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MANAGEMENT ACCOUNTING - Solutions Manual

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CHAPTER 5

FINANCIAL STATEMENTS ANALYSIS - II

I. Questions

1. By looking at trends, an analyst hopes to get some idea of whether a

situation is improving, remaining the same, or deteriorating. Such

analyses can provide insight into what is likely to happen in the future.

Rather than looking at trends, an analyst may compare one company to

another or to industry averages using common-size financial statements.

2. Ratios highlight relationships, movements, and trends that are very

difficult to perceive looking at the raw underlying data standing alone.

Also, ratios make financial data easier to grasp by putting the data into

perspective. As to the limitation in the use of ratios, refer to page 129.

3. Price-earnings ratios are determined by how investors see a firms future

prospects. Current reported earnings are generally considered to be useful

only so far as they can assist investors in judging what will happen in the

future. For this reason, two firms might have the same current earnings,

but one might have a much higher price-earnings ratio if investors view it

to have superior future prospects. In some cases, firms with very small

current earnings enjoy very high price-earnings ratios. This is simply

because investors view these firms as having very favorable prospects for

earnings in future years. By definition, a stock with current earnings of

P4 and a price-earnings ratio of 20 would be selling for P80 per share.

4. A managers financing responsibilities relate to the acquisition of assets

for use in his or her company. The acquisition of assets can be financed

in a number of ways, including through issue of ordinary shares, through

issue of preference shares, through issue of long-term debt, through

leasing, etc. A managers operating responsibilities relate to how these

assets are used once they have been acquired. The return on total assets

ratio is designed to measure how well a manager is discharging his or her

operating responsibilities. It does this by looking at a companys income

before any consideration is given as to how the income will be distributed

among capital resources, i.e., before interest deductions.

Chapter 5 Financial Statement Analysis II

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5. Financial leverage, as the term is used in business practice, means

obtaining funds from investment sources that require a fixed annual rate

of return, in the hope of enhancing the well-being of the ordinary

shareholders. If the assets in which these funds are invested earn at a rate

greater that the return required by the suppliers of the funds, then leverage

is positive in the sense that the excess accrues to the benefit of the

ordinary shareholders. If the return on assets is less than the return

required by the suppliers of the funds, then leverage is negative in the

sense that part of the earnings from the assets provided by the ordinary

shareholders will have to go to make up the deficiency.

6. How a shareholder would feel would depend in large part on the stability

of the firm and its industry. If the firm is in an industry that experiences

wide fluctuations in earnings, then shareholders might be very pleased that

no interest-paying debt exists in the firms capital structure. In hard

times, interest payments might be very difficult to meet, or earnings might

be so poor that negative leverage would result.

7. No, the stock is not necessarily overpriced. Book value represents the

cumulative effects on the balance sheet of past activities evaluated using

historical prices. The market value of the stock reflects investors beliefs

about the companys future earning prospects. For most companies

market value exceeds book value because investors anticipate future

growth in earnings.

8. A company in a rapidly growing technological industry probably would

have many opportunities to invest its earnings at a high rate of return;

thus, one would expect it to have a low dividend payout ratio.

9. It is more difficult to obtain positive financial leverage from preference

shares than from long-term debt due to the fact that interest on long-term

debt is tax deductible, whereas dividends paid on preference shares are not

tax deductible.

10. The current ratio would probably be highest during January, when both

current assets and current liabilities are at a minimum. During peak

operating periods, current liabilities generally include short-term

borrowings that are used to temporarily finance inventories and

Financial Statement Analysis II Chapter 5

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receivables. As the peak periods end, these short-term borrowings are paid

off, thereby enhancing the current ratio.

11. A 2-to-1 current ratio might not be adequate for several reasons. First,

the composition of the current assets may be heavily weighted toward

slow-turning inventory, or the inventory may consist of large amounts of

obsolete goods. Second, the receivables may be large and of doubtful

collectibility, or the receivables may be turning very slowly due to poor

collection procedures.

12. Expenses (including the cost of goods sold) have been increasing at an

even faster rate than net sales. Thus Sunday is apparently having

difficulty in effectively controlling its expenses.

13. If the companys earnings are very low, they may become almost

insignificant in relation to stock price. While this means that the p/e ratio

becomes very high, it does not necessarily mean that investors are

optimistic. In fact, they may be valuing the company at its liquidation

value rather than a value based upon expected future earnings.

14. From the viewpoint of the companys shareholders, this situation

represents a favorable use of leverage. It is probable that little interest, if

any, is paid for the use of funds supplied by current creditors, and only

11% interest is being paid to long-term bondholders. Together these two

sources supply 40% of the total assets. Since the firm earns an average

return of 16% on all assets, the amount by which the return on 40% of the

assets exceeds the fixed-interest requirements on liabilities will accrue to

the residual equity holders the ordinary shareholders raising the return

on equity.

15. The length of operating cycle of the two companies cannot be determined

from the fact the one companys current ratio is higher. The operating

cycle depends on the relationships between receivables and sales, and

between inventories and cost of goods sold. The company with the higher

current ratio might have either small amounts of receivables and

inventories, or large sales and cost of sales, either of which would tend to

produce a relatively short operating cycle.

16. The investor is calculating the rate of return by dividing the dividend by

the purchase price of the investment (P5 P50 = 10%). A more


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meaningful figure for rate of return on investment is determined by

relating dividends to current market price, since the investor at the present

time is faced with the alternative of selling the stock for P100 and

investing the proceeds elsewhere or keeping the investment. A decision to

retain the stock constitutes, in effect, a decision to continue to invest P100

in it, at a return of 5%. It is true that in a historical sense the investor is

earning 10% on the original investment, but this is interesting history

rather than useful decision-making information.

17. A corporate net income of P1 million would be unreasonably low for a

large corporation, with, say, P100 million in sales, P50 million in assets,

and P40 million in equity. A return of only P1 million for a company of

this size would suggest that the owners could do much better by investing

in insured bank savings accounts or in government bonds which would be

virtually risk-free and would pay a higher return.

On the other hand, a profit of P1 million would be unreasonably high for a

corporation which had sales of only P5 million, assets of, say, P3 million,

and equity of perhaps one-half million pesos. In other words, the net

income of a corporation must be judged in relation to the scale of

operations and the amount invested.

II. True or False

1. True 3. True 5. True 7. True 9. False

2. True 4. False 6. True 8. True 10. False

III. Problems

Problem 1 (Common Size Income Statements)

Common size income statements for 2005 and 2006:

2006 2005

Sales ................................................ 100% 100%

Cost of goods sold............................ 66 67

Gross profit ..................................... 34% 33%

Operating expenses .......................... 28 29

Net income ...................................... 6% 4%


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The changes from 2005 to 2006 are all favorable. Sales increased and the

gross profit per peso of sales also increased. These two factors led to a

substantial increase in gross profit. Although operating expenses increased in

peso amount, the operating expenses per peso of sales decreased from 29 cents

to 28 cents. The combination of these three favorable factors caused net

income to rise from 4 cents to 6 cents out of each peso of sales.

Problem 2 (Measures of Liquidity)

Requirement (a)

Current assets:

Cash P 47,600

Marketable securities 175,040

Accounts receivable 230,540

Inventory 179,600

Unexpired insurance 4,500

Total current assets P637,280

Current liabilities:

Notes payable P 70,000

Accounts payable 125,430

Salaries payable 7,570

Income taxes payable 14,600

Unearned revenue 10,000

Total current liabilities P227,600

Requirement (b)

The current ratio is 2.8 to 1. It is computed by dividing the current assets of

P637,280 by the current liabilities of P227,600. The amount of working

capital is P409,680, computed by subtracting the current liabilities of

P227,600 from the current assets of P637,280.

The company appears to be in a strong position as to short-run debt-paying

ability. It has almost three pesos of current assets for each peso of current

liabilities. Even if some losses should be sustained in the sale of the

merchandise on hand or in the collection of the accounts receivable, it appears

probable that the company would still be able to pay its debts as they fall due

in the near future. Of course, additional information, such as the credit terms


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on the accounts receivable, would be helpful in a careful evaluation of the

companys current position.

Problem 3 (Common-Size Income Statement)

Requirement 1

2006 2005

Sales 100.0 % 100.0 %

Less cost of goods sold .................................................... 63.2 60.0

Gross margin .................................................................. 36.8 40.0

Selling expenses ............................................................. 18.0 17.5

Administrative expenses ................................................. 13.6 14.6

Total expenses ................................................................ 31.6 32.1

Net operating income...................................................... 5.2 7.9

Interest expense .............................................................. 1.4 1.0

Net income before taxes .................................................. 3.8 % 6.9 %

Requirement 2

The companys major problem seems to be the increase in cost of goods sold,

which increased from 60.0% of sales in 2005 to 63.2% of sales in 2006. This

suggests that the company is not passing the increases in costs of its products

on to its customers. As a result, cost of goods sold as a percentage of sales

has increased and gross margin has decreased. Selling expenses and interest

expense have both increased slightly during the year, which suggests that costs

generally are going up in the company. The only exception is the

administrative expenses, which have decreased from 14.6% of sales in 2005 to

13.6% of sales in 2006. This probably is a result of the companys efforts to

reduce administrative expenses during the year.

Problem 4 (Comparing Operating Results with Average Performance in

the Industry)

Requirement (a) Ms. Freeze,Inc. Industry Average

Sales (net) 100% 100%

Cost of goods sold 49 57

Gross profit on sales 51% 43%

Operating expenses:

Selling 21% 16%

General and administrative 17 20


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Total operating expenses 38% 36%

Operating income 13% 7%

Income taxes 6 3

Net income 7% 4%

Requirement (b)

Ms. Freezes operating results are significantly better than the average

performance within the industry. As a percentage of sales revenue, Ms.

Freezes operating income and net income after nearly twice the average for

the industry. As a percentage of total assets, Ms. Freezes profits amount to

an impressive 23% as compared to 14% for the industry.

The key to Ms. Freezes success seems to be its ability to earn a relatively

high rate of gross profit. Ms. Freezes exceptional gross profit rate (51%)

probably results from a combination of factors, such as an ability to command

a premium price for the companys products and production efficiencies which

lead to lower manufacturing costs.

As a percentage of sales, Ms. Freezes selling expenses are five points higher

than the industry average (21% compared to 16%). However, these higher

expenses may explain Ms. Freezes ability to command a premium price for

its products. Since the companys gross profit rate exceeds the industry

average by 8 percentage points, the higher-than-average selling costs may be

part of a successful marketing strategy. The companys general and

administrative expenses are significantly lower than the industry average,

which indicates that Ms. Freezes management is able to control expenses

effectively.

Problem 5 (Common-Size Statements)

Requirement 1

The income statement in common-size form would be:

2006 2005

Sales ....................................................... 100.0% 100.0%

Less cost of goods sold............................ 65.0 60.0

Gross margin .......................................... 35.0 40.0

Less operating expenses .......................... 26.3 30.4

Net operating income .............................. 8.7 9.6

Less interest expense ............................... 1.2 1.6


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Net income before taxes .......................... 7.5 8.0

Less income taxes (30%) ......................... 2.3 2.4

Net income ............................................. 5.3% 5.6%

The balance sheet in common-size form would be:

2006 2005

Current assets:

Cash ................................................. 2.0% 5.1%

Accounts receivable, net ................... 15.0 10.1

Inventory .......................................... 30.1 15.2

Prepaid expenses .............................. 1.0 1.3

Total current assets .................... 48.1 31.6

Plant and equipment ................................ 51.9 68.4

Total assets ............................................. 100.0% 100.0%

Liabilities:

Current liabilities .............................. 25.1% 12.7%

Bonds payable, 12% ......................... 20.1 25.3

Total liabilities ........................... 45.1 38.0

Equity:

Preference shares, 8%, P10 par ......... 15.0 19.0

Ordinary shares, P5 par .................... 10.0 12.7

Retained earnings ............................. 29.8 30.4

Total equity ................................ 54.9 62.0

Total liabilities and equity ....................... 100.0% 100.0%

Note: Columns do not total down in all cases due to rounding differences.

Requirement 2

The companys cost of goods sold has increased from 60 percent of sales in

2005 to 65 percent of sales in 2006. This appears to be the major reason the

companys profits showed so little increase between the two years. Some

benefits were realized from the companys cost-cutting efforts, as evidenced

by the fact that operating expenses were only 26.3 percent of sales in 2006 as

compared to 30.4 percent in 2005. Unfortunately, this reduction in operating

expenses was not enough to offset the increase in cost of goods sold. As a


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result, the companys net income declined from 5.6 percent of sales in 2005 to

5.3 percent of sales in 2006.

Problem 6 (Solvency of Alabang Supermarket)

Requirement (a)

(Pesos in

Millions)

Current assets:

Cash P 74.8

Receivables 152.7

Merchandise inventories 1,191.8

Prepaid expenses 95.5

Total current assets P1,514.8

Quick assets:

Cash P 74.8

Receivables 152.7

Total quick assets P 227.5

Requirement (b)

(1) Current ratio:

Current assets (Req. a) P1,514.8

Current liabilities P1,939.0

Current ratio (P1,514.8 P1,939.0) 0.8 to 1

(2) Quick ratio:

Quick assets (Req. a) P 227.5

Current liabilities P1,939.0

Quick ratio (P227.5 P1,939.0) 0.1 to 1

(3) Working capital:

Current assets (Req. a) P1,514.8

Less: Current liabilities P1,939.0

Working capital P(424.2)


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Requirement (c)

No. It is difficult to draw conclusions from the above ratios. Alabang

Supermarkets current ratio and quick ratio are well below safe levels,

according to traditional rules of thumb. On the other hand, some large

companies with steady ash flows are able to operate successfully with current

ratios lower than Alabang Supermarkets.

Requirement (d)

Due to characteristics of the industry, supermarkets tend to have smaller

amounts of current assets and quick assets than other types of merchandising

companies. An inventory of food has a short shelf life. Therefore, the

inventory of a supermarket usually represents only a few weeks sales. Other

merchandising companies may stock inventories representing several months

sales. Also, supermarkets sell primarily for cash. Thus, they have relatively

few receivables. Although supermarkets may generate large amounts of cash,

it is not profitable for them to hold assets in this form. Therefore, they are

likely to reinvest their cash flows in business operations as quickly as

possible.

Requirement (e)

In evaluating Alabang Supermarkets liquidity, it would be useful to review

the companys financial position in prior years, statements of cash flows, and

the financial ratios of other supermarket chains. One might also ascertain the

companys credit rating from an agency such as Dun & Bradstreet.

Note to Instructor: Prior to the year in which the data for this problem was

collected, Alabang Supermarket had reported a negative retained earnings

balance in its balance sheet for several consecutive periods. The fact that

Alabang Supermarket has only recently removed the deficit from its financial

statements is also worrisome.

Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk)

Requirement (a)

(1) Quick assets:

Cash P 47,524


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Marketable securities (short-term) 55,926


Total quick assets P127,003

(2) Current assets:

Cash P 47,524

Marketable securities (short-term) 55,926


Inventories 32,210

Prepaid expenses 5,736

Total current assets P164,949

(3) Current liabilities:

Notes payable to banks (due within one year) P 20,000

Accounts payable 5,912

Dividends payable 1,424

Accrued liabilities (short-term) 21,532

Income taxes payable 6,438

Total current liabilities P 55,306

Requirement (b)

(1) Quick ratio:

Quick assets (Req. a) P127,003

Current liabilities (Req. a) P 55,306

Quick ratio (P127,003 P55,306) 2.3 to 1

(2) Current ratio:

Current assets (Req. a) P164,949

Current liabilities (Req. a) P 55,306

Current ratio (P164,949 P55,306) 3.0 to 1

(3) Working capital:

Current assets (Req. a) P164,949

Less: Current liabilities (Req. a) 55,306


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Working capital P109,643

(4) Debt ratio:

Total liabilities (given) P 81,630

Total assets (given) P353,816

Debt ratio (P81,630 P353,816) 23.1%

Requirement (c)

(1) From the viewpoint of short-term creditors, Bonbon Sweets appear

highly liquid. Its quick and current ratios are well above normal rules of

thumb, and the companys cash and marketable securities alone are

almost twice its current liabilities.

(2) Long-term creditors also have little to worry about. Not only is the

company highly liquid, but creditors claims amount to only 23.1% of

total assets. If Bonbon Sweets were to go out of business and liquidate

its assets, it would have to raise only 23 cents from every peso of assets

for creditors to emerge intact.

(3) From the viewpoint of shareholders, Bonbon Sweets appears overly

liquid. Current assets generally do not generate high rates of return.

Thus, the companys relatively large holdings of current assets dilutes its

return on total assets. This should be of concern to shareholders. If

Bonbon Sweets is unable to invest its highly liquid assets more

productively in its business, shareholders probably would like to see the

money distributed as dividends.

Problem 8 (Selected Financial Measures for Short-term Creditors)

Requirement 1

Current assets (P80,000 + P460,000 + P750,000 +

P10,000) .............................................................................. P1,300,000

Current liabilities (P1,300,000 2.5) ....................................... 520,000

Working capital ....................................................................... P 780,000


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Requirement 2

Requirement 3

a. Working capital would not be affected:

Current assets (P1,300,000 P100,000) ............................... P1,200,000

Current liabilities (P520,000 P100,000) ............................. 420,000

Working capital .................................................................... P 780,000

b. The current ratio would rise:

Problem 9 (Selected Financial Ratios)

1. Gross margin percentage:

2. Current ratio:

3. Acid-test ratio:

Acid-test ratio = Cash + Marketable securities + Accounts receivable

Current liabilities

Acid-test ratio = P80,000 + P0 + P460,000

P520,000 = 1.04 to 1 (rounded)

Current ratio = Current assets

Current liabilities

Current rate = P1,200,000

P420,000 = 2.9 to 1 (rounded)

Gross margin

Sales

P840,000

P2,100,000 = 40% =

Current assets

Current liabilities

P490,000

P200,000 = 2.45 to 1 =

Quick assets

Current liabilities

P181,000

P200,000 = 0.91 to 1 (rounded) =


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4. Accounts receivable turnover:

5. Inventory turnover:

6. Debt-to-equity ratio:

7. Times interest earned:

8. Book value per share:

* P100,000 total par value P5 par value per share = 20,000 shares

Problem 10 (Selected Financial Ratios for Ordinary Shareholders)

1. Earnings per share:

Sales

Average accounts receivables

P2,100,000

P150,000 = 14 times =

365 days

14 times = 26.1 days (rounded)

Cost of goods sold

Average inventory

P1,260,000

P280,000 = 4.5 times =

365 days

4.5 times = 81.1 days to turn (rounded)

Total liabilities

Total equity

P500,000

P800,000 = 0.63 to 1 (rounded) =

Earnings before interest

and income taxes

Interest expense

P180,000

P30,000 = 6.0 times =

Equity

Ordinary shares outstanding

P800,000

20,000 shares* = P40 per share =

Net income to ordinary shares

Average ordinary shares

outstanding

P105,000

20,000 shares = P5.25 per share =


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2. Dividend payout ratio:

3. Dividend yield ratio:

4. Price-earnings ratio:

Problem 11 (Selected Financial Ratios for Ordinary Shareholders)

1. Return on total assets:

2. Return on ordinary shareholders equity:

Dividends paid per share

Earnings per share

P3.15

P5.25 = 60% =

Dividends paid per share

Market price per share

P3.15

P63.00 = 5% =


Earnings per share

P63.00

P5.25 = 12.0 =

Return on

total assets =

Net income + [Interest expense x (1 Tax rate)]

Average total assets

= P105,000 + [P30,000 x (1 0.30)]

(P1,100,000 + P1,300,000)

P126,000

P1,200,000 = 10.5% =

Return on ordinary

shareholders equity =

Net income preference dividends

Average ordinary shareholders equity

= P105,000

(P725,000 + P800,000)

P105,000

P762,500 = 13.8% (rounded) =


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3. Financial leverage was positive, since the rate of return to the ordinary

shareholders (13.8%) was greater than the rate of return on total assets

(10.5%). This positive leverage is traceable in part to the companys

current liabilities, which may carry no interest cost, and to the bonds

payable, which have an after-tax interest cost of only 7%.

10% interest rate (1 0.30) = 7% after-tax cost.

Problem 12 (Selected Financial Measures for Short-Term Creditors)

Requirement (1)

Current assets

(P80,000 + P460,000 + P750,000 + P10,000)...........................P1,300,000

Current liabilities (P1,300,000 2.5) ............................................ 520,000

Working capital ............................................................................P 780,000

Requirement (2)

Requirement (3)

a. Working capital would not be affected by a P100,000 payment on

accounts payable:

Current assets (P1,300,000 P100,000) ........................... P1,200,000

Current liabilities (P520,000 P100,000) ......................... 420,000

Working capital ................................................................ P 780,000

b. The current ratio would increase if the company makes a P100,000

Acid-test

ratio =

Cash + Marketable securities

+ Accounts receivable + Short-term notes

Current liabilities

= P80,000 + P0 + P460,000 + P0

P520,000 = 1.04 (rounded)


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payment on accounts payable:

Problem 13 (Effects of Transactions on Various Financial Ratios)

1. Decrease Sale of inventory at a profit will be reflected in an increase

in retained earnings, which is part of shareholders equity.

An increase in shareholders equity will result in a decrease

in the ratio of assets provided by creditors as compared to

assets provided by owners.

2. No effect Purchasing land for cash has no effect on earnings or on the

number of ordinary shares outstanding. One asset is

exchanged for another.

3. Increase A sale of inventory on account will increase the quick assets

(cash, accounts receivable, marketable securities) but have

no effect on the current liabilities. For this reason, the acid-

test ratio will increase.

4. No effect Payments on account reduce cash and accounts payable by

equal amounts; thus, the net amount of working capital is

not affected.

5. Decrease When a customer pays a bill, the accounts receivable

balance is reduced. This increases the accounts receivable

turnover, which in turn decreases the average collection

period.

6. Decrease Declaring a cash dividend will increase current liabilities,

but have no effect on current assets. Therefore, the current

ratio will decrease.


Current liabilities

= P1,200,000

P420,000 = 2.9 (rounded)


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7. Increase Payment of a previously declared cash dividend will reduce

both current assets and current liabilities by the same

amount. An equal reduction in both current assets and

current liabilities will always result in an increase in the

current ratio, so long as the current assets exceed the

current liabilities.

8. No effect Book value per share is not affected by the current market

price of the companys stock.

9. Decrease The dividend yield ratio is obtained by dividing the

dividend per share by the market price per share. If the

dividend per share remains unchanged and the market

price goes up, then the yield will decrease.

10. Increase Selling property for a profit would increase net income and

therefore the return on total assets would increase.

11. Increase A write-off of inventory will reduce the inventory balance,

thereby increasing the turnover in relation to a given level

of cost of goods sold.

12. Increase Since the companys assets earn at a rate that is higher

than the rate paid on the bonds, leverage is positive,

increasing the return to the ordinary shareholders.

13. No effect Changes in the market price of a stock have no direct

effect on the dividends paid or on the earnings per share

and therefore have no effect on this ratio.

14. Decrease A decrease in net income would mean less income

available to cover interest payments. Therefore, the times-

interest-earned ratio would decrease.

15. No effect Write-off of an uncollectible account against the

Allowance for Bad Debts will have no effect on total

current assets. For this reason, the current ratio will

remain unchanged.

16. Decrease A purchase of inventory on account will increase current

liabilities, but will not increase the quick assets (cash,


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accounts receivable, marketable securities). Therefore, the

ratio of quick assets to current liabilities will decrease.

17. Increase The price-earnings ratio is obtained by dividing the market

price per share by the earnings per share. If the earnings

per share remains unchanged, and the market price goes

up, then the price-earnings ratio will increase.

18. Decrease Payments to creditors will reduce the total liabilities of a

company, thereby decreasing the ratio of total debt to total

equity.

Problem 14 (Interpretation of Financial Ratios)

a. The market price is going down. The dividends paid per share over the

three-year period are unchanged, but the dividend yield is going up.

Therefore, the market price per share of stock must be decreasing.

b. The earnings per share is increasing. Again, the dividends paid per share

have remained constant. However, the dividend payout ratio is decreasing.

In order for the dividend payout ratio to be decreasing, the earnings per

share must be increasing.

c. The price-earnings ratio is going down. If the market price of the stock is

going down [see part (a) above], and the earnings per share are going up

[see part (b) above], then the price-earnings ratio must be decreasing.

d. In Year 1, leverage was negative because in that year the return on total

assets exceeded the return on ordinary equity. In Year 2 and in Year 3,

leverage was positive because in those years the return on ordinary equity

exceeded the return on total assets employed.

e. It is becoming more difficult for the company to pay its bills as they come

due. Although the current ratio has improved over the three years, the

acid-test ratio is down. Also note that the accounts receivable and

inventory are both turning more slowly, indicating that an increasing

portion of the current assets is being made up of those items, from which

bills cannot be paid.

f. Customers are paying their bills more slowly in Year 3 than in Year 1.

This is evidenced by the decline in accounts receivable turnover.


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g. Accounts receivable is increasing. This is evidenced both by a slowdown

in turnover and in an increase in total sales.

h. The level of inventory undoubtedly is increasing. Notice that the inventory

turnover is decreasing. Even if sales (and cost of goods sold) just

remained constant, this would be evidence of a larger average inventory on

hand. However, sales are not constant but rather are increasing. With sales

increasing (and undoubtedly cost of goods sold also increasing), the

average level of inventory must be increasing as well in order to service

the larger volume of sales.

IV. Cases

Case 1 (Common-Size Statements and Financial Ratios for Creditors)

Requirement 1

This Year Last Year

a. Current assets .............................................. P2,060,000 P1,470,000

Current liabilities ......................................... 1,100,000 600,000

Working capital............................................ P 960,000 P 870,000

b. Current assets (a) ......................................... P2,060,000 P1,470,000

Current liabilities (b) .................................... P1,100,000 P600,000

Current ratio (a) (b) .................................. 1.87 to 1 2.45 to 1

c. Quick assets (a) ........................................... P740,000 P650,000

Current liabilities (b) .................................... P1,100,000 P600,000

Acid-test ratio (a) (b) ................................ 0.67 to 1 1.08 to 1

d. Sales on account (a) ..................................... P7,000,000 P6,000,000

Average receivables (b) ................................ P525,000 P375,000

Turnover of receivables (a) (b) .................. 13.3 times 16.0 times

Average age of receivables:

365 turnover ............................................. 27.4 days 22.8 days

e. Cost of goods sold (a) .................................. P5,400,000 P4,800,000


5-21

Average inventory (b) ................................... P1,050,000 P760,000

Inventory turnover (a) (b) .......................... 5.1 times 6.3 times

Turnover in days: 365 turnover ................. 71.6 days 57.9 days

f. Total liabilities (a) ........................................ P1,850,000 P1,350,000

Equity (b) .................................................... P2,150,000 P1,950,000

Debt-to-equity ratio (a) (b) ........................ 0.86 to 1 0.69 to 1

g. Net income before interest and taxes (a) ....... P630,000 P490,000

Interest expense (b) ...................................... P90,000 P90,000

Times interest earned (a) (b) ...................... 7.0 times 5.4 times

Requirement 2

a. METRO BUILDING SUPPLY

Common-Size Balance Sheets

This Year Last Year

Current assets:

Cash ........................................................ 2.3 % 6.1 %

Marketable securities ............................... 0.0 1.5

Accounts receivable, net........................... 16.3 12.1

Inventory ................................................. 32.5 24.2

Prepaid expenses ..................................... 0.5 0.6

Total current assets ...................................... 51.5 44.5

Plant and equipment, net .............................. 48.5 55.5

Total assets ................................................. 100.0 % 100.0 %

Liabilities:

Current liabilities ..................................... 27.5 % 18.2 %

Bonds payable, 12% ................................ 18.8 22.7

Total liabilities............................................. 46.3 40.9

Equity:

Preference shares, P50 par, 8% ................ 5.0 6.1

Ordinary shares, P10 par ......................... 12.5 15.2

Retained earnings..................................... 36.3 37.9

Total equity ................................................. 53.8 59.1

Total liabilities and equity ............................ 100.0 % 100.0 %


5-22

Note: Columns do not total down in all cases due to rounding.

b. METRO BUILDING SUPPLY

Common-Size Income Statements

This Year Last Year

Sales ............................................................ 100.0 % 100.0 %

Less cost of goods sold ................................. 77.1 80.0

Gross margin ................................................ 22.9 20.0

Less operating expenses ................................ 13.9 11.8

Net operating income .................................... 9.0 8.2

Less interest expense .................................... 1.3 1.5

Net income before taxes ................................ 7.7 6.7

Less income taxes ......................................... 3.1 2.7

Net income ................................................... 4.6 % 4.0 %

Requirement 3

The following points can be made from the analytical work in parts (1) and (2)

above:

The company has improved its profit margin from last year. This is

attributable to an increase in gross margin, which is offset somewhat by an

increase in operating expenses. In both years the companys net income as a

percentage of sales equals or exceeds the industry average of 4%.

Although the companys working capital has increased, its current position

actually has deteriorated significantly since last year. Both the current ratio

and the acid-test ratio are well below the industry average, and both are

trending downward. (This shows the importance of not just looking at the

working capital in assessing the financial strength of a company.) Given the

present trend, it soon will be impossible for the company to pay its bills as

they come due.

The drain on the cash account seems to be a result mostly of a large buildup in

accounts receivable and inventory. This is evident both from the common-size

balance sheet and from the financial ratios. Notice that the average age of the

receivables has increased by 5 days since last year, and that it is now 9 days


5-23

over the industry average. Many of the companys customers are not taking

their discounts, since the average collection period is 27 days and collection

terms are 2/10, n/30. This suggests financial weakness on the part of these

customers, or sales to customers who are poor credit risks. Perhaps the

company has been too aggressive in expanding its sales.

The inventory turned only 5 times this year as compared to over 6 times last

year. It takes three weeks longer for the company to turn its inventory than the

average for the industry (71 days as compared to 50 days for the industry).

This suggests that inventory stocks are higher than they need to be.

In the authors opinion, the loan should be approved on the condition that the

company take immediate steps to get its accounts receivable and inventory

back under control. This would mean more rigorous checks of

creditworthiness before sales are made and perhaps paring out of slow paying

customers. It would also mean a sharp reduction of inventory levels to a more

manageable size. If these steps are taken, it appears that sufficient funds

could be generated to repay the loan in a reasonable period of time.

Case 2 (Financial Ratios for Ordinary Shareholders)

Requirement 1

a. This Year Last Year

Net income .................................................. P324,000 P240,000

Less preference dividends ............................ 16,000 16,000

Net income remaining for ordinary (a) ......... P308,000 P224,000

Average number of ordinary shares (b) ........ 50,000 50,000

Earnings per share (a) (b) ......................... P6.16 P4.48

b. Ordinary dividend per share (a)*.................. P2.16 P1.20

Market price per share (b) ........................... P45.00 P36.00

Dividend yield ratio (a) (b) ....................... 4.8% 3.33%

*P108,000 50,000 shares = P2.16;

P60,000 50,000 shares = P1.20

c. Ordinary dividend per share (a) ................... P2.16 P1.20

Earnings per share (b)................................. P6.16 P4.48


5-24

Dividend payout ratio (a) (b) ................... 35.1% 26.8%

d. Market price per share (a) ........................... P45.00 P36.00

Earnings per share (b)................................. P6.16 P4.48

Price-earnings ratio (a) (b) ....................... 7.3 8.0

Investors regard Metro Building Supply less favorably than other firms in

the industry. This is evidenced by the fact that they are willing to pay only

7.3 times current earnings for a share of the companys stock, as

compared to 9 times current earnings for the average of all stocks in the

industry. If investors were willing to pay 9 times current earnings for

Metro Building Supplys stock, then it would be selling for about P55 per

share (9 P6.16), rather than for only P45 per share.

e. This Year Last Year

Equity ........................................................ P2,150,000 P1,950,000

Less preference shares ................................ 200,000 200,000

Ordinary equity (a) ..................................... P1,950,000 P1,750,000

Number of ordinary shares (b) .................... 50,000 50,000

Book value per share (a) (b) .................... P39.00 P35.00

A market price in excess of book value does not mean that the price of a

stock is too high. Market value is an indication of investors perceptions

of future earnings and/or dividends, whereas book value is a result of

already completed transactions and is geared to the past.

Requirement 2

a. This Year Last Year

Net income ................................................. P 324,000 P 240,000 Add after-tax cost of interest paid:

[P90,000 (1 0.40)] ............................ 54,000 54,000

Total (a) ..................................................... P 378,000 P 294,000

Average total assets (b) ............................... P3,650,000 P3,000,000

Return on total assets (a) (b) .................... 10.4% 9.8%

b. This Year Last Year

Net income ................................................. P 324,000 P 240,000


5-25

Less preference dividends ........................... 16,000 16,000

Net income remaining for ordinary

shareholders (a) ...................................... P 308,000 P 224,000

Average total equity* .................................. P2,050,000 P1,868,000

Less average preference shares ................... 200,000 200,000

Average ordinary equity (b) ........................ P1,850,000 P1,668,000

*1/2(P2,150,000 + P1,950,000); 1/2(P1,950,000 + P1,786,000).

Return on ordinary equity (a) (b) ............. 16.6% 13.4%

c. Financial leverage is positive in both years, since the return on ordinary

equity is greater than the return on total assets. This positive financial

leverage is due to three factors: the preference shares, which has a

dividend of only 8%; the bonds, which have an after-tax interest cost of

only 7.2% [12% interest rate (1 0.40) = 7.2%]; and the accounts

payable, which may bear no interest cost.

Requirement 3

We would recommend keeping the stock. The stocks downside risk seems

small, since it is selling for only 7.3 times current earnings as compared to 9

times earnings for the average firm in the industry. In addition, its earnings

are strong and trending upward, and its return on ordinary equity (16.6%) is

extremely good. Its return on total assets (10.4%) compares favorably with

that of the industry.

The risk, of course, is whether the company can get its cash problem under

control. Conceivably, the cash problem could worsen, leading to an eventual

reduction in profits through inability to operate, a reduction in dividends, and

a precipitous drop in the market price of the companys stock. This does not

seem likely, however, since the company can easily control its cash problem

through more careful management of accounts receivable and inventory. If

this problem is brought under control, the price of the stock could rise sharply

over the next few years, making it an excellent investment.

Case 3 (Comprehensive Ratio Analysis)


5-26

Requirement 1

This Year Last Year

a. Net income ................................................. P 280,000 P 168,000 Add after-tax cost of interest:

P120,000 (1 0.30) ............................ 84,000

P100,000 (1 0.30) ............................ 70,000

Total (a) ..................................................... P 364,000 P 238,000

Average total assets (b) ............................... P5,330,000 P4,640,000

Return on total assets (a) (b) .................... 6.8% 5.1%

b. Net income ................................................. P 280,000 P 168,000 Less preference dividends ........................... 48,000 48,000

Net income remaining for ordinary (a) ........ P 232,000 P 120,000

Average total equity .................................... P3,120,000 P3,028,000

Less average preference shares ................... 600,000 600,000

Average ordinary equity (b) ........................ P2,520,000 P2,428,000

Return on ordinary equity (a) (b) ............. 9.2% 4.9%

c. Leverage is positive for this year, since the return on ordinary equity

(9.2%) is greater than the return on total assets (6.8%). For last year,

leverage is negative since the return on the ordinary equity (4.9%) is less

than the return on total assets (5.1%).

Requirement 2

This Year Last Year

a. Net income remaining for ordinary (a) ........ P 232,000 P 120,000 Average number of ordinary shares (b) ....... 50,000 50,000

Earnings per share (a) (b) ....................... P4.64 P2.40

b. Ordinary dividend per share (a) .................. P1.44 P0.72

Market price per share (b).......................... P36.00 P20.00

Dividend yield ratio (a) (b) ...................... 4.0% 3.6%


5-27

c. Ordinary dividend per share (a) .................. P1.44 P0.72

Earnings per share (b) ................................ P4.64 P2.40

Dividend payout ratio (a) (b)................... 31.0% 30.0%

d. Market price per share (a) .............................. P36.00 P20.00

Earnings per share (b) .................................... P4.64 P2.40

Price-earnings ratio (a) (b) .......................... 7.8 8.3

Notice from the data given in the problem that the average P/E ratio for

companies in Helixs industry is 10. Since Helix Company presently has

a P/E ratio of only 7.8, investors appear to regard it less well than they do

other companies in the industry. That is, investors are willing to pay only

7.8 times current earnings for a share of Helix Companys stock, as

compared to 10 times current earnings for a share of stock for the average

company in the industry.

e. Equity ....................................................... P3,200,000 P3,040,000

Less preference shares ............................... 600,000 600,000

Ordinary equity (a) .................................... P2,600,000 P2,440,000

Number of ordinary shares (b) ................... 50,000 50,000

Book value per share (a) (b) ................... P52.00 P48.80

Note that the book value of Helix Companys stock is greater than the

market value for both years. This does not necessarily indicate that the

stock is selling at a bargain price. Market value is an indication of

investors perceptions of future earnings and/or dividends, whereas book

value is a result of already completed transactions and is geared to the

past.

f. Gross margin (a) ....................................... P1,050,000 P860,000

Sales (b) .................................................... P5,250,000 P4,160,000

Gross margin percentage (a) (b) .............. 20.0% 20.7%

Requirement 3

This Year Last Year

a. Current assets ........................................... P2,600,000 P1,980,000

Current liabilities....................................... 1,300,000 920,000


5-28

Working capital ......................................... P1,300,000 P1,060,000

b. Current assets (a) ...................................... P2,600,000 P1,980,000

Current liabilities (b) ................................. P1,300,000 P920,000

Current ratio (a) (b) ................................ 2.0 to 1 2.15 to 1

c. Quick assets (a) ......................................... P1,220,000 P1,120,000

Current liabilities (b) ................................. P1,300,000 P920,000

Acid-test ratio (a) (b) .............................. 0.94 to 1 1.22 to 1

d. Sales on account (a) .................................. P5,250,000 P4,160,000

Average receivables (b).............................. P750,000 P560,000

Accounts receivable turnover (a) (b) ....... 7.0 times 7.4 times

Average age of receivables,

365 turnover ....................................... 52 days 49 days

e. Cost of goods sold (a) ................................ P4,200,000 P3,300,000

Average inventory (b) ................................ P1,050,000 P720,000

Inventory turnover (a) (b) ....................... 4.0 times 4.6 times

Number of days to turn inventory,

365 days turnover (rounded) ............... 91 days 79 days

f. Total liabilities (a) ..................................... P2,500,000 P1,920,000

Equity (b) .................................................. P3,200,000 P3,040,000

Debt-to-equity ratio (a) (b) ..................... 0.78 to 1 0.63 to 1

g. Net income before interest and taxes (a) ..... P520,000 P340,000

Interest expense (b) ................................... P120,000 P100,000

Times interest earned (a) (b) ................... 4.3 times 3.4 times

Requirement 4

As stated by Meri Ramos, both net income and sales are up from last year.

The return on total assets has improved from 5.1% last year to 6.8% this year,

and the return on ordinary equity is up to 9.2% from 4.9% the year before.

But this appears to be the only bright spot in the companys operating picture.

Virtually all other ratios are below the industry average, and, more important,

they are trending downward. The deterioration in the gross margin

percentage, while not large, is worrisome. Sales and inventories have

increased substantially, which should ordinarily result in an improvement in


5-29

the gross margin percentage as fixed costs are spread over more units.

However, the gross margin percentage has declined.

Notice particularly that the average age of receivables has lengthened to 52

daysabout three weeks over the industry averageand that the inventory

turnover is 50% longer than the industry average. One wonders if the increase

in sales was obtained at least in part by extending credit to high-risk

customers. Also notice that the debt-to-equity ratio is rising rapidly. If the

P1,000,000 loan is granted, the ratio will rise further to 1.09 to 1.

In the authors opinion, what the company needs is more equitynot more

debt. Therefore, the loan should not be approved. The company should be

encouraged to make another issue of ordinary stock in order to provide a

broader equity base on which to operate.

Case 4 (Statement Reconstruction Using Ratios)

Bulacan Company

Income Statement

For the Year Ended December 31, 2005

Sales P140,800

Less: Cost of Sales (4) 84,480

Gross Profit P 56,320

Less: Expenses 46,320

Net Income (1) P 10,000

Bulacan Company

Balance Sheet

December 31, 2005

A s s e t s

Current Assets:

Cash P 27,720

Accounts Receivable (5) 28,160

Merchandise Inventory (3) 21,120

Total Current Assets (2) P 77,000

Fixed Assets (8) 55,000

Total Assets P132,000


5-30

Liabilities and Equity

Current Liabilities:

Accounts Payable (2) P 44,000

Equity:

Share Capital (issued 20,000 shares) (6) P40,000

Retained Earnings 48,000 88,000

Total Liabilities and Equity P132,000

Supporting Computations:

(1) Earnings Per Share =

P0.50 =

X (Net Income) = P10,000

(2) Current Assets Pxx 1.75

Current Liabilities xx 1

Working Capital P33,000 0.75

Current Liabilities = P33,000 0.75

= P44,000

(3) Current Ratio =

1.27 =

X (Current Assets) = P77,000

Net Income

Ordinary Shares Outstanding

X

20,000

X

44,000

Current Assets

Current Liabilities


5-31

Quick Ratio =

1.27 =

X (Current Assets) = P55,880

Current Assets P77,000

Quick Assets 55,800

Inventory P21,120

(4) Inventory turnover =

4 =

X (Cost of Sales) = P84,480

(5) Average age of outstanding =

Accounts Receivable

= 73 days (Average age of

receivables)

= 5

= 5

X (Receivables) = P28,160

Another Method:

X

44,000

X

P21,120

P140,800

X

Quick Assets

Current Liabilities

Cost of Sales

Ave. Inventory

Quick Assets

Current Liabilities

365

5

Net Sales

Average Receivables


5-32

= 73 days = P28,160 Accounts receivable

(6) Earnings for the year as a percentage of Share Capital

= 25%

Share Capital = P40,000

(7) Current Fixed Current Liabilities +

Assets Assets = Equity

P77,000 + 0.625X = P44,000 + X

0.375X = P33,000

X = P88,000 Equity

(8) Fixed Assets to Equity

= 0.625

= 0.625

X (Fixed Assets) = P55,000

Case 5 (Ethics and the Manager)

Requirement 1

The loan officer stipulated that the current ratio prior to obtaining the loan

must be higher than 2.0, the acid-test ratio must be higher than 1.0, and the

interest on the loan must be no more than four times net operating income.

These ratios are computed below:

P140,800

365

P10,000

Share Capital

X

P140,800

+

Fixed Assets

Equity


Current liabilities

Current rate = P290,000

P164,000 = 1.8 (rounded)


5-33

The company would fail to qualify for the loan because both its current ratio

and its acid-test ratio are too low.

Requirement 2

By reclassifying the P45 thousand net book value of the old machine as

inventory, the current ratio would improve, but there would be no effect on the

acid-test ratio. This happens because inventory is considered to be a current

asset but is not included in the numerator when computing the acid-test ratio.

Even if this tactic had succeeded in qualifying the company for the loan, we

strongly advise against it. Inventories are assets the company has acquired for

the sole purpose of selling them to outsiders in the normal course of business.

Used production equipment is not considered to be inventoryeven if there is

a clear intention to sell it in the near future. Since the loan officer would not

expect used equipment to be included in inventories, doing so would be

intentionally misleading.

Nevertheless, the old equipment is an asset that could be turned into cash. If

this were done, the company would immediately qualify for the loan since the

P45 thousand in cash would be included in the numerator in both the current

ratio and in the acid-test ratio.

Acid-test ratio = Cash + Marketable securities + Accounts receivable

Current liabilities


P164,000 = 0.70 (rounded)

Net operating income

Interest on the loan

P20,000

P80,000 x 0.10 x (6/12) = 5.0 =


Current liabilities

Current rate = P290,000 + P45,000

P164,000 = 2.0 (rounded)

Acid-test ratio = Cash + Marketable securities + Current receivables

Current liabilities


P164,000 = 0.70 (rounded)


5-34

However, other options may be available. After all, the old machine is being

used to relieve bottlenecks in the plastic injection molding process and it

would be desirable to keep this standby capacity. We would advise Rome to

fully and honestly explain the situation to the loan officer. The loan officer

might insist that the machine be sold before any loan is approved, but he might

instead grant a waiver of the current ratio and acid-test ratio requirements on

the basis that they could be satisfied by selling the old machine. Or he may

approve the loan on the condition that the equipment is pledged as collateral.

In that case, Rome would only have to sell the machine if he would otherwise

be unable to pay back the loan.

Case 6 (Financial Ratios for Ordinary Shareholders)

[pesos in thousands]

Requirement (1)

Calculation of the gross margin percentage:

Requirement (2)

Calculation of the earnings per share:


Current liabilities

Current rate = P290,000 + P45,000

P164,000 = 2.0 (rounded)

Acid-test ratio = Cash + Marketable securities + Current receivables

Current liabilities

Acid-test ratio = P70,000 + P0 + P50,000 + P45,000

P164,000 = 1.00 (rounded)

Gross margin percentage = Gross margin

Sales

= P23,000

P66,000 = 34.8%

Earnings per share = Net income Preference dividends

Average number of ordinary shares outstanding

= P1,980 P60

600 shares = P3.20 per share


5-35

Requirement (3)

Calculation of the price-earnings ratio:

Requirement (4)

Calculation of the dividend payout ratio:

Requirement (5)

Calculation of the dividend yield ratio:

Requirement (6)

Calculation of the return on total assets:

Requirement (7)

Price-earnings ratio = Market price per share

Earnings per share

= P26

P3.20 = 8.1

Dividend payout ratio = Dividends per share

Earnings per share

= P0.75

P3.20 = 23.4%

Dividend yield ratio = Dividends per share


= P0.75

P26.00 = 2.9%

Return on total assets = Net income + [Interest expense x (1 Tax rate)]

Average total assets

= P1,980 + [P800 x (1 0.40)]

(P65,810 + P68,480) / 2 = 3.7%


5-36

Calculation of the return on ordinary shareholders equity:

Beginning balance, shareholders equity (a) P39,610

Ending balance, shareholders equity (b) 41,080

Average shareholders equity [(a) + (b)]/2 40,345

Average preference shares 1,000

Average ordinary shareholders equity P39,345

Requirement (8)

Calculation of the book value per share:

Case 7 (Financial Ratios for Short-Term Creditors)

Requirement (1)

Calculation of working capital:

Requirement (2)

Calculation of the current ratio:

Requirement (3)

Return on ordinary

shareholders equity =

Net income Preference dividends

Average ordinary shareholders equity

= P1,980 P60

P39,345 = 4.9%

Book value

per share =

Total shareholders equity Preference shares

Number of ordinary shares outstanding

= P41,080 P1,000

600 shares = P66.80 per share

Working capital = Current assets Current liabilities

= P22,680 P19,400 = P3,280


Current liabilities

= P22,680

P19,400 = 1.17


5-37

Calculation of the acid-test ratio:

Requirement (4)

Calculation of accounts receivable turnover:

Requirement (5)

Calculation of the average collection period:

Requirement (6)

Calculation of inventory turnover:

Acid-test ratio =

Cash + Marketable securities

+ Accounts receivable + Short-term notes

Current liabilities

Acid-test ratio = P1,080 + P0 + P9,000 + P0

P19,400 = 0.52

= 8.5

Sales on account

Average accounts receivable balance

Acid-test ratio = P66,000

(P6,500 + P9,000) / 2

Accounts receivable

turnover =

365 days

Accounts receivable turnover

Acid-test ratio = 365 days

8.5

Average collection

period =

= 42.9 days

Cost of goods sold

Average inventory balance


(P10,600 + P12,000) / 2

Inventory

turnover =

= 3.8


5-38

Requirement (7)

Calculation of the average sale period:

Case 8 (Financial Ratios for Long-Term Creditors)

Requirement (1)

Calculation of the times interest earned ratio:

Requirement (2)

Calculation of the debt-to-equity ratio:

V. Multiple Choice Questions

1. A 11. C 21. B 31. C 41. C

2. C 12. A 22. D 32. D

3. D 13. C 23. A 33. C

4. B 14. B 24. C 34. A

5. A 15. D 25. A 35. A

6. D 16. B 26. C 36. C

365 days

Inventory turnover

Acid-test ratio = 365 days

3.8

Average sale

period =

= 96.1 days

Earnings before interest expense

and income taxes

Inventory expense


P800

Times interest

earned ratio =

= 5.1

Total liabilities

Shareholders equity


P41,080

Debt-to-equity

ratio =

= 0.67


5-39

7. C 17. A 27. D 37. A

8. D 18. C 28. A 38. A

9. A 19. A 29. D 39. C

10. B 20. C 30. A 40. C

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