Solutions to Chapter 12

Financial Statement Analysis

Concept Questions
1. Financial statement analysis provides useful information to supplement information directly provided in the financial statements. Ratio analysis provides additional information to management, lenders, and stockholders that enhances the decision-making ability of these and other financial statement users. The ratios show how well a company has done in the past and are useful in predicting the future results of the company. 2. Ratio analysis by itself does not indicate the various accounting methods, estimates, and assumptions that a company used in the preparation of financial statements. Inventory methods such as LIFO or FIFO are an example of this. If a company has changed accounting methods, periodto-period comparisons may be difficult. In addition, comparing companies of different size and complexity as well as companies in different industries can be misleading when based solely on ratio analysis. Finally, ratio analysis (like any analysis using financial statements) uses historical costs, which may not accurately reflect market values. 3. Trend analysis) Decision makers might wish to perform a trend analysis because it is useful in building prediction models to forecast financial performance in the future. It can also be used to identify problem areas for sudden or abnormal changes in accounts. 4. Trend analysis: Number of years) Decision makers should use more years because this enables them to make more accurate prediction models and identify patterns and trends in financial performance. 5. Usefulness of common-size financial statements) Common-size financial statements are useful because they allow decision makers to remove size (i.e., dollar amounts) as a relevant variable in ratio analysis, and they can be used to compare companies that make similar products and that are different in size.

Solutions to Chapter 12
6. Working capital) Working capital is a measure of a firms liquidity and so it provides a measure of whether a company can meet its immediate financial obligations. 7. Formula to compute accounts receivable turnover) The accounts receivable turnover is computed by dividing net credit sales by the average accounts receivable. 8. Decreasing the current ratio) High current ratios can indicate problems in collecting accounts receivable, managing inventory and/or investing idle cash. A company can decrease its current ratio in a number of ways. It can invest idle funds in productive assets, reduce levels of inventory and tighten its credit policies in an effort to reduce accounts receivable. 9. Increasing the current ratio) While a current ratio of 2.0 is probably adequate, the company may need additional cash to finance new investments or could be expecting a seasonal downturn in sales that would make it prudent to hold more cash. The current ratio can be increased by financing inventory and other purchases with long-term borrowings, loosening credit policies to encourage more sales on account, refinancing its current liabilities with long-term liabilities, selling long-term investments or capital assets for cash and by borrowing cash with long-term financing or raising cash through the sales of stock. 10. Interpretation of the debt-to-equity ratio) The debt-to-equity ratio tells how a company is capitalized, that is, how much debt the company has relative to money invested by the owners. Higher debt-toequity ratios suggest that a company has borrowed more money relative to the amounts invested by owners. 11. Calculation of the asset turnover ratio) Asset turnover = Sales Average operating assets Therefore, the asset turnover ratio is 1.06 ($475 sales/$450 average assets).

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Solutions to Chapter 12 Exercises

1. Return on assets: Margin vs. turnover Dans Duds is likely the specialty retailer. It has a higher profit margin (7.06%) than Handsome Hals (4.49%) and a lower turnover (1.97 compared to Hals turnover of 3.59). Handsome Hals ends up with the highest return on assets (16.12% compared to Dans ROA of 13.91%).
ROA = Profit margin
U

Asset turnover
U

ROA = Dans ROA

Net income + Interest Expense (net of tax) Sales

Sales Average total assets

U

= $245 + $64(1 0.34) $4,071

U

$4,071 $2,061
U

= 7.06% = 13.91% Hals ROA

1.97

= $837 + $136(1 0.34) $20,649

U U

$20,649 $5,746
U

= 4.49% = 16.12% 2. Liquidity ratios)

3.59

Accounts receivable turnover = Net credit sales Average accounts receivable Average number of days in accounts receivable = 365 Accounts receivable turnover

A.

Kelloggs Quaker Oats Kelloggs Quaker Oats 7.0

= =

$3,793 = 15.4 times per year ($219 + $275)/2

U

$3,671 = 7.0 times per year ($505 + $537)/2

U U

B.

= =

365 15.4 365

U

= 23.7 days = 52.1 days

C.

Kelloggs collects its accounts receivable more quickly than Quaker Oats. However, Quaker Oats may have more liberal credit and collection policies than Kelloggs in an effort to stimulate sales. It is difficult to

Solutions to Chapter 12
conclude which company manages their receivables more effectively without additional information. 3. Liquidity ratios) A. Inventory turnover = Cost of goods sold Average inventory
U

Year 1 $1,175 = 1.8 $662

U U U

Year 2 $1,346 = 1.9 $694

U U U

Year 3 $1,303 = 2.0 $655

U U U

Year 4 $1,337 = 2.1 $645

U U U

B.
U

Number of days sales in average inventory = 365 Inventory turnover Year 1 365 = 203 1.8
U U U U

Year 2 365 = 192 1.9

U U U

Year 3 365 = 183 2.0

U U U

Year 4 365 = 174 2.1

U U U

C.
U

Cost of goods sold to sales = Cost of goods sold Sales

U

Year 1 $1,175 = 35.9% $3,271

U

Year 2 $1,346 = 36.2% $3,720

U U U

Year 3 $1,303 = 35.8% $3,644

U U U

Year 4 $1,337 = 32.9% $4,070

U U U

D.

The increasing rate of inventory turnover coupled with the decreasing cost of goods sold suggests one or more of the following. Eli Lily may have instituted improved inventory control systems that reduced the level of inventory carried. This action reduced inventory carrying and obsolescence costs resulting in a lower cost of goods sold percentage. It is also possible that Eli Lily shifted its product mix to those with higher gross margin and faster turnover. However, given the usual trade-off between profit margin and turnover, this is not likely.

4.

Asset turnover ratio) A. Asset turnover = Sales Average total assets

U U

Year 1 $210 = 3.0 $70

U U

Year 2 $538 = 3.7 $145

U U U

Year 3 $1,051 = 4.1 $256

U U

B.

The company appears to be growing rapidly. While its total assets have increased by almost 300 percent in three years, sales have increased by 400 percent, resulting in a higher asset turnover ratio.

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Solutions to Chapter 12
5. Solvency ratio: Calculation of debt-to-equity) Debt-to-equity = Total liabilities Total stockholders equity Debt-to-equity = ($60,000 + $20,000) ($250,000 + $100,000) = 0.23 6. Return on assets: Margin vs. turnover)
ROA = Return on Sales
U U

Asset turnover Sales Average total assets

U U U

ROA =

Net income + Interest Expense (net of tax) Sales

U U

Virtual Videos ROA = $524 + $80(1 0.34) $15,134 = 3.81% = Games Galores ROA 18.94%

$15,134 $3,048

4.97

= $982 + $150(1 0.34) $20,143

U

$20,143 $7,125

= 5.37% = 15.20%

2.83

Games Galore has a higher return on sales but a lower asset turnover ratio than Virtual Video. The company makes more money on each dollar of sales of video games but does not sell as much for the level of investment (the turnover is lower). Virtual Video has a lower return on sales but a much higher turnover resulting in a higher overall return on assets.

Problems
7. (LO 1, 2, 4, 5, and 6Ratio analysis: Decision focus) A. The current ratio measures overall short-term liquidity and is an indicator of the short-term debt paying ability of the firm. The quick ratio is also a measure of short-term liquidity. However, it is a measure of more immediate liquidity and is an indicator of the ability of a firm to pay current debts from cash or near cash assets. Inventory turnover measures the number of times a firm sells its average inventory during the year. A low turnover may indicate excessive inventory accumulation or obsolete inventory. Profit margin is a measure of the income generated per dollar of sales. Taken together with turnover, it can be a good measure of overall profitability. The debt to equity ratio compares the amount of resources provided by creditors to the resources provided by stockholders. Thus, it

Solutions to Chapter 12
measures the extent of leverage in a companys financial structure and is used as a measure of risk. B.
8B

Mid Coastal Bank : Current and quick ratios as well as debt-to-equity Ozawa Company : Current ratio, quick ratio, and inventory turnover Drucker and Denon : Profit margin and turnover (ROA) Working Capital Management Committee : Current ratio, quick ratio, and inventory turnover
7BU U U U U U U U

C.

Avantronics current and quick ratios have been improving over time and are currently near or above industry averages. However, one must look at the total picture when analyzing the companys liquidity and working capital management. A relatively large amount of money could be tied up in current assets (including inventory). This is confirmed by the deteriorating inventory turnover ratio.
9B

Their inventory turnover is very poor. The amount of inventory on hand may help the current ratio, but also shows poor or ineffective inventory management, which may result eventually in obsolete inventory. The companys profitability is very good. The profit margin has been increasing and is greater than the industry average. However, this is tempered by the lower than average inventory turnover. Overall return on assets declined slightly from 2007 to 2008, although it increased again in 2009. The companys debt-to-equity ratio has grown in the last three years indicating that a much larger amount of its assets are debt financed than the industry average.

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Solutions to Chapter 12
8. Horizontal analysis
Martha's Miscellaneous Comparative Statements of Income and Retained Earnings Sales revenue Cost of goods sold Gross profit Payroll expense Insurance expense Rent expense Depreciation Total expenses Operating income Interest expense Gain on vehicle sale Loss on sale of securities Interest revenue Net income before interest and taxes Tax Net income Dividends To Retained earnings Retained earnings: 1/1 Retained earnings: 12/31 2009 2008 $700,000 $650,000 500,000 455,000 $200,000 $195,000 50,000 42,250 30,000 29,000 18,000 18,000 35,000 15,000 $133,000 $104,250 $ 67,000 $ 90,750 (7,000) (5,000) 25,000 0 (25,000) 0 75,000 50,000 $135,000 $135,750 40,000 40,250 $ 95,000 $ 95,500 38,000 38,000 $ 57,000 $ 57,500 193,500 136,000 $250,500 $193,500
U U U U U U U U U U U U U U U U U U U U U U U U U U

$ change $ 50,000 45,000 $ 5,000 7,750 1,000 0 20,000 $ 28,750 $(23,750) 2,000 25,000 (25,000) 25,000 $ (750) (250) $ (500)
U U U U U U U U U

% change 7.7% 9.9% 2.6% 18.3% 3.4% 0.0% 133.3% 27.6% (26.2%) 40.0%

50.0% (0.6%) (0.6%) (0.5%)

9.

Comprehensive ratio analysis A. Profit margin ratio = Net income + Interest exp.(net of tax) Sales
N

= $ 70,000 + $9,000(1 0.50) $420,000

U

= 17.7%

B.

0BU

Sales Average Total Assets

$420,000 ($430,000 + $392,000)/2

U U

= 1.02

C.

ROA

=Net income + Interest expense(net of tax) Average total assets = $ 70,000 + $9,000(1 0.50) $411,000
U U

= 18.1%

D.

1B

ROCSE =

Net income _ Average stockholders equity

U U

= $70,000 = 32.6% ($250,000 + $180,000)/2

U

Solutions to Chapter 12
E.
2B

EPS =

Net income # of shares outstanding

U U

$70,000 = $2.33/share 30,000 shares

U

F.
4B

Cost of goods sold Average inventory

3BU

$214,000 ($110,000 + $70,000)/2

U U

= 2.38

G.

Current assets Current liabilities

U

$ 40,000 + $30,000 + $110,000 $60,000

= 3.0

H.

Quick assets Current liabilities

U 5BU

$40,000 + $30,000 = 1.17 $60,000

U U U

I.

Net sales Average accounts receivable Total liabilities Stockholders equity

U U U

= $420,000 ($30,000 + $55,000)/2 $180,000 $250,000

U U

= 9.88

J.
6B

= 0.72

K.

Net income + Interest expense + Income taxes Interest expense

U U

= $ 70,000 + $70,000 + $9,000 $9,000

= 16.56 times

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