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Module 1

Q1-1.

Organizations undertake planning activities that shape three major


activities: financing, investing, and operating. Financing is the
means a company uses to pay for resources. Investing refers to
the buying and selling of resources necessary to carry out the
organizations plans. Operating activities are the actual carrying
out of these plans. Planning is the glue that connects these
activities, including the organizations ideas, goals and strategies.
Financial accounting information provides valuable input into the
planning process, and, subsequently, reports on the results of
plans so that corrective action can be taken, if necessary.

Q1-2.

An organizations financing activities (liabilities and equity =


sources of funds) pay for investing activities (assets = uses of
funds). An organizations assets cannot be more or less than its
liabilities and equity combined. This means: assets = liabilities +
equity. This relation is called the accounting equation (sometimes
called the balance sheet equation), and it applies to all
organizations at all times.

Q1-3.

The four main financial statements are: income statement, balance


sheet, statement of stockholders equity, and statement of cash
flows. The income statement provides information about the
companys revenues, expenses and profitability over a period of
time. The balance sheet lists the companys assets (what it owns),
liabilities (what it owes), and stockholders equity (the residual
claims of its owners) as of a point in time. The statement of
stockholders equity reports on the changes to each stockholders
equity account during the period. The statement of cash flows
identifies the sources (inflows) and uses (outflows) of cash, that
is, where the company got its cash from and what it did with it.
Together, the four statements provide a complete picture of the
financial condition of the company.

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Q1-4.

The balance sheet provides information that helps users


understand a companys resources (assets) and claims to those
resources (liabilities and stockholders equity) as of a given point
in time.

Q1-5.

The income statement covers a period of time. An income


statement reports whether the business has earned a net income
(also called profit or earnings) or incurred a net loss. Importantly,
the income statement lists the types and amounts of revenues and
expenses making up net income or net loss.

Q1-6.

The statement of cash flows reports on the cash inflows and


outflows relating to a companys operating, investing, and
financing activities over a period of time. The sum of these three
activities yields the net change in cash for the period. This
statement is a useful complement to the income statement, which
reports on revenues and expenses, but which conveys relatively
little information about cash flows.

Q1-7.

Retained earnings (reported on the balance sheet) is increased


each period by any net income earned during the period (as
reported in the income statement) and decreased each period by
the payment of dividends (as reported in the statement of cash
flows and the statement of stockholders equity). Transactions
reflected on the statement of cash flows link the previous periods
balance sheet to the current periods balance sheet. The ending
cash balance appears on both the balance sheet and the statement
of cash flows.

Q1-8.

External users and their uses of accounting information include:


(a) lenders for measuring the risk and return of loans; (b)
shareholders for assessing the return and risk in acquiring shares;
and (c) analysts for assessing investment potential. Other users
are auditors, consultants, officers, directors for overseeing
management, employees for judging employment opportunities,
regulators, unions, suppliers, and appraisers.

Q1-9.

Forecasting is a method of formally expressing our expectations


of a company's future payoffs. When forecasting company

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payoffs, we need to consider the effects of their business


environment on the company's ability to achieve those future
payoffs. Competitive forces as well as opportunities and threats
will impact what the company can pay in the future. This in turn
affects what payoffs are expected. A better understanding of
business environment and accounting information leads to more
accurate forecasts of the future and more reliable valuation
estimates.
Q1-10.A Procter & Gambles independent auditor is Deloitte & Touche LLP.
The auditor expressly states that our responsibility is to express
an opinion on these financial statements based on our audits.
The auditor also states that these financial statements are the
responsibility of the companys management. Thus, the auditor
does not assume responsibility for the financial statements.
Q1-11.B While firms acknowledge the increasing need for more complete
disclosure of financial and nonfinancial information, they have
resisted these demands to protect their competitive position.
Corporate executives must weigh the benefits they receive from
the financial markets as a result of more transparent and revealing
financial reporting against the costs of divulging proprietary
information to competitors and others.
Q1-12.B Generally Accepted Accounting Principles (GAAP) are the various
methods, rules, practices, and other procedures that have evolved
over time in response to the need to regulate the preparation of
financial statements. They are primarily set by the Financial
Accounting Standards Board (FASB), a private sector entity with
representatives from companies that issue financial statements,
accounting firms that audit those statements, and users of
financial information. Other bodies that contribute to GAAP are the
AICPA, the EITF, and the SEC.

Solutions Manual

Q1-13.B Corporate governance is the system of policies, procedures and


mechanisms that protect the interests of stakeholders in the
business. These stakeholders include investors, creditors,
regulatory bodies, and employees, to name a few. Sound
corporate governance involves the maintenance of an effective
internal auditing function, an independent and effective external
auditing function, an informed and impartial board of directors,
governmental oversight (such as from the SEC), and the oversight
of the courts.
Q1-14.B The auditors primary function is to express an opinion as to
whether the financial statements fairly present the financial
condition of the company and are free from material
misstatements. Auditors do not prepare the financial statements;
they only audit them and issue their opinion on them. The
auditors provide no guarantees about the financial statements or
about the companys continued performance.
Q1-15.

Financial accounting information is frequently used in order to


evaluate management performance. The return on equity (ROE)
and return on assets (ROA) provide useful measures of financial
performance as they combine elements from both the income
statement and the balance sheet. Financial accounting information
is also frequently used to monitor compliance with external
contract terms. Banks often set limits on such items as the
amount of total liabilities in relation to stockholders equity or the
amount of dividends that a company may pay. Audited financial
statements provide information that can be used to monitor
compliance with these limits (often called covenants). Regulators
and taxing authorities also utilize financial information to monitor
items of interest.

Q1-16.

Managers are vitally concerned about disclosing proprietary


information that might benefit the companys competitors. Of most
concern, is the cost of losing some competitive advantage.
There has traditionally been tension between companies and the
financial professionals (especially investment analysts) who press
firms for more and more financial and nonfinancial information.

Solutions Manual

Q1-17.

Net income is an important measure of financial performance. It


indicates that the market values the companys products or
services, that is, it is willing to pay a price for the products or
services enough to cover the costs to bring them to market and to
provide the companys investors with a profit. Net income does
not tell the whole story, however. A company can always increase
its net income with additional investment in something as simple
as a bank savings account. A more meaningful measure of
financial performance comes from measuring the level of net
income relative to the investment made. One investment measure
is the balance of stockholders equity, and the comparison of net
income to average stockholders equity (ROE) is a fundamental
measure of financial performance.

Q1-18.

Borrowed money must be repaid, both the principal amount


borrowed, as well as interest on the borrowed funds. These
payments have contractual due dates. If payments are not prompt,
creditors have powerful legal remedies, including forcing the
company into bankruptcy. Consequently, when comparing two
companies with the same return on equity, the one using less debt
would generally be viewed as a safer (less risky) investment.

Solutions Manual

M1-21
($ millions)

Hewlett-Packard
General Mills
Target

Assets

Liabilities

Equity

$124,503

$83,722

(a) $40,781

$18,674

(b) $12,062

$6,612

(c) $43,705

$28,218

$15,487

The percent of owner financing for each company follows:


Hewlett-Packard ..................... 32.8%

($40,781 million / $124,503 million)

General Mills ........................... 35.4%

($6,612 million / $18,674 million)

Target ...................................... 35.4%

($15,487 million / $43,705 million)

General Mills and Target are more owner financed, while Hewlett-Packard is
more nonowner financed, but all are financed with roughly the same level
of debt and equity. All three enjoy relatively stable cash flows and can,
therefore, utilize a greater proportion of debt vs. equity. As the uncertainty
of cash flows increases, companies generally substitute equity for debt in
order to reduce the magnitude of contractual payment obligations.

M1-24
a. BS and SCF

d. BS and SE

g. SCF and SE

b. IS

e. SCF

h. SCF and SE

c. BS

f. BS and SE

i. IS, SE, and SCF

Solutions Manual

E1-27
a. Target has a proprietary credit card (the Target Card). Customers
unpaid credit card balances at the end of the reporting period are similar
to accounts receivable.
b. Targets inventories consist of the product lines it carries: clothing,
electronics, home furnishings, food products, and so forth.
c. Targets PPE assets consist of land, buildings, store improvements
such as lighting, flooring, HVAC, store shelving, shopping carriages,
and cash registers.
d. Although Target sells some of its merchandise via its Website, the
majority of its sales activity is conducted in its retail locations. These
stores represent a substantial and necessary capital investment for its
business model.

Solutions Manual

P1-36
a.
General Mills, Inc.
Income Statement ($ millions)
For Year Ended May 29, 2011
Revenue ............................................................................... $14,880.2
Cost of goods sold ..............................................................
8,926.7
Gross profit ..........................................................................
5,953.5
Total expenses ....................................................................
4,155.2
Net income ........................................................................... $ 1,798.3

General Mills, Inc.


Balance Sheet ($ millions)
May 29, 2011
Cash ..................................
$ 619.6
Noncash assets ................
18,054.9
Total assets ......................
$18,674.5

Total liabilities ........................


$12,062.3
Stockholders equity .............. 6,612.2
Total liabilities and equity .....
$18,674.5

General Mills, Inc.


Statement of Cash Flows ($ millions)
For Year Ended May 29, 2011
Cash from operating activities
Cash from investing activities
Cash from financing activities
Net change in cash
Cash, beginning year
Cash, ending year

$ 1,526.8
(715.1)
(865.3)
(53.6)
673.2
$ 619.6

b. A negative amount for cash from investing activities reflects further


investment by the company in its long-term assets, which is generally a
positive sign of managements commitment to future business success.
A negative amount for cash from financing activities reflects the
reduction of long-term debt, which is often a positive sign of the
companys ability to retire debt obligations.

Solutions Manual

P1-47A

a. The auditors address their report to the companys board of directors


and the shareholders of Apple Inc. This is an important point. Auditors
work for the benefit of the shareholders and report directly to the board
of directors, the elected representatives of the shareholders whose job it
is to protect shareholder interests. It would not be appropriate for the
external auditors to report directly to management because the auditors
are examining managements activities as described in the companys
financial statements. Reporting to the board preserves the auditors
independence.
b. The audit process consists of two components. First the auditors
assess the companys system of internal controls to ensure the
information in the financial statements was gathered, recorded,
aggregated in accordance with GAAP. This involves an assessment of
the companys accounting policies together with the assumptions used
and estimates made in the preparation of the financial statements.
Second, the auditors examine, on a test basis, evidence supporting the
amounts and disclosures in the statements. The key word is test.
Auditors do not examine each transaction. They take a sample from the
transactions. If that sample does not uncover any irregularities, they go
no further. If it does, they expand the sample until they are confident
that the amounts presented in the statements fairly present the
companys performance and condition in accordance with GAAP.
c. The nature of the independent auditors opinion is that the financial
statements present fairly, in all material respects, the financial
condition of the company. Because this is standard audit-report
language, any deviations should raise a flag. Present fairly does not
mean absolute assurance that the financials are error-free. It means that
a reasonable person would conclude that the financial statements
reasonably describe the financial condition of the company.
d. KPMG also rendered an opinion on the companys system of internal
controls. Internal controls are designed to insure the integrity of the
financial reporting system and the preservation of the companys
assets. A well-functioning internal control system is a critical
component of the companys overall corporate governance system.

Solutions Manual

D1-53
Financing can come from a number of sources, including operating
creditors, borrowed funds, and the sale of stock. Each has its strengths
and weaknesses.
1. Operating creditors operating creditors are merchandise and service
suppliers, including employees. Generally, these liabilities are noninterest bearing. As a result, companies typically use this source of
credit to the fullest extent possible, often stretching payment times.
However, abuse of operating creditors has a significant downside. The
company may be unable to supply its operating needs and the damage
to employee morale might have significant repercussions. Operating
credit must, therefore, be used with care.
2. Borrowed funds borrowed money typically carries an interest rate.
Because interest expense is deductible for tax purposes, borrowed
funds reduce income tax expense. The taxes saved are called the tax
shield. The deductibility of interest reduces the effective cost of
borrowing. The downside of debt is that the company must make
principal and interest payments as scheduled. Failure to make payments
on time can result in severe consequences creditors have significant
legal remedies, including forcing the company into bankruptcy and
requiring its liquidation. The lower cost of debt must be balanced
against the fixed payment obligations.
3. Sale of stock companies can sell various classes of stock to investors.
Some classes of stock have mandatory dividend payments. On other
classes of stock, dividends are not a legal requirement until declared by
the board of directors. Consequently, unlike debt payments, some
dividends can be curtailed in business downturns. The downside of
stock issuance is its cost. Because equity is the most expensive source
of capital, companies use it sparingly.

Solutions Manual

Module 2
Q2-1.

An asset represents resources a company owns or controls.


Assets are expected to provide future economic benefits. Assets
arise from past events or transactions. A liability is an obligation
that will require a future economic sacrifice. Equity is the
difference between assets and liabilities. It represents the claims
of the companys owners to its income and assets. The following
are some examples of each:
Assets

Cash
Receivables
Inventories
Plant, property and equipment (PPE)

Liabilities

Accounts payable
Accrued liabilities
Deferred revenue
Notes payable
Long-term debt

Equity

Contributed capital (common and preferred stock)


Additional paid-in capital
Retained earnings
Accumulated other comprehensive income
Treasury stock

Q2-2.

A cost that creates an immediate benefit is reported on the income


statement as an expense. A cost that creates a future benefit is
added to the balance sheet as an asset (capitalized) and will be
transferred to the income statement as the benefit is realized. For
example, PPE creates a future benefit and the cost of the PPE is
transferred to the income statement (as depreciation expense)
over the life of the PPE.

Q2-3.

Accrual accounting means that we record revenues when earned,


and record expenses when they are incurred. Accrual accounting
does not rely on cash flows in determining when items are

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revenues or expenses. This is why net income (a GAAP measure)


differs from cash from operations.
Q2-4.

Transitory items are revenues and expenses that are not expected
to recur. One objective of financial analysis is to predict future
performance. Given that perspective, transitory (nonrecurring)
items are not relevant except to the extent that they convey
information about future financial performance.

Q2-5.

The statement of stockholders equity provides information about


the events that impact stockholders equity during the period. It
contains information relating to net income, stock sales and
repurchases, option exercises, dividends and other accumulated
comprehensive income.

Q2-6.

The statement of cash flows reports the companys cash inflows


and outflows during the period, and categorizes them according to
operating, investing and financing activities. The income
statement reports profit earned under accrual accounting, but
does not provide sufficient information concerning cash flows.
The statement of cash flows fills that void.

Q2-7.

Articulation refers to the fact that the four financial statements are
linked to each other and that changes in one statement affect the
other three. For example, net income reported on the income
statement is linked to the statement of retained earnings, which in
turn is linked to the balance sheet. Understanding how the
financial statements articulate helps us to analyze transactions
and events and to understand how events affect each financial
statement separately and all four together.

Q2-8.

When a company purchases a machine it records the cost as an


asset because it will provide future benefits. As the machine is
used up, a portion of this cost is transferred from the balance
sheet to the income statement as depreciation expense. The
machine asset is, thus, reduced by the depreciation, and equity is
reduced as the expense reduces net income and retained
earnings. If the entire cost of the machine was immediately
expensed, profit would be reduced considerably in the year the
machine was purchased. Then, in subsequent years, net income
would be far too high as none of the machines cost would be

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reported in those years even though the machine produced


revenues during that period.
Q2-9.

An asset must be owned or controlled, it must provide future


economic benefits, and it must arise from a past transaction or
event. Owning means having title to the asset (some leased assets
are also recorded on the balance sheet as we will discuss in our
Module 10 entitled, Reporting and Analyzing Off-Balance-Sheet
Financing). Future benefits may mean the future inflows of cash,
or an increase in another asset, or reduction of a liability. Past
event means the company has purchased the asset or acquired it
in some other cash or noncash transaction or event.

Q2-10.

Liquidity refers to the ready availability of cash. That is, how much
cash the company has on hand, how much cash is being
generated, and how much cash can be raised quickly. Liquidity is
essential to the survival of the business. After all, firms must pay
loans and employee wages with cash.

Q2-11.

Current means that the asset will be liquidated (converted to cash)


within the next year (or the operating cycle if longer than one
year).

Q2-12.

GAAP uses historical costs because they are less subjective than
market values. Market values can be biased for two reasons: first,
we may not be able to measure them accurately (consider our
inability to accurately measure the market value of a
manufacturing facility, for example), and second, managers may
intervene in the reporting process to intentionally bias the results
to achieve a particular objective (like enhancing the stock price).

Q2-13.

Generally, excluded intangible (unrecorded) assets are those that


contribute to a companys sustainable competitive advantage, but
that cannot be measured accurately. Some examples include the
value of a brand, the management of a company, employee
morale, a strong supply chain, superior store locations, credibility
with the financial markets, reputation, and so forth.

Solutions Manual

Q2-14.

An intangible asset is an asset that is not physical in nature. To be


included on the balance sheet, it has to meet two tests: the
company must own or control the asset, it must provide future
economic benefits, and the asset must arise from a past event or
transaction. Some examples are goodwill, patents and trademarks,
contractual agreements like royalties, leases, and franchise
agreements. An intangible asset is only recorded on the balance
sheet when it is purchased from an outside party. For example,
goodwill arises when the company acquires (either with cash or
stock) another companys brand name or any of the other
intangibles listed above.

Q2-15.

An accrued liability is an obligation for expenses that have been


incurred but not yet paid for with cash. Examples include wages
that have been earned by employees and not yet paid, interest
owing on a bank loan, and potential future warranty claims for
products sold to customers. When the liability is recognized on
the balance sheet, a corresponding expense is recognized in the
income statement.

Q2-16.

Net working capital = current assets current liabilities. Increasing


the amount of trade credit (e.g., accounts payable to suppliers)
increases current liabilities and reduces net working capital. Trade
credit is like borrowing from a supplier to make purchases. As
trade credit increases, the supplier is lending more money than
before. This frees up cash, which the company can use for other
purposes such as paying down interest-bearing debt or
purchasing additional productive assets. Thus, net working capital
decreases. This can be a good thing. As a business grows, its net
working capital grows because inventories and receivables
generally grow faster than accounts payable and accrued liabilities
do. Net working capital must be financed just like long-term
assets.

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Q2-17. Book value is the amount at which an asset (or liability) is


carried on the balance sheet. The book value of the company is
the book value of all the assets less the book value of all the
liabilities, that is, the book value of stockholders equity. Book
values are determined in accordance with GAAP. Market value is
the sale price of an asset or liability. Markets are not constrained
by GAAP standards and, therefore, can consider a number of
factors that accountants cannot. Market values, therefore,
generally differ significantly from book values.
Q2-18.

The arrow running from net income to earned capital in the


financial statement effects template denotes that retained earnings
(part of earned capital) have been updated for the profit earned
during the period. Retained earnings are reconciled as follows:
beginning retained earnings + profit ( loss) dividends = ending
retained earnings. The line, thus, represents the profits that have
been added (or the losses subtracted) to retained earnings
(dividends are recorded as a direct reduction of retained earnings
in the template).

M2-20
a. Balance sheet
b. Income statement
c. Balance sheet
d. Income statement
e. Balance sheet
f. Balance sheet
g. Balance sheet
h. Balance sheet
i. Income statement
j. Income statement
k. Balance sheet
l. Balance sheet

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M2-23
2011
Beginning retained earnings ..............................$89,089
Add: Net income (loss) ..................................... (19,455)
Less: Dividends ...................................................
0
Ending retained earnings ....................................$69,634

2012
$ 69,634
48,192
(15,060)
$102,766

E2-27
Barth Company
Income Statement
For Year Ended December 31, 2011
Sales revenue .................................................................
Expenses
Cost of goods sold .....................................................
$180,000
Wages expense .......................................................... 40,000
Supplies expense ....................................................... 6,000
Total expenses ...........................................................
Net income......................................................................

$400,000

226,000
$174,000

Barth Company
Balance Sheet
December 31, 2011
Assets
Liabilities and equity
Cash ....................................$ 48,000 Accounts payable ........................................................
$ 16,000
Accounts receivable .......... 30,000 Bonds payable .............................................................
200,000
Supplies inventory ............. 3,000 Total liabilities ..............................................................
216,000
Inventory ............................. 36,000
Land .................................... 80,000 Common stock .............................................................
150,000
Equipment .......................... 70,000 Retained earnings .......................................................
60,000
Buildings.............................151,000 Total equity...................................................................
210,000
Goodwill .............................. 8,000
Total assets ........................
$426,000 Total liabilities and equity ...........................................
$426,000

Solutions Manual

P2-39
a.
Balance Sheet

Income Statement

LiabilTransaction
Beginning bal.

Cash
Asset
0

Noncash
Assets

ities

+150,000
1. Sefcik invested $50,000
into the business in
exchange for common
stock; company also
borrowed $100,000
from a bank

2. Sefcik purchased
equipment for $95,000
cash and purchased
inventory of $40,000 on
credit

Cash

-95,000

+95,000

Cash

PPE

+100,000

+50,000

Note

Common

Payable

Stock

=
+40,000
+40,000
Accounts
Inventory
Payable

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Earned
Contrib.
Capital

Capital
0

Net
Revenues

Expenses

=
Income

P2-39 (continued)

Balance Sheet

Income Statement

LiabilTransaction

Cash
Asset

Noncash
Assets

Earned

=
ities

Contrib.
Capital

Capital

+50,000

Net
Revenues

Expenses

=
Income

+50,000
+50,000

Cash

Sales

+50,000

Retained
3. Sefcik Co.
sold
inventory
costing
$30,000
for
$50,000
cash

Earnings
=

-30,000

-30,000

Inventory

Retained

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=
-30,000

Cost of
Goods
Sold

Earnings

4. Sefcik Co.
paid
-10,000
$10,000
cash for
Cash
wages
owed
employees
for
October
work
5. Sefcik Co.
paid
-1,000
interest on
the bank
Cash
loan of
$1,000
cash

+30,000

-10,000

+10,000
-10,000

Retained

Wage

Earnings

Expense

-1,000

+1,000

-1,000
=

Retained
Earnings

Interest
Expense

P2-39 (continued)
Balance Sheet

Income Statement

LiabilTransaction

Cash
Asset

Earned

=
ities

Contrib.
Capital

Capital

Net
Revenues

-500

6. Sefcik Co.
recorded $500
depreciation
expense
related to
equipment
7. Sefcik Co.
paid
a dividend of
$2,000 cash

Noncash
Assets

Expenses

=
Income

+500

-500
=

Retained

Deprec.

-500

PPE
Earnings
-2,000

Exp

-2,000
=

Cash

Ending balance 92,000

Dividends
104,500

= 140,000

50,000

6,500

50,000

41,500

8,500

b.

b.
Sefcik Co.
Income Statement
For Month of October
Sales revenue .........................................................................................
$50,000
Total expenses .......................................................................................
41,500
Net income..............................................................................................
$ 8,500
Sefcik Co.
Retained Earnings Reconciliation
For Month of October
Retained earnings, October 1 .............................................................
$
0
Add: Net income ................................................................................ 8,500
Less: Dividends ..................................................................................(2,000)
Retained earnings, October 31 ...........................................................
$ 6,500

Sefcik Co.
Balance Sheet
October 31
Cash ....................................
$ 92,000 Liabilities .......................................................................
$140,000
Noncash assets..................
104,500
Contributed capital .......................................................
50,000
Retained earnings .........................................................
6,500
________ Total equity ....................................................................
56,500
Total assets ........................
$196,500 Total liabilities and equity ............................................
$196,500
Solutions Manual

P2-43
a. Depreciation is added back to undo the effect it had on the income
statement. Wal-Mart deducted $7,641 million of depreciation (and
amortization) expense in computing net income. Depreciation is a
noncash expense so Wal-Mart did not actually use $7,641 million of cash
to pay depreciation expense. Thus, to determine how much cash was
generated, net income is too low by the depreciation amount of $7,641
million. The depreciation add-back is NOT a source of cash as some
mistakenly believe. Cash is, ultimately, generated by profitable
operations, not by depreciation.
b. Revenue is recognized, and profit increased, when it is earned, whether
or not cash is received. Sales on account, therefore, increase profit, and
the deduction for the increase in receivables reflects the fact that cash
has not yet been received.
The negative sign on the increase in inventories reflects the outflow of
cash when inventories are purchased. Inventories are typically
purchased on account. As a result, payment is not made when the
inventories are purchased. The positive sign on the increase in
accounts payable offsets a portion of the negative sign on the inventory
increase, and the net amount represents the net cash paid for the
increase in inventories. Accounts payable are typically non-interest
bearing, thus providing a cheap and important source of cash.
Accruals relate to expenses that have been recognized in the income
statement that have not yet been paid. A decrease in accrued liabilities
means that cash paid out for expenses during the year was greater than
the expenses recognized in the income statement.
Therefore, a
decrease in accrued expenses is shown as a cash outflow.
c. Companies must continue to invest in their infrastructure, both for new
additions and replacement, to remain competitive. Depreciation expense
represents the using up of depreciable assets. In general, we should
expect capital expenditures (CAPEX) to exceed depreciation expense.
This indicates that the company is growing its infrastructure as well as
replacing the portion that is wearing out.

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P2-43 (concluded)
d. If Wal-Mart can make a better return on reinvesting its cash back into the
business than the return shareholders can earn for themselves on the
cash they would receive, Wal-Mart should forgo paying dividends or
repurchasing shares. Many companies with large cash inflows,
especially mature companies in relatively saturated markets, find it hard
to uncover additional investment opportunities. In those cases,
returning the cash to investors is better than investing it in marketable
securities, because investors can do that for themselves.
e. Wal-Mart is a large, mature, and profitable company. In fiscal 2011, the
company generated 39% more operating cash flows than reported
profits; $23.6 billion of operating cash flow compared to $17.0 billion in
net income. It funds capital expenditures for new stores and remodels
with operating cash flows with no need for external financing. In the
financing area, the company is borrowing to repurchase stock and to
pay dividends, a substitution of lower-cost debt for higher-cost equity.
This is a typical profile for a large, well-capitalized company like WalMart. In sum, Wal-Mart is exceptionally strong, and the company will
likely continue investing in its infrastructure.

Solutions Manual

Module 3
Q3-1.

Return on investment measures profitability in relation to the


amount of investment that has been made in the business. A
company can always increase dollar profit by increasing the
amount of investment (assuming it is a profitable investment). So,
dollar profits are not necessarily a meaningful way to look at
financial performance. Using return on investment in our analysis,
whether as investors or business managers, requires us to focus
not only on the income statement, but also on the balance sheet.

Q3-2.A

Increasing leverage increases ROE as long as the assets earn a


greater operating return than the cost of the additional debt.
Financial leverage is also related to risk: the risk of potential
bankruptcy and the risk of increased variability of profits.
Companies must, therefore, balance the positive effects of
financial leverage against their potential negative consequences. It
is for this reason that we do not witness companies entirely
financed with debt.

Q3-3.

Gross profit margins can decline because 1) the industry has


become more competitive, and/or the firms products have lost
their competitive advantage so that the company has reduced
selling prices or is selling fewer units or 2) product costs have
increased, or 3) the sales mix has changed from highermargin/slowly turning products to lower-margin/higher turning
products. Declining gross profit margins are usually viewed
negatively. On the other hand, cost increases that reflect broader
economic events or certain strategic product mix changes might
not be viewed as negatively.

Q3-4.

Reducing advertising or R&D expenditures can increase current


operating profit at the expense of the long-term competitive
position of the firm. Expenditures on advertising or R&D often
create long-term economic benefits.

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Q3-5.

Asset turnover measures the amount of revenue compared with


the investment in an asset. Generally speaking, we want turnover
to be higher rather than lower. Turnover measures productivity
and an important company objective is to make assets as
productive as possible. Because turnover is one of the
components of ROE (via RNOA), increasing turnover increases
shareholder value. Turnover is, therefore, viewed as a value driver.

Q3-6.

ROE>RNOA implies a positive return on nonoperating activities.


This results from borrowed funds being invested in operating
assets whose return (RNOA) exceeds the cost of borrowing. In this
case, borrowing money increases ROE.

Q3-7.A

Once a business segment has been sold or designated for sale, it


is classified as a discontinued operation. Consequently, sales and
expenses related to the business segment are reported separately,
Thus, the income statement reports income from continuing
operations, discontinued operations, and net income (which
includes both continuing and discontinued operations). On the
balance sheet, the business segments assets and liabilities are
similarly segregated. Because the business segment was or will
be sold, it no longer contributes to the operating activities of the
company. One of the primary uses of financial information is to
project future financial results so that investors and others can
properly price the companys securities and evaluate strategic
plans. The discontinued operations will not affect future results
(other than via investment of the proceeds from the sale), and,
therefore, should not be considered as a component of operating
activities.

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Q3-9.

The net in net operating assets, means operating assets net of


operating liabilities. This netting recognizes that a portion of the
costs of operating assets is funded by third parties. For example,
payables and accrued expenses help fund inventories, wages,
utilities, and other operating costs. Similarly, long-term operating
liabilities also help fund the cost of long-term operating assets.
Thus, these long-term operating liabilities are deducted from longterm operating assets.

Q3-10.

Companies must manage both the income statement and the


balance sheet in order to maximize RNOA. This is important, as
too often managers look only to the income statement and do not
fully appreciate the value added by effective balance sheet
management. The disaggregation of RNOA into its profit and
turnover components focuses analysis on both of these areas.

Q3-11.

There are an infinite number of possible combinations of profit


margin and asset turnover that will yield a given level of RNOA.
The relative weighting of profit margin and asset turnover is driven
in large part by the companys business model. As a result, since
companies in an industry tend to adopt similar business models,
industries will generally trend toward points along the
margin/turnover continuum.

Q3-12.

Liquidity refers to cash: how much cash a company has, how


much cash is coming in the door, and how much cash can be
raised quickly. Companies must generate cash in order to pay
their debts, pay their employees, and provide their shareholders a
return on investment. Cash is, therefore, critical to a companys
survival.

Solutions Manual

M3-20B
($ millions)
a. ROE
= Net income / Average equity
= $847 / [($5,530 + $4,653)/2]
= 16.64%
b. PM
AT

= Net income / Sales = $847 / $25,003 = 3.39%


= Sales / Average assets = $25,003 / [($20,631 + $21,300)/2]
= 1.19

FL

= Average assets / Average equity


= [($20,631 + $21,300)/2] / [($5,530 + $4,653)/2]
= 4.12

ROA

PM AT FL = 3.39% 1.19 4.12 = 16.62%


(0.02% rounding difference)

P3-36
($ millions)
a. 2010 NOPAT = $5,918 - [$1,592 + ($163 0.37)] = $4,266
b. 2010 NOA =
($30,156 - $3,377 - $1,101- $540 - $146) - ($6,089 - $1,269) - $2,013 - $1,854
= $16,305
2009 NOA
= ($27,250 - $3,040 - $744 - $825 - $103) - ($4,897 - $613) - $2,227 - $1,727
= $14,300
c. 2010 RNOA = $4,266 / [($16,305 + $14,300) / 2] = 27.88%

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2010 NOPM = $4,266 / $26,662 = 16.00%


2010 NOAT = $26,662 / [($16,305 + $14,300) / 2] = 1.74
2010 RNOA = 16.00% 1.74 = 27.84% (0.0004 rounding error)
e. 2010 ROE = $4,085 / [($15,663 + $12,764) / 2] = 28.74%
f. 2010 nonoperating return = ROE RNOA = 28.74% - 27.88% = 0.86%
g. ROE>RNOA implies that 3M is able to borrow money to fund operating
assets that yield a return greater than the cost of the debt. The excess
accrues to the benefit of 3Ms stockholders.

P3-39
($ millions)

a. 2011 NOPAT = ($2,114 + $2) - [$714 + ($87 - $51) 0.37)] = $1,389


b. 2011 NOA

= $17,849 - $1,103 - $22 - ($8,663 - $557 - $441) - $1,183


= $7,876

2010 NOA

= $18,302 - $1,826 - $90 - ($8,978 - $663 - $35) - $1,256


= $6,850

c. 2011 RNOA = $1,389 / [($7,876 + $6,850) / 2] = 18.86%


2011 NOPM = $1,389 / $50,272 = 2.76%
2011 NOAT = $50,272 / [($7,876 + $6,850) / 2] = 6.83
2011 RNOA = 2.76% 6.83 = 18.85% (.0001 rounding error)
BBYs RNOA of 18.86% is significantly higher than the industry median
of about 11%. It is driven primarily by the very high turnover of net
operating assets of 6.83, well in excess of the industry median of 3.27.
BBYs NOPM is slightly below the median of 3.32%. BBYs high
performance is driven by its exceptional management of its balance
sheet.

Solutions Manual

P3-39 (concluded)
e. 2011 ROE = $1,277 / [($6,602 + $6,320) / 2] = 19.76%
f. 2011 nonoperating return = ROE RNOA = 19.76% - 18.86% = 0.90%
g.

ROE > RNOA implies that Best Buy is able to borrow money to
fund operating assets that yield a return greater than the cost of
its debt. The excess accrues to the benefit of BBYs stockholders.

D3-55
a. Raising prices and/or reducing manufacturing costs are not necessarily
independent solutions, and are likely related to other factors. The effect
of a price increase on gross profit is a function of the demand curve for
the companys product. If the demand curve is relatively elastic,
customers are sensitive to price hikes. Thus, a price increase could
significantly reduce demand, thereby decreasing, rather than increasing,
gross profit (an example is a 10% increase in price and a 20% decrease
in demand). A price increase will have a more desired effect if the
demand curve is relatively inelastic (an example is a 10% price increase
with a 3% decrease in demand).
Cutting manufacturing costs will increase gross profit (via reduction of
COGS) if the more inexpensively made product is not perceived to be of
lesser quality, thereby reducing demand.
b. Raising prices is difficult in competitive markets. As the number of
product substitutes increases, companies are less able to raise prices.
Rather, they must be able to effectively differentiate their products in
some manner in order to reduce consumers substitution. This can be
accomplished, for example, by product design and/or advertising. These
efforts, however, likely entail additional cost, and, while gross profit
might be increased as a result, SG&A expense may also increase with
little effect on the bottom line.
Manufacturing costs consist of raw materials, labor and overhead. Each
can be targeted for cost reduction. A reduction of raw materials costs
generally implies some reduction in product quality, but not necessarily.
It might be the case that the product contains features that are not in
demand by consumers. Eliminating those features will reduce product
costs with little effect on selling price.
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Similarly, companies can utilize less expensive sources of labor (offshore production, for example), that can significantly reduce product
costs and increase gross profit, provided that product quality is
maintained.
Finally, manufacturing overhead can be reduced by more efficient
production. Wages and depreciation expense are two significant
components of manufacturing overhead. These are largely fixed costs,
and the per unit product cost can often be reduced by increasing
capacity utilization of manufacturing facilities (provided, of course, that
the increased inventory produced can be sold).
The bottom line is that increasing gross profit is a difficult process that
can only be accomplished by effective management and innovation.

D3-56
a. Working capital management is an important component of the
management of a company. By reducing the level of working capital,
companies reduce the costs of carrying excess assets. This can have a
significantly positive effect on financial performance. Common ways to
decrease receivables and inventories, and increase payables, include
the following:
Reduce receivables

Constricting the payment terms on product sales


Better credit policies that limit credit to high-risk customers
Better reporting to identify delinquencies
Automated notices to delinquent accounts
Increased collection efforts
Prepayment of orders or billing as milestones are reached
Use of electronic (ACH) payment
Use of third-party guarantors, including bank letters of credit

Reduce inventories

Reduce inventory costs via less costly components (of equal quality), produce
with lower wage rates, eliminate product features (costs) not valued by
customers
Outsource production to reduce product cost and/or inventories the company
must carry on its balance sheet
Reduce raw materials inventories via just-in-time deliveries

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Eliminate bottlenecks in manufacturing to reduce work-in-process inventories


Reduce finished goods inventories by producing to order rather than
producing to estimated demand

Increase payables

Extend the time for payment of low or no-cost payablesso long as the
relationship with suppliers is not harmed

b. Payment terms to customers are a marketing tool, similar to product


price and advertising programs. Many companies promote payment
terms separately from other promotions (no payment for six months or
interest-free financing, for example). As companies restrict credit terms,
the level of receivables will likely decrease, thereby reducing working
capital. The restriction of credit terms may also have the undesirable
effect of reducing demand for the companys products. The cost of
credit terms must be weighed against the benefits, and credit terms
must be managed with care so as to optimize costs rather than minimize
them. Credit policy is as much art as it is science.
Likewise, the depth and breadth of the inventories that companies carry
impact customer perception. At the extreme, inventory stock-outs result
in not only the loss of current sales, but also the potential loss of future
sales as customers are introduced to competitors and may develop an
impression of the company as thinly stocked. Inventories are costly to
maintain, as they must be financed, insured, stocked, moved, and so
forth. Reduction in inventory levels can reduce these costs. On the other
hand, the amount and type of inventories carried is a marketing decision
and must be managed with care so as to optimize the level inventories,
not necessarily to minimize them.
One companys account payable is anothers account receivable. So,
just as one company seeks to extend the time of payment to reduce its
working capital, so does the other company seek to reduce the average
collection period to accomplish the same objective. Capable,
dependable suppliers are a valuable resource for the company, and the
supplier relation must be handled with care. All companies take as long
to pay their accounts payable as the supplier allows in its credit terms.
Extending the payment terms beyond that point begins to negatively
impact the supplier relation, ultimately resulting in the loss of the
supplier. The supplier relation must be managed with care so as to

Solutions Manual

optimize the terms of payment, rather than necessarily to minimize


them.
D3-57
a. The parties affected by schemes to manage earnings is often much
broader than first thought. It includes the following affected parties:
1. employees above and below the level at which the scheme is
implemented
2. stockholders and elected members of the board of directors
3. creditors of the company (suppliers and lenders) and their
employees, stockholders, and board of directors
4. competitors of the company
5. the companys independent auditors
6. regulators and taxing authorities
b. Managers often believe that earnings management activities will be
short-lived, and will be curtailed once its operations turn around.
Often, this does not prove to be the case. Interviews with managers and
employees who have engaged in this activity often reveal that they
started rather innocuously (just managing earnings to make the
numbers in one quarter), but, quickly, earnings management became a
slippery slope. Ultimately, the parties the company was trying to protect
(shareholders, for example) are hurt more than they would have been
had the company reported its results correctly, exposing problems early
so that corrective action could be taken (possibly by removing
managers) to protect the broader stakeholders in the company.
c. Company managers are just ordinary people. They desire to improve
their compensation, which is often linked to financial performance.
Managers may act to maximize their current compensation at the
expense of long-term growth in shareholder value. The reduction in the
average employment period at all levels of the company has
exacerbated the problem.
d. Unfortunately, the separation of ownership and control often leads to
less informed shareholders who are unable to effectively monitor the
actions of the managers they have hired. To the extent that
compensation programs are linked to financial measures, managers can
use the flexibility given to them under GAAP to their benefit, even
without violating GAAP per se. These actions can only be uncovered by
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effective auditing and enforced by an effective audit committee of the


board. Corporate governance has grown considerably in importance
following the accounting scandals of the early 2000s. The SarbanesOxley Act mandates new levels of corporate governance. The stock
market and the courts are helping to enforce this mandate.

Solutions Manual

Module 4
Q4-1.

Lenders distinguish between cyclical cash needs and cash needed


to fund operating losses because the second type of cash is
riskier. It is typical for firms such as retailers to experience
cyclical cash flows during the year as they gear up for busy
season (October December for many retailers). This happens in
the ordinary course of business. In contrast, operating losses are
not routine and can signal ongoing liquidity problems, or at worst,
bankruptcy.

Q4-2.

Younger firms typically face high start-up costs: economies of


scale dictate large costs at the outset of business. Moreover, the
set of positive net present value projects for young firms is
typically greater and more diverse than that of a mature company.
Mature companies exhibit more stable outlays of cash for both
ongoing projects and capital outlays to replace deteriorating or
obsolescent fixed assets.
With regards to financing activities, firms may use cash
borrowings to repay other maturing debt securities, pay dividends
or repurchase stock.

Q4-3.

A number of parties supply credit; they include the following:


i. Suppliers extend non-interest-bearing trade credit to regular
customers.
ii. Financial institutions, such as banks, extend many forms of
credit to industrial firms, including lines of credit, letters of
credit, revolving credit, term loans and mortgages.
iii. Private financing can be obtained from nonbank entities such
as venture capitalists who may be more willing to take on
riskier loans because they have contextual expertise or deeper
industry knowledge.

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iv. Lease financing is another form of borrowing, wherein firms


may reap the benefits of fixed assets without an initial cash
outlay to purchase the equipment outright.
v. Publicly traded debt markets provide a cost-efficient manner to
raise capital over the short term with commercial paper, or the
long term with bond issuances.
Q4-4.

Lines of credit are made available to a borrowing company over a


period of time as a form of backup financing. In this arrangement,
banks charge interest on both the used and unused portions of the
credit line. Letters of credit effectively replace the borrowing
companies credit ratings with the banks credit rating and
guarantee the return of borrowed funds.
While letters of credit are typically used in international
transactions to reduce credit risk, lines of credit are more typically
used as a source of financing to avoid default in the short run for
domestic obligations.

Q4-5.

Banks provide numerous sources of credit to companies; they


include the following:
i. Revolving credit lines offer a flexible credit source by allowing
the borrower to take money as needed and replace it as able.
Usually, these terms are tied to floating interest rates in order to
reduce the interest-rate risk of the bank.
ii. Lines of credit are similar to revolving credit. They are typically
negotiated with a bank or consortium of banks to provide shortrun liquidity. However, the amount of funding is stipulated and
interest is charged on both the used and unused portions of the
credit line.
iii. Letters of credit are used to substitute the credit rating of a
company with the banks credit rating, effectively making the
bank the mediator between two parties of a transaction that
guarantees the return of funds and assuages the risk of default.

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iv. Perhaps the most prevalent source of bank funding is term


loans. These often involve a principal amount as well as a
stipulated interest rate to be charged for borrowing the money.
v. Banks may extend mortgages or real property to companies for
agreed-upon interest payments. The mortgage holder becomes
the entitled owner and may foreclose on the mortgage in the
case of default, lowering the credit risk.

Q4-6.

Credit risk encapsulates the chance of loss resulting from a


creditors default (either interest or principal).
Assessing credit risk via a credit analysis allows suppliers of
credit to determine 1) whether they wish to extend credit to a
particular entity, and if so, 2) what the credit terms should be (e.g.
interest rate, covenants, and other contractual restrictions). For
example, a lender would be more likely to impose greater
restrictions and a higher rate of interest for entities that posed a
larger credit risk than those with lower credit risk ratings. The
junk bonds of the 80s yielded high returns for the very reason
these loans posed high credit risks.

Q4-7.

The four steps in assessing the chance of default are:


i. Assess the nature and purpose of the loan. Is the loan needed?
What was the purpose of the loan needed?
ii. Assess the macroeconomic environment and industry
conditions.
Is
the
industry
competitive?
Are
its
consumers/suppliers powerful? How does the condition of the
global economy impact this business? Is the market perfectly
competitive with many substitutes?
iii. Perform financial analysis being sure to adjust financial
statements for more accurate ratios and forecasts of a
companys ability to timely meet payments. This includes
analyzing the firms short-term liquidity, long-term solvency,
and interest coverage ratios.

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iv. Perform prospective analysis. This analysis considers that the


companys current financial position and ratios may not predict
the future. And it is future ability to generate cash and repay
obligations that determines chance of default.
Q4-8.

Credit analysis attempts to discern whether a company will be able


to pay back its obligations. Because various methods exist for
companies to obtain off-balance-sheet financing, it is imperative
to adjust the financials for any obligations not listed on the
balance sheet because these are real economic obligations that
must be honored and may have senior claim in certain situations.
Operating leases are an example of a financing vehicle with
stipulated payment terms. Understanding the implications of
operating leases may not be possible from a cursory glance at the
financial statements.

Q4-9.

Liquidity refers to cash availability: how much cash the company


has and how quickly it can generate more on short notice.
Solvency refers to a companys ability to meet its financial
obligations over the short and long run.
Both measures provide perspective on companies credit risks
and thus measure the likelihood of default or potential bankruptcy.
Coverage analysis differs from typical measures of liquidity and
solvency because it uses flow variables (from the income
statement and cash flow statement) to calculate how likely it is
that the company will be able to make principal and interest
payments.

Q4-10.

Two factors impact credit risk: potential for default, and the
magnitude of loss given a default.
Chance of default can be measured via credit analysis, which
attempts to capture the probability that a company will not
generate cash flows great enough to meet its obligations.
The magnitude of loss captures the likelihood of receiving
compensation when the company defaults. The magnitude of
recovery can be based on the seniority of the debt in question

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amongst the other creditors that the company owes money. In the
case of a junior claim, the loss given default is commonly the
entire amount borrowed, whereas a more senior claim may recoup
most if not all of its loan.
Q4-11.

Creditors take collateral in order to increase the likelihood of


recouping their loss in the case of default. The pledged asset can
be used to repay the debt.
Real and personal property is usually the basis of collateral where
the creditor may take possession of a real estate mortgage or, in
some cases, marketable securities, accounts receivable, and
inventory.

Q4-12.

Covenants represent terms or conditions placed on the borrower


to limit the loss given default by protecting cash flows the
company will have to repay the loan. Loan covenants tied to
financial ratios also aid creditors by providing evidence of
deteriorating conditions within the firm.
Three types of common covenants: those that require borrowers
to take certain actions, those that restrict the borrower from taking
certain actions, and those that require the borrower to maintain
certain financial conditions.

Q4-13.

Credit ratings are the opinions of an entitys creditworthiness


provided by independent firms that professionally analyze and
rate the credit risk of a company.
Credit ratings impact the cost of debt and consequentially the
credit terms (higher cost of debt implies higher interest rates
attached to term loans). Credit ratings may also trigger a noninvestment grade classification that may limit the company from
issuing in certain debt markets. Indeed, many investment firms
will not invest in companies given a poor classification by credit
rating agencies.

Solutions Manual

M4-17
Pfizer, Inc., (PFE) demonstrates marked improvement in almost all aspects
of financial health, making the company less risky to creditors in 2006. Its
2006 liquidity ratios (both current and quick) are higher than the prior year.
In terms of solvency, leverage decreased in 2006, as the company seems to
be drawing upon equity financing more than debt financing according to its
liabilities-to-equity and long-term debt-to-equity ratios.
Finally, although its factor of times interest earned decreased marginally, it
is still clearly covering all interest expenses associated with debt
obligations (nearly 30 times over), and its cash from operations to total
debt and free operating cash flow to total debt increased markedly from
2005 to 2006.
E4-27
a.

2006 Current ratio = $3,168.33 / $6,057.95 = 0.523


2004 Current ratio = $3,563.56 / $3,285.39 = 1.085
2006 Quick ratio = ($1,503.36 + $735.30) / $6,057.95 = 0.370
2004 Quick ratio = ($1,376.73 + $1,097.16) / $3,285.39 = 0.753
2006 Liabilities-to-equity = $25,743.17 / -$7,152.90 = -3.60
2004 Liabilities-to-equity = $22,628.42 / $4,587.67 = 4.93
2006 Long-term debt-to-equity = $3,351.63 / -$7,152.90 = -0.469
2004 Long-term debt-to-equity = $16,940.81 / $4,587.67 = 3.69
2006 Times interest earned = $1,877.84 / $1,288.29 = 1.46
2004 Times interest earned = $1,589.84 / $1,516.90 = 1.05
2006 Cash from operations to total debt
= $155.98 / ($4,568.83 + $3,351.63) = 0.0197
2004 Cash from operations to total debt
= $ 9.89 / ($1,033.96 + $16,940.81) = 0.0006
2006 Free operating cash flow to total debt
= ($155.98 - $211.50) / ($4,568.83 + $3,351.63) = -0.007

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2004 Free operating cash flow to total debt


= ($ 9.89 - $1,545.48) / ($1,033.96 + $16,940.81) = -0.085
b. Despite gaining slight ground on its interest coverage ratios, Calpine
Corp. seems to be struggling with both liquidity and solvency issues in
2006 compared to two years prior. Moreover, the interest coverage
ratios are exceedingly low.
Both the quick ratio and current ratio are lower than 1.0 and have
decreased in the past two years, suggesting the company does not have
enough assets expected to be converted to cash in the current year to
pay obligations due in the coming year. Equity became negative over
the two years, suggesting a large share buyback or perhaps a large
earnings loss in 2005. Either way, Calpines financing seems heavily
stacked toward debt over equity, which may lead to an increase in the
cost of equity capital for the firm.
Overall, this results in a rather significant increase not only in the
probability that the company will face default, but also in the magnitude
of the loss if it does. Therefore, credit risk is higher in 2006 than it was
in 2004.

P4-31
a. 2005 current ratio = $10,529 / $9,428 = 1.12
2004 current ratio = $8,953 / $8,566 = 1.05
2005 quick ratio = ($2,244 + $429 + $4,579) / $9,428 = 0.77
2004 quick ratio = ($1,060 + $396 + $4,094) / $8,566 = 0.65
Lockheed Martin is fairly liquid. Both the current and quick ratios have
increased during 2005, but neither is particularly high.
b. 2005 total liabilities to stockholders equity
= ($9,428 + $4,784 + $2,097 + $1,277 + $2,291) / $7,867 = 2.53
2004 total liabilities to stockholders equity
= ($8,566 + $5,104 + $1,660 + $1,236 + $1,967) / $7,021 = 2.64

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2005 long-term debt-to-equity = ($202 + $4,784) / $7,867 = 0.634


2004 long-term debt-to-equity = ($15 + $5,104) / $7,021 = 0.729
Lockheed Martins total liabilities to stockholders equity has decreased
in 2005 but remains relatively high, while its long-term debt-to-equity
ratio decreased from 2004 to 2005. The difference between these two
measures reveals that any solvency concerns would be for the short
run, as it has a more balanced portfolio of debt-to-equity when
considering its long-term debt obligations.
c. 2005 times interest earned = ($2,616 + $370) / $370 = 8.07
2004 times interest earned = ($1,664 + $425) / $425 = 4.92

2005 cash from operations to total debt = $3,194 / ($202 + $4,784) = 0.64
2004 cash from operations to total debt = $2,924 / ($ 15 + $5,104) = 0.57

2005 free operating cash flow to total debt


= ($3,194 - $865) / ($202+ $4,784) = 0.47
2004 free operating cash flow to total debt
= ($2,924 - $769) / ($15 + $5,104) = 0.42
Lockheed Martins times interest earned increased significantly during
2005, due to both an increase in profitability and a decrease in interest
expense. Its cash to debt ratios also increased slightly over the year
2005 due to increased cash flow from operations and decreased levels
of debt. However, both ratios remain rather low.
d. Lockheed Martin is not particularly liquid and is financially leveraged. Its
times interest earned ratio is high, thus lessening any immediate
solvency concerns. The companys ability to meet its debt requirements
will depend on its continued profitability.
Solutions Manual