Download chapter 5

CHAPTER 5
USING FINANCIAL STATEMENT INFORMATION
EXERCISES
E5–5
a. Current Ratio = Current Assets ÷ Current Liabilities
2004: $6,304 ÷ $2,242 = 2.81
2005: $5,239 ÷ $1,942 = 2.70
2006: $5,029 ÷ $2,272 = 2.21
b. Gross Profit as a % of Sales = Gross Profit ÷ Net Sales
2004: $6,381 ÷ $16,267 = .39
2005: $5,869 ÷ $16,023 = .37
2006: $5,649 ÷ $15,943 = .35
c. Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
2005: $10,154 ÷ [($1,814 + $1,696) ÷ 2]
= 5.79
2006: $10,294 ÷ [($1,696 + $1,796) ÷ 2] = 5.90
Average Days Supply of Inventory = 365 ÷ Inventory Turnover
2005:
2006:
d.
365 ÷ 5.79 = 63 days
365 ÷ 5.90 = 62 days
Over the three-year period, solvency has deteriorated, as has the profitability per sale.
Inventory turnover has improved slightly, reducing the average shelf time of the inventory by
one day.
E5–7
a. (1) Current Ratio = Current Assets ÷ Current Liabilities
2008: $385,000 ÷ $170,000 = 2.26
2009: $400,000 ÷ $460,000 = 0.87
(2) Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) ÷ Current Liabilities
2008: ($30,000 + $10,000 + $95,000) ÷ $170,000 = 0.794
2009: ($15,000 + $225,000+ $90,000) ÷ $460,000 = 0.717
b. Receivables Turnover = Net Credit Sales ÷ Average Accounts Receivable
2008: $780,000 ÷ [($100,000 + $95,000) ÷ 2] = 8.00
2009: $800,000 ÷ [($95,000 + $90,000) ÷ 2] = 8.65
Number of Days Outstanding = 365 ÷ Receivables Turnover
1
2008: 365 ÷ 8.00 = 45.625
2009: 365 ÷ 8.65 = 42.197
c. Solvency refers to a company's ability to meet its debts as they come due. Current liabilities
represent the debts that are expected to come due first. Therefore, to be solvent, a company
must have sufficient cash or near-cash assets to meet these current liabilities. Total current
assets is one measure of near-cash assets. As indicated by the change in the company's
current ratio, the company has insufficient current assets available to settle its current
liabilities. The company's quick ratio worsened during 2009. Given that the company has
insufficient current assets and insufficient cash, marketable securities, and accounts
receivable to meet its debts, it can probably be concluded that the company's overall solvency
position is not strong.
E5–9
a. Current Ratio = Current Assets ÷ Current Liabilities
2006:
2007:
2008:
2009:
$20,000 ÷ $8,000 = 2.500
$24,000 ÷ $13,000 = 1.846
$31,000 ÷ $25,000 = 1.240
$35,000 ÷ $30,000 = 1.167
Debt/Equity Ratio = Total Liabilities ÷ Total Stockholders' Equity
2006:
2007:
2008:
2009:
($8,000 + $15,000) ÷ ($20,000 + $10,000) = 0.767
($13,000 + $35,000) ÷ ($20,000 + $20,000) = 1.200
($25,000 + $40,000) ÷ ($20,000 + $32,000) = 1.250
($30,000 + $40,000) ÷ ($20,000 + $38,000) = 1.207
Return on Assets = (Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Average Total Assets
2006:
2007:
2008:
2009:
($13,000 + [$2,000 (1 - .3)])
($14,000 + [$4,000 (1 - .3)])
($21,000 + [$5,000 (1 - .3)])
($24,000 + [$5,000 (1 - .3)])
b.
÷
÷
÷
÷
[($53,000]
=
[($53,000 + $88,000) ÷ 2] =
[($88,000 + $117,000) ÷ 2] =
[($117,000 + $128,000) ÷ 2] =
2009
Current assets
Noncurrent assets
Total assets
Current liabilities
Long-term liabilities
Capital stock
Retained earnings
Total liabilities and
stockholders' equity
2008
0.272
0.238
0.239
0.224
2007
2006
27.34%
72.66
100.00%
26.50%
73.50
100.00%
27.27%
72.73
100.00%
37.74%
62.26
100.00%
23.44%
31.25
15.62
29.69
21.37%
34.19
17.09
27.35
14.77%
39.77
22.73
22.73
15.09%
28.30
37.74
18.87
100.00%
100.00%
100.00%
100.00%
c. Solvency measures a company's ability to meet its debts as they come due. The current ratio
provides one measure of a company's solvency. Based upon this ratio, Lotechnic has
sufficient current assets to meet its current obligations. However, the trend in its current ratio
indicates that the company's excess of current assets over current liabilities is decreasing.
Therefore, the company has relatively fewer current assets available to meet its current
2
obligations. This trend indicates that Lotechnic Enterprises' solvency position may be
worsening.
The debt/equity ratio provides an indication of a company's capitalization, which, in turn,
indicates how risky a company is. Lotechnic is relying increasingly on debt relative to
stockholders' equity to finance operations. At some point in time, the company will have to
repay this debt. The company will either have to repay this debt by (1) generating cash from
operations, (2) selling assets, (3) borrowing additional cash, or (4) acquiring cash by issuing
stock. From the statement of cash flows, the cash generated from operations has been
decreasing and is now negative; therefore, it appears that the company cannot rely on
operations to generate cash. The statement of cash flows also indicates that the company has
been using cash for investment purposes every year. This implies that the company may have
some assets that it could sell. But if these assets are used in operations, the company's
operations may be adversely affected by selling them.
Since total assets equal the sum of total liabilities and stockholders' equity, the proportion of
total liabilities to the sum of total liabilities and stockholders' equity reported on the commonsize balance sheet equals the proportion of total liabilities to total assets. This measure
indicates the proportion of total assets (based upon book value) that would have to be sold to
satisfy all the company's obligations. To meet its obligations, Lotechnic Enterprises would have
to sell approximately 55% of its total assets, which would virtually decimate its asset base.
Based upon the trend in the current ratio, the debt/equity ratio, cash flows from operations, and
the proportion of total liabilities to total assets, it appears that Lotechnic Enterprises may face
severe solvency problems as its long-term debt matures.
Earning power is defined as a company's ability to increase its wealth through operations and
to generate cash from operations. Earning power and solvency are closely related. A
company must have adequate resources to generate wealth. If a company experiences
solvency problems, it will most likely have to divert its resources to paying its obligations.
Therefore, due to its solvency problems, Lotechnic Enterprises may not have strong earning
power. Although Lotechnic's net income has increased every year, the company's
effectiveness at managing capital, as indicated by ROA, has decreased every year. This trend
indicates that the company may have limited earning power. This conclusion is also supported
by the trend in the company's cash flows from operations.
It must be remembered, however, that this analysis is based on very limited information. To
adequately analyze a company, additional information would be needed. Complete financial
statements, financial information for similar companies, and general economic information
should all be considered when analyzing a company's earning power and solvency position.
E5–10
Transaction
Quick Ratio
Current Ratio
Debt/Equity Ratio
(1)
–
–
+
(2)
NE
NE
+
(3)
–
–
–
(4)
–
–
+a
b
(5)
+
+
–
(6)
+
+
–
__________________
a Wage Expense would be closed into Retained Earnings at the end of the accounting period as
part of the closing process. Thus, recording wage expense would decrease stockholders'
equity, and thereby increase the debt/equity ratio.
3
b
This transaction would increase both Sales and Cost of Goods Sold. Both of these accounts
would be closed into Retained Earnings as part of the closing process. Since the sales price
exceeds the cost of the inventory, the net effect of this transaction would be to increase
Retained Earnings. Thus, total stockholders' equity would increase, and thereby decrease the
debt/equity ratio.
PROBLEMS
P5–6
In order to consider an investment in Goodyear, let us first compute the following ratios:
1. Return on Equity
=
Net Income ÷ Average Stockholders’ Equity
2005: $ 228 ÷ [($73 + $74) ÷ 2] = 310.2%
2006: $(330) ÷ [($(758) + $73) ÷ 2] = (96.35%)
2. Return on Sales
(Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Net Sales
=
2005: ($228 + [$411 (1 – 0.30)]) ÷ $19,723 = 2.61%
2006: ($(330) + [$451 (1 – 0.30)]) ÷ $20,258 = (0.07%)
3. Current Ratio
Current Assets ÷ Current Liabilities
=
÷
÷
2005: $ 8,616
2006: $10,179
4. Debt/Equity Ratio
=
2005: $15,532
2006: $17,787
$5,441
$4,666
=
=
1.58
2.18
Total Liabilities ÷ Total Stockholders’ Equity
÷
÷
$73
($758)
=
=
212.77
NA
Generally, an equity investor would have much more information available to make a decision
than what is provided by Goodyear. However, based on the information provided, an equity
investment in Goodyear would be unwise. The company is showing a net loss on its income
statement and has negative equity on its balance sheet and is producing a decreasing amount
of cash from opeations. Until Goodyear can turn around its operations, it is not an attractive
opportunity.
P5–11
As a loan officer, I would be concerned with whether a potential borrower has the ability to meet its
debts as they come due. Since both companies are requesting only nine-month loans, I would be
interested in the potential borrowers' short-term solvency. Therefore, I would examine their current
ratios and quick ratios. Further, I would consider the effect of the potential loan on these ratios.
The current ratio is calculated as current assets divided by current liabilities.
Selig Equipment:
Mountain Bike:
$715,000 ÷ ($285,000 + $125,000) = 1.74
$835,000 ÷ ($325,000 + $125,000) = 1.86
It appears that both companies have more than sufficient current assets to meet their current
obligations, including the new loan. However, some current assets, such as prepaid expenses and
inventory, are not near-cash assets. Thus, a better measure of a potential borrower's ability to
4
meet its current obligations is the quick ratio. This ratio is calculated as the sum of cash,
marketable securities, and accounts receivable divided by current liabilities. Again, the effect of the
new loan should be considered.
Selig Equipment:
Mountain Bike:
($15,000 + $215,000) ÷ ($285,000 + $125,000) = .561
($160,000 + $470,000) ÷ ($325,000 + $125,000) = 1.400
Based on the quick ratio, Mountain Bike, Inc. appears to be a much better risk than Selig
Equipment. Mountain Bike has approximately 2.5 times more near-cash assets available than
Selig Equipment to meet its current obligations. Therefore, Mountain Bike does not have to rely as
heavily on converting other assets to cash as Selig does to meet its obligations. The company that
can most readily convert its inventory and receivables to cash might be the better risk. Two
possible measures of a company's ability to generate cash from its receivables and inventory are
the turnover and number-of-days ratios. Receivables turnover is calculated as net credit sales
divided by average accounts receivable, and the number of days for receivables is calculated as
365 divided by the receivables turnover.
Receivables turnover:
Selig Equipment: $1,005,000 ÷ $215,000 = 4.67
Mountain Bike:
$1,625,000 ÷ $470,000 = 3.46
Number of days:
Selig Equipment: 365 ÷ 4.67 = 78.16
Mountain Bike:
365 ÷ 3.46 = 105.49
These ratios indicate that Selig Equipment, on average, collects its receivables 27 days quicker
than Mountain Bike. Therefore, Selig Equipment can more easily convert its receivables to cash
than Mountain Bike can.
Inventory turnover is calculated as cost of goods sold divided by average inventory, and the
number of days is calculated as 365 divided by inventory turnover.
Inventory turnover:
Selig Equipment: $755,000 ÷ $305,000 = 2.48
Mountain Bike:
$960,000 ÷ $195,000 = 4.92
Number of days:
Selig Equipment: 365 ÷ 2.48 = 147.18
Mountain Bike:
365 ÷ 4.92 = 74.19
These ratios bode well for Mountain Bike. Mountain Bike sells its inventory, on average, 73 days
sooner than Selig Equipment sells its inventory. This difference implies that Mountain Bike
generates more sales which, in turn, implies that it generates more accounts receivable. Although
Mountain Bike does not turn over its receivables as often as Selig Equipment, it has a larger
amount of receivables to turn over. Thus, Mountain Bike potentially has more assets that can
easily be converted into cash than Selig Equipment.
Based upon Mountain Bike's superior quick ratio and potential ability to generate cash from its
larger receivables base, I would recommend that the bank grant the loan to Mountain Bike, Inc.
5
P5–12
a. Watson Metal Products' 2010 income statements under the different financing alternatives
would be as follows.
Income from operations*
Interest expense
Net income before taxes
Income taxes
Net income
* $16,500,000
Alternative 1
Alternative 2
Alternative 3
$ 16,500,000
4,000,000
$ 12,500,000
5,000,000
$ 7,500,000
$ 16,500,000
4,750,000
$ 11,750,000
4,700,000
$ 7,050,000
$ 16,500,000
4,375,000
$ 12,125,000
4,850,000
$ 7,275,000
= $15,000,000 2010 income from operations from non-French
operations per the 2009 income statement + $1,500,000 2010
income from operations from French operations.
The formulas for the requested ratios are:
Earnings per Share
Return on Equity
Return on Assets
Financial Leverage
Debt/Equity Ratio
=
=
=
=
=
Net Income ÷ Average Number of Common Shares Outstanding
Net Income ÷ Average Stockholders' Equity
(Net Income + [Interest Expense (1– Tax Rate)]÷ Average Total Assets
Return on Equity – Return on Assets
Total Liabilities ÷ Total Stockholders' Equity
Note: Although several of the ratios use averages, ending balances were used as specified
in the problem.
Alternative 1
EPS: $7,500,000 ÷ (2,000,000 shares* + 200,000 shares) = $3.41
* 2,000,000 shares = $6,600,000 2009 net income ÷ $3.30 2009 earnings per share
ROE: $7,500,000 ÷ ($45,000,000 + $5,000,000a + $7,500,000b) = .1304
a $5,000,000 = 200,000 shares  $25 per share
b $7,500,000 = 2010 net income
ROA: ($7,500,000 + [$4,000,000 (1 – .4)]) ÷ ($35,000,000 + $45,000,000 + $5,000,000 +
$7,500,000) = .1070
Leverage: .1304 – .1070 = .0234
Debt/Equity:
$35,000,000 ÷ ($45,000,000 + $5,000,000 + $7,500,000) = .609
6
P5–12
Continued
Alternative 2
EPS: $7,050,000 ÷ 2,000,000 shares = $3.53
ROE: $7,050,000 ÷ ($45,000,000 + $7,050,000) = .1354
ROA: ($7,050,000 + [$4,750,000 (1 - .40]) ÷ ($35,000,000 + $45,000,000 + $5,000,000 +
$7,050,000) = .1076
Leverage: .1354 – .1076 = .0278
Debt/Equity:
($35,000,000 + $5,000,000) ÷ ($45,000,000 + $7,050,000) = .768
Alternative 3
EPS: $7,275,000 ÷ (2,000,000 shares + 100,000 shares) = $3.46
ROE: $7,275,000 ÷ ($45,000,000 + $2,500,000* + $7,275,000) = .1328
* $2,500,000 = 100,000 shares  $25 per share
ROA: ($7,275,000 + [$4,375,000 (1 - .4)]) ÷ ($35,000,000 + $45,000,000 + $5,000,000 +
$7,275,000) = .1073
Leverage: .1328 – .1073 = .0255
Debt/Equity: ($35,000,000 + $2,500,000) ÷ ($45,000,000 + $2,500,000 + $7,275,000) = .685
b. Alternative 2 prevents a dilution of the stockholders' position. Since this alternative did not
require any additional shares of stock to be issued, it provides the largest earnings per share.
Alternative 2 allows the company to more effectively manage its stockholders' investment, as
evidenced by return on equity, and all investments, as evidenced by return on assets. The only
potentially serious drawback of this alternative is that it makes the company more risky, as
evidenced by it having the largest debt/equity ratio. Further, Alternative 2 allows the company
to use debt to benefit stockholders more effectively than is allowed with either of the other two
alternatives. Under Alternative 3, stockholders earn a slightly smaller return on their equity, but
incur fewer risks, since the company has issued less debt. Alternative 1 provides a marginally
lower return to stockholders, but imposes even less risk on them. Stockholders must trade off
the risk from issuing debt against the benefits of issuing debt. If the company is close to
violating debt covenants or projects weak future cash flows, then Alternatives 1 or 3 would
probably be preferable. Otherwise, Alternatives 2 or 3 would probably be preferable.
7
P5–12
c.
Concluded
Alternative 1
$3.30 = ($6,600,000 + Net income from expansion project) ÷ (2,000,000 shares +
200,000 shares)
Net income from expansion project = $660,000
Alternative 2
$3.30 = ($6,600,000 + Net income from expansion project) ÷ 2,000,000 shares
Net income from expansion project = $0
Alternative 3
$3.30 = ($6,600,000 + Net income from expansion project) ÷ (2,000,000 shares +
100,000 shares)
Net income from expansion project = $330,000
ISSUES FOR DISCUSSION
ID5–15
Profile #1 – EchoStar
Profile #2 – US Airways
Profile #3 – Wal-Mart
EchoStar is a relatively new company with a relatively new product. The company has been
growing, as more consumers switch from traditional and cable television services to satellite
television. The growth of the company has generated positive cash from operations. However,
the company has had to take that cash and invest it back into its business; the negative cash from
investing in all three years shows that the company is growing its business by investing in longterm assets. The growth is not sufficiently funded by operations, so the company is raising money
from debt and equity sources (financing activities) to fund its business. At the present time, the
company is not returning cash to its shareholders or repaying debt. It is borrowing additional funds
and raising additional equity to fund its growth.
US Airways operates in a difficult industry. The company has been unable to generate a positive
cash flow from its operations, a definite red flag for any business. The cash outflow from
operations has been paired with negative cash from investing activities, as the company must
reinvest in long term assets (aircraft) to remain competitive in its industry. The only source of cash
to fund the negative operations and the investments is financing (issuing debt and selling equity).
The long term prospects for the company do not look healthy. No business can sustain itself
through endless financing activities to fund cash; if the company is going to survive, it will
eventually have to generate cash from its operations so that it can eventually repay debt and return
some cash to shareholders.
Wal-Mart is an excellent example of a successful company that has reached the stage in its
maturity that its operations throw off enough cash to fund the company’s still-impressive growth
(investing activities) AND to return cash to shareholders and/or repay debt (financing activities).
The company can rely on its daily operations to generate cash, which is then used to add more
stores and fund dividends and debt reduction.
8