Chapter 17

How Well Am I Doing? Financial Statement Analysis

Solutions to Questions
17-1 Horizontal analysis involves examining how a particular item on a financial statement such as sales or cost of goods sold behaves over time. Vertical analysis involves analysis of items on an income statement or balance sheet for a single year. In vertical analysis, all the items on the financial statement are stated as a percentage of a single item such as sales revenues or total assets. 17-2 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. 17-3 Price-earnings ratios reflect investors expectations concerning future earnings. The higher the price-earnings ratio, the greater the growth in earnings expected by investors. For this reason, two companies might have the same current earnings and yet have quite different price-earnings ratios. By definition, a stock with current earnings of $4 and a priceearnings ratio of 20 would be selling for $80 per share. 17-4 A company in a rapidly growing technological industry probably would have many opportunities to invest its earnings at a rate of return higher than stockholders could earn in other investments. From the stockholders Solutions Manual, Chapter 17 perspective, in this situation it would be better for the company to reinvest its earnings rather than pay out its earnings in the form of dividends. Thus, one would expect the company to have a low dividend payout ratio. 17-5 The dividend yield is the return on an investment from simply collecting dividends. The other source of return on an investment in stock is increases in market value. The dividend yield is computed by dividing the dividend per share by the current market price per share of common stock. 17-6 Financial leverage results from borrowing funds at an interest rate that differs from the rate of return on assets acquired using those funds. If the rate of return on the assets is higher than the interest rate at which the funds were borrowed, financial leverage is positive and stockholders gain. If the return on the assets is lower than the interest rate, then financial leverage is negative and the stockholders lose. 17-7 How a stockholder would feel would depend in large part on the stability of the company and its industry. If the company experiences wide fluctuations in earnings, stockholders might be very pleased that the company has no debt. In hard times, interest payments might be very difficult to meet. On the other hand, if investments within the company can earn a rate of return that exceeds the cost of the debt, stockholders get the benefits of positive 237

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leverage. A company that will not take on debt also places limitations on its own ability to grow, due to the fact that its sources of new investment funds will be limited to current earnings and new issues of stock. 17-8 No, the market value of a share of common stock often exceeds the book value per share. 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 expectations about the companys future earnings. For most companies market value exceeds book

value because investors anticipate future growth in earnings. 17-9 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 and difficult-to-liquidate inventory, or the inventory may contain large amounts of obsolete goods. Second, the receivables may be low quality, including large amounts of accounts that may be difficult to collect.

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Exercise 17-1 (15 minutes) 1. This Year Last Year 100.0% 100.0% 62.3 58.6 37.7 41.4 18.5 8.9 27.4 10.3 1.2 9.1% 18.2 10.3 28.5 12.9 1.4 11.5%

Sales..................................... Less cost of goods sold......... Gross margin......................... Less operating expenses: Selling expenses................. Administrative expenses..... Total expenses...................... Net operating income........... Less interest expense........... Net income before taxes.......

2. The companys major problem seems to be the increase in cost of goods sold, which increased from 58.6% of sales last year to 62.3% of sales this year. 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. This change has been offset somewhat by reduction in administrative expenses as a percentage of sales. Note that administrative expenses decrease from 10.3% to only 8.9% of sales over the two years. However, this decrease was not enough to completely offset the increased cost of goods sold, so the companys net income decreased as a percentage of sales this year.

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Exercise 17-2 (30 minutes) 1. Calculation of the gross margin percentage: Gross margin percentage = Gross margin Sales $27,000 = = 34.2% $79,000

2. Calculation of the earnings per share: Earnings per share = Net income - Preferred dividends Average number of common shares outstanding $3,540 - $120 = = $4.28 per share 800 shares Market price per share Earnings per share $18 = = 4.2 $4.28 Dividends per share Earnings per share $0.25 = = 5.8% $4.28

3. Calculation of the price-earnings ratio: Price-earnings ratio =

4. Calculation of the dividend payout ratio: Dividend payout ratio =

5. Calculation of the dividend yield ratio: Dividend yield ratio = Dividends per share Market price per share $0.25 = = 1.4% $18.00

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Exercise 17-2 (continued) 6. Calculation of the return on total assets: Beginning balance, total assets (a).............................................. Ending balance, total assets (b). . . Average total assets [(a) + (b)]/2. $45,960 50,280 $48,120

Net income + [Interest expense (1 - Tax rate)] Return on total assets = Average total assets = $3,540 + [$600 (1 - 0.40)] = 8.1% $48,120

7. Calculation of the return on common stockholders equity: Beginning balance, stockholders equity (a)............................................ $31,660 Ending balance, stockholders equity (b)....................................................... 34,880 Average stockholders equity [(a) + (b)]/2................................................... 33,270 Average preferred stock........................ 2,000 Average common stockholders equity.. $31,270 Net income - Preferred dividends Return on common = stockholders' equity Average common stockholders' equity = $3,540 - $120 = 10.9% $31,270

8. Calculation of the book value per share: Book value per share = = Total stockholders' equity - Preferred stock Number of common shares outstanding $34,880 - $2,000 = $41.10 per share 800 shares

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Exercise 17-3 (30 minutes) 1. Calculation of working capital: Current assets............. $25,080 Current liabilities......... 10,400 Working capital........... $14,680 2. Calculation of the current ratio: Current ratio = Current assets Current liabilities $25,080 = = 2.4 $10,400

3. Calculation of the acid-test ratio: Cash + Marketable securities + Current receivables Acid-test ratio = Current liabilities $1,280 + $0 + $12,300 = = 1.3 $10,400 4. Calculation of accounts receivable turnover: Beginning balance, accounts receivable (a)...... $ 9,100 Ending balance, accounts receivable (b)........... 12,300 Average accounts receivable balance [(a) + (b)]/2............................................................... $10,700 Sales on account Accounts receivable = turnover Average accounts receivable balance $79,000 = = 7.4 $10,700 5. Calculation of the average collection period: Average collection period = 365 days Accounts receivable turnover 365 days = = 49.3 days 7.4
Managerial Accounting, 11th Edition

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Exercise 17-3 (continued) 6. Calculation of inventory turnover: Beginning balance, inventory (a)....................... Ending balance, inventory (b)........................... Average inventory balance [(a) + (b)]/2............ Inventory turnover = Cost of goods sold Average inventory balance $52,000 = = 5.8 $8,950 $8,200 9,700 $8,950

7. Calculation of the average sale period: Average sale period = 365 days Inventory turnover 365 days = = 62.9 days 5.8

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Exercise 17-4 (15 minutes) 1. Calculation of the times interest earned ratio: Earnings before interest expense and income taxes Times interest = earned ratio Interest expense = $6,500 = 10.8 $600

2. Calculation of the debt-to-equity ratio: Debt-to-equity ratio = Total liabilities Stockholders' equity $15,400 = = 0.4 $34,880

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Exercise 17-5 (15 minutes) 1. Return on total assets: Interest expense ( 1 - Tax rate) Return on = Net income + total assets Average total assets $280,000 + $60,000 ( 1 - 0.30) = 1/2 ( $3,000,000 + $3,600,000) = $322,000 = 9.8% (rounded) $3,300,000 $ 280,000 72,000 $ 208,000 $2,300,000 900,000 $1,400,000

2. Return on common stockholders equity: Net income as reported...................... Less preferred dividends: 8% $900,000.......................................... Net income remaining for common (a).................................................... Average stockholders equity: 1/2 ($2,200,000 + $2,400,000)........ Less average preferred stock.............. Average common stockholders equity (b)......................................... Return on common stockholders equity (a) (b)...........................................

14.9% (rounded)

3. Leverage is positive since the return on common stockholders equity (14.9%) is greater than the return on total assets (9.8%). This positive leverage arises from the long-term debt, which has an after-tax interest cost of only 8.4% [12% interest rate (1 0.30)], and the preferred stock, which carries a dividend rate of only 8%. Both of these rates of return are smaller than the return that the company is earning on its total assets; thus, the difference goes to the common stockholders.

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Exercise 17-6 (15 minutes) 1. Current assets (Kr90,000 + Kr260,000 + Kr490,000 + Kr10,000).......................................................... Current liabilities (Kr850,000 2.5).................... Working capital....................................................

Kr850,000 340,000 Kr510,000

2. Acid-test Cash + Marketable securities + Accounts receivable = ratio Current liabilities = Kr90,000 + Kr0 + Kr260,000 = 1.03 (rounded) Kr340,000

3. a. Working capital would not be affected: Current assets (Kr850,000 Kr40,000).. Kr810,000 Current liabilities (Kr340,000 Kr40,000)............................................ 300,000 Working capital..................................... Kr510,000 b. The current ratio would rise: Current ratio = = Current assets Current liabilities Kr810,000 = 2.7 Kr300,000

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Exercise 17-7 (15 minutes) 1. The trend percentages are: Year Year Year Year 5 Year 4 3 2 1 125.0 120.0 115.0 110.0 100.0 60.0 80.0 96.0 130.0 190.0 170.0 135.0 115.0 125.0 120.0 115.0 110.0 142.1 133.7 120.3 112.6 100.0 100.0 100.0 100.0

Sales............................ Cash............................ Accounts receivable..... Inventory..................... Total............................. Current liabilities......... 2. Sales: Assets:

160.0 145.0 130.0 110.0 100.0

The sales are increasing at a steady and consistent rate. The most noticeable thing about the assets is that the accounts receivable have been increasing at a rapid ratefar outstripping the increase in sales. This disproportionate increase in receivables is probably the chief cause of the decrease in cash over the five-year period. The inventory seems to be growing at a well-balanced rate in comparison with sales. The current liabilities are growing more rapidly than the total current assets. The reason is probably traceable to the rapid buildup in receivables in that the company doesnt have the cash needed to pay bills as they come due.

Liabilities :

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Exercise 17-8 (30 minutes) 1. Gross margin percentage: Gross margin $127,500 = = 30.4% (rounded) Sales $420,000 2. Current ratio: Current assets $115,000 = = 2.3 Current liabilities $50,000 3. Acid-test ratio: Quick assets $41,500 = = 0.83 Current liabilities $50,000 4. Debt-to-equity ratio: Total liabilities $130,000 = = 0.76 (rounded) Total stockholders' equity $170,000 5. Average collection period: Sales on account $420,000 = = 14 Average accounts receivable $30,000 365 days = 26 days (rounded) 14 times 6. Average sale period: Cost of goods sold $292,500 = = 4.5 Average inventory $65,000 365 days = 81 days (rounded) 4.5 times 7. Times interest earned: Earnings before interest and income taxes $38,000 = = 4.75 Interest expense $8,000

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Exercise 17-8 (continued) 8. Book value per share: Stockholders' equity $170,000 = = $28.33 per share Common shares outstanding 6,000 shares

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Exercise 17-9 (20 minutes) 1. Earnings per share: Net income to common stock $21,000 = = $3.50 per share Average number of common 6,000 shares shares outstanding 2. Dividend payout ratio: Dividends paid per share $2.10 = = 60% Earnings per share $3.50 3. Dividend yield ratio: Dividends paid per share $2.10 = = 5% Market price per share $42.00 4. Price-earnings ratio: Market price per share $42.00 = = 12 Earnings per share $3.50

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Exercise 17-10 (20 minutes) 1. Return on total assets: Interest expense ( 1 - Tax rate) Return on = Net Income + total assets Average total assets $21,000 + $8,000 ( 1 - 0.30) = 1/2 ( $280,000 + $300,000) = $26,600 = 9.2% (rounded) $290,000

2. Return on common stockholders equity: Net income - Preferred dividends Return on common = stockholders' equity Average common stockholders' equity $21,000 = 1/2 ( $161,600+$170,000) = $21,000 = 12.7% (rounded) $165,800

3. Financial leverage was positive, since the rate of return to the common stockholders (12.7%) was greater than the rate of return on total assets (9.2%). This positive leverage is traceable in part to the companys current liabilities, which may have no interest cost, and in part to the bonds payable, which have an after-tax interest cost of only 7%. 10% interest rate (1 0.30) = 7%

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Problem 17-11 (30 minutes) 1. a. Computation of working capital: Current assets: Cash.................................. $50,000 Marketable securities......... 30,000 Accounts receivable, net.... 200,000 Inventory........................... 210,000 Prepaid expenses............... 10,000 Total current assets.............. 500,000 Current liabilities: Accounts payable.............. Notes due in one year........ Accrued liabilities............... Total current liabilities.......... 150,000 30,000 20,000 200,000

Working capital.................... $300,000 b. Computation of the current ratio: Current assets $500,000 = = 2.5 Current liabilities $200,000 c. Computation of the acid-test ratio: Cash + Marketable securities + Accounts receivable $280,000 = = 1.4 Current liabilities $200,000

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Problem 17-11 (continued) 2. The Effect on Workin Acidg Current Test Transaction Capital Ratio Ratio Issued capital stock for cash.... Increase Increase Increase Sold inventory at a gain........... Increase Increase Increase Wrote off uncollectible accounts................................ None None None Decreas Decreas Declared a cash dividend......... e e Decrease Paid accounts payable............. None Increase Increase Decreas Borrowed on a short-term note None e Decrease Decreas Decreas Sold inventory at a loss............ e e Increase Purchased inventory on Decreas account................................. None e Decrease Paid short-term notes............... None Increase Increase Decreas Decreas Purchased equipment for cash. e e Decrease Sold marketable securities at a Decreas Decreas loss........................................ e e Decrease Collected accounts receivable.. None None None

(a) (b) (c) (d) (e) (f) (g) (h) (i) (j) (k) (l)

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Problem 17-12 (60 minutes) This Year Last Year 1. a. Current assets.................................. $1,520,000 $1,090,000 Current liabilities.............................. 800,000 430,000 Working capital................................. $ 720,000 $ 660,000 b. Current assets (a)............................. $1,520,000 $1,090,000 Current liabilities (b)......................... $800,000 $430,000 Current ratio (a) (b)...................... 1.90 2.53 c. Quick assets (a)................................ Current liabilities (b)......................... Acid-test ratio (a) (b).................... $550,000 $800,000 0.69 $468,000 $430,000 1.09

d. Sales on account (a)......................... $5,000,000 $4,350,000 Average receivables (b).................... $390,000 $275,000 Accounts receivables turnover (a) (b).................................................. 12.8 15.8 Average collection period: 365 days turnover...................... 28.5 days 23.1 days

e. Cost of goods sold (a)....................... $3,875,000 $3,450,000 Average inventory (b)....................... $775,000 $550,000 Inventory turnover (a) (b)............. 5.0 6.3 Average sales period: 365 days turnover...................... 73 days 58 days

f. Total liabilities (a)............................. $1,400,000 $1,030,000 Stockholders equity (b)................... $1,600,000 $1,430,000 Debt-to-equity ratio (a) (b)........... 0.875 0.720 Net income before interest and g. taxes (a)......................................... Interest expense (b)......................... Times interest earned (a) (b)........ $472,000 $72,000 6.6 $352,000 $72,000 4.9

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Problem 17-12 (continued) 2. a. SABIN ELECTRONICS Common-Size Balance Sheets This Year Current assets: Cash................................................ 2.3% Marketable securities...................... 0.0 Accounts receivable, net................. 16.0 Inventory........................................ 31.7 Prepaid expenses............................ 0.7 Total current assets........................... 50.7 Plant and equipment, net.................. 49.3 Total assets........................................ 100.0% Current liabilities............................... 26.7% Bonds payable, 12%.......................... 20.0 Total liabilities................................. 46.7 Stockholders equity: Preferred stock, $25 par, 8%........... 8.3 Common stock, $10 par.................. 16.7 Retained earnings........................... 28.3 Total stockholders equity.................. 53.3 Total liabilities and equity.................. 100.0% Last Year 6.1% 0.7 12.2 24.4 0.9 44.3 55.7 100.0% 17.5% 24.4 41.9 10.2 20.3 27.6 58.1 100.0%

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Problem 17-12 (continued) b. SABIN ELECTRONICS Common-Size Income Statements This Last Year Year 100.0% 100.0 % 77.5 79.3 22.5 20.7 13.1 12.6 9.4 8.1 1.4 1.7 8.0 6.4 2.4 1.9 5.6% 4.5 %

Sales............................................... Less cost of goods sold................... Gross margin.................................. Less operating expenses................. Net operating income..................... Less interest expense..................... Net income before taxes................. Less income taxes........................... Net income.....................................

3. The following points can be made from the analytical work in parts (1) and (2) above: a. The company has improved its profit margin from last year. This is attributable primarily to an increase in gross margin, which is offset somewhat by a small increase in operating expenses. Overall, the companys income statement looks very good. b. The companys current position has deteriorated significantly since last year. Both the current ratio and the acid-test ratio are well below the industry average and are trending downward. At the present rate, it will soon be impossible for the company to pay its bills as they come due. c. The drain on the cash account seems to be a result mostly of a large buildup in accounts receivable and inventory. Notice that the average age of the receivables has increased by five days since last year, and now is 10 days over the industry average. Many of the companys customers are not taking their discounts, since the average collection period is 28 days and collections 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.

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Problem 17-12 (continued) d. The inventory turned only five times this year as compared to over six times last year. It takes nearly two weeks longer for the company to turn its inventory than the average for the industry (73 days as compared to 60 days for the industry). This suggests that inventory stocks are higher than they need to be. e. In the authors opinion, the loan should be approved only if the company gets its accounts receivable and inventory back under control. If the accounts receivable collection period is reduced to about 20 days, and if the inventory is pared down enough to reduce the turnover time to about 60 days, enough funds could be released to substantially improve the companys cash position. Then a loan might not even be needed.

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Problem 17-13 (45 minutes) This Last Year Year $280,00 $196,00 0 0 20,000 20,000 $260,00 $176,00 0 0 50,000 $5.20 $1.80 $40.00 4.5% $1.80 $5.20 34.6% $40.00 $5.20 7.7 50,000 $3.52 $1.50 $36.00 4.2% $1.50 $3.52 42.6% $36.00 $3.52 10.2

1. a. Net income.................................... Less preferred dividends................ Net income remaining for common (a)............................................... Average number of common shares (b).................................... Earnings per share (a) (b).......... b. Common dividend per share (a). . . . Market price per share (b)............. Dividend yield ratio (a) (b)......... c. Common dividend per share (a). . . . Earnings per share (b)................... Payout ratio (a) (b)..................... d. Market price per share (a)............. Earnings per share (b)................... Price-earnings ratio (a) (b).........

Investors regard Sabin Electronics less favorably than other firms in the industry. This is evidenced by the fact that they are willing to pay only 7.7 times current earnings for a share of Sabins stock, as compared to 12 times current earnings for the average of all stocks in the industry. If investors were willing to pay 12 times current earnings for Sabins stock, it would be selling for about $62.40 per share (12 $5.20), rather than for only $40 per share.

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Problem 17-13 (continued) This Year Last Year $1,600,00 $1,430,00 0 0 250,00 250,000 0 $1,350,00 $1,180,00 0 0 50,000 $27.00 50,000 $23.60

e.

Stockholders equity......................... Less preferred stock......................... Common stockholders equity (a)..... Number of common shares (b)......... Book value per share (a) (b)..........

The market value is above book value for both years. However, this does not necessarily indicate that the stock is overpriced. Market value reflects investors perceptions of future earnings, whereas book value is a result of already completed transactions and is geared to the past. 2. a. Net income..................................... $ 280,000 Add after-tax cost of interest paid: [$72,000 (1 0.30)].................. 50,400 Total (a).......................................... $ 330,400 $ 196,000 50,400 $ 246,400

$2,380,00 Average total assets (b).................. $2,730,000 0 Return on total assets (a) (b)...... 12.1% 10.4% $ 196,000 20,000 $ 176,000

b. Net income..................................... $ 280,000 Less preferred dividends................. 20,000 Net income remaining for common (a)................................................ $ 260,000

$1,379,50 Average total stockholders equity. $1,515,000 0 Less average preferred stock.......... 250,000 250,000 $1,129,50 Average common equity (b)........... $1,265,000 0 Return on common equity (a) (b)
Solutions Manual, Chapter 17

20.6%

15.6%
259

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Problem 17-13 (continued) c. Financial leverage is positive in both years, since the return on common equity is greater than the return on total assets. This positive financial leverage is due to three factors: the preferred stock, which has a dividend rate of only 8%; the bonds, which have an after-tax interest cost of only 8.4% [12% interest rate (1 0.30) = 8.4%]; and the accounts payable, which may bear no interest cost. 3. We would recommend purchase. The stocks downside risk seems small, since it is now selling for only 7.7 times earnings to 12 times earnings for the average firm in the industry. In addition, its earnings are strong and trending upward, and its return on common equity (20.6%) is extremely good. Its return on total assets (12.1%) compares well 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 discontinuance of dividends, and a precipitous drop in the market price of the companys stock. This does not seem likely, however, since the company has borrowing capacity available, and can easily control its cash problem through more careful management of accounts receivable and inventory. The client must understand, of course, that there is risk in the purchase of any stock; the risk seems well justified in this case since the upward potential of the stock is great if the company gets its problems under control.

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Problem 17-14 (90 minutes) This Year Last Year $ 840,00 0 $ 504,000 252,000 $ 1,092,00 0$ 210,000 714,000

1. a. Net income.................................... Add after-tax cost of interest: $360,000 (1 0.30)................. $300,000 (1 0.30)................. Total (a)......................................... Average total assets (b)................ Return on total assets (a) (b).....

$15,990,00 $13,920,00 0 0 6.8% 5.1%

b. Net income.................................... $ 840,000 $ 504,000 Less preferred dividends............... 144,000 144,000 Net income remaining for common (a)................................ $ 696,000 $ 360,000 Average total stockholders equity $ 9,360,000 $ 9,084,000 Less average preferred stock........ 1,800,000 1,800,000 Average common equity (b).......... $ 7,560,000 $ 7,284,000 Return on common equity (a) (b)............................................... 9.2% 4.9%

c. Leverage is positive for this year, since the return on common equity (9.2%) is greater than the return on total assets (6.8%). For last year, leverage is negative since the return on common equity (4.9%) is less than the return on total assets (5.1%).

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Problem 17-14 (continued) Net income remaining for common 2. a. (a)................................................ Average number of common shares (b)..................................... Earnings per share (a) (b)........... b. Common dividend per share (a)..... Market price per share (b).............. Dividend yield ratio (a) (b).......... c. Common dividend per share (a)..... Earnings per share (b).................... Dividend payout ratio (a) (b)....... d. Market price per share (a)............... Earnings per share (b)..................... Price-earnings ratio (a) (b)........... This Year $696,000 75,000 $9.28 $2.88 $72.00 4.0% $2.88 $9.28 31.0% $72.00 $9.28 7.8 Last Year $360,000 75,000 $4.80 $1.44 $40.00 3.6% $1.44 $4.80 30.0% $40.00 $4.80 8.3

Notice from the data given in the problem that the average P/E ratio for firms in Lydex Companys industry is 10. Since Lydex Company presently has a P/E ratio of only 7.8, investors appear to regard it less well than they do other firms in the industry. That is, investors are willing to pay only 7.8 times current earnings for a share of Lydex Companys stock, as compared to 10 times current earnings for a share of stock for the average firm in the industry. e. Stockholders equity....................... $9,600,000 $9,120,000 Less preferred stock....................... 1,800,000 1,800,000 Common stockholders equity (a)... $7,800,000 $7,320,000 Number of common shares (b)....... Book value per share (a) (b)........ 75,000 $104.00 75,000 $97.60

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Problem 17-14 (continued) Notice that market value is below book value for both years for the common stock. This does not necessarily indicate that the stock is selling at a bargain price. Market value reflects investors expectations concerning future earnings, whereas book value is a result of already completed transactions and is geared to the past. Gross margin (a)............................. Sales (b)......................................... Gross margin percentage (a) (b). This Year Last Year $3,150,000 $2,580,000 $15,750,00 $12,480,00 0 0 20.0% 20.7%

This Year Last Year 3. a. Current assets................................. $7,800,000 $5,940,000 Current liabilities............................. 3,900,000 2,760,000 Working capital................................ $3,900,000 $3,180,000 b. Current assets (a)............................ $7,800,000 $5,940,000 Current liabilities (b)........................ $3,900,000 $2,760,000 Current ratio (a) (b)...................... 2.0 2.15 c. Quick assets (a)............................... $3,660,000 $3,360,000 Current liabilities (b)........................ $3,900,000 $2,760,000 Acid-test ratio (a) (b).................... 0.94 1.22 $15,750,00 $12,480,00 d. Sales on account (a)........................ 0 0 Average receivables (b)................... $2,250,000 $1,680,000 Turnover of receivables (a) (b)..... 7 7.4 Average collection period, 365 days turnover..................... 52 days 49 days

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Problem 17-14 (continued) This Year Last Year $12,600,00 e. Cost of goods sold (a)...................... 0 $9,900,000 Average inventory (b)...................... $3,150,000 $2,160,000 Inventory turnover (a) (b)............ 4.0 4.6 Average sale period, 365 days turnover..................... 91.25 days 79.3 days f. Total liabilities (a)............................. $7,500,000 $5,760,000 Stockholders equity (b)................... $9,600,000 $9,120,000 Debt-to-equity ratio (a) (b)........... 0.78 0.63 Net income before interest and g. taxes (a)........................................ $1,560,000 $1,020,000 Interest expense (b)........................ $360,000 $300,000 Times interest earned (a) (b)........ 4.3 3.4 4. Both net income and sales are up from last year. The return on total assets has improved from 5.1% to 6.8%, and the return on common equity is up from 4.9% to 9.2%. But this is the only bright spot. 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. Ordinarily, this should result in an improvement in the gross margin percentage due to fixed costs being spread over a greater number of units. However, the gross margin percentage has declined. Notice particularly that the average collection period has lengthened to 52 daysabout three weeks over the industry average. One wonders if the increase in sales was obtained at least in part by extending credit to high-risk customers. Notice also that the debt-to-equity ratio is rising rapidly. If the $3,000,000 loan is granted, the ratio will rise further to 1.09. What the company probably needs is more equitynot more debt. Therefore, the loan should not be approved. The company should be encouraged to issue more common stock to provide
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a broader equity base on which to operate.

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Problem 17-15 (30 minutes) 1. LYDEX COMPANY Comparative Balance Sheets This Year Current assets: Cash.............................................. Marketable securities.................... Accounts receivable, net............... Inventory...................................... Prepaid expenses.......................... Total current assets......................... Plant and equipment, net................ Total assets..................................... Current liabilities............................. Note payable, 10%.......................... Total liabilities.................................. Stockholders equity: Preferred stock, 8%, $30 par value.......................................... Common stock, $80 par value...... Retained earnings......................... Total stockholders equity................ Total liabilities and equity................ Last Year

5.6% 8.5% 0.0 2.0 15.8 12.1 22.8 16.1 1.4 1.2 45.6 39.9 54.4 60.1 100.0% 100.0% 22.8% 21.1 43.9 18.5% 20.2 38.7

10.5 12.1 35.1 40.3 10.5 8.9 56.1 61.3 100.0% 100.0%

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Problem 17-15 (continued) 2. LYDEX COMPANY Comparative Income Statements This Year 100.0% 80.0 20.0 10.1 9.9 2.3 7.6 2.3 5.3% Last Year 100.0% 79.3 20.7 12.5 8.2 2.4 5.8 1.7 4.0%*

Sales............................................... Less cost of goods sold.................... Gross margin................................... Less operating expenses.................. Net operating income...................... Less interest expense...................... Net income before taxes.................. Less income taxes (30%)................. Net income......................................

* Due to rounding, figures may not fully reconcile down a column. 3. The companys current position has declined substantially between the two years. Cash this year represents only 5.6% of total assets, whereas it represented 10.5% last year (cash + marketable securities). In addition, both accounts receivable and inventory are up from last year, which helps to explain the decrease in the cash account. The company is building inventories, but not collecting from customers. (See Problem 17-14 for a ratio analysis of the current assets.) Apparently a part of the financing required to build inventories was supplied by short-term creditors, as evidenced by the increase in current liabilities. Looking at the income statement, as noted in the solution to the preceding problem there has been a slight deterioration in the gross margin percentage. Ordinarily, the increase in sales (and in inventories) should have resulted in an increase in the gross margin percentage since fixed manufacturing costs would be spread across more units. Note that the other operating expenses are down as a percentage of salespossibly because many of them are likely to be fixed.
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Problem 17-16 (30 minutes) a. 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 notice 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 these items, from which bills cannot be paid. b. Customers are paying their bills more slowly in Year 3 than in Year 1. This is evidenced by the decline in accounts receivable turnover. c. The total of accounts receivable is increasing. This is evidenced both by a slowdown in turnover and in an increase in total sales. d. 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 to service the larger volume of sales. e. 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. f. The amount of 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. g. The price-earnings ratio is going down. If the market price of the stock is going down [see Part (e) above], and the earnings per share are going up [see Part (f) above], then the priceearnings ratio must be decreasing. h. In Year 1 and in Year 2 there was negative leverage, since in both years the return on total assets exceeded the return on
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common equity. In Year 3 there was positive leverage since in that year the return on common equity exceeded the return on total assets employed.

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Problem 17-17 (45 minutes) Effect on Ratio Reason for Increase, Decrease, or No Effect 1. Decrease Declaring a cash dividend will increase current liabilities, but have no effect on current assets. Therefore, the current ratio will decrease. 2. 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. The same effect would result regardless of whether the inventory was sold at cost, at a profit, or at a loss. That is, the acid-test ratio would increase in all cases; the only difference would be the amount of the increase. Increase The interest rate on the bonds is only 8%. Since the companys assets earn at a rate of return of 10%, positive leverage would come into effect, increasing the return to the common stockholders.

3.

4. Decrease A decrease in net income would mean less income available to cover interest payments. Therefore, the times-interest-earned ratio would decrease. 5. 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. No Effect The dividend payout ratio is a function of the dividends paid per share in relation to the earnings per share. Changes in the market price of a stock have no effect on this ratio.

6.

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Problem 17-17 (continued) Effect on Ratio Reason for Increase, Decrease, or No Effect 7. Increase A write-off of inventory will reduce the inventory balance, thereby increasing the turnover in relation to a given level of sales. 8. Decreas Sale of inventory at a profit will increase the assets e of a company. The increase in assets will be reflected in an increase in retained earnings, which is part of stockholders equity. An increase in stockholders equity will result in a decrease in the ratio of assets provided by creditors as compared to assets provided by owners. 9. Decreas Extended credit terms for customers means that e customers on the average will be taking longer to pay their bills. As a result, the accounts receivable will turn over, or be collected, less frequently during a given year. 10. Decreas A common stock dividend will result in a greater e number of shares outstanding, with no change in the underlying assets. The result will be a decrease in the book value per share. 11. No Book value per share is dependent on historical Effect costs of already completed transactions as reflected on a companys balance sheet. It is not affected by current market prices for the companys stock. No Payments on account reduce cash and accounts Effect payable by equal amounts; thus, the net amount of working capital is not affected.

12.

13. Decreas The stock dividend will increase the number of e common shares outstanding, thereby reducing the earnings per share.
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Problem 17-17 (continued) Effect on Ratio Reason for Increase, Decrease, or No Effect 14. Decreas Payments to creditors will reduce the total liabilities e of a company, thereby decreasing the ratio of total debt to total equity. 15. Decreas A purchase of inventory on account will increase e current liabilities, but will not increase the quick assets (cash, accounts receivable, marketable securities). Therefore, the ratio of quick assets to current liabilities will decrease. 16. No Write-off of an uncollectible account against the Effect Allowance for Bad Debts will have no effect on total current assets. For this reason, the current ratio will remain unchanged.

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. Decreas The dividend yield ratio is obtained by dividing the e 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.

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Problem 17-18 (45 minutes) 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 less than four times net operating income. These ratios are computed below: Current ratio = = Current assets Current liabilities $290,000 = 1.8 (rounded) $164,000 Cash + Marketable securities + Current receivables Current liabilities $70,000 + $0 + $50,000 = 0.7 (rounded) $164,000

Acid-test ratio = =

Net operating income $20,000 = = 5.0 Interest on the loan $80,000 0.10 (6/12) The company would fail to qualify for the loan because both its current ratio and its acid-test ratio are too low.

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Problem 17-18 (continued) 2. By reclassifying the $45 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. Current ratio = = Current assets Current liabilities $290,000 + $45,000 = 2.0 (rounded) $164,000 Cash + Marketable securities + Current receivables Current liabilities $70,000 + $0 + $50,000 = 0.7 (rounded) $164,000

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 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.

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Problem 17-18 (continued) Nevertheless, the old machine is an asset that could be turned into cash. If this were done, the company would immediately qualify for the loan since the $45 thousand in cash would be included in the numerator in both the current ratio and in the acid-test ratio. Current ratio = = Current assets Current liabilities $290,000 + $45,000 = 2.0 (rounded) $164,000 Cash + Marketable securities + Current receivables Current liabilities $70,000 + $0 + $50,000 + $45,000 = 1.0 (rounded) $164,000

Acid-test ratio = =

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 Russ 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 she might instead grant a waiver of the current ratio and acidtest ratio requirements on the basis that they could be satisfied by selling the old machine. Or she may approve the loan on the condition that the machine is pledged as collateral. In that case, Russ would only have to sell the machine if he would otherwise be unable to pay back the loan.

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Problem 17-19 (60 minutes or longer) PEPPER INDUSTRIES Income Statement For the Year Ended March 31

Sales.......................................... Less cost of goods sold.............. Gross margin.............................. Less operating expenses............ Net operating income................ Less interest expense................ Net income before taxes............ Less income taxes (30%)........... Net income................................ PEPPER INDUSTRIES Balance Sheet March 31 Current assets: Cash........................................ Accounts receivable, net.......... Inventory................................. Total current assets.................... Plant and equipment.................. Total assets................................ Current liabilities........................ Bonds payable, 10%.................. Total liabilities............................ Stockholders equity: Common stock, $5 par value.. . Retained earnings.................... Total stockholders equity........... Total liabilities and equity...........

$4,200,000 2,730,000 1,470,000 930,000 540,000 80,000 460,000 138,000 $ 322,000

Key to Computatio n (h) (i) (j) (a) (b) (c) (d)

$ 70,000 330,000 480,000 880,000 1,520,000 $2,400,000 $ 320,000 800,000 1,120,000 700,000 580,000 1,280,000 $2,400,000

(f) (e) (g) (g) (q) (p) (k) (l) (m) (o) (n) (p)

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Problem 17-19 (continued) Computation of missing amounts: a. Times interest earned = = Earnings before interest and taxes Interest expense Earnings before interest and taxes $80,000

= 6.75 Therefore, the earnings before interest and taxes for the year must be $540,000. b. $540,000 $80,000 = $460,000. c. Income tax expense = $460,000 30% tax rate = $138,000. d. $460,000 $138,000 = $322,000. e. Sales on account Accounts receivable = turnover Average accounts receivable balance = $4,200,000 Average accounts receivable balance

= 14.0 Therefore, the average accounts receivable balance for the year must have been $300,000. Since the beginning balance was $270,000, the ending balance must have been $330,000. f.
Acid-test ratio= Cash + Marketable securities + Current receivables Current liabilities Cash + Marketable securities + Current receivables $320,000

= 1.25
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Problem 17-19 (continued) Therefore, the total quick assets must be $400,000. Since there are no marketable securities and since the accounts receivable are $330,000, the cash must be $70,000. g. Current ratio = = Current assets Current liabilities Current assets $320,000

= 2.75 Therefore, the current assets must total $880,000. Since the quick assets (cash and accounts receivable) total $400,000 of this amount, the inventory must be $480,000. h. Inventory turnover = = = Cost of goods sold Average inventory Cost of goods sold 1/2($360,000+$480,000) Cost of goods sold $420,000

= 6.5 Therefore, the cost of goods sold for the year must be $2,730,000. i. Gross margin = $4,200,000 $2,730,000 = $1,470,000. j. Net operating income = Gross margin - Operating expenses Operating expenses = Gross margin - Net operating income = $1,470,000 - $540,000 = $930,000

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Problem 17-19 (continued) k. Since the interest expense for the year was $80,000 and the interest rate was 10%, the bonds payable must total $800,000. l. $320,000 + $800,000 = $1,120,000. Net income - Preferred dividends Earnings per share = m Average number of common shares outstanding . $322,000 = Average number of common shares outstanding = $2.30 Therefore, there must be 140,000 common shares outstanding. Since the stock is $5 par value per share, the total common stock must be $700,000. n. Debt-to-equity ratio = = Total liabilities Stockholders' equity $1,120,000 Stockholders' equity

= 0.875 Therefore, the total stockholders equity must be $1,280,000. o. Total stockholders' equity = Common stock + Retained earnings Retained earnings = Total stockholders' equity - Common Stock = $1,280,000 - $700,000 = $580,000

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Problem 17-19 (continued) p. Total assets = Liabilities + Stockholders' equity = $1,120,000 + $1,280,000 = $2,400,000 This answer can also be obtained using the return on total assets: Return on = Net income + [Interest expense (1 - Tax rate)] total assets Average total assets = = $322,000 + [$80,000 (1 - 0.30)] Average total assets $378,000 Average total assets

= 18.0% Therefore the average total assets must be $2,100,000. Since the total assets at the beginning of the year were $1,800,000, the total assets at the end of the year must have been $2,400,000 (which would also equal the total of the liabilities and the stockholders equity). q. Total assets = Current assets + Plant and equipment $2,400,000 = $880,000 + Plant and equipment Plant and equipment = $2,400,000 - $880,000 = $1,520,000

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Problem 17-20 (60 minutes) This Year Last Year 1. a. Net income.................................. $1,050,000 $ 840,000 Less preferred dividends............. 120,000 120,000 Net income remaining for common (a)................................ $ 930,000 $ 720,000 Average number of common shares outstanding (b)................ 200,000 * 200,000 * Earnings per share (a) (b)........ $4.65 $3.60 *$1,000,000 $5 par value = 200,000 shares. b. Cash dividends per share (a)....... Market price per share (b)........... Dividend yield ratio (a) (b)....... $1.80 * $60.00 3.0% $1.40 * $45.00 3.1%

*Last Year: $280,000 200,000 shares = $1.40 per share This Year: $360,000 200,000 shares = $1.80 per share c. Cash dividends per share (a)....... Earnings per share (b)................. Dividend payout ratio (a) (b). . . d. Market price per share (a)........... Earnings per share (b)................. Price-earnings ratio (a) (b)....... $1.80 $4.65 38.7% $60.00 $4.65 12.9 $1.40 $3.60 38.9% $45.00 $3.60 12.5 $4,900,000 1,500,000 $3,400,000 200,000 $17.00 $6,000,000 $15,000,00 0 40%

e. Total stockholders equity............ $5,470,000 Less preferred stock.................... 1,500,000 Common stockholders equity (a) $3,970,000 Common shares outstanding (b). Book value per share (a) (b).... 200,000 $19.85

f. Gross margin (a).......................... $7,000,000 $20,000,00 Sales (b)...................................... 0 Gross margin percentage (a) (b)............................................. 35%

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Problem 17-20 (continued) This Year Last Year 2. a. Net income....................................... $1,050,000 $ 840,000 Add after-tax cost of interest paid: $240,000 (1 0.30).................... 168,000 168,000 Total (a)............................................. $1,218,000 $1,008,000 Average total assets (b).................... $8,935,000 $7,200,000 Return on total assets (a) (b)......... 13.6% 14.0%

b. Net income....................................... $1,050,000 $ 840,000 Less preferred dividends................... 120,000 120,000 Net income remaining for common (a).................................................. $ 930,000 $ 720,000 Average common stockholders equity (b)........................................ $3,685,000 $3,150,000 Return on common stockholders equity (a) (b).........................................

25.2%

22.9%

c. Financial leverage is positive in both years, since the return on common equity is greater than the return on total assets. This positive leverage arises from the preferred stock, which has a dividend cost of only 8%; and the bonds, which have an after-tax interest cost of only 8.4% [12% interest rate (1 0.30)]; and the current liabilities, which may have no interest cost. 3. The companys common stock is probably not an attractive investment. While most of the financial ratios are near the industry averages, the company has a relatively low priceearnings ratio. This indicates that the market does not view the companys future prospects as favorably as other companies in the industry. The sharp deterioration in the gross margin percentage is particularly troubling. Both sales and inventories have been growing, which should usually result in an improvement in the gross margin percentage due to fixed costs being spread over a greater number of units. However, the gross margin percentage has declined from 40% down to 35%.
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This suggests the existence of some major operating problems.

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Problem 17-21 (45 minutes) This Year Last Year $ 4,800,00 0 $2,500,000 2,500,000 1,000,000 $ 2,300,00 0 $1,500,000 $4,800,000 $2,500,000 $2,500,000 $1,000,000 1.92 2.50 $1,700,000 $1,200,000 $2,500,000 $1,000,000 0.68 1.20 $20,000,00 $15,000,00 0 0 $1,150,000 $700,000 17.4 21.0 days 21.4 17.1 days

1. a. Current assets............................... Current liabilities........................... Working capital............................. b. Current assets (a)......................... Current liabilities (b)..................... Current ratio (a) (b)................... c. Quick assets (a)............................ Current liabilities (b)..................... Acid-test ratio (a) (b)................. d. Sales on account (a)..................... Average accounts receivable (b)... Accounts receivable turnover (a) (b)........................................... Average collection period: 365 days turnover................... e. Cost of goods sold (a)................... Average inventory (b)................... Inventory turnover (a) (b).......... Average sale period: 365 days turnover................... f. Net operating income (a).............. Interest expense (b)...................... Times interest earned (a) (b)..... g. Total liabilities (a).......................... Total stockholders equity (b)........ Debt-to-equity ratio (a) (b)........

$13,000,00 0 $9,000,000 $2,100,000 $1,100,000 6.2 8.2 58.9 days 44.5 days

$1,740,000 $1,440,000 $240,000 $240,000 7.25 6.0 $4,500,000 $3,000,000 $5,470,000 $4,900,000 0.82 0.61

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Problem 17-21 (continued) 2. The following comments can be made relative to the companys current financial condition: a. The working capital is increasing, but both the current ratio and the acid-test ratio have deteriorated significantly over the last year. (This shows the danger of relying on working capital alone in assessing the well-being of a company.) With an acid-test ratio of only 0.68, it is not surprising that the company is having difficulty paying its bills. b. The company is taking 5 days longer to collect an account than the average for the industry. Equally significant, the collection period has increased over the last year. This is the result either of poor collection efforts or sales to customers who are poor credit risks. c. The company is taking nearly 19 days longer to turn its inventory than the average for the industry. And the average sale period has increased significantly over the last year. Slow turnover of inventory is usually indicative of inventory stocks that are too large or include too many unsalable goods. d. The companys earning power is very strong, as evidenced by its excellent times-interest-earned ratio. e. The companys 0.82 debt-to-equity ratio is already above the industry average of 0.70, even without the proposed $500,000 loan. 3. Despite the problems noted in (2) above, we would approve the loan. With the help of the $500,000 in new funds, the company should have breathing room to tighten up the collection of its accounts receivable and to reduce its inventory. If the receivables and inventory are brought under control, then several hundred thousand dollars should become available either to pay off the loan or to further strengthen the companys current financial condition. This is not a hopeless situation; it is simply a situation where a good company has allowed control over certain key assets to slip over the last year or so.
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Problem 17-22 (30 minutes) 1. The income statement in common-size format would be: This Last Year Year 100.0% 100.0% 65.0 60.0 35.0 40.0 26.3 30.4 8.7 9.6 1.2 1.6 7.5 8.0 2.3 2.4 5.2% 5.6% This Year Last Year 2.0% 15.0 30.1 1.0 48.1 51.9 100.0% 25.1% 20.1 45.1 15.0 10.0 29.8 54.9 100.0% 5.1% 10.1 15.2 1.3 31.6 68.4 100.0% 12.7% 25.3 38.0 19.0 12.7 30.4 62.0 100.0%

Sales............................................... Less cost of goods sold.................... Gross margin................................... Less operating expenses................. Net operating income...................... Less interest expense...................... Net income before taxes................. Less income taxes........................... Net income......................................

The balance sheet in common-size format would be: Current assets: Cash.............................................. Accounts receivable....................... Inventory....................................... Prepaid expenses.......................... Total current assets.......................... Plant and equipment........................ Total assets...................................... Liabilities: Current liabilities........................... Bonds payable, 12%...................... Total liabilities.................................. Stockholders equity: Preferred stock, 8%, $10 par.......... Common stock, $5 par................... Retained earnings.......................... Total stockholders equity................. Total liabilities and stockholders equity............................................

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

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Problem 17-22 (continued) 2. The companys cost of goods sold has increased from 60% of sales last year to 65% of sales this year. 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% of sales this year as compared to 30.4% last year. Unfortunately, this reduction in operating expenses was not enough to offset the increase in cost of goods sold. As a result, the companys net income declined from 5.6% of sales last year to 5.2% of sales this year.

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Group Exercise 17-23 The answers to this question will depend on the company that the students decide to analyze.

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