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### CHAPTER 16 FINANCIAL STATEMENT ANALYSIS.doc.doc

1. 1. CHAPTER 16 FINANCIAL STATEMENT ANALYSIS DISCUSSION QUESTIONS 1. The two major types of financial statement a high turnover ratio is desired and viewed analysis discussed in this chapter are as a positive signal of success. As long as common-size analysis and ratio analysis. the company is able to produce quickly to fill customer orders, a high inventory turnover 2. Horizontal analysis expresses line items of ratio may be a good sign of success. financial statements as a percentage of a prior-period amount. Vertical analysis ex- 9. The debt ratio is computed as total liabilities presses the line item as a percentage of divided by total assets. By restricting the some other line item for the same time peri- debt ratio, the bank is trying to reduce the od. Both should be done as each provides risk of default by ensuring that assets re- different insights into the financial strength of main relatively high compared with liabilities. a company. 10. The purchase alternative would increase the 3. Horizontal analysis reveals trends—both fa- liabilities reported on the balance sheet. In- vorable and unfavorable. Vertical analysis creasing liabilities may cause the company reveals the current strengths and weakness- to violate some existing debt covenants. The es of key financial factors. In both lease payment, however, had an immediate cases, the information provided is useful for impact on the income statement rather than decision making. For example, vertical anal- the balance sheet. ysis helps managers determine the relationship of costs to sales. Horizontal 11. The debt ratio may provide a measure of the analysis can show the upward or downward riskiness of the investment. The higher the trend in sales and costs over time. ratio, the more likely the company will go bankrupt, causing the investors to lose much 4. Liquidity ratios measure the ability of a firm to meet its short-term obligations. Leverage of their investment. ratios measure the ability of a firm to meet 12. For someone retiring, an annual income both long- and short-term obligations. Prof- would be needed. Accordingly, companies itability ratios measure the earning ability of that have high yields and payout ratios a firm. would be preferred to those that have lower 5. Two types of standards used in ratio analy- ratios. sis are historical and industrial standards. 13. The price-earnings ratio can be compared Historical standards allow one to assess with an investor’s expectation of future trends over time. Industrial standards allow growth. If it is low (high) based on this ex- one to assess a company’s performance rel- pectation, then the price is too low (high) ative to that of other firms. and the price will change based on the bid- 6. The current ratio includes all current assets, ding that results. from very liquid cash to less liquid invento- ries. The quick ratio excludes inventories 14. The dilutive effect is of interest to stockhold- and thus provides a better measure of liquid- ers because their share of earnings can ity (inventories are sometimes obsolete or drop if and when conversions are made. may turn over slowly). 15. The inventory turnover ratio can signal 7. It may indicate a need to modify credit and movement toward the goal of zero invento- collection policies to speed up the conver- ries. sion of receivables to cash. 16. Yes. As inventories are reduced to insignifi- 8. A high inventory turnover ratio does not nec- cant levels, the current ratio approaches the essarily provide evidence of stockouts and quick ratio. disgruntled customers. In a JIT environment, 16-1
2. 2. 16-2
3. 3. MULTIPLE-CHOICE EXERCISES 16–1 c 16–2 c 16–3 a 16–4 c 16–5 d 16–6 e 16–7 e 16–8 a 16–9 b 16–10 b 16-3
4. 4. CORNERSTONE EXERCISES Cornerstone Exercise 16–11 Year 1 is the base year. Therefore, every dollar amount in year 1 is 100 percent of itself. Dollar amount of line item Percent for a line item = × 100 Dollar amount of base year line item \$1,000,000 Percent year 1 net sales = × 100 = 100% \$1,000,000 \$1,100,000 Percent year 2 net sales = × 100 = 110% \$1,000,000 \$1,250,000 Percent year 3 net sales = × 100 = 125% \$1,000,000 Year 1 Year 2 Year 3 Dollars Percent Dollars Percent Dollars Percent Net sales \$1,000,000 100% \$1,100,000 110% \$1,250,000 125% Less: Cost of goods sold (700,000) 100 (750,000) 107 (810,000) 116 Gross margin \$ 300,000 100 \$ 350,000 117 \$ 440,000 147 Less: Operating expenses (200,000) 100 (240,000) 120 (310,000) 155 Income taxes (40,000) 100 (44,000) 110 (52,000) 130 Net income \$ 60,000 100 \$ 66,000 110 \$ 78,000 130 Cornerstone Exercise 16–12 Since the analysis is based on net sales, net sales in each year equals 100 per- cent of itself. Then, every line item on the income statement is expressed as a percent of that year’s net sales. Dollar amount of line item Percent for a line item = × 100 Dollar amount of that year' s sales \$1,000,000 Percent year 1 net sales = × 100 = 100% \$1,000,000 \$1,100,000 Percent year 2 net sales = × 100 = 100% \$1,100,000 16-4
5. 5. Cornerstone Exercise 16–12 (Concluded) \$1,250,000 Percent year 3 net sales = × 100 = 100% \$1,250,000 Year 1 Year 2 Year 3 Dollars Percent Dollars Percent Dollars Percent Net sales \$1,000,000 100% \$1,100,000 100.0% \$1,250,000 100.0% Less: Cost of goods sold (700,000) 70 (750,000) 68 (810,000) 65 Gross margin \$ 300,000 30 \$ 350,000 32 \$ 440,000 35 Less: Operating expenses \$ (200,000) 20 \$ (240,000) 22 \$ (310,000) 25 Income taxes (40,000) 4 (44,000) 4 (52,000) 4 Net income \$ 60,000 6 \$ 66,000 6 \$ 78,000 6 Cornerstone Exercise 16–13 Current assets 1. Current ratio = Current liabilities \$3,800,000 = \$2,000,000 = 1.9 Cash + Marketable securities + Receivables 2. Quick ratio = Current liabilities You first need to calculate marketable securities by subtracting the specific known current assets from the given total current assets. Therefore, mar- ketable securities = \$3,800,000 – \$1,200,000 cash – \$1,800,000 accounts re- ceivable – \$500,000 inventories. Thus, marketable securities = \$300,000. Cash + Marketable securities + Receivables Finally, Quick ratio = Current liabilities \$1,200,000 + \$300,000 + \$1,800,000 = \$2,000,000 = 1.65 16-5
6. 6. Cornerstone Exercise 16–14 Beginning receivables + Ending receivables 1. Average accounts receivables = 2 \$725,000 + \$775,000 = = \$750,000 2 Net sales 2. Accounts receivable turnover ratio = Average accounts receivable \$9,375,000 = = 12.5 \$750,000 Days in a year 3. Accounts receivable in days = Accounts receivable turnover ratio 365 = = 29.2 days 12.5 Cornerstone Exercise 16–15 Beginning inventory + Ending inventory 1. Average inventory = 2 \$450,000 + \$425,000 = 2 = \$437,500 Cost of goods sold 2. Inventory turnover ratio = Average inventory \$4,812,000 = \$437,500 = 11.0 Days in a year 3. Inventory turnover in days = Inventory turnover ratio 365 = = 33.2 days 11 16-6
7. 7. Cornerstone Exercise 16–16 Income before taxes + Interest expense Times-interest-earned ratio = Interest expense \$3,653,035 + \$487,015 = \$487,015 = 8.5 Cornerstone Exercise 16–17 Total liabililties 1. Debt ratio = Total assets \$32,800,30 0 = \$43,150,30 0 = 0.76, or 76% Total liabilities 2. Debt-to-equity ratio = Total stockholders' equity \$32,800,30 0 = \$10,350,00 0 = 3.17 Cornerstone Exercise 16–18 Net income Return on sales = Sales \$915,197 = \$8,281,989 = 0.1105, or 11.1% 16-7
8. 8. Cornerstone Exercise 16–19 1. Average total assets = Beginning Total Assets + Ending Total Assets 2 \$6,521,576 + \$8,121,576 = 2 = \$7,321,576 \$915,197 + (\$50,000* × (1- 0.40)) 2. Return on total assets = \$7,321,576 \$915,197 + \$30,000 = \$7,321,576 \$945,197 = \$7,321,576 = 0.12909, or 12.91% *Note: \$50,000 of interest expense = \$500,000 of Bonds Payable @ 10% rate as stated in Jeanette’s balance sheet. Cornerstone Exercise 16–20 \$4,316,655 + \$4,949,965 1. Average common stockholders’ equity = 2 = \$4,633,310 Note: Common stockholders’ equity for each year is calculated by summing common stock, additional paid-in capital, and retained earnings. Therefore, common stockholders’ equity for 2010 = \$337,500 + \$2,000,000 + \$2,612,465 = \$4,949,965. Net income - Preferred dividends 2. Return on stockholders’ equity = Average common stockholders' equity \$915,197 - \$80,000 = \$4,633,310 \$835,197 = \$4,633,310 = 0.18025, or 18.03% 16-8
9. 9. Cornerstone Exercise 16–21 1. Preferred dividends = \$1,000,000 × 0.08 = \$80,000 (Recall that the preferred shares pay a dividend of 8 percent as shown in Jeanette Company’s balance sheet.) \$337,500 2. Number of common shares = = 225,000 \$1.50 Net income - Preferred dividends 3. Earnings per share = Average common shares \$915,197 - \$80,000 = 225,000 \$835,197 = 225,000 = \$3.711986, or \$3.71 of earnings per share Cornerstone Exercise 16–22 Before the price-earnings ratio can be computed, earnings per share must be cal- culated for use as the denominator in the price-earnings ratio. Earnings per share for Jeanette equal \$3.71. Refer to Cornerstone Exercise 16–21 for specific guid- ance on how to calculate earnings per share. Market price per share Price-earnings ratio = Earnings per share \$8.10 = \$3.71 = 2.18328, or 2.18 16-9
10. 10. Cornerstone Exercise 16–23 \$201,887 1. Dividends per share = = \$0.8972, or 0.90. 225,000 \$337,500 Note: Number of common shares = par value per common share = \$1.50 225,000 common shares (see Cornerstone Exercise 16–21 for specific guid- ance on how to calculate the number of common shares). Dividends per common share 2. Dividend yield = Market price per common share \$0.90 = \$8.10 = 0.1111, or 11.11% Common dividends 3. Dividend payout ratio = Net income - Preferred dividends \$201,887 = \$915,197 - \$80,000 \$201,887 = \$835,197 = 0.24172, or .24 16-10
11. 11. EXERCISES Exercise 16–24 Percent of Year 2 Amount Year 1 Amount Sales..................................................................... \$ 1,800,000 90.0% Less: Cost of goods sold................................... (1,200,000) 85.7 Gross margin................................................. \$ 600,000 100.0 Less operating expenses: Selling expenses............................................ (300,000) 100.0 Administrative expenses.............................. (110,000) 110.0 Net operating income......................................... \$ 190,000 95.0 Less: Interest expense....................................... (40,000) 80.0 Income before taxes...................................... \$ 150,000 100.0 Exercise 16–25 1. Percent of Year 1 Year 1 Sales Sales................................................................ \$ 2,000,000 100.0% Less: Cost of goods sold.............................. (1,400,000) 70.0 Gross margin............................................ \$ 600,000 30.0 Less operating expenses: Selling expenses...................................... (300,000) 15.0 Administrative expenses......................... (100,000) 5.0 Net operating income.................................... \$ 200,000 10.0 Less: Interest expense.................................. (50,000) 2.5 Income before taxes................................. \$ 150,000 7.5 2. Percent of Year 2 Year 2 Sales Sales................................................................ \$ 1,800,000 100.0% Less: Cost of goods sold.............................. (1,200,000) 66.7 Gross margin............................................ \$ 600,000 33.3 Less operating expenses: Selling expenses...................................... (300,000) 16.7 Administrative expenses......................... (110,000) 6.1 Net operating income.................................... \$ 190,000 10.6 Less: Interest expense.................................. (40,000) 2.2 Income before taxes................................. \$ 150,000 8.3 16-11
12. 12. Exercise 16–26 1. Percent of Year 2 Year 1 Sales................................................................ \$ 1,200,000 120.0% Less: Cost of goods sold.............................. (700,000) 100.0 Gross margin............................................ \$ 500,000 166.7 Less operating expenses: Selling expenses...................................... (220,000) 146.7 Administrative expenses......................... (60,000) 120.0 Net operating income.................................... \$ 220,000 220.0 Less: Interest expense.................................. (25,000) 100.0 Income before taxes................................. \$ 195,000 260.0 2. Percent of Year 3 Year 1 Sales................................................................ \$ 1,700,000 170.0% Less: Cost of goods sold.............................. (1,000,000) 142.9 Gross margin............................................ \$ 700,000 233.3 Less operating expenses: Selling expenses...................................... (250,000) 166.7 Administrative expenses......................... (120,000) 240.0 Net operating income.................................... \$ 330,000 330.0 Less: Interest expense.................................. (25,000) 100.0 Income before taxes................................. \$ 305,000 406.7 Exercise 16–27 1. Percent of Year 1 Sales in Year 1 Sales................................................................ \$ 1,000,000 100.0% Less: Cost of goods sold.............................. (700,000) 70.0 Gross margin............................................ \$ 300,000 30.0 Less operating expenses: Selling expenses...................................... (150,000) 15.0 Administrative expenses......................... (50,000) 5.0 Net operating income.................................... \$ 100,000 10.0 Less: Interest expense.................................. (25,000) 2.5 Income before taxes................................. \$ 75,000 7.5 16-12
13. 13. Exercise 16–27 (Concluded) 2. Percent of Year 2 Sales in Year 2 Sales................................................................ \$ 1,200,000 100.0% Less: Cost of goods sold.............................. (700,000) 58.3 Gross margin............................................ \$ 500,000 41.7 Less operating expenses: Selling expenses...................................... (220,000) 18.3 Administrative expenses......................... (60,000) 5.0 Net operating income.................................... \$ 220,000 18.3 Less: Interest expense.................................. (25,000) 2.1 Income before taxes................................. \$ 195,000 16.3 3. Percent of Year 3 Sales in Year 3 Sales................................................................ \$ 1,700,000 100.0% Less: Cost of goods sold.............................. (1,000,000) 58.8 Gross margin............................................ \$ 700,000 41.2 Less operating expenses: Selling expenses...................................... (250,000) 14.7 Administrative expenses......................... (120,000) 7.1 Net operating income.................................... \$ 330,000 19.4 Less: Interest expense.................................. (25,000) 1.5 Income before taxes................................. \$ 305,000 17.9 Exercise 16–28 Current assets 1. Current ratio = Current liabilities \$5,400,000 = \$2,000,000 = 2.7 Current assets - Inventories 2. Quick (acid-test) ratio = Current liabilities \$5,400,000 - \$1,600,000 = \$2,000,000 = 1.9 16-13
14. 14. Exercise 16–29 Current assets 1. Current ratio = Current liabilities \$250,000 = \$200,000 = 1.25 Current assets - Inventories 2. Quick (acid-test) ratio = Current liabilities \$250,000 - \$60,000 = \$200,000 = 0.95 Exercise 16–30 1. Average accounts receivable Beginning accounts receivable + Ending accounts receivable = 2 \$306,100 + \$281,100 = 2 = \$293,600 Net sales 2. Accounts receivable turnover ratio = Average receivables \$850,000 = \$293,600 = 2.9 Days in a year 3. Accounts receivable in days = Accounts receivable turnover ratio 365 = 2.9 = 125.9 days 16-14
15. 15. Exercise 16–31 1. Average accounts receivable Beginning accounts receivable + Ending accounts receivable = 2 \$1,100,400 + \$965,800 = 2 = \$1,033,100 Net sales 2. Accounts receivable turnover ratio = Average receivables \$6,500,300 = \$1,033,100 = 6.29 Days in a year 3. Accounts receivable in days = Accounts receivable turnover ratio 365 = 6.29 = 58.03 days Exercise 16–32 Beginning inventory + Ending inventory 1. Average inventory = 2 \$335,000,000 + \$350,000,000 = 2 = \$342,500,000 Cost of goods sold 2. Inventory turnover ratio = Average inventory \$1,557,850 ,000 = \$342,500,0 00 = 4.55 16-15
16. 16. Exercise 16–32 (Concluded) Days in a year 3. Inventory turnover in days = Inventory turnover ratio 365 = 4.55 = 80.22 days Exercise 16–33 Beginning inventory + Ending inventory 1. Average inventory = 2 \$53,420 + \$62,640 = 2 = \$58,030 Cost of goods sold 2. Inventory turnover ratio = Average inventory However, Cost of Goods Sold is not given. Instead, Sales and Gross Margin are given and from these two numbers Cost of Goods Sold can be computed. Specifically, Sales – Cost of Goods Sold = Gross Margin. Therefore, \$3,948,340 – Cost of Goods Sold = \$1,859,260; so Cost of Goods Sold = \$2,089,080 \$2,089,080 Inventory turnover ratio = \$58,030 = 36 Days in a year 3. Inventory turnover in days = Inventory turnover ratio 365 = 36 = 10.1 days 16-16
17. 17. Exercise 16–34 Income before taxes + Interest expense Times-interest-earned ratio = Interest expense \$450,000 + \$50,000 = \$50,000 = 10.0 Exercise 16–35 Total liabilities 1. Debt ratio = Total assets \$678,000 = \$904,000 = 0.75 Total liabilities 2. Debt-to-equity ratio = Total equity \$678,000 = \$226,000 = 3.00 Exercise 16–36 Income before taxes + Interest expense 1. Times-interest-earned ratio = Interest expense \$3,5000,000 + \$1,000,000 = \$1,000,000 = 4.50 Total liabilities 2. Debt ratio = Total assets \$10,250,00 0 = \$16,400,00 0 = 0.63 16-17
18. 18. Exercise 16–36 (Concluded) Total liabilities 3. Debt-to-equity ratio = Total equity \$10,250,000 = \$6,150,000 = 1.67 Exercise 16–37 Net income Return on sales = Sales \$2,100,000 = \$11,300,000 = 0.1858, or 18.58% Exercise 16–38 Beginning total assets + Ending total assets 1. Average total assets = 2 \$17,350,000 + \$16,400,000 = 2 = \$16,875,000 Net income + [Interest expense(1 − tax rate)] 2. Return on assets = Average total assets \$2,100,000 + [\$1,000,000(1 - 0.4)] = \$16,875,000 \$2,100,000 + \$600,000 = \$16,875,000 = 0.16, or 16.00% 16-18
19. 19. Exercise 16–39 1. Average common stockholders’ equity = Beginning common stockholders’ equity + Ending common stockholders’ equity 2 \$11,800,000 + \$12,050,000 = 2 = \$11,925,000 Note: Remember that beginning (or ending) Common Stockholders’ Equity equals Total Equity minus Preferred Stock. 2. Return on common stockholders' equity Net income - Preferred dividends = Average common stockholders' equity \$3,182,000 - \$320,000 = \$11,925,000 = 0.24, or 24% Exercise 16–40 1. Preferred dividends = \$4,000,000 × 0.08 = \$320,000 \$3,000,000 2. Number of common shares = = 1,000,000 \$3 Net income - Preferred dividends 3. Earnings per share = Average common shares \$3,182,000 - \$320,000 = 1,000,000 \$2,862,000 = 1,000,000 = \$2.86 Market price per share 4. Price-earnings ratio = Earnings per share \$51.50 = \$2.86 = 18 16-19
20. 20. Exercise 16–41 \$2,600,000 1. Dividends per share = = \$2.60 1,000,000 Dividends per common share 2. Dividend yield = Market price per common share \$2.60 = \$51.50 = 0.05, or 5.0% Common dividends 3. Dividend payout ratio = Net income - Preferred dividends \$2,600,000 = \$3,182,000 - \$320,000 \$2,600,000 = \$2,862,000 = 0.91 16-20
21. 21. PROBLEMS Problem 16–42 1. Current assets = \$250,000 + \$400,000 + \$100,000 + \$200,000 + \$50,000 = \$1,000,000 Current liabilities = \$175,000 + \$85,000 + \$90,000 + \$50,000 = \$400,000 Current assets Current ratio = Current liabilities \$1,000,000 = \$400,000 = 2.5 Cash + Marketable securities + Receivables 2. Quick or acid-test ratio = Current liabilities \$700,000 = \$400,000 = 1.75 Net sales 3. Accounts receivable turnover ratio = Average receivables \$2,450,000 = \$350,000* = 7 times per year \$300,000 + \$400,000 *Average receivables = 2 365 4. Accounts receivable turnover ratio in days = Accounts receivable turnover 365 = 7 = 52.14 days 16-21
22. 22. Problem 16–42 (Concluded) Cost of goods sold 5. Inventory turnover ratio = Average inventory \$1,300,000 = \$225,000* = 5.78 times per year \$200,000 + \$250,000 *Average inventory = 2 365 6. Inventory turnover ratio in days = Inventory turnover ratio 365 = 5.78 = 63.15 days Problem 16–43 Income before taxes + Interest expense 1. Times-interest-earned ratio = Interest expense \$200,000 + \$140,000 = \$140,000 \$340,000 = \$140,000 = 2.43 Total liabilities 2. Debt ratio = Total assets* \$2,500,000 = \$7,250,000 = 0.35 *Total assets = Total liabilities + Total equity = \$2,500,000 + \$4,750,000 = \$7,250,000 16-22
23. 23. Problem 16–43 (Concluded) 3. The times-interest-earned ratio is very close to the lower quartile, which means that relative to most companies in the industry, Timmins Company has a significant expense burden (relative to its income). Its debt ratio is in the up- per quartile, which means that the company may still have additional credit. Because of its interest expense and income level, however, Timmins should be very careful about taking on additional debt. Problem 16–44 Net income + [Interest expense(1 − tax rate)] 1. Return on total assets = Average total assets \$5,000,000 + (\$400,000 × 0.66) = \$60,000,000 = 0.088 Net income - Preferred dividends 2. Return on common equity = Average common stockholders' equity \$5,000,000 - \$400,000 = \$20,000,000 \$4,600,000 = \$20,000,00 0 = 0.23 Net income - Preferred dividends 3. Earnings per share = Average common shares \$5,000,000 - \$400,000 = 800,000 = \$5.75 Market price per share 4. Price-earnings ratio = Earnings per share \$40 = \$5.75 = 6.96 16-23
24. 24. Problem 16–44 (Concluded) Dividends per common share 5. Dividend yield = Market price per common share \$1,200,000 ÷ 800,000 = \$40 1.5 = 40 = 0.0375 Common dividends 6. Dividend payout ratio = Net income - Preferred dividends \$1,200,000 = \$5,000,000 - \$400,000 = 0.26 Problem 16–45 1. Kepler Company Comparative Balance Sheets Percent This Year Last Year Change Assets Current assets: Cash \$ 50,000 \$100,000 (50.0%) Accounts receivable, net 300,000 150,000 100.0 Inventory 600,000 400,000 50.0 Prepaid expenses 25,000 30,000 (16.7) Total current assets \$ 975,000 \$680,000 43.4 Property and equipment, net 125,000 150,000 (16.7) Total assets \$1,100,000 \$830,000 32.5 16-24
25. 25. Problem 16–45 (Concluded) Kepler Company Comparative Balance Sheets Continued Percent This Year Last Year Change Liabilities and Stockholders’ Equity Liabilities: Current liabilities: Accounts payable \$ 400,000 \$290,000 37.9% Short-term notes payable 200,000 60,000 233.3 Total current liabilities \$ 600,000 \$350,000 71.4 Long-term bonds payable, 12% 100,000 150,000 (33.3) Total liabilities \$ 700,000 \$500,000 40.0 Stockholders’ equity: Common stock (100,000 shares) 200,000 200,000 0.0 Retained earnings 200,000 130,000 53.8 Total liabilities and equity \$1,100,000 \$830,000 32.5 Kepler Company Comparative Income Statements Percent This Year Last Year Change Sales \$ 950,000 \$ 900,000 5.6% Less cost of goods sold (500,000) (490,000) 2.0 Gross margin \$ 450,000 \$ 410,000 9.8 Less selling and admin. exp. (275,000) (260,000) 5.8 Operating income \$ 175,000 \$ 150,000 16.7 Less interest expense (12,000) (18,000) (33.3) Income before taxes \$ 163,000 \$ 132,000 23.5 Less taxes (65,200) (52,800) 23.5 Net income \$ 97,800 \$ 79,200 23.5 Less dividends (27,800) (19,200) 44.8 Net income, retained \$ 70,000 \$ 60,000 16.7 2. Cash has decreased by 50%, accounts receivables have doubled, and invento- ry has increased by 50%. At the same time, liabilities have increased by 40%, mostly due to increases in short-term liabilities. Management may want to know why inventories and receivables increased so dramatically. 16-25
26. 26. Problem 16–46 1. Assets This Year Last Year Current assets: Cash \$ 50,000 4.5% \$100,000 12.0% Accounts receivable, net 300,000 27.3 150,000 18.1 Inventory 600,000 54.5 400,000 48.2 Prepaid expenses 25,000 2.3 30,000 3.6 Total current assets \$975,000 88.6 \$680,000 81.9 Property and equipment, net 125,000 11.4 150,000 18.1 Total assets \$1,100,000 100.0 \$830,000 100.0 2. Liabilities and Stockholders’ Equity Liabilities: This Year Last Year Current liabilities: Accounts payable \$ 400,000 36.4% \$290,000 34.9% Notes payable 200,000 18.2 60,000 7.2 Total current liabilities \$ 600,000 54.5 \$350,000 42.2 Bonds payable, 12% 100,000 9.1 150,000 18.1 Total liabilities \$ 700,000 63.6 \$500,000 60.2 Stockholders’ equity: Common stock 200,000 18.2 200,000 24.1 Retained earnings 200,000 18.2 130,000 15.7 Total liabilities and equity \$1,100,000 100.0 \$830,000 100.0 3. This Year Last Year Sales \$ 950,000 100.0% \$ 900,000 100.0% Less cost of goods sold (500,000) 52.6 (490,000) 54.4 Gross margin \$ 450,000 47.4 \$ 410,000 45.6 Less selling and admin. expense (275,000) 28.9 (260,000) 28.9 Operating income \$ 175,000 18.4 \$ 150,000 16.7 Less interest expense (12,000) 1.3 (18,000) 2.0 Income before taxes \$ 163,000 17.2 \$ 132,000 14.7 Less taxes (65,200) 6.9 (52,800) 5.9 Net income \$ 97,800 10.3 \$ 79,200 8.8 Less dividends (27,800) 2.9 (19,200) 2.1 Net income, retained \$ 70,000 7.4 \$ 60,000 6.7 16-26
27. 27. Problem 16–47 Current assets 1. a. Current ratio = Current liabililties This Year Last Year \$975,000 \$680,000 Current ratio = = \$600,000 \$350,000 = 1.625 = 1.943 Cash + Marketable securities + Receivables b. Quick ratio = Current liabilities This Year Last Year \$50,000 + \$300,000 \$100,000 + \$150,000 Quick ratio = = \$600,000 \$350,000 \$350,000 \$250,000 = = \$600,000 \$350,000 = 0.583 = 0.714 Net sales c. Receivables turnover = Average receivables This Year Last Year \$950,000 \$900,000 Receivables turnover = = \$225,000 \$150,000* = 4.22 =6 365 365 Turnover in days = = 4.22 6 = 86.49 days = 60.83 days *Since the beginning balance is not known for receivables, the average is assumed to be the ending balance. 16-27
28. 28. Problem 16–47 (Concluded) Cost of goods sold d. Inventory turnover = Average inventory This Year Last Year \$500,000 \$490,000 Inventory turnover = = \$600,000 \$400,000* = 0.83 = 1.225 365 365 Turnover in days = = 0.83 1.225 = 439.8 days = 297.96 days *Since the beginning balance is not known for inventory, the average is as- sumed to be the ending balance. 2. The liquidity of Kepler has declined over the past year as measured by the turnover ratios and the current and quick ratios. Industrial liquidity perfor- mance would allow us to assess what is normal for the industry and thus bet- ter assess what is a reasonable liquidity level for Kepler. 16-28
29. 29. Problem 16–48 Income before taxes + Interest expense 1. a. Times-interest-earned ratio = Interest expense This Year Last Year \$163,000 + \$12,000 \$132,000 + \$18,000 Times-interest-earned = = \$12,000 \$18,000 \$175,000 \$150,000 = = \$12,000 \$18,000 = 14.58 = 8.33 Total liabilities b. Debt ratio = Total assets This Year Last Year \$700,000 \$500,000 Debt ratio = = \$1,100,000 \$830,000 = 0.6364 = 0.6024 2. There appears to be good income coverage of interest. The debt ratio is over 50%, but whether this is good or bad depends to some extent on what is nor- mal for the firm’s industry. The fact that the proportion of debt has increased is certainly a negative factor. Knowing the industrial statistics would help in the assessment. 16-29
30. 30. Problem 16–49 Net income + [Interest expense(1 − tax rate)] 1. a. Return on total assets = Average total assets This Year Last Year \$77,200a \$70,800b Return on total assets = = \$965,000 \$830,000 = 0.0800 = 0.0853 a \$70,000 + [\$12,000(1 – 0.40)] b \$60,000 + [\$18,000(1 – 0.40)] Net income - Preferred dividends b. Return on common stockholders’ equity = Average stockholders' equity This Year Last Year \$70,000 \$60,000 Return on equity = = \$365,000 \$330,000 = 0.192, or 19.2% = 0.182, or 18.2% Net income c. Earnings per share = Average common shares This Year Last Year \$70,000 \$60,000 EPS = EPS = \$100,000 \$100,000 = \$0.70 = \$0.60 Market price per share d. Price-earnings ratio = Earnings per share This Year Last Year \$2.98 \$2.98 PE ratio = PE ratio = \$0.70 \$0.60 = 4.26 = 4.97 16-30
31. 31. Problem 16–49 (Concluded) Dividends per common share e. Dividend yield = Market price per share This Year Last Year \$0.278 \$0.192 Yield = Yield = \$2.98 \$2.98 = 0.0933, or 9.33% = 0.0644, or 6.44% Common dividends f. Dividend payout = Net income - Preferred dividends This Year Last Year \$27,800 \$19,200 Payout = Payout = \$70,000 \$60,000 = 0.397 = 0.32 2. The return on assets and the PE ratio have declined, while EPS, return on eq- uity, yield, and payout measures have increased. Thus, the profitability mea- sures are providing mixed signals. More information is needed before an in- vestment decision is made. Will the decline in the return on assets continue? How do these returns compare to other firms in the same industry? Will the dividend payout continue? What is the historical performance of this firm? Problem 16–50 Net income 1. a. Return on sales = Sales \$10,500 = \$100,000 = 0.105, or 10.5% 16-31
32. 32. Problem 16–50 (Continued) Net income + [Interest expense(1 − tax rate)] b. Return on assets = Average total assets \$10,500 + (\$350 × 0.6) = \$123,000* \$10,710 = \$123,000 = 0.087, or 8.7% = 8.7% \$120,000 + \$126,000 *Average total assets = 2 Net income - Preferred dividends c. Return on equity = Average stockholders' equity \$10,500 - \$300 = \$55,000 \$10,200 = \$55,000 = 0.185, or 18.5% Net income - Preferred dividends d. EPS = Average common shares \$10,500 - \$300 = 35,000* \$10,200 = 35,000 = \$0.29 per share 30,000 + 40,000 *Average common shares = 2 16-32
33. 33. Problem 16–50 (Concluded) Market price per share e. PE ratio = Earnings per share \$12 = \$0.29 = 41.38 Dividends per common share f. Dividend yield = Market price per share \$0.20* = \$12 = 0.017, or 1.7% \$8,000 *Dividends per share = = \$0.20 40,000 Common dividends g. Dividend payout ratio = Income - Preferred dividends \$8,000 = \$10,500 - \$300 = 0.7843 2. Since all the ratios are profitability ratios, they should all be of interest to in- vestors. Some, however, may be of more interest than others, depending on the objectives of the potential investor. For example, an investor looking for retirement income may be particularly interested in the dividend yield ratio. 16-33
34. 34. Problem 16–51 Net sales 1. Accounts receivables turnover = Average receivables \$500,000 2005 Accounts receivables turnover = =5 \$100,000 365 Days = = 73 5 \$600,000 2006 Accounts receivables turnover = = 5.45 \$110,000* 365 Days = = 67 5.45 \$100,000 + \$120,000 *Average receivables = 2 \$510,000 2007 Accounts receivables turnover = = 4.64 \$110,000* 365 Days = = 78.7 4.64 \$120,000 + \$100,000 *Average receivables = 2 \$510,000 2008 Accounts receivables turnover = = 4.08 \$125,000* 365 Days = = 89.5 4.08 \$100,000 + \$150,000 *Average receivables = 2 \$520,000 2009 Accounts receivables turnover = = 3.06 \$170,000* 365 Days = = 119.3 3.06 \$150,000 + \$190,000 *Average receivables = 2 16-34
35. 35. Problem 16–51 (Concluded) 2. The new credit policy reduced the accounts receivable turnover because of the fact that the customer now has 60 days before full payment of the account is required. This in turn slowed the inflow of cash to the company. The slower inflow of cash created the company’s difficulty in meeting its short-term obli- gations. 3. If Ted Pendleton had known that the industry had an average receivables turnover of six times per year, he may not have liberalized the company’s credit policy because the turnover was already slower than the industry aver- age. Problem 16–52 \$2,640,000 - \$300,000 1. a. Company A EPS = 1,000,000 = \$2.34 \$2,640,000 - \$100,000 Company B EPS = 1,200,000 = \$2.12 \$840,000 - \$1(300,000) b. Company A dividends per common share = 1,000,000 = \$0.54 \$0.54 Company A dividend yield ratio = \$5.00 = 0.108 \$1,040,000 - \$1(100,000) Company B dividends per common share = \$1,200,000 = \$0.7833 \$0.7833 Company B dividend yield ratio = \$9.80 = 0.08 16-35
36. 36. Problem 16–52 (Concluded) \$540,000 c. Company A dividend payout ratio = \$2,640,000 - \$300,000 = 0.231 \$940,000 Company B dividend payout ratio = \$2,640,000 - \$100,000 = 0.370 \$5.00 d. Company A price-earnings ratio = \$2.34 = 2.14 \$9.80 Company B price-earnings ratio = \$2.12 = 4.62 \$2,640,000 + [\$1,000,000(1 - 0.34)] e. Company A return on total assets = \$20,000,000 = 0.165 \$2,640,000 + [\$3,000,000(1 - 0.34)] Company B return on total assets = \$22,000,000 = 0.210 \$2,640,000 - \$300,000 f. Company A return on common equity = 10,000,000 = 0.234 \$2,640,000 - \$100,000 Company B return on common equity = 13,000,000 = 0.195 2. Company B dominates on every profitability measure except the EPS, divi- dend yield ratio, and return on equity. If this pattern is expected to persist in the future, B appears to be the better investment. 16-36
37. 37. CASES Case 16–53 1. Pete Donaldson’s behavior is not ethical. Hiding a loan and obsolete safety equipment is dishonest. The \$30,000 cannot be considered to be donated when he is making interest payments of \$3,000 per year and has a requirement to return the \$30,000. (Standard III: 2, 3) 2. a. First, consult with Pete Donaldson and tell him that you cannot prepare the statements in the way he has requested and explain why. If he insists on their preparation following his classification, then resignation is called for. To prepare the statements would violate a number of standards of ethical conduct and would be prohibited by most corporate codes of conduct. (Even if Donaldson Mining Supplies does not have a written corporate code of conduct, lying on financial statements is neither ethical nor legal.) (Stan- dard III: 2, 3) b. First, Pete Donaldson should be approached. He should be requested to withdraw the loan request or provide corrected financial statements. Should he refuse, then the ethical dilemma has been significantly com- pounded. Communication of the problem to outside parties is usually not considered appropriate unless legally prescribed. If a possibility of being held legally responsible for the fraudulent statements is present, then the correct action would be to notify the bank that new information has sur- faced that makes the financial statements unreliable. In fact, consultation with an attorney is strongly recommended. The attorney could then deter- mine the means by which the bank is notified. 3. One possible solution is to approach the father-in-law who gave the loan origi- nally and offer part ownership in the company. The loan could then legitimate- ly be converted to equity in exchange for an ownership share. With the legiti- mate reclassification, a loan application could be submitted in good con- science. Case 16–54 Answers will vary. NOTE TO INSTRUCTOR: You can easily turn this into a group exercise by forming groups of two or three and assigning each group an industry (e.g., airlines, medical care, retail, computer hardware or software developers). Then the group members can complete this exercise and present their findings to the class. 16-37