14 CHAPTER (MAN) FINANCIAL STATEMENT ANALYSIS
EYE OPENERS
1. Horizontal analysis is the percentage analysis of increases and decreases in corresponding statements. The percent change in the cash balances at the end of the pre-ceding year from the end of the current year is an example. Vertical analysis is the percentage analysis showing the relationship of the component parts to the total in a single statement. The percent of cash as a portion of total assets at the end of the current year is an example. 2. Comparative statements provide information as to changes between dates or periods. Trends indicated by comparisons may be far more significant than the data for a single date or period. 3. Before this question can be answered, the increase in net income should be compared with changes in sales, expenses, and assets devoted to the business for the current year. The return on assets for both periods should also be compared. If these comparisons indicate favorable trends, the operating performance has improved; if not, the apparent favorable increase in net income may be offset by unfavorable trends in other areas. 4. You should first determine if the expense amount in the base year (denominator) is significant. An 80% or more increase of a very small expense item may be of little concern. However, if the expense amount in the base year is significant, then over an 80% increase may require further investigation. 5. Generally, the two ratios would be very close, because most service businesses sell services and hold very little inventory. 6. The amount of working capital and the change in working capital are just two indicators of the strength of the current position. A comparison of the current ratio and the quick ratio, along with the amount of working capital, gives a better analysis of the current position. Such a comparison shows: Current Preceding Year Year Working capital....... $100,000 $90,000 Current ratio............ 2.0 2.5 Quick ratio............... 0.8 1.4 It is apparent that, although working capital has increased, the current ratio has fallen from 2.5 to 2.0, and the quick ratio has fallen from 1.4 to 0.8. 7. The bulk of Wal-Mart sales are to final customers that pay with credit cards or cash. In either case, there is no accounts receivable. Procter & Gamble, in contrast, sells almost exclusively to other businesses, such as Wal-Mart. Such sales are on account, and thus, create accounts receivable that must be collected. A recent financial statement showed Wal-Marts accounts receivable turning 64 times, while Procter & Gambles turned only 6 times. 8. No, an accounts receivable turnover of 5 with sales on a n/45 basis is not satisfactory. It indicates that accounts receivable are collected, on the average, in one-fifth of a year, or approximately 73 days from the date of sale. Assuming that some customers pay within the 45-day term, it indicates that other accounts are running beyond 73 days. It is also possible that there is a substantial amount of past-due accounts of doubtful collectibility on the books. 9. a. A high inventory turnover minimizes the amount invested in inventories, thus freeing funds for more advantageous use. Storage costs, administrative expenses, and losses caused by obsolescence and adverse changes in prices are also kept to a minimum. b. Yes. The inventory turnover could be high because the quantity of inventory on hand is very low. This condition might result in the lack of sufficient goods on hand to meet sales orders.
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c. Yes. The inventory turnover relates to the turnover of inventory during the year, while the number of days sales in inventory relates to the amount of inventory on hand at the beginning and end of the year. Therefore, a business could have a high inventory turnover during the year, yet have a high number of days sales in inventory based on the beginning and end-of-year inventory amounts. 10. The ratio of fixed assets to long-term liabilities increased from 3.0 for the preceding year to 4.0 for the current year, indicating that the company is in a stronger position now than in the preceding year to borrow additional funds on a long-term basis. 11. a. The rate earned on total assets adds interest expense to the net income, which is divided by average total assets. It measures the profitability of total assets, without regard for how the assets are financed. The rate earned on stockholders equity divides net income by average total stockholders equity. It measures the profitability of the stockholders investment. b. The rate earned on stockholders equity is normally higher than the rate earned on total assets. This is because of leverage, which compensates stockholders for the higher risk of their investments. 12. a. Due to leverage, the rate on stockholders equity will often be greater than the rate on total assets. This occurs because the amount earned on assets acquired through the use of funds provided by creditors exceeds the interest charges paid to creditors.
13. 14. 15.
16.
17.
b. Higher. The concept of leverage applies to preferred stock as well as debt. The rate earned on common stockholders equity ordinarily exceeds the rate earned on total stockholders equity because the amount earned on assets acquired through the use of funds provided by preferred stockholders normally exceeds the dividends paid to preferred stockholders. The earnings per share in the preceding year were $40 per share ($80/2), adjusted for the stock split in the latest year. A share of common stock is currently selling at 12 times current annual earnings. The dividend yield on common stock is a measure of the rate of return to common stockholders in terms of cash dividend distributions. Companies in growth industries typically reinvest a significant portion of the amount earned in common stockholders equity to expand operations rather than to return earnings to stockholders in the form of cash dividends. During periods when sales are increasing, it is likely that a company will increase its inventories and expand its plant. Such situations frequently result in an increase in current liabilities out of proportion to the increase in current assets and thus lower the current ratio. One report is the Report on Internal Control, which verifies managements conclusions on internal control. Another report is the Report on Fairness of the Financial Statements, where the Certified Public Accounting (CPA) firm that conducts the audit renders an opinion on the fairness of the statements.
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PRACTICE EXERCISES PE 141A (Man)
Accounts payable Long-term debt $8,400 increase ($78,400 $70,000), or 12% $5,760 increase ($101,760 $96,000), or 6%
PE 141B (Man)
Temporary investments Inventory $10,800 increase ($70,800 $60,000), or 18% $11,000 decrease ($99,000 $110,000), or 10%
PE 142A (Man)
Amount Sales Gross profit Net income $500,000 140,000 40,000 Percentage 100% 28 8 ($500,000 $500,000) ($140,000 $500,000) ($40,000 $500,000)
PE 142B (Man)
Amount Sales Cost of goods sold Gross profit $600,000 480,000 $120,000 Percentage 100% 80 20 % ($600,000 $600,000) ($480,000 $600,000) ($120,000 $600,000)
PE 143A (Man)
a. Current Ratio = Current Assets Current Liabilities Current Ratio = ($190,000 + $150,000 + $260,000 + $300,000) $600,000 Current Ratio = 1.5 b. Quick Ratio = Quick Assets Current Liabilities Quick Ratio = ($190,000 + $150,000 + $260,000) $600,000 Quick Ratio = 1.0
PE 143B (Man)
a. Current Ratio = Current Assets Current Liabilities Current Ratio = ($140,000 + $60,000 + $40,000 + $80,000) $160,000 Current Ratio = 2.0 b. Quick Ratio = Quick Assets Current Liabilities Quick Ratio = ($140,000 + $60,000 + $40,000) $160,000 Quick Ratio = 1.5
PE 144A (Man)
a. Accounts Receivable Turnover = Net Sales Average Accounts Receivable Accounts Receivable Turnover = $560,000 $40,000 Accounts Receivable Turnover = 14.0 b. Number of Days Sales in Receivables = Average Accounts Receivable Average Daily Sales Number of Days Sales in Receivables = $40,000 ($560,000 365) = $40,000 $1,534 Number of Days Sales in Receivables = 26.1 days
PE 144B (Man)
a. Accounts Receivable Turnover = Net Sales Average Accounts Receivable Accounts Receivable Turnover = $600,000 $60,000 Accounts Receivable Turnover = 10.0 b. Number of Days Sales in Receivables = Average Accounts Receivable Average Daily Sales Number of Days Sales in Receivables = $60,000 ($600,000 365) = $60,000 $1,644 Number of Days Sales in Receivables = 36.5 days
PE 145A (Man)
a. Inventory Turnover = Cost of Goods Sold Average Inventory Inventory Turnover = $510,000 $60,000 Inventory Turnover = 8.5 b. Number of Days Sales in Inventory = Average Inventory Average Daily Cost of Goods Sold Number of Days Sales in Inventory = $60,000 ($510,000 365) = $60,000 $1,397 Number of Days Sales in Inventory = 42.9 days
PE 145B (Man)
a. Inventory Turnover = Cost of Goods Sold Average Inventory Inventory Turnover = $480,000 $80,000 Inventory Turnover = 6.0 b. Number of Days Sales in Inventory = Average Inventory Average Daily Cost of Goods Sold Number of Days Sales in Inventory = $80,000 ($480,000 365) = $80,000 $1,315 Number of Days Sales in Inventory = 60.8 days
PE 146A (Man)
a. Ratio of Fixed Assets to Long-Term Liabilities = Fixed Assets Long-Term Liabilities Ratio of Fixed Assets to Long-Term Liabilities = $600,000 $400,000 Ratio of Fixed Assets to Long-Term Liabilities = 1.5 b. Ratio of Liabilities to Stockholders Equity = Total Liabilities Total Stockholders Equity Ratio of Liabilities to Stockholders Equity = $600,000 $400,000 Ratio of Liabilities to Stockholders Equity = 1.5
PE 146B (Man)
a. Ratio of Fixed Assets to Long-Term Liabilities = Fixed Assets Long-Term Liabilities Ratio of Fixed Assets to Long-Term Liabilities = $1,000,000 $500,000 Ratio of Fixed Assets to Long-Term Liabilities = 2.0 b. Ratio of Liabilities to Stockholders Equity = Total Liabilities Total Stockholders Equity Ratio of Liabilities to Stockholders Equity = $800,000 $800,000 Ratio of Liabilities to Stockholders Equity = 1.0
PE 147A (Man)
Number of Times Interest Charges Are Earned = (Income Before Income Tax + Interest Expense) Interest Expense Number of Times Interest Charges Are Earned = ($2,000,000 + $80,000) $80,000 Number of Times Interest Charges Are Earned = 26.0
PE 147B (Man)
Number of Times Interest Charges Are Earned = (Income Before Income Tax + Interest Expense) Interest Expense Number of Times Interest Charges Are Earned = ($1,500,000 + $200,000) $200,000 Number of Times Interest Charges Are Earned = 8.5
PE 148A (Man)
Ratio of Net Sales to Assets = Net Sales Average Total Assets Ratio of Net Sales to Assets = $2,400,000 $1,600,000 Ratio of Net Sales to Assets = 1.5
PE 148B (Man)
Ratio of Net Sales to Assets = Net Sales Average Total Assets Ratio of Net Sales to Assets = $1,200,000 $1,000,000 Ratio of Net Sales to Assets = 1.2
PE 149A (Man)
Rate Earned on Total Assets = (Net Income + Interest Expense) Average Total Assets Rate Earned on Total Assets = ($400,000 + $20,000) $3,500,000 Rate Earned on Total Assets = $420,000 $3,500,000 Rate Earned on Total Assets = 12.0%
PE 149B (Man)
Rate Earned on Total Assets = (Net Income + Interest Expense) Average Total Assets Rate Earned on Total Assets = ($600,000 + $75,000) $4,500,000 Rate Earned on Total Assets = $675,000 $4,500,000 Rate Earned on Total Assets = 15.0%
PE 1410A (Man)
a. Rate Earned on Stockholders Equity = Net Income Average Stockholders Equity Rate Earned on Stockholders Equity = $120,000 $600,000 Rate Earned on Stockholders Equity = 20.0%
b. Rate Earned on Common Stockholders Equity = (Net Income Preferred Dividends) Average Common Stockholders Equity Rate Earned on Common Stockholders Equity = ($120,000 $20,000) $500,000 Rate Earned on Common Stockholders Equity = 20.0%
PE 1410B (Man)
a. Rate Earned on Stockholders Equity = Net Income Average Stockholders Equity Rate Earned on Stockholders Equity = $180,000 $1,200,000 Rate Earned on Stockholders Equity = 15.0%
b. Rate Earned on Common Stockholders Equity = (Net Income Preferred Dividends) Average Common Stockholders Equity Rate Earned on Common Stockholders Equity = ($180,000 $12,000) $800,000 Rate Earned on Common Stockholders Equity = 21.0%
PE 1411A (Man)
a. Earnings per Share on Common Stock = (Net Income Preferred Dividends) Shares of Common Stock Outstanding Earnings per Share = ($340,000 $40,000) 40,000 Earnings per Share = $7.50
b. Price-Earnings Ratio = Market Price per Share of Common Stock Earnings per Share on Common Stock Price-Earnings Ratio = $60.00 $7.50 Price-Earnings Ratio = 8.0
PE 1411B (Man)
a. Earnings per Share on Common Stock = (Net Income Preferred Dividends) Shares of Common Stock Outstanding Earnings per Share = ($140,000 $20,000) 60,000 Earnings per Share = $2.00
b. Price-Earnings Ratio = Market Price per Share of Common Stock Earnings per Share on Common Stock Price-Earnings Ratio = $50.00 $2.00 Price-Earnings Ratio = 25.0
EXERCISES Ex. 141 (Man)
a. ROGAN TECHNOLOGIES CO. Comparative Income Statement For the Years Ended December 31, 2010 and 2009 2010 Amount Percent Sales............................................. Cost of goods sold..................... Gross profit................................. Selling expenses........................ Administrative operating expenses................................ Total expenses............................ Income from operations............ Income tax expense................... Net income.................................. $500,000 325,000 $175,000 $ 70,000 75,000 $145,000 $ 30,000 25,000 $ 5,000 100.0% 65.0 35.0% 14.0% 15.0 29.0% 6.0% 5.0 1.0% Amount $440,000 242,000 $198,000 $ 79,200 70,400 $149,600 $ 48,400 26,400 $ 22,000 2009 Percent 100.0% 55.0 45.0% 18.0% 16.0 34.0% 11.0% 6.0 5.0%
b. The vertical analysis indicates that the cost of goods sold as a percent of sales increased by 10 percentage points (65.0% 55.0%), while selling expenses de creased by 4 percentage points (14% 18%), administrative expenses de creased by 1% (15% 16%), and Income Tax Expense decreased by 1 percent age point (5% 6%). Thus, net income as a percent of sales dropped by 4% (4% + 1% + 1% 10%).
Ex. 142 (Man)
a. SPEEDWAY MOTORSPORTS, INC. Comparative Income Statement (in thousands of dollars) For the Years Ended December 31, 2006 and 2005 2006 Revenues: Admissions....................................... Event-related revenue..................... NASCAR broadcasting revenue..... Other operating revenue................. Total revenue.............................. Expenses and other: Direct expense of events................ NASCAR purse and sanction fees. Other direct expenses..................... General and administrative............. Total expenses and other.......... Income from continuing operations. . . $175,208 183,404 162,715 46,038 $567,365 $ 95,990 105,826 113,141 78,070 $393,027 $174,338 30.9% 32.3 28.7 8.1 100.0% 16.9% 18.7 19.9 13.8 69.3% 30.7% 2005 $177,352 168,359 140,956 57,401 $544,068 $ 97,042 96,306 102,535 73,281 $369,164 $174,904 32.6% 30.9 25.9 10.6 100.0% 17.8% 17.7 18.8 13.5 67.8% 32.2%
b. While overall revenue increased some between the two years, the overall mix of revenue sources did change somewhat. The NASCAR broadcasting revenue in creased as a percent of total revenue by almost three percentage points, while the percent of admissions revenue to total revenue decreased by almost two percentage points. All three of the major expense categories (Direct expense of events, NASCAR purse and sanction fees, and Other direct expenses) as a per cent of total revenue increased by approximately 1 percentage point. Overall, the income from continuing operations decreased 1.4 percentage points of total revenue between the two years, which is a slightly unfavorable trend. However, the income from continuing operations as a percent of sales exceeds 25% in the most recent year, which is excellent. Apparently, owning and operating motor speedways is a business that produces high operating profit margins. Note to Instructors: The high operating margin is probably necessary to compensate for the extensive investment in speedway assets.
Ex. 143 (Man)
a. SORENSON ELECTRONICS COMPANY Common-Sized Income Statement For the Year Ended December 31, 20 Sorenson Electronics Company Amount Percent Sales.................................................................. Sales returns and allowances......................... Net sales............................................................ Cost of goods sold........................................... Gross profit....................................................... Selling expenses.............................................. Administrative expenses................................. Total operating expenses................................ Operating income............................................. Other income.................................................... Other expense.................................................. Income before income tax............................... Income tax expense......................................... Net income........................................................ $ 2,050,000 50,000 $ 2,000,000 1,100,000 $ 900,000 $ 560,000 220,000 $ 780,000 $ 120,000 44,000 $ 164,000 20,000 $ 144,000 60,000 $ 84,000 102.5% 2.5 100.0% 55.0 45.0% 28.0% 11.0 39.0% 6.0% 2.2 8.2% 1.0 7.2% 3.0 4.2% Electronics Industry Average 102.5% 2.5 100.0% 61.0 39.0% 23.0% 10.0 33.0% 6.0% 2.2 8.2% 1.0 7.2% 5.0 2.2%
b. The cost of goods sold is 6 percentage points lower than the industry average, but the selling expenses and administrative expenses are five percentage points and 1 percentage point higher than the industry average. The combined impact is for net income as a percent of sales to be 2 percentage points better than the industry average. Apparently, the company is managing the cost of manufacturing product better than the industry but has slightly higher selling and administrative expenses relative to the industry. The cause of the higher selling and administrative expenses as a percent of sales, relative to the industry, can be investigated further.
Ex. 144 (Man)
HANES COMPANY Comparative Balance Sheet December 31, 2010 and 2009 2010 Amount Percent Current assets.............................. $ 320,000 32.0% Property, plant, and equipment. 560,000 56.0 Intangible assets.......................... 120,000 12.0 Total assets.................................. $ 1,000,000 100.0% Current liabilities.......................... $ 210,000 21.0% Long-term liabilities..................... 350,000 35.0 Common stock............................. 100,000 10.0 Retained earnings........................ 340,000 34.0 Total liabilities and stockholders equity.............. $ 1,000,000 100.0% 2009 Amount Percent $200,000 560,000 40,000 $800,000 $120,000 300,000 100,000 280,000 $800,000 25.0% 70.0 5.0 100.0% 15.0% 37.5 12.5 35.0 100.0%
Ex. 145 (Man)
a. GRENDEL IMAGES COMPANY Comparative Income Statement For the Years Ended December 31, 2010 and 2009 2010 Amount Sales............................................. Cost of goods sold..................... Gross profit................................. Selling expenses........................ Administrative expenses........... Total operating expenses.......... Income before income tax......... Income tax expense................... Net income.................................. $196,000 170,100 $ 25,900 $ 12,200 9,750 $ 21,950 $ 3,950 2,000 $ 1,950 2009 Amount $160,000 140,000 $ 20,000 $ 10,000 8,000 $ 18,000 $ 2,000 1,000 $ 1,000 Increase (Decrease) Amount Percent $ 36,000 30,100 $ 5,900 $ 2,200 1,750 $ 3,950 $ 1,950 1,000 $ 950 22.5% 21.5 29.5 22.0 21.9 21.9 97.5 100.0 95.0
b. The net income for Grendel Images Company increased by 95% from 2009 to 2010. This increase was the combined result of an increase in sales of 22.5% and lower expenses. The cost of goods sold increased at a slower rate than the increase in sales, thus causing gross profit to increase more than the increase in sales.
Ex. 146 (Man)
a. (1) Working Capital = Current Assets Current Liabilities 2010: $1,000,000 = $1,500,000 $500,000 2009: $644,000 = $1,104,000 $460,000 (2) Current Ratio = 2010: Current Assets Current Liabilities $1,500,000 = 3.0 2009: $500,000 Quick Assets Current Liabilities $900,000 = 1.8 2009: $500,000
$1,104,000 = 2.4 $460,000
(3) Quick Ratio = 2010:
$690,000 = 1.5 $460,000
b. The liquidity of Bock Suppliers has improved from the preceding year to the cur rent year. The working capital, current ratio, and quick ratio have all increased. Most of these changes are the result of an increase in current assets.
Ex. 147 (Man)
a. (1) Current Ratio = Dec. 30, 2006: (2) Quick Ratio = Dec. 30, 2006: Current Assets Current Liabilities $9,130 = 1.3 $6,860 Quick Assets Current Liabilities $6,547 = 1.0 $6,860 Dec. 31, 2005: $8,143 = 0.9 $9,406 Dec. 31, 2005: $10,454 = 1.1 $9,406
b. The liquidity of PepsiCo has increased some over this time period. Both the cur rent and quick ratios have increased. The current ratio increased from 1.1 to 1.3, and the quick ratio increased from 0.9 to 1.0. PepsiCo is a strong company with ample resources for meeting short-term obligations.
Ex. 148 (Man)
a. The working capital, current ratio, and quick ratio are calculated incorrectly. The working capital and current ratio incorrectly include intangible assets and prop erty, plant, and equipment as a part of current assets. Both are noncurrent. The quick ratio has both an incorrect numerator and denominator. The numerator of the quick ratio is incorrectly calculated as the sum of inventories, prepaid ex penses, and property, plant, and equipment ($40,000 + $60,000 + $92,000). The denominator is also incorrect, as it does not include accrued liabilities. The de nominator of the quick ratio should be total current liabilities. The correct calculations are as follows: Working Capital = Current Assets Current Liabilities $50,000 = $550,000 $500,000 Current Assets Current Liabilities
Current Ratio =
$550,000 = 1.1 $500,000 Quick Assets Current Liabilities
Quick Ratio =
$170,000 + $80,000 + $200,000 = 0.9 $500,000 b. Unfortunately, the working capital, current ratio, and quick ratio are all below the minimum threshold required by the bond indenture. This may require the company to renegotiate the bond contract, including a possible unfavorable change in the interest rate.
Ex. 149 (Man)
a. (1) Accounts Receivable Turnover = 2010: $975,000 = 6.4 $152,750 Net Sales on Account Average Monthly Accounts Receivable 2009: $900,000 = 5.6 $161,500
(2) Number of Days Sales in Receivables = $152,750 1 2010: = 57.2 days $2,6712 2009:
1 2 3 4
Average Accounts Receivable Average Daily Sales on Account
$161,500 3 = 65.5 days $2,466 4
$152,750 = ($147,500 + $158,000) 2 $2,671 = $975,000 365 days $161,500 = ($158,000 + $165,000) 2 $2,466 = $900,000 365 days
b. The collection of accounts receivable has improved. This can be seen in both the increase in accounts receivable turnover and the reduction in the collection period. The credit terms require payment in 60 days. In 2009, the collection peri od exceeded these terms. However, the company apparently became more ag gressive in collecting accounts receivable or more restrictive in granting credit to customers. Thus, in 2010, the collection period is within the credit terms of the company.
Ex. 1410 (Man)
a. (1) Accounts Receivable Turnover = Xavier: Net Sales on Account Average Accounts Receivable
$28,000 = 11.2 ($2,750 + $2,250) 2 $65,000 = 5.0 ($15,000 + $11,000) 2 Accounts Receivable Average Daily Sales on Account
Lestrade:
(2) Number of Days Sales in Receivables = Xavier:
( $2,750 + $2,250) 2
$76.711 $178.08 2
= 32.6 days = 73.0 days
Lestrade:
1 2
( $15,000 + $11,000) 2
$76.71 = $28,000 365 days $178.08 = $65,000 365 days
b. Xaviers accounts receivable turnover is much higher than Lestrades (11.2 for Xavier vs. 5.0 for Lestrade). The number of days sales in receivables is lower for Xavier than for Lestrade (32.6 days for Xavier vs. 73.0 days for Lestrade). These differences indicate that Xavier is able to turn over its receivables more quickly than Lestrade. As a result, it takes Xavier less time to collect its receivables.
Ex. 1411 (Man)
a. (1) Inventory Turnover = Current Year: Cost of Goods Sold Average Inventory
$569,800 = 7.4 ($74,000 + $80,000) 2 $662,400 = 9.2 ($80,000 + $64,000) 2 Average Inventory Average Daily Cost of Goods Sold
Preceding Year:
(2) Number of Days Sales in Inventory = Current Year:
($74,000 + $80,000) 2 = 49.3 days $1,5611 ($80,000 + $64,000) 2 = 39.7 days $1,815 2
Preceding Year:
1 2
$1,561 = $569,800 365 days $1,815 = $662,400 365 days
b. The inventory position of the business has deteriorated. The inventory turnover has decreased, while the number of days sales in inventory has increased. The sales volume has declined faster than the inventory has declined, thus resulting in the deteriorating inventory position.
Ex. 1412 (Man)
a. (1) Inventory Turnover = Dell: HP: Cost of Goods Sold Average Inventory
$47,904 = 76.8 ($588 + $660) 2 $69,427 = 9.5 ($6,877 + $7,750) 2 Average Inventory Average Daily Cost of Goods Sold
(2) Number of Days Sales in Inventory = Dell: HP:
1
($588 + $660) 2 = 4.8 days $1311 ($6,877 + $7,750) 2 = 38.5 days $190 2
$131 = $47,904 365 days 2 $190 = $69,427 365 days b. Dell has a much higher inventory turnover ratio than does HP (76.8 vs. 9.5 for HP). Likewise, Dell has a much smaller number of days sales in inventory (4.8 days vs. 38.5 days for HP). These significant differences are a result of Dells make-to-order strategy. Dell has successfully developed a manufacturing process that is able to fill a customer order quickly. As a result, Dell does not need to prebuild computers to inventory. HP, in contrast, prebuilds computers, print ers, and other equipment to be sold by retail stores and other retail channels. In this industry, there is great obsolescence risk in holding computers in invent ory. New technology can make an inventory of computers difficult to sell; therefore, inventory is costly and risky. Dells operating strategy is considered revolutionary and is now being adopted by many both in and out of the computer industry. Apple Computer, Inc., also employs similar manufacturing techniques, and thus enjoys excellent inventory efficiency.
Ex. 1413 (Man)
a. Ratio of Liabilities to Stockholders Equity = Dec. 31, 2010: $2,700,000 = 0.6 $4,500,000 Total Liabilitie s Total Stockholders' Equity $3,080,000 = 0.8 $3,850,000
Dec. 31, 2009:
b.
Number of Times Bond Interest Charges Are Earned = Dec. 31, 2010: Dec. 31, 2009:
Income Before Tax + Interest Expense Interest Expense
$720,000 + $240,000 * = 4.0 $240,000 $560,000 + $280,000 ** = 3.0 $280,000
*($2,000,000 + $400,000) 10% = $240,000 **($2,400,000 + $400,000) 10% = $280,000 c. Both the ratio of liabilities to stockholders equity and the number of times bond interest charges were earned have improved from 2009 to 2010. These results are the combined result of a larger income before taxes and lower serial bonds payable in the year 2010 compared to 2009.
Ex. 1414 (Man)
a. Ratio of Liabilities to Stockholders Equity = Hasbro: $1,400,790 = 0.9 $1,538,160 $2,522,910 = 1.0 $2,432,974 Total Liabilities Total Stockholders' Equity
Mattel, Inc.:
b. Income Before Tax + Interest Expense Number of Times = Interest Charges Are Earned Interest Expense Hasbro: $376,363 + $27,521 = 14.7 $27,521 $728,818 + $79,853 = 10.1 $79,853
Mattel, Inc.:
c. Both companies carry a moderate proportion of debt to the stockholders equity, near 1.0 times stockholders equity. The companies debt as a percent of stockholders equity is similar. Both companies also have very strong interest coverage, earning in excess of 10 times interest charges. Together, these ratios indicate that both companies provide creditors with a margin of safety, and that earnings appear more than enough to make interest payments.
Ex. 1415 (Man)
a. Ratio of Liabilities to Stockholders Equity = H.J. Heinz: Total Liabilities Total Stockholders' Equity
$2,505,106 + $4,413,641 + $1,272,596 = 4.4 $1,841,683
Hershey:
$1,453,538 + $1,248,128 + $486,473 = 4.7 $683,423 Fixed Assets (net) Long-Term Liabilitie s
b. Ratio of Fixed Assets to Long-Term Liabilities = H.J. Heinz: $1,998,153 = 0.35 $5,686,237
Hershey:
$1,651,300 = 0.95 $1,734,601
c. H.J. Heinz uses more debt than does Hershey. While the total liabilities to stockholders equity ratio is similar for both companies (4.4 vs. 4.7), the ratio of fixed assets is very different. H.J. Heinz has a much lower ratio of fixed assets to long-term liabilities than Hershey. This ratio divides the property, plant, and equipment (net) by the long-term debt. The ratio for H.J. Heinz is ag gressive with only 35% of fixed assets covering the long-term debt. That is, the creditors of H.J. Heinz have 35 cents of property, plant, and equipment covering every dollar of long-term debt. The same ratio for Hershey shows fixed assets covering 0.95 times the long-term debt. That is, Hersheys creditors have $0.95 of property, plant, and equipment covering every dollar of long-term debt. This would suggest that Hershey has stronger creditor protection and borrowing ca pacity than does H.J. Heinz.
Ex. 1416 (Man)
a. Ratio of Net Sales to Total Assets: YRC Worldwide: $9,918,690 = 1.7 $5,829,713 Net Sales Total Assets
Union Pacific:
$15,578,00 0 = 0.4 $36,067,50 0 $6,566,194 = 4.3 $1,513,381
C.H. Robinson Worldwide, Inc.:
b. The ratio of net sales to assets measures the number of sales dollars earned for each dollar of assets. The greater the number of sales dollars earned for every dollar of assets, the more efficient a firm is in using assets. Thus, the ratio is a measure of the efficiency in using assets. The three companies are different in their efficiency in using assets, because they are different in the nature of their operations. Union Pacific earns only 40 cents for every dollar of assets. This is because Union Pacific is very asset intensive. That is, Union Pacific must invest in locomotives, railcars, terminals, tracks, right-of-way, and information systems in order to earn revenues. These investments are significant. YRC Worldwide is able to earn $1.70 for every dollar of assets, and thus, is able to earn more rev enue for every dollar of assets than the railroad. This is because the motor carri er invests in trucks, trailers, and terminals, which require less investment per dollar of revenue than does the railroad. Moreover, the motor carrier does not in vest in the highway system, because the government owns the highway system. Thus, the motor carrier has no investment in the transportation network itself unlike the railroad. C.H. Robinson Worldwide, Inc., the transportation arranger, hires transportation services from motor carriers and railroads, but does not own these assets itself. The transportation arranger has assets in accounts receivable and information systems but does not require transportation assets; thus, it is able to earn the highest revenue per dollar of assets.
Ex. 1416 (Man)
Concluded
Note to Instructors: Students may wonder how asset-intensive companies overcome their asset efficiency disadvantages to competitors with better asset effi ciencies, as in the case between railroads and motor carriers. Asset efficiency is part of the financial equation; the other part is the profit margin made on each dollar of sales. Thus, companies with high asset efficiency often operate on thinner margins than do companies with lower asset efficiency. For example, the motor carrier must pay highway taxes, which lowers its operating margins when compared to railroads that own their right-of-way, and thus do not have the tax expense of the highway. While not required in this exercise, the railroad has the highest profit margins, the motor carrier is in the middle, while the transportation arranger operates on very thin margins.
Ex. 1417 (Man)
a. Rate Earned on Total Assets = 2010: Net Income + Interest Expense Average Total Assets 2009: $308,000 + $100,000 = 16.0% $2,550,000 * *
$242,000 + $100,000 = 12.0% $2,850,000 *
*($3,000,000 + $2,700,000) 2 Rate Earned on Stockholders Equity = 2010: $242,000 = 15.0% $1,611,000 *
**($2,700,000 + $2,400,000) 2 Net Income Average Stockholders' Equity 2009: $308,000 = 22.8% $1,348,000 **
*($1,726,000 + $1,496,000) 2
**($1,496,000 + $1,200,000) 2
Net Income Preferred Dividends Rate Earned on = Common Stockholders' Equity Average Common Stockholders' Equity 2010: $242,000 $12,000 = 16.3% $1,411,000 *
-
2009:
$308,000 $12,000 = 25.8% $1,148,000 **
-
*($1,526,000 + $1,296,000) 2
**($1,296,000 + $1,000,000) 2
b. The profitability ratios indicate that The Sigemund Groups profitability has de teriorated. Most of this change is from net income falling from $308,000 in 2009 to $242,000 in 2010. The cost of debt is 10%. Since the rate of return on assets exceeds this amount in either year, there is positive leverage from use of debt. However, this leverage is greater in 2009 because the rate of return on assets exceeds the cost of debt by a greater amount in 2009.
Ex. 1418 (Man)
a. Rate Earned on Total Assets = Fiscal Year 2006: Net Income + Interest Expense Average Total Assets
$142,982 + $2,230 = 9.5% ($1,568,50 3 + $1,492,906 ) 2 $81,872 + $2,083 = 6.0% ($1,492,90 6 + $1,327,338 ) 2 Net Income Average Total Stockholders' Equity
Fiscal Year 2005:
b. Rate Earned on Stockholders Equity = Fiscal Year 2006:
$142,982 = 13.7% ($1,049,91 1 + $1,034,482 ) 2 $81,872 = 8.3% ($1,034,48 2 + $926,744) 2
Fiscal Year 2005:
c. Both the rate earned on total assets and the rate earned on stockholders equity have increased over the two-year period. The rate earned on total assets increased from 6.0% to 9.5%, and the rate earned on stockholders equity increased from 8.3% to 13.7%. The rate earned on stockholders equity exceeds the rate earned on total assets due to the positive use of leverage. d. During fiscal 2006, Ann Taylors results were strong compared to the industry average. The rate earned on total assets for Ann Taylor was more than the in dustry average (9.5% vs. 8.2%). The rate earned on stockholders equity was more than the industry average (13.7% vs. 10.0%). These relationships suggest that Ann Taylor has more leverage than the industry, on average.
Ex. 1419 (Man)
a. Ratio of Fixed Assets to Long-Term Liabilities = $1,600,000 = 1.6 $1,000,000 b. Ratio of Liabilities to Stockholders Equity = $1,200,000 = 0.4 $3,000,000 c. Ratio of Net Sales to Assets = $10,000,00 0 = 5.0 $2,000,000 * *[($4,000,000 + $4,200,000) 2] $2,100,000. The end-of-period total assets are equal to the sum of total liabilities ($1,200,000) and stockholders equity ($3,000,000). d. Rate Earned on Total Assets = $400,000 + $100,000 = 12.2% $4,100,000 * *($4,000,000 + $4,200,000) 2 e. Rate Earned on Stockholders Equity = $400,000 = 13.8% $2,900,000 * *[($1,000,000 + $1,000,000 + $800,000) + $3,000,000] 2 f. Net Income Preferred Dividends Rate Earned on Common Stockholders' Equity = Average Common Stockholders' Equity $400,000 $100,000 = 15.8% $1,900,000 * * [($1,000,000 + $1,000,000) + ($1,000,000 + $800,000)] 2 Net Income Average Stockholders' Equity Net Income + Interest Expense Average Total Assets Net Sales Average Total Assets (excluding investments) Total Liabilities Total Stockholders' Equity Fixed Assets Long-Term Liabilities
-
Ex. 1420 (Man)
a. Income Before Tax + Interest Expense Number of Times Bond = Interest Charges Are Earned Interest Expense $1,000,000 + $400,000 = 3.5 times $400,000 Net Income Preferred Dividends
b. Number of Times Preferred Dividends Are Earned = $850,000 = 17.0 times $50,000
c. Earnings per Share on Common Stock = $850,000 $50,000 = $4.00 200,000 shares
-
Net Income Preferred Dividends Common Shares Outstanding
d. Price-Earnings Ratio = $40 = 10.0 $4.00
Market Price per Share Earnings per Share
e. Dividends per Share of Common Stock = $200,000 = $1.00 200,000 shares
Common Dividends Common Shares Outstanding
f.
Dividend Yield = $1.00 = 2.5% $40.00
Common Dividend per Share Share Price
Ex. 1421 (Man)
a. Earnings per Share = Net Income Preferred Dividends Common Shares Outstanding
-
$600,000 $200,000 = $1.60 250,000 shares b. Price-Earnings Ratio = $20.00 = 12.5 $1.60 c. Dividends per Share = Common Dividends Common Shares Outstanding Market Price per Share Earnings per Share
-
$125,000 = $0.50 250,000 shares d. Dividend Yield = $0.50 = 2.5% $20.00 Common Dividend per Share Share Price
Ex. 1422 (Man)
a. Price-Earnings Ratio = Bank of America: eBay: Market Price per Share Earnings per Share
$52.99 = 11.5 $ 4. 59
$33.51 = 58.8 $0.57 $47.76 = 22.1 $ 2. 16 Dividends per Share Market Price per Share $2.12 = 4.0% $52.99
Coca-Cola:
Dividend Yield =
Bank of America: eBay:
$0.00 = 0% $33.51 $1.24 = 2.6% $47.76
Coca-Cola:
b. Bank of America has the largest dividend yield, but the smallest price-earnings ratio. Stock market participants value Bank of America common stock on the basis of its dividend. The dividend is an attractive yield at this date. Because of this attractive yield, stock market participants do not expect the share price to grow significantly, hence the low price-earnings valuation. This is a typical pattern for companies that pay high dividends. eBay shows the opposite extreme. eBay pays no dividend, and thus has no dividend yield. However, eBay has the largest price-earnings ratio of the three companies. Stock market participants are expecting a return on their investment from appreciation in the stock price. Some would say that the stock is priced very aggressively at 58.8 times earn ings. Coca-Cola is priced in between the other two companies. Coca-Cola has a moderate dividend producing yield a of 2.6%. The price-earnings ratio is near 22, which is close to the market average at this writing. Thus, Coca-Cola is expected to produce shareholder returns through a combination of some share price appreciation and a small dividend.
Appendix Ex. 1423 (Man)
a. Earnings per share on income before extraordinary items: Net income....................................................................... $2,500,000 Less gain on condemnation.......................................... (500,000) Plus loss from flood damage......................................... 200,000 Income before extraordinary items............................... $2,200,000 Earnings Before Extraordinary Items per Share on Common Stock = Income Before Extraordinary Items Preferred Dividends Common Shares Outstanding $2,200,000 $160,000 = $20.40 per share 100,000 shares b. Earnings per Share on Common Stock = Net Income Preferred Dividends Common Shares Outstanding
-
-
-
$2,500,000 $160,000 = $23.40 per share 100,000 shares
-
Appendix Ex. 1424 (Man)
a. b. c. d. NR NR E NR e. E f. NR g. NR
Appendix Ex. 1425 (Man)
a. BRADY, INC. Partial Income Statement For the Year Ended December 31, 2010 Income from continuing operations before income tax................. Income tax expense............................................................................ Income from continuing operations.................................................. Loss from discontinued operations.................................................. Income before extraordinary item..................................................... Extraordinary item: Loss due to hurricane.................................................................. Net income............................................................................................ b. BRADY, INC. Partial Income Statement For the Year Ended December 31, 2010 Earnings per common share: Income from continuing operations.................................................. Loss from discontinued operations.................................................. Income before extraordinary item..................................................... Extraordinary item: Loss due to hurricane.................................................................. Net income............................................................................................
1 2
$500,000 200,000 $300,000 90,000 $210,000 60,000 $150,000
$7.501 2.252 $5.25 1.503 $3.75
$7.50 = $300,000 40,000 $2.25 = $90,000 40,000 3 $1.50 = $60,000 40,000
Appendix Ex. 1426 (Man)
a. Baxter Company reported this item correctly in the financial statements. This item is an error in the recognition, measurement, or presentation in the financial statements, which is correctly handled by retroactively restating prior-period earnings. b. Baxter Company did not report this item correctly. This item is a change from one generally accepted accounting principle to another, which is correctly handled by retroactively restating prior-period earnings. In this case, Baxter reports this change cumulatively in the current period, which is incorrect.
PROBLEMS Prob. 141A (Man)
1. WIGLAF TECHNOLOGY COMPANY Comparative Income Statement For the Years Ended December 31, 2010 and 2009 2010 Sales............................................... Sales returns and allowances...... Net sales......................................... Cost of goods sold....................... Gross profit.................................... Selling expenses........................... Administrative expenses.............. Total operating expenses............ Income from operations............... Other income................................. Income before income tax............ Income tax expense...................... Net income..................................... $560,000 37,500 $522,500 372,000 $150,500 $ 52,000 30,500 $ 82,500 $ 68,000 3,000 $ 71,000 5,500 $ 65,500 2009 $500,000 25,000 $475,000 300,000 $175,000 $ 40,000 25,000 $ 65,000 $110,000 2,000 $112,000 5,000 $107,000 Increase (Decrease) Amount Percent $ 60,000 12,500 $ 47,500 72,000 $ (24,500) $ 12,000 5,500 $ 17,500 $ (42,000) 1,000 $ (41,000) 500 $ (41,500) 12.0% 50.0 10.0 24.0 (14.0) 30.0 22.0 26.9 (38.2) 50.0 (36.6) 10.0 (38.8)
2. Net income has declined from 2009 to 2010. Net sales have increased by 10.0%; however, cost of goods sold has increased by 24.0%, causing the gross profit to grow at a rate less than sales relative to the base year. In addition, total operat ing expenses have increased at a faster rate than sales (26.9% increase vs. 10.0% net sales increase). Increases in costs and expenses that are higher than the increase in sales have caused the net income to decline by 38.8%.
Prob. 142A (Man)
1. OTHERE TECHNOLOGY COMPANY Comparative Income Statement For the Years Ended December 31, 2010 and 2009 2010 Amount Percent Sales............................................. Sales returns and allowances... Net sales...................................... Cost of goods sold..................... Gross profit................................. Selling expenses........................ Administrative expenses........... Total operating expenses.......... Income from operations............ Other income.............................. Income before income tax......... Income tax expense................... Net income.................................. $ 714,000 14,000 $ 700,000 322,000 $ 378,000 $ 154,000 70,000 $ 224,000 $ 154,000 28,000 $ 182,000 70,000 $ 112,000 102.0% 2.0 100.0% 46.0 54.0% 22.0% 10.0 32.0% 22.0% 4.0 26.0% 10.0 16.0% 2009 Amount Percent $ 612,000 12,000 $ 600,000 312,000 $ 288,000 $ 120,000 66,000 $ 186,000 $ 102,000 24,000 $ 126,000 60,000 $ 66,000 102.0% 2.0 100.0% 52.0 48.0% 20.0% 11.0 31.0% 17.0% 4.0 21.0% 10.0 11.0%
2. The vertical analysis indicates that the costs other than selling expenses (cost of goods sold and administrative expenses) improved as a percentage of sales. As a result, net income as a percentage of sales increased from 11.0% to 16.0%. The sales promotion campaign appears to have been successful. While selling expenses as a percent of sales increased slightly (2%), the increased cost was more than made up for by increased sales.
Prob. 143A (Man)
1. a. Working Capital = Current Assets Current Liabilities $1,120,000 $400,000 = $720,000 Current Ratio = Current Assets Current Liabilities
b.
$1,120,000 = 2.8 $400,000 c. Quick Ratio = Quick Assets Current Liabilities $240,000 + $120,000 + $360,000 = 1.8 $400,000
2. Working Transaction Capital a. b. c. d. e. f. g. h. i. j. $ 720,000 720,000 720,000 720,000 640,000 720,000 920,000 720,000 1,120,000 720,000 Current Ratio 2.8 3.3 2.6 3.4 2.3 2.8 3.3 2.8 3.8 2.8 Quick Ratio 1.8 2.0 1.6 2.1 1.5 1.8 2.3 1.8 2.8 1.7 Supporting Calculations Current Quick Current Assets Assets Liabilities $1,120,000 1,040,000 1,170,000 1,020,000 1,120,000 1,120,000 1,320,000 1,120,000 1,520,000 1,120,000 $ 720,000 640,000 720,000 620,000 720,000 720,000 920,000 720,000 1,120,000 680,000 $400,000 320,000 450,000 300,000 480,000 400,000 400,000 400,000 400,000 400,000
Prob. 144A (Man)
1. Working Capital: $1,116,000 $360,000 = $756,000 Ratio Numerator Denominator Calculated Value
2. Current ratio................... $1,116,000 $360,000 3.1 3. Quick ratio..................... $864,000 $360,000 2.4 4. Accounts receivable turnover.......................... $1,602,080 ($260,000 + $211,200) 2 6.8 5. Number of days sales in receivables...... ($260,000 + $211,200) 2 ($1,602,080 365) 53.7 6. Inventory turnover......... $480,200 ($208,000 + $66,400) 2 3.5 7. Number of days sales in inventory.......... ($208,000 + $66,400) 2 ($480,200 365) 104.3 8. Ratio of fixed assets to long-term liabilities....... $1,539,200 $1,184,000 1.3 9. Ratio of liabilities to stockholders equity..... $1,544,000 $1,316,000 1.2 10. Number of times interest charges earned............................ $477,160 + $110,720 $110,720 5.3 11. Number of times preferred dividends earned............................ $428,000 $4,000 107.0 12. Ratio of net sales to assets............................. $1,602,080 ($2,655,200 + $1,768,000) 2 0.7 13. Rate earned on total assets............................. $428,000 + $110,720 ($2,860,000 + $2,024,000) 2 22.1% 14. Rate earned on stockholders equity............... $428,000 ($1,316,000 + $904,000) 2 38.6% 15. Rate earned on common stockholders equity............... ($428,000 $4,000) ($1,216,000 + $804,000) 2 42.0% 16. Earnings per share on common stock.......... ($428,000 $4,000) 40,000 $10.60 17. Price-earnings ratio...... $60.00 $10.60 5.7 18. Dividends per share of common stock........... $12,000 40,000 $0.30 19. Dividend yield................ $0.30 $60.00 0.5%
Prob. 145A (Man)
1. a.
25%
Rate Earned on Total Assets
20%
15%
10%
5%
0% 2010 2009 2008 2007 2006
Year
Industry rate earned on total assets Lancelot rate earned on total assets
Rate Earned on Total Assets =
Net Income + Interest Expense Average Total Assets $890,000 = 19.3% $4,620,000 $700,000 = 19.4% $3,600,000
2010:
$2,330,700 = 22.9% $10,171,98 0 $1,632,000 = 20.9% $7,824,600
$ 1,275,000 $ 5,922,000
2007:
2009:
2006:
2008: = 21.5%
Prob. 145A (Man)
1. b.
Rate Earned on Stockholders' Equity
40% 35% 30% 25% 20% 15% 10% 5% 0%
Continued
2010
2009
2008
2007
2006
Year
Industry rate earned on stockholders' equity Lancelot rate earned on stockholders' equity
Rate Earned on Stockholders Equity =
Net Income Average Total Stockholders' Equity $650,000 = 29.2% $2,225,000 $500,000 = 30.3% $1,650,000
2010:
$1,930,500 = 33.4% $5,777,250 $1,287,000 = 30.9% $4,168,500 $975,000 = 32.1% $3,037,500
2007:
2009:
2006:
2008:
Prob. 145A (Man)
1. c.
Number of Times Interest Charges Earned 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 0.0
Continued
2010
2009
2008 Year
2007
2006
Industry num ber of tim es interest charges earned Lancelot num ber of tim es interest charges earned
Number of Times Net Income + Income Tax Expense + Interest Expense Interest Charges = Interest Expense Earned $2,808,060 = 7.0 $400,200 $1,950,240 = 5.7 $345,000 $1,519,800 = 5.1 $300,000 $1,053,200 = 4.4 $240,000 $820,000 = 4.1 $200,000
2010:
2007:
2009:
2006:
2008:
Prob. 145A (Man)
1. d.
Ratio of Liabilities to Stockholders' Equity 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0
Continued
2010
2009
2008 Year
2007
2006
Industry ratio of liabilities to stockholders' equity Lancelot ratio of liabilities to stockholders' equity
Ratio of Liabilities to Stockholders Equity =
Total Liabilities Total Stockholders' Equity $2,490,000 = 1.0 $2,550,000 $2,300,000 = 1.2 $1,900,000
2010:
$4,756,260 = 0.7 $6,742,500 $4,033,200 = 0.8 $4,812,000 $3,279,000 = 0.9 $3,525,000
2007:
2009:
2006:
2008:
Note: The total liabilities are the difference between the total assets and total stockholders equity ending balances.
Prob. 145A (Man)
2.
Concluded
Both the rate earned on total assets and rate earned on stockholders equity are above the industry average for all five years. The rate earned on total assets is actually improving gradually. The rate earned on stockholders equity exceeds the rate earned on total assets, providing evidence of the positive use of leverage. The company is clearly growing earnings as fast as the asset and equity base. In addition, the ratio of liabilities to stockholders equity indicates that the proportion of debt to stockholders equity has been declining over the period. The firm is adding to debt at a slower rate than the assets are growing from earnings. The number of times interest charges were earned ratio is improving during this time period. Again, the firm is increasing earnings faster than the increase in interest charges. Overall, these ratios indicate excellent financial performance coupled with appropriate use of debt (leverage).
Prob. 141B (Man)
1. EGILS INC. Comparative Income Statement For the Years Ended December 31, 2010 and 2009 2010 Sales.................................................. Sales returns and allowances........ Net sales........................................... Cost of goods sold.......................... Gross profit....................................... Selling expenses.............................. Administrative expenses................ Total operating expenses............... Income from operations.................. Other income.................................... Income before income tax.............. Income tax expense......................... Net income........................................ $126,200 2,426 $123,774 58,800 $ 64,974 $ 17,310 13,464 $ 30,774 $ 34,200 1,000 $ 35,200 12,000 $ 23,200 2009 $100,000 2,000 $ 98,000 50,000 $ 48,000 $ 15,000 12,000 $ 27,000 $ 21,000 1,000 $ 22,000 6,000 $ 16,000 Increase (Decrease) Amount Percent $ 26,200 426 $ 25,774 8,800 $ 16,974 $ 2,310 1,464 $ 3,774 $ 13,200 0 $ 13,200 6,000 $ 7,200 26.2% 21.3 26.3 17.6 35.4 15.4 12.2 14.0 62.9 0.0 60.0 100.0 45.0
2. The profitability has significantly improved. Net sales have increased by 26.3% over the 2009 base year. However, cost of goods sold, selling expenses, and ad ministrative expenses grew at a slower rate. Increasing sales combined with costs that increase at a slower rate results in strong earnings growth. In this case, net income grew 45.0% over the base year.
Prob. 142B (Man)
1. EINAR INDUSTRIES INC. Comparative Income Statement For the Years Ended December 31, 2010 and 2009 2010 Amount Percent Sales.............................................. Sales returns and allowances.... Net sales....................................... Cost of goods sold...................... Gross profit.................................. Selling expenses.......................... Administrative expenses............ Total operating expenses........... Income from operations.............. Other income................................ Income before income tax.......... Income tax expense (benefit)..... Net income (loss)......................... $ 525,000 25,000 $ 500,000 280,000 $ 220,000 $ 130,000 65,000 $ 195,000 $ 25,000 30,000 $ 55,000 35,000 $ 20,000 105.0% 5.0 100.0% 56.0 44.0% 26.0% 13.0 39.0% 5.0% 6.0 11.0% 7.0 4.0% 2009 Amount Percent $ 420,000 20,000 $ 400,000 220,000 $ 180,000 $ 80,000 56,000 $ 136,000 $ 44,000 24,000 $ 68,000 28,000 $ 40,000 105.0% 5.0 100.0% 55.0 45.0% 20.0% 14.0 34.0% 11.0% 6.0 17.0% 7.0 10.0%
2. The net income as a percent of sales has declined. All the costs and expenses, other than selling expenses, have maintained their approximate cost as a percent of sales relationship between 2009 and 2010. Selling expenses as a percent of sales, however, have grown from 20.0% to 26.0% of sales. Apparently, the new advertising campaign has not been successful. The increased expense has not produced sufficient sales to maintain relative profitability. Thus, selling expenses as a percent of sales have increased.
Prob. 143B (Man)
1. a. Working Capital = Current Assets Current Liabilities $1,400,000 $1,000,000 = $400,000 b. Current Ratio = Current Assets Current Liabilitie s
$1,400,000 = 1.4 $1,000,000 c. Quick Ratio = Quick Assets Current Liabilitie s
$300,000 + $250,000 + $350,000 = 0.9 $1,000,000 2. Working Capital 400,000 400,000 400,000 400,000 275,000 400,000 800,000 400,000 1,200,000 400,000 Current Ratio 1.4 1.5 1.4 1.5 1.2 1.4 1.8 1.4 2.2 1.4 Quick Ratio 0.9 0.9 0.8 0.9 0.8 0.9 1.3 0.9 1.7 0.9 Supporting Calculations Current Quick Current Assets Assets Liabilities $1,400,000 $ 900,000 $1,000,000 1,200,000 700,000 800,000 1,480,000 900,000 1,080,000 1,200,000 700,000 800,000 1,400,000 900,000 1,125,000 1,400,000 900,000 1,000,000 1,800,000 1,300,000 1,000,000 1,400,000 900,000 1,000,000 2,200,000 1,700,000 1,000,000 1,400,000 880,000 1,000,000
Transaction a. b. c. d. e. f. g. h. i. j. $
Prob. 144B (Man)
1. Working capital: $2,080,000 $520,000 = $1,560,000 Ratio Numerator Denominator Calculated Value
2. Current ratio................... $2,080,000 $520,000 4.0 3. Quick ratio..................... $1,404,000 $520,000 2.7 4. Accounts receivable turnover.......................... $4,210,000 ($390,000 + $283,600) 2 12.5 5. Number of days sales in receivables................ ($390,000 + $283,600) 2 ($4,210,000 365) 29.2 6. Inventory turnover......... $1,866,150 ($631,000 + $500,000) 2 3.3 7. Number of days sales in inventory.................... ($631,000 + $500,000) 2 ($1,866,150 365) 110.6 8. Ratio of fixed assets to long-term liabilities....... $3,780,000 $1,800,000 2.1 9. Ratio of liabilities to stockholders equity..... $2,320,000 $3,864,450 0.6 10. Number of times interest charges earned.............. $692,850 + $196,000 $196,000 4.5 11. Number of times preferred dividends earned............................ $482,850 $24,000 20.1 12. Ratio of net sales to assets............................. $4,210,000 ($5,860,000 + $4,256,100) 2 0.8 13. Rate earned on total assets............................. $482,850 + $196,000 ($6,184,450 + $4,631,100) 2 12.6% 14. Rate earned on stockholders equity............... $482,850 ($3,864,450 + $3,453,600) 2 13.2% 15. Rate earned on common stockholders equity............... ($482,850 $24,000) ($3,064,450 + $2,653,600) 2 16.0% 16. Earnings per share on common stock.......... ($482,850 $24,000) 120,000 $3.82 17. Price-earnings ratio...... $40.00 $3.82 10.5 18. Dividends per share of common stock........... $48,000 120,000 $0.40 19. Dividend yield................ $0.40 $40.00 1.0%
Prob. 145B (Man)
1. a.
25% Rate Earned on Total Assets
20%
15%
10%
5%
0%
2010 2009 2008 2007 2006
Year
Industry rate earned on total assets Merlin's rate earned on total assets
Rate Earned on Total Assets =
Net Income + Interest Expense Average Total Assets $644,900 = 21.2% $3,044,250 $580,000 = 23.4% $2,475,000
2010:
$409,889 = 9.6% $4,270,764 $434,789 = 11.1% $3,928,396 $539,884 = 15.3% $3,535,472
2007:
2009:
2006:
2008:
Prob. 145B (Man)
1. b.
60%
Continued
Rate Earned on Stockholders' Equity
50%
40%
30%
20%
10%
0% 2010 2009 2008 2007 2006
Year
Industry rate earned on stockholders' equity Merlin's rate earned on stockholders' equity
Rate Earned on Stockholders Equity =
Net Income Average Total Stockholders' Equity $419,900 = 38.5% $1,089,950 $380,000 = 55.1% $690,000
2010:
$129,868 = 7.1% $1,839,431 $174,788 = 10.4% $1,687,103 $299,809 = 20.7% $1,449,804
2007:
2009:
2006:
2008:
Prob. 145B (Man)
1. c.
4.0 Number of Times Interest Charges Earned 3.5 3.0 2.5 2.0 1.5 1.0 0.5 0.0
Continued
2010
2009
2008 Year
2007
2006
Industry num ber of tim es interest charges earned Merlin's num ber of tim es interest charges earned
Number of Times Net Income + Income Tax Expense + Interest Expense Interest Charges = Interest Expense Earned $429,891 = 1.5 $280,021 $468,406 = 1.8 $260,001 $607,118 = 2.5 $240,075 $745,700 = 3.3 $225,000 $706,000 = 3.5 $200,000
2010:
2007:
2009:
2006:
2008:
Prob. 145B (Man)
1. d.
2.5 Ratio of Liabilities to Stockholders' Equity
Continued
2.0
1.5
1.0
0.5
0.0 2010 2009 2008 Year Industry ratio of liabilities to stockholders' equity Merlin's ratio of liabilities to stockholders' equity 2007 2006
Ratio of Liabilities to Stockholders Equity = 2010: 2009: 2008: $2,512,813 = 1.3 $1,904,365 $2,349,853 = 1.3 $1,774,497 $2,132,734 = 1.3 $1,599,709 2007: 2006:
Total Liabilities Total Stockholders' Equity $2,038,600 = 1.6 $1,299,900 $1,870,000 = 2.1 $880,000
Note: Total liabilities are determined by subtracting stockholders equity (ending balance) from the total assets (ending balance).
Prob. 145B (Man)
Concluded
2. Both the rate earned on total assets and the rate earned on stockholders equity have been moving in a negative direction in the last five years. Both measures have moved below the industry average over the last two years. The cause of this decline is driven by a rapid decline in earnings. The use of debt can be seen from the ratio of liabilities to stockholders equity. The ratio has declined over the time period and has declined below the industry average. Thus, the level of debt relative to the stockholders equity has gradually improved over the five years. Unfortunately, the earnings have declined at a faster rate, causing the rate earned on stockholders equity to decline. The rate earned on total assets ran below the interest cost on debt in 2009 and 2010, causing the rate earned on stockholders equity to drop below the rate earned on total assets. This is an example of negative leverage. The number of times interest charges were earned has been falling below the industry av erage for several years. This is the result of low profitability combined with high interest costs. The number of times interest is earned has fallen to a dangerously low level in 2010. The low profitability and time interest charges are earned in 2010, as well as the five-year trend, should be a major concern to the companys management, stockholders, and creditors.
NIKE, INC., PROBLEM
1. a. Total current assets..................................................... Total current liabilities................................................. Working capital......................................................... b. Total current assets..................................................... / Total current liabilities............................................... Current ratio.............................................................. c. Cash............................................................................... Short-term investments............................................... Accounts receivable.................................................... Total quick assets.................................................... / Total current liabilities........................................... Quick ratio..................................................................... d. Net sales........................................................................ Accounts receivable (net): Beginning of year..................................................... End of year................................................................ Total............................................................................... Average (Total / 2)........................................................ Accounts receivable turnover (Net sales/Average accounts receivable).............. Accounts receivable (average): Net sales.................................................................... Average daily sales (Sales / 365)............................ Number of days sales in receivables......................... Cost of goods sold...................................................... Inventories: Beginning of year..................................................... End of year................................................................ Total........................................................................... Average (Total / 2)........................................................ Inventory turnover (Cost of goods sold/Average inventory)............... 2007 $8,076.5 2,584.0 $5,492.5 2007 $8,076.5 2,584.0 3.1 2007 $1,856.7 990.3 2,494.7 $5,341.7 $2,584.0 2.1 $16,325.9 2,382.9 2,494.7 $4,877.6 2,438.8 6.7 2,438.8 $16,325.9 44.7 54.6 $9,165.4 2,076.7 2,121.9 $4,198.6 2,099.3 4.4 2006 $7,346.0 2,612.4 $4,733.6 2006 $7,346.0 2,612.4 2.8 2006 $ 954.2 1,348.8 2,382.9 $4,685.9 $2,612.4 1.8 $ 14,954.9 2,249.9 2,382.9 $4,632.8 2,316.4 6.5 2,316.4 $14,954.9 41.0 56.5 $8,367.9 1,811.1 2,076.7 $3,887.8 1,943.9 4.3
e.
f.
NIKE, Inc., Problem
g.
Continued
2,099.3 9,165.4 25.1 83.6 3,662.9 7,025.4 0.5 $ 16,325.9 $ 9,869.6 10,688.3 $ 20,557.9 10,279.0 1.6 $ 1,491.5 20.5 $ 1,512.0 $ 9,869.6 10,688.3 $ 20,557.9 10,279.0 14.5% $ 1,491.5 1,943.9 8,367.9 22.9 84.9 3,584.4 6,285.2 0.6 $ 14,954.9 $ 8,793.6 9,869.6 $18,663.2 9,331.6 1.6 $ 1,392.0 21.0 $ 1,413.0 $ 8,793.6 9,869.6 $18,663.2 9,331.6 14.9% $ 1,392.0
Inventory (average)...................................................... Cost of goods sold...................................................... Average daily cost of goods sold.............................. Number of days sales in inventory (Average inventory/Average daily cost of goods sold)........ Total liabilities.............................................................. / Total stockholders equity........................................ Ratio of liabilities to stockholders equity................ Net sales........................................................................ Total assets (excluding long-term investments): Beginning of year..................................................... End of year................................................................ Total........................................................................... Average total assets.................................................... Ratio of net sales to assets........................................ Net income.................................................................... Plus interest expense.................................................. Total........................................................................... Total assets: Beginning of year..................................................... End of year................................................................ Total........................................................................... Average total assets.................................................... Rate earned on total assets (Net income/Average total assets)......................... Net income.................................................................... Stockholders equity: Beginning of year..................................................... End of year................................................................ Total........................................................................... Average stockholders equity..................................... Rate earned on stockholders equity......................... Market price per share of common stock................. Earnings per share on common stock...................... Price-earnings ratio on common stock.....................
h.
i.
j.
k.
$ 6,285.2 $ 5,644.2 7,025.4 6,285.2 $ 13,310.6 $11,929.4 6,655.3 5,964.7 22.4% 23.3% 56.75 $2.96 19.2% 40.16 $2.69 14.9%
l.
NIKE, Inc., Problem
Concluded
$1,491.5 $1,392.0 $16,325.9 $14,954.9 9.1% 9.3%
m. Net income.................................................................... Net sales........................................................................ Net income to net sales............................................... 2. a
Before reaching definitive conclusions, each measure should be compared with past years, industry averages, and similar firms in the industry. The working capital increased significantly.
b. and c. The current ratio increased during 2007. d. and e. The accounts receivable turnover and number of days sales in receivables indicate a slight increase in efficiency of collecting accounts receivable. The accounts receivable turnover increased from 6.5 to 6.7. The number of days sales in receivables decreased slightly from 56.5 to 54.6. Thus, it takes the company about two months to collect its accounts receivable from credit sales. These numbers should be compared to their competitors, industry averages, and Nikes credit policy to determine draw definitive conclusions. f. and g. The results of these two analyses show a very slight increase in inventory turnover, and reduction in the number of days sales in inventory. Both trends are small. Inventory management is critical to Nike, so this ratio trend should be watched in the future. h. The margin of protection to creditors dropped during 2007. While this trend is in the wrong direction, the company still provides sound protection to its credit ors. i. j. These analyses indicate that the effectiveness in the use of assets to generate revenues remained constant across both years. The rate earned on average total assets decreased slightly during 2007. Overall, rates earned on assets that exceed 10% are usually considered good performance. The rate earned on average common stockholders equity increased slightly. This is also evidence of the positive use of leverage, since the rate earned on stockholders equity exceeds the rate earned on assets. The rates earned on average common stockholders equity shown for these two years would be considered excellent performance. The price-earnings ratio increased significantly from 2006 to 2007. This increase was driven by a significant increase in Nikes stock price, from $40.16 at the end of fiscal 2006 to $56.75 at the end of 2007. This increase accompanied an overall increase in the price-earnings ratios for the whole market during this time. In addition, market participants are revaluing Nikes growth prospects upward.
k.
l.
m. The percent of net income to sales dropped very slightly during 2007.
SPECIAL ACTIVITIES Activity 141 (Man)
This position does not allow the shareholders to take advantage of leverage. As a result, the return on shareholders equity cannot be improved by using debt. In contrast, a low or no debt load does provide the company great flexibility in the case of a national calamity. However, the no debt position only makes sense with in the national calamity scenario. Within normal business operations, most companies can assume some debt without much loss of flexibility or control. Garden Isle Brewery is competing against companies that will not be so inclined to avoid debt. As a result, they will likely be able to grow faster than Garden Isle. The Garden Isle management should consider the risk of not being able to keep up with the competition because of their conservative financing policies.
Activity 142 (Man)
Holly is concerned about the inventory and accounts receivable levels because she must determine their value. Inventory that cannot be sold (or sold at a large discount) or accounts receivable that cannot be collected must be written down to reflect their reduced value. Holly has conducted the ratio analysis and interviewed Doug to help make this determination. The inventory and accounts receivable levels have grown alarmingly. Dougs response to Holly is not reassuring. The inventory represents obsolete technology that is left over after the holiday season. The accounts receivable have apparently grown from loosening the credit standards. Holly may need to insist on write-downs of the inventory and accounts receivable balances to reflect their net realizable values. Doug is correct in pointing out that the current ratio has probably improved. Thus, although Doug calls this good, it is only such if the current assets in the numerator are fairly valued. Under these circumstances, the current ratio is probably overstated because the inventory and accounts receivable balances are inflated relative to their net realizable values.
Activity 143 (Man)
DELL INC. AND APPLE COMPUTER, INC. Common-Sized Statements Dell Inc. Sales (net).................................................... Cost of sales................................................ Gross profit................................................. Operating expenses: Selling, general, and administrative.... Research and development................. Total operating expenses................. Operating income....................................... *Rounded to the nearest tenth of a percent. The common-sized analysis indicates that Dell and Apple are very different computer companies. Dells income from operations was 10.6% of sales, while Apples was 18.4% of sales. There is almost an 8 percentage point difference between the two companies. What explains this difference? The gross profit for Dell was 21.8% of sales, which is fairly narrow. Apple, in contrast, had a gross profit of 34.0% of sales, which is over 12 points better than Dells. This suggests Apple is able to charge high er prices than Dell for its products (assuming that they are both equally efficient in making products). Apples selling, general, and administrative expenses were at about 12.3% of sales, while Dells are only 10.4% of sales. Dell designed the business for efficiency; thus, it operates on a low-cost structure. The selling, general, and administrative expenses do not include expensive advertising campaigns, complex sales channel administration, or complex product support activities. Apple, in contrast, has larger selling, general, and administrative costs as a percent of sales. It attempts to sell a unique machine to a unique audience. This requires significant SG&A effort. Another big difference between the two companies is in research and development. Dells R&D was a narrow 0.9% of sales, while Apples was 3.3% of sales. Essentially, Dell focuses its R&D effort on the final assembly of the computer. Dell relies on its suppliers to develop innovation in the components and operating system software (Microsoft). Apple, on the other hand, must constantly spend R&D on computers, peripherals, and its own operating system software. This is because Apple chooses not to follow the industry standards and thus must pave its own way on both hard ware and software. This feature of Apple also contributes to its larger selling, general, and administrative costs as a percent of sales. The higher gross profit as a percent age of sales for Apple carries through to its income from operations, generating a significantly higher operating income as a percentage of sales compared to Dell. 100.0% 78.2 21.8% 10.4% 0.9 11.2%* 10.6% Apple Computer, Inc. 100.0% 66.0 34.0% 12.3% 3.3 15.6% 18.4%
Activity 144 (Man)
1. a. Rate Earned on Total Assets = 2006: 2005: $960 + $36.15 = 18.6% $5,369 $890 + $22.72 = 17.5% $5,203 $761 + $17.64 = 17.7% $4,392 Net Income Average Total Stockholders' Equity Net Income + Interest Expense Average Total Assets
2004:
b. Rate Earned on Total Stockholders Equity = 2006: 2005: $960 = 30.5% $3,151 $890 = 28.8% $3,088 $761 = 29.3% $2,595
2004:
c. Earnings per Share = 2006: 2005: 2004:
Net Income Preferred Dividends Common Shares Outstanding
$960 $0.00 = $3.43 280 $890 $0.00 = $3.02 295 $761 $0.00 = $2.52 302
Activity 144 (Man)
d. Dividend Yield = 2006: 2005: 2004:
Continued
Dividend per Share of Common Stock Market Price per Share of Common Stock
$0.63 = 1.1% $56.12 $0.41 = 0.8% $54.14 $0.20 = 0.4% $46.87 Market Price per Share of Common Stock Earnings per Share of Common Stock
e. Price-Earnings Ratio = 2006: 2005: 2004: $56.12 = 16.4% $3.43 $54.14 = 17.9 $3.02 $46.87 = 18.6 $2.52
Average Liabilities Ratio of Average Liabilities to 2. Average Stockholders' Equity = Average Stockholders' Equity 2006: $5,369 $3,151 = 0.7 $3,151
Activity 144 (Man)
Concluded
3. Harley-Davidsons profitability, as measured by earnings per share, dramatically improved from 2004 levels. The rate earned on total assets improved moderately, as did the rate earned on stockholders equity. The dividend yield doubled from 0.4% in 2004 to 0.8% in 2005, indicating that the company has a greater amount of cash available to distribute to common stockholders. The price-earnings ratio is interesting. During the three-year period, the price-earnings ratio has decreased somewhat. This is predominantly due to the significant increase in earnings per share during the period. The companys stock price has also increased during this period, but at a slower rate than the increase in earnings per share. The rate of the decrease in the price-earnings ratio is lower than the rate of in crease in earnings per share. Thus, the market does not appear to expect HarleyDavidsons profitability to continue at the rate it has experienced in recent years. 4. Apparently, stock market participants are not willing to pay as high a price for future earnings because of concern that Harley-Davidson will not be able to con tinue to grow earnings at the rate it has in recent years. It appears that HarleyDavidsons expansion to international markets has been quite successful, but the market is not convinced that this strategy will be able to continue to grow at its current rate.
Activity 145 (Man)
1. a. Rate Earned on Total Assets = $608 + $124 = 10.6% $6,933 Net Income + Interest Expense Average Total Assets
Marriott: Hilton:
$572 + $498 = 8.5% $12,612 Net Income Average Total Stockholders' Equity
b. Rate Earned on Total Stockholders Equity = $608 = 20.7% $2,935
Marriott: Hilton: c.
$572 = 17.5% $3,269
Number of Income Before Income Tax Expense + Interest Expense Times Interest = Interest Expense Charges Are Earned Marriott: Hilton: $894 + $124 = 8.2 $124
$838 + $498 = 2.7 $498 Total Liabilities Total Stockholders' Equity
d. Ratio of Liabilities to Stockholders Equity = $5,970 = 2.3 $2,618
Marriott: Hilton:
$12,754 = 3.4 $3,727
Activity 145 (Man)
Summary Table:
Concluded
Rate earned on total assets Rate earned on total stockholders equity Number of times interest charges are earned Ratio of liabilities to stockholders equity
Marriott 10.6% 20.7% 8.2 2.3
Hilton 8.5% 17.5% 2.7 3.4
2. Marriott has a higher rate earned on total assets (10.6% vs. 8.5%), and a higher rate on stockholders equity (20.7% vs. 17.5%), compared to Hilton. Hiltons weaker performance relative to Marriott appears to be due to its inability to manage its debt. Hilton has much more leverage than Marriott. This is confirmed by the ratio of liabilities to stockholders equity, which shows the relative debt held by Marriott is 2.3 times stockholders equity, compared to 3.4 times for Hilton. The number of times interest charges are earned shows that Marriott covers its interest charges 8.2 times. The comparable number for Hilton is 2.7, which is marginally sufficient. Hiltons higher debt level is generating large interest expense, which is negatively affecting the rate earned on total assets and stockholders equity. In summary, Hiltons high debt level is affecting the companys ability to earn returns for stockholders.