CHAPTER 2

Self-Test Problems
ST2-1 K. Billingsworth & Company had earnings per share of $4 last year, and it paid a $2 diidend.
Total retained earnings in!reased "y $12 million d#ring the year, and "oo$ al#e per share at
year-end was $4%. Billingsworth has no preferred sto!$, and no new !ommon sto!$ was iss#ed
d#ring the year. &f the !ompany's year-end de"t (whi!h e)#als its total lia"ilities* was $12% million,
what was its year-end de"t+assets ratio,
ST2-2 -efreshing .ool Corporation reported net operating in!ome e)#al to $12%,%%% this year.
/0amination of the !ompany's "alan!e sheet and in!ome statement shows that the ta0 rate was
4% per!ent, the depre!iation e0pense was $21,%%%, $11%,%%% was inested in assets d#ring the
year, and inested !apital e)#als $1%%,%%%. The firm's if aerage after-ta0 !ost of f#nds is 12
per!ent. 2hat was the firm's (1* operating !ash flow, (2* free !ash flow, and (3* e!onomi! al#e
added (/45*,
ST2-3 The following data apply to 5.6. Kaiser & Company ($ million*7
Cash and e)#ialents $1%%.%%
8i0ed assets $293.1%
Sales $1,%%%.%%
:et in!ome $1%.%%
;#i!$ ratio 2.%0
C#rrent ratio 3.%0
<S= 4%.% days
-=/ 12.%>
Kaiser has no preferred sto!$?only !ommon e)#ity, !#rrent lia"ilities, and long-term de"t.
a. 8ind Kaiser's (1* a!!o#nts re!eia"le (5+-*, (2* !#rrent lia"ilities, (3* !#rrent assets, (4* total
assets, (1* -=5, (@* !ommon e)#ity, and (A* long-term de"t.
". &n part (a*, yo# sho#ld hae fo#nd Kaiser's a!!o#nts re!eia"le (5+-* to "e $1%B.@ million. &f
Kaiser !o#ld red#!e its <S= from 4% days to 3% days while holding other things !onstant,
how m#!h !ash wo#ld it generate, &f this !ash were #sed to "#y "a!$ !ommon sto!$ (at "oo$
al#e* and there"y red#!e the amo#nt of !ommon e)#ity, how wo#ld this a!tion affe!t the
!ompany's (1* -=/, (2* -=5, and (3* total de"t+total assets ratio,
Problems
2-1 /arth's Best Company has sales of $2%%,%%%, a net in!ome of $11,%%%, and the following "alan!e
sheet7
Cash $ 1%,%%% 5!!o#nts paya"le $ 3%,%%%
-e!eia"les 1%,%%% =ther !#rrent lia"ilities 2%,%%%
&nentories 11%,%%% 6ong-term de"t 1%,%%%
:et fi0ed assets B%,%%% Common e)#ity 2%%,%%%
Total assets $3%%,%%% Total lia"ilities and e)#ity $3%%,%%%
a. The !ompany's new owner thin$s that inentories are e0!essie and !an "e lowered to the
point where the !#rrent ratio is e)#al to the ind#stry aerage, 2.10, witho#t affe!ting either
sales or net in!ome. &f inentories are sold off and not repla!ed so as to red#!e the !#rrent
ratio to 2.10, if the f#nds generated are #sed to red#!e !ommon e)#ity (sto!$ !an "e
rep#r!hased at "oo$ al#e*, and if no other !hanges o!!#r, "y how m#!h will the ret#rn on
e)#ity (-=/* !hange,
". :ow s#ppose we wanted to ta$e this pro"lem and modify it for #se on an e0am?that is, to
!reate a new pro"lem that yo# hae not seen to test yo#r $nowledge of this type of pro"lem.
Cow wo#ld yo#r answer !hange if we made the following !hanges7 (1* 2e do#"led all of the
dollar amo#nts, (2* 2e stated that the target !#rrent ratio was 3.%0, (3 * 2e said that the
!ompany had 1%,%%% shares of sto!$ o#tstanding, and we as$ed how m#!h the !hange in
part (a* wo#ld in!rease earnings per share (/.S*, (4* 2hat wo#ld yo#r answer to (3* "e if we
!hanged the original pro"lem to state that the sto!$ was selling for twi!e "oo$ al#e, so
!ommon e)#ity wo#ld not "e red#!ed on a dollar-for-dollar "asis,
2-2 The !onsolidated "alan!e sheets for 6loyd 6#m"er Company at the "eginning and end of the
year follow. The !ompany "o#ght $1% million worth of fi0ed assets. The !harge for depre!iation
d#ring the year was $1% million. :et in!ome was $33 million, and the !ompany paid o#t $1 million
in diidends.
a. 8ill in the amo#nt of the so#r!e or #se in the appropriate !ol#mn.
6loyd 6#m"er Company7 Balan!e Sheets at Beginning and /nd of the year ($ million*
Change
Dan. 1 <e!. 31 So#r!e Ese
Cash $ A $ 1
Far$eta"le se!#rities % 11
:et re!eia"les 3% 22
&nentories 13 A1
Total !#rrent assets $ B% $ 23
Gross fi0ed assets A1 121
6ess7 5!!#m#lated depre!iation ( 21 * (231 *
:et fi0ed assets $ 1% $ B%
Total assets $14% $213
5!!o#nts paya"le $19 $ 11
:otes paya"le 3 11
=ther !#rrent lia"ilities 11 A
6ong-term de"t 9 24
Common sto!$ 2B 1A
-etained earnings @A B1
Total lia"ilities and e)#ity $14% $213
:ote7 Total so#r!es m#st e)#al total #ses.
". .repare a statement of !ash flows.
!. Briefly s#mmariHe yo#r findings.
2-3 FonteIo Corporation e0pe!ts sales to "e $12 million. =perating !osts other than depre!iation are
e0pe!ted to "e A1 per!ent of sales, and depre!iation is e0pe!ted to "e $1.1 million d#ring the
ne0t year. 5ll sales reen#es will "e !olle!ted in !ash, and !osts other than depre!iation m#st "e
paid d#ring the year. FonteIo's interest e0pense is e0pe!ted to "e $1 million, and it is ta0ed at a
4% per!ent rate.
a. Set #p an in!ome statement and a !ash flow statement (#se two !ol#mns on one page* for
FonteIo. 2hat is the e0pe!ted !ash flow from operations,
". S#ppose Congress !hanged the ta0 laws so that FonteIo's depre!iation e0penses do#"led,
"#t no other !hanges o!!#rred. 2hat wo#ld happen to the net in!ome and !ash flow from
operations e0pe!ted d#ring the year,
!. S#ppose that Congress, rather than in!reasing FonteIo's depre!iation, red#!ed it "y 1%
per!ent. Cow wo#ld the in!ome and !ash flows "e affe!ted,
d. &f this !ompany "elonged to yo#, wo#ld yo# prefer that Congress in!rease or de!rease the
depre!iation e0pense allowed yo#r !ompany, /0plain why.
2-4 <ata for Enilate Te0tiles' 2%1% finan!ial statements are gien in Ta"les 2.1 and 2.2 the !hapter.
a. Comp#te the 2%1% al#es of the following ratios7
2%1% 4al#es
-atio Enilate &nd#stry
C#rrent ratio 3.B0
<ays sales o#tstanding 33.1 days
&nentory t#rnoer A.20
8i0ed assets t#rnoer 4.10
<e"t ratio 43.%>
:et profit margin 4.@>
-et#rn on assets B.B>
". Briefly !omment on Enilate's 2%1% finan!ial position. Can yo# see any o"io#s strengths or
wea$nesses,
!. Compare Enilate's 2%1% ratios with its 2%11 ratios, whi!h are presented in Ta"le 2.@.
Comment on whether yo# "eliee Enilate's finan!ial position improed or deteriorated d#ring
2%11.
d. 2hat other information wo#ld "e #sef#l for proIe!ting whether Enilate's finan!ial position is
e0pe!ted to improe or deteriorate in the f#t#re,
2-1 <ata for Campsey Comp#ter Company and its ind#stry aerages follow.
a. Cal!#late the indi!ated ratios for Campsey.
". Constr#!t the <#.ont e)#ation for "oth Campsey and the ind#stry.
!. =#tline Campsey's strengths and wea$nesses as reealed "y yo#r analysis.
d. S#ppose Campsey had do#"led its sales as well as its inentories, a!!o#nts re!eia"le, and
!ommon e)#ity d#ring the year. Cow wo#ld that information affe!t the alidity of yo#r ratio
analysis, (Hint: Thin$ a"o#t aerages and the effe!ts of rapid growth on ratios if aerages
are not #sed. :o !al!#lations are needed.*
Campsey Comp#ter Company7 Balan!e Sheet as of <e!em"er 31
Cash $ AA,1%% 5!!o#nts paya"le $12B,%%%
-e!eia"les 33@,%%% :otes paya"le 94,%%%
&nentories 241,1%% =ther !#rrent lia"ilities 11A,%%%
Total !#rrent assets $@11,%%% Total !#rrent lia"ilities $33%,%%%
:et fi0ed assets 2B2,1%% 6ong-term de"t 21@,1%%
Common e)#ity 3@1,%%%
Total assets $B4A,1%% Total lia"ilities and e)#ity $B4A,1%%
Campsey Comp#ter Company7 &n!ome Statement for Jear /nded <e!em"er 31
Sales $1,@%A,1%%
Cost of goods sold (1,313,%%% *
Gross profit $ 214,1%%
8i0ed operating e0penses e0!ept depre!iation ( 143,%%% *
/arnings "efore interest, ta0es, depre!iation,
and amortiHation (/B&T<5* $ 111,1%%
<epre!iation ( 41,1%% *
/arnings "efore interest and ta0es (/B&T* $ A%,%%%
&nterest ( 24,1%% *
/arnings "efore ta0es (/BT* $ 41,1%%
Ta0es (4%>* ( 19,2%% *
:et in!ome $ 2A,3%%
-atio Campsey &nd#stry 5erage
C#rrent ratio 2.%0
<ays sales o#tstanding 31.% days
&nentory t#rnoer 1.@0
Total assets t#rnoer 3.%0
:et profit margin 1.2>
-et#rn on assets (-=5* 3.@>
-et#rn on e)#ity (-=/* B.%>
<e"t ratio @%.%>
2-@ Complete the "alan!e sheet and sales information in the ta"le that follows for &s"erg &nd#stries
#sing the following finan!ial data7
<e"t ratio7 1%>
;#i!$ ratio7 %.9%0
Total assets t#rnoer7 1.10
<ays sales o#tstanding7 3@.% days
Gross profit margin on sales7 (Sales K Cost of goods sold*+Sales L 21>
&nentory t#rnoer ratio7 1.%0
Balan!e Sheet7
Cash 5!!o#nts paya"le
5!!o#nts re!eia"le 6ong-term de"t $ @%,%%%
&nentories Common sto!$
8i0ed assets -etained earnings $ BA,1%%
Total assets $3%%,%%% Total lia"ilities and e)#ity
Sales Cost of goods sold
2-A The 8innerty 8#rnit#re Company, a man#fa!t#rer and wholesaler of high-)#ality home
f#rnishings, has e0perien!ed low profita"ility in re!ent years. 5s a res#lt, the "oard of dire!tors
has repla!ed the president of the firm with a new president, /liHa"eth Brannigan, who has as$ed
yo# to ma$e an analysis of the firm's finan!ial position #sing the <#.ont !hart. The most re!ent
ind#stry aerage ratios and 8innerty's finan!ial statements are as follows7
&nd#stry 5erage -atios
C#rrent ratio 2.%0 8i0ed assets t#rnoer @.%0
<e"t ratio 3%.%> Total assets t#rnoer 3.%0
Times interest earned A.%0 .rofit margin on sales 3.%>
&nentory t#rnoer 9.10 -et#rn on total assets B.%>
<ays sales o#tstanding 24.% days -et#rn on !ommon e)#ity 12.B>
8innerty 8#rnit#re Company7 Balan!e Sheet as of <e!em"er 31 ($ million*
Cash $ 41 5!!o#nts paya"les $ 41
Far$eta"le se!#rities 33 :otes paya"le 41
:et re!eia"les @@ =ther !#rrent lia"ilities 21
&nentories 11B Total !#rrent lia"ilities $111
Total !#rrent assets $3%3 6ong-term de"t 24
Total lia"ilities $131
Gross fi0ed assets 221 Common sto!$ 114
6ess depre!iation (A9* -etained earnings 2%1
:et fi0ed assets $14A Total sto!$holders' e)#ity $311
Total assets $41% Total lia"ilities and e)#ity $41%
8innerty 8#rnit#re Company7 &n!ome Statement for Jear /nded <e!em"er 31
($ million*
:et sales $AB1.%
Cost of goods sold (@@% .%*
Gross profit $131.%
Selling e0penses ( A3.1*
<epre!iation e0pense ( 12 .%*
/arnings "efore interest and ta0es (/B&T* $ 4B.1
&nterest e0pense ( 4 .1*
/arnings "efore ta0es (/BT* $ 41.%
Ta0es (4%>* ( 19 .%*
:et in!ome $ 2A .%
a. Cal!#late those ratios that yo# thin$ wo#ld "e #sef#l in this analysis.
". Constr#!t a <#.ont e)#ation for 8innerty, and !ompare the !ompany's ratios to the ind#stry
aerage ratios.
!. <o the "alan!e sheet a!!o#nts or the in!ome statement fig#res seem to "e primarily
responsi"le for the low profit,
d. 2hi!h spe!ifi! a!!o#nts seem to "e most o#t of line !ompared with those of other firms in
the ind#stry,
e. &f 8innerty had a prono#n!ed seasonal sales pattern, or if it grew rapidly d#ring the year,
how might that affe!t the alidity of yo#r ratio analysis, Cow might yo# !orre!t for s#!h
potential pro"lems,
2-9 Cary Corporation's fore!asted finan!ial statements follow, along with ind#stry aerage ratios.
a. Cal!#late Cary's fore!asted ratios, !ompare them with the ind#stry aerage data, and
!omment "riefly on Cary's proIe!ted strengths and wea$nesses.
". 2hat do yo# thin$ wo#ld happen to Cary's ratios if the !ompany initiated !ost !#tting
meas#res that allowed it to hold lower leels of inentory and s#"stantially de!rease the !ost
of goods sold, :o !al!#lations are ne!essary. Thin$ a"o#t whi!h ratios wo#ld "e affe!ted "y
!hanges in these two a!!o#nts.
Cary Corporation7 8ore!asted Balan!e Sheet as of <e!em"er 31
Cash $ A2,%%% 5!!o#nts and notes paya"le $432,%%%
5!!o#nts re!eia"le 43B,%%% 5!!r#als 1A%,%%%
&nentories 9B4,%%% Total !#rrent assets $@%2,%%%
Total !#rrent assets $1,4%1,%%% 6ong-term de"t 4%4,2B%
6and and "#ilding 239,%%% Common sto!$ 1A1,%%%
Fa!hinery 132,%%% -etained earnings 214,A1%
=ther fi0ed assets @1,%%%
Total assets $1,93@,%%% Total lia"ilities and e)#ity $1,93@,%%%
Cary Corporation 8ore!asted &n!ome Statement
Sales $4,2B%,%%%
Cost of goods sold ( 3,19%,%%% *
Gross operating profit $ A1%,%%%
General administratie and selling e0penses ( 23@,32%*
<epre!iation ( 11B,%%%*
Fis!ellaneo#s ( 134,%%% *
/arnings "efore ta0es (/BT* $ 19%,@9%
Ta0es (4%>* ( A2,2A2 *
:et in!ome $ 1%9,4%9
:#m"er of shares o#tstanding 23,%%%
Per-Share Data
/.S $ 4.A1
Cash diidends per share $ %.B1
.+/ ratio 1.%0
Far$et pri!e (aerage* $23.1A
&nd#stry 8inan!ial -atios
;#i!$ ratio 1.%0
C#rrent ratio 2.A0
&nentory t#rnoer 1.90
<ays sales o#tstanding 32 days
8i0ed assets t#rnoer 13.%0
Total assets t#rnoer 2.@0
-et#rn on assets B.1>
-et#rn on e)#ity 19.2>
<e"t ratio 1%.%>
.rofit margin on sales 3.1>
.+/ ratio @.%0
Computer-Related Problem
Work the problem in this section only if you are using the computer problem spreadsheet.
2-B Ese the !omp#teriHed model in the 8ile C%2 to sole this pro"lem.
a. -efer to .ro"lem 2-9. S#ppose Cary Corporation is !onsidering installing a new !omp#ter
system that wo#ld proide tighter !ontrol of inentories, a!!o#nts re!eia"le, and a!!o#nts
paya"le. &f the new system is installed, the following data are proIe!ted (rather than the data
gien in .ro"lem 2-9* for the indi!ated "alan!e sheet and in!ome statement a!!o#nts7
5!!o#nts re!eia"le $ 3B1,%%%
&nentories $A%%,%%%
=ther fi0ed assets $11%,%%%
5!!o#nts and notes paya"le $2A1,%%%
5!!r#als $12%,%%%
Cost of goods sold $3,41%,%%%
5dministratie and selling e0penses $249,AA1
.+/ ratio @.%0
Cow do these !hanges affe!t the proIe!ted ratios and the !omparison with the ind#stry
aerages, (:ote that any !hanges to the in!ome statement will !hange the amo#nt of
retained earningsM therefore, the model is set #p to !al!#late fore!asted retained earnings as
retained earnings reported on the "alan!e sheet the preio#s year pl#s fore!asted net
in!ome min#s diidends paid. The model also adI#sts the !ash "alan!e so that the "alan!e
sheet "alan!es.*
". &f the new !omp#ter were een more effi!ient than Cary's management had estimated and
th#s !a#sed the !ost of goods sold to de!rease "y $121,%%% from the proIe!tions in part (a*,
what effe!t wo#ld it hae on the !ompany's finan!ial position,
!. &f the new !omp#ter were less effi!ient than Cary's management had estimated and !a#sed
the !ost of goods sold to in!rease "y $121,%%% from the proIe!tions in part (a*, what effe!t
wo#ld it hae on the !ompany's finan!ial position,
d. Change, one "y one, the other items in part (a* to see how ea!h !hange affe!ts the ratio
analysis. Then thin$ a"o#t and write a paragraph des!ri"ing how !omp#ter models s#!h as
this one !an "e #sed to help ma$e "etter de!isions a"o#t the p#r!hase of s#!h items as a
new !omp#ter system.