Chapter 4 Review of Accounting

Transcription

1 Chapter 4 Review of Accounting Overview: This chapter provides a review of accounting principles and practices. The components of the balance sheet, income statement, and cash flow statements are reviewed. You also learn to calculate depreciation and taxes. An understanding of these financial statements enables the financial manager to analyze the cash needs of his/her firm, enabling him/her to help the firm achieve financial success. What You Should Know From This Chapter: 1. Explain how financial managers use the three basic accounting financial statements: the income statement, the balance sheet, and the statement of cash flows: Income Statement: The items on the income statement that you should understand include revenue items such as sales; and expenses which are listed as follows: a. Cost of goods sold (labor, materials, overhead expenses) b. Selling and administrative expenses (marketing salaries, office support, insurance, etc.) c. Depreciation (allocation of cost of plant and equipment) d. Interest (payments associated with any interest-bearing liabilities of the company) You should also understand the difference between operating income (EBIT), earnings before taxes (EBT), and net income. The importance of earnings per share is also discussed. 31

2 Balance Sheet: The items on the balance sheet that you should understand include the categories of assets, liabilities, and equity and are described as follows: Assets: Current Assets are short-term liquid assets and include such items as: Cash, marketable securities, inventory, accounts receivable, and prepaid expenses. Fixed Assets include assets that are expected to provide a benefit to the firm for more than one year. Liabilities: How the assets are financed. Current Liabilities are short-term debt obligations and include such items as notes payable, accounts payable, and wages payable. Long-term Liabilities include bonds payable and other debt not due in less than one year. Equity: How the assets are financed other than by debt. Common Stock is the stated value on the stock certificate times the number of shares issued. Capital in excess of par is the total of the original market price per share for each stock sold minus the par value of the stock. Retained Earnings represents the sum of all the net income of a business that has not been paid out in dividends. Statement of Cash Flows: This statement shows how cash flows into and out of a company over a given period of time. 2. Discuss how depreciation affects cash flow, and compute depreciation expense: Depreciation expense for a given period is determined by calculating the total amount to be depreciated and then calculating the percentage of that total to be allocated to a given time period. Methods used include straight-line where you divide the cost of the asset by the number of years of life for the asset according to classification rules, and charge off the result as depreciation expense each year. The Modified Accelerated Cost Recovery System (MACRS) specifies that some percent of the cost of assets will be charged each year as depreciation expense during the asset s life. Larger percentages are allocated to early years under this system. The table of deduction percentages allowed is given in Table 4-1 on page 73 of the text. 32

3 3. Explain how to explain how taxes affect a firm s value, and calculate marginal and average tax rates: The marginal tax rate generally increases as the level of taxable income increases. This pattern reflects the progressive tax rate structure imposed by the federal government. The marginal tax rate is the rate applied to the next dollar of taxable income. The average tax rate is calculated by dividing tax dollars paid by earnings before taxes: 33

4 Terminology and Concept Review 4-1. The shows the firm s assets, liabilities, and equity at a given point in time are assets that are expected to provide a benefit to the firm for more than one year The contains audited financial statements submitted annually to the SEC for distribution to the public The tax rate that applies to the next dollar of taxable income earned, the, changes as the level of taxable income changes specifies the percent of the cost of assets that will be charged each year as depreciation expense during the asset s life as dictated by the Tax Reform Act of In addition to the income statement, many firms prepare a short that records dividend and retained earnings information Which of the following would be considered either current assets or liabilities? Cash, Fixed Assets, Retained Earnings, Accounts Payable, Inventory 4-8. What statement measures a firm s profitability over a period of time? 4-9. What is the formula for EPS? Current assets minus current liabilities = Give the formula for calculating the effective tax rate Finish the following statement: The matching principle says that True or False: Net profit is equivalent to net cash flow at the end of an accounting period The stated value printed on the stock certificate is called the Finish the following statement: Depreciation basis is equal to. 34

5 Problems and Short-Answer Questions What is the difference between capital in excess of par and common stock? Explain the difference between a prepaid expense and an accrued expense; why is one considered an asset and one a liability? Retained earnings includes net income before any dividends are deducted. Comment on this statement You have a net income of $76,000; taxes are paid at a rate of 40%; common stock dividends paid are $40,000; and shares of stock outstanding are 50,000. Calculate the EPS Cash at the end of 2011 was $100,000 and cash at the end of 2012 was $105,000. Your cash flow statement shows a net cash position of zero. Is this possible? Explain. 35

6 4-21. The following information corresponds to Flynn Corporation s 2012 operations. COGS $400,000 S&A Expenses 50,000 Depreciation 400,000 Sales 1,000,000 Interest Expense 10,000 Tax Rate 35% Calculate the following income statement items: a. Gross Profit b. EBIT c. EBT d. Taxes e. Net Income The following information corresponds to AREO Corporation s 2012 operations. Sales $13,000,000 Net Income 400,000 Interest Expense 100,000 Preferred Dividends 200,000 Common Stock Dividends 300,000 Beginning Retained Earnings 900,000 Calculate Ending Retained Earnings: Explain why the change in retained earnings is not included on the cash-flow statement. 36

7 Use the following information for Questions 4-24 to 4-29: Balance Sheet Dec-12 Dec-11 Dec-12 Dec-11 Assets Liabilities Cash Notes Payable 0 0 Marketable Securities Accounts Payable Net Receivables Taxes Payable Inventories Accrued Expenses Prepaids Long-Term Debt Gross Plant & Equip Stockholders' Equity Accumulated Dep Common Stock Net Plant & Equip Retained Earnings Compute the following totals for Dec of 2011 and a. Current Assets b. Total Assets c. Current Liabilities d. Total Liabilities e. Total Stockholders Equity Show whether or not the basic accounting equation is satisfied in problem

8 4-26. Calculate the cash flows from the changes in the following from the end of 2011 to the end of Indicate inflow or outflow. a. Accumulated Depreciation b. Net Receivables c. Inventories d. Prepaids e. Plant and Equipment f. Accounts Payable g. Accrued Expenses h. Long-Term Debt i. Common Stock j. Taxes Payable k. Marketable Securities Prepare a statement of cash flows in proper form using the inflows and outflows from question Assume net income from the 2012 income statement was $1, Show whether or not your net cash flow matches the change in cash between the end of 2011 and end of 2012 balance sheets Show whether or not the retained earnings equation balances. 38

9 4-30. A firm expects to have earnings before depreciation and taxes of $200,000 in each of the next three years. There are no interest payments and taxes are at a rate of 35%. It is considering the purchase of an asset costing $200,000 requiring $20,000 in installation costs and having a MACRS recovery period of three years. a. Calculate the annual depreciation for each year using the MACRS depreciation percentages. (Schedule on page 73) b. If common stock dividends paid are $20,000 and shares of common stock outstanding are 25,000, what is the EPS in year two? Calculate earnings per share for the following: Net income 575,000 Interest expense 40,000 Common dividends paid 125,000 Common shares outstanding 450, Silverun, Inc., has before tax income of $500,000. a. Using the corporate progressive tax rate schedule, calculate its tax obligation. (Schedule in Table 4-2 on page 74) b. What is its marginal tax rate? c. What is Silverun s average (effective) tax rate? 39

10 4-33. Hibbert Inc. had retained earnings at the end of 2011 of $3,500, net income was $500,000 and retained earnings for the end of 2012 was $3,700,000. What was the amount paid in dividends to common stockholders in 2012? Wilmot Manufacturing bought new equipment in 2012 for $500,000 (total cost). The equipment falls into the MACRS seven-year class. What would be the depreciation taken on this equipment in year 3 using MACRS rules? 40

11 Answers 4-1. Balance sheet (Page 72) 4-2. Fixed assets (Page 72) K report (Page 68) 4-4. Marginal tax rate (Page 79) 4-5. MACRS (Page 78) 4-6. Statement of retained earnings (Page 71) 4-7. Cash, accounts payable, inventory (Page 72) 4-8. Income Statement (Page 68) 4-9. Net Income Number of shares of common stock outstanding (Page 71) Net Working Capital (Page 72) Effective taxes paid EBT (Page 80) Expenses should be matched to the revenues they help to generate. (Page 78) False (Page 77) Par value (Page 74) The cost of the asset plus any setup or delivery costs that may be incurred. (Page 78) The common stock reflects the par value printed on the stock certificate times the number of shares issued which is usually very low. Capital in excess of par is the total of the original market price per share value for each stock sold minus the par value. (Page 74) A prepaid expense represents future expenses expected but that have been paid in advance. The benefit is owed to the company and is considered an asset. Accrued expenses are business expenses that have not been paid yet and are owed by the company and are considered liabilities. (Page 72) Retained earnings represent the accumulation of earnings after dividends have been paid out that have been retained for reinvestment in the firm. Dividends paid out by definition are not retained. (Page 74) EPS: $76,000/50,000 shares = $1.52 (Page 71) No, this is not possible. The statement of cash flows shows the changes in the cash position; thus the change in the actual cash account should be equal to the change in cash position as reflected on the cash-flow statement. (Page 74) a. GP = $600,000 b. EBIT = $150,000 c. EBT = $140,000 d. Taxes = $ 49,000 e. Net Profit = $ 91,000 (Page 69) 41

12 4-22. Beginning retained earnings plus net income minus dividends = ending retained earnings: 900, , , ,000 = $800,000 (Page 71) If the change in retained earnings is included on the cash-flow statement, there would be a problem with double counting as income has already been added at the beginning of the statement. Retained earnings reflects net income (less dividends paid). (Page 71) a. CA = $6,018 $4,938 b. TA = $7,210 $5,868 c. CL = $1,347 $ 913 d. TL = $1,877 $ 913 e. TE = $5,333 $4,955 (Page 72) $7,210 = $1,877 + $5,333 $5,868 = $913 + $4,955 (Page 73) a. Depreciation 200 inflow b. Net Receivables 106 outflow c. Inventory 14 inflow d. Prepaids 80 outflow e. Plant/Equipment 462 outflow f. Accounts Payable 239 inflow g. Accrued Expenses 90 inflow h. Long-Term Debt 530 inflow i. Common Stock 0 j. Taxes Payable 105 inflow k. Marketable Sec. 228 inflow (Page 74) 42

13 4-27. Operations Net Income $1, Plus: Depreciation Marketable Sec Inventory Accounts Payable Taxes Payable Accrued Expenses Minus: Net Receivables Prepaids Total Operating Cash Flow +$2, Investments Minus: Increase in Plant/Equipment $ Total Cash Flow from Invest. -$ Financing Plus: Increase in Long-Term Debt $ Minus: Dividends 1, Total Financing Cash Flow -$ Net Cash Flow +$1, (Page 77) Beginning cash: $3,614 Ending cash: 4,750 Change $1,136 (page 77) Beginning Retained Earnings: $2,950 + Net Income: $1, Dividends: $1, = Ending Retained Earnings: $3,328. (Page 74) a. Year Depreciation 1 $ 73, , , ,280 b. EPS: Revenues $200,000 Depreciation 97,900 EBT 102,100 Taxes 35,735 Net Income 66,365 66,365/25,000 = $2.65 (Page 70) 43

14 4-31. = $1.28 (Page 70) a. 15% $7,500 25% 6,250 34% 8,500 39% 91,650 34% 56,100 $170,000 b. 34% c. 170,000/500,000 = 34% (Page 80) $3,500, ,000 3,700,000 = $300,000 (Page 74) $400,000 x 17.5% = $87,500 (Page 78). 44

15 Chapter 5 Analysis of Financial Statements Overview: In order to understand how a firm is doing from a financial perspective, it is useful to do a financial analysis. This is accomplished through the construction of a series of financial ratios. These ratios help the manager to analyze the firm in terms of its profitability, liquidity levels, debt load, and asset utilization. By comparing these ratios over a series of years, the analyst can get a picture of the firm s overall financial strength. The analyst can also compare these ratios with those of other firms in the industry to see how well the firm is doing compared to its peers. After reading this chapter and working through the problems, you should feel comfortable in doing your own analysis of a firm and should be able to tell a story about the firm s ability to remain a going concern. What You Should Know From This Chapter: 1. Explain how financial ratio analysis helps financial managers assess the health of a company: Financial ratios are numbers that express the value of one financial variable relative to another. They are comparative measures because they show relative value and allow the financial analysts to compare information that could not be compared in its raw form. Ratios may be used to compare: One ratio to a related ratio The firm s performance to management s goals The firm s past and present performance The firm s performance to that of similar firms. 45

16 2. Compute profitability, liquidity, debt, asset utilization, and market value ratios: Profitability ratios measure how much company revenue is eaten up by expenses, how much a company earns relative to sales generated, and the amount earned relative to the value of the firm s assets and equity. Liquidity Ratios measure the ability of a firm to meet its short-term obligations. Current Ratio = Current Assets Current Liabilities Quick Ratio = Current Assets Less Inventory Current Liabilities Debt Ratios assess the relative size of a firm s debt load and the firm s ability to pay off the debt. 46

17 Asset Activity Ratios measure how efficiently a firm uses its assets. Market Value Ratios measure the market s perception of the future earning power of a company as reflected in the stock share price. Economic Value Added (EVA) measures the amount of profit remaining after accounting for the return expected by the firm s investors and is said to be an estimate of the true economic profit. EVA = EBIT(1-TR) (IC x Ka) Where EBIT = earnings before interest and taxes TR = the effective or average income tax rate IC = invested capital Ka = investors required rate of return on their investment. Market Value Added (MVA) is the market value of the firm, debt plus equity, minus the total amount of capital invested in the firm and is similar to the market to book (M/B) ratio. MVA, however focuses on total market value and total invested capital, whereas M/B focuses on the per share stock price and invested equity capital. 47

18 The Du Pont System of ratio analysis examines the relationships between ratios. Du Pont Equation: Return on Assets = Net Profit Margin x Total Asset Turnover Modified Du Pont Equation: ROE = Net Profit Margin x Total Asset Turnover x Equity Multiplier 3. Compare financial information over time and among companies: Trend analysis uses computed ratio values for several time periods and compares them. Industry analysis (Cross-Sectional analysis) judges whether a firm s ratio is too high or too low in comparison with other firms in the industry. 4. Locate ratio value data for specific companies and industries: Analysts can gather information about publicly traded corporations at most libraries, on CD-ROM databases, and on the Internet. 48

19 Terminology and Concept Review 5-1. The compares all the current assets of the firm to all the company s current liabilities The difference between the firm s future earnings and liquidation value is the of the firm In the modified Du Pont equation, ROE is the product of net profit margin, total asset turnover, and the One way to judge whether a firm s ratio is too high or too low is to compare it to the ratios of other firms in the industry. This is sometimes called The tells us how efficiently the firm converts inventory to sales The is the percentage of debt relative to the amount of equity of the firm The measures how much profit out of each sales dollar is left after all expenses are subtracted The measures the average return on the firm s capital contributions from its owners The measures how many days, on average, the company s credit customers take to pay their accounts The is the market price per share of a company s common stock divided by the accounting book-value-per-share ratio The measures how efficiently a firm utilizes its assets Explain trend analysis What is meant by the leverage effect? Explain the difference between the current and the quick ratio What is a mixed ratio? 49

20 5-16. Why is the EVA an important new tool in financial analysis? Why are M/B and MVA highly correlated? 50

21 Problems and Short-Answer Questions Use the following information to construct and solve the Du Pont and Modified Du Pont equations for Ace International: (Hint: Solve for equity) Sales $18,530,000 Net Income 377,900 Total Assets 11,097,510 Debt/Total Assets 64.20% Given $2,044,000 in total assets, $1,351,000 in total stockholders equity, and debt-to-total-asset ratio of 33.90%, calculate the debt to equity ratio. 51

22 Use the following information to answer questions 5-20 to 5-24: Year 2012 Computer Whiz, Inc. Dec 31, 2012 Income Statement Balance Sheet Sales 5,937,000 Assets Cost of Goods Sold 608,000 Cash 4,750,000 Gross Profit 5,329,000 Net Receivables 581,000 Selling & Ad. Expenses 3,022,000 Inventories 88,000 Depreciation 269,000 Prepaid Operating Income 2,038,000 Other Current 201,000 (EBIT) Interest Expense 221,000 Total Current Assets 5,620,000 Other Expense 177,000 EBT 1,640,000 Gross Plant & Equip.. 1,907,000 Taxes 714,000 Accumulated Dep. 715,000 Net Income 926,000 Net Plant & Equip.. 1,192,000 Other Assets 398,000 Total Assets 7,210,000 Liabilities Accounts Payable 563,000 Taxes Payable 410,000 Accrued Expenses 130,000 Other Current Liabilities 244,000 Total Current Liabilities 1,347,000 Long-Term Debt 530,000 Total Liabilities 1,877,000 Equity Preferred Stock 0 Common Stock 2,005,000 Capital in Excess of Par 0 Retained Earnings 3,328,000 Total Common Equity 5,333,000 Total Equity 5,333,000 Total Liabilities & Equity 7,210,000 52

23 5-20. Calculate the following profitability ratios for a. Gross Profit Margin b. Operating Profit Margin c. Net Profit Margin d. Return on Assets e. Return on Equity Calculate the following liquidity ratios for the end of a. Current Ratio b. Quick ratio Calculate the following debt ratios for the end of a. Debt to Total Assets b. Times Interest Earned 53

24 5-23. Calculate the following asset activity ratios for the end of a. Average Collection Period b. Inventory Turnover c. Total Asset Turnover Construct and solve Computer Whiz, Inc. s, Modified Du Pont equation for

25 Use the following information to answer questions 5-25 to 5-29: Income Statement Year 2012 ABC Fitness Company Balance Sheet Dec 31, 2012 Sales 1,968,016 Assets Cost of Goods Sold 1,466,733 Cash 89,469 Gross Profit 501,283 Net Receivables 55,514 Selling/G&A 361,402 Inventories 322,433 Depreciation 35,700 Prepaid 8,775 Operating Income eeeexpen (EBIT) 104,181 Total Current Assets 476,191 Interest Expense 6,234 Other Expense 14,124 Gross Plant & Equip.. 955,661 EBT 83,823 Accumulated Dep. 338,513 Taxes 24,701 Net Plant & Equip.. 617,148 Net Income 59,122 Other Assets 24,621 Total Assets 1,117,960 Liabilities Notes Payable 1,127 Accounts Payable 144,638 Taxes Payable 16,797 Accrued Expenses 98,233 Total Current Liabilities 260,795 Long-Term Debt 415,138 Deferred Taxes 20,396 Total Liabilities 696,329 Equity Common Stock 200,320 Capital in Excess of Par 42,843 Retained Earnings 178,468 Total Equity 421,631 Total Liab. & Equity 1,117, Calculate the following profitability ratios for a. Gross Profit Margin b. Operating Profit Margin c. Net Profit Margin 55

26 d. Return on Assets e. Return on Equity Calculate the following liquidity ratios for the end of a. Current Ratio b. Quick Ratio Calculate the following debt ratios for the end of a. Debt to Total Assets b. Times Interest Earned Calculate the following asset activity ratios for the end of a. Average Collection Period b. Inventory Turnover c. Total Asset Turnover 56

27 5-29. Construct and solve ABC Fitness Company s Modified Du Pont equation for From the values of the different ratios given, calculate the missing balance sheet and income statement items of XYZ Inc. (round up the figures to nearest tens). Average Collection Period 8.29 days Inventory Turnover 4.63x Debt to Asset Ratios 64.20% Current Ratio 1.67 Return on Equity 9.51% Return on Assets 3.41% Operating Profit Margin 4.27% Gross Profit Margin 26.34% 57

28 Use the following information to answer questions 5-30 to 5-37: XYZ Inc. Income Statement Balance Sheet Assets Sales 1,852,929 Cash Cost of Goods Sold Net Receivables Gross Profit Selling & Ad. Expenses Depreciation ExExpense Operating Income (EBIT) Year: 2012 Inventories Dec 31, 2012 Prepaids 13,001 53,474 Total Current Assets 468,289 Interest Expense Gross Plant & Equip.. 920,841 Other Expense 13,742 Accumulated Dep. 302,777 EBT Net Plant & Equip.. 618,064 Taxes 24,628 Other Assets 21,857 Net Income Total Assets Liabilities Notes Payable Accounts Payable 149,293 Taxes Payable 30,000 Accrued Expenses 86,470 Total Current Liabilities 281,476 Long-Term Debt Deferred Taxes 17,423 Total Liabilities 710,839 Equity Common Stock 200,320 Capital in Excess of Par 42,843 Retained Earnings Total Equity Total Liab. & Equity 1,108, What must net income be in 2012 if XYZ Inc. wants to maintain a net profit margin of 12% on net sales of $100,000? Explain what a debt to equity ratio of 10 means A high inventory turnover ratio is always good. Comment on this statement. 58

29 5-34. Explain the purpose of the Du Pont model Explain what a P/E ratio of 18 means Given the following information, calculate the current ratio and the ROE. Total Equity $10,000 Total Liabilities 15,000 Total Sales 20,000 Current Assets 10,000 Long-Term Liabilities 5,000 Net Profit Margin 8% 59

30 5-37. Assume the Riddley Venture Corporation has: Total Common Stock Equity at Year-End 2012 $10,000,000 Number of Common Shares Outstanding 750,000 Market Price per share $200 Calculate the following: a. Book value per share b. Market to book value ratio 60

31 5-38. Year 2012 ABC Fitness Company Dec 31, 2012 Income Statement Balance Sheet Sales 1,968,016 Assets Cost of Goods Sold 1,466,733 Cash 89,469 Gross Profit 501,283 Net Receivables 55,514 Selling & Ad. Expenses 361,402 Inventories 322,433 Depreciation 35,700 Prepaids 8,775 Operating Income (EBIT) 104,181 Total Current Assets 476,191 Interest Expense 6,234 Other Expense 14,124 Gross Plant & Equip.. 955,661 EBT 83,823 Accumulated Dep. 338,513 Taxes 29,338 Net Plant & Equip.. 617,148 Net Income 54,485 Other Assets 24,621 Total Assets 1,117,960 Liabilities Notes Payable 1,127 Accounts Payable 144,638 Taxes Payable 16,797 Accrued Expenses 98,233 Total Current Liabilities 260,795 Long-Term Debt 415,138 Deferred Taxes 20,396 Total Liabilities 696,329 Equity Common Stock 200,320 Capital in Excess of Par 42,843 Retained Earnings 178,468 Total Equity 421,631 Total Liab. & Equity 1,117,960 a. For ABC Fitness Company, calculate the economic value added (EVA) if the weighted average rate of return expected by the suppliers of the firm s capital is 11%, and the market price of the firm s stock is $12, and there are 100,000 shares outstanding. 61

32 b. Calculate the market value added (MVA) for ABC Fitness. c. Comment on your two answers. 62

33 Answers 5-1. Current ratio (Page 100) 5-2. Going concern value (Page 105) 5-3. Equity multiplier (Page 108) 5-4. Cross-sectional analysis (Page 110) 5-5. Inventory turnover ratio (Page 103) 5-6. Debt to equity ratio (Page 101) 5-7. Net profit margin (Page 98) 5-8. Return on equity (Page 99) 5-9. Average collection period (Page 102) Market to book value ratio (Page 104) Total asset turnover Ratio (Page 103) Trend analysis uses ratios to compare a firm s past and present performance. (Page 111) The leverage effect is a result of debt on the balance sheet. By using borrowed funds, the firm can increase its ROE. (Page 101) The quick ratio is similar to the current ratio but is a more rigorous measure of liquidity because it excludes inventory from current assets. (Page 100) A mixed ratio is a ratio that uses both income statement and balance sheet variables as inputs. (Page 99) It enables the investors to see whether the income earned was sufficient to cover their expected return. It is an estimate of the amount that earnings exceed or fall short of the required minimum rate of return investors could get investing in other securities of comparable risk. (Page 106) Both focus on the value of the stock: MVA focuses on total market value while M/B focuses on per share stock price and both focus on total invested capital. (Page 105) Debt/Total Assets = 64.20%; Equity/Total Assets = 35.80%; Total Assets/Equity = Du Pont Model =.0204 x 1.67 = 3.41% Modified Model =.0204 x 1.67 x 2.79 = 9.52%. (Page 108) x/ =.3390; x(debt) = 692,916; Debt/Equity = 692,916/ = 51%. (Page 101) a. $5,329/5,937 = 89.76% b. $2,038/5,937 = 34.33% c. $926/5,937 = 15.60% d. $926/7,210 = 12.84% e. $926/5,333 = 17.36% (Pages 96-99) 63

34 5-21. a. $5,620/1,347 = 4.17 b. $5,532/1,347 = 4.11 (Page 100) a. $1,877/7,210 = 26.03% b. $2,038/221 = 9.22 (Page 101) a. $581/($5,937/365) = days b. $5,937/88 = c. $5,937/7,210 = (Page 102) ROE = profit margin x total asset turnover x equity multiplier: 17.36% = 15.6% x.823 x (Page 108) a. $ /1, = 25.47% b. $ /1, = 5.29% c. $59.122/1, = 3.00% d. $59.122/1, = 5.29% e. $59.122/ = 14.02% (Page ) a. $ / = 1.83 b. $ / =.59 (Page 100) a. $ /1, = 62.29% b. $ / = 3.02 (Page 101) a. $55.514/(1, /365) = 10.3 days b. $1, / = 6.10 c. $1, /1, = 1.76 (Page 102) ROE = net profit margin x total asset turnover x equity multiplier: 14.02% = 3% x 1.76 x (Page 108) 64

35 5-30. Balance Sheet Assets Income Statement Cash 13,008 Sales 1,852,929 Net Receivables 42,080 Cost of Goods Sold 1,364,868 Inventories 400,200 Gross Profit 488,061 Prepaids 13,001 Selling & Ad. Expenses 355,467 Total Current Assets 468,289 Depreciation 53,474 Operating Profit 79,120 Gross Plant & Equip. 920,841 Interest Expense 2,960 Accumulated Dep. 302,777 Other Expense 13,742 Net Plant & Equip.. 618,064 PreTax Income 62,418 Other Assets 21,857 Taxes (39.46%) 24,628 Total Assets 1,108,210 Net Profit 37,790 Liabilities Notes Payable 15,710 Accounts Payable 149,293 Taxes Payable 30,000 Accrued Expenses 86,473 Total Current Liabilities 281,476 Long-Term Debt 411,940 Deferred Taxes 17,423 Total Liabilities 710,839 Equity Common Stock 200,320 Capital in Excess of Par 42,843 Retained Earnings 154,208 Total Equity 397,371 Total Liabilities & Equity 1,108, x 100,000 = $12,000 (Page 98) This means that the firm has 10 times as much debt as equity. (Page 101) While the firm may want to see inventory turning over which means good sales; perhaps the firm is not maintaining enough inventory on hand which could mean a loss of potential sales. (Page 103) The Du Pont model enables the firm to look at the components of both ROA and ROE to see what impact individual ratios have upon these returns. For example, is profitability too low, or are turnover ratios too low. The firm can look at the factors comprising their various returns to better analyze their effectiveness. (Page 104) A P/E ratio of 18 measures how much investors are willing to pay for claim to one dollar of the earnings per share of the firm. It would take 18 years of the company s current earnings rate for the investor to earn net profits of $18 per share. (Page 104) 65

36 5-36. Current ratio = 10,000/10,000 = 1. (Page 100) ROE = 1,600/10,000 = 16%. (Page 99) a. $10,000,000/750,000 = $13.33 per share b. $200/$13.33 = $15.00 per share (Page 104) a. EVA = 104,181(1-0.35) ((120, ,268 x 0.11)) = ($110,071) b. MVA = ($1,200, ,268) (421, ,268) = $778,366 c. Although the EVA is negative, the MVA is positive which could mean that for this year, there might have been some unusual happening in the firm which caused a lower than average EBIT, in turn causing a low EVA. It would be important to review trends before becoming too alarmed at this point. (Pages ) 66

37 Chapter 6 Forecasting for Financial Planning Overview: Once you have completed the financial analysis of your firm, you are ready to forecast the financial needs for the future. An estimate of sales is prepared, and the financial manager must determine the future financial needs of the firm based on the change in forecasted sales. Increased levels of sales will necessitate growth in other assets and liabilities and could affect the future financial standing of the firm. It is up to the financial manager to determine those needs so that the firm is not faced with an unexpected demand for new funds; a demand which could over-burden the firm with debt or liquidity problems if not properly addressed. What You Should Know From This Chapter: 1. Explain why forecasting is vital to business success: Forecasting in business is especially important because failing to anticipate future trends can be devastating. Financial decisions are based on forecasts of situations a business expects to confront in the future. There are three general approaches discussed in this chapter: experience, probability, and correlation. Experience means that we think things will happen a certain way in the future because they happened that way in the past. Probability means things will happen a certain way in the future because the laws of probability indicate that it will be so. Correlation means we think things will happen a certain way in the future because there is a high correlation between the behavior of one item and the behavior of another item that we know more about. 2. Describe the financial statement forecasting process: The forecasting process depends on the demand for a firm s products and the strength of the competition. Sales, marketing, and production personnel all usually provide estimates for top management to use in their strategic decisions affecting the firm as a whole. Sales forecasting is a group effort. 67

38 3. Prepare pro forma (projected) financial statements: The cash budget and capital budget are used in the preparation of pro forma financial statements. The cash budget shows the projected flow of cash in and out of the firm for specified time periods, while the capital budget shows planned expenditures for major asset acquisitions. The pro forma income statement projects values for sales, costs and expenses associated with sales, general and administrative expenses, depreciation, interest, taxes, dividends paid, and addition to retained earnings. Items which tend to move spontaneously with changes in the sales level include COGS and selling and marketing expenses. General and administrative expenses are more fixed in nature and tend to change as levels of fixed expenditures change. Depreciation changes according to the depreciation schedule not directly with changes in sales. Interest expense will change only as debt levels change. Dividends paid can be as a percent of sales and thus move with sales, but this is also a discretionary item decided upon by management. Retained earnings is calculated by adding net income after dividends paid to beginning retained earnings. The pro forma balance sheet is created by examining each individual line-item account. Most current assets and current liabilities (with the exception of notes payable) move spontaneously with sales. Usually it is assumed that notes payable will be paid off at year end and new financing needs will be plugged into this account to balance the statement. Plant and equipment changes will be based on the capital budget expenditures. Long-term debt and new stock issues will depend on the calculated financial needs when the pro forma statements are completed. Additional funds needed is one of the most important reasons for producing pro forma financial statements. Additional funds needed occurs when forecast assets exceed forecast liabilities and equity. It is called excess financing when forecast liabilities and equity exceed forecast assets. With this knowledge, financial managers can make the necessary financing arrangements in the financial markets before a crisis occurs. Once additional funds needed have been calculated, forecasters should revise the pro forma income statement to reflect the new interest charges. However, if they make the revision, it will reduce the next year s net income, which in turn will reduce the new year s retained earnings on the balance sheet forecast. Everything is thrown out of balance. This is known as the balancing problem. You need to recast the financial statements several times over until the additional amount of interest expense becomes negligible. 68

39 4. Explain the importance of analyzing forecasts: The forecasts enable the financial manager to see where current trends are leading the firm in the future, what effect management s current plans and budgets will have on the firm, and what actions to take to avoid problems revealed in the pro forma statements. These points are discussed in detail in this chapter. 69

40 Terminology and Concept Review 6-1. The shows the projected flow of cash in and out of the firm for specified time periods The difference between forecasted assets and forecasted liabilities and equity before external financing is called Forecasted financial statements are commonly referred to as The shows planned expenditures for major asset acquisitions True or False: General and Administrative Expenses usually move spontaneously with sales When forecasted liabilities and equity exceed forecasted assets, it is called The balancing problem refers to what variable? 6-8. List eight items from the balance sheet and income statement, which would probably move spontaneously with sales What are the most important reasons for doing pro forma statements? Write the equation for ending retained earnings What is the forecasted value for notes payable when a first pass pro forma balance sheet is prepared? True or False: Cash rarely moves with changes in sales forecasts. 70

41 Problems and Short-Answer Questions Use the following information to answer questions 6-13 through 6-16: Income Statement Balance Sheet December 31, 2012 December 31, 2012 (in thousands) (in thousands) Sales $40,000 Assets: COGS 18,200 Total Current Assets $100,000 21,800 Net Plant & Equipment 70,000 Total Assets $170,000 Selling Expenses 4,000 Depreciation 3,000 Liabilities & Equity: Fixed Expenses 4,000 Accounts Payable $40,000 Notes Payable 10,000 EBIT 10,800 Accrued Expenses 10,000 Taxes (40%) 4,320 Bonds Payable 40,000 Net Income 6,480 Common Stock 40,000 Paid-in-Surplus 20,000 Common Stock Div. 1,200 Retained Earnings 10,000 $ 5,280 Total Liabilities & Equity $170,000 Sales for 2013 are projected to be $60,000; the firm currently uses straight line depreciation. No new equipment purchases are planned for There will be a 10% earnings distribution for Notes Payable will be paid off at the end of Forecast net income for Forecast retained earnings for Forecast total assets for

42 6-16. Forecast additional funds needed in Use the following information to answer question 6-17: 2012 Cash $20,000 Accounts Receivable 30,000 Inventory 70,000 Fixed Assets, gross 110,000 Accumulated Depreciation 30,000 Fixed Assets, net 80, The firm currently uses straight line depreciation. Depreciation in 2012 was $4,000. Sales are expected to grow by 50% in All net income is paid out in dividends and no new stock issues are planned. Calculate total assets for Explain what is meant by the balancing problem in forecasting Explain which of the following items would move spontaneously with sales and which would not. a. Retained Earnings b. Notes Payable c. Accounts Receivable d. Long-Term Debt e. Accounts Payable 72

43 Use the following information to answer questions 6-20 through 6-23: Balance Sheet December 31, 2012 (in thousands) Assets: Liabilities: Cash 10,000 Accounts Payable $30,000 Accounts Receivable 40,000 Notes Payable 20,000 Inventory 30,000 Accrued Expenses 10,000 Total Current 80,000 Total Current 60,000 Fixed Assets, net 40,000 Long-Term Debt 20,000 Common Stock 32,000 Total assets $120,000 Retained Earnings 8,000 Total Liability and Equity $120,000 Net income for 2012 was $20,000. Sales for 2013 are projected to increase by 20%. No new equipment purchases are planned for 2013; the dividend payout ratio will be 100% in Notes Payable are paid off at the end of Net income for 2013 is projected to be $24, Project net profits for Projected Additional Funds Needed in 2013 will be: Project retained earnings for Project total assets for

44 6-24. Explain the importance of knowing additional funds needed. Use the following information to answer question 6-25: 2012 Total Assets $37,500 Accounts Payable $ 1,500 Notes Payable 2,500 Long-Term Debt 10,000 Common Stock 12,500 Retained Earnings 11,000 Total Liabilities/Equity $37,500 Total sales in 2012were $50,000, resulting in a net income of $5,000. Sales are expected to grow by 10% in 2013; the dividend payout ratio is 15% of net income. Net income for 2013 is projected to be $5, Project common equity for Use the following information to answer question 6-26: 2012 Total Assets $150,000 Accounts Payable $ 6,000 Notes Payable 10,000 Long-Term Debt 40,000 Common Stock 50,000 Retained Earnings 44,000 Total Liabilities/Equity $ 150,000 Total sales in 2012 were $200,000 resulting in a net income of $20,000. Sales are expected to grow by 50% in 2013, the dividend payout ratio is 0% of net income. Net income is projected to be $30,000 in

45 6-26. Project common equity for Why is it important to consider the current ratio and debt ratio if additional funds are needed? 75

46 Use the following information to answer questions 6-28 and Sales Variable Costs Fixed Costs Net Income Dividends Current Assets Fixed Assets Total Assets Current Liabilities Long-Term Debt Common Stock Retained Earnings Total Liabilities & Equity Compute the following ratios for 2011 and 2012: a. Current Ratio b. Debt to Assets Ratio c. Net Profit Margin d. Return on Assets e. Return on Equity Comment on any trends revealed by your ratio analysis. 76

47 6-30. EBIT has been 20% of sales for the past three years and is expected to continue at this level. If sales in 2013 are projected at $1,000,000, what would EBIT be? Sales are expected to double in 2013 to $200,000. General and Administrative expenses were $25,000 in Calculate General and Administrative expenses for

48 Answers 6-1. Cash budget (Page 138) 6-2. Additional funds needed (Page 145) 6-3. Pro forma financial statements (Page 138) 6-4. Capital budget (Page 138) 6-5. False (Page 141) 6-6. Excess financing (Page 145) 6-7. Interest expense (Page 146) 6-8. COGS, selling expense, cash, marketable securities, inventory, accounts receivable, accounts payable, accrued expenses. (Comprehensive) 6-9. The importance of knowing additional funds needed (Page 145) Beginning Retained Earnings + Net Income - Dividends Paid. (Page 144) Zero (Page 144) False (Page 142) 6-13 to 6-16: Income Statement Balance Sheet December 31, 2013 December 31, 2013 (in thousands) (in thousands) Sales $60,000 Assets: COGS 27,300 Total Current Assets $150,000 32,700 Net Plant & Equipment 67,000 Total Assets $217,000 Selling Expenses 6,000 Depreciation 3,000 Liabilities & Equity: Fixed Expenses 4,000 Accounts Payable $ 60,000 Notes Payable -0- EBIT 19,700 Accrued Expenses 15,000 Taxes (40%) 7,880 Bonds Payable 40,000 Net Income 11,820 Common Stock 40,000 Paid-in-Surplus 20,000 Common Stock Div. 1,182 Retained Earnings 20,638 To Retained Earnings 10,638 Total Liabilities & Equity $195, Net Income = $11, Retained Earnings = $20, Total Assets = $217, Additional Funds Needed = $217,000 $195,638 = $21,362 (Comprehensive) 78

49 Cash $20,000 $30,000 Accounts Receivable 30,000 45,000 Inventory 70, ,000 Fixed Assets, gross 110, ,000 Accumulated Depreciation 30,000 34,000 Fixed Assets, net 80,000 76,000 $256,000 Total Assets (Page 147) If a company borrows the additional funds needed, then the firm will incur new interest charges that were not included in the original pro forma income statement. To be accurate, forecasters should revise the pro forma income statement to include the new interest. However, this will reduce net income and retained earnings, which will throw the balance sheet out of balance again. (Page 146) As sales increase, there will be more accounts receivable as customers buy more goods, and accounts payable will increase as the firm purchases more goods to accommodate new sales; thus, both move spontaneously with sales. Notes payable typically is paid off at year end and can be a plug for additional funds needed. Long-term debt by definition is not a short-term item and will be changed only if the change in sales causes some new long-term new needs on the balance sheet. Retained earnings increases by net income but depends on the dividend payout ratio and thus does not move spontaneously with sales. (Pages ) 6-20 through 6-23: Balance Sheet December 31, 2013 (in thousands) Assets: Liabilities: Cash 12,000 Accounts Payable $36,000 Accounts Receivable 48,000 Notes Payable -0- Inventory 36,000 Accrued Expenses 12,000 Total Current 96,000 Total Current 48,000 Other Assets 40,000 Long-Term Debt 20,000 Common Stock 32,000 Total assets $136,000 Retained Earnings 8,000 Total Liability and Equity $108,000 79

50 6-20. Net Profits = $24, Additional Funds Needed = $28, Retained Earnings = $8, Total Assets = $136,000 (Comprehensive) The determination of additional funds needed is one of the most important reasons for producing pro forma financial statements. With this knowledge, the financial manager can make the necessary financing arrangements in the financial markets before a crisis occurs. (Page 145) Beginning Retained Earnings: $11,000 + Net Income: $5,500 Dividends paid: $825 = Ending Retained Earnings: $15,675 + Common Stock: $12,500 = Total Common Equity: $28,175. (Page 144) Beginning Retained Earnings: $44,000 + Net Income: $30,000 Dividends paid: $0 = Ending Retained Earnings: $74,000+ Common Stock: $50,000 = Total Common Equity: $124,000. (Page 144) You need to consider the liquidity level of the firm as well as the overall debt position. Debt financing increase the risk level of the firm if the financial manager is not careful. Liquidity decreases as the firm may be unable to meet its debt payments. (Page 146) a. Current Ratio b. Debt to Assets Ratio 25% 41% c. Net Profit Margin 10% 25% d. Return on Assets 6.25% 20.4% e. Return on Equity 8.33% 34.48% (Comprehensive) Profitability is obviously up by a great deal. The financial manager, however, should consider the price of this increase. The large increase in the debt level could make bankers and investors nervous. The decrease in liquidity levels should also be addressed. Of course, more years of statements as well as industry analysis is needed to do a good job of financial analysis. (Comprehensive) $200,000 (Pages ) Without any additional information, we would assume that G & A Expenses would remain unchanged as they do not typically move spontaneously with sales. (Page 141) 80