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Chapter 6

Liquidity of Short-term Assets:

Related Debt-Paying Ability

PROBLEMS
PROBLEM 6-1

Current Assets Current Current Assets – Inventory Acid-Test

= =
Current Liabilities Ratio Current Liabilities Ratio

Current Assets $1,000,000 – Inventory

= 2.5 = 2.0
$400,000 $400,000

Current Assets = $1,000,000 $1,000,000 – Inventory = $800,000

$1,000,000 – $800,000 = Inventory

$200,000 = Inventory

Cost of
Inventory Turnover =
Sales

Inventory

Cost of Sales
= 3
Inventory

Cost of Sales
= 3
$200,000

Cost of Sales = $600,000

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PROBLEM 6-2

a.

Gross Receivables
Days’ sales in receivables
Net Sales/365
=

$220,385 + $11,180
2011: = 71.62 days
$1,180,178/365

$240,360 + $12,300
2010: = 41.92 days
$2,200,000/365

b.

Net Sales
Accounts receivable turnover
=
Average Gross Receivables

$1,180,178 4.87 times

2011: =
($240,360 + $12,300 + $220,385 + $11,180) / per year
2

$2,200,000 8.98 times

=
($230,180 + $7,180 + $240,360 + $12,300) / per year
2010:
2

b. The Hawk Company receivables have been much less liquid in 2011 in comparison with
2010. The days' sales in receivables at the end of the year have increased from 41.92 days
in 2010 to 71.62 days in 2011. The accounts receivable turnover declined in 2011 to 4.87
from a turnover of 8.98 in 2010. These figures represent a major deterioration in the
liquidation of receivables. The reasons for this deterioration should be determined. Some
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possible reasons are a major customer not paying its bills, a general deterioration of all
Gross Receivables
Days’ salesaccounts,
receivable in receivables
or a change in the Hawk Company credit terms.
Net Sales/365
=

PROBLEM 6-3
a.
$55,400 + $3,500
December 31, 2011: = 26.87 days
$800,000/365

$90,150 + $4,100
July 31, 2011: = 43.55 days
$790,000/365

Net Sales
b.
Average Gross Receivables
Accounts receivable turnover

$800,000
December 31, 2011:
($50,000 + $3,000 + $55,400 + $3,500)/2
=

14.30 times per year

$790,000
July 31, 2011:
($89,000 + $4,000 + $90,150 + $4,100)/2
=
8.44 times per year

c. This company appears to have a seasonal business because of the materially different days'
sales in receivables and accounts receivable turnover when computed at the two different
dates. The ratios computed will not be meaningful in an absolute sense, but they would be
meaningful in a comparative sense when comparing the same dates from year to year.
They would not be meaningful when comparing different dates.
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PROBLEM 6-4

a.

Gross Receivables
Days’ sales in receivables
Net Sales/365
=

L. Solomon company days’ $110,000 + $8,000

sales in receivables = 23.93 days
$1,800,000/365

L. Konrath Company days’ $60,000 + $4,000

sales in receivables = 12.63 days
$1,850,000/365

b. It appears that the L. Konrath Company manages receivables better than does L. Solomon
Company. They have 12.63 days' sales in receivables, while the L. Solomon Company has
23.93 days' sales in receivables. Actually, we cannot make a fair comparison between these
two companies because the L. Solomon Company is using the calendar year, while the L.
Konrath Company appears to be using a natural business year. By using a natural business
year, the L. Konrath Company has its receivables at a low point at the end of the year. This
would make its liquidity overstated at the end of the year.

233
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PROBLEM 6-5

a. 365 days 365

Accounts = = 10.14 times per year

36
receivable
turnover in days

b. 365 days
= 30.42 days
12.0 times per year

c. Gross Receivables $280,000

= = 47.36 days
Net Sales/365 $2,158,000/365

d. Net Sales $3,500,000

= = 10.80 times per year
Accounts Gross Receivables $324,000

PROBLEM 6-6

a. Ending Inventory
= Days’ Sales in Inventory
Cost of Goods Sold/365

$360,500
= 62.66 days
$2,100,000/365

b. No. Since J. Shaffer Company uses LIFO inventory, the ending inventory is computed using
costs that are not representative of the current cost. The cost of goods sold is representative of
the approximate current cost and, therefore, the average daily cost of goods sold is
representative of current cost. When the average daily cost of goods sold is divided into the
inventory, the result is an unrealistically low number of days' sales in inventory. Thus, the
liquidity is overstated.

c. The number of days' sales in inventory would be a helpful guide when compared with prior
periods. The actual computed number of days' sales in inventory would not be meaningful
because of the LIFO inventory.
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PROBLEM 6-7

a. Average Inventory
= Inventory Turnover in Days
Cost of Goods Sold/365
$280,000
= = 81.76 Days
$1,250,000/365

b. Cost of Goods
= Merchandise Inventory Turnover
Sold Average

Inventory
$1,250,000
= 4.46 times per year
$280,000

or

365
= Merchandise Inventory Turnover
Inventory Turnover in Days

365
= 4.46 times per years
81.8
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PROBLEM 6-8

Average Gross Receivable

a. Accounts Receivable Turnover (in days)
Net Sales/365
=

($180,000 + $160,000)/2
= 19.70 days
$3,150,000/365

Average Inventory
b. Inventory Turnover (in days)
Cost of Goods Sold/365
=

($480,000 + $390,000)/2 $435,000

= = 70.57 days
$2,250,000/365 $2,250,000/365

Operating Accounts Receivable Inventory Turnover

c. = +
Cycle Turnover in Days In Days

= 19.70 days + 70.57 days = 90.27 days

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PROBLEM 6-9

Days’ Sales in Days Sales in

Estimated days to realize cash
+ =
Receivables Inventory from ending inventory

Gross Receivables
Days’ Sales in Receivables =
Net Sales/365

$560,000 + $30,000 $590,000

= = 49.51 days
$4,350,000/365 $4,350,000/365

Days’ Sales Ending Inventory $680,000

= = = 68.94 days
in Inventory Cost of Goods Sold/365 $3,600,000/365

49.51 Days + 68.94 Days = 118.45 days

PROBLEM 6-10

Days’
a. Sales in Gross Receivables $480,000 + $25,000
= = = 50.50 days
Receivables
Net Sales/365 $3,650,000/365

b. Days’ Sales in Ending Inventory $570,000

Inventory Using
= = = 73.00 days
the Cost Figure Cost of Goods Sold/365 $2,850,000/365
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c. Days' sales in inventory using the replacement cost for the inventory and the cost of
goods sold.

Ending Inventory $900,000

= = 104.29 days
Cost of Goods Sold/365 $3,150,000/365

d. The replacement cost data should be used for inventory and cost of goods sold when it is
disclosed. Replacement cost places inventory and cost of goods sold on a comparable basis.
When the historical cost figures are used and the company uses LIFO, then the cost of goods
sold and the inventory are not on a comparable basis. This is because the inventory has the
older costs and the cost of goods sold has recent costs. For Laura Badora Company, the
actual days' sales in inventory based on replacement cost are over 30 days more than was
indicated by using the cost figures

PROBLEM 6-11

a. Working
Current Current
= –
Capital
Assets Liabilities

= $1,052,820 – $459,842 = $592,978

Current Assets $1,052,820

b. Current Ratio = = 2.29
=
Current Liabilities $459,842

Cash Equivalents & Net Receivables &

c. Acid-Test Ratio Marketable Securities

= Current Liabilities

$33,493 + $215,147 + $255,000 $503,640

= = 1.10
$459,842 $459,842
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Cash Equivalents + Marketable

d. Securities
Cash Ratio =
Current Liabilities

$33,493 + $215,147 $248,640

= = 0.54
$459,842 $459,842

Gross Receivables
e. Days’ Sales in Receivables
Net Sales/365
=

$255,000 + $6,000 $261,000

= = 31.23 days
$3,050,600/365 $3,050,600/365

Average Gross Receivables

f. Accounts Receivable Turnover in Days
Net Sales/365
=
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($255,000 + $6,000 + $288,000)/2 $274,500

= = 32.84 days
$3,050,600/365 $3,050,600/365

Days’
g. Sales Ending Inventory $532,000
= = = 87.36 days
in Inventory Cost of Goods Sold/365 $2,185,100/365

Average Inventory
h. Inventory Turnover in Days
Cost of Goods Sold/365
=

($523,000 + $565,000)/2 $544,000

= = 90.87 days
$2,185,100/365 $2,185,100/365

Accounts Receivable Inventory Turnover

i. Operating Cycle +
Turnover in Days in days
=

123.71 days = 32.84 days + 90.87 days

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PROBLEM 6-12

Total Total Net

Current Current Working Current
Assets Liabilities Capital Ratio

a. + 0 + +

b. + 0 + +

c. + 0 + +

d. — — 0 +

e. — 0 — —

f. 0 0 0 0

g. + 0 + +

h. 0 0 0 0

i. — 0 — —

j. 0 — + +

k. 0 0 0 0

l. 0 + — —

m. + + 0 —

n. 0 + — —

o. — 0 — —

PROBLEM 6-13

Company E and Company D have the same amount of working capital. Company D has a
current ratio of 2 to 1, while Company E has a current ratio of 1.29 to 1. Company D is in a
better short-term financial position than Company E because its liabilities are covered better with
a higher current ratio. Working capital is not very significant because the amount of working
capital does not indicate the relative size of the companies and the amount needed.
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PROBLEM 6-14

Company T has twice the working capital of Company R. Both companies have a current ratio
of 2 to 1. In general, both companies are in the same relative position because of the same
current ratio. The greater amount of working capital in Company T is not very significant
because the amount of working capital does not indicate the relative size of the companies and
the amount needed.

PROBLEM 6-15
a. (1) Working Capital:

2011: $500,000 - $340,000 = $160,000

2010: $400,000 - $300,000 = $100,000

(2) Current Ratio:

2011: $500,000 / $340,000 = 1.47 to 1

2010: $400,000 / $300,000 = 1.33 to 1

(3) Acid-Test Ratio:

2011: $500,000 - $250,000 = 0.74 to 1

$340,000

2010: $400,000 - $200,000 = 0.67 to 1

$300,000
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(4) Accounts Receivable Turnover:

2011: $1,400,000 = 13.02 times per year

($110,000 + $105,000)/2

2010: $1,500,000 = 13.04 times per year

($120,000 + $110,000)/2

(5) Inventory Turnover:

2011: $1,120,000 = 4.98 times per year

($200,000 + $250,000)/2

2010: $1,020,000 = 4.25 times per year

($280,000 + $200,000)/2

(6) Inventory Turnover In Days:

2011: 365/4.98 = 73.29 days

2010: 365/4.25 = 85.88 days

b. The short-term liquidity of the firm has improved between 2010 and 2011. The working
capital increased by $60,000, while the current ratio increased from 1.33 to 1.47. The acid-
test ratio increased from 0.67 to 0.74. Using a rule of thumb of two for the current ratio and
one for the acid-test, this firm needs to improve its current liquidity position.

The accounts receivable turnover stayed the same, while the inventory improved from 4.25 to
4.98. The days' sales in inventory improved from 85.88 to 73.29 days.

Much of the improvement in the current position can be attributed to the improved control of
the inventory.
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PROBLEM 6-16

a. Based on the year-end figures

(1) Accounts Receivable Turnover in Days:

Average Gross Receivables ($75,000 + 50,000)/2

= = 5.70 Days
Net Sales / 365 $4,000,000/365

(2) Accounts Receivable Turnover per Year:

Net Sales $4,000,000

= = 64.00 Times per year
Average Gross Receivables ($75,000 + $50,000)/2

(3) Inventory Turnover in Days:

Average Inventory ($350,000 + $400,000)/2

= = 76.04 Days
Cost of Goods Sold / 365 $1,800,000/365

(4) Inventory Turnover per Year:

Cost of Goods Sold $1,800,000
= = 4.80 Times per year
Average Inventory ($350,000 + 400,000)/2

b. Using average figures:

Total Monthly Gross Receivables $ 6,360,000

12

Average $ 530,000

Total Monthly Inventory $ 5,875,000

12

Average $ 489,583
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(1) Accounts Receivable Turnover in Days:

Average Gross Receivables $530,000

= = 48.36 days
Net Sales / 365 $4,000,000 / 365

(2) Accounts Receivable Turnover per Year:

Net Sales $4,000,000

= = 7.55 times per year
Average Gross Receivables $530,000

(3) Inventory Turnover in Days:

Average Inventory $489,583

= = 99.28 days
Cost of Goods Sold/365 $1,800,000/365

(4) Inventory Turnover per Year:

Cost of Goods Sold = $1,800,000 = 3.68 times per year

Average Inventory $489,583

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c. Based on the year-end averages, the liquidity of the receivables and inventory are overstated
and, therefore, they are unrealistic. The table shows the overstatement of liquidity in
comparison with monthly averages.
Based on Year-End Figures Based on Monthly Figures

Accounts Receivable 5.70 days 48.36 days

Turnover in Days

Accounts Receivable 64.00 times per year 7.55 times per year

Turnover per Year

Inventory Turnover 76.04 days 99.28 days

in Days

Inventory Turnover 4.80 times per year 3.68 times per year

per Year

d. Days' Sales in Receivables:

Gross Receivables $50,000

= = 4.56 days
Net Sales/365 $4,000,000/365

e. Days' Sales in Inventory:

Ending Inventory $400,000

= = 81.11 days
Cost of Goods Sold/365 $1,800,000/365

f. The days' sales in receivables and the days' sales in inventory are understated based on the
year-end figures because the receivables and inventory numbers are abnormally low at this
time. Therefore, the liquidity of the receivables and the inventory is overstated.
Anne Elizabeth Corporation is using a natural business year; therefore, at year-end, the
receivables and the inventory are below average for the year.
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PROBLEM 6-17

a. First-In, First-Out (FIFO):

Ending Inventory

August 1, Purchase 200 @ $7.00 $1,400

November 1, Purchase 200 @ $7.50 1,500

$2,900

Remaining cost is cost of goods sold ($10,900 - $2,900) $8,000

b. Last-In, First-Out (LIFO):

Ending Inventory

January 1, Inventory (400 x $5.00) = $2,000

Remaining cost is cost of goods sold ($10,900 - $2,000) $8,900

c. Average Cost (Weighted Average):

Total Cost $10,900
Average Cost = = $6.06
=
Total Units 1,800
Inventory (400 x $6.06) = $2,424

Remaining cost is cost of goods sold ($10,900 - $2,424) $8,476

d. Specific Identification:

March 1, Purchase cost $6.00

Ending Inventory (400 x $6.00) = $2,400

Remaining cost is cost of goods sold ($10,900 - $2,400) $8,500

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PROBLEM 6-18

a. First-In, First-Out (FIFO):

Ending

Inventory Cost of Goods Sold

December 10 Purchase

500 x $5.00 $2,500

October 22 Purchase

100 x $4.90 490

$2,990

Remaining cost is cost of goods sold ($20,325 - $2,990) $17,335

b. Last-In, First-Out (LIFO):

Ending

Inventory Cost of Goods Sold

January 1, Beginning Inventory

(600 x $4.00) $2,400

Remaining cost is cost of goods sold ($20,325 - $2,400) $17,925

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c. Average Cost (Weighted Average):

Total Cost $20,325

= = $4,619
Total Units 4,400

Ending Inventory (600 x $4.62) = $2,772

Cost of Goods Sold ($20,325 - $2,772) = $17,553

d. Specific Identification:

July 1 purchase cost $5.00

Ending Inventory (600 x $5.00) = $ 3,000

Cost of Goods Sold ($20,325 - $3,000) = $17,325

PROBLEM 6-19

a. Sales to Working Capital:

2011 2010 2009

$650,000 $600,000 $500,000

= 2.41 = 2.31 = 2.08
$270,000 $260,000 $240,000

Industry
Average 4.10 4.05 4.00
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b. The sales to working capital ratio for J. A. Appliance Company was substantially below the
industry average for all three years. This tentatively indicates that working capital is not
efficient in relation to the sales. There was some improvement in the ratio each year.

PROBLEM 6-20

a. 3 A payment of a trade account payable would reduce both current assets and current
liabilities. This would have the effect of increasing both the current and quick ratios
since total quick assets exceeded total current liabilities both before and after the
transactions.
b. 2 This would increase current assets and current liabilities by the same amount. This
would have the effect of decreasing the current ratio because total quick assets
exceeded total current liabilities both before and after the transaction.
c. 5 The collection of a current account receivable would not change the numerator or
the denominator in either the current or quick ratios.
d. 4 A write-off of inventory would decrease the numerator in the current ratio.

e. 2 The liquidation of a long-term note would reduce the numerator in both the quick ratio
and the current ratio, but it would reduce the numerator of the quick ratio
proportionately more than the numerator of the current ratio.

PROBLEM 6-21

a. 2 Cash Equivalents + Marketable Securities + Net Receivables

Current Liabilities

$2,100,000 + 7,200,000 + $50,500,000

= 1.76
$34,000,000

b. 1 The collection of accounts receivable does not change the total numerator or the
denominator of the current ratio formula, nor does the collection change
total current assets or total current liabilities.

PROBLEM 6-22
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a. 1 Net Sales

Average Gross Receivables

$1,500,000
= 20.0 times per year
($8,000 + $72,000 + $10,000 + $60,000)/2

b. 2 December 31 represents a date when the accounts receivable would be low and
unrepresentative; thus, the accounts receivable turnover computed on December
31 will be overstated.

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PROBLEM 6-23

a. 3 Cash Equivalents + Marketable Securities + Net Receivables

Current Liabilities

$8,000 + $32,000 + $40,000 $80,000

= = 0.89
$60,000 + $30,000 $90,000

b. 1 Net Sales (use only credit sales when available)/Average Gross Receivables (only net
receivables in this problem)

Net Sales

Average Gross Receivables

Note: Use only credit sales when available.

$600,000 $600,000
= = 8.00 times
($40,000 + $110,000)/2 $75,000

c. 1 Cost of Goods Sold

Average Inventory

$1,260,000 $1,260,000
= = 11.45 times
($80,000 + $140,000)/2 $110,000

d. 4 Current Assets

Current Liabilities

$8,000 + $32,000 + $40,000 + $80,000 $160,000

$60,000 + $30,000 = 1.78 times
=. $90,000

e. 2 As long as the current ratio is greater than 1 to 1, any payment will increase the current
ratio because the current liabilities go down more in proportion than do the
current assets.
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PROBLEM 6-24

a. 1 An increase in inventory would increase the current ratio. To the extent that the
increase in inventory used current funds available, this would decrease the acid-test.

b. 4 LIFO would result in a lower inventory figure. This would decrease the current ratio
and increase inventory turnover.

c. 3 Current Assets
X = 3.0
=
Current Liabilities $600,000

X = $1,800,000

Current Assets - Inventory = $1,800,000 – Y = 2.5

Current Liabilities $600,000

Y = $300,000

Cost of Sales $500,000

= = 1.67
Inventory $300,000

d. 2 The most logical reason for the current ratio to be high and the quick ratio low is that the
firm has a large investment in inventory.

e. 5 Low default risk, readily marketable, and a short-term to maturity is a proper description
of investment instruments used to invest temporarily idle cash balances.

f. 1 A proper management of accounts receivable should achieve a combination of sales

volume, bad debt experience, and receivables turnover that maximizes the profits of the
corporation.
g. 5 Any of the four items could be used to cover payroll expenses.

PROBLEM 6-25
Gross Receivables
1. Days’ Sales in Receivables =
Net Sales/365
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$131,000 + $1,000
2011: = 54.75 days
$880,000/365

$128,000 + $900
2010: = 51.70 days
$910,000/365

$127,000 + $900
2009: = 55.58 days
$840,000/365

$126,000 + $800
2008: = 56.10 days
$825,000/365

$125,000 + $1,200
2007: = 56.17 days
$820,000/365

Net Sales
2. Accounts Receivable Turnover
Gross Receivables
=

$880,000
2011: = 6.67 times per year
$131,000 + $1,000

$910,000
2010: = 7.06 times per year
$128,000 + $900

$840,000
2009: = 6.57 times per year
$127,000 + $900

$825,000
2008: = 6.51 times per year
$126,000 + $800

$820,000 $125,000 + $1,200

2007:
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= 6.50 times per year

$820,000
2007: = 6.50 times per year
$125,000 + $1,200
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Gross Receivables
3. Accounts Receivable Turnover in Days
Net Sales/365
=

$131,000 + $1,000
2011: = 54.75 days
$880,000/365

$128,000 + $900
2010: = 51.70 days
$910,000/365

$127,000 + $900
2009: = 55.58 days
$840,000/365

$126,000 + $800
2008: = 56.10 days
$825,000/365

$125,000 + $1,200
2007: = 56.17 days
$820,000/365
Ending Inventory

4. Days’ Sales in Inventory Cost of Goods Sold/365

=

$122,000
2011: = 60.18 days
$740,000/365

$124,000
2010: = 59.55 days
$760,000/365

$126,000
2009: = 65.33 days
$704,000/365

$127,000 $695,000/365
2008:
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= 66.70 days

$125,000
2007: = 65.93 days
$692,000/365
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Cost of Goods Sold

5. Inventory Turnover
=
Ending Inventory

$740,000
2011: = 6.07 times per year
$122,000

$760,000
2010: = 6.13 times per year
$124,000

$704,000
2009: = 5.59 times per year
$126,000

$695,000
2008: = 5.47 times per year
$127,000

$692,000
2007: = 5.54 times per year
$125,000

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Ending Inventory
6. Inventory Turnover in Days
=
Cost of Goods Sold/365

$122,000
2011: = 60.18 days
$740,000/365

$124,000
2010: = 59.55 days
$760,000/365

$126,000
2009: = 65.33 days
$704,000/365

$127,000
2008: = 66.70 days
$695,000/365

$125,000
2007: = 65.93 days
$692,000/365

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Accounts Inventory Turnover

7. Operating Cycle +
= in Days
Receivable

Turnover in Days

2011: 54.75 + 60.18 = 114.93

2010: 51.70 + 59.55 = 111.25

2009: 55.58 + 65.33 = 120.91

2008: 56.10 + 66.70 = 122.80

2007: 56.17 + 65.93 = 122.10

8. Working Capital = Current Assets – Current Liabilities

2011: $305,200 – $109,500 = $195,700

2010: $303,000 – $110,000 = $193,000

2009: $303,000 – $113,500 = $189,500

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2008: $301,000 – $114,500 = $186,500

2007: $297,000 – $115,500 = $181,500

Current Assets
9. Current Ratio
=
Current Liabilities

$305,200
2011: = 2.79
$109,500

$303,000
2010: = 2.75
$110,000

$303,000
2009: = 2.67
$113,500

$301,000
2008: = 2.63
$114,500

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$297,000
2007: = 2.57
$115,500

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Cash Equivalents + Marketable Services + Net Receivables

10. Acid-Test Ratio
=
Current Liabilities

$47,200 + $2,000 + $131,000

2011: = 1.65
$109,500

$46,000 + $2,500 + $128,000

2010: = 1.60
$110,000

$45,000 + $3,000 + $127,000

2009: = 1.54
$113,500

$44,000 + $3,000 + $126,000

2008: = 1.51
$114,500

$43,000 + $3,000 + $125,000

2007: = 1.48
$115,500

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Cash Equivalents + Marketable Securities

11. Cash Ratio
=
Current Liabilities

$47,200 + $2,000
2011: = 0.45
$109,500

$46,000 + $2,500
2010: = 0.44
$110,000

$45,000 + $3,000
2009: = 0.42
$113,500

$44,000 + $3,000
2008: = 0.41
$114,500

$43,000 + $3,000
2007: = 0.40
$115,500

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Net Sales
12. Sales to Working Capital
=
Working Capital

$880,000
2011: = 4.50
$195,700

$910,000
2010: = 4.72
$193,000

$840,000
2009: = 4.43
$189,500

$825,000
2008: = 4.42
$186,500

$820,000
2007: = 4.52
$181,500

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Average Gross Receivables

13. 1. Days' Sales in Receivables
=
Net Sales/365

($131,000 + $1,000 + $128,000 + $900)/2

2011: = 54.11 days
$880,000/365

($128,000 + $900 + $127,000 + $900)/2

2010: = 51.50 days
$910,000/365

($127,000 + $900 + $126,000 + $800)/2

2009: = 55.34 days
$840,000/365

($126,000 + $800 + $125,000 + $1,200)/2

2008: = 55.97 days
$825,000/365

2007: Not sufficient data to compute using average gross receivables.

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Net Sales
14. Accounts Receivable Turnover =
Average Gross Receivables

$880,000
2011: = 6.75
(131,000 + $1,000 + $128,000 + $900)/2

$910,000
2010: = 7.09
($128,000 + $900 + $127,000 + $900)/2

$840,000
2009: = 6.60
($127,000 + $900 + $127,000 + $900)/2

$825,000
2008: = 6.52
($126,000 + $800 + $125,000 + $1,200)/2

2007: Not sufficient data to compute using average gross receivables.

15. Accounts Receivable Turnover in Days = Average Gross Receivables

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Net Sales/365

($131,000 + $1,000 + $128,000 + $900)/2

2011: = 54.11 days
$880,000/365

($128,000 + $900 + $127,000 + $900)/2

2010: = 51.50 days
$910,000/365

($127,000 + $900 + $126,000 + $800)/2

2009: = 55.34 days
$840,000/365

($126,000 + $800 + $125,000 + $1,200)/2

2008: = 55.97 days
$825,000/365

2007: Not sufficient data to compute using average gross receivables.

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Average Inventory
16. Days' Sales In Inventory
Cost of Goods Sold/365
=

($122,000 + $124,000)/2
2011: = 60.67 days
$740,000/365

($124,000 + $126,000)/2
2010: = 60.03 days
$760,000/365

($126,000 + $127,000)/2
2009: = 65.59 days
$704,000/365

($127,000 + $125,000)/2
2008: = 66.17 days
$695,000/365

2007: Not sufficient data to compute using average inventory.

17. Inventory Turnover = Cost of Goods Sold

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Average Inventory

$740,000
2011: = 6.02 times per year
($122,000 +

$124,000)/2

$760,000
2010: = 6.08 times per year
($124,000 +

$126,000)/2

$704,000
2009: = 5.57 times per year
($126,000 +

$127,000)/2

$695,000
2008: = 5.52 times per year
($127,000 +

$125,000)/2

2007: Not sufficient data to compute using average inventory.

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Average Inventory
18. Inventory Turnover In Days
Cost of Goods Sold/365
=

($122,000 + $124,000)/2
2011: = 60.67 days
$740,000/365

($124,000 + $126,000)/2
2010: = 60.03 days
$760,000/365

($126,000 + $127,000)/2
2009: = 65.59 days
$704,000/365

($127,000 + $125,000)/2
2008: = 66.17 days
$695,000/365

2007: Not sufficient data to compute using average inventory.

19. Operating Cycle = Accounts Receivable + Inventory Turnover

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Turnover In Days in Days

2011: 54.11 + 60.67 = 114.78

2010: 51.50 + 60.03 = 111.53

2009: 55.34 + 65.59 = 120.93

2008: 55.97 + 66.17 = 122.14

2007: Not sufficient data to compute.

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20. Working Capital = Average Current Assets – Average Current Liabilities

2011: ($305,200 + $303,000)/2 - ($109,500 + $110,000)/2

$304,100 - $109,750 = $194,350

2010: ($303,000 + $303,000)/2 - ($110,000 + $113,500)/2

$303,000 - $111,750 = $191,250

2009: ($303,000 + $301,000)/2 - ($113,500 + $114,500)/2

$302,000 - $114,000 = $188,000

2008: ($301,000 + $297,000)/2 - ($114,500 + $115,500)/2

$299,000 - $115,000 = $184,000

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2007: Not sufficient data to compute.

Average Current Assets

21. Current Ratio
Average Current Liabilities
=

$304,100
2011: = 2.77
$109,750

$303,000
2010: = 2.71
$111,750

$302,000
2009: = 2.65
$114,000

2008: $299,000 = 2.60

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$115,000

2007: Not sufficient data to compute using average inventory.

Average (Cash Equivalents + Marketable

22. Acid-Test Ratio Securities + Net Receivables)

= Average Current Liabilities

(($47,200 + $2,000 + $131,000) + ($46,000 + $2,500 + $128,000))/2

2011:
($109,500 + $110,000)/2

$178,350
= 1.63
$109,750

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(($46,000 + $2,500 + $128,000) + ($45,000 + $3,000 + $127,000))/2

2010:
($110,000 + $113,500)/2

$175,750
= 1.57
$111,750

(($45,000 + $3,000 + $127,000) + ($44,000 + $3,000 + $126,000))/2

2009:
($113,500 + $114,500)/2

$174,000
= 1.53
$114,000

(($44,000 + $3,000 + $126,000) + ($43,000 + $3,000 + $125,000))/2

2008:
($114,500 + $115,500)/2

$172,000
= 1.50
$115,000

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2007: Not sufficient data to compute using average inventory.

Average (Cash Equivalents + Marketable Securities)

23. Cash Ratio
Average Current Liabilities
=

($47,200 + $2,000) + ($46,000 + $2,500)/2

2011:
($109,500 + $110,000)/2

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$48,850
= 0.45
$109,750

($46,000 + $2,500) + ($45,000 + 3,000)/2

2010:
($110,000 + $113,500)/2

$48,250
= 0.43
$111,750

($45,000 + $3,000) + ($44,000 + 3,000)/2

2009:
($113,500 + $114,500)/2

$47,500
= 0.42
$114,000

($44,000 + $3,000) + ($43,000 + 3,000)/2

2009:
($114,500 + $115,500)/2

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$46,500
= 0.40
$115,000

2007: Not sufficient data to compute using average inventory.

24. Sales to Working Capital = Net Sales

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Average Working Capital

$880,000
2011: = 4.53
($305,200 - $109,500 + $303,000 - $110,000)/2

$910,000
2010: = 4.76
($303,000 - $110,000 + $303,000 - $113,500)/2

$840,000
2009: = 4.47
($303,000 - $113,500 + $301,000 - $114,500)/2

$825,000
2008: = 4.48
($301,000 - $114,500 + $297,000 - $115,500)/2

2007: Not sufficient data to compute.

b. 1. Days' Sales in Receivables increased slightly each year using year end data.

2. Accounts Receivable Turnover decreased slightly each year using year end dates.

3. Account Receivable Turnover in days increased slightly each year using year end data.

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4. Days Sales in Inventory decreased slightly each year using year end data except
for 2008.

5. Inventory Turnover increased slightly each year using year end data except for 2008.

6. Inventory Turnover in days decreased slightly each year using year end data except
for 2008.

7. Operating cycle in some years increased slightly and in some years decreased slightly.

8. Working Capital increased slightly each year using year end data.

9. Current Ratio increased slightly each year using year end data.

10. Acid-Test Ratio increased slightly each year using year end data.

11. Cash Ratio stayed the same in 2011 and 2009. It increased slightly using 2010 and
2008.

12. Sales to Working Capital decreased slightly each year using year end data.

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PROBLEM 6-26 ALLOWANCE FOR UNCOLLECTIBLE ACCOUNTS – ETHICS vs.

CONSERVATISM

a. 1. Current balance $2,000

Needed to adjust 4,050

Adjusted balance $6,050

This will add $4,050 to expense

2. Current balance $ 2,000

Needed to adjust 10,000

Adjusted balance $12,000

This will add $10,000 to expense

b. Unethical

The accountant cannot use the conservatism concept to justify arbitrarily low numbers, such
as lower income. What is proposed would be unethical.

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PROBLEM 6-27 ACCOUNTS RECEIVABLE – NOTE RECEOVABLE - ETHICS

a. Yes

b. It should improve the liquidity appearance. In reality, it will likely make the liquidity

worse.

c. As stated in the case, it would be unethical. It could be made ethical with a detailed

review of the customers situation, adequate discussions with Eric Page, the CEO,

and adequate disclosure.

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Chapter 7
Long-Term Debt-Paying Ability
PROBLEMS

PROBLEM 7-1

Recurring Earnings, Excluding Interest Expense, Tax

Times Interest Earned Expense, Equity Earnings, and Minority Earnings

=
Interest Expense, Including Capitalized Interest

Earnings before interest and tax:

Net sales $ 1,079,143

Cost of sales (792,755)

Selling and administration (264,566)

$ 21,822

a. Times Interest Earned = $21,822 = 5.06 times per year

b. Cash basis times interest earned:

$21,822 + $40,000 $61,822

= = 14.34 times per year
$4,311 $4,311

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PROBLEM 7-2

Recurring Earnings, Excluding Interest Expense, Tax

a. Times Interest Earned Expense, Equity Earnings, and Minority Earnings

= Interest Expense, Including Capitalized Interest

Income before income taxes $ 675

Plus interest 60

Adjusted income $ 735

Interest expense $ 60

Times interest earned = $735 = 12.25 times per year

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$60

Recurring Earnings, Excluding Interest Expense, Tax

Expense, Equity Earnings, and Minority Earnings + Interest

b. Fixed Charge Coverage Portion of Rentals

= Interest Expense, Including Capitalized Interest + Interest

Portion of Rentals

Adjusted income from part (a) $ 735

1/3 of operating lease payments (1/3 x $150) 50

Adjusted income, including rentals $ 785

Interest expense $ 60

1/3 of operating lease payments 50

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$ 110

$785
Fixed Charge Coverage = 7.14 times per year
$110
=

PROBLEM 7-3

Recurring Earnings, Excluding Interest Expense, Tax

a. Times Interest Earned Expense, Equity Earnings, and Minority Earnings

= Interest Expense, Including Capitalized Interest

Income before income taxes and extraordinary charges $ 36

Plus interest 16

(1) Adjusted income 52

(2) Interest expense $ 16

Times Interest Earned: (1) divided by (2) = 3.25 times per year

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Recurring Earnings, Excluding Interest Expense, Tax

Expense, Equity Earnings, and Minority Earnings + Interest

b. Fixed Charge Coverage Portion of Rentals

= Interest Expense, Including Capitalized Interest + Interest

Portion of Rentals

Adjusted income from part (a) $ 52

1/3 of operating lease payments (1/3 x $150) 50

(1) Adjusted income, including rentals $ 102

Interest expense $ 16

1/3 of operating lease payments 50

(2) Adjusted interest expense $ 66

Fixed charge coverage: (1) ÷ (2) = 1.55 times per year

PROBLEM 7-4

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Total Liabilities $174,979

a. Debt Ratio = = 41.2%
=
Total Assets $424,201

Total Liabilities $174,979

b. Debt/Equity Ratio = = 70.2%
=
Stockholders’ Equity $249,222

c. Ratio of Total Debt to Tangible Net Worth =

Total Liabilities $174,979 $174,979

= = = 70.9%
Tangible Net Worth $249,222 – $2,324 $246,898

d. Kaufman Company has financed over 41% of its assets by the use of funds from outside
creditors. The Debt/Equity Ratio and the Debt to Tangible Net Worth Ratio are over
70%. Whether these ratios are reasonable depends upon the stability of earnings.

PROBLEM 7-5
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Times Debt to

Interest Debt Debt/Equit Tangible

y Ratio
Transaction Earned Ratio Net Worth

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a. Purchase of buildings financed

by mortgage
- + + +

b. Purchase of inventory on
short-term loan at 1%
over prime rate
- + + +

c. Declaration and payment of

cash dividend

0 + + +
d. Declaration and payment of
stock dividend

0 0 0 0
e. Firm increases profits by cutting
cost of sales

f. Appropriation of retained earnings + - - -

g. Sale of common stock 0 0 0 0

h. Repayment of long-term bank loan 0 - - -

i. Conversion of bonds to common

stock
+ - - -

j. Sale of inventory at greater 346

than cost
+ - - -
 Stuvia.com - The Marketplace to Buy and Sell your Study Material

PROBLEM 7-6

a. Times Interest Earned:

Times interest earned relates earnings before interest expense, tax, minority earnings, and
equity income to interest expense. The higher this ratio, the better the interest coverage. The
times interest earned has improved materially in strengthening the long-term debt position.
Considering that the debt ratio and the debt to tangible net worth have remained fairly
constant, the probable reason for the improvement is an increase in profits.

The times interest earned only indicates the interest coverage. It is limited in that it does not
consider other possible fixed charges, and it does not indicate the proportion of the firm’s
resources that have come from debt.

Debt Ratio:

The debt ratio relates the total liabilities to the total assets.

The lower this ratio, the lower the proportion of assets that have been financed by creditors.

For Arodex Company, this ratio has been steady for the past three years. This ratio indicates
that about 40% of the total assets have been financed by creditors. For most firms, a 40%
debt ratio would be considered to be reasonable.

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The debt ratio is limited in that it relates liabilities to the book value of total assets. Many
assets would have a value greater than book value. This tends to overstate the debt ratio and,
therefore, usually results in a conservative ratio. The debt ratio does not consider immediate
profitability and, therefore, can be misleading as to the firm’s ability to handle long-term
debt.

Debt to Tangible Net Worth:

The debt to tangible net worth relates total liabilities to shareholders' equity less intangible
assets. The lower this ratio, the lower the proportion of tangible assets that has been financed
by creditors.

Arodex Company has had a stable ratio of approximately 81% for the past three years. This
indicates that creditors have financed 81% as much as the shareholders after eliminating
intangibles from the shareholders contribution – for most firms, this would be considered to
be reasonable. The debt to tangible net worth ratio is more conservative than the debt ratio
because of the elimination of intangible items. It is also conservative for the same reason
that the debt ratio was conservative, in that book value is used for the assets and many
assets have a value greater than book value. The debt to tangible net worth ratio also does
not consider immediate profitability and, therefore, can be misleading as to the firm's ability
to handle long-term debt.

Collective inferences one may draw from the ratios of Arodex Company:

Overall it appears that Arodex Company has a reasonable and improving long-term debt
position. The debt ratio and the debt to tangible net worth ratios indicate that the proportion
of debt appears to be reasonable. The times interest earned appears to be reasonable and
improving.

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The stability of earnings and comparison with industry ratios will be important in reaching
a conclusion on the long-term debt position of Arodex Company.

b. Ratios are based on past data. The future is what is important, and uncertainties of the
future cannot be accurately determined by ratios based upon past data.

Ratios provide only one aspect of a firm's long-term debt-paying ability. Other information,
such as information about management and products, is also important.

A comparison of this firm's ratios with ratios of other firms in the same industry would be
helpful in order to decide if the ratios are reasonable.

PROBLEM 7-7

Recurring Earnings, Excluding Interest Expense, Tax

a. 1. Times Interest Earned Expense, Equity Earnings, and Noncontrolling Interest

= Interest Expense, Including Capitalized Interest

$162,000 = 8.1 times per year

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$20,000

Total Liabilities
2. Debt Ratio
Total Assets
=

$162,000 = 8.1 times per year

$ 20,000

$193,000
= 32.2%
$600,000

Total Liabilities
3. Debt/Equity Ratio
Stockholders’ Equity
=

$193,000
= 47.4%
$407,000

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Total Liabilities
4. Debt to Tangible Net Worth Ratio
Tangible Net Worth
=

$193,000
= 49.9%
$407,000 – $20,000

b. New asset structure for all plans:

Assets

Current Assets $ 226,000

Property, plant and equipment 554,000

Intangibles 20,000

Total assets $ 800,000

Liabilities and Equity

Plan A

Current Liabilities $ 93,000

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Long-term debt 100,000

Preferred stock 250,000

Common equity 357,000 No change in net income

$ 800,000

Plan B

Current Liabilities $ 93,000

Long-term debt 100,000

Preferred stock 50,000

Common stock 120,000

Premium on common stock 300,000

Retained earnings 137,000 No change in net income

$ 800,000

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Plan C

Current liabilities $ 93,000 Operating income $ 162,000

Long-term debt 300,000 Interest expense 36,000*

Preferred stock 50,000 $ 126,000

Common equity 357,000 Taxes (40%) 50,400

$ 800,000 Net income $ 75,600

*$20,000 + 8%($200,000) = $36,000

Recurring Earnings, Excluding Interest Expense, Tax

1. Times Interest Earned Expense, Equity Earnings, and Noncontrolling Interest

= Interest Expense, Including Capitalized Interest

Plan A Plan B Plan C

$162,000 $162,000 $162,000

= 8.1 times = 8.1 times = 4.5 times
$20,000 $20,000 $36,000

Total Liabilities
2. Debt Ratio
Total Assets
=

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Plan A Plan B Plan C

$193,000 $193,000 $393,000

= 24.1% = 24.1% = 49.1%
$800,000 $800,000 $800,000

Total Liabilities
3. Debt/Equity Ratio
Stockholders’ Equity
=

Plan A Plan B Plan C

$193,000 $193,000 $393,000

= 31.8% = 31.8% = 96.6%
$607,000 $607,000 407,000

Total Liabilities
4. Debt to Tangible Net Worth
Tangible Net Worth
=

Plan A Plan B Plan C

$193,000 $193,000 $393,000

= 32.9% = 32.9% = 101.6%
$607,000 – $20,000 $607,000 – $20,000 $407,000 – $20,000

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c. Preferred Stock Alternative:

Advantages:

1. Lesser drop in earnings per share than under the common stock alternative.

2. Not the absolute reduction in earnings that accompanied the debt alternative.

3. There would be an improvement in the Debt Ratio, Debt/Equity Ratio, and Total Debt
to Tangible Net Worth Ratio.

4. Does not have the reduced times interest earned that accompanied alternative of
issuing long-term debt.

Disadvantage:

1. An increase in the fixed preferred dividend charge that the firm must pay before
any dividends can be paid to common stockholders.

Common Stock Alternative:

Advantages:

1. No increase in fixed obligations.

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2. There would be an improvement in the Debt Ratio, Debt/Equity Ratio, and the Total Debt
to Tangible Net Worth Ratio.

3. Not the absolute reduction in earnings that accompanied the debt alternative.

4. Does not have the reduced times interest earned that accompanied alternative of
issuing long-term debt.

Disadvantage:

1. Maximum dilution in earnings per share of the three alternatives.

Long-Term Bonds Alternative:

Advantage:

1. Higher earnings per share than with common stock.

Disadvantages:

1. Material decline in Times Interest Earned.

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2. A material increase in the Debt Ratio, Debt/Equity Ratio, and Total Debt to Tangible
Net Worth Ratio.

3. Absolute reduction in earnings.

4. Increase in the interest fixed charge that must be paid.

d. The 5% preferred stock increased the preferred dividends which are not tax deductible;
therefore, the cost of these funds is the 5% amount. The 8% bond interest is tax deductible
and, therefore, the after-tax cost is 4.8% [8% x (1-.40)(1-the corporate tax rate)].

Note to Instructor: You may want to take this opportunity to point out to the students that
the alternative that should be selected is greatly influenced by the change in earnings and
the specific debt structure. The conclusions in this problem would not necessarily be true
with changed assumptions.

PROBLEM 7-8

Recurring Earnings, Excluding Interest Expense, Tax

a. Times Interest Earned Expense, Equity Earnings, and Noncontrolling Interest

= Interest Expense, Including Capitalized Interest

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Earnings from continuing operations before

income taxes and equity earnings

Add back interest expense $ 74,780,000

Adjusted earnings (1) $ 37,646,000

(2) $ 112,426,000

Times interest earned: [(2) + (1)] 2.99 times per year

b.

Adjusted earnings (see a, above) $ 112,426,000

Plus equity earnings 27,749,000

Interest expense (1) $ 140,175,000

(2) $ 37,646,000

Times interest earned: (1) / (2) = 3.72 times per year

c. Including equity earnings gives a less conservative times interest earned ratio. The equity
income is usually substantially more than the cash dividend received from the related
investments. Therefore, the firm cannot depend on this income to cover interest payments.

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PROBLEM 7-9

Recurring Earnings, Excluding Interest Expense, Tax

a. 1. Times Interest Earned Expense, Equity Earnings, and Noncontrolling Interest

= Interest Expense, Including Capitalized Interest

$95,000 $170,000
= 9.5 times = 5.3 times
$10,000 $32,000

Total Liabilities $160,000 $575,000

2. Debt Ratio = = = 44.9% = 58.4%
Total Assets $356,000 $985,000

Total Liabilities $160,000 $575,000

3. Debt Equity = = 81.6% = 140.2%
=
Shareholders’ Equity $196,000 $410,000

Total Liabilities
4. Debt to Tangible Net Worth
Shareholders’ Equity – Intangibles
=

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$160,000
= 86.5%
$196,000 – $11,000

$575,000
= 147.4%
$410,000 – $20,000

b. No, Barker Company has a times interest earned of 5.3 times while the industry average is
7.2 times. This indicates that Barker Company has less than average coverage of its interest.
Also, Barker Company has a much higher than average debt/equity ratio, and debt to
tangible net worth ratio.

c. Allen Company has a better times interest earned, debt ratio, debt/equity ratio, and debt to
tangible net worth.

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PROBLEM 7-10

Recurring Earnings, Excluding Interest Expense, Tax

a. 1. Times Interest Earned Expense, Equity Earnings, and Noncontrolling Interest

=
Interest Expense, Including Capitalized Interest

$280,000 – $156,000
2011:
= 7.29 times per year
$17,000

$302,000 – $157,000
2010:
= 9.06 times per year
$16,000

$286,000 – $154,000
2009:
= 8.80 times per year
$15,000

$270,000 – $150,000
2008:
= 8.28 times per year
$14,500

$248,000 – $147,000
2007:
= 4.39 times per year
$23,000

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Recurring Earnings, Excluding Interest Expense, Tax

Expense, Equity Earnings, and Noncontrolling Interest

2. Fixed Charge Coverage + Interest Portion of Rentals

= Interest Expense, Including Capitalized Interest + Interest

Portion of Rentals

$280,000 – $156,000 + $10,000

2011:
= 4.96 times per year
$17,000 + $10,000

$302,000 – $157,000 + $9,000

2010:
= 6.16 times per year
$16,000 + $9,000

$286,000 – $154,000 + $9,500

2009:
= 5.78 times per year
$15,000 + $9,500

$270,000 – $150,000 + $10,000

2008:
= 5.31 times per year
$14,500 + $10,000

$248,000 – $147,000 + $9,000

2007:
= 3.44 times per year
$23,000 + $9,000

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Total Liabilities
3. Debt Ratio
Total Assets
=

$88,000 + $170,000
2011: = 46.07%
$560,000

$89,500 + $168,000
2010: = 46.48%
$554,000

$90,500 + $165,000
2009: = 46.14%
$553,800

$90,000 + $164,000
2008: = 46.31%
$548,500

$91,500 + $262,000
2007: = 65.83%
$537,000

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Total Liabilities
4. Debt/Equity Ratio
Shareholders’ Equity
=

$88,000 + $170,000
2011: = 85.43%
$302,000

$89,500 + $168,000
2010: = 86.85%
$296,500

$90,500 + $165,000
2009: = 85.65%
$298,300

$90,000 + $164,000
2008: = 86.25%
$294,500

$91,500 + $262,000
2007: = 192.64%
$183,500

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Total Liabilities
5. Debt to Tangible Net Worth
Shareholders’ Equity – Intangible Assets
=

$88,000 + $170,000
2011: = 91.49%
$302,000 – $20,000

$89,500 + $168,000
2010: = 92.46%
$296,500 – $18,000

$90,500 + $165,000
2009: = 90.83%
$298,300 – $17,000

$90,000 + $164,000
2008: = 91.20%
$294,500 – $16,000

$91,500 + $262,000
2007: = 209.79%
$183,500 – $15,000

b. Both the times interest earned and the fixed charge coverage are good. The times interest
earned is substantially better than the fixed charge coverage because of the operating leases.
Both of these ratios materially declined in 2011.

The debt ratio, debt/equity ratio, and debt to tangible net worth materially improved between
2007 and 2008 when long-term debt was reduced and funding shifted to equity. During the
period 2008 – 2011, these ratios were relatively steady and appeared to be good. The debt to
tangible net worth ratio is not as good as the debt/equity ratio because of the influence of
intangibles.

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PROBLEM 7-11

a. 4 The times interest earned ratio indicates a firm’s long-term debt-paying ability from
the income statement view.

b. 5 Preferred stock is owned by stockholders.

c. 5 The bonds payable liability will be shown on the balance sheet.

d. 5 The denominator of the debt ratio is total assets. Therefore, none of these assets are
subtracted.
e. 5 The current ratio is considered to be a liquidity ratio.

f. 4 The debt/equity ratio represents a balance sheet view of debt.

g. 5 There is not adequate information to form an opinion on the long-term debt position.

h. 2 With a times interest earned ratio of .20 to 1, net income is less than the interest expense.

i. 5 Intangible assets are subtracted in the denominator. Land and bonds payable are not intangible assets.

j. 2 The ratio fixed charge coverage is an income statement indication of debt-paying

ability.

k. 1 The Employee Retirement Income Security Act calls for a company to be liable for
its pension plan up to 30 percent of its net worth.

l. 1 Capitalized interest should be included with interest expense when computing

times interest earned.
m. 3 Minority shareholders’ interest does not represent a definite commitment to pay out
funds in the future.
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Chapter 8
Profitability

PROBLEMS
PROBLEM 8-1

Net Income Before Minority Share of

Net Profit Margin Earnings and Nonrecurring Items

= Net Sales

2011 2010

$52,500 $40,000

$1,050,000 $1,000,000

= 5.00% = 4.00%

Net Income Before Minority Share of

Return on Assets Earnings and Nonrecurring Items

= Average Total Assets

2011 2010

$52,500 $40,000

$230,000 $200,000

= 22.83% = 20.00%
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Net Sales
Total Asset Turnover
Average Total Assets
=

2011 2010

$1,050,000 $1,000,000

$230,000 $200,000

=4.57 =5.00 times

times per per year

year

Net Income Before Nonrecurring

Return on Common Equity Items – Preferred Dividends

= Average Common Equity

2011 2010

$52,500 $40,000

$170,000 $160,000

= 30.88% = 25.00%

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Ahl Enterprise has had a substantial rise in profit to sales. This is somewhat tempered by a
reduction in asset turnover. Given a slight rise in common equity, there is a substantial rise
in return on common equity.

PROBLEM 8-2

a.

2011 2010

Sales 100.0% 100.0%

Cost of goods sold 60.7 60.8

Gross profit 39.3 39.2

Selling expense 14.6 20.0

General expense 10.0 8.3

Operating income 14.7 10.9

Income tax 5.9 4.2

Net income 8.8% 6.7%

b. Starr Canning has had a sharp decrease in selling expense coupled with only a modest rise
in general expenses giving an overall rise in the net profit margin.

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PROBLEM 8-3

Earnings before interest and tax $ 245,000

Interest (750,000 x 6%) 45,000

Earnings before tax $ 200,000

Tax 80,000

Net income $ 120,000

Preferred dividends 15,000

Income available to common $ 105,000

Net Income Before Minority Share of

Earnings Equity Income and
a. Return on Assets Nonrecurring Items = $120,000 = 4.00%
=
Average Total Assets $3,000,000

Net Income Before Nonrecurring

Items – Dividends on
b. Return on Total Equity
Redeemable Preferred Stock = $120,000 = 6.67%
=
Average Total Equity $1,800,000

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Net Income Before Nonrecurring Items –

c. Return on Common Equity Preferred Dividends

= Average Common Equity

$120,000 – $15,000
= 7.00%
$1,500,000

Recurring Earnings, Excluding Interest

Expense, Tax Expense Equity Earnings,
and Noncontrolling Interest = $245,000 = 5.44 times
d. Times Interest Earned

=
Interest Expense, Including $45,000 per year

Capitalized Interest

PROBLEM 8-4

Vent Plastics
Industry
Molded

Plastics
Sales 101.0% 100.3%

Sales returns 1.0 0.3

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Cost of goods sold 72.1 67.1

Selling expense 9.4 10.1

General expense 7.0 7.9

Other income 0.4 0.4

Other expense 1.5 1.3

Income tax 4.8 5.5

Net income 5.5% 8.5%

Sales returns are higher than the industry. Cost of sales is much higher, offset some by
lower operating expenses. Other expense (perhaps interest) is somewhat higher. Lower
taxes are perhaps caused by lower income. Overall profit is less, primarily due to cost of
sales.

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PROBLEM 8-5

$1,589,150
a. = 122.72%
$1,294,966

2011 sales were 122.72% of those in 2010.

$138,204
b. = 100.80%
$137,110

2011 net earnings were 100.80% of those in 2010.

Net Income Before Minority Share of Earnings,

c. 1. Net Profit Margin Equity Income and Nonrecurring Items

= Net Sales

2011 2010

$149,260 $149,760
= 9.39% 11.56%
=
$1,589,150 $1,294,966

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Net Income Before Minority Share of

• Return on Assets Earnings and Nonrecurring Items

= Average Total Assets

2011 2010

$149,260 $149,760
= 10.38% 12.67%
=
$1,437,636* $1,182,110*

*Used year end because average could not be computed for 2010.

Net Sales
• Total Asset Turnover
Average Total Assets
=

2011 2010

$1,589,150 $1,294,966
= 1.11 times = 1.10 times
$1,437,636* $1,182,110*

*Used year end because average could not be computed for 2010.

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• DuPont Analysis: Return on Assets Net Profit Total Asset

= x
Margin Turnover

2011 10.42* = 9.39% x 1.11

2010 10.72* = 11.56% x 1.10

*Rounding causes the difference from the 10.38% and 12.67% computed in (2).

2011 2010

Operating income

Net sales $ 1,589,150 $ 1,294,966

Less: Cost of product sold $ 651,390 $ 466,250

Research and development expenses 135,314 113,100

General and selling 526,680 446,110

Operating income $ 275,766 $ 269,506

Operating Income
Operating Income Margin
Net Sales
=

2011 2010

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$275,766 $269,506

$1,589,150 $1,294,966

= 17.35% = 20.81%

Operating Income
• Return on Operating Assets
Average Operating Assets
=

2011 2010

$275,766 $269,506

$1,411,686* $1,159,666*

= 19.53% = 23.24%

*Used year end because average could not be computed for 2010.

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Net Sales
• Operating Asset Turnover
Average Operating Assets
=

2011 2010

$1,589,150 $1,294,966

$1,411,686* $1,159,666*

= 1.13 = 1.12 times per

times per year
year

*Used year end because average could not be computed for 2010.

Operating Operating
• DuPont Analysis: Return on Operating
= Income x Asset
Assets
Margin Turnover

2011: 19.61%* = 17.35% x 1.13

2010: 23.31%* = 20.81 x 1.12

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*Rounding causes the difference from the 19.53% and 23.24% computed in (6).

Net Income Before Minority Share of Earnings and Nonrecurring

• Return on Investment Items + [(Interest Expense) x (1 – Tax Rate)]

= Average (Long-Term Liabilities) + Equity

2011 2010

Net earnings before minority share $ 149,260 $ 149,760

Interest expense 18,768 11,522

Earnings before tax 263,762 271,500

Provision for income tax 114,502 121,740

Tax rate 43.4% 44.8%

1 – tax rate 56.6% 55.2%

Interest expense x (1 – tax rate) 10,623 6,360

Net earnings before minority share +

interest expense x 1(1 – tax rate)] 159,883 156,120

Long-term debt and equity 1,019,420 933,232

Return on investment 15.7% 16.7%

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Net Income Before Nonrecurring

• Return on Common Equity Items – Preferred Dividends

= Ending Common Equity

2011 2010

$138,204 $137,110

$810,292 $720,530

= 17.06% = 19.03%

d. Profits in relation to sales, assets, and equity have all declined. Turnover has remained
stable. Overall, although absolute profits have increased in 2011, compared with 2010, the
profitability ratios show a decline.

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PROBLEM 8-6

Net Income Before Noncontrolling Interest, Equity

a. 1. Net Profit Margin Income and Nonrecurring Items

= Net Sales

2011 2010 2009

$97,051 $51,419 $45,101

$1,600,000 $1,300,000 $1,200,000

= 6.07% = 3.96% = 3.76%

Net Income Before Noncontrolling

2. Return on Assets Interest and Nonrecurring Items

= Average Total Assets

2011 2010 2009

$97,051 $51,419 $45,101

$1,440,600 $1,220,000 $1,180,000

= 6.74% = 4.21% = 3.82%

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Net Sales
3. Total Asset Turnover
Average Total Assets
=

2011 2010 2009

$1,600,000 $1,300,000 $1,200,000

$1,440,600 $1,220,000 $1,180,000

= 1.11 times = 1.07 times = 1.02 times

per year per year per year

4. DuPont Analysis

Return on Assets = Net Profit Margin x Total Asset Turnover

2011: 6.74% = 6.07% x 1.11 times

2010: 4.24%* = 3.96% x 1.07 times

2009: 3.84%* = 3.76% x 1.02 times

*Rounding difference from the 4.21% and 3.82% computed in (2).

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Operating Income
5. Operating Income Margin
Net Sales
=

2011 2010 2009

(2) Net sales $ 1,600,000 $ 1,300,000 $ 1,200,000

Less:

Material and manufacturing

costs of products sold 740,000 624,000 576,000

Research and development 90,000 78,000 71,400

General and selling 600,000 500,500 465,000

$ 1,430,000 $ 1,202,500 $ 1,112,400

(1) Operating income $ 170,000 $ 97,500 $ 87,600

(1) Divided by (2) 10.63% 7.50% 7.30%

Operating Income
6. Return on Operating Assets
Average Operating Assets
=

2011 2010 2009

Operating Income $170,000 $97,500 $87,000

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Average Operating Assets $1,390,200 $1,160,000 $1,090,000

= 12.23% = 8.41% = 7.98%

Net Sales
7. Operating Asset Turnover
Average Operating Assets
=

2011 2010 2009

Net Sales $1,600,000 $1,300,000 $1,200,000

Average Operating Assets $1,390,200 $1,160,000 $1,090,000

= 1.15 times = 1.12 times = 1.10 times

8. DuPont Analysis with operating ratios

Return on Operating = Net Profit Margin x Total Asset Turnover

Assets

2011: 12.22%* = 10.63% x 1.15

2010: 8.40%* = 7.50% x 1.12

2009: 8.03% = 7.30% x 1.10

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*Rounding difference from the 12.23%, 8.41%, and 7.98% computed in (6).

Net Income Before Minority Share of Earnings and Nonrecurring

9. Return on Investment Items + [(Interest Expense) x (1 – Tax Rate)]

= Average (Long-Term Liabilities) + Equity

Estimated tax rate:

2011 2010 2009

(1) Provision for income taxes $ 62,049 $ 35,731 $ 32,659

(2) Earnings before income taxes and

minority equity $ 159,100 $ 87,150 $ 77,760

(1) ÷ (2) 39.00% 41.00% 42.00%

1 – tax rate 61.00% 59.00% 58.00%

(3) Interest expense x (1 – tax rate)

$19,000 x 61.00% 11,590

$18,200 x 59.00% 10,738

$17,040 x 58.00% 9,883

(4) Earnings before minority equity 97,051 51,419 45,101

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(3) + (4) (A) 108,641 62,157 54,984

(5) Total long-term debt 211,100 121,800 214,000

(6) Total stockholders’ equity 811,200 790,100 770,000

(5) + (6) = (B) 1,022,300 911,900 984,000

(A) ÷ (B) 10.63% 6.82% 5.59%

Net Income Before Nonrecurring Items –

10. Return on Total Equity Dividends on Redeemable Preferred Stock

= Average Total Equity

2011 2010 2009

Net income etc. $ 86,851 $ 42,919 $ 37,001

Average total equity $ 811,200 $ 790,100 $ 770,000

=10.71% = 5.43% = 4.81

b. All ratios computed indicate a significant improvement in profitability.

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PROBLEM 8-7

Net Income Before Noncontrolling Interest, Equity

a. 1. Net Profit Margin Income and Nonrecurring Items

= Net Sales

2011 2010 2009

$171,115 $163,497 $143,990

$1,002,100 $980,500 $900,000

= 17.08% = 16.67% = 16.00%

Net Income Before Noncontrolling

2. Return on Assets Interest and Nonrecurring Items

= Average Total Assets

2011 2010 2009

$171,115 $163,497 $143,990

$839,000 $770,000 $765,000

= 20.40% = 21.23% = 18.82%

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Net Sales
3. Total Asset Turnover
Average Total Assets
=

2011 2010 2009

$1,002,100 $980,500 $900,000

$839,000 $770,000 $765,000

= 1.19 = 1.27 times = 1.18 times

times per per year per year

year

4. DuPont Analysis

Return on Net Profit Total Asset Turnover

Assets = x
Margin

2011: 20.33%* = 17.08% x 1.19 times per year

2010: 21.17%* = 16.67% x 1.27 times per year

2009: 18.88%* = 16.00% x 1.18 times per year

*Rounding difference from the 20.40%, 21.23%, and 18.82% computed in (2).

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Net Income Before Noncontrolling Interest and Nonrecurring

5. Return on Investment Items + [(Interest Expense) x (1 – Tax Rate)]

= Average (Long-Term Liabilities) + Equity

Estimated tax rate:

2011 2010 2009

(1) Provision for income taxes $ 116,473 $ 113,616 $ 105,560

(2) Earnings before income taxes $ 287,588 $ 277,113 $ 249,550

Tax rate [(1) + (2)] 40.50% 41.00% 42.30%

1 – tax rate 59.50% 59.00% 57.70%

(3) Interest expense x (1 – tax rate)

$14,620 x 59.50% 8,699

$12,100 x 59.00% 7,139

$11,250 x 57.70% 6,491

(4) Net earnings 171,115 163,497 143,990

(3) + (4) = (A) 179,814 170,636 150,481

(5) Average long-term debt 120,000 112,000 101,000

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(6) Average shareholders’ equity 406,000 369,500 342,000

(5) + (6) = (B) 526,000 481,500 443,000

(A) ÷ (B) 34.19% 35.44% 33.97%

Net Income Before Nonrecurring Items –

6. Return on Total Equity Dividends on Redeemable Preferred Stock

= Average Total Equity

2011 2010 2009

Net earnings $171,115 $163,497 $143,990

Average total equity $406,000 $369,500 $342,000

= 42.15% = 44.25% = 42.10%

Net Sales
7. Sales to Fixed Assets
Average Net Fixed Assets
=

2011 2010 2009

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$1,002,100 $980,500 $900,000

$302,500 $281,000 $173,000

= 3.31 = 3.49 = 5.20

b. The ratios computed indicate a very profitable firm. Most ratios indicate a very slight
reduction in profitability in 2011.

Sales to fixed assets has declined materially, but this is the only ratio for which the trend
appears to be negative.

PROBLEM 8-8

Net Income Before Noncontrolling Interest, Equity

a. 1. Net Profit Margin Income and Nonrecurring Items

= Net Sales

2011 2010 2009

$20,070 – $8,028 $16,660 – $6,830 $15,380 – $6,229

$297,580 $256,360 $242,150

= 4.05% = 3.83% = 3.78%

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Net Income Before Minority Share of

2. Return on Assets Earnings and Nonrecurring Items

= Total Assets

2011 2010 2009

$20,070 – $8,028 $16,660 – $6,830 $15,380 – $6,229

$145,760 $137,000 $136,000

= 8.26% = 7.18% = 6.73%

Net Sales
3. Total Asset Turnover
Total Assets
=

2011 2010 2009

$297,580 $256,360 $242,150

$145,760 $137,000 $136,000

= 2.04 times = 1.87 times = 1.78 times

per year per year per year

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4. DuPont Analysis

Return on Operating Income Total Asset

= x
Assets Margin Turnover

2011: 8.26% = 4.05% x 2.04 times

2010: 7.16%* = 3.83% x 1.87 times

2009: 6.73% = 3.78% x 1.78 times

*Rounding difference from the 7.18% computed in (2).

Operating Income
5. Operating Income Margin
Net Sales
=

2011 2010 2009

$26,380 $22,860 $20,180

$297,580 $256,360 $242,150

= 8.86% = 8.92% = 8.33%

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Operating Income
6. Return on Operating Assets
End of Year Operating Assets
=

2011 2010 2009

$26,380 $22,860 $20,180

$89,800 + $45,850 $84,500 + $40,300 $83,100 + $39,800

= 19.45% = 18.32% = 16.42%

Net Sales
7. Operating Assets Turnover
End of Year Operating Assets
=

2011 2010 2009

$297,580 $265,360 $242,150

$89,800 + $45,850 $84,500 + $40,300 $83,100 + $39,800

= 2.19 = 2.13 times = 1.97 times

times per per year per year

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8. DuPont Analysis

Return on Operating Operating Income Operating Asset

= x
Assets Margin Turnover

2011: 19.40%* = 8.86% x 2.19 times

2010: 18.29%* = 8.92% x 2.05 times

2009: 16.41%* = 8.33% x 1.97 times

*Rounding difference from the 19.45%, 18.32%, and 16.42% computed in (6).

Gross Profit
9. Gross Profit Margin
Net Sales
=

2011 2010 2009

$91,580 $80,060 $76,180

$297,580 $256,360 $242,150

= 30.77% = 31.23% = 31.46%

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b. Net profit margin and total asset turnover both improved. This resulted in a substantial
improvement to return on assets.

Operating income margin declined slightly in 2011 after a substantial improvement in 2010.
Operating asset turnover improved each year. The result of the improvement in operating
income margin and operating asset turnover was a substantial improvement in return on
operating assets.

Gross profit margin declined slightly each year.

Overall profitability improved substantially over the three-year period.

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PROBLEM 8-9

Net Income Before Noncontrolling

a. 1. Return on Assets Interest and Nonrecurring Items

= End of Year Total Assets

2011 2010 2009

(A) $ 2,100,000 $ 1,950,000 $ 1,700,000

$ 2,600,000 $ 2,300,000 $ 2,200,000

7,000,000 6,200,000 5,800,000

100,000 100,000 100,000

10,000,000 9,000,000 8,300,000

(B) $ 19,700,000 $ 17,600,000 $ 16,400,000

(A) ÷ (B) 10.66% 11.08% 10.37%

Net Income Before Noncontrolling Interest and Nonrecurring

2. Return on Investment Items + [(Interest Expense) x (1 – Tax Rate)]

= End of Year (Long-Term Liabilities + Equity)

Estimated tax rate:

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2011 2010 2009

(1) Provision for income taxes $ 1,500,000 $ 1,450,000 $ 1,050,000

(2) Income before tax 3,600,000 3,400,000 2,750,000

Tax rate = (1) ÷ (2) 41.67% 42.65% 38.18%

1 – tax rate 58.33% 57.35% 61.82%

(3) Interest expense x (1 – tax rate)

$800,000 x 58.33% $ 466,640

$600,000 x 57.35% $ 344,100

$550,000 x 61.82% $ 340,010

(4) Net income $ 2,100,000 $ 1,950,000 $ 1,700,000

(3) + (4) (A) $ 2,566,640 $ 2,294,100 $ 2,040,010

Long-term debt $ 7,000,000 $ 6,200,000 $ 5,800,000

Preferred stock 100,000 100,000 100,000

Common equity 10,000,000 9,000,000 8,300,000

(B) $ 17,100,000 $ 15,300,000 $ 14,200,000

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(A) ÷ (B) 15.01% 14.99% 14.37%

Net Income Before Nonrecurring Items –

3. Return on Total Equity Dividends on Redeemable Preferred Stock

= Ending Total Equity

2011 2010 2009

$2,100,000 $1,950,000 $1,700,000

$100,000 + $10,000,000 $100,000 + $9,000,000 $100,000 + $8,300,000

= 20.79% = 21.43% = 20.24%

Net Income Before Nonrecurring

4. Return on Common Equity Items – Preferred Dividends

= Ending Common Equity

2011 2010 2009

$2,100,000 – $14,000 $1,950,000 – $14,000 $1,700,000 – $14,000

$10,000,000 $9,000,000 $8,300,000

= 20.86% = 21.51% = 20.31%

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b. Return on assets improved in 2010 and then declined in 2011. Return on investment
improved each year. Return on total equity improved and then declined. Return on common
equity improved and then declined.

In general, profitability has improved in 2010 over 2009 but was down slightly in 2011.

c. The use of long-term debt and preferred stock both benefited profitability.

Return on common equity is slightly more than return on total equity, indicating a benefit
from preferred stock.

Return on total equity is substantially higher than return on investment, indicating a benefit
from long-term debt.

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PROBLEM 8-10

a.

Sales $ 120,000

Gross profit (40%) 48,000

Cost of goods sold (60%) $ 72,000

Beginning inventory $ 10,000

+ Purchases 100,000

Total available $ 110,000

– Ending inventory ?

Cost of goods sold $ 72,000

Ending inventory ($110,000 – $72,000) $ 38,000

b. If gross profit were 50%, the analysis would be as follows:

Sales $ 120,000

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Gross profit (50%) 60,000

Cost of goods sold (50%) $ 60,000

Beginning inventory $ 10,000

+ Purchases 100,000

Total available $ 110,000

– Ending inventory 50,000

Cost of goods sold $ 60,000

Ending inventory ($110,000 – $60,000) $50,000

If gross profit were higher, the loss would be higher because ending inventory would be
estimated at $50,000 instead of $38,000.

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PROBLEM 8-11

Total

Net Retained Stockholders’

Profit Earnings Equity

a. A stock dividend is

declared and paid. 0 - 0

b. Merchandise is

purchased on credit. 0 0 0

c. Marketable securities are

sold above cost. + + +

d. Accounts receivable are

collected. 0 0 0

e. A cash dividend is

declared and paid. 0 - -

f. Treasury stock is

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purchased and recorded

at cost. 0 0 -

g. Treasury stock is

sold above cost. 0 0 +

h. Common stock is sold. 0 0 +

i. A fixed asset is sold for

less than book value. - - -

j. Bonds are converted into

common stock. 0 0 +

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PROBLEM 8-12

Net Income Before Noncontrolling Interest, Equity

a. 1. Net Profit Margin Income and Nonrecurring Items

= Net Sales

$72,700
2011: = 7.42%
$980,000

$64,900
2010: = 6.76%
$960,000

$57,800
2009: = 6.15%
$940,000

$51,200
2008: = 5.69%
$900,000

$44,900
2007: = 5.10%
$880,000

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Net Sales
2. Total Asset Turnover
Average Total Assets
=

$980,000
2011: = 1.14 times per year
($859,000 +

$861,000)/2

$960,000
2010: = 1.11 times per year
($861,000 +

$870,000)/2

$940,000
2009: = 1.08 times per year
($870,000 +

$867,000)/2

$900,000
2008: = 1.04 times per year
($867,000 +

$863,000)/2

2007: Cannot compute average assets.

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Year-End Balance Sheet Figures – Total Asset Turnover

$980,000
2011: = 1.14 times per year
$859,000

$960,000
2010: = 1.11 times per year
$861,000

$940,000
2009: = 1.08 times per year
$870,000

$900,000
2008: = 1.04 times per year
$867,000

$880,000
2007: = 1.02 times per year
$863,000

Net Income Before Noncontrolling and

3. Return on Assets Nonrecurring Items

= Average Total Assets

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Average Balance Sheet Figures

$72,700
2011: = 8.45%
($859,000 +

$861,000)/2

$64,900
2010: = 7.50%
($861,000 +

$870,000)/2

$57,800
2009: = 6.66%
($870,000 +

$867,000)/2

$51,200
2008: = 5.92%
($867,000 +

$863,000)/2

2007: Cannot compute average assets.

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Year-End Balance Sheet Figures – Return on Assets

$72,700
2011: = 8.46%
$859,000

$64,900
2010: = 7.54%
$861,000

$57,800
2009: = 6.64%
$870,000

$51,200
2008: = 5.91%
$867,000

$44,900
2007: = 5.20%
$863,000

4. DuPont Return on Assets = Net Profit Margin x Total Asset Turnover

Average Balance Sheet Figures

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Net Profit Margin Total Asset Turnover

2011: 7.42% X 1.14 times = 8.46%

2010: 6.76% X 1.11 times = 7.50%

2009 6.15% X 1.08 times = 6.64%

2008: 5.69% X 1.04 times = 5.92%

2007: Cannot compute average assets

Year-End Balance Sheet Figures

Net Profit Margin Total Asset Turnover

2011: 7.42% X 1.14 times = 8.46%

2010: 6.76% X 1.11 times = 7.50%

2009 6.15% X 1.08 times = 6.64%

2008: 5.69% X 1.04 times = 5.92%

2007: 5.10% X 1.02 times = 5.20%

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Operating Income
5. Operating Income Margin
Net Sales
=

$355,000 – $240,000
2011:
= 11.73%
$980,000

$344,000 – $239,000
2010:
= 10.94%
$960,000

$333,000 – $238,000
2009:
= 10.11%
$940,000

$320,000 – $239,000
2008:
= 9.00%
$900,000

$314,000 – $235,000
2007:
= 8.98%
$880,000

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Net Sales
6. Operating Asset Turnover
Average Operating Assets
=

$980,000
2011: = 1.26 times per year
($859,000 – $80,000 – $861,000 – $85,000)/2

$960,000
2010: = 1.23 times per year
($861,000 – $85,000 – $870,000 – $90,000)/2

$940,000
2009: = 1.21 times per year
($870,000 – $90,000 – $867,000 – $95,000)/2

$900,000
2008: = 1.17 times per year
($867,000 – $95,000 – $863,000 – $100,000)/2

2007: Average assets cannot be computed.

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Year-End Balance Sheet Figures – Operating Asset Turnover

$980,000
2011: = 1.26 times per year
$859,000 – $80,000

$960,000
2010: = 1.24 times per year
$861,000 – $85,000

$940,000
2009: = 1.21 times per year
$870,000 – $90,000

$900,000
2008: = 1.17 times per year
$867,000 – $95,000

$880,000
2007: = 1.15 times per year
$863,000 – $100,000

7. Return on Operating Assets = Operating Income

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Average Operating Assets

$355,000 – $240,000
2011:
= 14.79%
($859,000 – $80,000 – $861,000 – $85,000)/2

$344,000 – $239,000
2010:
= 13.50%
($861,000 – $85,000 – $870,000 – $90,000)/2

$333,000 – $238,000
2009:
= 12.24%
($870,000 – $90,000 – $867,000 – $95,000)/2

$320,000 – $239,000
2008:
= 10.55%
($867,000 – $95,000 – $863,000 – $100,000)/2

2007: Average assets cannot be computed.

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Year-End Balance Sheet Figures – Return on Operating Assts

$355,000 – $240,000
2011:
= 14.76%
$859,000 – $80,000

$344,000 – $239,000
2010:
= 13.53%
$861,000 – $85,000

$333,000 – $238,000
2009:
= 12.81%
$870,000 – $90,000

$320,000 – $239,000
2008:
= 10.49%
$867,000 – $95,000

$314,000 – $235,000
2007:
= 10.35%
$863,000 – $100,000

8. DuPont Return on Operating Assets Operating Income Margin x

= Operating Asset Turnover

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Average Balance Sheet Figures

Operating Operating Return on Operating

Income Margin Assets
Asset Turnover

2011: 11.73% X 1.26 = 14.78%

2010: 10.94% X 1.23 = 13.46%

2009 10.11% X 1.21 = 12.23%

2008: 9.00% X 1.17 = 10.53%

2007: Average assets cannot be computed

Year-End Balance Sheet Figures

Operating Operating Return on Operating

Income Margin Assets
Asset Turnover

2011: 11.73% X 1.26 = 14.78%

2010: 10.94% X 1.23 = 13.46%

2009 10.11% X 1.21 = 12.23%

2008: 9.00% X 1.17 = 10.53%

2007: 8.98% X 1.15 = 10.33%

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Net Sales
9. Sales to Fixed Assets
Average Net Fixed Assets
=

$980,000
2011: = 1.98
($500,000 +

$491,000)/2

$960,000
2010: = 1.97
($491,000 +

$485,000)/2

$940,000
2009: = 1.95
($485,000 +

$479,000)/2

$900,000
2008: = 1.90
($479,000 +

$470,000)/2

2007: Average net fixed assets cannot be computed.

Year-End Balance Sheet Figures – Sales to Fixed Assets

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$980,000
2011: = 1.96
$500,000

$960,000
2010: = 1.96
$491,000

$940,000
2009: = 1.94
$485,000

$900,000
2008: = 1.88
$479,000

$880,000
2007: = 1.87
$470,000

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Net Income Before Noncontrolling Interest and Nonrecurring

10. Return on Investment Items + [Interest Expense x (1 – Tax Rate)]

= Average (Long-Term Liabilities + Equity)

Average Balance Sheet Figures

$72,700 + $6,500(1 – 0.33)

2011:
= 11.58%
($859,000 – $194,000 + $861,000 –

$195,500)/2

$64,900 + $6,700(1 – 0.34)

2010:
= 10.35%
($861,000 – $195,500 + $870,000 –

$195,500)/2

$57,800 + $8,000(1 – 0.34)

2009:
= 9.37%
($870,000 – $195,500 + $867,000 –

$195,000)/2

$51,200 + $8,100(1 – 0.30)

2008:
= 8.50%
($867,000 – $195,000 + $863,000 –

$196,500)/2

2007: Average long-term liabilities + equity cannot be computed.

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Year-End Balance Sheet Figures – Return on Investment

$72,700 + $6,500(1 – 0.33)

2011:
= 11.59%
$859,000 – $194,000

$64,900 + $6,700(1 – 0.34)

2010:
= 10.42%
$861,000 – $195,500

$57,800 + $8,000(1 – 0.34)

2009:
= 9.35%
$870,000 – $195,500

$51,200 + $8,100(1 – 0.30)

2008:
= 8.46%
$867,000 – $195,000

$44,900 + $11,000(1 – 0.34)

2007:
= 7.83%
$863,000 – $196,500

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Net Income Before Nonrecurring Items –

11. Return on Total Equity Dividends on Redeemable Preferred Stock

= Average Total Equity

Average Balance Sheet Figures

$72,700 – $6,400
2011:
= 12.77%
($520,000 +

$518,000)/2

$64,900 – $6,400
2010:
= 11.33%
($518,000 +

$515,000)/2

$57,800 – $6,400
2009:
= 10.03%
($515,000 +

$510,000)/2

$51,200 – $6,400
2008:
= 8.38%
($510,000 +

$559,000)/2

2007: Average total equity cannot be computed.

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Year-End Balance Sheet Figures – Return on Total Equity

$72,700 – $6,400
2011:
= 12.75%
$520,000

$64,900 – $6,400
2010:
= 11.29%
$518,000

$57,800 – $6,400
2009:
= 9.98%
$515,000

$51,200 – $6,400
2008:
= 8.78%
$510,000

$44,900
2007: = 8.03%
$559,000

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Net Income Before Nonrecurring

12. Return on Common Equity Items – Preferred Dividends

= Average Common Equity

Average Balance Sheet Figures

$72,700 – $6,400 – $6,300

2011:
= 13.36%
($520,000 – $70,000 + $518,000 – $70,200)/2

$64,900 – $6,400 – $6,300

2010:
= 11.69%
($518,000 – $70,000 + $515,000 – $70,000)/2

$57,800 – $ 6,400 – $6,300

2009:
= 10.19%
($515,000 – $70,000 + $510,000 – $70,000)/2

$51,200 – $6,400 – $6,300

2008:
= 8.76%
($510,000 – $70,000 + $559,000 – $120,000)/2

2007: Average common equity cannot be computed.

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Year-End Balance Sheet Figures – Return on Common Equity

$72,700 – $6,400 – $6,300

2011:
= 13.33%
$520,000 – $70,000

$64,900 – $6,400 – $6,300

2010:
= 11.65%
$518,000 – $70,000

$57,800 – $ 6,400 – $6,300

2009:
= 10.13%
$515,000 – $70,000

$51,200 – $6,400 – $6,300

2008:
= 8.75%
$510,000 – $70,000

$44,900 – $10,800
2007:
= 7.77%
$559,000 – $120,000

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Gross Profit
13. Gross Profit Margin
Net Sales
=

$355,000
2011: = 36.22%
$980,000

$344,000
2010: = 35.83%
$960,000

$333,000
2009: = 35.43%
$940,000

$320,000
2008: = 35.56%
$900,000

$314,000
2007: = 35.68%
$880,000

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b. In general, the profitability appears to be very good and the trend is positive.

There was not a significant difference in results between using average balance sheet
figures and year-end figures. The year-end figure allowed for an additional year was not
a very profitable year in relation to subsequent years.

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PROBLEM 8 - 13

a. 4 Interest expense represents a recurring item.

b. 5 Ideally, return on common equity will indicate the highest return. This is the way
it should be since the common equity holders take the most risk.

c. 3 A selling price increase would increase the gross profit.

d. 2 It would not be feasible to estimate administrative expenses by using gross

profit analysis.

e. 2 Total asset turnover measures the ability of the firm to generate sales through the use
of assets.

f. 4 Equity earnings can represent a problem in analyzing profitability because equity

earnings are not from operations.

g. 1 Intangibles are not considered to be an operating asset.

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h. 4 Earnings based on percent of holdings by outside owners of consolidated subsidiaries

are termed minority earnings.

i. 1 Net profit margin x total asset turnover measures DuPont return on assets.

j. 4 If net profit margin declines and the total asset turnover declines, then the return on
assets cannot rise.

k. 3 A reason that equity earnings create a problem in analyzing profitability is

because equity earnings are usually less than the related cash flow.

l. 3 Usually the return on common equity will have the highest percent of the ratios listed.

m. 4 Usually the return on total assets will have the lowest percent of the ratios listed.

n. 4 Gain from selling land will be reported on the income statement.

o. 5 None of the above describes minority share of earnings.

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p. 1 Purchase of land at year-end could cause return on assets to decline when the net profit
margin is increasing. The year-end purchase of land would not have contributed to
profits.

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PROBLEM 8 - 14

a. 1.

Balance in account $400,000

Adjustment needed 200,000

Adjusting to $600,000

Adjusting to $600,000 will result in $200,000 in expense for the current year.

2.

Balance in account $400,000

Adjustment needed 500,000

Adjusting to $900,000

Adjusting to $900,000 will result in $500,000 in expense for the current year.

b. No. Payments will result from meeting obligations. The warranty obligation account could
be too high or too low.

c. The account should not be manipulated. It would not be ethical to provide too much or too
little on the account with the objective of manipulating profits.

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Chapter 9

For the Investor

PROBLEMS

PROBLEM 9-1

Earnings Before Interest, Tax, Noncontrolling Interest,

Equity Income and Nonrecurring Items
Degree of Financial Leverage

= Earnings Before Tax, Noncontrolling Interest, Equity

Income, and Nonrecurring Items

$975,000 + $70,000 $1,045,000

= = 1.07
$975,000 $975,000

PROBLEM 9-2

Earnings Before Interest, Tax

Noncontrolling Interest, Equity Income,
and Nonrecurring Items
a. Degree of Financial Leverage
=
Earnings Before Tax, Noncontrolling
Interest, Equity Income, and Nonrecurring
Items

$1,000,000
=
$800,000

= 1.25
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b. Prior earnings before interest and tax $ 1,000,000

10% increase 100,000

Adjusted income before interest and tax $ 1,100,000

Interest 200,000

Income before tax $ 900,000

Tax (50% rate) 450,000

Net income 450,000

Earnings will increase by 12.5% to $450,000

($400,000 x 112.5% = $450,000)

c. $800,000 Earnings before interest and tax

200,000 Interest

600,000 Earnings before tax

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300,000 Tax

$300,000 Net Income

This is a decline in profit of 25%.

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PROBLEM 9-3

Net Income – All Dividends

a. 1. Percentage of Earnings Retained

= Net Income

2011 2010 2009

Net income (A) $ 31,200,000 $ 30,600,000 $ 29,800,000

Less:

Common dividend 21,700,000 19,500,000 18,360,000

Preferred dividend 910,000 910,000 910,000

(B) $ 22,610,000 $ 20,410,000 $ 19,270,000

(A) – (B) = (C) 8,590,000 10,190,000 10,530,000

(C) ÷ (A) 27.53% 33.30% 35.34%

Market Price Per Share

2. Price/Earnings Ratio
Fully Diluted Earnings Per Share
=

2011 2010 2009

$12.80 $14.00 $16.30

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$1.12 $1.20 $1.27

= 11.43 = 11.67 = 12.83

Dividends Per Common Share

3. Dividend Payout
Fully Diluted Earnings Per Share
=

2011 2010 2009

$0.90 $0.85 $0.82

$1.12 $1.20 $1.27

= 80.36% = 70.83% = 64.57%

Dividends Per Common Share

4. Dividend Yield
Market Price Per Common Share
=

2011 2010 2009

$0.90 $0.85 $0.82

$12.80 $14.00 $16.30

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= 7.03% = 6.07% = 5.03%

Total Stockholders' Equity – Preferred Stock Equity

5. Book Value Per Share

= Number of Common Shares Outstanding

2011 2010 2009

Total assets: $ $1,280,100,000 $ $1,267,200,000 $ 1,260,400,000

Less:

Liabilities (800,400,000) (808,500,000) (799,200,000)

Stockholders’ Equity 479,700,000 458,700,000 461,200,000

Less:

Nonredeemable
preferred stock
(15,300,000) (15,300,000) (15,300,000)

(A) Common stock

equity
$ $464,400,000 $ $443,400,000 $ $445,900,000

(B) Shares
24,280,000 23,100,000 22,500,000
outstanding end

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of year

(A) ÷ (B) $ $19.13 $ $19.19 $ $19.82

b. The percentage of earnings retained is decreasing. The related ratio, dividend payout, is
therefore increasing.

The price/earnings ratio has been relatively stable. The dividend yield has increased and is
relatively high. The market price per share is substantially below the book value. It appears
that this stock is being purchased for the relatively high dividend and not for growth
potential.

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PROBLEM 9-4

Net Income – All Dividends

a. 1. Percentage of Earnings Retained
=
Net Income

2011 2010 2009

Net income (B) $ 9,100,000 $ 13,300,000 $ 16,500,000

Less:

Cash dividends (A) (6,080,000) (5,900,000) (6,050,000)

$ 3,020,000 $ 7,400,000 $ 10,450,000

(A) ÷ (B) 33.19% 55.64% 63.33%

Market Price Per Share

2. Price/Earnings Ratio
Fully Diluted Earnings Per Share
=

2011 2010 2009

$41.25 $35.00 $29.00

$2.30 $3.40 $4.54

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= 17.93 = 10.29 = 6.39

Dividends Per Common Share

3. Dividend Payout
Fully Diluted Earnings Per Share
=

2011 2010 2009

$1.90 $1.90 $1.90

$2.30 $3.40 $4.54

= 82.61% = 55.88% = 41.85%

Dividends Per Common Share

4. Dividend Yield
Market Price Per Common Share
=

2011 2010 2009

$1.90 $1.90 $1.90

$41.25 $35.00 $29.00

= 4.61% = 5.43% = 6.55%

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Market Price Value

5. Book Value Per Share
Ratio of Market Price to Book Value
=

2011 2010 2009

$41.25 $35.00 $29.00

120.5% 108.0% 105.0%

= $34.23 = $32.41 = $27.62

b. The percentage of earnings retained materially declined. The related ratio, dividend payout,
materially increased.

The price earnings ratio materially increased, which is difficult to explain, considering the
decline in earnings and the other ratios computed. The dividend yield has declined each
year, while the book value per share increased each year.

The increase in market price and the increase in price earnings ratio appears to be explained
by the increase in order backlog at year-end and the increase in net contracts awarded.

PROBLEM 9-5

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PROBLEM 9-5

Net Income – Preferred Dividends

Simple Earnings Per Share

Weighted Average Number of
= Common Shares Outstanding

Year 1 Year 2

$40,000 – $22,500 $42,000 – $27,500

38,000 38,000

$0.46 $0.38

The decline in earnings per share is caused mainly by the issuance of preferred stock.

PROBLEM 9-6

January 1, shares outstanding 50,000 shares

July 1, two-for-one stock split 2

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Adjusted shares outstanding for the year (A) 100,000

October 1 stock issue 10,000 shares

Proportion of year that the new shares were outstanding 0.25

Weighted average for the new shares on an annual

basis (B) 2,500

Denominator of the earnings per share

computation for the current year (A) + (B) 102,500

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PROBLEM 9-7

Revision of 2010 earnings per share:

2010 reported earnings per share $ 2.00

July 1, 2011 stock split x 0.5

Adjusted 2010 earnings per share $ 1.00

December 31, 2011 stock split x 0.5

Adjusted 2010 earnings per share $ 0.50

Comparative Earnings Per Share

2011 2010

Earnings Per Share $1.50 $.50

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PROBLEM 9-8

a. Numerator Denominator

Net income $ 35,000

Preferred dividends (3,000)

January 1, 2011 shares of common stock

outstanding 20,000

July 1, 2011 common stock issue, 1,000 shares

x½ 500

$ 32,000 20,500

Earnings per share $1.56

b. From (a) $ 32,000 20,500 shares

Less extraordinary gain 5,000

$ 27,000 20,500

Recurring earnings per share $1.32

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PROBLEM 9-9

a. Numerator Denominator

Net income $ 200,000

Preferred dividends (10,000)

Common shares outstanding on

January 1 20,000 shares

Common stock issue on July 1,

5,000 shares 2,500 (5,000 x ½)

Weighted average 22,500

Two-for-one stock split on

December 31 2

(a) $ 190,000 (b) 45,000 shares

Earnings per share (a) ÷ (b) $4.27

b. Current Year Prior Year

Earnings per share reported

for the prior year $8.00

Two-for-one stock split on

December 31 of the current year ($8.00

$4.00

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x 0.5) = $4.00

Earnings per share computed

in (a) for the current year $4.27

PROBLEM 9-10

Net Income – All Dividends

a. 1. Percentage of Earnings Retained

= Net Income

2011 2010

Cash dividends $0.80 x 25,380,000 $0.76 x 25,316,000

$20,304,000 $19,240,160

Preferred dividends 4,567,000 930,000

Total dividends 24,871,000 20,170,160

Net income (B) 32,094,000 31,049,000

Net income – dividends (A) 7,223,000 10,878,840

Percentage of earnings
retained (A) ÷ (B) 22.51% 35.04%

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Market Price
2. Price/Earnings Ratio
Fully Diluted Earnings Per Share
=

2011 2010

$12.94 $15.19

$1.08 $1.14

= 11.98% = 13.32%

Dividends Per Share

3. Dividend Payout
Fully Diluted Earnings Per Share
=

2011 2010

$0.80 $0.76

$1.08 $1.14

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= 74.07% = 66.67%

Dividends Per Share

4. Dividend Yield
Market Price Per Share
=

2011 2010

$0.80 $0.76

$12.94 $15.19

= 6.18% = 5.00%

Common Equity
5. Book Value Per Share
Shares Outstanding
=

2011 2010

Total assets $ 1,264,086,000 $ 1,173,924,000

Less: total liabilities (823,758,000) (742,499,000)

Less: nonredeemable preferred stock (16,600,000) (16,600,000)

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Common equity (A) $ 423,728,000 $ 414,825,000

Shares outstanding + 25,380,000 + 25,316,000

Book value per share (A) ÷ (B) $16.70 $16.39

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b. Having the percentage of earnings retained decline provides mixed feelings. It implies that
more is going to shareholders, but at the same time, earnings retained for growth have
diminished. The rise in the dividend payout ratio supports this position.

The price/earnings ratio has declined as a result of the drop in price. This decline indicates
lower shareholder expectations but might also indicate a good time to buy.

Dividend yield is up, caused by the rise in dividends and more so by the drop in price.

Book value per share is up. However, book value is above market, which shows that the
investors do not view the assets as worth their book value. This is not a good sign.

Overall the signals are mixed. There is not enough information to determine if this is a good
security.

PROBLEM 9-11

a. The major advantage of receiving stock appreciation rights instead of stock options is that the
executive does not have to make a big cash outlay at the date of exercise, but rather receives
a payment for the share appreciation. This helps the executive’s cash flow.

b. The related credit is to a liability under the stock appreciation plan that would probably be
classified as long-term, since exercise cannot occur until 2014.

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c. In 2014, the company must pay off the liability related to the appreciation in cash. For
this problem, it is $30,000. In doing financial statement analysis, this future cash flow, if
material, must be considered. As in this case, the full impact may not be apparent until the
last year, if the market price rises sharply.

PROBLEM 9-12

a. 3 Common shareholders’ equity divided by the number of common chares outstanding

gives book value per share.

Total Stockholders’ Equity –

b. 2 Book Value Per Share Preferred Stock (At Liquidation)

Number of Common Shares Outstanding

$1,000,000 + $1,500,000 + $500,000 + $1,100,000

= $12.67
150,000 Shares

PROBLEM 9-13

a. 1. Degree of Financial Leverage Earnings Before Interest, Tax, Noncontrolling

= Interest, Equity Income, and Nonrecurring Items

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Earnings Before Tax, Noncontrolling Interest, Equity

Income, and Nonrecurring Items

$110,500 + $9,500
2011: = 1.09
$110,500

$107,700 + $6,600
2010: = 1.06
$107,700

$100,450 + $6,800
2009: = 1.07
$100,450

$124,100 + $6,900
2008: = 1.06
$124,100

$119,000 + $7,000
2007: = 1.06
$119,000

2. Earnings Per Common Share

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2011: Continuing operations $ 2.67*

Extraordinary gain .69

$ 3.36

* Should be used in primary analysis.

2010: $2.57

2009: $2.36

2008: $3.23

2007: $2.81

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Market Price Per Share

3. Price/Earnings Ratio
Earnings Per Share
=

$24.00
2011: = 8.99
$2.67

$22.00
2010: = 8.56
$2.57

$21.00
2009: = 8.90
$2.36

$37.00
2008: = 11.46
$3.23

$29.00
2007: = 10.32
$2.81

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Net Income – All Dividends

4. Percentage of Earnings Retained

= Net Income

$97,500 – $3,920 – $91,640

2011:
= 1.99%
$97,500

$74,400 – $6,100 – $66,410

2010:
= 2.54%
$74,400

$68,350 – $6,400 – $60,900

2009:
= 1.54%
$68,350

$93,700 – $6,600 – $84,970

2008:
= 2.27%
$93,700

$81,600 – $6,000 – $81,200

2007:
= (6.86%)
$81,600
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Dividends Per Common Share

5. Dividend Payout
Fully Diluted Earnings Per Share
=

$3.16
2011: = 118.35%
$2.67

$2.29
2010: = 89.11%
$2.57

$2.10
2009: = 88.98%
$2.36

$2.93
2008: = 90.71%
$3.23

$2.80
2007: = 99.64%
$2.81

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Dividends Per Common Share

6. Dividend Yield
Market Price Per Common Share
=

$3.16
2011: = 13.17%
$24.00

$2.29
2010: = 10.41%
$22.00

$2.10
2009: = 10.00%
$21.00

$2.93
2008: = 7.92%
$37.00

$2.80
2007: = 9.66%
$29.00

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Total Stockholders’ Equity – Preferred Stock Equity

7. Book Value Per Share

= Number of Common Shares Outstanding

$489,000 – $49,000
2011:
= $15.17
29,000

$514,000 – $76,000
2010:
= $15.10
29,000

$516,000 – $80,000
2009:
= $15.03
29,000

$517,000 – $82,000
2008:
= $15.00
29,000

$508,000 – $75,000
2007:
= $14.93
29,000

8. Materiality of Options = Stock Options Outstanding

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Number of Shares of Common Stock Outstanding

$1,000,000
2007 - 2011: = 3.45%
29,000,000

b. This firm has a very low degree of financial leverage.

Earnings from continuing operations and the price/earnings ratio have been relatively stable.

Practically all of the earnings have been paid out in dividends, thus, book value per share has
only increased slightly.

The dividend yield is very high. The market price has declined substantially.

Options outstanding appear to be immaterial.

In general, the investor analysis is positive if the investor wants high dividends. Growth
prospects do not appear to be good.

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PROBLEM 9-14

a. 3

2011 2010 2009

EPS previously reported ----- $1.00 $.80
2011 declared a 4-for-1 stock split .25 .20
2011 reported .30 EPS .30 .25 .20

b. 4

New EBIT $ 2,000,000

Prior EBIT 1,000,000
(a) $ 1,000,000
Financial leverage (b) 1.5
(a) x (b) $ 1,500,000

c. 4 Adjust the shares in 2011 by adding 10% additional shares. Divide the previous
number of shares for 2011 by the new number of shares. This is the percentage
of the previous reported earnings per share that should be reported as the
adjusted earnings per share. For illustration, assume the following;

(A) Previous shares 100,000

10% stock dividend 10,000
(B) New number of shares 110,000
(A) ÷ (B) 100,000/110,000 = .909

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d. 3 The price/earnings ratio usually reflects investor’s opinions of the future

prospects for the firm.

e. 4 Degree of financial leverage gives a perspective on risk in the capital structure.

f. 3 The earnings per share ratio is computed for common stock.

g. 2 Increasing financial leverage can be a risky strategy from the viewpoint

of stockholders of companies having low and falling profits.

h. 1 10% x 1.3 = 13%

i. 2 Dividend yield represents dividends per common share in relation to market

price per common share.

j. 5 Book value per share may not approximate market value per share because of all
of the reasons listed.

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