# Brief Exercise 14-2 (20 minutes)

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1 Brief Exercise 14-2 (20 minutes) 1. This Year Last Year Sales % 100.0% Cost of goods sold Gross margin Operating expenses: Selling expenses Administrative expenses Total expenses Net operating income Interest expense Net income before taxes % 11.5% 2. The company s major problem seems to be the increase in cost of goods sold, which increased from 58.6% of sales last year to 62.3% of sales this year. This suggests that the company is not passing the increases in costs of its products on to its customers. As a result, cost of goods sold as a percentage of sales has increased and gross margin has decreased. This change has been offset somewhat by reduction in administrative expenses as a percentage of sales. Note that administrative expenses decrease from 10.3% to only 8.9% of sales over the two years. However, this decrease was not enough to completely offset the increased cost of goods sold, so the company s net income decreased as a percentage of sales this year. Solutions Manual, Chapter 14 1

2 Brief Exercise 14-3 (45 minutes) 1. Calculation of the gross margin percentage: Gross margin Gross margin percentage = Sales \$27,000 = = 34.2% \$79, Calculation of the earnings per share: Net income - Preferred dividends Earnings per share = Average number of common shares outstanding \$3,540 - \$120 = = \$4.28 per share 800 shares 3. Calculation of the price-earnings ratio: Market price per share Price-earnings ratio = Earnings per share \$18 = = 4.2 \$ Calculation of the dividend payout ratio: Dividends per share Dividend payout ratio = Earnings per share \$0.25 = = 5.8% \$ Calculation of the dividend yield ratio: Dividends per share Dividend yield ratio = Market price per share \$0.25 = = 1.4% \$ Introduction to Managerial Accounting, 3rd Edition

3 Brief Exercise 14-3 (continued) 6. Calculation of the return on total assets: Beginning balance, total assets (a)... \$45,960 Ending balance, total assets (b)... 50,280 Average total assets [(a) + (b)]/2... \$48,120 Return on total assets = Net income + [Interest expense (1 - Tax rate)] Average total assets \$3,540 + [\$600 (1-0.40)] = = 8.1% \$48, Calculation of the return on common stockholders equity: Beginning balance, stockholders equity (a)... \$31,660 Ending balance, stockholders equity (b)... 34,880 Average stockholders equity [(a) + (b)]/ ,270 Average preferred stock... 2,000 Average common stockholders equity... \$31,270 Return on common = stockholders' equity Net income - Preferred dividends Average common stockholders' equity \$3,540 - \$120 = = 10.9% \$31, Calculation of the book value per share: Book value per share = Total stockholders' equity - Preferred stock Number of common shares outstanding \$34,880 - \$2,000 = = \$41.10 per share 800 shares Solutions Manual, Chapter 14 3

4 Brief Exercise 14-4 (45 minutes) 1. Calculation of working capital: Current assets... \$25,080 Current liabilities... 10,400 Working capital... \$14, Calculation of the current ratio: Current assets Current ratio = Current liabilities \$25,080 = = 2.41 \$10, Calculation of the acid-test ratio: Cash + Marketable securities + Current receivables Acid-test ratio = Current liabilities \$1,280 + \$0 + \$12,300 = = 1.31 \$10, Calculation of accounts receivable turnover: Beginning balance, accounts receivable (a)... \$ 9,100 Ending balance, accounts receivable (b)... 12,300 Average accounts receivable balance [(a) + (b)]/2... \$10,700 Accounts receivable = turnover Sales on account Average accounts receivable balance \$79,000 = = 7.4 \$10, Calculation of the average collection period: 365 days Average collection period = Accounts receivable turnover 365 days = = 49.3 days Introduction to Managerial Accounting, 3rd Edition

5 Brief Exercise 14-4 (continued) 6. Calculation of inventory turnover: Beginning balance, inventory (a)... \$8,200 Ending balance, inventory (b)... 9,700 Average inventory balance [(a) + (b)]/2... \$8,950 Cost of goods sold Inventory turnover = Average inventory balance \$52,000 = = 5.8 \$8, Calculation of the average sale period: 365 days Average sale period = Inventory turnover 365 days = = 62.9 days 5.8 Solutions Manual, Chapter 14 5

6 Brief Exercise 14-5 (15 minutes) 1. Calculation of the times interest earned ratio: Earnings before interest Times interest expense and income taxes = earned ratio Interest expense \$6,500 = = 10.8 \$ Calculation of the debt-to-equity ratio: Total liabilities Debt-to-equity ratio = Stockholders' equity \$15,400 = = 0.44 \$34,880 6 Introduction to Managerial Accounting, 3rd Edition

7 Exercise 14-8 (45 minutes) 1. Gross margin percentage: Gross margin \$127,500 = = 30.4% (rounded) Sales \$420, Current ratio: Current assets \$115,000 = = 2.30 Current liabilities \$50, Acid-test ratio: Quick assets \$41,500 = = 0.83 Current liabilities \$50, Debt-to-equity ratio: Total liabilities \$130,000 = = 0.76 (rounded) Total stockholders' equity \$170, Average collection period: Sales on account \$420,000 = = 14 Average accounts receivable \$30, Average sale period: 365 days = 26 days (rounded) 14 times Cost of goods sold \$292,500 = = 4.5 Average inventory \$65, Times interest earned: 365 days = 81 days (rounded) 4.5 times Earnings before interest and income taxes \$38,000 = = 4.75 Interest expense \$8,000 Solutions Manual, Chapter 14 7

8 Exercise 14-8 (continued) 8. Book value per share: Stockholders' equity \$170,000 = = \$28.33 per share Common shares outstanding 6,000 shares 8 Introduction to Managerial Accounting, 3rd Edition

9 Problem 14-11A (90 minutes) This Year Last Year 1. a. Current assets... \$1,520,000 \$1,090,000 Current liabilities , ,000 Working capital... \$ 720,000 \$ 660,000 b. Current assets (a)... \$1,520,000 \$1,090,000 Current liabilities (b)... \$800,000 \$430,000 Current ratio (a) (b) c. Quick assets (a)... \$550,000 \$468,000 Current liabilities (b)... \$800,000 \$430,000 Acid-test ratio (a) (b) d. Sales on account (a)... \$5,000,000 \$4,350,000 Average receivables (b)... \$390,000 \$275,000 Accounts receivables turnover (a) (b) Average collection period: 365 days turnover days 23.1 days e. Cost of goods sold (a)... \$3,875,000 \$3,450,000 Average inventory (b)... \$775,000 \$550,000 Inventory turnover (a) (b) Average sales period: 365 days turnover days 58 days f. Total liabilities (a)... \$1,400,000 \$1,030,000 Stockholders equity (b)... \$1,600,000 \$1,430,000 Debt-to-equity ratio (a) (b) g. Net income before interest and taxes (a)... \$472,000 \$352,000 Interest expense (b)... \$72,000 \$72,000 Times interest earned (a) (b) Solutions Manual, Chapter 14 9

10 Problem 14-11A (continued) 2. a. Sabin Electronics Common-Size Balance Sheets This Year Last Year Current assets: Cash % 6.1 % Marketable securities Accounts receivable, net Inventory Prepaid expenses Total current assets Plant and equipment, net Total assets % % Current liabilities % 17.5 % Bonds payable, 12% Total liabilities Stockholders equity: Preferred stock, \$25 par, 8% Common stock, \$10 par Retained earnings Total stockholders equity Total liabilities and equity % % 10 Introduction to Managerial Accounting, 3rd Edition

11 Problem 14-11A (continued) b. Sabin Electronics Common-Size Income Statements This Year Last Year Sales % % Cost of goods sold Gross margin Operating expenses Net operating income Interest expense Net income before taxes Income taxes Net income % 4.5 % 3. The following points can be made from the analytical work in parts (1) and (2) above: a. The company has improved its profit margin from last year. This is attributable primarily to an increase in gross margin, which is offset somewhat by a small increase in operating expenses. Overall, the company s income statement looks very good. b. The company s current position has deteriorated significantly since last year. Both the current ratio and the acid-test ratio are well below the industry average and are trending downward. At the present rate, it will soon be impossible for the company to pay its bills as they come due. c. The drain on the cash account seems to be a result mostly of a large buildup in accounts receivable and inventory. Notice that the average age of the receivables has increased by five days since last year, and now is 10 days over the industry average. Many of the company s customers are not taking their discounts, since the average collection period is 28 days and collections terms are 2/10, n/30. This suggests financial weakness on the part of these customers, or sales to customers who are poor credit risks. Solutions Manual, Chapter 14 11

12 Problem 14-11A (continued) d. The inventory turned only five times this year as compared to over six times last year. It takes nearly two weeks longer for the company to turn its inventory than the average for the industry (73 days as compared to 60 days for the industry). This suggests that inventory stocks are higher than they need to be. e. In the authors opinion, the loan should be approved only if the company gets its accounts receivable and inventory back under control. If the accounts receivable collection period is reduced to about 20 days, and if the inventory is pared down enough to reduce the turnover time to about 60 days, enough funds could be released to substantially improve the company s cash position. Then a loan might not even be needed. 12 Introduction to Managerial Accounting, 3rd Edition

13 Problem 14-13A (120 minutes) This Year Last Year 1. a. Net income... \$ 840,000 \$ 504,000 Add after-tax cost of interest: \$360,000 (1 0.30) ,000 \$300,000 (1 0.30) ,000 Total (a)... \$ 1,092,000 \$ 714,000 Average total assets (b)... \$15,990,000 \$13,920,000 Return on total assets (a) (b) % 5.1% b. Net income... \$ 840,000 \$ 504,000 Less preferred dividends , ,000 Net income remaining for common (a).. \$ 696,000 \$ 360,000 Average total stockholders equity... \$ 9,360,000 \$ 9,084,000 Less average preferred stock... 1,800,000 1,800,000 Average common equity (b)... \$ 7,560,000 \$ 7,284,000 Return on common equity (a) (b) % 4.9% c. Leverage is positive for this year, since the return on common equity (9.2%) is greater than the return on total assets (6.8%). For last year, leverage is negative since the return on common equity (4.9%) is less than the return on total assets (5.1%). Solutions Manual, Chapter 14 13

14 Problem 14-13A (continued) This Year Last Year 2. a. Net income remaining for common (a)... \$696,000 \$360,000 Average number of common shares (b)... 75,000 75,000 Earnings per share (a) (b)... \$9.28 \$4.80 b. Common dividend per share (a)... \$2.88 \$1.44 Market price per share (b)... \$72.00 \$40.00 Dividend yield ratio (a) (b) % 3.6% c. Common dividend per share (a)... \$2.88 \$1.44 Earnings per share (b)... \$9.28 \$4.80 Dividend payout ratio (a) (b) % 30.0% d. Market price per share (a)... \$72.00 \$40.00 Earnings per share (b)... \$9.28 \$4.80 Price-earnings ratio (a) (b) Notice from the data given in the problem that the average P/E ratio for firms in Lydex Company s industry is 10. Since Lydex Company presently has a P/E ratio of only 7.8, investors appear to regard it less well than they do other firms in the industry. That is, investors are willing to pay only 7.8 times current earnings for a share of Lydex Company s stock, as compared to 10 times current earnings for a share of stock for the average firm in the industry. e. Stockholders equity... \$9,600,000 \$9,120,000 Less preferred stock... 1,800,000 1,800,000 Common stockholders equity (a)... \$7,800,000 \$7,320,000 Number of common shares (b)... 75,000 75,000 Book value per share (a) (b)... \$ \$ Introduction to Managerial Accounting, 3rd Edition

15 Problem 14-13A (continued) Notice that market value is below book value for both years for the common stock. This does not necessarily indicate that the stock is selling at a bargain price. Market value reflects investors expectations concerning future earnings, whereas book value is a result of already completed transactions and is geared to the past. f. This Year Last Year Gross margin (a)... \$3,150,000 \$2,580,000 Sales (b)... \$15,750,000 \$12,480,000 Gross margin percentage (a) (b) % 20.7% This Year Last Year 3. a. Current assets... \$7,800,000 \$5,940,000 Current liabilities... 3,900,000 2,760,000 Working capital... \$3,900,000 \$3,180,000 b. Current assets (a)... \$7,800,000 \$5,940,000 Current liabilities (b)... \$3,900,000 \$2,760,000 Current ratio (a) (b) c. Quick assets (a)... \$3,660,000 \$3,360,000 Current liabilities (b)... \$3,900,000 \$2,760,000 Acid-test ratio (a) (b) d. Sales on account (a)... \$15,750,000 \$12,480,000 Average receivables (b)... \$2,250,000 \$1,680,000 Turnover of receivables (a) (b) Average collection period, 365 days turnover days 49 days Solutions Manual, Chapter 14 15

16 Problem 14-13A (continued) This Year Last Year e. Cost of goods sold (a)... \$12,600,000 \$9,900,000 Average inventory (b)... \$3,150,000 \$2,160,000 Inventory turnover (a) (b) Average sale period, 365 days turnover days 79 days f. Total liabilities (a)... \$7,500,000 \$5,760,000 Stockholders equity (b)... \$9,600,000 \$9,120,000 Debt-to-equity ratio (a) (b) g. Net income before interest and taxes (a).. \$1,560,000 \$1,020,000 Interest expense (b)... \$360,000 \$300,000 Times interest earned (a) (b) Both net income and sales are up from last year. The return on total assets has improved from 5.1% to 6.8%, and the return on common equity is up from 4.9% to 9.2%. But this is the only bright spot. Virtually all other ratios are below the industry average, and, more important, they are trending downward. The deterioration in the gross margin percentage, while not large, is worrisome. Sales and inventories have increased substantially. Ordinarily, this should result in an improvement in the gross margin percentage due to fixed costs being spread over a greater number of units. However, the gross margin percentage has declined. Notice particularly that the average collection period has lengthened to 52 days about three weeks over the industry average. One wonders if the increase in sales was obtained at least in part by extending credit to high-risk customers. Notice also that the debt-to-equity ratio is rising rapidly. If the \$3,000,000 loan is granted, the ratio will rise further to What the company probably needs is more equity not more debt. Therefore, the loan should not be approved. The company should be encouraged to issue more common stock to provide a broader equity base on which to operate. 16 Introduction to Managerial Accounting, 3rd Edition

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