MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual

CHAPTER 5
FINANCIAL STATEMENTS ANALYSIS - II
I.

Questions
1. By looking at trends, an analyst hopes to get some idea of whether a
situation is improving, remaining the same, or deteriorating. Such
analyses can provide insight into what is likely to happen in the future.
Rather than looking at trends, an analyst may compare one company to
another or to industry averages using common-size financial statements.
2. Ratios highlight relationships, movements, and trends that are very
difficult to perceive looking at the raw underlying data standing alone.
Also, ratios make financial data easier to grasp by putting the data into
perspective. As to the limitation in the use of ratios, refer to page 129.
3. Price-earnings ratios are determined by how investors see a firms future
prospects. Current reported earnings are generally considered to be useful
only so far as they can assist investors in judging what will happen in the
future. For this reason, two firms might have the same current earnings,
but one might have a much higher price-earnings ratio if investors view it
to have superior future prospects. In some cases, firms with very small
current earnings enjoy very high price-earnings ratios. This is simply
because investors view these firms as having very favorable prospects for
earnings in future years. By definition, a stock with current earnings of
P4 and a price-earnings ratio of 20 would be selling for P80 per share.
4. A managers financing responsibilities relate to the acquisition of assets
for use in his or her company. The acquisition of assets can be financed in
a number of ways, including through issue of ordinary shares, through
issue of preference shares, through issue of long-term debt, through
leasing, etc. A managers operating responsibilities relate to how these
assets are used once they have been acquired. The return on total assets
ratio is designed to measure how well a manager is discharging his or her
operating responsibilities. It does this by looking at a companys income
before any consideration is given as to how the income will be distributed
among capital resources, i.e., before interest deductions.

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Chapter 5 Financial Statement Analysis II

5. Financial leverage, as the term is used in business practice, means

obtaining funds from investment sources that require a fixed annual rate
of return, in the hope of enhancing the well-being of the ordinary
shareholders. If the assets in which these funds are invested earn at a rate
greater that the return required by the suppliers of the funds, then leverage
is positive in the sense that the excess accrues to the benefit of the
ordinary shareholders. If the return on assets is less than the return
required by the suppliers of the funds, then leverage is negative in the
sense that part of the earnings from the assets provided by the ordinary
shareholders will have to go to make up the deficiency.
6. How a shareholder would feel would depend in large part on the stability
of the firm and its industry. If the firm is in an industry that experiences
wide fluctuations in earnings, then shareholders might be very pleased that
no interest-paying debt exists in the firms capital structure. In hard
times, interest payments might be very difficult to meet, or earnings might
be so poor that negative leverage would result.
7. No, the stock is not necessarily overpriced. Book value represents the
cumulative effects on the balance sheet of past activities evaluated using
historical prices. The market value of the stock reflects investors beliefs
about the companys future earning prospects. For most companies
market value exceeds book value because investors anticipate future
growth in earnings.
8. A company in a rapidly growing technological industry probably would
have many opportunities to invest its earnings at a high rate of return;
thus, one would expect it to have a low dividend payout ratio.
9. It is more difficult to obtain positive financial leverage from preference
shares than from long-term debt due to the fact that interest on long-term
debt is tax deductible, whereas dividends paid on preference shares are not
tax deductible.
10. The current ratio would probably be highest during January, when both
current assets and current liabilities are at a minimum. During peak
operating periods, current liabilities generally include short-term
borrowings that are used to temporarily finance inventories and
receivables. As the peak periods end, these short-term borrowings are paid
off, thereby enhancing the current ratio.
11. A 2-to-1 current ratio might not be adequate for several reasons. First, the
composition of the current assets may be heavily weighted toward slow5-2

Financial Statement Analysis II Chapter 5

turning inventory, or the inventory may consist of large amounts of

obsolete goods. Second, the receivables may be large and of doubtful
collectibility, or the receivables may be turning very slowly due to poor
collection procedures.
12. Expenses (including the cost of goods sold) have been increasing at an
even faster rate than net sales. Thus Sunday is apparently having
difficulty in effectively controlling its expenses.
13. 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.
14. From the viewpoint of the companys shareholders, 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 holders the ordinary shareholders raising the return
on equity.
15. The length of operating cycle of the two companies cannot be determined
from the fact the 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.
16. The investor is calculating the rate of return by dividing the dividend by
the purchase price of the investment (P5 P50 = 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 P100 and
investing the proceeds elsewhere or keeping the investment. A decision to
retain the stock constitutes, in effect, a decision to continue to invest P100
in it, at a return of 5%. It is true that in a historical sense the investor is

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Chapter 5 Financial Statement Analysis II

earning 10% on the original investment, but this is interesting history

rather than useful decision-making information.
17. A corporate net income of P1 million would be unreasonably low for a
large corporation, with, say, P100 million in sales, P50 million in assets,
and P40 million in equity. A return of only P1 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 P1 million would be unreasonably high for a
corporation which had sales of only P5 million, assets of, say, P3 million,
and equity of perhaps one-half million pesos. In other words, the net
income of a corporation must be judged in relation to the scale of
operations and the amount invested.
II. True or False
1. True
2. True

3. True
4. False

5. True
6. True

7. True
8. True

9. False
10. False

III. Problems
Problem 1 (Common Size Income Statements)
Common size income statements for 2005 and 2006:

2006
2005
Sales.................................................
100%
100%
Cost of goods sold.............................
66
67
Gross profit.......................................
34%
33%
Operating expenses...........................
28
29
Net income........................................
6%
4%
The changes from 2005 to 2006 are all favorable. Sales increased and the
gross profit per peso of sales also increased. These two factors led to a
substantial increase in gross profit. Although operating expenses increased in
peso amount, the operating expenses per peso of sales decreased from 29 cents
to 28 cents. The combination of these three favorable factors caused net
income to rise from 4 cents to 6 cents out of each peso of sales.
Problem 2 (Measures of Liquidity)
Requirement (a)
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Financial Statement Analysis II Chapter 5

Current assets:
Cash
Marketable securities
Accounts receivable
Inventory
Unexpired insurance
Total current assets
Current liabilities:
Notes payable
Accounts payable
Salaries payable
Income taxes payable
Unearned revenue
Total current liabilities

P 47,600
175,040
230,540
179,600
4,500
P637,280
P 70,000
125,430
7,570
14,600
10,000
P227,600

Requirement (b)
The current ratio is 2.8 to 1. It is computed by dividing the current assets of
P637,280 by the current liabilities of P227,600. The amount of working
capital is P409,680, computed by subtracting the current liabilities of
P227,600 from the current assets of P637,280.
The company appears to be in a strong position as to short-run debt-paying
ability. It has almost three pesos of current assets for each peso of current
liabilities. Even if some losses should be sustained in the sale of the
merchandise on hand or in the collection of the accounts receivable, it appears
probable that the company would still be able to pay its debts as they fall due
in the near future. Of course, additional information, such as the credit terms
on the accounts receivable, would be helpful in a careful evaluation of the
companys current position.
Problem 3 (Common-Size Income Statement)
Requirement 1
2006
2005
Sales........................................................................................................................
100.0 %
100.0 %
Less cost of goods sold............................................................................................
63.2
60.0
Gross margin...........................................................................................................
36.8
40.0
Selling expenses.......................................................................................................
18.0
17.5
Administrative expenses..........................................................................................
13.6
14.6
Total expenses.........................................................................................................
31.6
32.1
Net operating income...............................................................................................
5.2
7.9
Interest expense.......................................................................................................
1.4
1.0
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Chapter 5 Financial Statement Analysis II

Net income before taxes...........................................................................................

3.8 %
6.9 %
Requirement 2
The companys major problem seems to be the increase in cost of goods sold,
which increased from 60.0% of sales in 2005 to 63.2% of sales in 2006. This
suggests that the company is not passing the increases in costs of its products
on to its customers. As a result, cost of goods sold as a percentage of sales
has increased and gross margin has decreased. Selling expenses and interest
expense have both increased slightly during the year, which suggests that costs
generally are going up in the company. The only exception is the
administrative expenses, which have decreased from 14.6% of sales in 2005 to
13.6% of sales in 2006. This probably is a result of the companys efforts to
reduce administrative expenses during the year.
Problem 4 (Comparing Operating Results with Average Performance in
the Industry)
Requirement (a)
Sales (net)
Cost of goods sold
Gross profit on sales
Operating expenses:
Selling
General and administrative
Total operating expenses
Operating income
Income taxes
Net income........................................

Ms. Freeze,
Inc.
100%
49
51%
21%
17
38%
13%
6
7%

Industry Average
100%
57
43%
16%
20
36%
7%
3
4%

Requirement (b)
Ms. Freezes operating results are significantly better than the average
performance within the industry. As a percentage of sales revenue, Ms.
Freezes operating income and net income after nearly twice the average for
the industry. As a percentage of total assets, Ms. Freezes profits amount to
an impressive 23% as compared to 14% for the industry.
The key to Ms. Freezes success seems to be its ability to earn a relatively
high rate of gross profit. Ms. Freezes exceptional gross profit rate (51%)
probably results from a combination of factors, such as an ability to command
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Financial Statement Analysis II Chapter 5

a premium price for the companys products and production efficiencies which
lead to lower manufacturing costs.
As a percentage of sales, Ms. Freezes selling expenses are five points higher
than the industry average (21% compared to 16%). However, these higher
expenses may explain Ms. Freezes ability to command a premium price for
its products. Since the companys gross profit rate exceeds the industry
average by 8 percentage points, the higher-than-average selling costs may be
part of a successful marketing strategy. The companys general and
administrative expenses are significantly lower than the industry average,
which indicates that Ms. Freezes management is able to control expenses
effectively.
Problem 5 (Common-Size Statements)
Requirement 1
The income statement in common-size form would be:

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

2006
100.0%
65.0
35.0
26.3
8.7
1.2
7.5
2.3
5.3%

2005
100.0%
60.0
40.0
30.4
9.6
1.6
8.0
2.4
5.6%

The balance sheet in common-size form would be:

2006
Current assets:
Cash
..........................................................
Accounts receivable, net
..........................................................
Inventory
..........................................................
Prepaid expenses
..........................................................
Total current assets
5-7

2.0%

2005
5.1%

15.0

10.1

30.1

15.2

1.0

1.3

48.1

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Chapter 5 Financial Statement Analysis II

Plant and equipment.................................

Total assets...............................................

51.9
100.0%

68.4
100.0%

25.1%
20.1
45.1

12.7%
25.3
38.0

15.0

19.0

Ordinary shares, P5 par

10.0

12.7

Retained earnings

29.8

30.4

54.9

62.0

100.0%

100.0%

Liabilities:
Current liabilities...............................
Bonds payable, 12%...........................
Total liabilities.............................
Equity:
Preference shares, 8%, P10 par

Total equity
Total liabilities and equity.........................

Note: Columns do not total down in all cases due to rounding differences.
Requirement 2
The companys cost of goods sold has increased from 60 percent of sales in
2005 to 65 percent of sales in 2006. This appears to be the major reason the
companys profits showed so little increase between the two years. Some
benefits were realized from the companys cost-cutting efforts, as evidenced by
the fact that operating expenses were only 26.3 percent of sales in 2006 as
compared to 30.4 percent in 2005. Unfortunately, this reduction in operating
expenses was not enough to offset the increase in cost of goods sold. As a
result, the companys net income declined from 5.6 percent of sales in 2005 to
5.3 percent of sales in 2006.
Problem 6 (Solvency of Alabang Supermarket)
Requirement (a)
(Pesos in
Millions)
Current assets:
Cash
Receivables
Merchandise inventories
Prepaid expenses
Total current assets

74.8
152.7
1,191.8
95.5
P1,514.8
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Financial Statement Analysis II Chapter 5

Quick assets:
Cash
Receivables
Total quick assets

74.8
152.7
P 227.5

Requirement (b)
(1) Current ratio:
Current assets (Req. a)
Current liabilities
Current ratio (P1,514.8 P1,939.0)

P1,514.8
P1,939.0
0.8 to 1

(2) Quick ratio:

Quick assets (Req. a)
Current liabilities
Quick ratio (P227.5 P1,939.0)

P 227.5
P1,939.0
0.1 to 1

(3) Working capital:

Current assets (Req. a)
Less: Current liabilities
Working capital

P1,514.8
P1,939.0
P(424.2)

Requirement (c)
No. It is difficult to draw conclusions from the above ratios. Alabang
Supermarkets 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 ash flows are able to operate successfully with current
ratios lower than Alabang Supermarkets.
Requirement (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
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Chapter 5 Financial Statement Analysis II

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.
Requirement (e)
In evaluating Alabang Supermarkets 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, Alabang Supermarket had reported a negative retained earnings
balance in its balance sheet for several consecutive periods. The fact that
Alabang Supermarket has only recently removed the deficit from its financial
statements is also worrisome.

Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk)

Requirement (a)
(1) Quick assets:
Cash
Marketable securities (short-term)
Accounts receivable
Total quick assets

P 47,524
55,926
23,553
P127,003

(2) Current assets:

Cash
Marketable securities (short-term)
Accounts receivable
Inventories
Prepaid expenses
Total current assets

P 47,524
55,926
23,553
32,210
5,736
P164,949

(3) Current liabilities:

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Financial Statement Analysis II Chapter 5

Notes payable to banks (due within one year)

Accounts payable
Dividends payable
Accrued liabilities (short-term)
Income taxes payable
Total current liabilities

P 20,000
5,912
1,424
21,532
6,438
P 55,306

Requirement (b)
(1) Quick ratio:
Quick assets (Req. a)
Current liabilities (Req. a)
Quick ratio (P127,003 P55,306)

P127,003
P 55,306
2.3 to 1

(2) Current ratio:

Current assets (Req. a)
Current liabilities (Req. a)
Current ratio (P164,949 P55,306)

P164,949
P 55,306
3.0 to 1

(3) Working capital:

Current assets (Req. a)
Less: Current liabilities (Req. a)
Working capital

P164,949
55,306
P109,643

(4) Debt ratio:

Total liabilities (given)
Total assets (given)
Debt ratio (P81,630 P353,816)

P 81,630
P353,816
23.1%

Requirement (c)
(1) From the viewpoint of short-term creditors, Bonbon Sweets appear
highly liquid. Its quick and current ratios are well above normal rules of
thumb, and the companys cash and marketable securities alone are almost
twice its current liabilities.
(2) Long-term creditors also have little to worry about. Not only is the
company highly liquid, but creditors claims amount to only 23.1% of
total assets. If Bonbon Sweets were to go out of business and liquidate

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its assets, it would have to raise only 23 cents from every peso of assets
for creditors to emerge intact.
(3) From the viewpoint of shareholders, Bonbon Sweets appears overly
liquid. Current assets generally do not generate high rates of return.
Thus, the companys relatively large holdings of current assets dilutes its
return on total assets. This should be of concern to shareholders. If
Bonbon Sweets is unable to invest its highly liquid assets more
productively in its business, shareholders probably would like to see the
money distributed as dividends.
Problem 8 (Selected Financial Measures for Short-term Creditors)
Requirement 1
Current assets (P80,000 + P460,000 + P750,000 +
P10,000)..............................................................................................................
P1,300,000
Current liabilities (P1,300,000 2.5)......................................................................
520,000
P 780,000
Working capital.......................................................................................................
Requirement 2
Acid-test ratio =

Cash + Marketable securities + Accounts receivable

Current liabilities

Acid-test ratio =

P80,000 + P0 + P460,000
P520,000

= 1.04 to 1 (rounded)

Requirement 3
a. Working capital would not be affected:
Current assets (P1,300,000 P100,000).................................................................
P1,200,000
Current liabilities (P520,000 P100,000)...............................................................
420,000
Working capital.......................................................................................................
P 780,000
b. The current ratio would rise:
Current ratio

Current rate

Current assets
Current liabilities
P1,200,000
P420,000

Problem 9 (Selected Financial Ratios)

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= 2.9 to 1 (rounded)

Financial Statement Analysis II Chapter 5

1. Gross margin percentage:

Gross margin
Sales

P840,000
P2,100,000

2. Current ratio:
Current assets
Current liabilities

= 40%

P490,000
P200,000

= 2.45 to 1

3. Acid-test ratio:
Quick assets
Current liabilities

P181,000
P200,000

= 0.91 to 1 (rounded)

4. Accounts receivable turnover:

Sales
Average accounts receivables

365 days
14 times

P2,100,000
P150,000

= 14 times

= 26.1 days (rounded)

5. Inventory turnover:
Cost of goods sold
Average inventory

365 days
4.5 times

P1,260,000
P280,000

= 4.5 times

= 81.1 days to turn (rounded)

6. Debt-to-equity ratio:
Total liabilities
Total equity

P500,000
P800,000

= 0.63 to 1 (rounded)

7. Times interest earned:

Earnings before interest
and income taxes
Interest expense

5-13

P180,000
P30,000

= 6.0 times

Chapter 5 Financial Statement Analysis II

8. Book value per share:

Equity
Ordinary shares outstanding

P800,000
20,000 shares*

= P40 per share

* P100,000 total par value P5 par value per share = 20,000 shares

Problem 10 (Selected Financial Ratios for Ordinary Shareholders)

1. Earnings per share:
Net income to ordinary shares
Average ordinary shares
outstanding

2. Dividend payout ratio:

Dividends paid per share
Earnings per share
3. Dividend yield ratio:
Dividends paid per share
Market price per share
4. Price-earnings ratio:
Market price per share
Earnings per share

P105,000
20,000 shares

= P5.25 per share

P3.15
P5.25

= 60%

P3.15
P63.00

= 5%

P63.00
P5.25

= 12.0

Problem 11 (Selected Financial Ratios for Ordinary Shareholders)

1. Return on total assets:
Return on total =
assets
=
=

Net income + [Interest expense x (1 Tax rate)]

Average total assets
P105,000 + [P30,000 x (1 0.30)]
(P1,100,000 + P1,300,000)
P126,000
P1,200,000

5-14

= 10.5%

Financial Statement Analysis II Chapter 5

2. Return on ordinary shareholders equity:

Return on ordinary
shareholders equity

Net income preference dividends

Average ordinary shareholders equity
P105,000
(P725,000 + P800,000)

=
=

P105,000
P762,500

= 13.8% (rounded)

3. Financial leverage was positive, since the rate of return to the ordinary
shareholders (13.8%) was greater than the rate of return on total assets
(10.5%). This positive leverage is traceable in part to the companys
current liabilities, which may carry no interest cost, and to the bonds
payable, which have an after-tax interest cost of only 7%.
10% interest rate (1 0.30) = 7% after-tax cost.
IV. Cases
Case 1 (Common-Size Statements and Financial Ratios for Creditors)
Requirement 1
This Year
P2,060,000
1,100,000
P 960,000

Last Year
P1,470,000
600,000
P 870,000

b. Current assets (a)

Current liabilities (b)
Current ratio (a) (b)

P2,060,000
P1,100,000
1.87 to 1

P1,470,000
P600,000
2.45 to 1

c. Quick assets (a)

Current liabilities (b)
Acid-test ratio (a) (b)

P740,000
P1,100,000
0.67 to 1

P650,000
P600,000
1.08 to 1

d. Sales on account (a)

Average receivables (b)
Turnover of receivables (a) (b)

P7,000,000
P525,000
13.3 times

P6,000,000
P375,000
16.0 times

a. Current assets
Current liabilities
Working capital

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Chapter 5 Financial Statement Analysis II

Average age of receivables:

365 turnover

27.4 days

22.8 days

e. Cost of goods sold (a)

Average inventory (b)
Inventory turnover (a) (b)

P5,400,000
P1,050,000
5.1 times

P4,800,000
P760,000
6.3 times

71.6 days
P1,850,000
P2,150,000
0.86 to 1

57.9 days
P1,350,000
P1,950,000
0.69 to 1

P630,000
P90,000
7.0 times

P490,000
P90,000
5.4 times

f.

Turnover in days: 365 turnover

Total liabilities (a)
Equity (b)
Debt-to-equity ratio (a) (b)

g. Net income before interest and taxes (a)

Interest expense (b)
Times interest earned (a) (b)
Requirement 2
a.

METRO BUILDING SUPPLY

Common-Size Balance Sheets

Current assets:
Cash
Marketable securities
Accounts receivable, net
Inventory
Prepaid expenses
Total current assets
Plant and equipment, net
Total assets
Liabilities:
Current liabilities
Bonds payable, 12%
Total liabilities
Equity:
Preference shares, P50 par, 8%
Ordinary shares, P10 par
Retained earnings
Total equity
Total liabilities and equity
5-16

This Year

Last Year

2.3 %
0.0
16.3
32.5
0.5
51.5
48.5
100.0 %

6.1 %
1.5
12.1
24.2
0.6
44.5
55.5
100.0 %

27.5 %
18.8
46.3

18.2 %
22.7
40.9

5.0
12.5
36.3
53.8
100.0 %

6.1
15.2
37.9
59.1
100.0 %

Financial Statement Analysis II Chapter 5

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

b.

METRO BUILDING SUPPLY

Common-Size Income Statements
This Year
100.0 %
77.1
22.9
13.9
9.0
1.3
7.7
3.1
4.6 %

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

Last Year
100.0 %
80.0
20.0
11.8
8.2
1.5
6.7
2.7
4.0 %

Requirement 3
The following points can be made from the analytical work in parts (1) and (2)
above:
The company has improved its profit margin from last year. This is
attributable to an increase in gross margin, which is offset somewhat by an
increase in operating expenses. In both years the companys net income as a
percentage of sales equals or exceeds the industry average of 4%.
Although the companys working capital has increased, its current position
actually has deteriorated significantly since last year. Both the current ratio
and the acid-test ratio are well below the industry average, and both are
trending downward. (This shows the importance of not just looking at the
working capital in assessing the financial strength of a company.) Given the
present trend, it soon will be impossible for the company to pay its bills as
they come due.
The drain on the cash account seems to be a result mostly of a large buildup in
accounts receivable and inventory. This is evident both from the common-size
balance sheet and from the financial ratios. Notice that the average age of the
receivables has increased by 5 days since last year, and that it is now 9 days
over the industry average. Many of the companys customers are not taking
their discounts, since the average collection period is 27 days and collection
terms are 2/10, n/30. This suggests financial weakness on the part of these
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Chapter 5 Financial Statement Analysis II

customers, or sales to customers who are poor credit risks. Perhaps the
company has been too aggressive in expanding its sales.
The inventory turned only 5 times this year as compared to over 6 times last
year. It takes three weeks longer for the company to turn its inventory than the
average for the industry (71 days as compared to 50 days for the industry).
This suggests that inventory stocks are higher than they need to be.
In the authors opinion, the loan should be approved on the condition that the
company take immediate steps to get its accounts receivable and inventory
back under control.
This would mean more rigorous checks of
creditworthiness before sales are made and perhaps paring out of slow paying
customers. It would also mean a sharp reduction of inventory levels to a more
manageable size. If these steps are taken, it appears that sufficient funds
could be generated to repay the loan in a reasonable period of time.
Case 2 (Financial Ratios for Ordinary Shareholders)
Requirement 1
a.

This Year
P324,000
16,000

Last Year
P240,000
16,000

P308,000

P224,000

Earnings per share (a) (b)

50,000
P6.16

50,000
P4.48

b. Ordinary dividend per share (a)*

Market price per share (b)
Dividend yield ratio (a) (b)

P2.16
P45.00
4.8%

P1.20
P36.00
3.33%

Net income
Less preference dividends
Net income remaining for ordinary (a)
Average number of ordinary shares (b)

*P108,000 50,000 shares = P2.16;

P60,000 50,000 shares = P1.20
c. Ordinary dividend per share (a)...............................................................................
P2.16
P1.20
Earnings per share (b).............................................................................................
P6.16
P4.48
Dividend payout ratio (a) (b)................................................................................
35.1%
26.8%
d. Market price per share (a).......................................................................................
P45.00
P36.00
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Financial Statement Analysis II Chapter 5

Earnings per share (b).............................................................................................

P6.16
P4.48
Price-earnings ratio (a) (b)...................................................................................
7.3
8.0
Investors regard Metro Building Supply less favorably than other firms in
the industry. This is evidenced by the fact that they are willing to pay only
7.3 times current earnings for a share of the companys stock, as
compared to 9 times current earnings for the average of all stocks in the
industry. If investors were willing to pay 9 times current earnings for
Metro Building Supplys stock, then it would be selling for about P55 per
share (9 P6.16), rather than for only P45 per share.
e.

This Year
Last Year
Equity......................................................................................................................
P2,150,000
P1,950,000
Less preference shares.............................................................................................
200,000
200,000
Ordinary equity (a)..................................................................................................
P1,950,000
P1,750,000
Number of ordinary shares (b).................................................................................
50,000
50,000
Book value per share (a) (b).................................................................................
P39.00
P35.00
A market price in excess of book value does not mean that the price of a
stock is too high. Market value is an indication of investors perceptions
of future earnings and/or dividends, whereas book value is a result of
already completed transactions and is geared to the past.

Requirement 2
a.

This Year
Last Year
P 324,000
P 240,000
Net income..............................................................................................................
Add after-tax cost of interest paid:
[P90,000 (1 0.40)].........................................................................................
54,000
54,000
P

294,000
Total (a)...................................................................................................................
P 378,000
Average total assets (b)............................................................................................
P3,650,000
P3,000,000
Return on total assets (a) (b)................................................................................
10.4%
9.8%

b.

This Year
Last Year
P 324,000
P 240,000
Net income..............................................................................................................
Less preference dividends........................................................................................
16,000
16,000
Net income remaining for ordinary
P 308,000
P 224,000
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Chapter 5 Financial Statement Analysis II

shareholders (a)...................................................................................................
Average total equity*...............................................................................................
P2,050,000
P1,868,000
Less average preference shares................................................................................
200,000
200,000
Average ordinary equity (b).....................................................................................
P1,850,000
P1,668,000
*1/2(P2,150,000 + P1,950,000); 1/2(P1,950,000 + P1,786,000).
Return on ordinary equity (a) (b)

16.6%

13.4%

c. Financial leverage is positive in both years, since the return on ordinary

equity is greater than the return on total assets. This positive financial
leverage is due to three factors: the preference shares, which has a
dividend of only 8%; the bonds, which have an after-tax interest cost of
only 7.2% [12% interest rate (1 0.40) = 7.2%]; and the accounts
payable, which may bear no interest cost.
Requirement 3
We would recommend keeping the stock. The stocks downside risk seems
small, since it is selling for only 7.3 times current earnings as compared to 9
times earnings for the average firm in the industry. In addition, its earnings
are strong and trending upward, and its return on ordinary equity (16.6%) is
extremely good. Its return on total assets (10.4%) compares favorably with
that of the industry.
The risk, of course, is whether the company can get its cash problem under
control. Conceivably, the cash problem could worsen, leading to an eventual
reduction in profits through inability to operate, a reduction in dividends, and
a precipitous drop in the market price of the companys stock. This does not
seem likely, however, since the company can easily control its cash problem
through more careful management of accounts receivable and inventory. If
this problem is brought under control, the price of the stock could rise sharply
over the next few years, making it an excellent investment.
Case 3 (Comprehensive Ratio Analysis)
Requirement 1
This Year
Last Year
P 280,000
P 168,000
a. Net income..............................................................................................................
Add after-tax cost of interest:
P120,000 (1 0.30).........................................................................................
84,000
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Financial Statement Analysis II Chapter 5

P100,000 (1 0.30).........................................................................................
70,000
P

364,000
P

238,000
Total (a)...................................................................................................................
Average total assets (b)............................................................................................
P5,330,000
P4,640,000
Return on total assets (a) (b)................................................................................
6.8%
5.1%
P 280,000
P 168,000
b. Net income..............................................................................................................
Less preference dividends........................................................................................
48,000
48,000
P 232,000
P 120,000
Net income remaining for ordinary (a).....................................................................
Average total equity.................................................................................................
P3,120,000
P3,028,000
Less average preference shares................................................................................
600,000
600,000
Average ordinary equity (b).....................................................................................
P2,520,000
P2,428,000
Return on ordinary equity (a) (b)..........................................................................
9.2%
4.9%
c. Leverage is positive for this year, since the return on ordinary equity
(9.2%) is greater than the return on total assets (6.8%). For last year,
leverage is negative since the return on the ordinary equity (4.9%) is less
than the return on total assets (5.1%).
Requirement 2
P 232,000
50,000
P4.64

P 120,000
50,000
P2.40

b. Ordinary dividend per share (a)

Market price per share (b)
Dividend yield ratio (a) (b)

P1.44
P36.00
4.0%

P0.72
P20.00
3.6%

c. Ordinary dividend per share (a)

Earnings per share (b)
Dividend payout ratio (a) (b)

This Year
P1.44
P4.64
31.0%

Last Year
P0.72
P2.40
30.0%

P36.00
P4.64
7.8

P20.00
P2.40
8.3

a. Net income remaining for ordinary (a)

Average number of ordinary shares (b)
Earnings per share (a) (b)

d. Market price per share (a)

Earnings per share (b)
Price-earnings ratio (a) (b)

Notice from the data given in the problem that the average P/E ratio for
companies in Helixs industry is 10. Since Helix Company presently has
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Chapter 5 Financial Statement Analysis II

a P/E ratio of only 7.8, investors appear to regard it less well than they do
other companies in the industry. That is, investors are willing to pay only
7.8 times current earnings for a share of Helix Companys stock, as
compared to 10 times current earnings for a share of stock for the average
company in the industry.
e. Equity
Less preference shares
Ordinary equity (a)
Number of ordinary shares (b)
Book value per share (a) (b)

P3,200,000
600,000
P2,600,000

P3,040,000
600,000
P2,440,000

50,000
P52.00

50,000
P48.80

Note that the book value of Helix Companys stock is greater than the
market value for both years. This does not necessarily indicate that the
stock is selling at a bargain price. Market value is an indication of
investors perceptions of future earnings and/or dividends, whereas book
value is a result of already completed transactions and is geared to the
past.
f.

Gross margin (a)

Sales (b)
Gross margin percentage (a) (b)

P1,050,000
P5,250,000
20.0%

P860,000
P4,160,000
20.7%

This Year
P2,600,000
1,300,000
P1,300,000

Last Year
P1,980,000
920,000
P1,060,000

b. Current assets (a)

Current liabilities (b)
Current ratio (a) (b)

P2,600,000
P1,300,000
2.0 to 1

P1,980,000
P920,000
2.15 to 1

c. Quick assets (a)

Current liabilities (b)
Acid-test ratio (a) (b)

P1,220,000
P1,300,000
0.94 to 1

P1,120,000
P920,000
1.22 to 1

d. Sales on account (a)

P5,250,000

P4,160,000

Requirement 3
a. Current assets
Current liabilities
Working capital

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Financial Statement Analysis II Chapter 5

Average receivables (b)

Accounts receivable turnover (a) (b)
Average age of receivables,
365 turnover

P750,000
7.0 times

P560,000
7.4 times

52 days

49 days

e. Cost of goods sold (a)

Average inventory (b)
Inventory turnover (a) (b)
Number of days to turn inventory,
365 days turnover (rounded)

P4,200,000
P1,050,000
4.0 times

P3,300,000
P720,000
4.6 times

91 days

79 days

f.

P2,500,000
P3,200,000
0.78 to 1

P1,920,000
P3,040,000
0.63 to 1

P520,000
P120,000
4.3 times

P340,000
P100,000
3.4 times

Total liabilities (a)

Equity (b)
Debt-to-equity ratio (a) (b)

g. Net income before interest and taxes (a)

Interest expense (b)
Times interest earned (a) (b)
Requirement 4

As stated by Meri Ramos, both net income and sales are up from last year.
The return on total assets has improved from 5.1% last year to 6.8% this year,
and the return on ordinary equity is up to 9.2% from 4.9% the year before.
But this appears to be the only bright spot in the companys operating picture.
Virtually all other ratios are below the industry average, and, more important,
they are trending downward. The deterioration in the gross margin percentage,
while not large, is worrisome. Sales and inventories have increased
substantially, which should ordinarily result in an improvement in the gross
margin percentage as fixed costs are spread over more units. However, the
gross margin percentage has declined.
Notice particularly that the average age of receivables has lengthened to 52
daysabout three weeks over the industry averageand that the inventory
turnover is 50% longer than the industry average. One wonders if the increase
in sales was obtained at least in part by extending credit to high-risk
customers. Also notice that the debt-to-equity ratio is rising rapidly. If the
P1,000,000 loan is granted, the ratio will rise further to 1.09 to 1.
In the authors opinion, what the company needs is more equitynot more
debt. Therefore, the loan should not be approved. The company should be
encouraged to make another issue of ordinary stock in order to provide a
broader equity base on which to operate.
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Chapter 5 Financial Statement Analysis II

Case 4 (Statement Reconstruction Using Ratios)

Bulacan Company
Income Statement
For the Year Ended December 31, 2005
Sales
Less: Cost of Sales (4)
Gross Profit
Less: Expenses
Net Income (1)

P140,800
84,480
P 56,320
46,320
P 10,000

Bulacan Company
Balance Sheet
December 31, 2005
As s e t s
Current Assets:
Cash
Accounts Receivable (5)
Merchandise Inventory (3)
Total Current Assets (2)
Fixed Assets (8)
Total Assets

P 27,720
28,160
21,120
P 77,000
55,000
P132,000

Liabilities and Equity

Current Liabilities:
Accounts Payable (2)
Equity:
Share Capital (issued 20,000
shares) (6)
Retained Earnings
Total Liabilities and Equity

P 44,000
P40,000
48,000
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88,000
P132,000

Financial Statement Analysis II Chapter 5

Supporting Computations:
(1) Earnings Per Share

Net Income
Ordinary Shares Outstanding

P0.50

X
20,000

X (Net Income)

P10,000

(2) Current Assets

Pxx
Current Liabilities xx
Working Capital
P33,000

1.75
1
0.75

Current Liabilities
(3) Current Ratio

P33,000 0.75

=
=

P44,000
Current Assets
Current Liabilities
X
44,000

1.27

X (Current Assets)

P77,000

Quick Assets
Current Liabilities

1.27

X
44,000

X (Current Assets)

P55,880

Quick Ratio

Current Assets
Quick Assets
Inventory

P77,000
55,800
P21,120

(4) Inventory turnover

X (Cost of Sales)

=
5-25

Cost of Sales
Ave. Inventory
X
P21,120
P84,480

Chapter 5 Financial Statement Analysis II

(5) Average age of outstanding

Accounts Receivable

Quick Assets
Current Liabilities

365
5

73 days (Average age of

receivables)

Net Sales
Average Receivables

P140,800
X

X (Receivables)

P28,160

Another Method:
P140,800
365

73 days

P28,160 Accounts receivable

(6) Earnings for the year as a percentage of Share Capital

P10,000
= 25%
Share Capital
Share Capital

P40,000

Fixed
Assets

Current Liabilities +
Equity

P77,000 + 0.625X

P44,000 + X

0.375X

P33,000

P88,000 Equity

(7) Current
Assets

(8) Fixed Assets to Equity

Fixed Assets
Equity
X
P140,800
X (Fixed Assets)

0.625

0.625

P55,000

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Financial Statement Analysis II Chapter 5

Case 5 (Ethics and the Manager)

Requirement 1
The loan officer stipulated that the current ratio prior to obtaining the loan
must be higher than 2.0, the acid-test ratio must be higher than 1.0, and the
interest on the loan must be no more than four times net operating income.
These ratios are computed below:
Current ratio
Current rate
Acid-test ratio =

Current assets
Current liabilities

P290,000
= 1.8 (rounded)
P164,000
Cash + Marketable securities + Accounts receivable
Current liabilities
=

P70,000 + P0 + P50,000
= 0.70 (rounded)
P164,000
Net operating income
P20,000
=
P80,000 x 0.10 x (6/12) = 5.0
Interest on the loan

Acid-test ratio =

The company would fail to qualify for the loan because both its current ratio
and its acid-test ratio are too low.
Requirement 2
By reclassifying the P45 thousand net book value of the old machine as
inventory, the current ratio would improve, but there would be no effect on the
acid-test ratio. This happens because inventory is considered to be a current
asset but is not included in the numerator when computing the acid-test ratio.
Current ratio

Current rate

Acid-test ratio =

Current assets
Current liabilities
P290,000 + P45,000
= 2.0 (rounded)
P164,000

Cash + Marketable securities + Current receivables

Current liabilities

P70,000 + P0 + P50,000
= 0.70 (rounded)
P164,000
Even if this tactic had succeeded in qualifying the company for the loan, we
Acid-test ratio =

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Chapter 5 Financial Statement Analysis II

strongly advise against it. Inventories are assets the company has acquired for
the sole purpose of selling them to outsiders in the normal course of business.
Used production equipment is not considered to be inventoryeven if there is
a clear intention to sell it in the near future. Since the loan officer would not
expect used equipment to be included in inventories, doing so would be
intentionally misleading.
Nevertheless, the old equipment is an asset that could be turned into cash. If
this were done, the company would immediately qualify for the loan since the
P45 thousand in cash would be included in the numerator in both the current
ratio and in the acid-test ratio.
Current ratio

Current rate

Current assets
Current liabilities
P290,000 + P45,000
= 2.0 (rounded)
P164,000

Acid-test ratio =

Cash + Marketable securities + Current receivables

Current liabilities

Acid-test ratio =

P70,000 + P0 + P50,000 + P45,000

P164,000

= 1.00 (rounded)

However, other options may be available. After all, the old machine is being
used to relieve bottlenecks in the plastic injection molding process and it
would be desirable to keep this standby capacity. We would advise Rome to
fully and honestly explain the situation to the loan officer. The loan officer
might insist that the machine be sold before any loan is approved, but he might
instead grant a waiver of the current ratio and acid-test ratio requirements on
the basis that they could be satisfied by selling the old machine. Or he may
approve the loan on the condition that the equipment is pledged as collateral.
In that case, Rome would only have to sell the machine if he would otherwise
be unable to pay back the loan.
V. Multiple Choice Questions
1.
2.
3.
4.
5.
6.
7.
8.

A
C
D
B
A
D
C
D

11.
12.
13.
14.
15.
16.
17.
18.

C
A
C
B
D
B
A
C

21.
22.
23.
24.
25.
26.
27.
28.

B
D
A
C
A
C
D
A

31.
32.
33.
34.
35.
36.
37.
38.
5-28

C
D
C
A
A
C
A
A

41. C

Financial Statement Analysis II Chapter 5

9. A
10. B

19. A
20. C

29. D
30. A

39. C
40. C

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