14
Analyzing Chapter Financial Statements
ANSWERS TO QUESTIONS
1. Primary items on the financial statements about which creditors usually are concerned include: (a) income--profit potential of the business, (b) cash flows--ability of the business to generate cash, and (c) assets and debts-- financial position. The notes to the financial statements are particularly important to decision makers because they explain, usually in narrative fashion, circumstances and special events which cannot be communicated adequately in the body of the financial statements. The notes call attention to such items as pending problems, contingent liabilities, and circumstances surrounding certain judgments that were made in measuring and reporting. They are useful in interpreting the amounts given in the financial statements and in making projections of the future performance of the business. The primary purpose of comparative financial statements is to provide the user with information on the short-term trends of the various financial factors reported in the financial statements. For example, the trends of such factors as sales, expenses, income, amount of debt, retained earnings, and earnings per share are particularly important in assessing the record of the company in the past and the present. These short-term trends should be used in predicting future performance of the business. Comparative statements usually report only two consecutive periods which often is too short to assess adequately certain trends. Statement users are interested especially in financial summaries covering several years because the long-term trends of the business are revealed. Statement users must make projections of the future performance of the business in their decisions to either invest or disinvest. Long-term financial summaries provide particularly useful information in making these projections. Financial data covering only one or two periods have limited usefulness for this particular type of decision. The primary limitation of unusually long-term summaries is that early years may not be useful because of changes in the business, industry, and environment.
2.
3.
4.
5. Ratio analysis is a technique for computing and pinpointing certain significant relationships in the financial statements. A ratio or percent
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expresses a proportionate relationship between two different amounts reported on the financial statements. A ratio is computed by dividing one amount by another amount; the divisor is known as the base amount. For example, the profit margin ratio is computed by dividing net income by net sales. Ratio analysis is particularly useful because it may reveal critical relationships that are not readily apparent from absolute dollar amounts. 6. Component percentages are representations, as ratios or percents, of the relationships between each of the several individual amounts that make up a single total. For example, on the balance sheet the component percentages for assets are computed by dividing the amount of each individual asset by the amount of total assets. The resulting ratios or percentages will sum to 100 percent. Component percentages are useful because they reveal relative relationships that are not readily apparent from absolute dollar amounts. 7. Fundamentally, return on investment is income divided by investment. The two concepts of return on investment are: (a) Return on equity (net income divided by owners' investment). This rate reflects the return earned for the owners after deducting the return to the creditors (interest expense is a deduction to derive income). (b) Return on assets (return on total assets, which includes both owners' equity and creditors' equity). This rate reflects the return earned on the total resources employed. The computation is net income plus after-tax interest expense divided by total assets. Usually both concepts are applied because each serves a somewhat different purpose. Return on equity reflects the viewpoint of the owners because it measures the net return on their investment only. Return on assets reflects the earnings performance of the company on total resources used (i.e., from both owners and creditors). 8. Financial leverage percentage is measured as the difference between the rate of return on equity and the rate of return on assets. This difference is caused only by interest on debt. An excess of the rate of return on equity over the rate of return on assets is due to financial leverage; that is, the company earned a higher rate on total investment than the net-of-tax interest rate on all debt. This advantage accrues to the benefit of the stockholders (i.e., positive leverage). 9. Profit margin is the ratio between net income and net sales. It reflects performance in respect to the control of expenses to net sales but is deficient as a measure of profitability because it does not consider the amount of resources (i.e., investment) used to earn the income amount. Profitability is best measured as the ratio of income to investment.
10. The current ratio is computed by dividing total current assets by total current liabilities. In contrast, the quick ratio is computed by dividing quick assets
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(i.e., the sum of cash, short-term investments, and accounts receivable) by current liabilities. The current ratio tends to measure liquidity and to indicate the cushion of current assets over current liabilities. In contrast the quick ratio is a much more severe test of current liquidity because the assets used in computing the ratio are cash and those that are very near to cash. 11. A debt/equity ratio reflects the portion of total assets or resources used by a business that was provided by creditors versus owners. In some companies, the amount of debt is approximately 70 percent of the total assets which means that the company is highly leveraged, which is a favorable side of financing by debt. That is, a company earning, say, 20 percent on total assets, while at the same time paying interest of 8 percent on debt, would generate a difference which accrues to the benefit of the stockholders. On the other side, the interest on debt must be paid each period, regardless of whether income was earned, and at the maturity of the debt, the full principal must be paid. In contrast, resources provided by owners are much less risky to the business because dividends do not have to be paid and there is no fixed maturity amount to be paid on a specific date. 12. Market tests are intended to measure the market worth per share of stock. Market tests relate some amount to a share of stock (such as EPS or dividends paid per share). Each time the share price changes the measurement changes. The two commonly used market tests are: (a) price/earnings ratio (i.e., market price per share divided by EPS) and (b) dividend yield ratio (i.e., dividends per share divided by the market price per share). 13. The primary limitations associated with using ratios are: (a) no specification exists (which is generally agreed upon) of how each ratio should be computed and (b) evaluation of the results (i.e., whether a ratio at a given amount is good or bad) is subjective. The latter problem indicates a need to select one or more standards against which the computed ratio amount may be compared.
ANSWERS TO MULTIPLE CHOICE
1. c) 6. d) 2. c) 7. c) 3. c) 8. a) 4. c) 9. b) 5. a) 10. d)
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Authors' Recommended Solution Time
(Time in minutes)
Mini exercises No. Time 1 5 2 5 3 5 4 5 5 5 6 5 7 5 8 5 9 5 10 5
Exercises No. Time 1 20 2 20 3 20 4 25 5 15 6 20 7 20 8 20 9 20 10 20 11 20 12 20 13 20 14 25 15 25
Problems No. Time 1 60 2 45 3 60 4 20 5 60 6 30 7 60 8 30 9 50 10 20 11 45
Alternate Problems No. Time 1 60 2 45 3 20 4 60 5 60 6 30 7 30
Cases and Projects No. Time 1 50 2 50 3 60 4 45 5 20 6 20 7 40 8 30 9 25
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MINI-EXERCISES
M141.
X $1,680,145,000 X
= =
55.9% $939,201,055
Revenue Cost of Goods Sold Gross Profit Cost of Goods Sold M142. 2007 Sales Cost of Goods Sold Gross Profit *Sales 2007:
$1,680,145,000 (X) $939,201,055 $740,943,945
$22,339 * ($9,330) $13,009 $20,917 x 1.068 = $22,339
Gross Profit %: $13,009 $22,339 = 58.2% M143. $185,000 / [($1,000,000 + $1,200,000) 2] = 16.8% M144. 22% - 8% = 14% M145. If the average sales volume remains the same, then the cost of goods sold will also remain the same. If the inventory decreases by 25%, the inventory turnover ratio will increase.
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M146. Current Assets + Non-Current Assets Total Assets Current Assets = $720,000 $720,000 Current Liabilities = 1.5 Current Liabilities = $480,000 M147. Current Ratio = Current Assets Current Liabilities X $480,000 $1,200,000
Quick Ratio
=
Quick Assets Current Liabilities
By the definitions of current ratio and quick ratio, one can see that the quick ratio must always be less than or equal to the current ratio. We know that a mistake has been made in this case because the quick ratio is greater than the current ratio and that is not possible. M148. Market Price per Share $212.50 Earnings per Share $8.50 = P / E multiplier 25 $8.50 x 1.20 = $10.20 $10.20 x 25 = New Stock Price $255 M149. 5% = $2.00 Market Price per Share
$40.00 = Market Price per Share
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M1410. In most circumstances, a change from FIFO to LIFO will cause inventory to decrease and cost of good sold to increase.
Profit Margin Fixed Asset Turnover Current Ratio Quick Ratio
Will decrease Will not be affected Will decrease Will not be affected
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EXERCISES
E141. 1. 2. 3. 4. Car manufacturer (high inventory; high property & equipment; lower inventory turnover) Wholesale candy company (high inventory turnover) Retail fur store (high gross profit; high inventory) Advertising agency (low inventory; absence of gross profit)
E142. 1. 2. 3. 4. Meat packer (high inventory turnover) Travel agency (no gross profit or inventory; high receivables) Hotel (high property & equipment; no gross profit or inventory) Drug company (high gross profit, low inventory turnover)
E143. 1. 2. 3. 4. Cable T.V. Company (no gross profit; high property & equipment) Accounting firm (high receivables; no gross profit) Retail jewelry store (high inventory; high gross profit) Grocery store (high inventory turnover)
E144. 1. 2. 3. 4. Restaurant (high inventory turnover; high property & equipment) Full-line department store (high cost of inventory; high gross profit) Automobile dealer (high cost of inventory; low property & equipment) Wholesale fish company (high inventory turnover; lower gross profit)
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E145. 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. 11. 12. 13. 14. 15. 16. 17. A H B L C G K M E I J D N F Q O P Profit margin Inventory turnover ratio Average collection period Dividend yield ratio Return on equity Current ratio Debt/equity ratio Price/earnings ratio Financial leverage percentage Receivable turnover ratio Average days' supply of inventory Earnings per share Return on assets Quick ratio Times interest earned ratio Cash coverage ratio Fixed asset turnover
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E146.
(In Millions, Except Per Share Data)
1/31/2004
%
1/31/2004
%
Net Sales Cost of Sales Gross Margin Expenses: Selling, General and Administrative Store Opening Costs Depreciation Interest Total Expenses Pre-Tax Earnings Income Tax Provision Earnings from Continuing Operations Earnings from Discontinued Operations, Net of Tax Net Earnings
$ 30,838 21,231 9,607
100.00% 68.85 31.15
$ 26,112 100.00 18,164 7,948 69.56 30.44
5,543 128 758 180 6,609 2,998 1,136 1,862 15 $1,877
17.97 0.42 2.46 0.58 21.43 9.72 3.68 6.04 0.05 6.09%
4,676 129 622 182 5,609 2,339 880 1,459 12 $ 1,471
17.91 0.49 2.38 0.70 21.48 8.96 3.37 5.59 0.05 5.63 %
There is a small but meaningful improvement in the gross margin. This improvement added significantly to the overall profitability of Lowe's. The other percentages are stable over the two years, indicating a well-run company.
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E147. Current Current Assets Current Liabilities Ratio (1) (2) (1 2) $54,000 ($54,000 1.8) $30,000 1.8 Inventory + 6,000 Accts. Pay. + 6,000 60,000 36,000 1.67 1,000 $59,000
Start Transaction (1) Subtotal
Transaction (2)* Cash
$36,000
1.64
*Debt and truck are noncurrent items. E148. Effect on Current Ratio 1. 2. 3. 4. E149. Turnover: Accounts receivable $15,422* [($3,038 + $4,062) 2] Inventory ($51,407 x .55) [($3,640 + $4,400) 2] *$51,407 x 30% = $15,422 Days: Accounts receivable (365 days 4.3) Inventory (365 days 7.0) E1410. Rate of return on equity $1,180 ($28,728 $16,506) Rate of return on assets $1,180 + ($16,506 x .08 x .7)] $28,728 Financial leverage percentage (positive) = = 4.3 7.0 Increase, assuming that cash was collected from sale Will decrease Will decrease Will increase
= 84.9 = 52.1
= 9.7 % = 7.3 % = 2.4 %
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E1411. Current Current Assets Current Liabilities Ratio (1) (2) (1 2) $100,000 ($100,000 1.5) $66,667 1.50 Cash 6,000 Accts. pay. 94,000 10,000 84,000 6,000 60,667 1.55
Start Transaction (1) Subtotal Transaction (2) Transaction (3)
Cash No impact Cash
60,667
1.38
Transaction (4)
84,000 25,000 Dividends pay. $ 59,000
60,667 25,000 $35,667
1.38 1.65
E1412. Cost of Goods Sold Cost of Goods Sold Net Sales Net Sales Less: COGS Gross Margin E1413. Turnover: Accounts receivable $720,000* [($80,000 + $60,000) 2] Inventory ($900,000 x .6) [($50,000 + $90,000) 2] *$900,000 x 80% = $720,000 Days: Accounts receivable (365 days 10.3) Inventory (365 days 7.7) = = 10.3 7.7 = = = = = = 3.0 x $721,843,000 $2,165,529,000 11.4 x $283,142,000 $3,227,818,800 ($2,165,529,000) $1,062,289,800
= 35.4 = 47.4
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E1414. Current Assets (1) Start $500,000 Transaction (1) A/R* +12,000 Subtotal 512,000 Transaction (2) Transaction (3) Cash Prepaid Transaction (4) Cash Transaction (5) Cash A/R Transaction (6) 462,000 512,000 -12,000 +12,000 512,000 -50,000 462,000 +12,000 -12,000 462,000 Current Liabilities (2) ($500,000 2) $250,000 250,000 Dividends pay. +50,000 300,000 Current Ratio (1 2) 2.00 2.05
1.71
Dividends pay.
300,000 -50,000 250,000
1.71 1.85
ST Lia.
250,000 +40,000 290,000
1.85 1.59
*We assume that the periodic inventory system is used and, therefore, there is no impact on inventory. Some students will try to try to reduce inventory as part of this transaction. E1415. Current Ratio $1,059,451 $279,964 $1,173,666 [($492,156 + $524,571) 2] $1,611,951 * [($291,277 + $271,766) 2] * $2,686,585 x 60% = $1,611,951 = 3.78
Inventory Turnover
=
2.31
Account Receivable Turnover
=
5.73
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PROBLEMS
P141. Students should include the following points in their papers: 1. Company A has a high level of liquidity as shown by the current ratio but the low quick ratio indicates that much of the liquidity is tied up in inventory. 2. The low inventory turnover is another indication of an excessive amount of inventory. Analysts would be concerned about whether the inventory could be quickly converted to cash. 3. In addition to liquidity concerns, Company A shows a high debt/equity ratio. 4. Company A does not seem to have good growth opportunities. The market has valued Company A at a low price/earnings multiple. P142. Students should include the following points in their papers: 1. Company A is either extremely efficient at inventory management or it does not carry enough inventory to support its operations. The low current ratio (in combination with an average quick ratio) and the high inventory turnover give an indication of low levels of inventory. 2. Company A appears to have the ability to borrow additional funds given its low debt/equity ratio. 3. Company A seems to pay low dividends and has a high price/earnings multiple. These ratios would suggest good growth opportunities.
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P143. Commerce Bank Cinergy Gas and Electric Compaq Computers Home Depot Motorola Starbucks America Online Amazon.com Pepsi P144. Sears is the stronger company and probably the better investment. Sears has a higher gross profit margin, which means that they make more gross profit on each dollar of sales than JCPenney. This is very significant since the two companies are in the same business, and operate in the same way. The current ratio of Sears is higher than the current ratio of JCPenney, but the Sears quick ratio is lower. This says that Sears has more inventory than JCPenney and this may be inefficient. If investors want more information about liquidity, they can refer to the Statements of Cash Flows. The Sears capital structure includes more debt which gives the company a higher degree of financial leverage. Their investors receive a higher return on equity but there is additional risk. JCPenney is paying out more dividends than they earned. Sears' dividend payout is lower, suggesting they are reinvesting earnings in the company. B. 12 E. 10 I. 82 H. 65 G. 108 A. 55 F. 143 D. N / A C. 26
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P145. Req. 1
Ratio Tests of profitability: 1. Return on equity 2. Return on assets 3. 4. 5. 6. Financial leverage percentage Earnings per share Profit margin Fixed asset turnover Armstrong Company $45,000 $240,000 = 19% [$45,000 + ($60,000 x 10% x.70)] $400,000 = 12% 19% 12% = 7% $45,000 15,000 sh. = $3.00 $45,000 $450,000 = 10% $450,000 $140,000 = 3.21 $35,000 $100,000 = .35 $175,000 $100,000 = 1.75 $75,000 $100,000 = .75 $150,000 [($20,000 + $40,000) 2] = 5.00 $245,000 [($92,000 + $100,000) 2] = 2.55 $160,000 $240,000 = .67 Blair Company $90,000 $680,000 = 13% [$90,000 + ($70,000 x 10% x .70)] $800,000 = 12% 13% 12% = 1% $90,000 50,000 sh. = $1.80 $90,000 $810,000 = 11% $810,000 $400,000 = 2.03 $22,000 $50,000 = .44 $92,000 $50,000 = 1.84 $52,000 $50,000 = 1.04 $270,000 [($38,000 + $30,000) 2] = 7.94 $405,000 [($45,000 + $40,000) 2] = 9.53 $120,000 $680,000 = .18
Tests of liquidity: 7. Cash ratio 8. Current ratio 9. Quick ratio 10. Receivable turnover 11. Inventory turnover Solvency and equity position: 12. Debt/equity ratio Market tests: 13. Price/earnings ratio 14. Dividend yield ratio
$18 $3.00 = 6.0 ($36,000 15,000 shares) $18 = 13.3%
$15 $1.80 = 8.33 ($150,000 50,000 shares) $15 = 20%
Req. 2 Recommended choice: Armstrong Company Basis for recommendation: 1. The reported information for Armstrong Company is audited; therefore, it has more credibility. 2. Profitability in the future has a higher probability for Armstrong Company because the return on equity is 19% (compared with 13%) although return on assets is the same (12%). The resulting leverage advantage of 7% (compared with 1%) is because of the use of debt. Armstrong Company obtains 40% of its total resources by borrowing compared with 15% by Blair Company (see the ratio: creditors' equity to total equities). Both companies can borrow at 7% net of tax while earning a 12% rate on assets (debt plus
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P145. (continued) Req. 2 (continued) owners' equity). Armstrong Company is taking better advantage of this leverage. The advantageous position of Armstrong Company also is reflected in EPS. Armstrong Company has a profit margin of 10% (compared with the better 11% profit margin of Blair Company). Armstrong Company earned net income of $45,000 while using total investment of only $400,000. Blair Company earned net income of $90,000 (twice as much) while using total investment $800,000 (also twice as much), but Armstrong Company obtained a much higher percent of its total investment through debt at only 7% (thus, a much better leverage factor, and a much higher return on owners' equity: 19% compared with 13%). Blair Company has a better liquidity position if measured in terms of the current ratio (1.84 compared with 1.75) and its quick ratio is better (1.04 compared with 0.75). Blair Company is in a better position in respect to credit and collections (turnover of 7.94 compared with 5.0). However, Armstrong Company reflects a significantly lower (unfavorable) inventory turnover (2.55 compared with 9.53). This difference, in view of sales revenue, suggests overstocking by Armstrong. The market tests do not favor either company. However, Blair Company declared and paid a dividend in excess of 2007 profits. This pattern cannot be continued. Blair Company is low on cash ($22,000). Also, the high amount of other assets ($308,000, or 39%) raises the question of their contribution to earnings.
3.
4.
Constraint--The above analysis is based on only one year which poses a problem of evaluation. Selected detailed data for the prior year should be analyzed in a similar manner. A five- to ten-year summary of selected values also would be quite useful. Other particularly important information should be evaluated, such as the characteristics of the company, the industry, economic conditions, and the quality of the management.
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P146. Req. 1 Increase (Decrease) 2007 over 2006 Amount Percent Income statement: Sales revenue ................................................................... Cost of goods sold ............................................................ Gross margin..................................................................... Operating expenses and interest expense ........................ Pretax income ................................................................... Income tax......................................................................... Net income ........................................................................ Balance sheet: Cash .................................................................................. Accounts receivable (net) .................................................. Inventory ........................................................................... Operational assets (net) .................................................... Current liabilities................................................................ Long-term liabilities ........................................................... Common stock ($5 par) ..................................................... Retained earnings ............................................................. $15,000 10,000 5,000 3,000 2,000 1,000 $ 1,000 $ (4,000) (4,000) 5,000 7,000 $ 4,000 $ (3,000) 0 0 7,000 $ 4,000 9.09 10.00 7.69 5.66 16.67 33.33 11.11 (50.00) (22.22) 14.29 18.42 4.04 (15.79) 0 0 140.00 4.04
Req. 2 Working capital: 2007 Current Assets: Cash............................................................................ $ 4,000 Accounts receivable (net) ............................................ 14,000 Inventory ..................................................................... 40,000 Total Current Assets ....................................................... 58,000 Current Liabilities ............................................................ 16,000 Working Capital ........................................................... $42,000 Change: $42,000 $42,000 = $0 no change Cash inflow from revenues: Total revenue Decrease in accounts receivable ($18,000 $14,000) Total
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2006 $ 8,000 18,000 35,000 61,000 19,000 $42,000
$180,000 4,000 $184,000
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P147.
Req. 1 Component Percentages 2007 Income statement: Sales revenue (the base amount) ............................................................. Cost of goods sold .................................................................................... Gross margin on sales .............................................................................. Operating expenses and interest expense ................................................ Pretax income ........................................................................................... Income taxes ............................................................................................. Net income ................................................................................................ Balance sheet Cash .......................................................................................................... Accounts receivable (net) .......................................................................... Inventory ................................................................................................... Operational assets (net) ............................................................................ Total assets (the base amount) ................................................................. Current liabilities........................................................................................ Long-term liabilities (10% interest) ............................................................ Common stock ($5 par) ............................................................................. Retained earnings ..................................................................................... Total liabilities and owners' equity (the base amount) ........................... *rounded 100 61 39 31 8 2 6 4 14 39 43* 100 16 43* 29 12 100
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P147. (continued) Req. 2 a. b. c. Average percentage markup on sales: $70,000 $180,000 = 38.89% Average income tax rate: $4,000 $14,000 = 28.57% Profit margin: $10,000 $180,000 = 5.56%. This is not a good measure of profitability because it does not consider the investment required to earn the income. Investment in operational assets: $45,000 $103,000 = 43.69% of total assets. Debt/equity ratio: $61,000 $42,000 = 1.45 A ratio of 1.45 indicates that the creditors provided almost one and a half times the amount of resources that the owners provided. A ratio of over 1 to 1 usually is considered too high; a ratio of approximately 0.5 to 1 usually would be considered better. However, it is an improvement over the previous year. f. Return on equity: $10,000 $38,500* = 26% *($42,000 + $35,000) 2 = $38,500 g. Return on assets: [($10,000 + ($4,500 x .7143)]* $101,000** = 13% *$45,000 x 10% = $4,500 (interest expense) $4,000 $14,000 = .2857 (average tax rate) 1.000 .2857 = .7143 (after-tax rate) **($103,000 + $99,000) 2 = $101,000. h. Financial leverage percentage: 26% 13% = 13%. The financial leverage percentage was positive (i.e., in favor of the stockholders) by a significant amount.
d. e.
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P148. Name and Computation of the Ratio Tests of profitability: (1) Return on equity: $10,000 $38,500* = 25.97% *($42,000 + $35,000) 2 = $38,500 (2) Return on assets: ($10,000 + $3,214*) $101,000 = 13.08% *($45,000 x 10% x .7143 = $3,214) The average tax rate was $4,000 $14,000 = 28.57% and 1.000 .2857 = .7143 ($103,000 + $99,000) 2 = $101,000 (3) Financial leverage percentage: 25.97% 13.08% = 12.89% positive Measures return earned for owners based upon their investment (including retained earnings) in the business. Measures the entity's performance in using total resources (total assets) available to it. Brief Explanation of the Ratio
Advantage to be gained by investors when the interest rate (net of tax) is less than the rate earned on total investment. Measures return earned on each share of common stock outstanding. A measure of whether reported earnings are supported by cash flows. Indicates percent of each sales dollar that was represented by income. An indication of how efficiently management is using fixed assets.
(4) Earnings per share $10,000 6,000 = $1. (5) Quality of income: This ratio cannot be computed with the available data (6) Profit margin $10,000 $180,000 = .0556 (or 5.56%) (7) Fixed asset turnover $180,000 $41,500* = 4.34 * $45,000 + $38,000 = $41,500 2
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P148. (continued) Name and Computation of the Ratio Tests of liquidity: (1) Cash ratio $4,000 $16,000 = .25 The most stringent test of liquidity; it measures the amount of cash available to pay current liabilities. Measures the adequacy of working capital by relating total current assets to total current liabilities. A severe test of liquidity by relating quick assets to total current liabilities. Measures effectiveness of credit granting and collection of receivables. Average number of days to collect an account receivable. Brief Explanation of the Ratio
(2) Current ratio $58,000 $16,000 = 3.63 to 1
(3) Quick Ratio $18,000 $16,000 = to 1.13 1 (4) Receivable turnover $60,000 $18,000 + $14,000 = 3.75 times 2 Average collection period 365 3.75 = 97.3 days (5) Inventory turnover $110,000 $35,000 + $40,000 = 2.9 times 2 Days' supply in inventory 365 2.9 = 126 days
An indication of the velocity with which merchandise flows through the business.
Indicates, as a days of supply figure, the velocity with which merchandise flows through the business.
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P148. (continued) Name and Computation of the Ratio Tests of solvency and equity position: (1) Times interest earned ($10,000 + $4,500 + $4,000) $4,500 = 4.11 (2) Cash coverage This ratio cannot be computed because cash flow data are not available (3) Debt/equity ratio $61,000 $42,000 = 1.45 A measure of the amount of earnings available to cover interest expense. Brief Explanation of the Ratio
This ratio measures the amount of cash flow from operating activities available to cover interest expense. Measures relationship between resources provided by owners versus resources provided by creditors.
Market tests: (1) Price/earnings ratio $28.00 $1.67 = 16.8 to 1 Measures earnings potential of the company that may benefit investors directly or indirectly. It is the ratio of income to the current market price of the stock. Measures cash return to the stockholder from dividends in relationship to the current market price of the stock.
(2) Dividend yield $0.50 $28.00 = 1.8%
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P149. Req. 1 Name and Computation of the 2007 Ratio Tests of profitability: (1) Return on equity: $23,000 $109,000* = 21.10%. *($116,000 + $102,000) 2 = $109,000 (2) Return on assets: ($23,000 + $4,900*) $188,000= 14.84%. *Bonds: $70,000 x 10% x .70 = $4,900 (The average tax rate was: $10,000 $33,000 = 30%) ($204,000 + $172,000) 2 = $188,000 (3) Financial leverage percentage: 21.10% 14.84% = 6.26% positive The advantage to be gained by investors when the interest rate (net of tax) is less than the return on assets. A measure of the return earned on each share of common stock outstanding. Indicates percent of each sales dollar that was represented by income. An indication of how efficiently management is using fixed assets. Measures return earned for owners based upon their investment (including retained earnings) in the business. Measures the entity's performance in using total resources (total assets) available to it. Brief Explanation of the Ratio
(4) Earnings per share $23,000 20,000 shares = $1.15
(5) Profit margin $23,000 $450,000 = 5.1% (6) Fixed asset turnover $450,000 [($130,000 + $120,000) 2] = 3.6
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P149. (continued) Req. 1 (continued) Name and Computation of the 2007 Ratio Tests of liquidity: (1) Cash ratio $6,800 $18,000 = .38 The most stringent test of liquidity; it measures the amount of cash available to pay current liabilities. Measures the adequacy of working capital by relating total current assets to total current liabilities. A severe test of liquidity by relating quick assets to total current liabilities. A measure of the effectiveness of credit granting and collection of receivables. Brief Explanation of the Ratio
(2) Current ratio $74,000 $18,000 = 4.11 to 1
(3) Quick ratio $48,800 $18,000 = 2.71 to 1 (4) Receivable turnover $180,000 [$42,000 + $28,000] 2 = 5.14 times Average collection period 365 5.14 = 71.01 days (5) Inventory turnover
Average number of days to collect an account receivable. An indication of the velocity with which merchandise flows through the business.
$250,000 [$25,000 + $20,000] 2 = 11.11 times Average days' supply 365 11.11 days = 32.85 days Indicates, as a days of supply figure, the velocity with which merchandise flows through the business.
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P149. (continued) Req. 1 (continued) Name and Computation of the 2007 Ratio Tests of solvency and equity position: (1) Times interest earned ($23,000 + $10,000 + $7,000) $7,000 = 5.7 (2) Debt/equity ratio $88,000 $116,000 = .76 A measure of the amount of earnings available to cover interest expense. Brief Explanation of the Ratio
Measures relationship between resources provided by owners versus resources provided by creditors.
Market tests: (1) Price/earnings ratio $18 $1.15 = 15.65 to 1 A measure of the earnings of a company that may benefit the investor directly or indirectly. It is the ratio of current market price of the stock to the EPS. Measures cash return to the stockholder from dividends in relationship to the current market price of the stock.
(2) Dividend yield ratio $0.45 $18 = 2.5%
Req. 2 (a) The financial leverage percentage indicates that a 6.26% advantage was earned for the stockholders because the company earned 21.10% on total (resources) used and paid 7.0% interest on debt (after tax). (b) The profit margin was 5% of net sales. This means that the business earned $.05 profit on each sales dollar. Whether it is good can be determined reasonably by comparing it with standards such as (a) prior years, (b) industry averages, (c) projections (planned), and (d) published averages. (c) The current ratio of 4.11 to 1 is more than the quick ratio of 2.71 to 1 because the latter ratio is a much more severe test of liquidity (it omits inventory and prepaid expenses). Each of these ratios probably would be good when compared with some standard (such as those listed in (b) above). However, there appears to be a severe liquidity problem that these two ratios do not divulge; that is, the extremely low amount of cash ($6,800) which is only 9.19% of total current assets ($6,800 $74,000). (d) There appears to be a credit and collection deficiency. The receivable collection period of 71.01 days compared with the 30-day credit terms indicates more uncollected accounts than should be expected.
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P1410. Analysis The case states that both companies are exactly alike except for the impact of the alternative methods to cost inventory. Use of LIFO (compared to FIFO), during a period of rising prices, causes (1) lower inventory amounts on the balance sheet, (2) lower net income on the income statement, and (3) a lower retained earnings balance on the balance sheet. Use of LIFO for federal income tax determination reduces both tax expense and tax liability. Inasmuch as both companies have paid their tax liabilities, the company using LIFO (Company B) will report a higher cash balance. 1. Current ratio--Company A will have a higher ratio because the inventory amount is higher under FIFO. The cash balance for Company A is less than the balance for Company B but the difference in cash balances is less than the difference in inventory amounts (because the cash difference is the inventory difference multiplied by the income tax rate). Quick ratio--Company B will have a higher ratio because of the higher cash balance. The difference in inventory amounts does not affect the quick ratio because inventory is excluded from quick assets. Debt/equity ratio--Company B will have a higher ratio because of reporting a lower amount of equity. LIFO results in lower net income which means that retained earnings (part of owners' equity) also will be lower. Return on equity--The analyst cannot be certain which company will report a higher ratio. The numerator of the ratio reflects differences for the current year and the denominator reflects differences for the current year plus all previous years. Without a quantification of the cumulative difference from previous years, it is impossible to be certain which company will have the higher ratio. EPS--Company A will have a higher ratio because of reporting higher net income.
2.
3.
4.
5.
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P1411. Return on equity: $457,584 ($1,279,866 + 1,371,703) 2 Return on assets: $457,584 + ($63,529 x 66%*) ($3,582,540 + 3,480,551) 2 *Assumed tax rate of 34% Financial leverage percentage: ROE ROI = 34.5% 14.1% = 20.4% (positive) Earnings per share: $457,584 (149,528+ 149,528) 2 = $3.06* = 14.1% = 34.5%
*Note: The EPS reported by Hershey ($3.48) is different because it used more precise procedures discussed in intermediate accounting. Quality of income: Cannot compute without the statement of cash flows. Profit margin: $457,584 $4,172,551 Fixed asset turnover: $4,172,551 ($1,661,939 + $1,486,055) 2 Cash ratio: $114,793 $585,810 Current ratio: $1,131,569 $585,810 Quick ratio: $522,405 $585,810
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=
2.7
= .20
= 1.9
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P1411. (continued) Receivable turnover: $4,172,551 * ($407,612 + $370,976) 2
=
10.7
* When amount of credit sales is not known, total sales may be used as a rough approximation. Unfortunately, this estimate is often not meaningful. Inventory turnover: $2,544,726 ($492,859 + $503,291) 2 Times interest earned: $457,584 + $63,529 + $267,875 $63,529 Cash coverage: Cannot compute without statement of cash flows. Debt/Equity: $2,302,674 $1,279,866 Price earnings: Cannot compute without current market price per share. Dividend yield: Cannot compute without current market price per share. = 1.8 = 12.4 = 5.1
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ALTERNATE PROBLEMS
AP141. Students should include the following points in their papers: 1. Company A shows a high EPS but a low ROA. There are a number of possible explanations for this situation. The high debt/equity ratio suggests that Company A is highly leveraged and is able to generate high earnings for stockholders by using a large amount of debt financing. 2. The low level of liquidity for Company A is a concern given its high debt/equity ratio. 3. Despite a high EPS, Company A has a low price/earnings multiple. This is often an indication of limited growth opportunities or concern in the market. 4. The dividend yield for Company A is high. The company may be paying significant dividends or its stock price may be currently depressed.
AP142. Students should include the following points in their papers: 1. Company A appears to be very profitable based on both ROA and profit margin. The use of leverage has enhanced the ROA. 2. Company A's solvency and liquidity are potential areas of concern. 3. The price/earnings multiple for Company A suggests a profitable company with good growth prospects. AP143. Coca-Cola is the stronger company and probably is the better investment. The biggest difference between the two companies are the P/E ratio, ROA, and the gross profit margin. Coca-Cola has a much larger P/E ratio, meaning that the market sees Coca-Cola as having more potential for growth than Pepsi. Also, the companies have similar business, but CocaCola's gross profit margin is significantly higher than Pepsi's. Coca-Cola earns more profit per dollar of sales than Pepsi does. The return on assets ratio for Coke is much better than Pepsi but Coke does appear to have a more risky capital structure because of its higher debt-to-equity ratio. Coke pays out a higher percentage of its earnings in dividends.
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AP144. Req. 1
Ratio Tests of profitability: 1. Return on equity 2. Return on assets 3. Financial leverage percentage 4. Earnings per share 5. Profit margin 6. Fixed asset turnover Tests of liquidity: 7. Cash ratio 8. Current ratio 9. Quick ratio 10. Receivable turnover 11. Inventory turnover Solvency and equity position: 12. Times Interest earned 13. Debt/equity ratio Market tests: 14. Price/earnings ratio 15. Dividend yield ratio Rand Company $80,000 $570,000 = 14% [$80,000 + ($190,000 x 12% x .70)] $880,000 = 10.9% 14.0% 10.9% = 3.1% $80,000 24,000 shares = $3.33 $80,000 $800,000 = 10% $800,000 $550,000 = 1.45 $25,000 $120,000 = .21 $190,000 $120,000 = 1.58 $80,000 $120,000 = .67 $400,000 [($47,000 + $55,000) 2] = 7.84 $480,000 [($95,000 + $110,000) 2] = 4.68 ($80,000 + $22,800 + $34,300) $22,800 = 6.01 $310,000 $570,000 = .54 $14.00 $3.33 = 4.20 ($20,000 24,000 shares) $14.00 = 6.0% Tand Company $35,000 $222,000 = 15.8% [$35,000 + ($55,000 x 12% x .70)] $292,000 = 13.6% 15.8% 13.6% = 2.2% $35,000 10,500 shares = $3.33 $35,000 $280,000 = 12.5% $280,000 $160,000 = 1.75 $45,000 $15,000 = 3 $75,000 $15,000 = 5 $50,000 $15,000 = 3.33 $70,000 [($11,000 + $5,000) 2] = 8.75 $150,000 [($38,000 + $25,000 2] = 4.76 ($35,000 + $6,600 + 15,000) $6,600 = 8.58 $70,000 $222,000 = .32 $11.00 $3.33 = 3.30 ($9,000 10,500 shares) $11.00 = 7.8%
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AP144. (continued) Req. 2 Preferable loan: Tand Company Basis for recommendation: 1. 2. Each set of financial statements is audited and each received an unqualified opinion; therefore, there is no preference on the quality of financial reporting. Profitability--Tand Company had a higher profit margin than Rand Company (12.5% compared with 10%). The earnings per share amounts were the same. Tand Company earned a rate of return on equity of 15.8% compared with 14% for Rand Company. Similarly, Tand Company had a rate of return on assets that was higher than Rand Company. In contrast, Tand Company had lower financial leverage. On balance, my conclusion is that Tand Company has a somewhat better future profitability potential than does Rand Company. Liquidity--Tand Company has higher liquidity than Rand Company as evidenced by the current ratio (5 compared with 1.58) and the quick ratio (3.33 compared with .67). Thus, on the basis of liquidity, a short-term loan to Tand Company would be somewhat preferable. Solvency and equity position--Tand Company clearly is in the better position on this factor. Tand Company financed its operations by obtaining 76% of its total assets from shareholders and 24% from debt. Stockholders' equity is much less risky because dividends do not have to be paid each period (interest does) and there is no maturity date for shares (which debt has). Therefore, on the basis of this analysis, a loan of $30,000 to Tand Company clearly is preferable to a loan of $75,000 to Rand Company. The price/earnings ratio provides little evidence in favor of either company. The dividend yield ratio shows that Tand Company provides the investor with higher current income. Constraint--The above analysis is based on only one year (which is relevant because it is the most recent) and the limited data given. However, selected detailed data for the prior year should be analyzed in a similar manner. A five- to ten-year summary of selected values also would be quite useful. Other particularly important data should be evaluated such as security for the loan (assets to mortgage), the management, the industry, economic conditions, cash flow projections, and reputation of the company.
3.
4.
5.
6.
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AP145. Req. 1 a. Tests of profitability*: (1) Return on equity: $12,600 $120,500 = 10.46%. (2) Return on assets: [$12,600 + ($4,000 x .70)] $199,750 = 7.71%. (3) Financial leverage percentage: 10.46% 7.71% = 2.75% positive (in favor of stockholders). (4) Earnings per share: $12,600 9,000 shares = $1.40. (5) Profit margin: $12,600 $110,000 = 11.4%. (6) Fixed asset turnover: $110,000 $100,000 = 1.1. *These ratios usually are computed on income before extraordinary items. Aftertax ratio: 1.00 .30 = .70. Investment amounts are based on the average of the 2006 and 2007 balances. b. Tests of liquidity: (7) Cash ratio: $49,500 $43,000 = 1.15 (8 Current ratio: $111,500 $43,000 = 2.59 to 1.00. $32,000 + $37,000 2 Average days to collect: 365 1.59 = 230 days. $38,000 + $25,000 2 Days' supply in inventory: 365 1.65 = 221 days. = 1.59 times
(9) Quick ratio: $86,500 $43,000 = 2.01 to 1.00. (10) Receivable turnover: $55,000
(11) Inventory turnover: $52,000
= 1.65 times
c.
Tests of solvency: (12) Times interest earned: ($12,600 + $4,000 + $5,400) $4,000 = 5.50 (13) Debt/equity ratio: $83,000 $123,500 = .67.
d.
Market tests: (14) Price/earnings ratio: $23 $1.40 = 16.43 times. (15) Dividend yield: $.75 $23 = 3.26%.
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AP145. (continued) Req. 2 a. Sales revenue Income before extraordinary items Net income Cash Inventory Debt ($110,000 $99,000) $99,000 = 11.11% ($12,600 $9,800) $9,800 = 28.57% ($11,200 $11,900) $11,900 = (5.88%) ($49,500 $18,000) $18,000 = 175% ($25,000 $38,000) $38,000 = (34.21%) ($83,000 $75,500) $75,500 = 9.93%
b.
Pretax interest rate on the long-term note: $4,000 $40,000 = 10%.
Req. 3 Potential problems are: 1. Average collection period of 230 days--long compared with the 30-day credit period. 2. Inventory turnover 1.65 (i.e., 221 days)--long shelf life for most businesses. 3. Increase in debt, nearly 10% from 2006 to 2007, is material in amount; investigate the cause. 4. There was a significant increase in the amount of cash reported on the balance sheet. Investigate why management wants to hold extra cash.
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AP146. Req. 1 Ratio a. Profit margin % b. Gross margin ratio c. Expenses as a % of sales excluding cost of goods sold d. Inventory turnover e. Days' supply in inventory f. Receivable turnover g. Average days to collect Computations: a. b. c. Profit margin: 2006, ($8) $44 = (18%); 2007, $5 $66 = 8%; 2008, $12 $80 = 15%; 2009, $11 $100 = 11%. Gross margin ratio: 2006, ($44 $28) $44 = .36; 2007, ($66 $40) 66 = .39; 2008, ($80 $55) $80 = .31; 2009, ($100 $62) $100 = .38. Expense percent of sales revenue: 2006, ($44 $28 + $8) $44 = 55%; 2007, ($66 $40 $5) $66 = 32%; 2008, ($80 $55 $12) $80 = 16%; 2009, ($100 $62 $11) $100 = 27%. Inventory turnover: 2006, $28 [($0 + $12) 2] = 4.67; 2007, $40 [($12 + $14) 2] = 3.08; 2008, $55 [($14 + $20) 2] = 3.24; 2009, $62 [($20 + $30) 2] = 2.48. Days' supply in inventory: 2006, 365 4.67 = 78; 2007, 365 3.08 = 119; 2008, 365 3.24 = 113; 2009, 365 2.48 = 147. Receivable turnover: 2006, $33 [($0 + $11) 2] = 6.0; 2007, $49.5 [($11 + $12) 2] = 4.3; 2008, $60 [($12 + $18) 2] = 4.0; 2009, $75 [($18 + $24) 2] = 3.6. Average days to collect: 2006, 365 6.0 = 61; 2007, 365 4.3 = 85; 2008, 365 4.0 = 91; 2009, 365 3.6 = 101. 2006 2007 (18%) 8% 36% 39% 55% 4.67 78 6.0 61 32% 3.08 119 4.3 85 2008 15% 31% 16% 3.24 113 4.0 91 2009 11% 38% 27% 2.48 147 3.6 101
d.
e. f.
g.
Req. 2 Revenue increased steadily each year. During the first years, profit margin increased, but it decreased in the last year. Gross margin changed each year, but increased the final year. Average markup chabged each year, but expenses as a percent of sales decreased each year with the exception of the last year. Recommendation: management should work to reverse the downward trend of income by increasing margin and reducing expenses.
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AP146. (continued) Req. 3 The inventory turnover ratio (and days' supply) reflect instability. This effect is even more pronounced when the turnover ratio is compared with the gross margin ratio and the profit margin ratio. These comparisons strongly suggest that inventory control (i.e., the amount of goods to stock) is seriously lacking. Recall that the higher the inventory turnover (and the lower the days' supply) the higher the profit margin. The receivable turnover ratio (and the average days to collect) for all years is in excess of what would be expected with credit terms of net, 30 days. These ratios vary significantly with a deteriorating trend over the period, which suggests considerable inefficiencies in credit and collections. Recommendation: That the management carefully assess the inventory situation and the credit and collection activities with a view to developing policies which will lead to the (a) determination of optimum inventory levels (to increase the inventory turnover ratio), and (b) optimum efficiency in the credit and collections activities (to increase the receivable turnover ratio and reduce the average days to collect).
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AP147. Return on equity: $751,391 ($3,263,774 + $2,229,157) 2 Return on assets: $751,391* ($6,775,432 + $5,755,633) 2 = 12.0% = 27.4%
*The income statement does not report any interest expense. The analyst could find this information in the notes to the statement. Financial leverage percentage: ROE ROA = 27.4% 12.0% = 15.4% (positive) Earnings per share: $751,391 (125,328 + 130,122)* 2 = $5.88
*Lennar has two classes of common stock. Only class A is held by the public. Some students may attempt to include class B in the computation. Quality of Income: Cannot compute without the statement of cash flows. Profit margin: $751,391 $8,907,619 Fixed asset turnover: Lennar combines home building and financial services, in addition to other business operations. The fixed asset ratio does not appear to be meaningful for this type of company. Cash ratio: $1,201,276 $1,040,961* = 1.15 = 8.4%
*Lennar does not clearly classify its liabilities in terms of current versus noncurrent. Therefore, the analyst must make a professional judgment.
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AP147. (continued) Current ratio: $4,917,769 $1,040,961* = 4.7
Lennar does not clearly classify its liabilities in terms of current versus noncurrent. Therefore, the analyst must make a professional judgment. Quick ratio: $1,261,668 $1,040,961* = 1.2
Lennar does not clearly classify its liabilities in terms of current versus noncurrent. Therefore, the analyst must make a professional judgment. Receivable turnover: $8,907,619 ($60,392 + $48,432) 2 = 163.7
While there is sufficient information to compute this ratio, the result is not meaningful for Lennar. The company does not does not finance the purchase of its new homes but instead sells mortgages to others. Inventory turnover: $7,288,356 ($3,656,101 + $3,237,577) 2 Times interest earned: Cannot compute without interest expense. Cash coverage: Cannot compute without statement of cash flows. Debt/Equity: $3,511,658 $3,263,774 = 1.1 = 2.1
Price earnings: Cannot compute without the current market price per share. Dividend yield: Cannot compute without information concerning dividends.
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CASES AND PROJECTS
FINANCIAL REPORTING AND ANALYSIS CASES CP141. PacSun Return on equity: $106,904 ($458,034 + $428,732) 2 = $443,383 Return on assets: $106,904 + 142 (1-.35) ($677,778 + $644,487) 2 = $661,132.5 Financial leverage percentage: ROE ROA = 24.1% - 16.2% = 7.9% (positive) Earnings per share: As reported $1.41 Quality of Income: $143,012 $106,904 Profit margin: $106,904 $1,229,762 = 8.7% = 1.34 = 16.2% = 24.1%
Fixed asset turnover: $1,229,762 ($304,222 + $272,869) 2 = $288,545.5 Cash ratio: $64,308 $95,310 = .67 = 4.26
Current ratio: $352,818 $95,310 = 3.70
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CP141. (continued) Quick ratio: $64,308 + 79,223 + 8,129 $95,310 = 1.59
Receivable turnover: This ratio cannot be computed because no information is provided about credit sales and net sales revenue is not a good approximation of credit sales for this company. Inventory turnover: $781,828 ($175,081 + $147,751) 2 = $161,416 Times interest earned: Not applicable Cash coverage: = 4.84
$143,012 + $142 + $59,081 $142
=
1,424
PacSun has little debt and correspondingly low interest payments. Thus, their cash coverage ratio is very high indicating no difficulty covering its interest obligations. Debt/Equity: $95,310 + $124,434 $458,034 = .48
Price earnings: (using high price for 4th quarter of fiscal year 2004) $25.46 $1.41 = 18.1
Dividend yield: 0% (No dividends were paid)
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CP142. American Eagle Return on equity: $213,343 ($963,486 + $637,377) 2 = $800,431.5 Return on assets: $213,343 + ($1,188* .65) ($1,293,659 + $932,414) 2 = $1,113,036.5 = 19.2% = 26.7%
*Interest expense is not reported as a separate item. We used cash interest payments as an approximation. Financial leverage percentage: ROE ROA = 26.7% - 19.2% = 7.5% (positive) Earnings per share: As reported $1.47 Quality of income: $368,683 $213,343 Profit margin: $213,343 $1,881,241 = 11.3% = 1.73
Fixed asset turnover: $1,881,241 ($353,213 + $340,955) 2 = $347,084 Cash ratio: $275,061 $253,265 Current ratio: $827,640 $253,265 = 3.27 = 1.09 = 5.42
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CP142. (continued) Quick ratio: $275,061 + $314,546 $253,265 = 2.33
Receivable turnover: This ratio cannot be computed because no information is provided about credit sales and net sales revenue is not a good approximation of credit sales for this company. Inventory turnover: $1,003,433 = 7.76 ($137,991 + $120,586) 2 = $129,288.5 Times interest earned: This ratio cannot be calculated because interest expense is not reported. Cash coverage:
$368,683 + $1,188 + $121,138 $1,188
=
413
American Eagle has little debt and correspondingly low interest payments. Thus, their cash coverage ratio is very high indicating no difficulty covering its interest obligations.
Debt/Equity $253,265+ $76,908 $963,486 = .34
Price earnings: (using high price in 4th quarter for 2004) $25.24 $1.47 = 17.2
Dividend yield: $.06 $25.24 = .24%
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CP143. For calculations, see CP14-1, CP14-2, and Appendix D. American Eagle PacSun Industry Average Return on equity 26.7% 24.1% 14.77% Return on assets 19.2% 16.2% 8.91% Financial leverage percentage 7.5% 7.9% 5.86% (14.77% - 8.91%) Quality of Income 1.73 1.34 2.28 Net Profit margin 11.3% 8.7% 4.52 Fixed asset turnover 5.42 4.26 7.44 Current ratio 3.27 3.70 2.32 Quick ratio 2.33 1.59 0.88 Inventory turnover 7.76 4.84 4.46 Debt/Equity .34 .48 0.61 Price earnings 17.2 18.1 18.02 Dividend yield .24% 0% 0.33%
CP144. Case 1: ROE = Net Income Average Owners' Equity $200,000 Average Owners' Equity
10%
=
Average Equity = $2,000,000 Case 2: Asset Turnover = Net Sales Average Total Assets
8 =
$8,000,000 Average Total Assets
Average Total Assets = $1,000,000
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CP144. (continued) Case 3: Asset Turnover = Net Sales Average Total Assets
5
=
Net Sales $1,000,000
Net Sales = $5,000,000 Net Profit Margin = Net Income Net Sales
10%
=
Net Income $5,000,000
Net Income = $500,000 ROE = Net Income Average Owners' Equity $500,000 Average Owners' Equity
15%
=
Average Owners' Equity = $3,333,333 Case 4: Asset Turnover = Net Sales Average Total Assets
5
=
$1,000,000 Average Total Assets
Average Assets = $200,000
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CP145. The two areas where we would expect the largest difference are profit margin and asset turnover. We would expect the high quality company to have higher margins. The low cost company could produce high returns to the owners. CP146. Company A is Nordstrom and Company B is J.C. Penney. The major impact of the different strategies can be seen in the margin. Nordstrom is able to maintain much higher profit margins with its quality strategy. CP147. We use this project to put ratio analysis into a broader context. We find that some students focus on the computation of ratios and the analysis of small differences between ratios for comparable companies. We try to help students see ratio analysis as one of many tools and financial information as only a subset of the relevant information that should be used when making investment decisions.
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CRITICAL THINKING CASES CP148. Although the amount of working capital was unchanged, the current ratio for Barton Company increased as a result of paying $420,000 to the trade creditors: Current assets Current liabilities Working capital Before $1,900,000 = 1.77 $1,075,000 $ 825,000 After $1,480,000 = 2.26 $655,000 $825,000
The current ratio has increased to an amount that is considered to be acceptable by First Federal Bank, but it appears that the increase is mere window dressing. Total working capital was unaffected by the transaction. In the process of improving the current ratio, Barton Company created a potential cash crisis. The cash balance was reduced to $10,000 ($430,000 $420,000) compared with current liabilities of $655,000. First Federal should deny the second loan request. A more fundamental point concerns the validity of the 2:1 criterion imposed by First Federal. The case illustrates the ease with which some ratios can be manipulated. Usually a rigid cut-off point is not advisable for ratio analysis. FINANCIAL REPORTING AND ANALYSIS PROJECTS CP149. The response to this question will depend on the company selected by the student.
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