Chapter 13. Analyzing Financial Statements QUESTIONS

Transcription

1 Chapter 13 Analyzing Financial Statements QUESTIONS 1. Financial reporting includes the entire process of preparing and issuing financial information about a company. Financial statements are an important part of financial reporting but they are less than the whole. 2. With comparative statements, financial statement items for two or more successive accounting periods are placed side by side on a single statement, with the change in each item expressed as both a dollar amount and a percent. Common-size comparative statements express each financial statement item as a percent of some base amount that is assigned a value of 100%. 3. Total assets (or equivalently, the total of liabilities plus equity) are assigned a value of 100% on a common-size balance sheet. Net sales (revenues) are assigned a value of 100% on a common-size income statement. 4. The nature of a company's business, the composition of its current assets, and the turnover of its current assets are three important factors that should be considered in deciding whether a current ratio is good or bad. 5. A 2-to-1 current ratio may not be adequate if the company's current assets consist of a large proportion of slow-turning accounts, notes, and merchandise inventory. The general nature of the business also may make the 2-to-1 rule of thumb inadequate. 6. Adequate working capital enables a company to carry sufficient inventories, meet current debts, take advantage of cash discounts, and extend favorable terms to customers. Working capital is a major factor in determining the short-term liquidity position of a company. 7. When evaluated in light of a company's credit terms, the number of days' sales uncollected indicates how quickly accounts receivable are converted into cash. This provides information about the relevance of accounts receivable balances in meeting the current obligations of the business. 8. A high accounts receivable turnover implies that accounts are collected quickly, thereby providing cash that can be used to meet obligations. A high turnover also means that a given sales volume can be supported with a lower investment in accounts receivable. 9. Users are interested in the capital structure of a company, as measured by debt and equity ratios, for at least two reasons. First, as a company includes more debt in its capital structure, the risk that it will be unable to meet interest and principal payments increases. Second, the existence of debt introduces financial leverage. If the company can earn a rate of return on its investments that exceeds the rate of interest paid to creditors, the debt will increase the rate of return to stockholders. Solutions Manual, Chapter

2 10. Inventory turnover reflects on the efficiency of inventory management. That is, a high inventory turnover means that a given sales volume can be supported with a smaller investment in inventory. This insight into the speed with which inventory is sold determines the relevance of the available inventory in meeting the current obligations of the business, which is a focus of short-term liquidity. 11. Since management is responsible for a company's performance, all ratios that are useful in evaluating a company are of some usefulness in assessing management performance. Profit margin, total asset turnover, return on total assets, and return on stockholders' equity are especially useful for assessing management's responsibility for operating efficiently and profitably. 12. Almost all companies have some liabilities. Since total assets equals total liabilities plus equity, total assets are almost always higher than common stockholders' equity. Thus, the denominator in return on total assets is larger than common stockholders' equity. Since the numerator is the same for both, and return on total assets has a larger denominator, it yields a smaller percent. [Instructor note: A more complete measure of return on assets would add back (Interest Expense x {1 Tax Rate}) to net income in the numerator reflecting the after-tax cost of debt. We leave the rationale for this adjustment to advanced courses.] 13. This gain is considered to be unusual but not infrequent. It would be included in the calculation of income from continuing operations, with other unusual or infrequent gains and losses in a category often labeled Other Gains and Losses. 14. Profit margin: Net Income / Sales ($ in thousands) 2011: $227,575/$2,656,949 = 8.6% 2010: $147,138/$1,991,139 = 7.4% 15. Equity ratio: Total Equity / Total Assets ($ in thousands) 2011: $183,036/$272,906 = 67.1% 2010: $167,339/$246,084 = 68.0% 16. Debt ratio: Total Liabilities / Total Assets ( in thousands) 2011: 1,073,966/ 1,520,184 = 70.6% 2010: 1,102,832/ 1,545,722 = 71.3% 17. Return on total assets: Net Income / Average Total Assets ( in thousands) 2011: 20,818/ (( 485, ,325)/2) = 4.5% 724 Financial & Managerial Accounting, 5th Edition

3 QUICK STUDY Quick Study 13-1 (5 minutes) Items not part of general-purpose financial statements: d. Prospectus. e. Stock price information and analysis. g. Management discussion and analysis of financial performance. i. Company news releases. Quick Study 13-2 (5 minutes) Trend percents % ($801,810/ $453,000) % (the given base amount) Quick Study 13-3 (5 minutes) Common-size percents % ($392,887 / $801,810) % ($134,088 / $453,000) Quick Study 13-4 (15 minutes) Dollar Change Percent Change Short-term investments... $374,634 $234,000 $140, % Accounts receivable... 97, ,000 (3,636) -3.6% Notes payable ,000 88,000 (not calculable) Solutions Manual, Chapter

4 Quick Study 13-5 (10 minutes) The four usual standards of comparisons are: Intracompany. The company under analysis provides standards for comparisons based on prior performance and relations between its financial items. Competitor. One or more direct competitors of the company under analysis can provide standards for comparisons. Industry. Industry statistics can provide standards of comparisons. Published industry statistics are available from several services such as Dun & Bradstreet, Standard and Poor's, and Moody's. Guidelines (Rules of Thumb). General standards of comparisons can develop from past experiences. Examples are the 2-to-1 level for the current ratio or 1-to-1 level for the acid-test ratio. All of these standards of comparisons are useful when properly applied. Yet, analysis measures taken from a selected competitor or group of competitors are often the best standards of comparisons. Also, intracompany and industry measures are important parts of all analyses. The standard that is least likely to provide a good basis for comparison is the use of guidelines, or rules of thumb. Guidelines must be applied with care, and then only if they seem reasonable in light of past experience and industry's norms. Quick Study 13-6 (10 minutes) Ratio Change 1. Profit Margin Ratio... 9% 8% Favorable 2. Debt Ratio... 47% 42% Unfavorable 3. Gross Margin Ratio... 34% 46% Unfavorable 4. Acid-test Ratio Unfavorable 5. Accounts Receivable Turnover Unfavorable 6. Basic Earnings Per Share... $1.25 $1.10 Favorable 7. Inventory Turnover Favorable 8. Dividend Yield % 1.2% Favorable 726 Financial & Managerial Accounting, 5th Edition

5 Quick-Study 13-7 (30 minutes) Parker has a greater amount of working capital. This by itself does not indicate whether the company is more capable of meeting its current obligations. However, support is provided by the current ratio and acidtest ratio, which show Parker is in a more liquid position than Morgan. This evidence does not mean that Morgan's liquidity is inadequate. Such a conclusion would require more information such as norms for the industry or its other competitors. Notably, Morgan's acid-test ratios approximate the traditional rule of thumb (1 to 1). This evidence also shows that Parker's working capital, current ratio, and acid-test ratio all increased dramatically over the three-year period. This trend toward greater liquidity may be positive, but it can also suggest that Parker holds an excess amount of highly liquid assets that typically earn low returns. The accounts receivable turnover and inventory turnover indicate that Morgan is more efficient in collecting its accounts receivable and in generating sales from available inventory. However, these statistics also may suggest that Morgan is too conservative in granting credit and investing in inventory. This could have a negative impact on sales and net income. Parker's ratios may be acceptable, but no definitive determination can be made without having information on industry (or other competitors ) standards. Quick Study 13-8 A (5 minutes) This material error should be reported on the statement of retained earnings (and/or the statement of stockholders equity) as a prior period adjustment to the beginning retained earnings balance. Also, if prior year s financial numbers are reported, they should be revised to show the correct numbers. Solutions Manual, Chapter

6 Quick Study 13-9 (10 minutes) a. Although ratio analysis can eliminate currency differences, it cannot eliminate differences in the application of GAAP under different accounting systems. For example, if we compare the gross margin percent for a European company applying FIFO under IFRS versus an American company applying LIFO under U.S. GAAP, the percents will be impacted by differences in FIFO versus LIFO. Thus, we must still adjust the accounting numbers for fundamental differences in accounting methods when performing ratio analysis. Additional examples that are arguably even more problematic: (1) Consider two companies, one reporting under U.S. GAAP and the other under IFRS, which we are reviewing via the Operating Cash Flow / Average Total Assets ratio. We can potentially see the dividends and the interest items reported differently for these two companies under the two different reporting regimes. That type of difference would persist (that is, not be reversed). (2) Consider the same type of comparison as we look at the Return on Total Assets ratio. Again, we can potentially see differences in asset values through IFRS s more aggressive methods. These methods include the mark up associated with reversals of previous write-downs. Also some long-term asset revaluation methods are also more aggressive than U.S. GAAP. Different from this paragraph s first example, however, many of these differences in asset revaluations will be captured over time (multiple periods) with both accounting systems. b. A key advantage to using horizontal and vertical analyses when examining companies reporting under different currencies is that the computation of the percentages eliminates the currency effects. This enhances our comparative analysis of companies. For example, the gross margin percent from a European company using IFRS, and from a Japanese company using Japan GAAP, and from an American company using U.S. GAAP can be directly compared and assessed. 728 Financial & Managerial Accounting, 5th Edition

7 EXERCISES Exercise 13-1 (10 minutes) 1. B 6. A 2. C 7. B 3. D 8. B 4. C 9. C 5. A 10. A Exercise 13-2 (5 minutes) 1. Profit Margin and the Total Asset Turnover. Return on Total Assets. 2. Working Capital, also called net working capital. 3. Accounts Receivable Turnover and the Days' Sales Uncollected. Exercise 13-3 (20 minutes) Sales Cost of goods sold Accounts receivable Analysis: The trend in sales is positive. While this is better than no growth, one cannot definitively say whether the sales trend is favorable without additional information about the economic conditions in which this trend occurred such as inflation rates and competitors performances. Given the trend in sales, the comparative trends in both cost of goods sold and accounts receivable are somewhat unfavorable. In particular, for the most recent year, both are increasing at slightly faster rates (indexes for cost of goods sold is 191 and accounts receivable is 201) compared to sales (index is 189). Solutions Manual, Chapter

8 Exercise 13-4 (25 minutes) Answer: Net income decreased. Supporting calculations: When the sum of each year's common-size cost of goods sold and total expenses is subtracted from the common-size sales percent, the net income percent is as follows: 2012 net income percent: = 25.8% of sales 2013 net income percent: = 23.3% of sales 2014 net income percent: = 21.3% of sales Next, if 2012 sales are assumed to be $100, then sales for 2013 are $ and the sales for 2014 are $ If the net income percents for the three years are applied to these amounts, the net incomes are: 2012 net income: $ x 25.8% = $ net income: $ x 23.3% = $ net income: $ x 21.3% = $22.45 This shows that net income decreased over the three-year period. Exercise 13-5 (25 minutes) Sales % 100.0% Cost of goods sold Gross profit Operating expenses Net income % 18.5% Analysis: Overall, this company s situation has worsened. This is evident from the substantial decline in net income as a percent of sales for 2013 (7.0%) relative to 2012 (18.5%). The main culprit is the increase in cost of goods sold as a percent of sales from 46.5% in 2012 to 75.7% in On a somewhat positive note, the company has not experienced any increase in operating expenses as a percent of sales; indeed, declining from 35.0% in 2012 to 17.3% in Even more positive is the company s level of sales increase from $625,000 in 2012 to $740,000 in Financial & Managerial Accounting, 5th Edition

9 Exercise 13-6 (30 minutes) COMPARATIVE ANALYSIS REPORT Clay's profit margins are higher than Roak's. However, Roak has significantly higher total asset turnover ratios. As a result, Roak generates a substantially higher return on total assets. The trends of both companies include evidence of growth in sales, total asset turnover, and return on total assets. However, Clay's rates of improvement are better than Roak's. These differences may result from the fact that Clay is only three years old, while Roak is a somewhat more established company. Clay's operations are considerably smaller than Roak's, but that will not persist many more years if both companies continue to grow at their current rates. To some extent, Roak's higher total asset turnover ratios may result from the fact that its assets may have been purchased years earlier. If the turnover calculations had been based on current values, the differences might be less striking. The relative ages of the assets also may explain some of the difference in profit margins. Assuming Clay's assets are newer, they may require smaller maintenance expenses. Finally, Roak successfully employed financial leverage in Its return on total assets is 9.0% compared to the 7% interest rate it paid to obtain financing from creditors. In contrast, Clay's return is only 5.9% as compared to the 7% interest rate paid to creditors. Solutions Manual, Chapter

10 Exercise 13-7 (20 minutes) Simon Company Common-Size Comparative Balance Sheets December 31, At December * 2012 Assets Cash % 8.0% 10.0% Accounts receivable, net Merchandise inventory Prepaid expenses Plant assets, net Total assets % 100.0% 100.0% Liabilities and Equity Accounts payable % 16.9% 13.6% Long-term notes payable secured by mortgages on plant assets Common stock, $10 par value Retained earnings Total liabilities and equity % 100.0% 100.0% * Column does not equal due to rounding. Analysis: Several observations can be made. (1) Cash as a percent of assets has declined this is favorable provided sufficient cash is available for operations. (2) Accounts receivable have increased as a percent of assets this may be unfavorable in that assets are tied up in an unproductive manner and there would be additional assets exposed to the risk of uncollection; it could be favorable if increased sales outweigh these costs and risk. (3) Plant assets have declined as a percent of assets this is favorable if the company is operating more efficiently; it could be unfavorable if the company is downsizing due to poor performance. (4) Accounts payable have markedly increased as a percent of assets this could reveal liquidity constraints. (5) Common stock has markedly declined this could reflect a stock buyback program or other mechanisms to reduce shares outstanding. 732 Financial & Managerial Accounting, 5th Edition

11 Exercise 13-8 (25 minutes) 1. Current ratio 2014: $31,800 + $89,500 + $112,500 + $10,700 = 1.88 to 1 $129, : $35,625 + $62,500 + $82,500 + $9,375 $75,250 = 2.52 to : $37,800 + $50,200 + $54,000 + $5,000 = 2.87 to 1 $51, Acid-test ratio 2014: $31,800 + $89,500 $129,900 = 0.93 to : $35,625 + $62,500 $75,250 = 1.30 to : $37,800 + $50,200 $51,250 = 1.72 to 1 Analysis and Interpretation: Simon's short-term liquidity position has deteriorated over this three-year period. Both the current and acid-test ratios show declining trends. Although we do not have information about the nature of the company's business, the acid-test ratio shifts from 1.72 to 1 down to 0.93 to 1 and the current ratio shifts from 2.87 to 1 down to 1.88 to 1 both suggest a potential liquidity problem. Still, we must recognize that industry standards could show that the 2012 ratios were too high (instead of 2014 ratios as being too low). Solutions Manual, Chapter

12 Exercise 13-9 (25 minutes) 1. Days' sales uncollected 2014: $89,500 x 365 = 48.5 days $673, : $62,500 x 365 = 42.9 days $532, Accounts receivable turnover $673, : ($89,500 + $62,500)/2 = 8.9 times $532, : ($62,500 + $50,200)/2 = 9.4 times 3. Inventory turnover $411, : = 4.2 times ($112,500 + $82,500)/2 $345, : = 5.1 times ($82,500 + $54,000)/2 4. Days sales in inventory $112, : x 365 = 99.9 days $411,225 $82, : x 365 = 87.2 days $345,500 Analysis and Interpretation: The number of days' sales uncollected has increased and the accounts receivable turnover has declined. Also, the inventory turnover has decreased and days sales in inventory has increased. While none of these changes in ratios that occurred from 2013 to 2014 appear dramatic, it seems that Simon is becoming less efficient in managing its inventory and in collecting its receivables. 734 Financial & Managerial Accounting, 5th Edition

13 Exercise (25 minutes) 1. Debt and equity ratios Total liabilities and debt ratio $129,900 + $98, $228, % $75,250 + $101, $176, % Total equity and equity ratio $163,500 + $131, , $163,500 + $104, , Total liabilities and equity... $523, % $445, % 2. Debt-to-equity ratio 2014: $228,400 / $294,600 = 0.78 to : $176,750 / $268,250 = 0.66 to 1 3. Times interest earned 2014: ($31,100 + $9,525 + $12,100) / $12,100 = 4.4 times 2013: ($29,375 + $8,845 + $13,300) / $13,300 = 3.9 times Analysis and Interpretation: Simon added debt to its capital structure during 2014, with the result that the debt ratio increased from 39.7% to 43.7%. In addition, the debt-to-equity ratio also increased from 0.66 to 1 to 0.78 to 1. We should note that the debt increase is mostly in current liabilities, which places a greater stress on short-term liquidity. Solutions Manual, Chapter

14 Exercise (30 minutes) 1. Profit margin 2014: $31,100 / $673,500 = 4.6% 2013: $29,375 / $532,000 = 5.5% 2. Total asset turnover $673, : ($523,000 + $445,000)/2 = 1.4 times $532, : ($445,000 + $377,500)/2 = 1.3 times 3. Return on total assets $31, : ($523,000 + $445,000)/2 = 6.4% $29, : ($445,000 + $377,500)/2 = 7.1% Analysis and Interpretation: Simon's operating efficiency appears to be declining because the return on total assets decreased from 7.1% to 6.4%. While the total asset turnover favorably increased slightly from 2013 to 2014, the profit margin unfavorably decreased from 5.5% to 4.6%. The decline in profit margin indicates that Simon's ability to generate net income from sales has declined. 736 Financial & Managerial Accounting, 5th Edition

15 Exercise (20 minutes) 1. Return on common stockholders' equity $31, : = 11.1% ($294,600 + $268,250)/2 $29, : = 11.5% ($268,250 + $242,750)/2 2. Price-earnings ratio, December : $30 / $1.90 = : $28 / $1.80 = Dividend yield 2014: $0.29 / $30 = 0.1% 2013: $0.24 / $28 = 0.9% Analysis and interpretation The company s return on common stockholders equity is good, but not great. An 11% return likely makes it an acceptable investment (in the business world) provided its risk is not too high. The company s price-earnings ratio is around 16. This suggests that the market does view this company to have some growth potential. The dividend yield is on the low side. Thus, this stock would likely be classified as a growth stock, and the price-earnings ratio suggests that the market does perceive a high likelihood of some growth. Exercise A (10 minutes) 1. A Income (loss) from continuing operations 2. C Extraordinary gain (loss) 3. A Income (loss) from continuing operations 4. A Income (loss) from continuing operations 5. A Income (loss) from continuing operations 6. B Gain (loss) from disposing of a discontinued segment 7. B Income (loss) from operating a discontinued segment 8 A Income (loss) from continuing operations Solutions Manual, Chapter

16 Exercise (15 minutes) RANDA MERCHANDISING, INC. Income Statement For Year Ended December 31, 2013 Net sales... $2,900,000 Expenses Cost of goods sold... $1,480,000 Salaries expense ,000 Depreciation expense ,500 Total expenses... 2,352,500 Income from continuing operations before taxes ,500 Income taxes expense ,000 Income from continuing operations ,500 Discontinued segment Loss from operating wholesale business segment (net of tax)... (444,000) Gain on sale of wholesale business segment (net of tax) , ,000 Income before extraordinary gain ,500 Extraordinary gain on condemnation of company property (net of tax) ,000 Net income... $ 891, Financial & Managerial Accounting, 5th Edition

17 Exercise (15 minutes) 1. Current ratio = (in s) 1,468,706 / 333,301 = 4.41 (in $s) $17,695,254 / $4,015,683 = 4.41 Net profit margin = (in s) 77,621 / 1,014,345 = 7.65% (in $s) $935,200 / $12,221,031 = 7.65% Sales-to-assets = (in s) 1,014,345 / 1,634,297 = 0.62 (in $s) $12,221,031 / $19,690,330 = The results in part 1 reveal that ratios can help us overcome differences attributable to currencies. However, ratios do not overcome potential differences in application of accounting principles. Solutions Manual, Chapter

18 PROBLEM SET A Problem 13-1A (60 minutes) Part 1 Current ratio: December 31, 2014: $52,390 / $22,800 = 2.3 to 1 December 31, 2013: $37,924 / $19,960 = 1.9 to 1 December 31, 2012: $51,748 / $20,300 = 2.5 to 1 Part 2 KORBIN COMPANY Common-Size Comparative Income Statements For Years Ended December 31, 2014, 2013, and Sales % % % Cost of goods sold Gross profit Selling expenses Administrative expenses Total expenses Income before taxes Income taxes Net income % 11.85% 12.53% 740 Financial & Managerial Accounting, 5th Edition

19 Problem 13-1A (Concluded) Part 3 Assets KORBIN COMPANY Balance Sheet Data in Trend Percents December 31, 2014, 2013, and Current assets % 73.29% % Long-term investments Plant assets, net Total assets Liabilities and Equity Current liabilities % 98.33% % Common stock Other paid-in capital Retained earnings Total liabilities and equity Part 4 Significant relations revealed Korbin s selling expenses and income taxes consumed smaller portions of each sales dollar in 2013 than However, cost of goods sold and administrative expenses consumed a larger portion in Therefore, income as a percent of sales declined from 2012 to In 2014, selling expenses, administrative expenses, and income tax took a greater portion of each sales dollar while the gross profit portion improved. The reduction in cost of goods sold allowed income as a percent of sales to increase from 2013 to 2014 Korbin expanded its plant assets in 2013, financing the expansion through the sale of long-term investments, through a reduction in working capital (the current ratio decreased from 2.5-to-1 to 1.9-to-1), and perhaps through the sale of a small amount of stock. As to the stock increase, it is not possible to tell from these two statements whether the company sold shares or declared a stock dividend. In either case, the increase in retained earnings during 2013 indicates that net income was larger than the reductions from cash (and perhaps stock) dividends. In 2014, working capital increased, the current ratio increased from 1.9-to-1 to 2.3-to-1, and cash dividends were paid. Solutions Manual, Chapter

20 Problem 13-2A (120 minutes) Part 1 HAROUN COMPANY Income Statement Trends For Years Ended December 31, Sales % 161.2% 147.6% 136.2% 127.8% 119.6% 100.0% Cost of goods sold Gross profit Operating expenses Net income HAROUN COMPANY Balance Sheet Trends December 31, Cash % 87.6% 92.1% 94.4% 98.9% 96.6% 100.0% Accounts recble., net Merchandise inventory Other current assets Long-term investments Plant assets, net Total assets Current liabilities Long-term liabilities Common stock Other paid-in capital Retained earnings Total liabilities & equity Financial & Managerial Accounting, 5th Edition

21 Problem 13-2A (concluded) Part 2 Analysis and Interpretation The statements and the trend percent data indicate that the company significantly expanded its plant assets in Prior to that time, the company enjoyed increasing gross profit and net income. Sales grew steadily for the entire period of 2008 to However, beginning in 2012, cost of goods sold and operating expenses increased dramatically relative to sales, resulting in a significant reduction in net income. In 2014, net income was only 52.7% of the 2008 base year amount. At the same time that net income was declining, assets were increasing. This indicates that Haroun was becoming less efficient in using its assets to generate income. The short-term liquidity of the company continued to decline. Accounts receivable did not change significantly for the period of 2012 to 2014, but cash steadily declined and inventory sharply increased as did current liabilities. Solutions Manual, Chapter

22 Problem 13-3A (60 minutes) Transaction Current Assets Quick Assets Current Liabilities Current Ratio Acid-Test Ratio Working Capital Beginning* $700,000 $308,000 $280, $420,000 May , ,000 Bal. 750, , , ,000 May , ,000-55,000 Bal. 805, , , ,000 May , ,000-20,000-20,000 Bal. 805, , , ,000 May 15-22,000-22,000-22,000 Bal. 783, , , ,000 May Bal. 783, , , ,000 May ,000 Bal. 783, , , ,000 May 26-50,000-50,000-50,000 Bal. 733, , , ,000 May , , ,000 Bal. 833, , , ,000 May , ,000 Bal. 913, , , ,000 May , ,000 Bal. $733,000 $346,000 $408, $325,000 *Beginning balances Current assets (given)... $700,000 Current liabilities ($700,000 / 2.50) ,000 Quick assets ($280,000 x 1.10) , Financial & Managerial Accounting, 5th Edition

23 Problem 13-4A (50 minutes) 1. Current ratio $10, ,400 + $29,200 + $4,500 + $32,150 + $2,650 $17,500 + $3,200 + $3,300 = 3.6 to 1 2. Acid-test ratio $10,000 + $8,400 + $29,200 + $4,500 $17,500 + $3,200 + $3,300 = 2.2 to 1 3. Days' sales uncollected $29,200 + $4,500 $448,600 x 365 = 27.4 days 4. Inventory turnover $297,250 ($48,900 + $32,150)/2 = 7.3 times 5. Days sales in inventory $32,150 $297,250 x 365 = 39.5 days 6. Debt-to-equity ratio ($17,500 + $3,200 + $3,300 + $63,400) / ($90,000 + $62,800) = 0.57 to 1 7. Times interest earned ($151,350 - $98,600) / $4,100 = 12.9 times 8. Profit margin ratio $29,052 $448,600 = 6.5% Solutions Manual, Chapter

24 Problem 13-4A (Concluded) 9. Total asset turnover $448,600 ($240,200 + $189,400)/2 = 2.1 times 10. Return on total assets $29,052 ($240,200 + $189,400)/2 = 13.5% 11. Return on common stockholders' equity $29,052 ($152,800 + $112,748)/2 = 21.9% 746 Financial & Managerial Accounting, 5th Edition

25 Problem 13-5A (60 minutes) Part 1 a. Current ratio Barco Company $155,440* $61,340 Kyan Company $238,050** = 2.5 to 1 = 2.6 to 1 $93,300 * $19,500 + $37,400 + $9,100 + $84,440 + $5,000 = $155,440 **$34,000 + $57,400 + $7,200 + $132,500 + $6,950 = $238,050 b. Acid-test ratio $66,000* $61,340 $98,600** = 1.1 to 1 $93,300 = 1.1 to 1 * $19,500 + $37,400 +$9,100 = $66,000 **$34,000 + $57,400 + $ 7,200 = $98,600 c. Accounts receivable turnover $770,000 ($37,400 + $9,100 + $29,800)/2 $880,200 = 20.2 times ($57,400 + $7,200 + $54,200)/2 = 14.8 times d. Inventory turnover $585,100 ($84,440 + $55,600)/2 $632,500 = 8.4 times = 5.3 times ($132,500 + $107,400)/2 e. Days sales in inventory $84,440 $585,100 x 365 = 52.7 days $132,500 $632,500 x 365 = 76.5 days f. Days' sales uncollected $37,400 + $9,100 $770,000 x 365 = 22.0 days $57,400 + $7,200 $880,200 x 365 = 26.8 days Short-term credit risk analysis: Barco and Kyan have essentially equal current ratios and equal acid-test ratios. However, Barco both turns its merchandise and collects its accounts receivable more rapidly than does Kyan. On this basis, Barco probably is the better short-term credit risk. Solutions Manual, Chapter

26 Problem 13-5A (Concluded) Part 2 Barco Company Kyan Company a. Profit margin ratio $162,200 $770,000 = 21.1% $210,400 = 23.9% $880,200 b. Total asset turnover $770,000 ($445,440 + $398,000)/2 = 1.8 times $880,200 = 1.9 times ($542,450 + $382,500)/2 c. Return on total assets $162,200 ($445,440 + $398,000)/2 = 38.5% $210,400 = 45.5% ($542,450 + $382,500)/2 d. Return on common stockholders' equity $162,200 ($303,300 + $278,300)/2 = 55.8% $210,400 = 65.0% ($348,150 + $299,600)/2 e. Price-earnings ratio $75 $4.51 = 16.6 $75 = 14.7 $5.11 f. Dividend yield $3.80 $75 = 5.1% $3.80 = 5.1% $75 Investment analysis: Kyan's profit margin ratio, total asset turnover, return on total assets, and return on common stockholders' equity are all higher than Barco s. Although the companies pay the same dividend, Kyan's priceearnings ratio is lower. All of these factors suggest that Kyan's stock is likely the better investment. 748 Financial & Managerial Accounting, 5th Edition

27 Problem 13-6A A (60 minutes) Part 1 Effect of income taxes (debits or losses in parentheses) Pretax 30% Tax Effect After-Tax i. Loss from operating a discontinued segment... (18,250) (5,475) (12,775) j. Gain on insurance recovery of tornado damage... 29,120 8,736 20,384 m. Correction of overstatement of prior year s sales... (16,000) (4,800) (11,200) n. Gain on sale of discontinued segment s assets... 34,000 10,200 23,800 Part 2 Income from continuing operations (and its components) k. Net sales... $ 998,500 a. Interest revenue... 14,000 g. Gain from settling lawsuit... 44,000 Total revenues and gains... 1,056,500 q. Cost of goods sold... $482,500 b. Depreciation expense Equipment... 34,000 l. Depreciation expense Buildings... 52,000 e. Other operating expenses ,400 c. Loss on sale of equipment... 25,850 o. Loss from settling lawsuit... 23,750 Total expenses... (724,500) Income from continuing operations before taxes ,000 p. Income taxes expense (30%)... (99,600) Income from continuing operations after taxes... $ 232,400 Solutions Manual, Chapter

28 Problem 13-6A A (Concluded) Part 3 Income from discontinued segment i. Loss from operating a discontinued segment (after-tax)... $ (12,775) n. Gain on sale of discontinued segment s assets (after-tax)... 23,800 Income from discontinued segment... $ 11,025 Part 4 Income before extraordinary items Income from continuing oper. after taxes (from Part 2)... $232,400 Income from discontinued segment (from Part 3)... 11,025 Income before extraordinary items... $221,375 Part 5 Net income Income before extraordinary items... $221,375 j. Extraordinary item Gain on insurance recovery of tornado damage (after-tax)... 20,384 Net income... $241, Financial & Managerial Accounting, 5th Edition

29 PROBLEM SET B Problem 13-1B (60 minutes) Part 1 Current ratio: December 31, 2014: $54,860 / $22,370 = 2.5 to 1 December 31, 2013: $32,660 / $19,180 = 1.7 to 1 December 31, 2012: $36,300 / $16,500 = 2.2 to 1 Part 2 BLUEGRASS CORPORATION Common-Size Comparative Income Statements For Years Ended December 31, 2014, 2013, and Sales % % % Cost of goods sold Gross profit Selling expenses Administrative expenses Total expenses Income before taxes Income taxes Net income % 23.80% 26.84% * Some totals do not reconcile due to rounding. Solutions Manual, Chapter

30 Problem 13-1B (Concluded) Part 3 Assets BLUEGRASS CORPORATION Balance Sheet Data in Trend Percents December 31, 2014, 2013, and Current assets % 89.97% % Long-term investments Plant assets Total assets Liabilities and Equity Current liabilities % % % Common stock Other paid in capital Retained earnings Total liabilities and equity Part 4 Significant relations revealed Bluegrass's cost of goods sold took a larger percent of sales each year. Selling and administrative expenses and income taxes took a somewhat smaller portion each year, but not enough to offset the effect of cost of goods sold. As a result, income became a smaller percent of sales each year. The large expansion of plant assets in 2013 was financed by a reduction in current assets, an increase in current liabilities, a large reduction in longterm investments, and apparently by a stock sale. One effect of this plan was to reduce the current ratio. However, the current ratio recovered in This apparently resulted from profits, limiting the amount of dividends paid, and the liquidation of long-term investments. 752 Financial & Managerial Accounting, 5th Edition

31 Problem 13-2B (120 minutes) Part 1 TRIPOLY COMPANY Income Statement Trends For Years Ended December 31, Sales % 70.9% 73.3% 79.1% 86.0% 89.5% 100.0% Cost of goods sold Gross profit Operating expenses Net income TRIPOLY COMPANY Balance Sheet Trends December 31, Cash % 67.6% 76.5% 79.4% 88.2% 91.2% 100.0% Accounts recble., net Merchandise inventory Other current assets Long-term investments Plant assets, net Total assets Current liabilities Long-term liabilities Common stock Other paid-in capital Retained earnings Total liabilities & equity Solutions Manual, Chapter

32 Problem 13-2B (Concluded) Part 2 Analysis and Interpretation The statements and the trend percent data show that sales declined every year. However, cost of goods sold did not fall as rapidly as sales. As a result, gross profit fell more rapidly than sales. Operating expenses fell less rapidly than gross profit, so the final result was that net income fell to 60.6% of the base year. Management was not able to reduce costs and expenses fast enough to keep up with the sales decline. Although the profits decreased during these years, the company did continue to earn a net income. It appears that the cash generated from operations was used primarily to reduce both current and long-term liabilities. The company made a large expansion of its plant assets during 2012, financing this expansion primarily through the liquidation of long-term investments. 754 Financial & Managerial Accounting, 5th Edition

33 Problem 13-3B (60 minutes) Transaction Current Assets Quick Assets Current Liabilities Current Ratio Acid-Test Ratio Working Capital Beginning* $300,000 $168,000 $120, $180,000 June , ,000-75,000 Bal. 345, , , ,000 June , ,000-88,000-88,000 Bal. 345, , , ,000 June , ,000 Bal. 495, , , ,000 June , , ,000 Bal. 595, , , ,000 June , ,000 Bal. 715, , , ,000 June , ,000 Bal. 440, , , ,000 June ,000 Bal. 440, , , (10,000) June Bal. 440, , , (10,000) June 22-12,000-12,000-12,000 Bal. 428, , , (10,000) June 30-80,000-80,000-80,000 Bal. $348,000 $141,000 $358, (10,000) *Beginning balances Current assets (given)... $300,000 Current liabilities ($300,000 / 2.50) ,000 Quick assets ($120,000 x 1.40) ,000 Solutions Manual, Chapter

34 Problem 13-4B (50 minutes) 1. Current ratio $6,100 + $6,900 + $12,100 + $3,000 + $13,500 + $2,000 $11,500 + $3,300 + $2,600 = 2.5 to 1 2. Acid-test ratio $6,100 + $6,900 + $12,100 + $3,000 $11,500 + $3,300 + $2,600 = 1.6 to 1 3. Days' sales uncollected $12,100 + $3,000 $315,500 x 365 = 17.5 days 4. Inventory turnover $236,100 ($13,500 + $17,400)/2 = 15.3 times 5. Days sales in inventory $13,500 $236,100 x 365 = 20.9 days 6. Debt-to-equity ratio ($11,500 + $3,300 + $2,600 + $30,000) / ($35,000 + $35,100) = 0.68 to 1 7. Times interest earned $30,200 / $2,200 = times 8. Profit margin ratio $23,800 $315,500 = 7.5% 756 Financial & Managerial Accounting, 5th Edition

35 Problem 13-4B (Concluded) 9. Total asset turnover $315,500 ($117,500 + $94,900)/2 = 3.0 times 10. Return on total assets $23,800 ($117,500 + $94,900)/2 = 22.4% 11. Return on common stockholders' equity $23,800 ($70,100 + $54,300)/2 = 38.3% Solutions Manual, Chapter

36 Problem 13-5B (60 minutes) Part 1 a. Current ratio Fargo Company $205,200 $90,500 Ball Company $208,100 = 2.3 to 1 = 2.1 to 1 $97,000 b. Acid-test ratio $108,700 $90,500 $116,000 = 1.2 to 1 = 1.2 to 1 $97,000 c. Accounts (and notes) receivable turnover $393,600 ($77,100 + $11,600 + $72,200)/2 = 4.9 times $667,500 = 8.7 times ($70,500 + $9,000 + $73,300)/2 d. Inventory turnover $290,600 ($86,800 + $105,100)/2 $480,000 = 3.0 times = 5.9 times ($82,000 + $80,500)/2 e. Days sales in inventory $86,800 $290,600 x 365 = days $82,000 $480,000 x 365 = 62.4 days f. Days' sales uncollected $77,100 + $11,600 $393,600 x 365 = 82.3 days $70,500 + $9,000 $667,500 x 365 = 43.5 days Short-term credit risk analysis: Fargo and Ball have nearly equal current ratios and equal acid-test ratios. However, Ball both turns its merchandise and collects its accounts receivable much more rapidly than Fargo. On this basis, Ball probably is the better short-term credit risk. 758 Financial & Managerial Accounting, 5th Edition

37 Problem 13-5B (Concluded) Part 2 Fargo Company Ball Company a. Profit margin ratio $33,850 $393,600 $61,700 = 8.6% = 9.2% $667,500 b. Total asset turnover $393,600 ($382,100 + $383,400)/2 $667,500 = 1.03 times = 1.48 times ($460,400 + $443,000)/2 c. Return on total assets $33,850 ($382,100 + $383,400)/2 $61,700 = 8.8% = 13.7% ($460,400 + $443,000)/2 d. Return on common stockholders' equity $33,850 ($198,600 + $182,100)/2 $61,700 = 17.8% = 23.7% ($270,100 + $250,700)/2 e. Price-earnings ratio $25 $1.27 $25 = 19.7 = 11.4 $2.19 f. Dividend yield $1.50 $25 $1.50 = 6.0% = 6.0% $25 Investment analysis: Ball s profit margin, total asset turnover, return on total assets, and return on common stockholders' equity are all higher than Fargo's. Also, Ball has a lower price-earnings ratio, while paying the same dividend. These factors indicate that Ball stock is likely the better investment. Solutions Manual, Chapter

38 Problem 13-6B A (60 minutes) Part 1 Effect of income taxes (debits or losses in parentheses) Pretax 25% Tax Effect After-Tax e. Loss on hurricane damage... (64,000) (16,000) (48,000) l. Loss from operating a discontinued segment... (120,000) (30,000) (90,000) n. Correction of overstatement of prior year s expense... 48,000 12,000 36,000 p. Loss on sale of discontinued segment s assets... (180,000) (45,000) (135,000) Part 2 Income from continuing operations (and its components) c. Net sales... $2,640,000 b. Interest revenue... 20,000 j. Gain from settling lawsuit... 68,000 Total revenues and gains... 2,728,000 o. Cost of goods sold... $1,040,000 h. Depreciation expense Equipment ,000 m. Depreciation expense Buildings ,000 g. Other operating expenses ,000 k. Loss on sale of equipment... 24,000 i. Loss from settling lawsuit... 36,000 Total expenses and losses... 1,684,000 Income from continuing operations before taxes.. 1,044,000 d. Income taxes expense (25%)... (261,000) Income from continuing operations after taxes... $ 783, Financial & Managerial Accounting, 5th Edition

39 Problem 13-6B A (Concluded) Part 3 Income from discontinued segment l. Loss from operating a discontinued segment (after-tax)... $ (90,000) p. Loss on sale of discontinued segment s assets (after-tax)... (135,000) Loss from discontinued segment... $(225,000) Part 4 Income before extraordinary items Income from cont. operations after taxes (from Part 2)... $ 783,000 Loss from discontinued segment (from Part 3)... (225,000) Income before extraordinary items... $ 558,000 Part 5 Net income Income before extraordinary items... $ 558,000 Extraordinary item: e. Loss on hurricane damage (after-tax)... (48,000) Net income... $ 510,000 Solutions Manual, Chapter

40 SERIAL PROBLEM SP 13 Serial Problem SP 13, Success Systems (45 minutes) 1. Gross margin with services revenue Gross margin = Total revenue Cost of goods sold = $43,853 - $14,052 = $29,801 Gross margin ratio = $29,801 / $43,853 = 68.0% Gross margin without services revenue Gross margin = Net (goods) sales Cost of goods sold = $18,693 - $14,052 = $4,641 Gross margin ratio = $4,641 / $18,693 = 24.8% Profit margin ratio = $18,686 / $43,853 = 42.6% 2. Current ratio = $105,209 / $875 = Acid-test ratio = $100,205 / $875 = Debt ratio = $875 / $129,909 = 0.7% Equity ratio = $129,034/$129,909 = 99.3% 4. Current assets are 81.0% of total assets ($105,209/$129,909) Long-term assets are 19.0% of total assets ($24,700/$129,909) 762 Financial & Managerial Accounting, 5th Edition

41 Reporting in Action BTN Trend percents for selected income statement accounts ($ in thousands) Revenues % 127.2% 100.0% $2,656,949 $1,991,139 $1,565,887 Cost of goods sold % 124.6% 100.0% $1,916,366 $1,460,926 $1,172,668 Operating income % 133.8% 100.0% $349,924 $220,721 $164,970 Non-operating expense (income) % 15.8% 100.0% $3,298 $2,180 $13,796 Income taxes (provision for income taxes) % 142.4% 100.0% $119,051 $71,403 $50,157 Net income % 145.7% 100.0% $227,575 $147,138 $101, Common-size percents for asset categories and accounts ($ in thousands) Total current assets % 76.1% $878,676 $808,145 Property and equipment, net % 17.3% $213,778 $184,011 Goodwill and other intangible assets % 2.9% $77,718 $31,313 Total assets for 2011 and 2010 are $1,228,024 and $1,061,647, respectively. 3. For 2011 and 2010, revenues grew at a higher rate than cost of goods sold. Operating income grew at a higher rate than revenues for 2011 and Non-operating expenses declined substantially in 2011 and Consequently, income increased for 2011 and 2010, at a higher rate than revenue growth. The common-size percent figures in part 2 show a shift away from current assets (71.6% in 2011 vs. 76.1% in 2010) and greater investment in goodwill and other intangible assets (6.3% in 2011 vs. 2.9% in 2010). Intangible assets show flat to slightly increased investment (17.4% in 2011 vs. 17.3% in 2010). 4. Answers depend on the financial statement information obtained. Solutions Manual, Chapter

42 Comparative Analysis BTN Key figures ($ thousands) Polaris Arctic Cat Cash and equivalents % $325, % $14,700 Accounts receivable, net % 115, % 23,732 Inventories % 298, % 61,478 Retained earnings % 321, % 177,493 Cost of sales % 1,916, % 363,142 Revenues % 2,656, % 464,651 Total assets % 1,228, % 272, Arctic Cat s retained earnings make up a much greater percentage of its total liabilities and equity (65.0%) vis-à-vis Polaris (26.2%). 3. Arctic Cat s cost of sales percent is slightly higher at 78.2% compared to Polaris s at 72.1%. This implies that Arctic Cat has the lower gross margin ratio on sales of 21.8%), while Polaris has the higher gross margin ratio at 27.9%. 4. Polaris has the higher percent of total assets in the form of inventory at 24.3%, compared to Arctic Cat s 22.5%. 764 Financial & Managerial Accounting, 5th Edition

43 Ethics Challenge BTN The CEO appears to have selectively chosen from the 11 available ratios to present only the ones that show trends that are favorable to the company. (However, some analysts may not interpret a decline in selling expenses as a percent of revenue as positive since it might imply a scaling back on advertising or promotion campaigns.) The CEO s motivation might be to make her performance, or the company s, or both, appear better than it is in the eyes of the analysts. 2. The consequences of this action by the CEO might be mixed. It is likely that the analysts will ask other questions that may reveal some negative trends such as the trends in return and profit margins. The CEO s actions may become transparent to the analysts as they discover the presence of less favorable trends through their questions. If discovered, such a disclosure ploy by the CEO will not reflect favorably on the company. Both the CEO and the company are likely to suffer losses in reputation and credibility. Even if the CEO is able to succeed with this strategy in the short term, once the financial statements are issued all users can compile additional ratio information and see that some of the trends are unfavorable to the company. This is likely to damage the credibility of the CEO. Communicating in Practice BTN 13-4 There is no set solution to this activity. Each team s memorandum will vary based on the industry and companies chosen for analysis. (Instructor: Consider having each team do a brief presentation discussing the findings in their memorandum to engage in a classroom discussion of the findings.) Solutions Manual, Chapter

44 Taking It to the Net BTN 13-5 ($ thousands) As of 12/31/2010 As of 12/31/ Profit margin ratio... $509,799/$5,671,009 = 9.0% $628,962/$6,080,788 = 10.3% 2. Gross profit ratio...$2,415,208/ $5,671,009 = 42.6% $2,531,892/$6,080,788 = 41.6% 3. Return on total $509,799 / ([$4,272,732 + assets... $3,675,031]/2) = 12.8% 4. Return on common stockholders equity*.. $509,799 / ([$937,601 + $760,339]/2) = 60.0% $628,962/ ([$4,412,199 + $4,272,732]/2) = 14.5% $628,962/ ([$872,648 + $937,601]/2) = 69.5% 5. Basic net income per common share**... *An acceptable alternative solution would be to include minority interest in equity. **Taken from consolidated statement of income. $ 2.29 $ 2.85 Analysis and Interpretation: Hershey s performance generally improved in all areas evaluated for the profitability metrics reported in the table above. Part 1 Teamwork in Action BTN 13-6 Team reports should look something like the following: Horizontal Analysis Horizontal analysis is comparing a company s financial statement amounts across time. We compare data from comparative statements that are horizontally aligned; that is, we compare the same items from one period to another period. The change disclosed by the comparison is generally expressed as a dollar amount and/or as a percent. For instance, we compare sales of one period to sales of another and determine the dollar amount of the increase or decrease. We also determine the percent of increase or decrease in sales that this change represents. This type of comparison is generally completed on a line-by-line basis for both income statement and balance sheet items (and sometimes for other financial statements). Example: Assume that prior year sales equal $240,000, and current year sales equal $300,000. Horizontal analysis of sales yields a $60,000 increase or a 25% increase in sales. (Computation is defined as: Amount of change / Base year [or $60,000/$240,000].) 766 Financial & Managerial Accounting, 5th Edition