Solution of Problems of Topic 2_Financial Statements and Ratio Analysis

❖ If nothing is mentioned in the question, use 365 days for a year.

2-15 LG 2, 3, 4, 5: Ratio comparisons

a. The four companies are in very different industries. The operating characteristics of
firms across different industries vary significantly resulting in very different ratio
values.

b. The explanation for the lower current and quick ratios most likely rests on the fact that
these two industries operate primarily on a cash basis. Their accounts receivable
balances are going to be much lower than for the other two companies.

c. High level of debt can be maintained if the firm has a large, predictable and steady cash
flow. Utilities tend to meet these cash flow requirements. The software firm will have
very uncertain and changing cash flow. The software industry is subject to greater
competition resulting in more volatile cash flow.

d. Although the software industry has potentially high profits and investment return
performance, it also has a large amount of uncertainty associated with the profits. Also,
by placing all of the money in one company, the benefits of reduced risk associated
with diversification are lost.

2-16 LG 3: Liquidity management

a Since net working capital is the difference between current assets and current liabilities,
the value of current liabilities can be found by subtracting net working capital from
current assets.
2008 2009 2010 2011
Total current assets $16,950 $21,900 $22,500 $27,000
Net working capital $7,950 $9,300 $9,900 $9,600
Total current liabilities $9,000 $12,600 $12,600 $17,400
Current ratio 1.88 1.74 1.79 1.55
Quick ratio 1.22 1.19 1.24 1.14

The time series of net working capital increases over time, the quick ratio fluctuates but
shows a downward trend, and the current ratio shows a clear downward trend.

b. Although net working capital is increasing over time, the current and quick ratios can
be more useful in that they show the liquidity position in proportional terms. The pattern
based on these ratios indicates a deteriorating liquidity position.

c. The low inventory turnover suggests that liquidity is even worse than the declining
liquidity measures indicate. Slow inventory turnover may indicate obsolete inventory.

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2-18 LG 3: Inventory management

a. Sales $4,000,000 100%

Cost of goods sold ? 60%
Gross profit $1,600,000 40%
COGS $2,400,000

Average inventory = $650,000

Inventory turnover = $2,400,000 ÷ $650,000 = 3.69 times
Average age of inventory = 365 ÷ 3.69 = 98.9 days

b. The Ello Manufacturing inventory turnover ratio significantly exceeds the industry.
Although this may represent efficient inventory management, it may also represent low
inventory levels resulting in stock outs.

2-20 LG 3: Interpreting liquidity and activity ratios

a. Oscar appears to be holding excess inventory relative to the industry. This fact is
supported by the low inventory turnover and the low quick ratio, even though the
current ratio is above the industry average. This excess inventory could be due to slow
sales relative to production or possibly from carrying obsolete inventory.

b. The accounts receivable of Oscar appears to be high due to the large number of days of
sales outstanding (73 versus the industry average of 52 days). An important question
for internal management is whether the company’s credit policy is too lenient or
customers are just paying slowly – or potentially not paying at all.

c. Since the firm is paying its accounts payable in 31 days versus the industry norm of 40
days, Oscar may not be taking full advantage of credit terms extended to them by their
suppliers. By having the receivables collection period over twice as long as the payables
payment period, the firm is financing a significant amount of current assets, possibly
from long-term sources.

d. The desire is that management will be able to curtail the level of inventory either by
reducing production or encouraging additional sales through a stronger sales program
or discounts. If the inventory is obsolete, then it must be written off to gain the income
tax benefit. The firm must also push to try to get their customers to pay earlier. Payment
timing can be increased by shortening credit terms or providing a discount for earlier
payment. Slowing down the payment of accounts payable would also reduce financing
costs.

Carrying out these recommendations may be difficult because of the potential loss of
customers due to stricter credit terms. The firm would also not want to increase their
costs of purchases by delaying payment beyond any discount period given by their
suppliers.

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2-21 LG 4: Debt analysis

Ratio Definition Calculation Creek Ind.

Debt Debt $36,500 0.73 0.51
Total assets $50,000

Times EBIT $ 3,000 3.00 7.30

Interest earned Interest $ 1,000

Fixed EBIT + Lease payment $3,000 + $200 1.19 1.85

Payment Interest + Lease payments $1,000 + $200 +
Coverage + {[(Principal + Preference {[($800 + $100)]
dividends)]  [1 (1-t)]}  [1 (1 – 0.4)]}

Because Creek Enterprises has a much higher degree of indebtedness and much lower
ability to service debt than the average firm in the industry, the loan should be rejected.

2-22 LG5: Calculating cash ratios

Total debt coverage ratio = [Cashflow/Total Debt]
Current debt coverage ratio = [(Cash + Marketable securities)/Total current liabilities]
Expense coverage ratio = [(Cash + Marketable securities + receivables)/ Annual cash
expenses]

2010 2011
Total debt coverage 14% 11%
Current debt coverage 21% 15%
Expense coverage 14% 16%

In the period 2010–2011 debt coverage had deteriorated whilst expense coverage improved.
Reduction in debt coverage might reflect a growth in debt to finance expansion or to cover
credit difficulties. Coverage of expenses is a positive indicator.

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2-23 LG 5: Common-size statement analysis

Creek Enterprises
Common-size income statement
for the years ended 31 December 2010 and 2011

2011 2010
Sales revenue 100.0% 100.0%
Less: Cost of goods sold 70.0% 65.9%
Gross profits 30.0% 34.1%

Less: Operating expenses:

Selling 10.0% 12.7%
General 6.0% 6.3%
Lease expense 0.7% 0.6%
Depreciation 3.3% 20.0% 3.6% 23.2%
Operating profits 10.0% 10.9%
Less: Interest expense 3.3% 1.5%
Net profits before taxes 6.7% 9.4%
Less: Taxes 2.7% 3.8%
Net profits after taxes 4.0% 5.6%

Sales have declined and cost of goods sold has increased as a percentage of sales,
probably due to a loss of productive efficiency. Operating expenses have decreased as
a percentage of sales; this appears favourable unless this decline has contributed toward
the fall in sales. The level of interest as a percentage of sales has increased significantly;
this is verified by the high debt measures in problem 2-21 and suggests that the firm
has too much debt.

Further analysis should be directed at the increased cost of goods sold and the high debt
level.

2-24 LG 4, 5: The relationship between financial leverage and profitability

a. (i)
Total liabilitie s
Debt ratio =
Total assets
$1,000,000
Debt ratioPelican = = .10 = 10%
$10,000,000
$5,000,000
Debt ratioT' land = = .50 = 50%
$10,000,000

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 (ii)
Earnings before interest and taxes
Times interest earned =
Interest
$6,250,000
Times interest earnedPelican = = 62.5
$100,000
$6,250,000
Times interest earnedT' land = = 12.5
$500,000

Timberland has a much higher degree of financial leverage than does Pelican. As a result
Timberland’s earnings will be more volatile, causing the ordinary shareholders to face
greater risk. This additional risk is supported by the significantly lower times interest earned
ratio of Timberland. Pelican can face a very large reduction in net income and still be able
to cover its interest expense.

b. (i)
Operating profit
Operating profit margin =
Sales
$6,250,000
Operating profit marginPelican = = .25 = 25%
$25,000,000
$6,250,000
Operating profit marginT' land = = .25 = 25%
$25,000,000
(ii)
Net income
Net profit margin =
Sales
$3,690,000
Net profit margin Pelican = = .1476 = 14.76%
$25,000,000
$3,450,000
Net profit margin T' land = = .138 = 13.80%
$25,000,000
(iii)
Net profit after taxes
Return on assets =
Total assets
$3,690,000
Return on assetsPelican = = .369 = 36.9%
$10,000,000
$3,450,000
Return on assetsT' land = = .345 = 34.5%
$10,000,000
(iv)
Net profit after taxes
Return on equity =
Shareholders equity
$3,690,000
Return on equityPelican = = .41 = 41.0%
$9,000,000
$3,450,000
Return on equityT' land = = .69 = 69.0%
$5,000,000

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 Pelican is more profitable than Timberland, as shown by the higher operating profit
margin, net profit margin and return on assets. However, the return on equity for
Timberland is higher than that of Pelican.

(c) Even though Pelican is more profitable, Timberland has a higher ROE than Pelican due
to the additional financial leverage risk. The lower profits of Timberland are due to the
fact that interest expense is deducted from EBIT. Timberland has $500,000 of interest
expense compared to Pelican’s $100,000. Even after the tax shield from the interest tax
deduction ($500,000 × 0.40 = $200,000) Timberland’s profits are less than Pelican’s
by $240,000. Since Timberland has a higher relative amount of debt, the shareholders’
equity is proportionally reduced resulting in the higher return to equity than that
obtained by Pelican. The higher ROE is at the expense of higher levels of financial risk
faced by Timberland equity holders.

2-25 LG 6: Ratio proficiency

a.
Gross profit = sales  gross profit margin
= $40,000,000  .8 = $32,000,000
b.
Cost of goods sold = sales − gross profit
= $40,000,000 − $32,000,000 = $8,000,000

c.
Operating profit = sales  operating profit margin
= $40,000,000  .35 = $14,000,000
d.
Operating expenses = gross profit - operating profit
= $32,000,000 - $14,000,000 = $18,000,000
e.
Net profit = sales  net profit margin = $40,000,00 0  .08 = $3,200,000

f.
sales $40,000,000
Total assets = = = $20,000,000
total asset turnover 2
g.
net income $3,200,000
Total equity = = = $16,000,000
ROE .20
h.
𝑆𝑎𝑙𝑒𝑠
Accounts receivable= Average collection period X
365
$40,000,000
= 62.2 days X =$6,816,438
365

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2-26 LG 6: Ratio application

Accounts payable= Average Payment period X [Annual purchases/360]

=45X[400,000/360]=50,000
Total liabilities and equity=Total assets = 50,000+40,000+10,000+120,000+80,000=300,000
Total sales= Total asset turnover X Total assets=1.6X300,000=480,000
Cost of goods sold=Sales X (1- Gross profit margin)=480,000X(1-0.2)=384,000
Inventory= Cost of goods sold/ Inventory turnover= 384,000/4=96,000
Current liabilities=50,000+40,000+10,000=1,00,000
Quick assets=Cash + Accounts receivable= Quick ratio X Current liabilities= 0.80X1,00,000
=80,000
Accounts receivable= Quick assets – Cash=80,000-15,000=65,000
Non-current assets=3,00,000-15,000-65,000-96,000=124,000

Pick Ltd
Balance Sheet
Assets Liabilities and owners’ equity
$ $
Cash 15,000 Accounts payable 50,000
Accounts receivable 65,000 Notes payable 40,000
Inventory 96,000 Accruals 10,000
Non-current assets 124,000 Non-current debts 120,000
Shareholder’s equity 80,000

Total 300,000 Total 300,000

2-27 LG 6: DuPont calculation

ROE = 4.5%  0.72  1.43 = 4.63%

The advantage of using the DuPont system to calculate ROE over the direct calculation
of earnings available for shareholders is that ROE, the most common measure for
shareholders, is broken into three distinct components. Starting at the right we see how
financial leverage has increased assets over the owners’ original equity. Next, moving
to the left, we see how efficiently the firm used its assets to generate sales. Finally, the
net profit margin shows the measure of profitability on sales. Each component can be
compared with industry standards to see if the firm is underperforming or over-
performing in any one of the three areas.

2-28 LG 6: Cross-sectional ratio analysis

a.
Technica Ltd
Ratio analysis

Industry Average Actual

2011 2011
Current ratio 2.35 1.84
Quick ratio 0.87 0.75
Inventory turnover 4.55 times 5.61 times

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 Average collection period* 35.3 days 20.7 days
Total asset turnover 1.09 1.47
Debt ratio 0.30 0.55
Times interest earned 12.3 8.0
Gross profit margin 0.202 0.233
Operating profit margin 0.135 0.133
Net profit margin 0.091 0.072
Return on total assets (ROA) 0.099 0.105
Return on equity (ROE) 0.167 0.234
Earnings per share $3.10 $2.15
* based on a 365-day year

Liquidity: The current and quick ratios show a weaker position relative to the industry
average.

Activity: All activity ratios indicate a faster turnover of assets compared to the industry.
Further analysis is necessary to determine whether the firm is in a weaker or stronger
position than the industry. A higher inventory turnover ratio may indicate low
inventory, resulting in stock outs and lost sales. A shorter average collection period may
indicate extremely efficient receivables management, an overly zealous credit
department, or credit terms that prohibit growth in sales.

Debt: The firm uses more debt than the average firm, resulting in higher interest
obligations which could reduce its ability to meet other financial obligations.

Profitability: The firm has a higher gross profit margin than the industry, indicating
either a higher sales price or a lower cost of goods sold. The operating profit margin is
in line with the industry, but the net profit margin is lower than industry, an indication
that expenses other than cost of goods sold are higher than the industry. Most likely,
the damaging factor is high interest expenses due to a greater than average amount of
debt. The increased leverage, however, magnifies the return the owners receive, as
evidenced by the superior ROE.

b. Technica Limited needs improvement in its liquidity ratios and possibly a reduction in
its total liabilities. The firm is more highly leveraged than the average firm in its
industry and therefore has more financial risk. The profitability of the firm is lower than
average but is enhanced by the use of debt in the capital structure, resulting in a superior
ROE.

2-29 LG 6: Financial statement analysis

a.
Ratio Analysis
OZ Industries

Industry Actual Actual

Average 2010 2011
Current ratio 1.80 1.84 1.04
Quick ratio 0.70 0.78 0.38
Inventory turnover 2.50 2.59 2.33

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 Average collection period 37 days 36 days 57 days
Debt ratio 65% 67% 61.3%
Times interest earned 3.8 4.0 2.8
Gross profit margin 38% 40% 34%
Net profit margin 3.5% 3.6% 4.1%
Return on assets 4.0% 4.0% 4.4%
Return on equity 9.5% 8.0% 11.3%
Market/book ratio 1.1 1.2 1.3
b.
(i) Liquidity: OZ Industries’ liquidity position has deteriorated from 2010 to 2011
and is inferior to the industry average. The firm may not be able to satisfy short-
term obligations as they come due.

(ii) Activity: OZ Industries’ ability to convert assets into cash has deteriorated from
2010 to 2011. Examination into the cause of the 21-day increase in the average
collection period is warranted. Inventory turnover has also decreased for the
period under review and is fair compared to industry. The firm may be holding
slightly excessive inventory.

(iii) Debt: OZ Industries’ long-term debt position has improved since 2010 and is
below industry average. OZ Industries’ ability to service interest payments has
deteriorated and is below industry.

(iv) Profitability: Although OZ Industries’ gross profit margin is below its industry
average, indicating high cost of goods sold, the firm has a superior net profit
margin in comparison to industry average. The firm has lower than average
operating expenses. The firm has a superior return on asset/investment and return
on equity in comparison to the industry and shows an upward trend.

(v) Market: OZ Industries’ increase in their market price relative to their book value
per share indicates that the firm’s performance has been interpreted as more
positive in 2011 than in 2010 and it is a little higher than the industry.

Overall, the firm maintains superior profitability at the risk of illiquidity. Investigation
into the management of accounts receivable and inventory is warranted.