ch. 13 exercises

Chapter 13

Financial Statement Analysisfor Decision Making

3Questions

1. Two groups of users of accounting information are investors and creditors. Investors pick certain stocks to buy, and, after making an investment, they must decide whether to keep the stock or sell it. Banks (creditors) decide which loans to approve.

2. Three analytical tools based on accounting information are (a) horizontal analysis, (b) vertical analysis, and (c) ratio analysis.

3. Horizontal analysis is the study of percentage changes in comparative financial statements. Decision makers may track the percentage changes in accounts over time to analyze trends.

4. Vertical analysis of a financial statement shows the relationship of each statement item to a specified base — total assets on the balance sheet and total revenues on the income statement. Its purpose is to show what percent of the base is represented by each item listed on a financial statement.

5. Common-size statements are used to compare a company’s performance from period to period; a company to its industry average; companies of different sizes, or a specific competitor; and to identify the need for corrective action.

Chapter 13 Financial Statement Analysis for Decision Making 777

6. The investor analyzes the statement of cash flows in order to identify danger signals about a company’s financial situation. For example, successful companies generate most of their cash from operations, not from borrowing or selling their fixed assets. The statement of cash flows reveals where cash comes from and how it is spent. An investor analyzes the investing activities for indications of how the company is using its money. This information is important because how a company invests cash determines its future sources of cash. Wise purchases of assets assure the company of future income. If the company makes unwise investments, its cash will eventually run short.

7. Ratios are an important tool of financial analysis because they express the relationship of one item to another item. For example, the ratio of current assets to current liabilities measures a company’s ability to pay its bills. (Students may give other examples of ratios.)

8. Two ratios used to measure the company’s ability to pay current liabilities are the current ratio and the acid-test ratio. These ratios are computed as follows:

Current assetsCurrent ratio =

Current liabilities

Cash + short-term investments+ net current receivables

Acit-test ratio = Current liabilities

9. The acid-test ratio is given that name because it measures the company’s ability to pay its current liabilities if they were to come due immediately (that is, if the company were put to the “acid test”).

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10. The inventory turnover ratio measures the number of times a company sells its average level of inventory during a year.

11. An increase in days’ sales in receivables is generally a bad sign about a company. It indicates that the length of time it takes to collect receivables is increasing. The company’s credit and collection department should strengthen its collection efforts.

12. An increase in a company’s debt ratio is important to the company’s creditors. This increase means that the company has a growing proportion of liabilities to assets. This growth, in turn, increases the risk that the company will not be able to pay its debts and generally results in the company’s having to pay a higher interest rate on new borrowings.

13. The debt ratio — the ratio of total liabilities to total assets — measures the effect of debt on financial position (the balance sheet). The times-interest-earned ratio — the ratio of income from operations to interest expense — measures the effect of debt on the company’s ability to pay interest expense (the income statement).

14. Company A, the grocery store chain, is likely to have the higher current ratio because of the greater relative importance of inventory to its asset structure. In contrast, Company B, the computer manufacturer, has a greater portion of long-term fixed assets (property, plant, and equipment) that are used to manufacture computers. The grocery company is likely to have the higher inventory turnover because its inventory is made up of low-cost items such as breakfast cereal and toothpaste, which turn over rapidly. Company B’s computer inventory takes longer to manufacture, costs more, and, therefore, turns over more slowly.


Company B, the computer manufacturer, is likely to have the higher rate of return on sales because its sales are composed of high-priced items that each bear a higher rate of profit when sold than the grocery’s inventory.

15. Four ratios measure the ability to earn profits, along with their computations and the information they provide:

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Rate of return on net sales

Net income Net sales

Shows the percentage of each sales dollar earned as net income.

Rate of return on total assets

Net income + interestexpense

Average total assets

Measures how profitably a company uses its assets.

Rate of return on common stockholders’ equity

Net income– preferred dividends

Average common stockholders’ equity

Indicates how much income is earned for every $1 invested by common shareholders.

Earnings per share of common stock

Net income– preferred dividendsNumber of shares of

common stock outstanding

Gives the net income per one share of common stock.

16. A price/earnings ratio of 6 for General Motors (GM), compared to a ratio of 45 for American Express, indicates that the market favors American Express. The market assigns a price of $6 for each $1 of GM earnings, and a price of $45 for each $1 of American Express earnings.


17. McDonald’s dividends yield is 0.014 ($0.7867 / $58). Dividend yield measures the percentage of the stock’s market value that is returned as dividends to the stockholder each period.

18. a. Good newsb. Bad newsc. Bad newsd. Bad newse. Good newsf. Bad newsg. Good newsh. Good news

19. Market price generally exceeds book value. An investor may come across a stock whose market price is falling to near its book value. He may purchase this stock in the hope that it will rise to a higher price in the future.

20. Ratio analysis may indicate that a company has a weakness (as a high temperature indicates to a physician that a patient is ill). However, ratios do not automatically reveal what the problem is or how to solve it.

21. EVA stands for economic value added. It measures whether or not a company’s operations have increased stockholder wealth.

3 Exercises

(5-15 min.) E 13-1

19X7 19X6 19X5

Total current assets $312,000 $290,000 $280,000

Total current liabilities 150,000 117,000 140,000

Working capital $162,000 $173,000 $140,000

Decrease IncreaseThe decreasing trend of working $(11,000) $33,000capital is reason for concern. (6.4%) 23.6%


(10-15 min.) E 13-2

Syntex IncorporatedHorizontal Analysis of Comparative Income Statement

For the Years Ended December 31, 19X9 and 19X8INCREASE (DECREASE)

19X9 19X8 AMOUNT PERCENT

Total revenues................. $410,000 $373,000 $37,000 9.9%

Expenses:

Cost of goods sold...... $202,000 $188,000 $14,000 7.4

Selling and general

expenses................ 98,000 93,000 5,000 5.4

Interest expense.......... 7,000 4,000 3,000 75.0

Income tax expense.... 42,000 37,000 5,000 13.5

Total expenses........... 349,000 322,000 27,000 8.4

Net income...................... $ 61,000 $ 51,000 $10,000 19.6

Net income increased by a higher percentage than total revenues did during 19X9 because revenues increased at a higher rate (9.9%) than did total expenses (8.4%).

(5-10 min.) E 13-3

Trend percentages:

Year 5 Year 4 Year 3 Year 2 Year 1

Net sales............ 135% 114% 106% 97% 100%

Net income........ 138 134 98 84 100

Net income grew by 38% during the period, compared to 35% for net sales.


(10-15 min.) E 13-4

Copy World, Inc.Vertical Analysis of Balance Sheet

December 31, 19X3

AMOUNT PERCENT

ASSETS

Total current assets....................................... $ 72,000 22.2%

Long-term investments................................. 35,000 10.8

Property, plant, and equipment, net.............. 217,000 67 .0

Total assets................................................... $324,000 100 .0 %

LIABILITIES

Total current liabilities.................................. $ 58,000 17.9%

Long-term debt............................................. 118,000 36 .4

Total liabilities.............................................. 176,000 54.3

STOCKHOLDERS’ EQUITY

Total stockholders’ equity............................ 148,000 45 .7

Total liabilities and stockholders’ equity...... $324,000 100 .0 %

(10-15 min.) E 13-5

Syntex IncorporatedComparative Common-Size Income Statement

For the Years Ended December 31, 19X9 and 19X8

19X9 19X8

Total revenues........................................................ 100.0% 100 .0 %

Expenses:

Cost of goods sold............................................. 49.3 50.4

Selling and general expenses............................. 23.9 24.9

Interest expense................................................. 1.7 1.1

Income tax expense........................................... 10 .2 9 .9

Total expense..................................................... 85.1 86 .3

Net income............................................................. 14 .9 % 13 .7 %


(10-15 min.) E 13-6

1. Net cash inflow from operations was only $71,000, compared to a much larger amount from investing activities. The company is selling fixed assets to generate cash.

2. Borrowing was $114,000, which far exceeds cash provided by operations.

3. Nemmer paid off a large amount of debt. In itself, this is not a weakness. However, paying off debt — coupled with more borrowing, selling fixed assets, and purchasing no new fixed assets — suggests that the company is in a weak position.

4. Nemmer paid dividends almost equal to net income.

(10-15 min.) E 13-7

$185,000a. Current ratio = = 1.53

$121,000

b. Acid-test (quick) $17,000 + $11,000 + $64,000ratio = = 0.76

$121,000

$257,000c. Inventory turnover = = 3.25

($87,000 + $71,000) / 2

d. Accounts receivable $454,000turnover = = 6.63

($64,000 + $73,000) / 2

e. Days’ sales in ($64,000 + $73,000) / 2average receivables = = 55 days

$454,000 / 365


(15-20 min.) E 13-8

a. Current ratio:$21,000 + $28,000 + $102,000 + $226,000 + $11,000

19X2: = 1.89 $205,000

$47,000 + $116,000 + $263,000 + $9,00019X1: = 1.80

$241,000

b. Acid-test ratio:$21,000 + $28,000 + $102,000

19X2: = 0.74 $205,000

$47,000 + $116,00019X1: = 0.68

$241,000

c. Debt ratio:$261,000 $273,000

19X2: = 0.52 19X1: = 0.56$503,000 $489,000

d. Times-interest-earned ratio:$165,000 $158,000

19X2: = 4.58 19X1: = 4.05$36,000 $39,000

Summary: The company’s ability to pay its current liabilities and long-term debt appears to have improved during 19X2, as shown by improvement in all four ratios.

(10-15 min.) E 13-9

a. Rate of return on net sales:

$8,000 $13,00019X6: = 0.046 19X5: = 0.082

$174,000 $158,000

b. Rate of return on total assets:

$8,000 + $21,000 $13,000 + $10,00019X6: = 0.142 19X5: = 0.120

$204,000 $191,000

c. Rate of return on common stockholders’ equity:

$8,000 – $3,000 $13,000 – $3,00019X6: = 0.052 19X5: = 0.112

$96,000 $89,000

d. Earnings per share of common stock:

$8,000 – $3,000 $13,000 – $3,00019X6: = $0.25 19X5: = $0.50

20,000 20,000

The company’s operating performance deteriorated during 19X6. Three of the profitability measures decreased. Only return on assets increased, and that was because of the high level of interest expense.


(10-15 min.) E 13-10

19X8 19X7

a. Price / earnings ratio:

$10.12 $7.75 = 18.4 = 15.1($58,000 – $14,000*) / 80,000 ($55,000 – $14,000*) / 80,000

b. Dividend yield:

($28,000 x 1/2) / 80,000 ($28,000 x 1/2) / 80,000 = 0.017 = 0.023 $10.12 $7.75

c. Book value per share of common stock:

$530,000 $500,000 = $6.63 = $6.25 80,000 80,000

The stock’s attractiveness increased during 19X7, as shown by the increases in the price / earnings ratio and in book value per share. The dividend yield decreased, but insignificantly. Overall, the change is not great.

*$28,000 / 2 = $14,000

(15-20 min.) E 13-11Req. 1

Student responses will vary considerably. Some may favor Texaco because the company is so much larger than IHOP. Others may favor IHOP because they eat there.

Req. 2(Amounts in millions)

IHOP TexacoEVA= $16 + $9 – [($35 + $108) x 0.12] $607 + $483 – [($4,240 + $9,519) x 0.12]

= $25 – $17 = $1,090 – $1,651= $8 = – $561

Based on the EVA analysis, IHOP appears to be the better investment.


(20-30 min.) E 13-12

Step Millions

6 Sales ($1,596 ÷ 0.2404)............................................ $6,639*

7 Operating expenses ($6,639 – $1,596)...................... 5,043

5 Operating income...................................................... 1,596

4 Interest expense......................................................... 413

2 Pretax income [$739 ÷ (1 – 0.3753)]........................ 1,183

3 Income tax expense ($1,183 x 0.3753)..................... 444

1 Net income ($3,605 x 0.205).................................... $ 739

Note: Start with net income and work up the statement. Due to rounding, amounts may differ by $1 million.

*Alternatively, $739 = $6,6400.1113

(20-30 min.) E 13-13

Step Millions

Given Current assets........................................................ $10,196

4 Property, plant, and equipment...............$10,817

Given Less Accumulated depreciation............... (448) 10,369

3 Total assets ($11,806 ÷ 0.57408).......................... $20,565

1 Current liabilities ($10,196 ÷ 1.51)....................... $ 6,752

2 Long-term liabilities ($11,806 – $6,752).............. 5,054

6 Stockholders’ equity ($20,565 – $11,806)............ 8,759

5 Total liabilities and stockholders’ equity.............. $20,565


3 Problems

Group A

(20-30 min.) P 13-1AReq. 1 (trend percentages)

Monica Hearn, Inc.Trend Percentages

19X6 19X5 19X4 19X3 19X2 19X1

Net sales 144% 130% 110% 117% 102% 100%

Net income 208 162 85 138 108 100

Total assets 178 153 126 119 109 100

Req. 2 (rate of return on net sales; dollar amounts in thousands)

19X6 19X5 19X4 19X3 19X2

Net income $27 $21 $11 $18 $14 = 0.078 = 0.067 = 0.041 = 0.064 = 0.057 Net sales $347 $313 $266 $281 $245

Req. 3 (evaluation)

Hearn’s rate of return on net sales compares favorably with the industry. Except for 19X4, return on sales has exceeded 5 percent, and the most recent annual rate of return (for 19X6) is 7.8 percent, which is considered very good.

(20-30 min.) P 13-2AReq. 1

Bull’s Eye Archery CompanyCommon-Size Income Statement Compared to Industry Average

For the Year Ended December 31, 19X3

BULL’S EYEINDUSTRYAVERAGE

Net sales................................................... 100.0% 100.0%

Cost of goods sold.................................... 68 .2 65 .9

Gross profit............................................... 31.8 34.1

Operating expenses................................... 26 .9 28 .1

Operating income..................................... 4.9 6.0

Other expenses......................................... 0 .2 0 .4

Net income............................................... 4 .7 % 5 .6 %

Bull’s Eye Archery CompanyCommon-Size Balance Sheet Compared to Industry Average

December 31, 19X3

BULL’S EYEINDUSTRYAVERAGE

Current assets............................................. 71.1% 74.4%

Fixed assets, net......................................... 20.1 20.0

Intangible assets, net.................................. 6.7 0.6

Other assets................................................ 2 .1 5 .0

Total assets................................................ 100 .0 % 100 .0 %

Current liabilities....................................... 39.0% 35.6%

Long-term liabilities.................................. 22.9 19.0

Stockholders’ equity.................................. 38 .1 45 .4

Total liabilities and stockholders’ equity... 100 .0 % 100 .0 %


(continued) P 13-2AReq. 2

Bull’s Eye’s common-size income statement shows that its (a) ratio of gross profit to net sales, (b) ratio of operating income to net sales, and (c) ratio of net income to net sales are worse than the industry averages. Overall, Bull’s Eye’s profit performance is slightly worse than average for the industry.

Req. 3

Bull’s Eye’s common-size balance sheet shows that its (a) ratio of current to total assets and (b) ratio of stockholders’ equity to total assets are worse than the industry averages. Overall, Bull’s Eye’s financial position is worse than average for companies in its industry.

(20-30 min.) P 13-3A

Norwegian Express’s statement of cash flows reveals the following strengths (no significant weaknesses):

1. During both years, operating activities were the major source of cash.

2. The company’s heavy investments in fixed assets suggest expansion. The use of cash, coupled with increasing income and net cash inflow from operations, suggests successful operations.

3. The cash balance is higher than that of the other company and is increasing.

Wisconsin Airways’ statement of cash flows reveals only one strong point, an increase during 19X9 in the purchase of fixed assets. The company’s weaknesses include:

1. Income from operations is down significantly, with the company incurring a loss during 19X9.

2. Operating activities provided a much smaller proportion of cash in 19X9 than in 19X8. In both years, borrowing and selling fixed assets — not operations — were the primary source of cash inflows, which is an unfavorable signal about the company.

3. The large payments on notes payable suggest that the company has a lot of debt. Coupled with the loss during 19X9 and the decrease in net cash inflow from operations, the payments on notes payable may indicate that the company has too much debt.

4. The company’s cash balance decreased by $35,000 during 19X9 to $96,000, the lowest point for either company during the two-year period.

Conclusion: Norwegian Express appears to be the stronger company and thus the better investment.


(30-40 min.) P 13-4AReq. 1 (ratios before the transactions)

TriState Optical Company(Dollar Amounts and Stock Quantities in Thousands)

Current Ratio Debt RatioEarnings Per

Share

$459 $442 $47 + $21 + $102 + $274 + $15 $218 + $146 + $78 $119 = 2.11 = 0.47 = $5.41 $72 + $96 + $50 $933 22

$218

(continued) P 13-4AReq. 2 (ratios after the transactions)

(Dollar Amounts and Stock Quantities in Thousands)Trans-action Current Ratio Debt Ratio Earnings Per Share

a. $459 + $76 $442 + $76 No effect = 2.45 = 0.51 $218 $933 + $76

b. $459 + ($44 –$66) $442 $119 + ($44 – $66) = 2.00 = 0.49 = $4.41 $218 $933 + ($44 – $66) 22

c. $459 + $168 $442 $119 = 2.88 = 0.40 = $3.31 $218 $933 + $168 22 + 14

d. No effect No effect No effect

e. $459 – $51 $442 – $51 No effect = 2.44 = 0.44$218 – $51 $933 – $51

f. $459 + $48 $442 + $48 No effect = 1.91 = 0.50$218 + $48 $933 + $48

g. $459 – $78 $442 – $78 No effect = 1.75 = 0.43 $218 $933 – $78

h. $459 $442 + $51 No effect = 1.71 = 0.53$218 + $51 $933


(40-50 min.) P 13-5AReq. 1

Dunn’s Brass Foundry(Dollar Amounts and Stock Quantities in Thousands)

19X6 19X5a. Current ratio: $602 $497

= 2.10 = 1.86$286 $267

b. Inventory turnover: $378 $283 = 1.18 = 1.20($352 + $286) / 2 ($286 + $184) / 2

c. Accounts receivable $667 $599turnover: = 3.72 = 4.15

($208 + $151) / 2 ($151 + $138) / 2

d. Times-interest-earned ratio: $160 $169 = 2.81 = 4.12 $57 $41

e. Return on assets: $69 + $57 $75 + $41 = 0.152 = 0.157($889 + $773) / 2 ($773 + $707) / 2

f. Return on common $69 – $2 $75 – $2stockholders’ equity: = 0.253 = 0.396

($308 + $221) / 2 ($221 + $148) / 2

g. Earnings per share of $69 – $2 $75 – $2common stock: = $4.47* = $5.21*

15 14

h. Price / earnings ratio: $30.75* $40.25* = 6.9* = 7.7* $4.47* $5.21*

i. Book value per share of $308 $221common stock: = $20.53* = $15.79*

15 14

*Not in thousands


Decisions:a. The company’s financial position deteriorated during 19X6 as

shown by decreases in the inventory turnover, receivable turnover, and the times-interest-earned ratio. Of the first four ratios computed, only the current ratio improved.

b. The common stock’s attractiveness dropped during 19X6, as shown by the decrease in the market price of the common stock. This decrease is consistent with the decrease in return on assets, return on common stockholders’ equity, earnings per share of common stock, and the price / earnings ratio. Of the last five ratios, only book value per share of common stock increased.

Req. 3

This problem gives students practice at computing and evaluating several of the ratios used in investment analysis. By analyzing the two-year trends in the ratios, a student can see whether the company’s abilities to pay its debts, sell its inventory, collect its receivables, and generate profits have improved or deteriorated during this period. Improving ratio values generally indicate an attractive investment, and deteriorating ratio values usually signal an unattractive investment. Investment analysis is complex, and this problem helps develop some of the skills that students can use to evaluate an investment.


(45-60 min.) P 13-6AReq. 1

(Dollar Amounts and Stock Quantities in Thousands)

Scott & White Pediatric Supply1. Current ratio: $414 $450

= 1.22 = 1.23$338 $366

2. Acid-test ratio: $39 + $13 + $164 $25 + $6 + $189 = 0.64 = 0.60 $338 $366

3. Inventory turnover: $387 $454 = 2.04 = 2.16($183 + $197) / 2 ($211 + $209) / 2

4. Days’ sales in average ($164 + $193) / 2 ($189 + $142) / 2receivables: = 126 = 100

$519 / 365 $603 / 365

5. Debt ratio: $691 $667 = 0.74 = 0.68$938 $974

6. Times-interest-earned $72 Ratio is not meaningfulratio: = 9.00 because Pediatric Supply

$8 has virtually no interestexpense.

7. Return on net sales: $38 $56 = 0.073 = 0.093$519 $603

8. Return on total assets: $38 + $8 $56 = 0.050 = 0.062($938 + $909) / 2 ($974 + $842) / 2

9. Return on common $38 – ($25 x 0.04) $56stockholders’ equity:

[($247 – $25) + ($215 – $25)] / 2 ($307 + $263) / 2

= 0.180 = 0.196

(continued) P 13-6A


Scott & White Pediatric Supply10. Earnings per share of $38 – ($25 x 0.04) $56

common stock: = $1.85* = $0.37* 20 150

11. Book value per share $247 – $25 $307of common stock: = $11.10* = $2.05*

20 150

12. Price / earnings ratio: $47.50* $9.00* = 25.7* = 24.3* $1.85* $.37*

*Not in thousands

Decision:Pediatric Supply’s common stock seems to fit the investment strategy better. Its price / earnings ratio is lower than that of Scott & White, and Pediatric Supply appears to be in slightly better shape financially than Scott & White. On several of the ratios, the two companies are relatively close. Those that tip the decision in favor of Pediatric Supply are days’ sales in average receivables, the debt ratio, and the three rates of return.



Scott & White Pediatric Supply

EVA = $38,000 + $8,000 – [($303,000 + $247,000) x 0.10] $56,000 – [($4,000 + $307,000) x 0.10]= $46,000 – $55,000 = $56,000 – $31,000= – $9,000 = $25,000

The EVA analysis confirms the conclusion from the ratio analysis, that Pediatric Supply appears to be the better investment.

3 Problems

Group B

(20-30 min.) P 13-1BReq. 1 (trend percentages)

Bear Utilities, Inc.Trend Percentages

19X7 19X6 19X5 19X4 19X3 19X2

Net sales 120% 113% 101% 104% 101% 100%

Net income 153 113 80 120 103 100

Common stock-

holders’ equity 153 140 131 117 108 100


(continued) P 13-1B

Req. 2 (rate of return on average stockholders’ equity)

19X7 19X6 19X5 19X4 19X3

Net income $61 $45 $32 $48 $41Avg. common = 0.165 = 0.132 = 0.102 = 0.169 = 0.156 S/E* $370 $342 $313 $284 $262

19X7 19X6 19X5 19X4 19X3

*Computationof average $386 + $354 $354 + $330 $330 + $296 $296 + $272 $272 + $252stockholders’equity 2 2 2 2 2

= $370 = $342 = $313 = $284 = $262

Req. 3 (evaluation)

Bear Utilities’ return on average common stockholders’ equity is slightly above average for the industry, when considered over the five-year period.

(20-30 min.) P 13-2BReq. 1

Alto Auto GlassCommon-Size Income Statement Compared to Industry Average

For the Year Ended December 31, 19X6

ALTOINDUSTRYAVERAGE

Net sales........................................................... 100.0% 100.0% Cost of goods sold............................................ 63 .6 65 .8 Gross profit....................................................... 36.4 34.2 Operating expenses.......................................... 20 .9 19 .7 Operating income............................................. 15.5 14.5 Other expenses................................................. 0 .6 0 .4 Net income....................................................... 14 .9 % 14 .1 %

Alto Auto GlassCommon-Size Balance Sheet Compared to Industry Average

December 31, 19X6

ALTOINDUSTRYAVERAGE

Current assets.................................................... 77.8% 70.9% Fixed assets, net................................................ 16.4 23.6 Intangible assets, net......................................... 0.9 0.8 Other assets....................................................... 4 .9 4 .7 Total assets........................................................ 100 .0 % 100 .0 %

Current liabilities.............................................. 46.0% 48.1% Long-term liabilities......................................... 13.8 16.6 Stockholders’ equity......................................... 40 .2 35 .3 Total liabilities and stockholders’ equity.......... 100 .0 % 100 .0 %


(continued) P 13-2BReq. 2

Alto’s common-size income statement shows that its (a) ratio of gross profit to net sales, (b) ratio of operating income to net sales, and (c) ratio of net income to net sales are slightly better than the industry averages. Overall, Alto’s profit performance is slightly better than average for the auto glass industry.

Req. 3

Alto’s common-size balance sheet shows that its (a) ratio of current to total assets is better than the industry average. Alto’s (b) ratio of stockholders’ equity to total assets is also better than the industry average. Overall, Alto’s financial position is better than the industry average.

(20-30 min.) P 13-3B

Allied’s statement of cash flows reveals few strengths. About the only bright spot is that cash increased. The company’s weaknesses include:

1. Income from operations is down significantly.

2. Operating activities provided less cash than selling fixed assets. This shows that operations are not the prime source of cash inflow. When selling fixed assets is the major source of cash, the business may be in trouble. Moreover, net cash inflow from operating activities is down during the current year, another negative signal.

3. The company is not investing large amounts in the property, plant, and equipment needed to sustain operations in the future. This is not necessarily a weakness, for the company may have acquired fixed assets in earlier years and may now be paying the debts incurred to purchase those assets. However, the company’s downward trends of income and net cash inflow from operations suggest that its operations are not very successful.

4. Payments on debt are high. This, coupled with the decrease in income, indicates that the debt burden may have hurt the company.

5. The company’s cash balance has been low during the two-year period, a negative sign.


(continued) P 13-3B

Northern Leasing Corp.’s statement of cash flows reveals the following strengths (no significant weaknesses):

1. During both years, operating activities generated more cash than financing activities or selling fixed assets. Furthermore, the income trend is up, a favorable sign.

2. The company is steadily increasing its investments in fixed assets, which suggests the company is expanding. This investing activity, coupled with increasing income and net cash inflow from operating activities, suggests successful operations.

3. The cash balance is higher than that of the other company. Cash increased during the current year.

Conclusion: Northern Leasing appears to be the stronger company and thus the better investment.

(30-40 min.) P 13-4BReq. 1 (ratios before the transactions)

Mennonite Industries, Inc.(Dollar Amounts and Stock Quantities in Thousands)

Current Ratio Debt RatioEarnings Per

Share

$273 $381

$22 + $19 + $83 + $141 + $8 $190* + $160 + $31 $71 = 1.44 = 0.58 = $1.78 $49 + $103 + $38 $657 40

$190

*$49 + $103 + $38 = $190


(continued) P 13-4BReq. 2 (ratios after the transactions)

(Dollar Amounts and Stock Quantities in Thousands)Trans-action Current Ratio Debt Ratio Earnings Per Share

a. $273 + $26 $381 + $26 No effect = 1.38 = 0.60$190 + $26 $657 + $26

b. $273 – $31 $381 – $31 No effect = 1.27 = 0.56 $190 $657 – $31

c. $273 $381 + $22 No effect = 1.29 = 0.61$190 + $22 $657

d. $273 + $85 $381 + $85 No effect = 1.88 = 0.63 $190 $657 + $85

e. $273 + ($18 – $11) $381 $71 + ($18 – $11) = 1.47 = 0.57 = $1.95 $190 $657 + ($18 – $11) 40

f. $273 + $120 $381 $71 = 2.07 = 0.48 = $1.58 $190 $657 + $120 40 + 5

g. No effect No effect No effect

h. $273 – $32 $381 – $32 No effect = 1.53 = 0.56$190 – $32 $657 – $32

(40-50 min.) P 13-5BReq. 1

Wahl Furniture Co.(Dollar Amounts and Stock Quantities in Thousands)

19X4 19X3a. Current ratio: $396 $382

= 1.92 = 1.71$206 $223

b. Inventory turnover: $229 $218 = 1.37 = 1.18($172 + $162) / 2 ($162 + $207) / 2

c. Accounts receivable turnover: $462 $427 = 4.05 = 3.90($112 + $116) / 2 ($116 + $103) / 2

d. Times-interest-earned ratio: $97 $75 = 8.82 = 6.25 $11 $12

e. Return on assets: $56 + $11 $36 + $12 = 0.117 = 0.083($585 + $560) / 2 ($560 + $598) / 2

f. Return on common $56 – $6 $36 – $6stockholders’ equity: = 0.357 = 0.286

($160 + $120) / 2 ($120 + $90) / 2

g. Earnings per share of $56 – $6 $36 – $6common stock: = $5.00* = $3.33*

10 9

h. Price / earnings ratio: $49* $32.50* = 9.8* = 9.8 $5* $3.33*

i. Book value per share of $160 $120common stock: = 16* = $13.33*

10 9

*Not in thousands



Decisions:a. The company’s financial position improved during 19X4, as shown

by increases in the current ratio, inventory turnover, accounts receivable turnover, and times-interest-earned ratio.

b. The common stock’s attractiveness grew a little during 19X4, as shown by the rise in the stock’s market price. This increase in market price is consistent with the increases in return on assets, return on common stockholders’ equity, earnings per share of common stock, and book value per share. Return on common stockholders’ equity is very high. The price / earnings ratio remained the same.

Req. 3

This problem gives students practice at computing and evaluating several of the ratios used in investment analysis. By analyzing the two-year trends in the ratios, a student can see whether the company’s abilities to pay its debts, sell its inventory, collect its receivables, and generate profits have improved or deteriorated during this period. Improving ratio values generally indicate an attractive investment, and deteriorating ratio values usually signal an unattractive investment. Investment analysis is complex, and this problem helps develop some of the skills that students can use to evaluate an investment.

(45-60 min.) P 13-6BReq. 1


Smajstrla, Inc. DuBois Corp.1. Current ratio: $186 $173

= 1.90 = 1.60$98 $108

2. Acid-test ratio: $19 + $18 + $46 $22 + $20 + $42 = 0.85 = 0.78 $98 $108

3. Inventory turnover: $258 $209 = 2.74 = 2.32($100 + $88) / 2 ($87 + $93) / 2

4. Days’ sales in average ($46 + $48) / 2 ($42 + $40) / 2receivables: = 35 = 40

$497 / 365 $371 / 365

5. Debt ratio: $131 $108 = 0.40 = 0.41$328 $265

6. Times-interest-earned $138 Ratio is not meaningfulratio: = 7.26 because DuBois has no

$19 interest expense.

7. Return on net sales: $72 $48 = 0.145 = 0.129$497 $371

8. Return on total assets: $72 + $19 $48 = 0.304 = 0.183($328 + $270) / 2 ($265 + $259) / 2

9. Return on common $72 – ($20 x 0.05) $48stockholders’ equity: = 0.349

[($197 – $20) + ($126 – $20)] / 2 ($157 + $118) / 2

= 0.502


(continued) P 13-6B


Smajstrla, Inc. DuBois Corp.10. Earnings per share of $72 – ($20 x 0.05) $48

common stock: = $14.20* = $4.80* 5 10

11. Book value per share $197 – $20 $157of common stock: = $35.40* = $15.70*

5 10

12. Price / earnings ratio: $112.00* $51.00* = 7.9* = 10.6* $14.20* $4.80*

*Not in thousands

Decision:Smajstrla’s common stock seems to fit the investment strategy better. Its price / earnings ratio is lower than that of DuBois, and Smajstrla appears to be in better shape financially than DuBois, as indicated by all the ratio values.


Smajstrla, Inc. DuBois Corp.

EVA = $72,000 + $19,000 – [($86,000 + $197,000) x 0.12] $48,000 – [($1,000 + $157,000) x 0.12]= $91,000 – $34,000 = $48,000 – $19,000= $57,000 = $29,000

The EVA analysis confirms the conclusion from the ratio analysis, that Smajstrla appears to be the better investment.


3 Decision Cases

(20-30 min.) Decision Case 1

To reduce losses and establish profitable operations, Wheel Sports should take the following steps.

1. Make a dedicated effort to collect receivables and consider extending less credit to customers. Receivables make up 15.2 percent of assets, compared to 11.0 percent for the industry average. The company’s inability to collect its receivables may explain the shortage of cash (3.0 percent of total assets compared to 6.8 percent for the industry).

2. Reduce the amount of the company’s interest-bearing debt. The company’s interest-bearing short-term notes payable equal 17.1 percent of total assets, compared to 14.0 percent for the industry average. Interest-bearing long-term debt equals 19.7 percent of total assets, compared to 16.4 percent for the industry. Wheel Sports’ total interest-bearing debt is 36.8 percent of total assets, compared to only 30.4 percent for the industry. This debt burden causes the company to pay more interest expense than the norm for the industry (5.8 percent of net sales, compared to only 1.3 percent for the average company in the industry). The high level of interest expense drags profits down.

3. Sell higher profit-margin products. Cost of sales is 68.2 percent of sales, compared to 64.8 for the industry average. Consequently, gross profit is only 31.8 percent of net sales, which is less than the 35.2 percent industry average.

4. Cut operating expenses below their current level of 37.1 percent of sales by finding cheaper ways of doing business. The company should consider operating out of a less expensive building, spending less on advertising, laying off employees, and other cost-cutting measures to trim operating expenses.

(20-30 min.) Decision Case 2

a. Dividend yield is the ratio of dividends per share to the market value of a share of stock. Dividend yield can be high because the stock’s market value is low. This may signal that the company is in trouble. A wise investor should also examine other information to evaluate a company as an investment. Examples include the trends of earnings per share, current ratio, debt ratio, rate of return on total assets, and rate of return on common stockholders’ equity.

b. Days’ sales in receivables is computed as follows:

Average Net Accounts ReceivableOne Day’s Sales

This ratio can increase because accounts receivable are not being collected in a timely manner, because sales are declining, or a combination of the two. The owner is wise to be concerned because an increase in days’ sales in receivables may signal a cash shortage.

c. 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. These data are illustrative:

Correct Amounts(No cash payment

entries in December)

Amount of cash

payment

Reported amounts(Cash payment recorded

in December)

Current assets $100 – $10 = $100 – $10 $90 = = 2.0 = = 2.25Current liabilities $50 – $10 $50 – $10 $40

Quick assets $70 – $10 = $70 – $10 $60 = = 1.4 = = 1.50Current liabilities $50 – $10 $50 – $10 $40


3 Ethical Issues

1. Reclassifying the long-term investments as short-term will increase current assets and, therefore, increase the current ratio. River Front’s 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 River Front 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, River Front 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.

3 Financial Statement Cases

(30-40 min.) Financial Statement Case 1Req. 1

1996 1995 1994a. Percent of pretax income to

net sales......................................... 4.9% 6.0% 8.0%

b. Net income per share..................... $0.89 $1.03 $1.22

c. Rate of return on common stockholders’ equity...................... 16% 20% 28%

d. Rate of return on total assets.......... 10% 13% 18%

Req. 21996 1995 1994

$222,089 $198,168 $192,276a. Current ratio = 1.94 = 1.93 = 2.11

$114,744 $102,717 $91,049

$114,744 + $7,561 $102,717 + $5,767 $91,049 + $5,496b. Debt ratio* = 0.38 = 0.36 = 0.35

$323,497 $297,612 $273,830

*Data from Eleven-Year Consolidated Financial Summary


(continued) Financial Statement Case 1Req. 3

1996 1995 1994

Inventory $588,017 $571,265 $514,052turnover

($164,816 + $168,652) / 2 ($168,652 + $152,108*) / 2 ($152,108 + $110,339**) / 2

= 3.53 = 3.56 = 3.92

*$168,652 – $16,544 (from statement of cash flows) = $152,108**$152,108 – $41,769 (from statement of cash flows) = $110,339

Req. 4Lands’ End has slipped a bit in all aspects of operations during the past three years. All four profitability measures decreased during the three-year period, as has the rate of inventory turnover. Return on stockholders’ equity is still fairly high, and it exceeds the rate of return on assets by a wide margin. The current ratio is decreasing, but its value is high. The debt ratio remains very low, so the company should have no trouble paying its debts.

Financial Statement Case 2

Because the students will be using the annual reports of real companies, the answers to this problem will vary widely.

Solutions to Internet Exercises

Bristol-Myers Squibb

(Answers based on 1995 annual report)

a. In 1994, upon being elected CEO, Mr. Heimbold set Bristol-Myers Squibb’s long-term financial goals as follows: Double sales, earnings, and earnings per share (EPS) by the end of the year 2000. To review Bristol-Myers Squibb’s success, one would monitor growth trends in sales, earnings, and EPS. A growth rate of 10% per year would be needed to achieve the stated goals.

b. Sales growth for the past two years 15% in 1995 5% in 1994

Earnings growth for the past two years (1.6)% in 1995 (6.0)% in 1994

EPS growth for the past two years (1.1)% in 1995 (4.7)% in 1994

Excluding special one-time charges, earnings showed growth of 11.6% and 2.7% in 1995 and 1994, respectively. EPS increased 12.2% and 4.1% when the special charges are not considered.

Evaluating Bristol-Myers Squibb’s performance depends on how one considers the special charges and restructuring costs. Without these costs, Bristol-Myers Squibb is achieving its objectives; otherwise, its performance is below expectations.

c. Bristol-Myers Squibb has four separate lines of business — pharmaceuticals, consumer products, nutritionals, and medical devices.


d. There are differences among the various industry segments for profitability, capital intensity, size, and international markets. In evaluating Bristol-Myers Squibb, the analysts should consider the company as four different companies and relate each company’s results against that industry’s average and competitors within that industry. Thus, analysis is conducted for the firm as a whole and at the individual industry level.

ch. 13 exercises

Business

ratio of current assets

ratio of income

higher current ratio

financial statement

companys debt ratio

ratio of total liabilities

grocery company

current assetscurrent