenced by a return on assets of 23.65% but a much higher return on stockholders’ equity of 34.78%. Further evidence of the company’s use of leverage could be found by examining the exact cost of each individual source of capital. For example, what are the terms of the instruments that make up long-term debt and what is the effective interest cost of each?


The times interest earned ratio indicates that earnings are nearly seven times the amount of interest expense—that would appear to be excellent coverage. However, how much cash is generated from operations? Is this cash sufficient to cover not only interest payments but also maturing principal amounts? Calculation of the debt service coverage ratio, with information found on a cash flows statement, would provide further evidence of the company’s solvency.

Finally, to fully evaluate the company’s financial health, it would be necessary to know more about its plans for the long run. Does it plan to expand plant and equipment? Are there any plans to take on additional products or acquire another company? Are any additional debt issues being contemplated?

LO 5,6 PROBLEM 13-6A PROJECTED RESULTS TO MEET CORPORATE OBJECTIVES

1. Projected results for the four objectives for Grout, Inc. (in thousands of dollars):

• Sales growth of 10% will be exceeded:

Sales increase for the year = $12,000 - $10,000 = 20% Sales for 2004 $10,000

• Return on stockholders’ equity of 20% will not be met:

Net income – preferred dividends = $400 - $0* Average stockholders’ equity ($5,000 + $5,000)/2

= $400/$5,000

= 8%

*No preferred stock.

• Long-term debt-to-equity ratio of not more than 1 will not be achieved:

Long-term debt at 9/30/05 = $5,500____Stockholders’ equity at 9/30/05 ($4,000 + $1,000)

= $5,500/$5,000

= 1.1 to 1

• A cash dividend of 50% of net income will be met (dividends of 100% of net income are projected), but a minimum dividend payment of $500,000 will not be met (the projected dividends are only $400,000).

2. Contributing factors to Grout’s failure to meet all its objectives include the following:


• Cost of goods sold, as a percentage of sales, is expected to increase in 2005 from 2004, and the other two operating expenses are expected to remain the same:

2004 2005Cost of goods sold 60% 66.67%Selling expenses 15% 15.00%Administrative expenses and interest 10% 10.00%

• Accounts receivable will increase by $500,000 during the year—a 24% increase compared with an increase in sales of 20%. The potential for an increase in bad debts will need to be monitored.

• Production will exceed sales needs, as is evidenced by the 20% expected increase in the amount of inventory. This will result in additional carrying costs for the year.

• Long-term borrowing increased by 37.5% in the first six months of 2005, and it is expected to stay at this level at the end of the year.

3. Possible actions that the controller could recommend to the president in response to the problems cited above include the following:

• Review the accounts receivable collection process to determine ways to speed up collection and to determine whether credit is being extended to high-risk customers.

• Slow down the production during the remainder of the year.

• Examine the reasons for an increase in the ratio of cost of goods sold to sales.

• Review the continuing increases in long-term debt and decide whether they are necessary. Consider the issuance of preferred stock as an alternative form of financing.


LO 4,5,6 PROBLEM 13-7A A COMPARISON WITH INDUSTRY AVERAGES

1. IndustryRatio Average Midwest, Inc.

Current ratio 1.20 1.26Acid-test (quick) ratio .50 .34Inventory turnover 35 times 37.27 timesDebt-to-equity ratio .50 .69Times interest earned 25 times 4.13 timesReturn on sales 3% 4.68%Asset turnover 3.5 times 3.82 timesReturn on common

stockholders’ equity 20% 23.19%

Calculations for Midwest’s ratios (thousands omitted):

Current ratio = Current assets/Current liabilities$12,440/$9,900 = 1.26 to 1

Acid-test ratio = (Cash + Marketable securities + Accounts receivable)/Current liabilities

($1,790 + $1,200 + $400)/$9,900 = $3,390/$9,900 = .34 to 1

Inventory turnover ratio = Cost of goods sold/Average inventory$300,000/[($7,400 + $8,700)/2] = $300,000/$8,050 = 37.27 times

Debt-to-equity ratio = Total liabilities/Total stockholders’ equity($9,900 + $36,000)/$66,100 = $45,900/$66,100 = .69 to 1

Times interest earned = (Net income + Interest expense + Income tax expense)/Interest expense

($14,900 + $8,600 + $12,000)/$8,600 = $35,500/$8,600 = 4.13 times

Return on sales = (Net income + Interest expense, net of tax)/Net sales[$14,900 + $8,600(1 –.446*)]/$420,500 = ($14,900 + $4,764)/$420,000 =

$19,664/$420,500 = 4.68%

*Tax rate is $12,000/$26,900 = 44.6%.

Asset turnover = Net sales/Average total assets$420,500/[($108,000 + $112,000)/2] = $420,500/$110,000 = 3.82 times

Return on common stockholders’ equity = (Net income – Preferred dividends)/Average common stockholders’ equity

$14,900/[($62,400 + $66,100)/2]= $14,900/$64,250 = 23.19%

2. Midwest is not quite as liquid as the average company in the industry, as is evidenced by its lower quick ratio. The inventory turnover ratio is very similar to the industry average. Midwest’s accounts payable has decreased during the year, although this is offset by increases in each of the other three current liabilities.


The company is not as solvent as the rest of the industry either, as is indicated by its higher debt-to-equity ratio and lower times interest earned ratio. The heavy reliance on outside funds, however, has not been a detriment to the company’s profitability. Midwest’s return on equity is higher than the industry average.

3. Midwest is already more highly leveraged than the average company in the industry, but as was indicated earlier, has used borrowed money effectively. However, the loan decision will depend on other factors in addition to the company’s relative standing in its industry. For example, the bank will look at how Midwest’s ratios this year compare with those of prior years. Maybe the company is smaller than others in the industry and has always performed at its current level. If the bank approves the loan, it will probably require a higher interest rate to compensate for any perceived additional risk.

D E C I S I O N C A S E S

READING AND INTERPRETING FINANCIAL STATEMENTS

LO 2 DECISION CASE 13-1 HORIZONTAL ANALYSIS FOR WINNEBAGO INDUSTRIES

1. and 2. (In millions of dollars)Increase (Decrease) from:

2001 to 2002 2000 to 2001

Income Statement Accounts Dollars % Dollars %Net revenues* $152.5 22.6% $(71.7) (9.6)%Cost of manufactured products 120 .3 20.4 (52 .6) (8.2)Gross profit 32.2 36.9 (19.1) (18.0)Selling expenses 1.3 7.2 (.4) (2.3)General, and administrative expenses 5.1 37.7 (3.5) (20.5)Financial income (.9) (23.8) .4 12.5Income before income taxes 24.8 41.9 (14.8) (20.0)Provision for taxes 13.9 89.9 (10.1) (40.0)Income before cumulative effect of change in accounting principle 10.9 25.0 (4.6) (9.6)Cumulative effect of change in accounting principle 1.1 (100.0) (1.1) 0Net income $12.0 28.0 $(5.7) (11.8)

* Includes both revenue from manufactured products and dealer financing revenue. Thus, the gross profit ratios include both of these forms of revenue also.


3. Net revenues increased by 22.6% in 2002, after a decrease in 2001 of 9.6%. Also, gross profit increased even more significantly, by 36.9%. These increases are reflected in the increase of 28% in net income.

LO 3 DECISION CASE 13-2 VERTICAL ANALYSIS FOR WINNEBAGO INDUSTRIES

1. Common-size comparative income statements:

WINNEBAGO INDUSTRIESCOMMON-SIZE CONSOLIDATED STATEMENTS OF INCOME

FOR THE YEARS ENDED AUGUST 31, 2002 AND AUGUST 25, 2001(IN MILLIONS OF DOLLARS)

2002 2001Dollars % Dollars %

Net revenues* $828.4 100.0% $ 675.9 100.0%Cost of manufactured products 708 .9 85 .6 588.6 87 .1 Gross profit 119.5 14.4 87.3 12.9Selling expenses 19.6 2.4 18.3 2.7General, and adminis-

trative expenses 18.7 2.3 13.6 2.0Financial income 2 .9 .4 3 .8 .6Income before income taxes 84.1 10.2 59.2 8.8Provision for taxes 29 .4 3 .5 15.5 2 .3 Income before cumulative effect of change in accounting principle 54.7 6.6 43.8 6.5Cumulative effect of change in acounting principle 0 0 1.1 .2 Net income $ 54 .7 6 .6 % $ 42.7 6 .3%

* Includes both revenue from manufactured products and dealer financing revenue. Thus, the gross profit ratios include both of these forms of revenue also.

2. Cost of manufactured products as a percentage of sales decreased by 1.5% from 2001 to 2002; as a result, the gross margin ratio is correspondingly 1.5% higher in 2002. Selling expenses decreased as a percentage of sales by .3% and was offset by the same percentage increase in general and administrative expenses. These factors contributed to a slight increase in net income as a percentage of sales, from 2001to 2002.


3. Common-size comparative balance sheets

WINNEBAGO INDUSTRIES COMMON-SIZE CONSOLIDATED BALANCE SHEETS

AT AUGUST 31, 2002 AND AUGUST 25, 2001(IN MILLIONS OF DOLLARS)


Cash and cash equivalents $ 42.2 12.5% $ 102.3 29.1%Receivables, less allowance for doubtful accounts 28.6 8.5 21.6 6.1Dealer financing receivables, less allowance for doubtful accounts 37.9 11.2 40.3 11.5Inventories 113.7 33.7 79.8 22.7Prepaid expenses 4.3 1.3 3.6 1.0Deferred income taxes 6 .9 2 .0 6 .7 1 .9

Total current assets 233 .6 69 .3 254 .3 72 .3 Property and equipment,

net 48.9 14.5 46.5 13.2Investment in life insurance 23.6 7.0 22.2 6.3Deferred income taxes 22.4 6.6 21.5 6.1Other assets 8 .5 2 .5 7 .4 2 .1 Total assets $ 337 .1 100 .0 % $ 351 .9 100 .0 %

Accounts payable, trade $ 44.2 13.1% $ 40.7 11.6%Income taxes payable 2.6 .8 4.9 1.4Accrued expenses: Accrued compensation 18.7 5.5 13.7 3.9 Product warranties 8.2 2.4 8.1 2.3 Insurance 6.0 1.8 4.6 1.3 Promotional 4.5 1.3 3.2 .9 Other 4.5 1.3 4.8 1.4

Total current liabilities 88.6 26.3 80.0 22.7Postretirement health care and Deferred compensation benefits 68 .7 20 .4 64 .5 18 .3 Common stock, par value 12.9 3.8 12.9 3.7Additional paid-in capital 25.7 7.6 22.3 6.3Reinvested earnings 284.9 84.5 234.1 66.5Treasury stock, at cost (143 .7 ) (42.6) (61 .9) (17 .6 )

Total stockholders’ equity 179 .8 53.3 207 .5 59.0Total equities $ 337 .1 100.0% $ 351 .9 100.0%


4. Within the current asset category, cash decreased significantly in relative importance from the prior year, 29.1% in 2001 versus 12.5% in 2002. Overall, there was a minor decrease in current assets as a percentage of total assets. Property, plant, and equipment increased slightly, from 13.2% of total assets to 14.5% of total assets.

Total current liabilities increased as a percentage of total equities from 22.7% in 2001 to 26.3% in 2002. The only other liability, postretirement health care and deferred compensation benefits increased in relative importance, from 18.3% in 2001 to 20.4% in 2002. The most significant change on the balance sheet was the large increase in treasury stock. Because the company purchased a significant amount of its own stock during 2002, this account increased dramatically, from less than 18% of total equities to over 42%.

LO 3 DECISION CASE 13-3 COMPARING TWO COMPANIES IN THE SAME INDUSTRY: WINNEBAGO INDUSTRIES AND MONACO COACH CORPORATION

1. Common-size comparative income statements:

MONACO COACH CORPORATION COMMON-SIZE CONSOLIDATED STATEMENTS OF INCOME

FOR THE YEARS ENDED DECEMBER 28, 2002 AND DECEMBER 29, 2001(IN MILLIONS OF DOLLARS)


Net sales $1,222.7 100.0% $ 937.1 100.0%Cost of sales 1,059 .6 86 .7 823 .1 87 .8 Gross profit 163.1 13.3 114.0 12.2Selling, general, and adminis-

trative expenses 87.2 7.1 70.7 7.5Amortization of goodwill 0 0 .6 .1 Operating income 75.9 6.2 42.7 4.6Other income, net .1 .3 .0Interest expense 2.8 .2 2 .4 2 .6 Income before income taxes 73.3 6.0 40.6 4.3Provision for income taxes 28.8 2 .4 15 .7 1 .7 Net income $44.5 3 .6 % $ 24 .9 2 .6 %

2. During 2002, Winnebago Industries reported a slightly higher gross profit ratio than Monaco Coach Corporation. Also, Winnebago Industries ratio of net income to net sales, or profit margin as it is called, was higher in 2002 than was the same ratio for Monaco Coach Corporation.


3. Common-size comparative balance sheets

MONACO COACH CORPORATIONCOMMON-SIZE CONSOLIDATED BALANCE SHEETSAT DECEMBER 28, 2002 AND DECEMBER 29, 2001

(IN MILLIONS OF DOLLARS)


Trade receivables, net $ 116.6 21.3% 82.9 19.4%Inventories 175.6 32.1 127.1 29.8Resort lot inventory 26.9 4.9 0 0Prepaid expenses 3.6 6.6 2.1 .5Deferred income taxes 33.4 6 .1 27.3 6 .4

Total current assets 356 .1 65 .1 239 .4 56 .1 Notes receivable 0 0 8.2 1.9Property, plant and equipment

net 135.4 24.7 122.8 28.8Debt issuance costs, net .7 .1 .9 .2Goodwill, net 55.3 10 .1 55 .9 13 .0 Total assets $ 547 .4 100 .0 % $ 427 .1 100 .0 %

Book overdraft $ 3.5 .6% $ 5.9 1.4%Line of credit 51.4 9.4 26.0 6.1Current portion of long-term Note payable 21.7 4.0 10.0 2.3Accounts payable 78.1 14.3 66.9 15.7Product liability reserve 21.3 3.9 19.9 4.7Product warranty reserve 31.7 5.8 22.8 5.3Income taxes payable 4.5 .8 0 0Accrued expenses and other liabilities 29.6 5 .4 19.2 4.5

Total current liabilities 241.9 44.2 175.7 41 .1 Long-term note payable 30.3 5.5 30.0 7.0

Deferred income taxes 14.6 2.7 8.3 1.9Common stock,par value .3 .1 .3 .1Additional paid-in capital 51.5 9.4 48.5 11.4Retained earnings 208.8 38.1 164 .3 38.5

Total stockholders’ equity 260.6 47.6 213 .1 50.0Total equities $ 547 .4 100.0% $ 427 .1 100 .0 %

4. Winnebago Industries has a slightly higher percentage of its total assets in the current assets category at the end of 2002 than does Monaco Coach Corporation. Conversely, Winnebago Industries’ current liabilities are a lower percentage of total liabilities and stockholders’ equity than for Monaco Coach Corporation. The ratio of stockholders equity to total liabilities and stockholders’ equity is about 53% for Winnebago Industries while this same ratio for Monaco Coach Corporation is about 48%.


LO 4,5,6 DECISION CASE 13-4 RATIO ANALYSIS FOR WINNEBAGO INDUSTRIES

1. Ratios and other amounts for Winnebago Industries (all dollar amounts in thousands):

a. Working capital = Current assets – Current liabilities2002: $233,596 – $88,601 = $144,9952001: $254,256 – $80,008 = $174,248

b. Current ratio = Current assets/Current liabilities2002: $233,596/$88,601 = 2.6 to 12001: $254,256/$80,008 = 3.2 to 1

c. Acid-test ratio = (Cash + Receivables + Dealer financing receivables) /Current liabilities

2002: ($42,225 + $28,616 + $37,880)/$88,601 = $108,721/$88,601= 1.2 to 1

2001: ($102,280 + $21,571 + $40,263)/$80,008 = $164,114/$80,008 2.1to 1

d. Cash flow from operations to current liabilities = Net cash provided by operating activities/Average current liabilities

2002: $36,790/$88,601 = 41.5 %2001: $81,912/$80,008 = 102.4%

e. Number of days’ sales in receivables = Number of days in the period/Accounts receivable turnover (Net credit sales/Average Receivables and Dealer financing receivables)

2002: Turnover = $828,403/($28,616 + $37,880) = 12.5Number days = 360 days/12.5 = 28.8 days

2001: Turnover = $675,927/($21,571 + $40,263) = 10.9Number days = 360 days/10.9 = 33.0 days

f. Number of days’ sales in inventory = Number of days in the period/Inventory turnover (Cost of manufactured products/Average inventory)

2002: Turnover = $708,865/$113,654 = 6.2Number days = 360 days/6.2 = 58.1 days

2001: Turnover = $588,561/$79,815 = 7.4Number days = 360 days/7.4 = 48.6 days

g. Debt-to-equity ratio = Total liabilities/Total stockholders’ equity2002: ($88,601 + $68,661)/$179,815 = $157,262/$179,815

= .87 to 12001: ($80,008 + $64,450)/$207,464 = $144,458/$207,464

= .70 to 1


h. Cash flow from operations to capital expenditures = (Cash flow from operations – Total dividends paid)/Cash paid for acquisitions

2002: ($36,790 - $3,954)/$10,997 = 298.6%2001: ($81,912 - $4,121)/$9,089 = 855.9%

i. Asset turnover = Net sales/Total assets2002: $828,403/$337,077 = 2.5 times2001: $675,927/$351,922 = 1.9 times

j. Return on sales = (Net income + Interest expense* net of tax)/Net sales2002: [$54,671 + $298(1 –.40)]/$828,403 = $54,849.8/$828,403 =

6.6%2001: [$42,704 + $89(1 – .40)]/$675,927 = $42,757.4/$675,927 =

6.3%* Interest expense appears as part of financial income on the income

statement and its amount is reported in Note 8 to the financial statements.

k. Return on assets = (Net income + Interest expense, net of tax)/Total assets

2002: $54,849.8 (from j.)/$337,077 = 16.3 %2001: $42,757.4 (from j.)/$351,922 = 12.1 %

l. Return on common stockholders’ equity = (Net income – preferred dividends)/Common stockholders’ equity

2002 ($54,671 - $0/$179,815 = 30.4%2001: ($42,704 - $0) /$207,464 = 20.6 %

2. Winnebago Industries appears to be relatively liquid over the two-year period, although all of the measures of liquidity declined in 2002, such as working capital, the current ratio, the acid-test ratio and cash flow from operations to current liabilities and the two turnover ratios.

The company’s debt-to-equity ratio increased slightly in 2002. The ratio of cash flows from operations to capital expenditures decreased dramatically in 2002, from 855.9% during 2001 to 298.6% in 2002, primarily as a result of a decrease in cash flow from operations.

Asset turnover increased from 1.9 times in 2001 to 2.5 times in 2002. Winnebago Industries’ return on sales remained relatively unchanged, its return on assets increased from 12.1% in 2001 to 16.3% in 2002, and its return on common stockholders’ equity decreased from 20.6% in 2001 to 30.4% in 2002.


MAKING FINANCIAL DECISIONS

LO 4,5,6 DECISION CASE 13-5 ACQUISITION DECISION

1. Several measures give an indication as to the company’s liquidity:

• Working capital has nearly doubled over the two-year period, from $88,930,000 in 2003 to $161,820,000 in 2004.

• Both the current ratio and the quick ratio have also increased:Current ratio = Current assets/Current liabilities

2004: $324,120/$162,300 = 2.00 to 12003: $215,180/$126,250 = 1.70 to 1

Quick ratio = (Cash + Marketable securities + Short-term receivables)/Current liabilities

2004: ($48,500 + $3,750 + $128,420)/$162,300 = 1.11 to 12003: ($24,980 +0 + $84,120)/$126,250 = .86 to 1

• The accounts receivable turnover for 2004 = Net credit sales/Average accounts receivable: $875,250/[($128,420 + $84,120)/2] = 8.24 times, or an average collection period of 360/8.24 = 44 days

Whether this is a reasonable number of days outstanding could be partially determined by an examination of the company’s credit terms.

• The inventory turnover for 2004 = Cost of goods sold/Average inventory: $542,750/[($135,850 + $96,780)/2] = 4.67 times, or an average number of days sales in inventory of 360/4.67 = 77 days

• The cash operating cycle for 2004 is 44 + 77 = 121 days

Conclusion: The company appears on the surface to be fairly liquid, but each of the above measures of liquidity should be compared with industry averages. One area of concern is the large increase in both receivables and inventories from the prior year. The company could be experiencing collection problems. The inventory should be examined more closely for possible obsolescence and slow-moving items.

2. The company’s solvency can be examined by looking at the following factors:

• The debt-to-equity ratio has increased slightly from the prior year: Total liabilities/Total stockholders’ equity

2004: ($162,300 + $275,000)/$532,710 = .82 to 12003: ($126,250 + $275,000)/$519,820 = .77 to 1

• The times interest earned ratio = Operating income*/Interest expense: $68,140/$45,000 or 1.51 times

*The ratio is normally calculated as net income + income tax expense + interest expense, divided by interest expense. Because the company has


an extraordinary gain to take into account, the easiest approach is to use the income number before taking all of these items into account, i.e., operating income.

Conclusion: The company is carrying a heavy debt burden even though the bonds are not due until 2011. It will continue to have large interest payments for the next seven years. Further information on the operating cash flows is necessary to see whether funds will be available to service the debt currently outstanding. Interest payments not only will be a significant cash drain but also will affect the company’s profitability.

3. Profitability can be assessed by looking at a number of ratios for 2004. The extraordinary gain should be ignored in assessing profitability for our purposes, because we are interested in the future performance of the company and this gain is not expected to recur in the future.• Return on assets = (Net income + Interest expense, net of tax)/Average

total assets: [$13,890 + ($45,000)(1–.40*)] divided by ($970,010 + $921,070)/2 = $40,890/$945,540 = 4.3%

*The tax rate can be approximated by dividing income tax expense of $9,250 by net income before taxes and extraordinary items of $23,140.

• Return on sales = (Net income + Interest expense, net of tax)/Net sales: $40,890/$875,250 = 4.7%

• Asset turnover = Net sales/Average total assets: $875,250/$945,540 = .93 times

• Return on common stockholders’ equity = (Net income – Preferred dividends)/Average common stockholders’ equity: $13,890/[($532,710 + $519,820)/2] = $13,890/$526,265 = 2.6%

• The average cost of borrowed funds can be approximated: $45,000 in interest expense divided by an average of short-term notes and bonds combined of [($80,000 + $275,000) + ($60,000 + $275,000)]/2 = $45,000/$345,000 = 13%. The after-tax cost of these borrowed funds is 13% X (1 – .40) = 7.8%.

4. It would be difficult to recommend to the vice-president of acquisitions that Heavy Duty be acquired. It has not demonstrated the ability to be a profitable member of the Diversified family over the long run. Disregarding the extraordinary gain, the profit margin before interest and taxes was only 7.8%. Heavy Duty relies on a considerable amount of outside debt for funding, but it is proving to be too costly at an after-tax cost of 7.8%. This is further evidenced by an overall return on assets, 4.3%, which is higher than the return to the stockholder of only 2.6%. While Heavy Duty is at least profitable, it is unlikely that the president and board of directors of Diversified will be satisfied with a company that yields such a low return. In addition, it may prove very difficult for Heavy Duty to generate the necessary funds to repay the bonds in 2011.


LO 3 DECISION CASE 13-6 PRICING DECISION

1. BPOCOMMON-SIZE COMPARATIVE INCOME STATEMENTS

FOR YEARS 1-3(IN THOUSANDS OF DOLLARS)

Year 3 Year 2 Year 1$ % $ % $ %

Sales $125 100.0% $110 100.0% $100 100.0%Cost of goods sold 62 49 .6 49 44 .5 40 40.0 Gross profit 63 50.4% 61 55.5% 60 60.0%Operating expenses 53 42 .4 49 44 .5 45 45.0 Net income $ 10 8 .0 % $ 12 11 .0 % $ 15 15.0%

2. Net income has decreased while sales have increased because BPO has not held the line on its product costs. The gross profit ratio has declined significantly, because of the increase in cost of goods sold relative to sales, from 40% to nearly 50%.

3. BPOINCOME STATEMENT

YEAR 4

Sales: $125,000 X 1.10 $ 137,500Cost of goods sold: $62,000 X 1.08 66,960 Gross profit $ 70,540Operating expenses $53,000 X 1.08 57,240 Net income $ 13,300

4. With a 10% increase in volume, BPO will not need to increase its prices. On the basis of the projections, it will report an increase in net income of 33%.

ACCOUNTING AND ETHICS: WHAT WOULD YOU DO?

LO 4,5 DECISION CASE 13-7 PROVISIONS IN A LOAN AGREEMENT

1. No, Midwest is not in violation of its existing loan agreement. The current ratio is $16/$10, or 1.6 to 1, which is above the minimum requirement of 1.5. The debt-to-equity ratio is $25/$55 or .45 to 1, which is below the maximum of .5.

2. Jackson has handled each of the two items incorrectly, and the controller has the responsibility to make corrections before the statements are released. The treatment of both items is in violation of accounting standards. First, the $5 million note should be included in current liabilities, since it is due in six months. The mere intent of the company to roll over or refinance the note does not by itself justify the exclusion of it from current


liabilities. [Note: The instructor may want to use this opportunity to point out that an accounting standard (SFAS No. 6) requires a company to demonstrate the ability to refinance an obligation before classifying it as long-term.] Second, the controller should not have recorded the deposit from the state as revenue. Instead, it is a liability until the work is completed.

3. Revised balance sheet:

Current assets $ 16 Current liabilities $ 17Long-term assets 64 Long-term debt 10

Stockholders’ equity 53 Total $ 80 Total $ 80

Current liabilities should be $10, as reported, plus $5 for the note due in six months and $2 for the deposit from the state. Long-term debt is reduced by $5 for the note that is reclassified as short-term. Stockholders’ equity is reduced by $2 because the deposit should be included in current liabilities rather than revenue as recorded by Jackson.

Revised ratios:Current ratio: $16/$17 = .94 to 1Debt-to-equity ratio: $27/$53 = .51 to 1

These revisions will put Midwest in violation of its loan agreement with Southern National Bank. The current ratio is significantly below the minimum level of 1.5, while the debt-to-equity ratio is slightly above the maximum of .5.

LO 4 DECISION CASE 13-8 INVENTORY TURNOVER

1. The president calculated the inventory turnover ratio of 90 times by dividing sales revenue of $3,690,000 by the average inventory balance of $41,000 (the average of $40,000 at the end of 2004 and $42,000 at the end of 2003).

2. The president has erroneously used sales rather than cost of goods sold to calculate inventory turnover. Because inventory is stated at cost, cost of goods sold must be used in the numerator, not sales. The correct calculation is

($3,690,000 X 1 – .40*)/$41,000 = $2,214,000/$41,000 = 54 times

*The gross profit ratio is 40%. Therefore, cost of goods sold is 1 – 40%, or 60% of sales.

3. It is understandable why the president would prefer to report an inventory turnover of 90 times, rather than 54 times. In the fruits and vegetables business, the company needs to be able to show that it turns the inventory frequently to maintain freshness. As controller, you have a responsibility to the public not to intentionally misrepresent the company. You must tell the president that his calculations are incorrect and explain to him how the ratio


should be computed.

FROM CONCEPT TO PRACTICE 13.1

Winnebago Industries’ annual report provides a ten-year summary of selected financial data following the auditors’ report. One of the most significant trends is the steady growth in net income, to a high of $54.7 million in 2002.

Monaco Coach provides a five-year summary of selected financial data after its auditors’ report of its annual report. One of the most significant trends for Monaco Coach has been its steady increase in net sales over this period, with a record-high level of over $1.2 billion in 2002.


Wrigley’s gross profit ratio for each year is as follows:

2002 2001 2000 1999 1998 1997 1996 1995 1994 1993 1992 58.1% 58.5% 57.5% 55.8% 55.0% 53.6% 53.2% 53.2% 53.8% 54.2% 52.9%

Over this time period, the ratio has seen a relatively steady increase, from a low of 52.9% in 1992 to a high of 58.5% in 2001.


Winnebago Industries’ dividend payout ratio for each year is:

2002: $.20/$2.74 = 7.3%2001: $.20/$2.06 = 9.7%

The amount of dividends paid per share was unchanged and the earnings per share was higher in 2002, resulting in a decrease in the dividend payout ratio in 2002.

Monaco Coach did not pay any dividends on its stock in either 2001 or 2002 and thus has a dividend payout ratio of zero in both years.


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SOLUTION TO INTEGRATIVE PROBLEM

GALLAGHER, INC.STATEMENT OF CASH FLOWS

FOR THE YEAR ENDED DECEMBER 31, 2004

Cash Flows from Operating ActivitiesNet income $ 3,440Adjustments to reconcile net income to net

cash provided by operating activities:Depreciation expense 700Increase in accounts receivable (3,500)Increase in inventories (2,500)Decrease in prepaid insurance 300Increase in accounts payable 2,300Increase in taxes payable 400

Net cash provided by operating activities $ 1,140 Cash Flows from Investing Activities

Acquisition of buildings and equipment $ (3,000 )Net cash used by investing activities $ (3,000 )Cash Flows from Financing Activities

Issuance of additional notes payable $ 800Payment of cash dividends (600)Payment of bonds (200 )

Net cash provided by financing activities $ 0 Net decrease in cash $ (1,860)Cash balance, December 31, 2003 2,700 Cash balance, December 31, 2004 $ 840

2. a. Current ratio = Current assets/Current liabilities= $21,440/$14,500 = 1.479 to 1

b. Acid-test ratio = (Cash + Accounts Receivable)/Current liabilities= ($840 + $12,500)/$14,500 = $13,340/$14,500 = .92 to 1

c. Cash flow from operations to current liabilities ratio = Net cash provided by operating activities/Average current liabilities

= $1,140/[($14,500 + $11,000)/2] = $1,140/$12,750 = 8.9%

d. Accounts receivable turnover ratio = Net credit sales/Average accounts receivable

= $48,000/[($12,500 + $9,000)/2] = $48,000/$10,750 = 4.465

e. Number of days’ sales in receivables = Number of days in the period/Accounts receivable turnover ratio = 360/4.47 = 80.54

f. Inventory turnover ratio = Cost of goods sold/Average inventory= $36,000/[($8,000 + $5,500)/2] = $36,000/$6,750 = 5.33


g. Number of days’ sales in inventory = Number of days in period/Inventory turnover ratio = 360/5.33 = 67.54

h. Debt-to-equity ratio = Total liabilities/Total stockholders’ equity= $15,900/$17,840 = .9 to 1

i. Debt service coverage ratio = Cash flow from operations, before interest and tax payments/Interest and principal payments

= ($1,140 + $280 + $2,280 - $400*)/($280 + $200) = $3,300/$480 = 6.88 to 1

* Increase in taxes payable account j. Cash flow from operations to capital expenditures ratio = (Cash flow from

operations – Total dividends paid)/Cash paid from acquisitions= ($1,140 – $600)/$3,000 = $540/$3,000 = 18%

3. Gallagher’s current ratio decreased from 1.6 in 2003 to 1.48 in 2004 and its acid-test ratio also decreased from 1.06 in 2003 to .92 in 2004. For many companies, an acid-test ratio below 1 is not desirable because it may signal the need to liquidate marketable securities to pay bills, regardless of the current trading price of the securities. Gallagher currently doesn’t own marketable securities and therefore it may have difficulty in paying its bills. Its cash flow from operations to current liabilities ratio is low also. The number of days’ sales in receivable indicates it should increase collection efforts while the number of days’ sales in inventory may indicate a large amount of obsolete inventory or problems in the sales department.

Gallagher’s debt-to-equity ratio indicates that for every $1 of capital that stockholders provided, creditors provided $.90. Gallagher generated almost $7 of cash from operations during 2004 to “cover” every $1 of required interest and principal payments. The cash flow from operations to capital expenditures ratio (18%) of less than 100% indicates that it is not able to finance all of its capital expenditures from operations and cover its dividend payments. Overall, Gallagher appears to have low liquidity and solvency ratios. However, these ratios should be compared to ratios in its industry as well as to ratios from prior years to get a better idea of how it is doing. Its credit policies should also be examined to determine its policy on collections. It should consider putting off future dividend payments until it gets its liquidity problems under control.

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