CHAPTER 14 FINANCIAL STATEMENT ANALYSIS

SUGGESTED ANSWERS TO DISCUSSION QUESTIONS

1. Observation of trends is useful primarily in determining whether a situation is improving, worsening, or remaining constant. By comparing current data with similar data of prior periods we gain insight into the direction in which future results are likely to move. Some other standards of comparison include comparison with other similar companies, comparison with industry standards, and comparison with previous years information. By comparing analytical data for one company with some independent yardstick, the analyst hopes to determine how the position of the company in question compares with some standard of performance. 2. A ratio is a mathematical expression of the relation of one figure to another. The purpose in computing a ratio is simply to draw attention to this relationship. The reader of a financial statement may observe, for example, that sales were $12 million and accounts receivable $1 million. If he or she states this relationship as a ratiothat is, that receivables turn over about 12 times per yearthe information may become more useful. 3. Trend percentages are used to show the increase or decrease in a financial statement amount over a period of years by comparing the amount in each year with the base-year amount. A component percentage is the percentage relationship between some financial amount and a total of which it is a part. Measuring the change in sales over a period of several years would call for use of trend percentages. The sales in the base year are assigned a weight of 100%. The percentage for each later year is computed by dividing that years sales by the sales in the base year. 4. The comparison of financial data over several time periods (over many years, second quarter of the year with the first quarter, etc.) is called horizontal analysis; the study of financial relationships within a given accounting period is called vertical analysis. 5. In analyzing the financial statements of Femco Corporation, analysts can better evaluate the significance of the various ratios and earnings rates computed for the latest year or for a period of years by comparing them to similar measurements for other companies in the chemical industry. In this way, the analyst is better able to judge whether Femco Corporation is more or less successful than its competitors and if its financial position is in line with that of other companies in the same industry. In comparing financial results of Femco Corporation with those of another chemical company, the analyst should be alert for any differences in accounting principles used by the two companies. Differences in accounting practices reduce the comparability of financial data for two companies and may produce artificial differences in ratios and other measurements typically used in analyzing financial statements. 6. Accounting methods that produce a conservative measurement of net income lead to a higher quality of earnings. Accelerated depreciation (a) and the use of a relatively short estimate of useful life, as in (c), both tend to provide larger amounts of depreciation expense, and therefore produce a more conservative measurement of net income and a higher quality of earnings. The FIFO method of inventory (b) minimizes the cost of goods sold during an inflationary period, thus reducing or lowering the quality of earnings.

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7. The purpose of classifications in financial statements is to develop useful subtotals, which help users analyze the statements. The most commonly used classifications are: In a balance sheet: current assets, plant and equipment, other assets, current liabilities, long-term (or noncurrent) liabilities, and stockholders equity. In a multiple-step income statement: revenue, cost of goods sold, operating expenses, and nonoperating items. The operating expense section often includes subclassifications for selling expenses and for general and administrative expenses. In a statement of cash flows: cash flows provided by or used in operating activities, investing activities, and financing activities. 8. In classified financial statements, similar items are grouped together to produce subtotals which may assist users in their analyses. Comparative financial statements show financial statements for two or more time periods in side-by-side columns. Consolidated statements include not only the financial statement amounts for a single company but also for any subsidiary companies that it owns. The financial statements of large corporations often possess all three of these characteristics. 9. Measures of liquidity include the following (three required): Current ratio (current assets divided by current liabilities). Quick ratio (quick assets divided by current liabilities). Working capital (current assets less current liabilities). Net cash provided by operating activities (appears in a statement of cash flows). 10. Current assets are expected to be converted into cash (or substituted for cash), or used up, within one year or an operating cycle, whichever is the longer period of time. The receivables of a company that regularly sells merchandise on 24- or 36-month installment plans are current assets, because the collection of these receivables is part of the companys operating cycle. 11. The quick ratio is the most liquid, or quick assets, (cash, marketable securities, and receivables) divided by current liabilities. Short-term creditors may consider the quick ratio more useful than the current ratio if inventories consist of slow-moving merchandise, or are unusually large in dollar amount. 12. The current ratio for Rockmore is 1.7 to 1 (current assets, $540,000, divided by current liabilities, $320,000). The quick ratio is 1.3 to 1 (quick assets, $420,000, divided by current liabilities, $320,000). Working capital amounts to $220,000 (current assets, $540,000, minus current liabilities, $320,000). 13. The debt ratio is computed by dividing total liabilities by total assets. It is considered a measure of the long-term safety of creditors claims, rather than a measure of short-term liquidity. 14. In a multiple-step income statement, different categories of expenses are deducted from revenue in a series of steps, thus resulting in various subtotals, such as gross profit and operating income. In a single-step income statement, all expenses are combined and deducted from total revenue in a single step. Both formats result in the same amount of net income. 15. Ratios and other measures used in evaluating profitability include (four required): Percentage change in net income from the prior year (dollar amount of the change divided by the amount in the prior year). Gross profit rate (dollar gross profit divided by net sales).

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Operating income (revenue from primary business activities less the cost of goods sold and operating expenses). Net income as a percentage of net sales (net income divided by net sales). Earnings per share (in the simplest case, net income divided by the number of shares of capital stock outstanding). Return on assets (operating income divided by average total assets). Return on stockholders equity (net income divided by average stockholders equity). 16. The store may not be selling 5% more merchandise. A portion of the increase in sales revenue may reflect inflationthat is, an increase in pricesrather than a higher physical sales volume. If the stores prices have increased at the general rate of inflation, the increase in physical sales volume would be equal to the rate of inflation less 5%. If prices are rising at more than 5% per year, the store is actually selling less merchandise each year. 17. Income taxes expense differs from most other expenses in several respects. First, income taxes expense does not contribute to the production of revenueit is based upon the overall profitability of the business. Income taxes expense also differs from other expenses in that management has little or no discretion concerning its payment as it does with many other expenses. Next, only businesses organized as corporations are subject to income taxes expense. The earnings of an unincorporated business are taxed directly to the owners. In a multiple-step income statement, income taxes expense is listed among the nonoperating items, following the determination of operating income. 18. Operating income is the difference between (1) revenue earned from customers, and (2) expenses closely related to the production of that revenue. Items such as income taxes, interest expense, and gains and losses from sales of investments are specifically excluded in the computation of operating income. Thus, operating income measures the profitability of the companys basic business activities. Net income, in contrast, is a broader measure of the profit or loss resulting from all business operations. 19. Expenses (including the cost of goods sold) have been increasing at an even faster rate than net sales. Thus, Maryville is apparently having difficulty in effectively controlling its expenses. 20. A large corporation may have thousands or even millions of individual stockholders. The extent of each stockholders ownership of the business is determined by the number of shares that he or she owns. Thus, the earnings per share measurement helps stockholders relate the total earnings of the business to their ownership investments. In addition, stock prices are stated on a per-share basis. Earnings per share information may be useful in assessing how well the company is doing in terms of earning a profit in comparison with the price to buy a share of stock. 21. P/e ratios reflect investors expectations concerning future profits. If the Congress announced an intention to limit the prices and profits of pharmaceutical companies, these expectations would likely be abruptly lowered. [Note to the instructor: President Clinton made such an announcement in 1993. As a result, the p/e ratios and stock prices of major pharmaceutical companies fell significantly. In the months following the Presidents announcement, Mercks stock price dropped from the low $50s to the mid-$30s, and the stock of Bristol-Myers/Squibb dropped from the low $70s to the mid-$50s.] 22. If the companys earnings are very low, they may become almost insignificant in relation to stock price. While this means that the p/e ratio becomes very high, it does not necessarily mean that investors are optimistic. In fact, they may be valuing the company at its liquidation value rather than a value based upon expected future earnings.

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23. From the viewpoint of the companys stockholders, this situation represents a favorable use of leverage. It is probable that little interest, if any, is paid for the use of funds supplied by current creditors, and only 11% interest is being paid to long-term bondholders. Together these two sources supply 40% of the total assets. Since the firm earns an average return of 16% on all assets, the amount by which the return on 40% of the assets exceeds the fixed-interest requirements on liabilities will accrue to the residual equity holdersthe common stockholdersraising the return on stockholders equity. 24. The length of the operating cycle of the two companies cannot be determined from the fact that one companys current ratio is higher. The operating cycle depends on the relationships between receivables and sales, and between inventories and cost of goods sold. The company with the higher current ratio might have either small amounts of receivables and inventories, or large sales and cost of sales, either of which would tend to produce a relatively short operating cycle. 25. The investor is calculating the rate of return by dividing the dividend by the purchase price of the investment ($5 $50 = 10%). A more meaningful figure for rate of return on investment is determined by relating dividends to current market price, since the investor at the present time is faced with the alternative of selling the stock for $100 and investing the proceeds elsewhere or keeping the investment. A decision to retain the stock constitutes, in effect, a decision to continue to invest $100 in it, at a return of 5%. It is true that in a historical sense the investor is earning 10% on the original investment, but this is interesting history rather than useful decision-making information. 26. Ramsons current ratio would probably be higher during July. At this time the amount of both current assets and current liabilities are likely to be at a minimum, and the ratio of current assets to current liabilities is thus likely to be larger. In general, it would be advisable for the company to end its fiscal year as of July 31. At this time inventories and receivables will be at a minimum; therefore, the chance of error in arriving at a valuation for these assets will be minimized, the work of taking inventories will be reduced, and a more accurate determination of net income is probable. 27. A corporate net income of $1 million would be unreasonably low for a large corporation, with, say, $100 million in sales, $50 million in assets, and $40 million in stockholders equity. A return of only $1 million for a company of this size would suggest that the owners could do much better by investing in insured bank savings accounts or in government bonds which would be virtually risk-free and would pay a higher return. On the other hand, a profit of $1 million would be unreasonably high for a corporation that had sales of only $5 million, assets of, say, $3 million, and stockholders equity of perhaps one-half million dollars. In other words, the net income of a corporation must be judged in relation to the size of the company, the scale of its operations, and the amount invested.

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SOLUTIONS TO EXERCISES
Ex. 141 a. Accounts receivable decreased 21% ($34,000 decrease $160,000 = 21% decrease). b. Marketable securities decreased 100% ($250,000 decrease $250,000 = 100% decrease). c. A percentage change cannot be calculated because retained earnings showed a negative amount (a deficit) in the base year and a positive amount in the following year. d. A percentage change cannot be calculated because of the zero amount of notes receivable in 2001, the base year. e. Notes payable increased 9% ($70,000 increase $800,000 = 9% increase). f. Cash increased 5% ($4,000 increase $80,000 = 5% increase). g. Sales increased 8% ($70,000 increase $900,000 = 8% increase).

Ex. 142 Sales ............................................... Cost of goods sold ..........................

2002 163% 195%

2001 148% 160%

2000 123% 135%

1999 118% 123%

1998 100% 100%

The trend of sales is favorable with an increase each year. However, the trend of cost of goods sold is unfavorable, because it is increasing faster than sales. This means that the gross profit margin is shrinking. Perhaps the increase in sales volume is being achieved through cutting sales prices. Another possibility is that the companys purchasing policies are becoming less efficient. Investigation of the cause of the trend in cost of goods sold is essential.

Ex. 144

a. b. c. d. e. f. g. h. i. j.

Earnings per share. Operating activities. Debt ratio. P/e ratio. None. (The statement describes return on assets.) Parent company. Operating income. Current ratio. None. (The statement describes an unincorporated business, such as a sole proprietorship or a partnership.) None. (The statement describes classified financial statements.)

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Ex. 1412 Accepting the job offer from Alpha Research might be justified in terms of the companys liquidity, profitability, and the growth potential of its common stock. Liquidity: At first glance, the high current and quick ratios of Omega Scientific make it appear to be more liquid than Alpha Research. However, these figures may also indicate that the company is having problems converting accounts receivable and inventories into cash. Alpha Research, on the other hand, reports liquidity ratios that are much more in line with industry norms. Further investigation regarding the ability of each firm to consistently generate adequate operating cash flow is certainly needed. Profitability: Alpha Research appears to be more efficient than Omega Scientific at generating a return on its assets and its equity. Furthermore, Alphas profitability by far exceeds industry norms, whereas Omegas ability to earn adequate returns falls somewhat short of industry standards. Judging from its high p/e ratio, it appears that market expectations that Alpha will continue its earnings growth are optimistic. Stock growth: Stock prices of relatively new and aggressive companies often appreciate in value at a faster rate than the stocks of older, more conservative, firms. Thus, if Alpha Research continues to gain market share, generate adequate cash flows, and increase its profitability, the prospects for the companys common stock investors may be very bright. As a result, the appreciation of the stock sold to Alphas employees at a reduced rate may more than offset its lower starting salaries. Note to instructor: Students should be cautioned not to rely completely upon financial information in the decisions they make. In deciding which job offer to accept, for example, one should take into consideration the people, fringe benefits, career growth opportunities, geographic location, potential long-term stability of each firm, etc.

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Ex. 1413 a. (1) Gross profit percentage: 2001: 33% [($610,000 $408,000) $610,000] 2002: 34% [($750,000 $495,000) $750,000] (2) Inventory turnover: 2001: 4 times ($408,000 $102,000 average inventory) 2002: 4.5 times ($495,000 $110,000 average inventory) (3) Accounts receivable turnover: 2001: 6 times ($610,000 $100,000 average accounts receivable) 2002: 5 times ($750,000 $150,000 average accounts receivable) b. There are three favorable trends. First, the growth in net sales from $610,000 to $750,000. This represents an increase of 23% ($140,000 increase, divided by $610,000 in the prior year). Next, the gross profit rate increased from 33% in 2001 to 34% in 2002. Not only is BargainCo selling more, but it is selling its merchandise at a higher profit margin. Finally, the inventory turnover has increased, indicating that the company has increased its sales without having to proportionately increase its investment in inventories. There is only one negative trend. The accounts receivable turnover rate has declined. One question immediately should come to mind: Has BargainCo liberalized its credit policies as part of its strategy to increase sales? If so, the slowdown in the receivables turnover may have been expected and be no cause for concern. On the other hand, if the company has not changed its credit policies, it apparently is encountering more difficulty in collecting its accounts receivable on a timely basis.

Ex. 1414 a. Current ratio: 3.7 to 1 ($550,000 $150,000) b. Quick ratio: 1.5 to 1 ($220,000 $150,000) c. Working capital: $400,000 ($550,000 $150,000) d. Debt ratio: 40% ($480,000 $1,210,000) e. Accounts receivable turnover: 19 times ($2,950,000 $155,000) f. Inventory turnover: 6.8 times ($1,834,000 $270,000) g. Book value per share of capital stock: $12.17 ($730,000 60,000 shares) Note: Cost of goods sold (item f) is $2,950,000 $1,116,000, or $1,834,000.

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25 Minutes, Easy

PROBLEM 144 SAFEWAY, INC.

(Dollars in Millions)

a.

Current assets: Cash Receivables Merchandise inventories Prepaid expenses Total current assets

7 4 1 5 2 1 1 9 1 9 5 $ 1 5 1 4

. . . . .

8 7 8 5 8

Quick assets: Cash Receivables Total quick assets

$ $

7 4. 8 1 5 2. 7 2 2 7. 5

b.

(1) Current ratio: Current assets (part a ) Current liabilities Current ratio ($1,514.8 $1,939.0)

$ 1 5 1 4. 8 $ 1 9 3 9. 0 .8 to 1

(2) Quick ratio: Quick assets (part a ) Current liabilities Quick ratio ($227.5 $1,939.0)

$ 2 2 7. 5 $ 1 9 3 9. 0 .1 to 1

(3) Working capital: Current assets (part a ) Less: Current liabilities Working capital

$ 1 5 1 4. 8 1 9 3 9. 0 $ ( 4 2 4. 2)

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PROBLEM 144 SAFEWAY, INC. (concluded)

c. No. It is difficult to draw conclusions from the above ratios. Safeways current ratio and quick ratio are well below safe levels, according to traditional rules of thumb. On the other hand, some large companies with steady cash flows are able to operate successfully with current ratios lower than Safeways. d. Due to characteristics of the industry, supermarkets tend to have smaller amounts of current assets and quick assets than other types of merchandising companies. An inventory of food has a short shelf life. Therefore, the inventory of a supermarket usually represents only a few weeks sales. Other merchandising companies may stock inventories representing several months sales. Also, supermarkets sell primarily for cash. Thus, they have relatively few receivables. Although supermarkets may generate large amounts of cash, it is not profitable for them to hold assets in this form. Therefore, they are likely to reinvest their cash flows in business operations as quickly as possible. e. In evaluating Safeways liquidity, it would be useful to review the companys financial position in prior years, statements of cash flows, and the financial ratios of other supermarket chains. One might also ascertain the companys credit rating from an agency such as Dun & Bradstreet. Note to instructor: Prior to the year in which the data for this problem was collected, Safeway had reported a negative retained earnings balance in its balance sheet for several consecutive periods. The fact that Safeway has only recently removed the deficit from its financial statements is also worrisome.

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25 Minutes, Medium

PROBLEM 1410 PETOCK PRODUCTS

a. (1) Inventory turnover: Cost of Goods Sold, $1,755,000 = 5 times Average Inventory, $351,000 (2) Accounts receivable turnover: Credit Sales, $2,750,000 = 9.2 times Average Accounts Receivable, $300,000

(3) Total operating expenses: Sales Less: Cost of goods sold Gross profit Less: Interest expense (non-operating item) Income taxes (non-operating item) Net income Operating expenses

$2 7 5 0 0 0 0 1755000 $ 995000 $ 45000 84000 159000 $

288000 707000

(4) Gross profit percentage: Sales, $2,750,000 cost of goods sold, $1,755,000 = gross profit, $995,000. $995,000 $2,750,000 = 36% (5) Return on average stockholders equity, $159,000 $895,000 = 17.8%

(6) Return on average assets: Operating income: Sales Cost of goods sold Gross profit Operating expenses Operating income Average investment in assets Return on average assets ($288,000 $1,800,000)

$2 7 5 0 1755 $ 995 707 $ 288 $1 8 0 0

0 0 0 0 0 0

0 0 0 0 0 0 1

0 0 0 0 0 0 6%

10

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PROBLEM 1410 PETOCK PRODUCTS (concluded)

b. Obtaining the loan will be desirable to stockholders because the return on average assets (16%) is greater than the prospective rate of payment to creditors (12%). In other words, the stockholders will gain from applying leverage, which is a form of financing using fixed-return securities as capital. Of course the assumption of long-term debt would increase the risk to the stockholders. In the event of a business downturn, the earnings of the company might fall far below the present levels and the company might be unable to meet the interest payments on the loan, which could entitle the creditor to take control of the company. Use of money borrowed at a rate of 12% will be beneficial to stockholders if we can assume that the company will continue to earn more than a 12% return on assets. 25 Minutes, Strong

PROBLEM 1413 HARDEMAN INDUSTRIES

(1) Decrease in quick ratio. Increases current liabilities; does not change quick assets. (2) Decrease in gross profit percentage. Smaller unit price means that gross profit margin per dollar of sales will decrease. (3) Decrease in current ratio. Declaration of dividend increases current liabilities; no change in current assets. (4) No change in current ratio. Write-off of an uncollectible account against the Allowance for Doubtful Accounts does not change the amount of net receivables or of current assets. (5) Decrease in debt ratio. This transaction increases stockholders equity and reduces liabilities. (6) Decrease in earnings per share. No change in earnings, but an increased number of shares are outstanding after the stock dividend. (7) Increase in interest coverage ratio. Conversion of bonds payable into common stock reduces interest charges but does not change operating income. (8) No change in rate of return on stockholders equity. Appropriation of retained earnings does not change either the amount of net income or the total stockholders equity. (9) Increase in inventory turnover. During a period of rising prices, a shift from FIFO to LIFO will probably increase the cost of goods sold and decrease the book value of the average inventory. (10) Decrease in debt ratio. Payment of a dividend decreases liabilities and assets by an equal amount. Subtracting the same amount from the numerator and denominator of a fraction decreases the fraction. (11) Decrease in current ratio. An equal amount is added to both current assets and current liabilities. Given a current ratio larger than 1 to 1, this will reduce the ratio. Note to instructor: You may wish to point out that if current assets equal current liabilities, there would be no change in the ratio; and if current assets were smaller than current liabilities, the ratio would increase. (12) Decrease in debt ratio. There is an increase in total assets but no change in total liabilities. Therefore, the percentage of assets financed by debt declines.

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