Chapter 13 Analyzing Financial Statements Problems

Chapter 13 - Analyzing Financial Statements ALTERNATE PROBLEMS AP13–1. 1. Company A shows a high EPS but a low ROA. There are a number of possible explanations for this situation. The high debt/equity ratio suggests that Company A is highly leveraged and is able to generate high earnings for stockholders by using a large amount of debt financing. 2. The low level of liquidity for Company A is a concern given its high debt/equity ratio. 3. Despite a high EPS, Company A has a low price/earnings multiple. This is often an indication of limited growth opportunities or concern in the market. 4. The dividend yield for Company A is high. The company may be paying significant dividends or its stock price may be currently depressed. AP13–2. 1. Company A appears to be very profitable based on both ROA and profit margin. The use of leverage has enhanced the ROA. 2. Company A’s solvency and liquidity are potential areas of concern. 3. The price/earnings multiple for Company A suggests a profitable company with good growth prospects. AP13–3. Coca-Cola is the stronger company and probably is the better investment. The biggest differences between the two companies are the P/E ratio, ROA, and the gross profit margin. Coca-Cola has a much larger P/E ratio, meaning that the market sees Coca-Cola as having more potential for growth than Pepsi. Also, the companies have similar business, but CocaCola’s gross profit margin is significantly higher than Pepsi’s. Coca-Cola earns more profit per dollar of sales than Pepsi does. The return on assets ratio for Coke is much better than Pepsi, but Coke does appear to have a more risky capital structure because of its higher debt-to-equity ratio. Coke pays out a higher percentage of its earnings in dividends. Financial Accounting, 8/e 13–23 Chapter 13 - Analyzing Financial Statements AP13–4. Req. 1 Name and Computation of the 2015 Ratio Brief Explanation of the Ratio Tests of profitability: (1) Return on equity: $25,200 ÷ $109,000* = 23.1%. *($116,000 + $102,000) ÷ 2 = $109,000 Measures return earned for owners based upon their investment (including retained earnings) in the business. (2) Return on assets: ($25,200 + $4,900*) ÷ $187,500†= 16.1%. Measures the entity’s performance in using total resources (total assets) available to it. *Bonds: $70,000 x 10% x .70 = $4,900 †($204,000 + $171,000) ÷ 2 = $187,500 (3) Financial leverage percentage: 23.1% – 16.1% = 7.0% positive The advantage to be gained by investors when the interest rate (net of tax) is less than the return on assets. (4) Earnings per share $25,200 ÷ 10,000 shares = $2.52 A measure of the return earned on each share of common stock outstanding. (5) Profit margin $25,200 ÷ $453,000 = 5.6% Indicates percent of each sales dollar that was represented by income. (6) Fixed asset turnover $453,000 ÷ [($130,000 + $120,000) ÷ 2] = 3.6 An indication of how efficiently management is using fixed assets. 13–24 Solutions Manual Chapter 13 - Analyzing Financial Statements AP13–4. (continued) Req. 1 (continued) Name and Computation of the 2015 Ratio Brief Explanation of the Ratio Tests of liquidity: (1) Cash ratio $6,800 ÷ $18,000 = .38 The most stringent test of liquidity; it measures the amount of cash available to pay current liabilities. (2) Current ratio $74,000 ÷ $18,000 = 4.1 to 1 Measures the adequacy of working capital by relating total current assets to total current liabilities. (3) Quick ratio $48,800 ÷ $18,000 = 2.7 to 1 A severe test of liquidity by relating quick assets to total current liabilities. (4) Receivable turnover A measure of the effectiveness of credit granting and collection of receivables. $181,200 ÷ [$42,000 + $29,000] 2 = 5.1 times Average collection period 365 ÷ 5.1 = 71.6 days (5) Inventory turnover $250,000 ÷ [$25,000 + $18,000] 2 Average number of days to collect an account receivable. An indication of the velocity with which merchandise flows through the business. = 11.6 times Average days’ supply 365 ÷ 11.6 days = 31.4 days Financial Accounting, 8/e Indicates, as a days of supply figure, the velocity with which merchandise flows through the business. 13–25 Chapter 13 - Analyzing Financial Statements AP13–4. (continued) Req. 1 (continued) Name and Computation of the 2015 Ratio Brief Explanation of the Ratio Tests of solvency and equity position: (1) Times interest earned ($25,200 + $10,800 + $7,000) ÷ $7,000 = 6.1 A measure of the amount of earnings available to cover interest expense. (2) Debt/equity ratio $88,000 ÷ $116,000 = .76 Measures relationship between resources provided by owners versus resources provided by creditors. Market tests: (1) Price/earnings ratio $18 ÷ $2.52 = 7.1 (2) Dividend yield ratio $0.45 ÷ $18 = 2.5% Req. 2 A measure of the earnings of a company that may benefit the investor directly or indirectly. It is the ratio of current market price of the stock to the EPS. Measures cash return to the stockholder from dividends in relationship to the current market price of the stock. (a) The financial leverage percentage indicates that an advantage was earned for the stockholders because the company earned a higher return on total resources used compared to the interest paid on debt (after tax). (b) The profit margin was more than 5% of net sales. This means that the business earned more than $.05 profit on each sales dollar. Whether it is ―good‖ can be determined reasonably by comparing it with standards such as (a) prior years, (b) industry averages, (c) projections (planned), and (d) published averages. (c) The current ratio is high and is more than the quick ratio because the latter ratio is a much more severe test of liquidity (it omits inventory and prepaid expenses). Each of these ratios probably would be ―good‖ when compared with some standard (such as those listed in (b) above). However, there appears to be a severe liquidity problem that these two ratios do not divulge; that is, the extremely low amount of cash. (d) There appears to be a credit and collection deficiency. The receivable collection period of over 70 days compared with the 30-day credit terms indicates more uncollected accounts than should be expected. 13–26 Solutions Manual Chapter 13 - Analyzing Financial Statements AP13–5. Req. 1 a. Tests of profitability: (1) Return on equity: $12,600 ÷ $120,500 = 10.5%. (2) Return on assets: [$12,600 + ($4,000 x .70)] ÷ $199,750 = 7.7%. (3) Financial leverage percentage: 10.5% – 7.7% = 2.8% positive (in favor of stockholders). (4) Earnings per share: $12,600 ÷ 18,000 shares = $0.70. (5) Profit margin: $12,600 ÷ $110,000 = 11.5%. (6) Fixed asset turnover: $110,000 ÷ $100,000 = 1.1. b. Tests of liquidity: (7) Cash ratio: $49,500 ÷ $43,000 = 1.2 (8) Current ratio: $111,500 ÷ $43,000 = 2.6 to 1.00. (9) Quick ratio: $86,500 ÷ $43,000 = 2.0 to 1.00. (10) Receivable turnover: $55,000 ÷ $32,000 + $37,000 2 Average days to collect: 365 ÷ 1.6 = 228 days. (11) Inventory turnover: $52,000 ÷ $38,000 + $25,000 2 Days’ supply in inventory: 365 ÷ 1.7 = 215 days. c. = 1.6 times = 1.7 times Tests of solvency: (12) Times interest earned: ($12,600 + $4,000 + $5,400) ÷ $4,000 = 5.5 (13) Debt/equity ratio: $83,000 ÷ $123,500 = .67. d. Market tests: (14) Price/earnings ratio: $23 ÷ $0.70 = 32.9 times. (15) Dividend yield: $.75 ÷ $23 = 3.3%. Financial Accounting, 8/e 13–27 Chapter 13 - Analyzing Financial Statements AP13–5. (continued) Req. 2 a. gt Sales revenue Net income Cash Inventory Debt ($110,000 – $99,000) ÷ $99,000 = 11.1% ($12,600 – $9,800) ÷ $9,800 = 28.6% ($49,500 – $18,000) ÷ $18,000 = 175% ($25,000 – $38,000) ÷ $38,000 = (34.2%) ($83,000 – $75,500) ÷ $75,500 = 9.9% b. Pretax interest rate on the long-term note: $4,000 ÷ $40,000 = 10%. Req. 3 Potential problems are: 1. Average collection period of 228 days—long compared with the 30-day credit period. 2. Inventory turnover 1.7 (i.e., 215 days)—long shelf life for most businesses. 3. Increase in accounts payable, nearly 20% from 2014 to 2015, is material in amount; investigate the cause. 4. There was a significant increase in the amount of cash reported on the balance sheet. Investigate why management wants to hold extra cash. 13–28 Solutions Manual Chapter 13 - Analyzing Financial Statements AP13–6. Req. 1 Ratio a. Profit margin % b. Gross profit ratio c. Expenses as a % of sales excluding cost of goods sold d. Inventory turnover e. Days’ supply in inventory f. Receivable turnover g. Average days to collect 2014 2015 (18%)) 8% 36% 39% 55% 4.7 78 6.0 61 32% 3.1 118 4.3 85 2016 15% 31% 2017 11% 38% 16% 3.2 114 4.0 91 27% 2.5 146 3.6 101 Computations: a. Profit margin: 2014, ($8) ÷ $44 = (18%); 2015, $5 ÷ $66 = 8%; 2016, $12 ÷ $80 = 15%; 2017, $11 ÷ $100 = 11%. b. Gross profit ratio: 2014, ($44 – $28) ÷ $44 = 36%; 2015, ($66 – $40) ÷ 66 = 39%; 2016, ($80 – $55) ÷ $80 = 31%; 2017, ($100 – $62) ÷ $100 = 38%. c. Expense percent of sales revenue: 2014, ($44 – $28 + $8) ÷ $44 = 55%; 2015, ($66 – $40 – $5) ÷ $66 = 32%; 2016, ($80 – $55 – $12) ÷ $80 = 16%; 2017, ($100 – $62 – $11) ÷ $100 = 27%. d. Inventory turnover: 2014, $28 ÷ [($0 + $12) ÷ 2] = 4.7; 2015, $40 ÷ [($12 + $14) ÷ 2] = 3.1; 2016, $55 ÷ [($14 + $20) ÷ 2] = 3.2; 2017, $62 ÷ [($20 + $30) ÷ 2] = 2.5. e. Days’ supply in inventory: 2014, 365 ÷ 4.7 = 78; 2015, 365 ÷ 3.1 = 118; 2016, 365 ÷ 3.2 = 114; 2017, 365 ÷ 2.5 = 146. f. Receivable turnover: 2014, $33 ÷ [($0 + $11) ÷ 2] = 6.0; 2015, $49.5 ÷ [($11 + $12) ÷ 2] = 4.3; 2016, $60 ÷ [($12 + $18) ÷ 2] = 4.0; 2017, $75 ÷ [($18 + $24) ÷ 2] = 3.6. g. Average days to collect: 2014, 365 ÷ 6.0 = 61; 2015, 365 ÷ 4.3 = 85; 2016, 365 ÷ 4.0 = 91; 2017, 365 ÷ 3.6 = 101. Financial Accounting, 8/e 13–29 Chapter 13 - Analyzing Financial Statements AP13–6. (continued) Req. 2 Revenue increased steadily each year. During the first years, profit margin increased, but it decreased in the last year. Gross profit changed each year, but increased the final year. Average markup changed each year, but expenses as a percent of sales decreased each year with the exception of the last year. Recommendation: management should work to reverse the downward trend of income by increasing margin and reducing expenses. Req. 3 The inventory turnover ratio (and days’ supply) reflect instability. This effect is even more pronounced when the turnover ratio is compared with the gross profit ratio and the profit margin ratio. These comparisons strongly suggest that inventory control (i.e., the amount of goods to stock) is seriously lacking. Recall that the higher the inventory turnover (and the lower the days’ supply) the higher the profit margin. The receivable turnover ratio (and the average days to collect) for all years is in excess of what would be expected with credit terms of net 30 days. These ratios vary significantly with a deteriorating trend over the period, which suggests considerable inefficiencies in credit and collections. Recommendation: That the management carefully assess the inventory situation and the credit and collection activities with a view to developing policies which will lead to the (a) determination of optimum inventory levels (to increase the inventory turnover ratio), and (b) optimum efficiency in the credit and collections activities (to increase the receivable turnover ratio and reduce the average days to collect). 13–30 Solutions Manual