Chapter 17 Financial Statement Analysis √
Quick Check
Answers: 1. b 2. c
3. d 4. a
5. a 6. b
7. b 8. d
9. c 10. a
Explanations: 1. b.
21% increase in Cash = ($2,345 − $1,934) / $1,934 = .21
2. c.
Cash = 9.6% of total assets = $2,345 / $24,501 = .096
3. d.
a, b, and c are all true.
4. a.
Acid-test ratio for 2002 = 0.61 [($2,345 + $2,097) / $7,341]. This value is less than 1.
5. a.
Inventory turnover = 6 times [$7,105 / ($1,294 + $1,055) / 2]
6. b.
Days’ sales in receivables receivabl es = 37 days, computed as follows: One day’s sales = $54 ($19,564 / 365 days) Average receivables [($2,097 + $1,882) / 2].. $ 1,990 One day’s sales………………………………… ÷ $54 Days’ sales in average receivables………… receivable s………… 37 days Chapter 17
Financial Statement Analysis
1065
7. b.
Times-interest-earned Times-interes t-earned ratio = 27 times, computed as follows: Operating income / Interest expense ($5,458 / $199 = 27 times)
8. d.
Strong return on common stockholders’ equity— return
for Liberty, Retur Return n on common common equity equity = Net income income / Aver Average age common common equity equity 0.263 0.263 = $3,050 $3,050 / ($11,800 ($11,800 + $11,366) $11,366) / 2
A 26% return on common stockholders’ equity is strong. 9. c.
EPS = $1.22 = Net income / Number of common shares outstanding = $3,050 / 2,500 shares
10. a. Price/earnings ratio = 36 = Market price of stock stock / EPS = $44 / $1.22
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7. b.
Times-interest-earned Times-interes t-earned ratio = 27 times, computed as follows: Operating income / Interest expense ($5,458 / $199 = 27 times)
8. d.
Strong return on common stockholders’ equity— return
for Liberty, Retur Return n on common common equity equity = Net income income / Aver Average age common common equity equity 0.263 0.263 = $3,050 $3,050 / ($11,800 ($11,800 + $11,366) $11,366) / 2
A 26% return on common stockholders’ equity is strong. 9. c.
EPS = $1.22 = Net income / Number of common shares outstanding = $3,050 / 2,500 shares
10. a. Price/earnings ratio = 36 = Market price of stock stock / EPS = $44 / $1.22
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√
Short Exercises (5-10 min.)
(A m o u n t s i n m i l l io ) io n s 2006 2005 2004 Revenues $9,993 $9,489 $8,995 Cost of sales 5,905 5,785 5,404 Gross profit $4,088 $3,704 $3,591
S 17-1
Increase (Decrease) 2006 2005 Amount Amount Percent Percent Amount Amount Percent Percent $504 5.3% $494 5.5% $384
10.4%
$113
(5-10 min.)
3.1%
S 17-2
1. Trend percentages: 2006 Revenues………… 114% Net income………. 141
2005 108% 131
2004 102% 128
2003 100% 100
2. Net income increased far faster than revenues.
Chapter 17
Financial Statement Analysis
1067
(10-15 min.)
S 17-3
Vertical analysis of assets: 2006 Cash Inventory Property, plant, and equipment, net Total assets
Amount $ 48,000 38,000
Percent 26.4% 20.9
96,000 $182,000
52.7 100.0%
(10 min.)
Net sales Cost of goods sold Other expense Net income
Sanchez Amou Amount nt Percen Percentt $9,489 100.0% 5,785 61.0 3,114 32.8 $ 590 6.2%
S 17-4
Alioto Amou Amount nt Percen Percentt $19,536 100.0% 14,101 72.2 4,497 23.0 $ 938 4.8%
Alioto earns more net income. Sanchez’s net income is a higher percentage of net sales.
These data show how common-size financial statements enable us to compare companies of different sizes.
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(5-10 min.)
S 17-5
1. (D o l l ar a m o u n t s i n b i l l io n s ) 2006 2005 Total current assets Total current liabilities
$6.7 $4.4
$5.6 $3.6
= 1.52
= 1.55
2. Lowe’s current ratio deteriorated a little during 2006.
Chapter 17
Financial Statement Analysis
1069
(10-15 min.)
S 17-6
(D o l l ar a m o u n t s i n b i l l io n s )
a. Inventory turnover =
Cost of goods sold = Average inventory
$21.2 ($4.6 + $4.0) / 2
=
$21.2 $ 4.3
= 4.9 times
b. Days’ sales in receivables: One day’s sales Days’ sales in receivables
=
$30.8 365
=
$.084
=
Average net receivables One day’s sales
=
$.15* $.084
__________ *($.1 + $.2) / 2 = $.15
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=
2 days
(5 min.)
S 17-7
(D o l l ar a m o u n t s i n b i l l i o n s )
1. Debt ratio
=
Total liabilities Total assets
=
$ 8.7 $19.0
=
0.46
2. The debt ratio is fairly low. The company’s ability to pay its liabilities appears strong.
Chapter 17
Financial Statement Analysis
1071
(10 min.)
S 17-8
(Dollar amo un ts in billions )
a. Rate of return on net sales =
Net income $1.9 = = 6.2% Net sales $30.8
Net Interest b. Rate of return income + expense $1.9 + $.2 = = on total assets Average total assets ($19.0 + $16.1) / 2 =
12.0%
c. Rate of return Net Preferred on common Income − dividends $1.9 − $0 = = = 20.4% stockholders' Average common ($10.3 + $8.3) / 2 equity stockholders' equity
These rates of return are strong.
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(5-10 min.) 1. EPS =
Net income − Preferred dividends = Number of shares of common stock outstanding =
S 17-9
$1.9 − $0 .8
$2.38
Market price per share 2. Price/earnings of common stock $66.50 = = = 28 times ratio EPS $2.38
Chapter 17
Financial Statement Analysis
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(10 min.)
S 17-10
Income Statement Thousands
Net sales Cost of goods sold Selling and administrative expenses Interest expense Other expenses Income before taxes Income tax expense Net income
$790 + $750 2
$7,200 4,235 (a) 1,710 105 (b) 150 1,000 316 (c) $ 684 (d)
(a)
=
(b)
= $7,200 − $4,235 − $1,710 − $150 − $1,000 = $105
(d)
= $7,200 × 0.095 = $684
(c)
= $1,000 − $684 = $316
1074
× 5.5 = $4,235
Accounting 7/e Solutions Manual
(15-20 min.)
S 17-11
Balance Sheet (A m o u n t s i n t h o u s a n d s )
Cash $ 50 580 (a) Total current liabilities Receivables Inventories 750 Long-term note payable 90 (b) Other long-term Prepaid expenses Total current assets 1,470 (c) liabilities Plant assets, net Other assets Total assets
$2,100 (e) 1,480 820
3,180 (d)
2,150 $6,800
Stockholders’ equity Total liabilities and equity
2,400 $6,800 (f)
(f) = $6,800 (same as total assets) (e) = $6,800 − $2,100 − $820 − $2,400 = $1,480 (c) = $2,100 × 0.70 = $1,470 (a) = $2,100 × 0.30 = $630; $630 − $50 = $580 (b) = $1,470 − $50 − $580 − $750 = $90 (d) = $6,800 − $1,470 − $2,150 = $3,180
Chapter 17
Financial Statement Analysis
1075
√
Exercises (5-15 min.)
Total current assets Total current liabilities Working capital
2009
2008
2007
$330,000
$300,000
$280,000
160,000
150,000
140,000
$170,000
$150,000
$140,000
Increase $20,000 13.3%
Increase $10,000 7.1%
The increasing trend of working capital is favorable.
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E 17-12
Accounting 7/e Solutions Manual
(10-15 min.)
E 17-13
Enchanted Designs, Inc. Horizontal Analysis of Comparative Income Statement Years Ended December 31, 2007 and 2006 INCREASE (DECREASE)
2007 Net sales revenue……
2006
AMOUNT PERCENT
$430,000 $373,000
$57,000
15.3%
$202,000 $188,000
$14,000
7.4
Expenses: Cost of goods sold. Selling and general expenses………...
98,000
93,000
5,000
5.4
Other expense…….
7,000
4,000
3,000
75.0
Total expenses……
307,000
285,000
22,000
7.7
$123,000 $ 88,000
$35,000
39.8
Net income…………….
Net income increased by a much higher percentage than total revenues during 2007 because revenues increased at a higher rate (15.3%) than did total expenses (7.7%).
Chapter 17
Financial Statement Analysis
1077
(5-10 min.)
E 17-14
Trend percentages: 2008
2007
2006
2005
2004
Total revenue…. 126%
114%
106%
97%
100%
Net income…..... 144
134
84
100
98
Net income grew by 44% during the period, compared to 26% for total revenue.
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(10-15 min.)
E 17-15
Alpha Graphics, Inc. Vertical Analysis of Balance Sheet December 31, 2006 AMOUNT PERCENT
ASSETS Total current assets……………………….. $ 42,000
14.8%
Property, plant, and equipment, net.……
207,000
72.9
Other assets…………………………………
35,000
12.3
Total assets…………………………………. $284,000
100.0%
LIABILITIES Total current liabilities……………………. $ 48,000
16.9%
Long-term debt……………………………..
108,000
38.0
Total liabilities………………………………
156,000
54.9
128,000
45.1
STOCKHOLDERS’ EQUITY Total stockholders’ equity………………..
Total liabilities and stockholders’ equity $284,000
Chapter 17
100.0%
Financial Statement Analysis
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(10-15 min.)
E 17-16
Enchanted Designs, Inc. Comparative Common-Size Income Statement Years Ended December 31, 2007 and 2006 2007
2006
Net sales revenue……………………………….. 100.0% 100.0% Expenses: Cost of goods sold…………………………..
47.0
50.4
Selling and general expenses……………..
22.8
24.9
Other expense………………………………..
1.6
1.1
Total expense………………………………...
71.4
76.4
28.6%
23.6%
Net income………………………………………..
An investor would be pleased with 2007 in comparison with 2006. Net sales and net income are both up significantly from 2006. Cost of goods sold and selling and general expenses — the two largest expenses — consumed smaller percentages of total revenues in 2007, and net income represents a higher percentage of revenues. Overall, profits are rising.
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(10-15 min.) $175,000 $131,000
E 17-17
a. Current ratio
=
b. Acid-test (quick) ratio
=
c. Inventory turnover
=
$317,000 ($77,000 + $71,000) / 2
= 4.28 times
d. Days’ sales in = average receivables
($54,000 + $73,000) / 2 $464,000 / 365
= 50 days
= 1.34
$17,000 + $11,000 + $54,000 = 0.63 $131,000
Chapter 17
Financial Statement Analysis
1081
E 17-18
(15-20 min.) a. Current ratio: 2007:
$61,000 + $28,000 + $122,000 + $237,000 $275,000
=
1.63
2006:
$47,000 + $116,000 + $272,000 $202,000
=
2.15
b. Acid-test ratio: 2007:
$61,000 + $28,000 + $122,000 $275,000
=
0.77
2006:
$47,000 + $116,000 $202,000
=
0.81
c. Debt ratio: $315,000* = 0.56 $560,000 __________ 2007:
*$275,000 + $40,000 = $315,000
$254,000** = 0.52 $490,000 __________
2006:
**$202,000 + $52,000 = $254,000
d. Times-interest-earned ratio: 2007:
$165,000 = 3.44 times $48,000
2006:
$158,000 $39,000
= 4.05 times
Summary: The company’s ability to pay its current liabilities, total liabilities, and interest expense deteriorated during 2007, as shown by the worsening of all four ratios.
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(10-15 min.)
E 17-19
(Dollars in thous ands )
a. Rate of return on net sales: 2006:
$16,000 = 0.092 $174,000
2005:
$12,000 = 0.076 $158,000
b. Rate of return on total assets: 2006:
$16,000 + $9,000 = 0.127 $197,500*
__________ *($204,000 + $191,000) / 2 = $197,500
2005:
$12,000 + $10,000 = 0.122 $181,000**
__________ **($191,000 + $171,000) / 2 = $181,000
c. Rate of return on common stockholders’ equity: 2006:
$16,000 − $3,000 = 0.141 $92,500***
__________ ***($96,000 + $89,000) / 2 = $92,500
2005:
$12,000 − $3,000 = 0.107 $84,000****
__________ ****($89,000 + $79,000) / 2 = $84,000
d. Earnings per share of common stock: 2006:
$16,000 − $3,000 = $0.65 20,000
2005:
$12,000 − $3,000 = $0.45 20,000
The company’s operating performance improved during 2006. All four profitability measures increased.
Chapter 17
Financial Statement Analysis
1083
(10-15 min.) 2008
E 17-20
2007
a. Price/earnings ratio: $16.50 ($60,000 − $12,000) / 80,000
= 27.5
$13 ($52,000 − $12,000) / 80,000
$20,000 / 80,000 $13
=
26
b. Dividend yield: $20,000 / 80,000 $16.50
= 0.015
= 0.019
c. Book value per share of common stock: $780,000 − $200,000 80,000
= $7.25
$600,000 − $200,000 80,000
=
$5
The stock’s attractiveness increased during 2008, as shown by the increases in the price/earnings ratio and in book value per share. The dividend yield decreased, but that would be important only to investors who want dividends. Overall, the common stock looks more attractive than it did a year ago.
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(20-30 min.)
E 17-21
ORDER OF COMPUTATION
Millions
Given Current assets……………………………………...
$10,500
4
Property, plant, and equipment……. $16,500
Given Less Accumulated depreciation……
(2,000)
14,500
3
Total assets ($15,000 ÷ 0.60)…………………….
1
Current liabilities ($10,500 ÷ 1.50)……………… $ 7,000
2
Long-term liabilities ($15,000 − $7,000)………..
8,000
6
Stockholders’ equity ($25,000 − $15,000)……..
10,000
5
Total liabilities and stockholders’ equity……... $25,000
Chapter 17
$25,000
Financial Statement Analysis
1085
√
Problems
Group A (20-30 min.)
P 17-22A
Req. 1
Shawnee Mission Corporation Trend Percentages 2008
2007
2006
2005
Net sales revenue
115%
106%
97%
100%
Net income
125
83
75
100
124
120
111
100
Common stockholders’ equity
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(continued)
P 17-22A
R eq . 2 D o l l ar am o u n t s i n t h o u s a n d s
2008 Net income $60 = 0.167 Avg. common $360 S/E*
2007 $40 $342
= 0.117
2006 $36 = 0.115 $313
__________ *Computation of average com. stockholders' equity
2008
2007
2006
$366 + $354 2
$354 + $330 2
$330 + $296 2
= $360
= $342
= $313
Chapter 17
Financial Statement Analysis
1087
(20-30 min.)
P 17-23A
Req. 1
Todd Department Stores, Inc. Common-Size Income Statement Compared to Industry Average Year Ended December 31, 2006 INDUSTRY TODD AVERAGE Net sales……………………………………… 100.0% 100.0% Cost of goods sold…………………………. 67.6 65.8 Gross profit…………………………….……. 32.4 34.2 Operating expenses……………………….. 20.9 19.7 Operating income………………………….. 11.5 14.5 Other expenses……………………………... 0.6 0.4 Net income…………………………………… 10.9% 14.1% Todd Department Stores, Inc. Common-Size Balance Sheet Compared to Industry Average December 31, 2006 INDUSTRY TODD AVERAGE Current assets………………………………. 67.8% 70.9% Fixed assets, net……………………………. 26.4 23.6 Intangible assets, net………………………. 0.9 0.8 Other assets…………………………………. 4.9 4.7 Total assets………………………………….. 100.0% 100.0% Current liabilities……………………………. Long-term liabilities………………………… Stockholders’ equity………………………... Total liabilities and stockholders’ equity.. 1088
Accounting 7/e Solutions Manual
46.0% 48.1% 22.7 16.6 31.3 35.3 100.0% 100.0%
(continued)
P 17-23A
Req. 2
Todd’s common-size income statement shows that its ratios of (a) gross profit to net sales, (b) operating income to net sales, and (c) net income to net sales are worse than the industry averages. Overall, the company’s profit performance is worse than the average for the industry.
Req. 3
Todd’s common-size balance sheet shows that its (a) ratio of current assets to total assets is less than that of the industry average. Todd’s (b) ratio of stockholders’ equity to total assets is also worse than the industry average. Overall, the company’s financial position is worse than the industry average.
Chapter 17
Financial Statement Analysis
1089
(30-40 min.)
P 17-24A
Req. 1 (ratios before the transactio ns )
(Dollar Amounts and Stock Quantities in Thousands) Current Ratio
Debt Ratio
$253
$381
$22 + $82 + $149 $49 + $103 + $38
= 1.33
$190 + $191 $637
Earnings per Share
= 0.60
$71 = $1.42* 50
$190
Req. 2 (ratios after the trans actio ns ) (Dollar Amounts and Stock Quantities in Thousands) Transaction
Current Ratio
Debt Ratio
a.
$253 + $46 $190 + $46
= 1.27
$381 + $46 $637 + $46
b.
$253 + $125 $190
= 1.99
$381 + $125 = 0.66 $637 + $125
c.
$253 + $120 $190
= 1.96
$381 = 0.50 $637 + $120
d.
No effect
No effect
__________ *Not in thousands
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= 0.63
Earnings per Share No effect
No effect $71 = $1.29* 50 + 5 No effect
(40-50 min.)
P 17-25A
Req. 1 (Dollar Amounts and Stock Quantities in Thousands) 2009 a. Current ratio:
$371 $226
b. Times-interestearned ratio: c. Inventory turnover:
$86 $11
2008 = 1.64
= 7.82
$240 = 1.55 ($147 + $162) / 2
d. Return on $50 − $6* = 0.338 common stock- ($140 + $120) / 2 holders' equity: e. Earnings per share of common stock:
$50 − $6* 10
f. Price/earnings ratio:
$49** $4.40**
$382 $243 $75 $12
= 1.57
= 6.25
$218 = 1.18 ($162 + $207) / 2 $36 − $6* ($120 + $90) / 2
= 0.286
= $4.40**
$36 − $6 9
= $3.33**
= 11.1
$32.50** $3.33**
= 9.8
__________ *$100,000 × .06 = $6,000 **Not in thousands
Chapter 17
Financial Statement Analysis
1091
(continued)
P 17-25A
Req. 2 Decisions:
a. The company’s a b i li t y t o p a y i t s d e b t s a n d t o s e l l in v e n t o r y improved during 2009, as shown by increases in the current ratio, times-interest-earned ratio, and inventory turnover. b. The c o m m o n s t o c k ’ s a t t r ac t i v e n es s improved during 2009, as shown by the rise in the stock’s market price. This increase in market price is consistent with the increases in return on common stockholders’ equity and earnings per share of common stock. Return on common stockholders’ equity is very high. The price/earnings ratio also increased.
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(45-60 min.)
P 17-26A
(Dollar Amounts and Stock Quantities in Thousands)
a. Acid-test ratio:
Singular $22 + $40 + $42 = 1.04 $100
b. Inventory turnover:
$209 ($67 + $83) / 2
= 2.79
$258 = 2.74 ($100 + $88) / 2
c. Days’ sales in average receivables:
($38 + $40) / 2 $421 / 365
= 34
($46 + $48) / 2 = 35 $497 / 365
$100 $265
= 0.38
$131 $328
$50 10
= $5.00*
$72 15
$80* $5*
= 16
d. Debt ratio:
e. Earnings per share of common stock: f. Price/earnings ratio: _________ *Not in thousands
Chapter 17
Very Zone $19 + $18 + $46 = 0.85 $98
$86.40* $4.8*
= 0.40
= $4.80*
= 18
Financial Statement Analysis
1093
(continued)
P 17-26A
Decision:
Singular’s common stock seems to fit the investment strategy better. Its price/earnings ratio is lower than that of Very Zone, and Singular appears to be in a little better shape financially than Very Zone, as indicated by all the ratio values.
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(15-20 min.) TO:
Prudential Bache Investment Committee
FROM:
Student Name
P 17-27A
SUBJECT: Investment Recommendation
I recommend that we invest in Mocek Corp. for the following reasons: 1. Mocek’s return on equity (ROE) is around 50% higher than Colortime’s. An investment in Mocek stock should therefore produce a higher return than an investment in Colortime stock. 2. Mocek’s ROE exceeds its return on assets by a wider margin than does Colortime’s. This means that Mocek is earning more with its borrowed funds than Colortime is earning. 3. Mocek can cover its interest expense with operating income 16 times compared to 9 times for Colortime. 4. Mocek collects receivables faster than Colortime does. This suggests that cash flow is stronger at Mocek. 5. Colortime is better than Mocek on inventory turnover and net income as a percent of sales. These ratios provide insight about companies’ operations, but ROE and interest coverage are more “bottom-line” oriented. Days’ sales in receivables provide insight about the company’s cash collections from customers. For this reason, I place more importance on ROE, interest-coverage, and days’ sales in receivables, and Mocek outstrips Colortime on these measures.
Chapter 17
Financial Statement Analysis
1095
√
Problems
Group B (20-30 min.)
P 17-28B
Req. 1
Azbell Electronics Trend Percentages
Net sales
2008
2007
2006
2005
109%
111%
95%
100%
Net income
50
117
61
100
Total assets
135
129
106
100
Req. 2 (Dollar amou nts in tho usand s)
2008 Net income Net sales
1096
2007
$9 $21 = 0.029 = 0.067 $307 $313
Accounting 7/e Solutions Manual
2006 $11 = 0.041 $266
(20-30 min.)
P 17-29B
Req. 1
Crescent City Music Company Common-Size Income Statement Compared to Industry Average Year Ended December 31, 2008 CRESCENT INDUSTRY CITY AVERAGE Net sales………………………………………
100.0%
100.0%
Cost of goods sold………………………….
64.1
65.9
Gross profit…………………………….……..
35.9
34.1
Operating expenses…………………………
21.3
28.1
Operating income……………………………
14.6
6.0
Other expenses………………………………
1.0
0.4
Net income……………………………………
13.6%
5.6%
Crescent City Music Company Common-Size Balance Sheet Compared to Industry Average December 31, 2008 CRESCENT INDUSTRY CITY AVERAGE Current assets………………………………..
77.1%
74.4%
Fixed assets, net…………………………….
18.6
20.0
Intangible assets, net……………………….
3.8
0.6
Other assets………………………………….
0.5
5.0
Total assets…………………………………..
100.0%
100.0%
Current liabilities………………………….…
39.0%
45.6%
Long-term liabilities…………………………
21.6
19.0
Stockholders’ equity………………………..
39.4
35.4
Total liabilities and stockholders’ equity..
100.0%
100.0%
Chapter 17
Financial Statement Analysis
1097
(continued)
P 17-29B
Req. 2
Crescent City’s common-size income statement shows that its •
ratio of gross profit to net sales.
•
ratio of operating income to net sales.
•
ratio of net income to net sales.
are all better than the industry averages. Overall, Crescent City’s profit performance is better than average for the industry.
Req. 3
Crescent City’s common-size balance sheet shows that its •
ratios of current assets and of current liabilities to total assets.
•
ratio of stockholders’ equity to total assets is better than the industry averages.
Overall, the company’s financial position is better than average for its industry.
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(20-30 min.)
P 17-30B
Req. 1 (ratios before the transaction s)
(Dollar Amounts and Stock Quantities in Thousands) Current Ratio
Debt Ratio
$359 $47 + $123 + $189 $72 + $96 + $50
Earnings per Share
$442 = 1.65
$218 + $224 $833
= 0.53
$110 20
= $5.50*
$218
Req. 2 (ratios after the trans actions ) (Dollar Amounts and Stock Quantities in Thousands) Transaction
Current Ratio
Debt Ratio
a.
$359 + $27 $218
b.
$359 + $108 = 2.14 $218
$442 = 0.47 $833 + $108
c.
$359 + $48 $218 + $48
$442 + $48 $833 + $48
d.
No effect
= 1.77
= 1.53
$442 + $27 $833 + $27
Earnings per Share
= 0.55
= 0.56
No effect
No effect
$110 = $3.67* 20 + 10 No effect No effect
__________ *Not in thousands
Chapter 17
Financial Statement Analysis
1099
(40-50 min.)
P 17-31B
Req. 1 (Dollar Amounts and Stock Quantities in Thousands) 2006
2005
a. Current ratio:
$548 $286
= 1.92
b. Times-interestearned ratio:
$160 $37
= 4.32
c. Inventory turnover:
$378 = 1.29 ($298 + $286) / 2
d. Return on $89 − $2* = 0.329 common stock- ($308 + $221) / 2 holders' equity:
$497 $267 $169 $51
= 1.86
= 3.31
$283 = 1.20 ($286 + $184) / 2 $65 − $2* = 0.301 ($221 + $198) / 2
e. Earnings per share $89 − $2* of common stock: 15
= $5.80**
$65 − $2* 14
= $4.50**
f. Price/earnings ratio:
= 16
$67.50** $4.50**
= 15
$92.80** $5.80**
__________ *$50,000 × .04 = $2,000 **Not in thousands
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Accounting 7/e Solutions Manual
(continued)
P 17-31B
Req. 2 Decisions:
a. The company’s f i n a n c i al p o s i t io n improved during 2006 as shown by increases in all the ratios. b. The s t o c k ’ s a t t r ac t i v e n es s improved during 2006, as shown by the increase in the market price of the common stock. This increase is consistent with the increases in return on common
stockholders’
equity,
earnings
per
share
of
common stock, and the price/earnings ratio.
Chapter 17
Financial Statement Analysis
1101
(45-60 min.)
P 17-32B
(Dollar Amounts and Stock Quantities in Thousands) MMM a. Acid-test ratio: $45 + $76 + $169 = 0.72 $306
Carolina $39 + $13 + $164 = 0.64 $338
b. Inventory turnover:
$484 = 2.30 ($211 + $209) / 2
$387 = 2.04 ($183 + $197) / 2
c. Days’ sales in average receivables:
($99 + $102) / 2 = 61 $603 / 365
($164 + $193) / 2 = 126 $519 / 365
d. Debt ratio:
$667 $974
= 0.68
$691 $938
= 0.74
e. Earnings per share of common stock:
$75 150
= $0.50*
$38 20
= $1.90*
f. Price/earnings ratio:
$8.00* $.50*
= 16
__________ *Not in thousands
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$41.80* $1.90*
= 22
(continued)
P 17-32B
Decision:
MMM’s common stock seems to fit the investment strategy better. Its price/earnings ratio is lower than that of Carolina, and MMM appears to be in better shape financially than Carolina. On all the ratios, MMM looks better than Carolina.
Chapter 17
Financial Statement Analysis
1103
(15-20 min.) TO:
A.G. Edwards Investment Committee
FROM:
Student Name
P 17-33B
SUBJECT: Investment Recommendation I recommend that we invest in Hourglass Company for the following reasons: 1. Hourglass’s return on equity (ROE) is 7% higher than PC Tech’s. An investment in Hourglass stock should therefore produce a higher return than an investment in PC Tech stock. 2. Hourglass’s ROE exceeds its return on assets by a wider margin than does PC Tech’s. This means that Hourglass is earning more with its borrowed funds than PC Tech is earning. 3. Hourglass can cover its interest expense with operating income 18 times compared to 12 times for PC Tech. 4. Hourglass collects receivables faster than PC Tech does. This suggests that cash flow is stronger at Hourglass. 5. Hourglass’s gross profit percentage is higher than PC Tech’s. 6. PC Tech is better than Hourglass on inventory turnover and net income as a percentage of sales. These ratios provide insight about companies’ operations, but ROE and interest coverage are more “bottom-line” oriented. And days’ sales in receivables give an indication about cash flow. For these reasons, I place more importance on ROE, interest-coverage, and days’ sales in receivables, and Hourglass outstrips PC Tech on these measures.
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√
Decision Cases (30 min.) Decision Case 1
Transaction
Current Ratio
Debt Ratio
Return on Equity
1
Increase
Increase
No effect
2
Decrease
Increase
Increase
3
No effect
Increase
Decrease
4
Decrease
Increase
No effect
5
Decrease
Increase
No effect
Chapter 17
Financial Statement Analysis
1105
(20-30 min.) Decision Case 2 Recording payments in December, but mailing the checks in January, understates Accounts Payable and Cash at year-end. This action makes the current ratio and the acid-test ratio look better than they really are—so long as the ratio values exceed 1.0. The following data illustrate the point: Correct amounts (No cash payments recorded in December)
Amount of cash payment
Reported amounts (Cash payment recorded in December)
Current assets $100 − $10 $100 − $10 $90 = = 2.0 = = = 2.25 Current liabilities $50 − $10 $50 − $10 $40 Quick assets = Current liabilities
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$70 $50
= 1.4
− $10 = − $10
Accounting 7/e Solutions Manual
$70 − $10 $60 = = 1.50 $50 − $10 $40
√
Ethical Issue
1. Reclassifying the long-term investments as short-term will increase current assets and, therefore, increase the current ratio. Ross’s true financial position is not improved by this reclassification because the company’s asset position has not changed. 2. Reclassifying a long-term investment as current to meet a debt agreement does not brand Ross managers as unethical. The managers may have honestly intended to sell the investments in order to meet obligations. In that case, the managers took appropriate action. Reclassifying the investments from current back to long-term may suggest to some observers that managers are playing a shell game. However, the case states that sales subsequent to the first reclassification have improved the current ratio. Under these circumstances, Ross may not need to sell the investments. The managers may prefer to hold the investments beyond one year and, therefore, need to reclassify them as long-term. In that case, the managers’ action is appropriate. This case illustrates how gray accounting can be. Here the debt agreement depends on the current ratio, which is affected by an asset classification that managers control simply by their intentions. Because the managers’ intentions cannot be observed, it would be hard to prove that the managers are behaving unethically.
Chapter 17
Financial Statement Analysis
1107
√
Financial Statement Case (15-25 min.) Financial Statement Case
Req. 1
Stockholders’ equity is very low.
Req. 2
Trend percentages: Net sales………………….. Net income………………..
2005
2004
2003
161 10257
131 16800
100 100
The trend percentage for net income looks strange because the base-year net income amount for 2003 was so low.
Req. 3
Inventory turnover: Cost of sales Average inventory
2005
2004
=
$6,451 ($566 + $480) / 2
$5,319 ($480 + $294) / 2
=
12.3 times
13.7 times
The trend of net income from 2004 to 2005 and the change in the rate of inventory turnover tell the same story. Both measures deteriorated in 2005.
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