SM Chapter 13.doc

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CHAPTER 13

Financial Statement Analysis

OVERVIEW OF EXERCISES, PROBLEMS, AND CASESEstimated

Time inLearning Objective Exercises Minutes Level

1. Explain the various limitations and considerations in financialstatement analysis.

2. Use comparative financial statements to analyze a company 12* 45 Modover time (horizontal analysis). 13* 30 Mod

3. Use common-size financial statements to compare various 12* 45 Modfinancial statement items (vertical analysis). 13* 30 Mod

4. Compute and use various ratios to assess liquidity. 1 15 Mod2 15 Mod3 30 Mod4 20 Mod

5 30 Mod

5. Compute and use various ratios to assess solvency. 6 20 Mod7 20 Mod

6. Compute and use various ratios to assess profitability. 8 20 Mod9 20 Mod

10 15 Mod11 10 Mod

7. Explain how to report on and analyze other income statementitems (Appendix)

*Exercise, problem, or case covers two or more learning objectivesLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)


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13-2 FINANCIAL ACCOUNTING SOLUTIONS MANUAL

Problems Estimatedand Time in

Learning Objective Alternates Minutes Level


2. Use comparative financial statements to analyze a company overtime (horizontal analysis).

3. Use common-size financial statements to compare various financialstatement items (vertical analysis).

4. Compute and use various ratios to assess liquidity. 1 40 Mod2 40 Mod5* 30 Mod7* 40 Mod

5. Compute and use various ratios to assess solvency. 1# 30 Mod2# 30 Mod5* 30 Mod

6* 40 Diff 7* 40 Mod

6. Compute and use various ratios to assess profitability. 3 20 Mod4 60 Diff 5* 30 Mod6* 40 Diff 7* 40 Mod

7. Explain how to report on and analyze other income statementitems (Appendix).

*Exercise, problem, or case covers two or more learning objectives

#Alternate problem onlyLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)


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CHAPTER 13 FINANCIAL STATEMENT ANALYSIS 13-3

EstimatedTime in

Learning Objective Cases Minutes Level


2. Use comparative financial statements to analyze a company over 1 45 Modtime (horizontal analysis).

3. Use common-size financial statements to compare various 2 45 Modfinancial statement items (vertical analysis). 3 45 Mod

6 45 Mod

4. Compute and use various ratios to assess liquidity. 4* 45 Mod5* 45 Mod7* 45 Diff 8 30 Med

5. Compute and use various ratios to assess solvency. 4* 45 Mod

5* 45 Mod7* 45 Diff

6. Compute and use various ratios to assess profitability. 4* 45 Mod5* 45 Mod

7. Explain how to report on and analyze other income statementitems (Appendix)

*Exercise, problem, or case covers two or more learning objectivesLevel = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)


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Q U E S T I O N S

1. The inventory valuation method used by a company will have a significanteffect on many ratios. Depending on the relative movement of prices, thechoice between LIFO and FIFO will result in significantly different amountsreported for inventory. For example, in a period of rising prices, the use ofLIFO will reduce inventory (relative to what it would have been underFIFO) and thus reduce the current ratio and the acid-test ratio. Theinventory turnover ratio will differ as well, because LIFO will result in morecost of goods sold expense. Thus, all other things being equal, in a periodof rising prices, a LIFO company will report a higher turnover of inventorythan a FIFO company. The LIFO companys cash flow will be betterbecause it will pay less in taxes. Thus, the various ratios that involve cashfrom operations will be affected. Finally, the profitability ratios will beaffected by the choice of an inventory method. For example, the LIFOcompany will report lower profits and thus have a lower profit margin.

2. One of the difficulties in comparing a companys ratios with industrystandards is that the standards are an average for all companiessurveyed. First, your company may be much larger or smaller than theaverage company in the survey. Second, many large companies today areconglomerates, and their operations cross over the traditional boundariesof any one industry. This makes comparison with industry standardsdifficult. Finally, your company may use different accounting methods thanmost others in the survey. If your company uses straight-line depreciationbut a majority of the sample companies use accelerated depreciation,comparisons can be difficult.

3. Published financial statements, as well as those often used bymanagement, are based on historical costs and have not been adjusted forinflation. Trend analysis is one type of analysis that must be performedwith particular caution if inflation is significant. An increase in sales, forexample, may be due to an increase in prices, rather than to an increasein the number of units sold. Inflation affects the various financialstatements differently. Some period expenses, such as advertising, areusually not seriously misstated in historical cost terms. However,depreciation based on costs paid for assets that are fifty years old will bemuch different from depreciation adjusted for the effects of inflation.

4. The analysis of financial statements over a series of years is calledhorizontal analysis. For example, by looking for trends in certain costsover a series of years (thus the name trendanalysis), the analyst is able tomore accurately predict future costs. Common-size financial statementsare statements in which all amounts are stated as a percentage of oneselected item on the statement, such as net sales. Thus, vertical analysisof a single years income statement will help the analyst discern therelative amounts incurred for various costs.


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5. Rising costs to either manufacture or purchase inventory could beresponsible for a decline in gross profit in the face of an increase in sales.

Assume that 1,000 units of a product are sold with a unit cost of $80 and aselling price of $100. Sales total $100,000, and gross profit is $20,000.

Assume that in the following year, the company raises the selling price to$115 because of rising costs. If the cost to make a unit goes up to $96and the company sells another 1,000 units, sales will increase by 15% to$115,000, but gross profit will decrease to 1,000 X ($115 $96), or$19,000a decrease in gross profit of 5%.

6. The composition of current assets indicates the relative size of cash,accounts receivable, inventory, and other short-term assets. A relativelylarge balance in inventory may indicate that a company is not turning overits products quickly enough. Similarly, a large accounts receivablebalance could signal a problem in the collection department. Finally, alarge cash balance may be a sign that the company is not takingadvantage of short-term investment opportunities.

7. Ratios can be categorized according to their use in performing three typesof analysis: (1) liquidity analysis, (2) solvency analysis, and (3) profitabilityanalysis.

8. The first stage in the operating cycle for a manufacturer is the purchase ofraw material and its transformation into a final product. The second step isthe sale of the product, and the third is the collection of any receivablefrom credit granted to the customer. The operating cycle differs for aretailer in that a finished product is purchased from a wholesaler and thereis not the time involved in production.

9. Current assets are reported on a balance sheet in the order of theirnearness to cash, or liquidity. Cash is obviously presented first, followedby short-term investments. Accounts receivable, one step removed fromcash, are shown next, and then inventory. Because prepaid assets, suchas supplies or insurance paid for in advance, will not be converted intocash, they are normally reported last in the current asset section of thebalance sheet.

10. A relatively low acid-test or quick ratio compared with the current ratioprobably indicates a large inventory balance. Large amounts of inventorymay be normal for a company, but on the other hand they could signalproblems in moving obsolete items. The inventory turnover ratio for the

most recent period should be compared with those of prior periods todetermine whether there has been a decrease in the number of turns peryear. A less likely explanation for a low quick ratio compared with thecurrent ratio would be large balances in various prepayments, such assupplies and insurance.


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11. All turnover ratios are a measure of the activity for a period compared withthe investment necessary to carry on that activity. For example, theinventory turnover ratio measures the relationship between inventory sold,on a cost basis, and the average amount of inventory on hand during thattime period. The base is the average inventory because it is divided intoan activity measure for the entire periodthat is, cost of goods sold.

12. An accounts receivable turnover of nine times translates to an averagenumber of days in receivables of 40 (360/9). If the credit departmentextends terms of 2/10, net 30, investigation of the companys actual creditpolicies is warranted. For example, the department may routinely givecustomers up to 40 or 50 days to pay. If this policy does not create anycash flow problems, why have terms of 2/10, net 30? Alternatively, theaverage time to collect may be an indication that the credit department isextending credit to customers who are not good credit risks.

13. One possible explanation for a decrease in inventory turnover is slow-moving items. Caution must be used, however, because a low inventoryturnover may simply be a seasonal phenomenon. For example, the ratiofor the third quarter of the year should be compared with that of the thirdquarter of the prior year. Problems in the sales department may alsopartially explain a low turnover of inventory. Or, the company may bepricing itself out of the market and need to consider lowering its prices tomeet the competition.

14. A manufacturers operating cycle runs from the purchase of raw materials,to the transformation of the materials into a final product, to sale, to thecollection of any receivable. This differs from the operating cycle of aservice business because the latter does not technically sell a product.

Service businesses must look for alternative measures of efficiency. Forexample, an airline would be interested in the average amount of timeelapsed between the sale of a ticket and collection from the passenger. Apublic accounting firm might want to know the average length of time thatpasses after an audit is finished before the client pays the bill.

15. Liquidity analysis is concerned with the ability of the company to pay itsdebts as they are due and thus focuses on the current assets andliabilities. Solvency is the ability to stay in business over the long run.The debt-to-equity ratio and the debt service coverage ratio are twomeasures of the firms solvency.

16. The debt service coverage ratio is superior to the times interest earnedratio as a measure of solvency for two reasons. First, the ratio considersthe need to pay both interest and principal, whereas the times interestearned ratio deals only with interest. Second, the necessary payments toservice debt are compared with the cash available to pay the debt, whilethe times interest earned ratio uses an accrual income number in itsnumerator.


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17. Both are right. Many different ratios are used to assess the relative mix ofa companys capital structure. The debt-to-equity ratio measures theamount of outstanding debt relative to the amount of stockholders equity.

An alternative measure is to divide the same debt by the total assets of thecompany. A different ratio will obviously result, but as long as the samemeasure is used consistently, either ratio is an indicator of solvency.

18. The debt service coverage ratio measures the amount of cash generatedfrom operating activities that is available to repay the interest and anymaturing debt. A loan officer is primarily concerned with the companysability to meet interest and principal payments on time and, therefore,would be very interested in this ratio.

19. Dividends are not a legal obligation, but they often become an expectationon the part of stockholders. Therefore, when computing the cash availableto make capital acquisitions, it is helpful to take into account the normaldividend requirements.

20. The numerator in any rate of return ratio must match the investment orbase in the denominator. If total assets is the base, the numerator mustbe a measure of the income available to all providers of capital. Interestexpense, net of tax, is added back to net income because the creditors areone of the sources of capital, and we want to consider the incomeavailable before any of the sources of funds are given a distribution.Interest must be on a net or after-tax basis to be consistent with netincome, which is on an after-tax basis.

21. A return on stockholders equity that is lower than the return on assetsmeans that the company is not successfully using borrowed funds. Returnon assets measures the return to all providers of capital, whereas returnon equity is concerned only with common stockholders. The company hasnot been able to earn an overall return that is as high as what is beingpaid to creditors and preferred stockholders. Leverage deals with the useof someone elses money to earn a favorable return. Presently, thiscompany is not successfully employing financial leverage.

22. The price/earnings ratio is sometimes used as an indicator of the quality ofa companys earnings because it combines a measure of the companysperformance, based on its earnings, and the companys worth asmeasured by the market price of its stock. The ratio of price to earnings isan indication of the markets assessment of the companys performance.

For example, the use of different accounting methods can cause themarket to value the price of one companys stock higher than anothercompanys stock, even though they report similar earnings. This could bethe case if one defers taxes by using LIFO whereas the other uses FIFO.This differing treatment of the two stocks is a statement by the marketabout the quality of the two companys earnings.


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23. Most of the liquidity ratios are primarily suited to use by management. Forexample, the investor would not normally place major emphasis on theturnover of either inventory or receivables. On the other hand, turnoverratios must be constantly monitored by management. The stockholder willbe very interested in both the dividend payout ratio and the dividend yield.

A banker would rely partially on a companys debt service coverage in thepast as an indication of its ability to repay a potential loan in the future.

24. The inventory turnover ratio is meaningless to a service business such asa law firm or a public accounting firm. These firms do not sell a tangibleproduct; instead, they sell their professional expertise and thus must relyon alternative measures of their efficiency in marketing their services. Anaccounting firm, for example, might keep detailed records on the numberof clients served, the average annual billings to each client, and the ratioof these billings to the average costs incurred on each audit.

25. Separate reporting of discontinued operations, extraordinary items and thecumulative effect of a change in accounting principle assists the reader ofthe statements in making predictions about the future profitability of thebusiness. For example, users of the income statement may want to ignorethese items when assessing the future prospects for the company becausethese items by their nature are not likely to reoccur in the future.

E X E R C I S E S

LO 4 EXERCISE 13-1 ACCOUNTS RECEIVABLE ANALYSIS

1. Accounts receivable turnover:Net credit sales/Average accounts receivable:

2004: $600,000/[($150,000 + $100,000)/2] = $600,000/$125,000 = 4.8 times2003: $540,000/[($100,000 + $80,000)/2] = $540,000/$90,000 = 6 times

2. Number of days sales in receivables:2004: 360/4.8 = 75 days2003: 360/6 = 60 days

3. The average age of a receivable in 2003 was the same number of days asthe maximum credit period of 60 days. The average age in 2004 of 75 days,

however, is significantly in excess of the credit period. The company needsto investigate this increase and decide whether efforts are needed to speedup the collection process. The company may decide that allowingcustomers more liberal payment terms has had a positive effect on sales, asevidenced by the increase in sales, and not want to press its customers forearlier payment. Conversely, the company may find that allowing an extra15 days for payment causes cash flow problems.


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LO 4 EXERCISE 13-2 INVENTORY ANALYSIS

1. Inventory turnover:

Cost of goods sold/Average inventory:2004: $7,100,000/[($200,000 + $150,000)/2] = $7,100,000/$175,000

= 40.57 times2003: $8,100,000/[($150,000 + $120,000)/2] = $8,100,000/$135,000= 60 times

2. Number of days sales in inventory:2004: 360/40.57 = 8.9 days2003: 360/60 = 6 days

3. Inventory turnover has declined dramatically from the prior year. Manydifferent explanations are possible for this decline, such as problems in thesales effort, over-pricing of the products relative to the competition, orinferior produce. Management needs to investigate the problem and decide

who should be held responsible for the slow movement. The company mayfind that no one department or individual is totally responsible and that manydifferent parts of the business need to work together to improve the turnoverof inventory.

LO 4 EXERCISE 13-3 ACCOUNTS RECEIVABLE AND INVENTORYANALYSES FOR COCA-COLA AND PEPSI

1. Calculations (all dollar amounts in millions):

a. Accounts Receivable Turnover Ratio:Coca-Cola Company

$19,564/[($2,097 + $1,882)/2] = $19,564/$1,989.5 = 9.83 times

PepsiCo, Inc.$25,112/[($2,531 + $2,142)/2] = $25,112/$2,336.5 = 10.75 times

b. Days Sales in Receivables:Coca-Cola Company360/9.83 = 36.6 days

PepsiCo, Inc.360/10.75 = 33.5 days

c. Inventory Turnover Ratio:Coca-Cola Company$7,105/[($1,294 + $1,055)/2] = $7,105/$1,174.5 = 6.0 times

PepsiCo, Inc.$11,497/[($1,342 + $1,310/2] = $11,497/$1,326 = 8.7 times


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d. Days Sales in Inventory:Coca-Cola Company360/6.0 = 60 days

PepsiCo, Inc.

360/8.7 = 41.4 days

e. Cash to Cash Operating Cycle:Coca-Cola Company36.6 + 60 = 96.6 days

PepsiCo, Inc.33.5 + 41.4 = 74.9 days

2. PepsiCo, Inc. has a higher accounts receivable turnover ratio and,accordingly, a lower number of days sales in receivables than Coca-Cola.PepsiCo, Inc. also a higher inventory turnover ratio and, accordingly, a

lower number of days sales in inventory. PepsiCo, Inc. also has a lowercash to cash operating cycle.

LO 4 EXERCISE 13-4 LIQUIDITY ANALYSES FOR COCA-COLA ANDPEPSICO

1. Calculations (all dollar amounts in millions):

Coca Cola Company PepsiCo, Inc.a. Current ratio $7,352/$7,341 = 1.00 to 1 $6,413/$6,052 = 1.06 to 1

b. Quick assets $2,126 + $219 + $2,097 $1,638 + 207 + $2,531

= $4,442 $4,376Acid-test or $4,442/$7,341 = .61 to 1 $4,376/$6,052 = .72 to 1

Quick ratio

2. PepsiCos current and acid-test (or quick) ratios are higher than CocaColas. Based on these measures, PepsiCo appears to be more liquid thanCoca Cola.

3. Other ratios that can be used to more fully assess the liquidity of these twocompanies are these: cash flow from operations to current liabilities ratio,accounts receivable turnover ratio, number of days sales in receivables,inventory turnover ratio, number of days sales in inventory, and cash to

cash operating cycle.


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LO 4 EXERCISE 13-5 LIQUIDITY ANALYSES FORMCDONALDS AND WENDYS

1. Calculations:

McDonalds Wendys

(In millions) (In thousands)a. Working capital $1,715.4 $2,422.3 $330,819 $360,075= $(706.9) = $(29,256)

b. Current ratio $1,715.4/$2,422.3 $330,819/$360,075= .71 =.92

c. Quick assets $330.4+$855.3 $171,944+$86,416+11,204= $1,185.7 = $ 269,564

Acid-test or $1,185.7/$2,422.3 $269,564/$360,075Quick ratio = .49 = .75

2. Both McDonalds and Wendys have negative working capital. Wendyscurrent and acid-test (or quick) ratios are both higher than McDonalds.Based on these measures, Wendys appears to be somewhat more liquidthan McDonalds.

3. Calculations of cash flow from operations to current liabilities ratios:

McDonalds (in millions)$2,890.1/[($2,422.3 + $2,248.3)/2] = $2,890.1/$2,335.3 = 123.8%

Wendys (in thousands)$444,256/[($360,075 + $296,687)/2] = $444,256/$328,381 = 135.3%

This ratio overcomes the two limitations of the current and the quick ratios,because it focuses on cash and cash flows. McDonalds cash flow fromoperations to current liabilities ratio is slightly lower than Wendys.Together with the current and quick ratios, Wendys appears to be moreliquid overall than is McDonalds.

4. McDonalds has negative working capital but a strong cash flow fromoperations to current liabilities ratio. As such, McDonalds might be able tocover its short-term cash requirements through short-term borrowings.


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LO 5 EXERCISE 13-6 SOLVENCY ANALYSES FORTOMMY HILFIGER

1. 2003 2002a. Debt-to-equity $984,776/$1,043,375 $1,096,989/1,497,462

ratio = .94 to 1 = .73 to 1

b. Times interest [($513,605)+ $46,976 + ($134,545+ $41,177 +earned $14,144]/$46,976 = $20,069)/$41,177 =

($452,485)/$46,976 $195,791/$41,177= (9.6) to 1 = 4.8 to 1

c. Debt service ($230,105 + $46,976 + ($353,100 + $41,177 +coverage $14,144)/($46,976 + $20,069)/($41,177+ratio* $74,234) = $291,225/ $155,538)= $414,346/

$121,210 = 2.4 times $196,715 = 2.1 times

*The amounts for interest and taxes represent interest expense and incometax expense rather than the amounts paid.

d. Cash flow from ($230,105 $0)/$71,903operations to ($353,1000)/$96,923to capital = 320.0% = 364.3%capital expen-ditures ratio

2. The companys debt to equity ratio increased during 2003, due in large partto the significantly lower stockholders equity, the result of the net lossrecorded for the year. The net loss results in a times interest earned ratiothat is a negative number for 2003. Interestingly, the company continued to

generate positive cash flow from operating activities, and even though theratio of this number to capital expenditures decreased slightly, the debtservice coverage ratio actually increased in 2003.

LO 5 EXERCISE 13-7 SOLVENCY ANALYSIS

1. a. Debt-to-equity ratio: Total liabilities/Total stockholders equity

At 12/31/04: ($350,000 + $600,000)/$1,650,000= $950,000/$1,650,000 = .58 to 1

At 12/31/03: ($405,000 + $800,000)/$1,500,000= $1,205,000/$1,500,000 = .80 to 1

b. Times interest earned for 2004 (Net income + Interest expense +Income tax expense)/Interest expense:

($150,000 + $89,000 + $111,000)/$89,000 = $350,000/$89,000 =3.93 to 1


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c. Debt service coverage for 2004 (Cash flows from operations beforeinterest and tax payments)/Interest and principal payments:

($185,000 + $89,000+ $96,000*)/($89,000 + $275,000**) =$370,000/$364,000 = 1.02 times

*Taxes payable, 12/31/03 $ 45,000Add: Tax expense 111,000Less: Taxes payable 12/31/04 65,000Taxes paid during 2004 $ 96,000

**Principal payments:a. Short-term notes payable $ 75,000b. Serial bonds 200,000

Total $ 275,000

2. The companys debt-to-equity ratio has decreased because of the

repayment of the short-term notes and the installment payment on the serialbonds. The ratio at the end of 2004 of almost .6 to 1 indicates a relativelyconservative balance of debt to stockholders equity. The times interestearned ratio indicates that Impacts profits before interest and taxes werealmost four times the amount of interest expense.

Two problems arise, however, in using the times interest earned ratio asthe sole measure of solvency. First, it considers the payment of onlyinterest, not principal. Second, principal and interest payments must bemade with cash, not profits. The debt service coverage ratio is a muchbetter indication of the companys ability to meet its obligations. A ratio of1.02 times indicates that Impact generated just enough cash from operationsto meet its principal and interest payments in 2004.

LO 6 EXERCISE 13-8 RETURN RATIOS AND LEVERAGE

1. Ratios:

a. Return on sales = (Net income + Interest expense, net of tax)/Net sales[($60,000 + ($50,000 X 60%)]/$650,000= $90,000/$650,000 = 13.85%

b. Asset turnover = Net sales/Average total assets$650,000/[($1,600,000 + $2,000,000*)/2]= $650,000/$1,800,000 = .36 times

*Total assets at end of year are the same as total liabilities andstockholders equity (given).

c. Return on assets = (Net income + Interest expense, net of tax)/Averagetotal assets

$90,000 (from Part a.)/$1,800,000 (from Part b.) = 5%


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d. Return on common stockholders equity = (Net income Preferreddividends)/Average common stockholders equity

($60,000 $25,000*)/[($950,000 + $915,000**)/2]= $35,000/$932,500 = 3.75%

*Preferred dividends: $250,000 par value X 10%

**Stockholders equity at beginning of year:Common stock $ 600,000Retained earnings $350,000 at end of

year less $60,000 net income plus$25,000 dividends 315,000

Stockholders equity at beginning of year $ 915,000

2. Evergreen has not been successful in using outside funds because thereturn on stockholders equity of 3.75% is less than the return to allproviders of capital, as measured by the return on assets of 5%.

Evidence that Evergreen has not successfully employed leverage is

found by looking closer at the cost of outside funds. The average cost ofborrowed funds is $50,000 in interest expense divided by $650,000 in short-term loans payable and long-term bonds. This cost of 7.7% times 1 minusthe tax rate, or 60%, translates to an after-tax borrowing rate of 4.62%. Thereturn paid to the preferred stockholders is 10%. Both of these rates exceedthe return to the common stockholder of 3.75% and indicate that Evergreenis not successfully employing leverage.

LO 6 EXERCISE 13-9 RELATIONSHIPS AMONGRETURN ON ASSETS, RETURN ON SALES, ANDASSET TURNOVER

Case 1. Return on assets = Net income (assuming no interestexpense)/Average total assets = $10,000/$60,000 = 16.67%.

Case 2. Return on sales = Net income/Net sales2% = $25,000/XNet sales = $1,250,000

Case 3. Return on assets = Return on sales X Asset turnoverX = 6% X 1.5Return on assets = 9%

Case 4. Asset turnover = Net sales/Average total assets.

1.25 = $50,000/XAverage total assets = $40,000

Return on assets = Net income (assuming no interest expense)/Averagetotal assets10% = X/$40,000Net income = $4,000


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Case 5. Return on assets = Net income (assuming no interestexpense)/Average total assets15% = $20,000/X

Average total assets = $133,333

LO 6EXERCISE 13-10 EPS, P/E RATIO, ANDDIVIDEND RATIOS

1. Ratios:a. Earnings per common share = (Net income less preferred

dividends)/Number of common shares outstanding:[$1,300,000 8%($5,000,000)]/400,000 shares= ($1,300,000 $400,000)/400,000= $900,000/400,000 = $2.25 per share

b. Price earnings ratio = Current market price/EPS= $24.75/$2.25 = 11 to 1

c. Dividend payout ratio = Common dividends per share/EPS= ($.40 X 4 quarters)/$2.25= $1.60/$2.25 = 71.11%

d. Dividend yield ratio = Common dividends per share/Market price= $1.60 (from Part c.)/$24.75 = 6.46%

2. An investment advisor needs to be aware of industry trends, the generaleconomic environment, the historical performance of the company, theinvestors attitudes about risk, and any other relevant data needed to makean informed decision.

LO 6 EXERCISE 13-11 EARNINGS PER SHARE ANDEXTRAORDINARY ITEMS (APPENDIX)

1. Earnings per share before extraordinary items = (Net income beforeextraordinary loss less preferred dividends)/Number of common sharesoutstanding:

[$5,850,000 (9%)($2,000,000)]/1,500,000 shares= ($5,850,000 $180,000)/1,500,000 shares= $5,670,000/1,500,000 shares = $3.78 per share

2. Earnings per share (after the extraordinary loss) = (Net income preferreddividends)/Number of common shares outstanding:($2,130,000 $180,000)/1,500,000 shares= $1,950,000/1,500,000 = $1.30 per share

3. Management is accountable for the overall operation of the company andthus, to some extent, must be evaluated on the basis of the bottom line asmeasured by the earnings per share after the extraordinary loss from theflood. In attempting to forecast future profits, however, both managementand a potential stockholder would be much more concerned with EPS


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exclusive of any extraordinary items, because these gains and losses areunusual in nature and infrequently occurring.

MULTI-CONCEPT EXERCISES

LO 2,3 EXERCISE 13-12 COMMON-SIZE BALANCESHEETS AND HORIZONTAL ANALYSIS

1. FARINET COMPANYCOMMON-SIZE COMPARATIVE BALANCE SHEETS

DECEMBER 31, 2004 AND 2003

12/31/04 12/31/03Dollars Percent Dollars Percent

Cash $ 16,000 1.7%* $ 20,000 2.5%*Accounts receivable 40,000 4.3 30,000 3.8Inventory 30,000 3.3 50,000 6.2Prepaid rent 18,000 2 .0 12,000 1 .5

Total current assets $ 104,000 11 .3 % $ 112,000 14 .0 %Land$ 150,000 16.2% 150,000 18.7%Plant and equipment 800,000 86.6 600,000 74.8

Accumulateddepreciation (130,000 ) (14 .1 ) (60,000 ) (7 .5 )

Total long-termassets $ 820,000 88 .7 $ 690,000 86 .0

Total assets $ 924,000 100 .0 % $ 802,000 100 .0 %

Accounts payable $ 24,000 2.6% $ 20,000 2.5%Income taxes payable 6,000 .6 10,000 1.3

Short-term notespayable 70,000 7 .6 50,000 6 .2

Total currentliabilities $ 100,000 10 .8 % $ 80,000 10 .0 %

Bonds payable $ 150,000 16 .2 % $ 200,000 24 .9 %Common stock $ 400,000 43.3% $ 300,000 37.4%Retained earnings 274,000 29 .7 222,000 27 .7

Total stockholdersequity $ 674,000 73 .0 %* $ 522,000 65 .1 %

Total liabilities andstockholders equity $ 924,000 100 .0 % $ 802,000 100 .0 %

*Rounded to total.

2. Observations from Farinets common-size balance sheets:


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a. Current assets as a percentage of total assets has decreased. At thesame time, current liabilities has accounted for about the samepercentage of total equities in the two years.

b. The relative mix of current assets has changed from one year to thenext. Cash now accounts for a smaller share of total assets, as doesinventory, whereas accounts receivable accounts for a slightly higherpercentage of total assets.

c. Major investments in plant and equipment have been made in 2004. Atthe end of 2003, plant and equipment accounted for three-fourths of thetotal assets, and now it accounts for over 86% of the total.

d. Bonds payable now make up a smaller share of the capital structure withthe retirement of $50,000 during 2004.

e. Short-term borrowings increased and now represent a larger share of the

current liabilities (from $50,000/$80,000, or 62.5%, to $70,000/$100,000,or 70%).


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3. FARINET COMPANYCOMPARATIVE BALANCE SHEETS

DECEMBER 31, 2004 AND 2003

December 31 Increase (Decrease)

2004 2003 Dollars PercentCash $ 16,000 $ 20,000 $ (4,000) (20)%Accounts receivable 40,000 30,000 10,000 33Inventory 30,000 50,000 (20,000) (40)Prepaid rent 18,000 12,000 6,000 50

Total current assets $ 104,000 $ 112,000 $ (8,000 ) (7 )%Land $ 150,000 $ 150,000 $ 0 0%Plant and equipment 800,000 600,000 200,000 33

Accumulateddepreciation (130,000 ) (60,000 ) (70,000 ) (117)

Total long-termassets $ 820,000 $ 690,000 $ 130,000 19 %

Total assets $ 924,000 $ 802,000 $ 122,000 15 %

Accounts payable $ 24,000 $ 20,000 $ 4,000 20%Income tax payable 6,000 10,000 (4,000) (40)Short-term notes

payable 70,000 50,000 20,000 40Total current

liabilities $ 100,000 $ 80,000 $ 20,000 25 %Bonds payable $ 150,000 $ 200,000 $ (50,000 ) (25 )%Common stock $ 400,000 $ 300,000 $ 100,000 33%Retained earnings 274,000 222,000 52,000 23

Total stockholdersequity $ 674,000 $ 522,000 $ 152,000 29 %

Total liabilities andstockholders equity $ 924,000 $ 802,000 $ 122,000 15 %


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4. Largest changes Refer toa. Accumulated depreciation Fixed asset records, showing

additions to plant andequipment and depreciation

calculationsb. Prepaid rent Rental agreementsc. Inventory Purchase orders, sales recordsd. Income tax payable Income tax return and

supporting recordse. Short-term notes payable Loan agreements

LO 2,3 EXERCISE 13-13 COMMON-SIZE INCOMESTATEMENTS AND HORIZONTAL ANALYSIS

1. MARINERS CORP.COMMON-SIZE COMPARATIVE INCOME STATEMENTS

FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003

(IN THOUSANDS OF DOLLARS)2004 2003

Dollars Percent Dollars PercentSales revenue $ 60,000 100.0% $50,000 100.0%Cost of goods sold 42,000 70 .0 30,000 60 .0

Gross profit $ 18,000 30.0% 20,000 40.0%Selling and adminis-

trative expense 9,000 15 .0 5,000 10 .0Operating income $ 9,000 15.0% $15,000 30.0%

Interest expense 2,000 3 .3 2,000 4 .0Income before tax $ 7,000 11.7% $13,000 26.0%

Income tax expense 2,000 3 .3 4,000 8 .0Net income $ 5,000 8 .4 %* $ 9,000 18.0%

*Rounded to total.

2. Observations from Mariners common-size statements:

a.Although sales increased in absolute dollars, the gross profit percentagehas decreased significantly because of a higher ratio of cost of goodssold to sales: from 60% to 70%.

b. Selling and administrative expenses have increased both in absolute

dollars and as a percentage of sales. An increase from 10% to 15% ofsales is a drastic increase in the importance of this cost relative to sales.

c. Interest expense remained the same in absolute dollars, but becausesales increased, it decreased slightly from 4% to 3.3% of sales.

d. The bottom line net income decreased both in absolute dollars and as apercentage of sales. The solid increase in sales is more than offset bythe large increases in both product costs and selling and administrativeexpenses.


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3. MARINERS CORP.COMPARATIVE STATEMENTS OF INCOME

FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003

December 31 Increase (Decrease)2004 2003 Dollars Percent

Sales revenue $60,000 $ 50,000 $10,000 20%Cost of goods sold 42,000 30,000 12,000 40

Gross profit $18,000 $ 20,000 $ (2,000) (10)%Selling and adminis-

trative expense 9,000 5,000 $ 4,000 80Operating income $ 9,000 $ 15,000 $ (6,000) (40)%

Interest expense 2,000 2,000 0 0Income before tax $ 7,000 $ 13,000 $ (6,000) (46)%

Income tax expense 2,000 4,000 (2,000 ) (50 )Net income $ 5,000 $ 9,000 $ (4,000 ) (44)%

4. Largest changes Refer toSelling and administrative Individual records, for the

expenses various expensesIncome tax expense Income tax return and supporting

records

P R O B L E M S

LO 4 PROBLEM 13-1 EFFECT OF TRANSACTIONS ONWORKING CAPITAL, CURRENT RATIO, ANDQUICK RATIO

1. Calculation of working capital, current ratio, and quick ratio (dollar amountsin thousands):

Working capital($70 + $60 + $80 + $100 + $10) ($75 + $25 + $40 + $60)= $320 $200 = $120

Current ratio$320/$200 = 1.60 to 1

Quick ratio($70 + $60 + $80)/$200 = $210/$200 = 1.05 to 1

2. Effect of transactions on working capital, current ratio, and quick ratio:


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Working Effect Effect EffectCapital of of of

(in Thou- Trans- Current Trans- Quick Trans-Transaction sands) action Ratio action Ratio action

a. Purchased inventory

on account, $20,000 $120 none 1.545 decrease .955 decreaseb. Purchased inventoryfor cash, $15,000 $120 none 1.60 none .975 decrease

c. Paid suppliers onaccount, $30,000 $120 none 1.706 increase 1.059 increase

d. Received cash onaccount, $40,000 $120 none 1.60 none 1.05 none

e. Paid insurance fornext year, $20,000 $120 none 1.60 none .95 decrease

f. Made sales on account,$60,000 $180 increase 1.90 increase 1.35 increase

g. Repaid short-term loansat bank, $25,000 $120 none 1.686 increase 1.057 increase

h. Borrowed $40,000 atbank for 90 days $120 none 1.50 decrease 1.042 decrease

i. Declared and paid$45,000 cash dividend $ 75 decrease 1.375 decrease .825 decrease

j. Purchased $20,000 oftrading securities $120 none 1.60 none 1.05 none

k. Paid $30,000 in salaries $ 90 decrease 1.45 decrease .90 decreasel. Accrued additional

$15,000 in taxes $105 decrease 1.488 decrease .977 decrease

LO 4 PROBLEM 13-2 EFFECT OF TRANSACTIONS ONWORKING CAPITAL, CURRENT RATIO, ANDQUICK RATIO

1. Calculation of working capital, current ratio and quick ratio (dollar amountsin thousands):

Working capital($70 + $60 + $80 + $100 + $10) ($75 + $25 + $40 + $210)= $320 $350 = $(30)

Current ratio$320/$350 = .91 to 1

Quick ratio($70 + $60 + $80)/$350 = $210/$350 = .60 to 1

2. Effect of transactions on working capital, current ratio, and quick ratio:


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Working Effect Effect EffectCapital of of of

(in Thou- Trans- Current Trans- Quick Trans-Transaction sands) action Ratio action Ratio action

a. Purchased inventory

on account, $20,000 $(30) none .919 increase .568 decreaseb. Purchased inventoryfor cash, $15,000 $(30) none .91 none .557 decrease

c. Paid suppliers onaccount, $30,000 $(30) none .906 decrease .563 decrease

d. Received cash onaccount, $40,000 $(30) none .91 none .60 none

e. Paid insurance fornext year, $20,000 $(30) none .91 none .543 decrease

f. Made sales on account,$60,000 $30 increase 1.086 increase .771 increase

g. Repaid short-term loansat bank, $25,000 $(30) none .908 decrease .564 decrease

h. Borrowed $40,000 at

bank for 90 days $(30) none .923 increase .641 increasei. Declared and paid

$45,000 cash dividend $(75) decrease .786 decrease .471 decreasej. Purchased $20,000 of

trading securities $(30) none .91 none .60 nonek. Paid $30,000 in salaries $(60) decrease .829 decrease .514 decreasel. Accrued additional

$15,000 in taxes $(45) decrease .887 decrease .575 decrease

LO 6 PROBLEM 13-3 GOALS FOR SALES AND RETURN ONASSETS

1. a. Return on sales = net income after adding back interest expense,net of tax/net sales

= $5,000,000/$60,000,000 = 8.33%

b.Asset turnover = net sales/average total assets= $60,000,000/$40,000,000 = 1.5 times

c. Return on assets = return on sales X asset turnover= 8.33% X 1.5 = 12.5%

2. Asset turnover = ($60,000,000 X 120%)/($40,000,000 X 112.5%)= $72,000,000/$45,000,000 = 1.6 times

3. If average total assets are $45,000,000 and the goal is a 15% return onassets, net income will need to be 15% of $45,000,000, or $6,750,000.

4. Income will have to increase by 35%, ($6,750,000 $5,000,000)/$5,000,000, to achieve the goal of a 15% return on assets. The presidenthas set a goal for an increase in sales of only 20%. To increase income bya larger percentage than the increase in sales will require cost-cutting in thevarious departments of the business. The company may want to look for


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cheaper sources of supply for its materials, as long as the quality of theproduct is maintained. Efforts will need to be made to cut selling, general,and administrative expenses as well.

LO 6 PROBLEM 13-4 GOALS FOR SALES AND

INCOME GROWTH

1. Selected financial data (in millions of dollars):

2007 2006 20051. Sales* 266.2 242.0 220.02. Net income(sales X 3%)* 7.986 7.26 6.63. Dividends declared and paid

(greater of $3,000,000or 50% of net income) 3.993 3.63 3.3

4. Owners equity, December 31balance (prior years balance +net income less dividends) 80.923 76.93 73.3

5. Debt, Dec. 31 balance** 52.177 44.07 36.7Selected ratios:

6. Return on owners equity(Item 2/Item 4) 9.9% 9.4% 9.0%

Note: The return on owners equity ratios in the problem for 2002-2004 arebased on year-end owners equity rather than the average for each year.Therefore, to be consistent, year-end balances are used for 2005-2007.

7. Debt to total assets[Item 5/(Item 4 + Item 5)] 39.2% 36.4% 33.4%

*Sales and net income increase at the rate of 10% per year.

**Calculation of total debt balance:Total assets (sales/asset

turnover rate of 2) $ 133.100 $121.00 $ 110.0Less: Owners equity

(Item 4) 80.923 76.93 73.3Debt $ 52.177 $ 44.07 $ 36.7

2. No, the CEO will not be able to meet all her requirements if a 10% per year

growth in income and sales is achieved. If under the stated assumptionsthat the net income to sales ratio be maintained at 3% with annual salesgrowth of 10%, and the asset turnover ratio be maintained at 2, the goal ofholding debt to 35% of total assets will be met only in 2005. The debt willincrease to 36.4% of total assets in 2006 and to 39.2% of total assets in2007 under the proposed plan. The calculations assume that all otherfactors remain constant. Because some of the factors that affect stockprices are outside the companys control, it cannot be determined whetherthe main requirement of improving the stock price can be met if the expectedperformance is accomplished.


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3. Alternative actions to be considered to improve the return on equity andsupport the increased dividend payments:

a. Improve the return on assets by

reducing the asset base through better asset management.

improving asset quality to generate higher returns per dollarinvested, including the acquisition of a subsidiary or a moreprofitable line of business.

b. Improve profits by

concentrating production and sales on high profit-producing lines.

cost control efforts to maintain and reduce both variable and fixedcosts.

4. The CEO is probably concerned with the potential impact that greater debtwould have on the companys cost of capital. Increasing debt relative to

owners equity creates added risk, which translates to higher returnsrequired by investors in the companys stocks and bonds. If investorsperceive that the companys financial risks have increased, the marketprices for its long-term debt issues will fall (interest rates will rise), andgreater dividend payments will be necessary to maintain the market price ofthe stock.

MULTI-CONCEPT PROBLEMS

LO 4,5,6 PROBLEM 13-5 BASIC FINANCIAL RATIOS

1. Financial ratios for 2004 for CCB Enterprises (thousands omitted):

a. Times interest earned = (Net income + Income tax expense + Interestexpense)/Interest expense

= ($72,000 + $48,000 + $20,000)/$20,000= $140,000/$20,000 = 7 to 1

b. Return on total assets = (Net income + Interest expense, net oftax)/Average total assets

= {$72,000 + [$20,000 X (1 40%*)]}/[($540,000 + $510,000)/2]= $84,000/$525,000 = 16%

*Tax rate = Income taxes/Income before tax = $48,000/$120,000 = 40%.

c. Return on common stockholders equity = (Net income Preferreddividends)/Average common stockholders equity

= $72,000/[($260,000 + $217,000)/2]= $72,000/$238,500 = 30.19%

d. Debt/equity ratio = Total liabilities/Total stockholders equity= $280,000/$260,000 = 1.08 to 1


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e. Current ratio = Current assets/Current liabilities= $144,000/$120,000 = 1.2 to 1

f. Quick (acid-test) ratio = (Cash + Marketable securities + Short-termreceivables)/Current liabilities

= ($26,000 + $48,000)/$120,000

= $74,000/$120,000 = .62 to 1

g. Accounts receivable turnover ratio = Net credit sales/Average accountsreceivable

= $800,000/[($48,000 + $50,000)/2]= $800,000/$49,000 = 16.3 times

h. Number of days sales in receivables = Number of days inperiod/Accounts receivable turnover

= 360 days/16.3 times = 22 days

i. Inventory turnover ratio = Cost of goods sold/Average inventory

= $540,000/[($65,000 + $62,000)/2]= $540,000/$63,500 = 8.5 times

j. Number of days sales in inventory = Number of days in period/Inventoryturnover


k. Number of days in cash operating cycle = Days sales in inventory + Dayssales in receivables

= 42 days + 22 days = 64 days

2. Comments on the overall financial health of CCB Enterprises:

The current ratio indicates a fairly strong liquidity position, although thesignificantly smaller quick ratio may signal a problem with excess inventory.Whether or not the quick ratio is indicative of a liquidity problem could bedetermined more accurately by comparing this ratio with prior years, as wellas with an industry average.

Inventory turnover of 8.5 times may not be a problem area (seediscussion of quick ratio above), but it should be compared with those ofprior years and with an industry averageturning over inventory every 42days may be normal for the industry.

The length of time that receivables are outstanding, 22 days, appears tobe relatively short. It may indicate that the credit department is doing a

good job in screening customers for credit. On the other hand, if the creditterms are too stringent, the company may be losing good customers.Comparison of this statistic with those of other companies in the same lineof business would help to determine whether there is a problem in the creditdepartment.

The company appears to be successfully using outside capital, as isevidenced by a return on assets of 16%, but a return on stockholders equityof almost double this30.2%. Further evidence of the companys use ofleverage could be found by examining the exact cost of each individual


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source of capital. For example, what are the terms of the instruments thatmake up long-term debt, and what is the effective interest cost of each?

The times interest earned ratio indicates that earnings are seven timesthe amount of interest expensewhat appears to be excellent coverage.However, how much cash is generated from operations? Is this cashsufficient to cover not only interest payments but also maturing principalamounts? Calculation of the debt service coverage ratio, with informationfound on a cash flows statement, would provide further evidence of thecompanys solvency.

Finally, to fully evaluate the companys financial health, it would benecessary to know more about its plans for the long run. Does it plan toexpand plant and equipment? Are there any plans to take on additionalproducts or acquire another company? Are any additional debt issues beingcontemplated?

LO 5,6 PROBLEM 13-6 PROJECTED RESULTS TOMEET CORPORATE OBJECTIVES

1. Projected results for the four objectives for Tablon, Inc. (in thousands ofdollars):

Sales growth of 20% will be achieved:

Sales increase for the year = $30,000 - $25,000 = 20%Sales for 2004 $25,000

Return on stockholders equity of 15% will not be met:

Net income preferred dividends = $1,200 - $0*_Average stockholders equity ($9,300 + $8,700)/2

= $1,200/$9,000

= 13.3%

*No preferred stock

Long-term debt-to-equity ratio of not more than 1 will not be achieved:

Long-term debt at 5/31/05 = $10,000____Stockholders equity at 5/31/05 $5,000 + $4,300)

= $10,000/$9,300

= 1.08 to 1

A cash dividend of 50% of net income, with a minimum payment of atleast $400,000 will be met:

50% X 2005 net income = .50 X $1,200 = $600


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($600 is the forecasted dividend payment)

2. Contributing factors to Tablons failure to meet all its objectives include thefollowing:

Each of the three expenses, cost of goods sold, selling expenses, and

administrative expenses and interest, as a percentage of sales, areexpected to increase in 2005 from 2004:

2004 2005Cost of goods sold 52% 53.33%Selling expenses 20% 23.33%

Administrative expenses and interest 16% 16.67%

Accounts receivable will increase by $3,000,000 during the yeara 73%increase, compared with an increase in sales of only 20%. This couldcause a cash flow problem and possibly an increase in bad debts.

Production will exceed sales needs, as is evidenced by the 23% expectedincrease in the amount of inventory. This will result in additional carryingcosts for the year.

Long-term borrowing increased by 50% in the first six months of 2004,and for the full year it is expected to be up by 66.67% from the beginningof the year.

3. Possible actions that the controller could recommend to the president inresponse to the problems cited above include the following:

Review the accounts receivable collection process to determine ways tospeed up collection and to determine whether credit is being extended tohigh-risk customers.

Slow down the production during the remainder of the year.

Examine the reasons for an increase in the ratio of cost of goods sold tosales.

Review the selling and administrative expenses to determine whethercertain areas can be cut back and still provide necessary services.

Review the continuing increases in long-term debt and decide whetherthey are necessary. Consider the issuance of preferred stock as analternative form of financing.

LO 4,5,6 PROBLEM 13-7 COMPARISON WITH INDUSTRY AVERAGES

1. Industry


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Ratio Average Heartland, Inc.Current ratio 1.23 .92

Acid-test (quick) ratio .75 .53Accounts receivable turnover 33 times 39 timesInventory turnover 29 times 31 timesDebt-to-equity ratio .53 .69Times interest earned 8.65 times 4.43 timesReturn on sales 6.57% 4.54%

Asset turnover 1.95 times 1.98 timesReturn on assets 12.81% 8.97%Return on common

stockholders equity 17.67% 11.78%

Calculations for Heartlands ratios (thousands omitted):

Current ratio = Current assets/Current liabilities$31,100/$33,945 = .92 to 1

Acid-test ratio = (Cash + Marketable securities + Accountsreceivable)/Current liabilities

($1,135 + $1,250 + $15,650)/$33,945 = $18,035/$33,945 = .53 to 1

Accounts receivable turnover ratio = Sales/Average accounts receivable$542,750/[($15,650 + $12,380/2] = $542,750/$14,015 = 39 times

Inventory turnover ratio = Cost of goods sold/Average inventory$435,650/[($12,680 + $15,870)/2] = $435,650/$14,275 = 31 times

Debt-to-equity ratio = Total liabilities/Total stockholders equity($33,945 + $80,000)/$165,580 = $113,945/$165,580 = .69 to 1

Times interest earned = (Net income + Interest expense + Income taxexpense)/Interest expense

$19,095 + $9,275 + $12,730)/$9,275 = $41,100/$9,275 = 4.43 times

Return on sales = (Net income + Interest expense, net of tax)/Net sales[$19,095 + $9,275(1 .40*)]/$542,750 = ($19,095 + $5,565)/$542,750 =$24,660/$542,750 = 4.54%

*Tax rate is $12,730/$31,825 = 40%.

Asset turnover = Net sales/Average total assets$542,750/[($279,525 + $270,095)/2] = $542,750/$274,810 = 1.98 times

Return on assets = (Net income + Interest expense, net of tax)/Average totalassets

$24,660 (above)/$274,810 (above) = 8.97%

Return on common stockholders equity = (Net income Preferreddividends)/Average common stockholders equity

$19,095/[($165,580 + $158,485)/2] = $19,095/$162,032.5 = 11.78%

2. Heartland is not as liquid as the average company in the industry, as isevidenced by its lower current and quick ratios. The inventory turnover ratio


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is very close to the industry average, whereas the accounts receivableturnover is significantly better. Note, however, that the industry has a veryhigh turnoverin fact, the average number of days in receivables for theindustry is 360/33, or 11 days. Heartlands accounts payable has increasedsignificantly during a year in which inventory has actually decreased.

The company is not as solvent as the rest of the industry, either, as isindicated by its higher debt-to-equity ratio and lower times interest earnedratio. The heavy reliance on outside funds is also reflected in theprofitability of the company. Even though Heartlands return on equity ishigher than its return on assets, both ratios are significantly lower than thecomparable industry averages. Its asset turnover is slightly higher than theindustry norm.

3. If the banks primary consideration in making the loan decision is thecompanys relative performance compared with that of the competition, itprobably will not approve the loan. Heartland is already more highlyleveraged than the average company in the industry, and it is not nearly as

profitable. However, the loan decision will depend on other factors inaddition to the companys relative standing in its industry. For example, thebank will look at how Heartlands ratios this year compare with those of prioryears. Maybe the company is smaller than others in the industry and hasalways performed at its current level. If the bank approves the loan, it willprobably require a higher interest rate to compensate for any perceivedadditional risk.

A L T E R N A T E P R O B L E M S


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LO 5 PROBLEM 13-1A EFFECT OF TRANSACTIONS ONDEBT-TO-EQUITY RATIO

1. Calculation of debt-to-equity ratio (ooos omitted):($150 + $375)/$400 = $525/$400 = 1.31 to 1

2. Effect of transactions on debt-to-equity ratio:

Debt-to-Equity Effect of Transaction Ratio Transaction

a. Purchased inventory onaccount, $20,000 1.363 increase

b. Purchased inventory forcash, $15,000 1.31 none

c. Paid suppliers onaccount, $30,000 1.238 decreased. Received cash on

account, $40,000 1.31 nonee. Paid insurance for next

year, $20,000 1.31 nonef. Made sales on account,

$60,000 1.141 decreaseg. Repaid short-term loans

at bank, $25,000 1.25 decrease

h. Borrowed $40,000 atbank for 90 days 1.413 increase

i. Declared and paid$45,000 cash dividend 1.479 increase

j. Purchased $20,000 oftrading securities 1.31 none

k. Paid $30,000 in salaries 1.419 increasel. Accrued additional

$15,000 in taxes 1.403 increase

LO 5 PROBLEM 13-2A EFFECT OF TRANSACTIONS ONDEBT-TO-EQUITY RATIO


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1. Calculation of debt-to-equity ratio (ooos omitted):($25 + $125)/$400 = $150/$400 = .38 to 1

2. Effect of transactions on debt-to-equity ratio:

Debt-to-Equity Effect of Transaction Ratio Transaction

a. Purchased inventory onaccount, $20,000 .425 increase

b. Purchased inventory forcash, $15,000 .38 none

c. Paid suppliers onaccount, $30,000 .30 decrease

d. Received cash onaccount, $40,000 .38 none

e. Paid insurance for nextyear, $20,000 .38 none

f. Made sales on account,$60,000 .326 decrease

g. Repaid short-term loansat bank, $25,000 .313 decrease

h. Borrowed $40,000 atbank for 90 days .475 increase

i. Declared and paid$45,000 cash dividend .423 increase

j. Purchased $20,000 of

trading securities .38 nonek. Paid $30,000 in salaries .405 increasel. Accrued additional

$15,000 in taxes .429 increase

LO 6 PROBLEM 13-3A GOALS FOR SALES ANDRETURN ON ASSETS

1. a. Return on sales = net income after adding back interest expense,net of tax/net sales

= $60,000/$750,000 = 8%

b.Asset turnover = net sales/average total assets= $750,000/$400,000 = 1.88 times

c. Return on assets = return on sales X asset turnover= 8% X 1.88 = 15.04%

2. Asset turnover = ($750,000 X 115%)/($400,000 X 110%)= $862,500/$440,000 = 1.96 times

3. If average total assets are $440,000 and the goal is a 20% return on assets,net income will need to be 20% of $440,000, or $88,000.


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4. Income will have to increase by 47%, ($88,000 $60,000)/$60,000, toachieve the goal of a 20% return on assets. The president has set a goalfor an increase in sales of only 15%. To increase income by a largerpercentage than the increase in sales will require cost-cutting in the variousdepartments of the business. The company may want to look for cheapersources of supply for its materials as long as the quality of the product ismaintained. Efforts will need to be made to cut selling, general, andadministrative expenses as well.

LO 6 PROBLEM 13-4A GOALS FOR SALES ANDINCOME GROWTH

1. Selected financial data (in millions of dollars):

2007 2006 20051. Sales* 133.1000 121.000 110.02. Net income(sales X 3%)* 3.9930 3.630 3.33. Dividends declared and paid

(greater of $2,000,000or 60% of net income) 2.3958 2.178 2.0

4. Owners equity, December 31balance (prior yearsbalance + net income lessdividends) 44.3492 42.752 41.3

5. Debt, Dec. 31 balance** 22.2008 17.748 13.7Selected ratios:

6. Return on owners equity(Item 2/Item 4) 9.0% 8.5% 8.0%

Note: The return on owners equity ratios in the problem for 2002-2004 arebased on year-end owners equity rather than the average for each year.Therefore, to be consistent, year-end balances are used for 2005-2007.

7. Debt to total assets[Item 5/(Item 4 + Item 5)] 33.36% 29.3% 24.9%

*Sales and net income increase at the rate of 10% per year.

**Calculation of total debt balance:Total assets (sales/asset

turnover rate of 2) $ 66.5500 $60.500 $ 55.0

Less: Owners equity(Item 4) 44.3492 42.752 41.3Debt $22.2008 $17.748 $13.7

2. No, the CEO will not be able to meet all his requirements if a 10% per yeargrowth in income and sales is achieved. If under the stated assumptionsthat the net income to sales ratio be maintained at 3% with annual salesgrowth of 10%, and the asset turnover ratio be maintained at 2, the goal of


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holding debt to 25% of total assets will only be met in 2005. The debt willincrease to 29.3% of total assets in 2006 and to 33.36% of total assets in2007 under the proposed plan. The calculations assume that all otherfactors remain constant. Because some of the factors that affect stockprices are outside the companys control, it cannot be determined whetherthe main requirement of improving the stock price can be met if the expectedperformance is accomplished.

3. Alternative actions to be considered to improve the return on equity andsupport the increased dividend payments:

a. Improve the return on assets by reducing the asset base through better asset management. improving asset quality to generate higher returns per

dollar invested, including the acquisition of a subsidiaryor a more profitable line of business.

b. Improve profits by concentrating production and sales on high profit-producing lines. cost control efforts to maintain and reduce both variable and fixed

costs.

ALTERNATE MULTI-CONCEPT PROBLEMS

LO 4,5,6 PROBLEM 13-5A BASIC FINANCIAL RATIOS

1. Financial ratios for 2004 for SST Enterprises (thousands omitted):

a. Times interest earned = (Net income + Income tax expense + Interest

expense)/Interest expense= ($60,000 + $27,000 + $15,000)/$15,000= $102,000/$15,000 = 6.8 times

b. Return on total assets = (Net income + Interest expense, net oftax)/Average total assets

= {$60,000 + [$15,000 X (1 31%*)]}/[($300,000 + $295,000)/2]= $70,350/$297,500 = 23.65%

*Tax rate = Income taxes/Income before tax = $27,000/$87,000 = 31%.

c. Return on common stockholders equity = (Net income Preferreddividends)/Average common stockholders equity

= $60,000/[($180,000 + $165,000)/2]= $60,000/$172,500 = 34.78%

d. Debt/equity ratio = Total liabilities/Total stockholders equity= $120,000/$180,000 = .67 to 1


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e. Current ratio = Current assets/Current liabilities= $100,000/$105,000 = .95 to 1

f. Quick (acid-test) ratio = (Cash + Marketable securities + Short-termreceivables)/Current liabilities

= ($27,000 + $36,000)/$105,000

= $63,000/$105,000 = .6 to 1

g.Accounts receivable turnover ratio = Net credit sales/Average accountsreceivable

= $600,000/[($36,000 + $37,000)/2]= $600,000/$36,500 = 16.4 times

h. Number of days sales in receivables = Number of days inperiod/Accounts receivable turnover


i. Inventory turnover ratio = Cost of goods sold/Average inventory

= $405,000/[($35,000 + $42,000)/2]= $405,000/$38,500 = 10.52 times

j. Number of days sales in inventory = Number of days in period/Inventoryturnover


k. Number of days in cash operating cycle = Days sales in inventory + Dayssales in receivables

= 34 days + 22 days = 56 days

2. Comments on the overall financial health of SST Enterprises:

The current ratio is slightly less than 1 to 1, and the significantly smallerquick ratio may signal a problem with excess inventory. Whether or not thequick ratio is indicative of a liquidity problem could be determined moreaccurately by comparing this ratio with those of prior years, as well as withan industry average.

Inventory turnover of 10.52 times may not be a problem area (seediscussion of quick ratio above), but it should be compared with those ofprior years and with an industry averageturning over inventory every 34days may be normal for the industry.

The length of time that receivables are outstanding, 22 days, appears tobe relatively short. It may be an indication that the credit department is

doing a good job in screening customers for credit. On the other hand, if thecredit terms are too stringent, the company may be losing good customers.Comparison of this statistic with other companies in the same line ofbusiness would help to determine whether there is a problem in the creditdepartment.

The company appears to be successfully using outside capital, as isevidenced by a return on assets of 23.65% but a much higher return onstockholders equity of 34.78%. Further evidence of the companys use ofleverage could be found by examining the exact cost of each individual


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source of capital. For example, what are the terms of the instruments thatmake up long-term debt and what is the effective interest cost of each?

The times interest earned ratio indicates that earnings are nearly seventimes the amount of interest expensethat would appear to be excellentcoverage. However, how much cash is generated from operations? Is thiscash sufficient to cover not only interest payments but also maturingprincipal amounts? Calculation of the debt service coverage ratio, withinformation found on a cash flows statement, would provide further evidenceof the companys solvency.

Finally, to fully evaluate the companys financial health, it would benecessary to know more about its plans for the long run. Does it plan toexpand plant and equipment? Are there any plans to take on additionalproducts or acquire another company? Are any additional debt issues beingcontemplated?

LO 5,6 PROBLEM 13-6A PROJECTED RESULTS TO MEET CORPORATEOBJECTIVES

1. Projected results for the four objectives for Grout, Inc. (in thousands ofdollars):

Sales growth of 10% will be exceeded:

Sales increase for the year = $12,000 - $10,000 = 20%Sales for 2004 $10,000

Return on stockholders equity of 20% will not be met:

Net income preferred dividends = $400 - $0*Average stockholders equity ($5,000 + $5,000)/2

= $400/$5,000

= 8%

*No preferred stock.

Long-term debt-to-equity ratio of not more than 1 will not be achieved:

Long-term debt at 9/30/05 = $5,500____Stockholders equity at 9/30/05 ($4,000 + $1,000)

= $5,500/$5,000= 1.1 to 1

A cash dividend of 50% of net income will be met (dividends of 100% ofnet income are projected), but a minimum dividend payment of $500,000will not be met (the projected dividends are only $400,000).


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2. Contributing factors to Grouts failure to meet all its objectives include thefollowing:

Cost of goods sold, as a percentage of sales, is expected to increase in2005 from 2004, and the other two operating expenses are expected toremain the same:

2004 2005Cost of goods sold 60% 66.67%Selling expenses 15% 15.00%

Administrative expenses and interest 10% 10.00%

Accounts receivable will increase by $500,000 during the yeara 24%increase compared with an increase in sales of 20%. The potential for anincrease in bad debts will need to be monitored.

Production will exceed sales needs, as is evidenced by the 20% expectedincrease in the amount of inventory. This will result in additional carryingcosts for the year.

Long-term borrowing increased by 37.5% in the first six months of 2005,and it is expected to stay at this level at the end of the year.

3. Possible actions that the controller could recommend to the president inresponse to the problems cited above include the following:

Review the accounts receivable collection process to determine ways tospeed up collection and to determine whether credit is being extended tohigh-risk customers.

Slow down the production during the remainder of the year.

Examine the reasons for an increase in the ratio of cost of goods sold tosales.

Review the continuing increases in long-term debt and decide whetherthey are necessary. Consider the issuance of preferred stock as analternative form of financing.


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LO 4,5,6 PROBLEM 13-7A A COMPARISON WITHINDUSTRY AVERAGES

1. IndustryRatio Average Midwest, Inc.

Current ratio 1.20 1.26

Acid-test (quick) ratio .50 .34Inventory turnover 35 times 37.27 timesDebt-to-equity ratio .50 .69Times interest earned 25 times 4.13 timesReturn on sales 3% 4.68%

Asset turnover 3.5 times 3.82 timesReturn on common

stockholders equity 20% 23.19%

Calculations for Midwests ratios (thousands omitted):

Current ratio = Current assets/Current liabilities

$12,440/$9,900 = 1.26 to 1Acid-test ratio = (Cash + Marketable securities + Accountsreceivable)/Current liabilities

($1,790 + $1,200 + $400)/$9,900 = $3,390/$9,900 = .34 to 1

Inventory turnover ratio = Cost of goods sold/Average inventory$300,000/[($7,400 + $8,700)/2] = $300,000/$8,050 = 37.27 times

Debt-to-equity ratio = Total liabilities/Total stockholders equity($9,900 + $36,000)/$66,100 = $45,900/$66,100 = .69 to 1

Times interest earned = (Net income + Interest expense + Income taxexpense)/Interest expense

($14,900 + $8,600 + $12,000)/$8,600 = $35,500/$8,600 = 4.13 times

Return on sales = (Net income + Interest expense, net of tax)/Net sales[$14,900 + $8,600(1 .446*)]/$420,500 = ($14,900 + $4,764)/$420,000 =

$19,664/$420,500 = 4.68%

*Tax rate is $12,000/$26,900 = 44.6%.

Asset turnover = Net sales/Average total assets$420,500/[($108,000 + $112,000)/2] = $420,500/$110,000 = 3.82times

Return on common stockholders equity = (Net income Preferreddividends)/Average common stockholders equity

$14,900/[($62,400 + $66,100)/2]= $14,900/$64,250 = 23.19%

2. Midwest is not quite as liquid as the average company in the industry, as isevidenced by its lower quick ratio. The inventory turnover ratio is verysimilar to the industry average. Midwests accounts payable has decreasedduring the year, although this is offset by increases in each of the otherthree current liabilities.


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The company is not as solvent as the rest of the industry either, as isindicated by its higher debt-to-equity ratio and lower times interest earnedratio. The heavy reliance on outside funds, however, has not been adetriment to the companys profitability. Midwests return on equity is higherthan the industry average.

3. Midwest is already more highly leveraged than the average company in theindustry, but as was indicated earlier, has used borrowed money effectively.However, the loan decision will depend on other factors in addition to thecompanys relative standing in its industry. For example, the bank will lookat how Midwests ratios this year compare with those of prior years. Maybethe company is smaller than others in the industry and has alwaysperformed at its current level. If the bank approves the loan, it will probablyrequire a higher interest rate to compensate for any perceived additionalrisk.

D E C I S I O N C A S E S

READING AND INTERPRETING FINANCIAL STATEMENTS

LO 2 DECISION CASE 13-1 HORIZONTAL ANALYSIS FOR WINNEBAGO INDUSTRIES

1. and 2. (In millions of dollars)Increase (Decrease) from:

2001 to 2002 2000 to 2001

Income Statement Accounts Dollars % Dollars %Net revenues* $152.5 22.6% $(71.7) (9.6)%

Cost of manufactured products 120 .3 20.4 (52 .6) (8.2)Gross profit 32.2 36.9 (19.1) (18.0)Selling expenses 1.3 7.2 (.4) (2.3)General, and administrative

expenses 5.1 37.7 (3.5) (20.5)Financial income (.9) (23.8) .4 12.5Income before income taxes 24.8 41.9 (14.8) (20.0)Provision for taxes 13.9 89.9 (10.1) (40.0)Income before cumulativeeffect of change in accountingprinciple 10.9 25.0 (4.6) (9.6)

Cumulative effect of changein accounting principle 1.1 (100.0) (1.1) 0

Net income $12.0 28.0 $(5.7) (11.8)

* Includes both revenue from manufactured products and dealer financingrevenue. Thus, the gross profit ratios include both of these forms of revenuealso.

3. Net revenues increased by 22.6% in 2002, after a decrease in 2001of 9.6%. Also, gross profit increased even more significantly, by


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36.9%. These increases are reflected in the increase of 28% in netincome.

LO 3 DECISION CASE 13-2 VERTICAL ANALYSIS FORWINNEBAGO INDUSTRIES

1. Common-size comparative income statements:

WINNEBAGO INDUSTRIESCOMMON-SIZE CONSOLIDATED STATEMENTS OF INCOME

FOR THE YEARS ENDED AUGUST 31, 2002 AND AUGUST 25, 2001(IN MILLIONS OF DOLLARS)

2002 2001Dollars % Dollars %

Net revenues* $828.4 100.0% $ 675.9 100.0%Cost of manufactured products 708 .9 85 .6 588.6 87 .1

Gross profit 119.5 14.4 87.3 12.9Selling expenses 19.6 2.4 18.3 2.7General, and adminis-

trative expenses 18.7 2.3 13.6 2.0Financial income 2 .9 .4 3 .8 .6Income before income taxes 84.1 10.2 59.2 8.8Provision for taxes 29 .4 3 .5 15.5 2 .3Income before cumulative effectof change in accounting principle 54.7 6.6 43.8 6.5

Cumulative effect of change inacounting principle 0 0 1.1 .2

Net income $ 54 .7 6 .6 % $ 42.7 6 .3%

* Includes both revenue from manufactured products and dealer financingrevenue. Thus, the gross profit ratios include both of these forms of revenuealso.

2. Cost of manufactured products as a percentage of sales decreased by 1.5%from 2001 to 2002; as a result, the gross margin ratio is correspondingly1.5% higher in 2002. Selling expenses decreased as a percentage of salesby .3% and was offset by the same percentage increase in general andadministrative expenses. These factors contributed to a slight increase innet income as a percentage of sales, from 2001to 2002.


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3. Common-size comparative balance sheets

WINNEBAGO INDUSTRIESCOMMON-SIZE CONSOLIDATED BALANCE SHEETS

AT AUGUST 31, 2002 AND AUGUST 25, 2001(IN MILLIONS OF DOLLARS)


Cash and cash equivalents $ 42.2 12.5% $ 102.3 29.1%Receivables, less allowancefor doubtful accounts 28.6 8.5 21.6 6.1

Dealer financing receivables,less allowance for doubtfulaccounts 37.9 11.2 40.3 11.5

Inventories 113.7 33.7 79.8 22.7

Prepaid expenses 4.3 1.3 3.6 1.0Deferred income taxes 6 .9 2 .0 6 .7 1 .9Total current assets 233 .6 69 .3 254 .3 72 .3

Property and equipment,net 48.9 14.5 46.5 13.2

Investment in life insurance 23.6 7.0 22.2 6.3Deferred income taxes 22.4 6.6 21.5 6.1Other assets 8 .5 2 .5 7 .4 2 .1Total assets $ 337 .1 100 .0 % $ 351 .9 100 .0 %

Accounts payable, trade $ 44.2 13.1% $ 40.7 11.6%Income taxes payable 2.6 .8 4.9 1.4

Accrued expenses:Accrued compensation 18.7 5.5 13.7 3.9Product warranties 8.2 2.4 8.1 2.3Insurance 6.0 1.8 4.6 1.3Promotional 4.5 1.3 3.2 .9Other 4.5 1.3 4.8 1.4

Total current liabilities 88.6 26.3 80.0 22.7Postretirement health care andDeferred compensation benefits 68 .7 20 .4 64 .5 18 .3

Common stock, par value 12.9 3.8 12.9 3.7Additional paid-in capital 25.7 7.6 22.3 6.3

Reinvested earnings 284.9 84.5 234.1 66.5Treasury stock, at cost (143 .7 ) (42.6) (61 .9) (17 .6 )

Total stockholders equity 179 .8 53.3 207 .5 59.0Total equities $ 337 .1 100.0% $ 351 .9 100.0%


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4. Within the current asset category, cash decreased significantly in relativeimportance from the prior year, 29.1% in 2001 versus 12.5% in 2002.Overall, there was a minor decrease in current assets as a percentage oftotal assets. Property, plant, and equipment increased slightly, from 13.2%of total assets to 14.5% of total assets.

Total current liabilities increased as a percentage of total equities from22.7% in 2001 to 26.3% in 2002. The only other liability, postretirementhealth care and deferred compensation benefits increased in relativeimportance, from 18.3% in 2001 to 20.4% in 2002. The most significantchange on the balance sheet was the large increase in treasury stock.Because the company purchased a significant amount of its own stockduring 2002, this account increased dramatically, from less than 18% of totalequities to over 42%.

LO 3 DECISION CASE 13-3 COMPARING TWO COMPANIES IN THESAME INDUSTRY: WINNEBAGO INDUSTRIES AND MONACOCOACH CORPORATION

1. Common-size comparative income statements:

MONACO COACH CORPORATIONCOMMON-SIZE CONSOLIDATED STATEMENTS OF INCOME

FOR THE YEARS ENDED DECEMBER 28, 2002 AND DECEMBER 29, 2001(IN MILLIONS OF DOLLARS)


Net sales $1,222.7 100.0% $ 937.1 100.0%Cost of sales 1,059 .6 86 .7 823 .1 87 .8Gross profit 163.1 13.3 114.0 12.2

Selling, general, and adminis-trative expenses 87.2 7.1 70.7 7.5

Amortization of goodwill 0 0 .6 .1Operating income 75.9 6.2 42.7 4.6Other income, net .1 .3 .0Interest expense 2.8 .2 2 .4 2 .6Income before income taxes 73.3 6.0 40.6 4.3Provision for income taxes 28.8 2 .4 15 .7 1 .7Net income $44.5 3 .6 % $ 24 .9 2 .6 %

2. During 2002, Winnebago Industries reported a slightly higher gross profitratio than Monaco Coach Corporation. Also, Winnebago Industries ratio ofnet income to net sales, or profit margin as it is called, was higher in 2002than was the same ratio for Monaco Coach Corporation.

3. Common-size comparative balance sheets


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MONACO COACH CORPORATIONCOMMON-SIZE CONSOLIDATED BALANCE SHEETSAT DECEMBER 28, 2002 AND DECEMBER 29, 2001

(IN MILLIONS OF DOLLARS)


Trade receivables, net $ 116.6 21.3% 82.9 19.4%Inventories 175.6 32.1 127.1 29.8Resort lot inventory 26.9 4.9 0 0Prepaid expenses 3.6 6.6 2.1 .5Deferred income taxes 33.4 6 .1 27.3 6 .4

Total current assets 356 .1 65 .1 239 .4 56 .1Notes receivable 0 0 8.2 1.9Property, plant and equipment

net 135.4 24.7 122.8 28.8

Debt issuance costs, net .7 .1 .9 .2Goodwill, net 55.3 10 .1 55 .9 13 .0Total assets $ 547 .4 100 .0 % $ 427 .1 100 .0 %

Book overdraft $ 3.5 .6% $ 5.9 1.4%Line of credit 51.4 9.4 26.0 6.1Current portion of long-termNote payable 21.7 4.0 10.0 2.3

Accounts payable 78.1 14.3 66.9 15.7Product liability reserve 21.3 3.9 19.9 4.7Product warranty reserve 31.7 5.8 22.8 5.3Income taxes payable 4.5 .8 0 0

Accrued expenses and otherliabilities 29.6 5 .4 19.2 4.5

Total current liabilities 241.9 44.2 175.7 41 .1Long-term note payable 30.3 5.5 30.0 7.0

Deferred income taxes 14.6 2.7 8.3 1.9Common stock,par value .3 .1 .3 .1

Additional paid-in capital 51.5 9.4 48.5 11.4Retained earnings 208.8 38.1 164 .3 38.5

Total stockholders equity 260.6 47.6 213 .1 50.0Total equities $ 547 .4 100.0% $ 427 .1 100 .0 %

4. Winnebago Industries has a slightly higher percentage of its total assets inthe current assets category at the end of 2002 than does Monaco CoachCorporation. Conversely, Winnebago Industries current liabilities are alower percentage of total liabilities and stockholders equity than for MonacoCoach Corporation. The ratio of stockholders equity to total liabilities andstockholders equity is about 53% for Winnebago Industries while this sameratio for Monaco Coach Corporation is about 48%.


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LO 4,5,6 DECISION CASE 13-4 RATIO ANALYSIS FORWINNEBAGO INDUSTRIES

1. Ratios and other amounts for Winnebago Industries (all dollar amounts inthousands):

a. Working capital = Current assets Current liabilities2002: $233,596 $88,601 = $144,9952001: $254,256 $80,008 = $174,248

b. Current ratio = Current assets/Current liabilities2002: $233,596/$88,601 = 2.6 to 12001: $254,256/$80,008 = 3.2 to 1

c. Acid-test ratio = (Cash + Receivables + Dealer financingreceivables) /Current liabilities

2002: ($42,225 + $28,616 + $37,880)/$88,601 = $108,721/$88,601

= 1.2 to 12001: ($102,280 + $21,571 + $40,263)/$80,008 =$164,114/$80,008 2.1to 1

d. Cash flow from operations to current liabilities = Net cash provided byoperating activities/Average current liabilities

2002: $36,790/$88,601 = 41.5 %2001: $81,912/$80,008 = 102.4%

e. Number of days sales in receivables = Number of days in theperiod/Accounts receivable turnover (Net credit sales/AverageReceivables and Dealer financing receivables)

2002: Turnover = $828,403/($28,616 + $37,880) = 12.5Number days = 360 days/12.5 = 28.8 days

2001: Turnover = $675,927/($21,571 + $40,263) = 10.9Number days = 360 days/10.9 = 33.0 days

f. Number of days sales in inventory = Number of days in theperiod/Inventory turnover (Cost of manufactured products/Averageinventory)

2002: Turnover = $708,865/$113,654 = 6.2Number days = 360 days/6.2 = 58.1 days

2001: Turnover = $588,561/$79,815 = 7.4Number days = 360 days/7.4 = 48.6 days

g. Debt-to-equity ratio = Total liabilities/Total stockholders equity2002: ($88,601 + $68,661)/$179,815 = $157,262/$179,815

= .87 to 12001: ($80,008 + $64,450)/$207,464 = $144,458/$207,464

= .70 to 1


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h. Cash flow from operations to capital expenditures = (Cash flow fromoperations Total dividends paid)/Cash paid for acquisitions

2002: ($36,790 - $3,954)/$10,997 = 298.6%2001: ($81,912 - $4,121)/$9,089 = 855.9%

i. Asset turnover = Net sales/Total assets2002: $828,403/$337,077 = 2.5 times2001: $675,927/$351,922 = 1.9 times

j. Return on sales = (Net income + Interest expense* net of tax)/Net sales2002: [$54,671 + $298(1 .40)]/$828,403 = $54,849.8/$828,403 =

6.6%2001: [$42,704 + $89(1 .40)]/$675,927 = $42,757.4/$675,927 =

6.3%* Interest expense appears as part of financial income on the income

statement and its amount is reported in Note 8 to the financialstatements.

k. Return on assets = (Net income + Interest expense, net of tax)/Totalassets

2002: $54,849.8 (fromj.)/$337,077 = 16.3 %2001: $42,757.4 (fromj.)/$351,922 = 12.1 %

l. Return on common stockholders equity = (Net income preferreddividends)/Common stockholders equity

2002 ($54,671 - $0/$179,815 = 30.4%2001: ($42,704 - $0) /$207,464 = 20.6 %

2. Winnebago Industries appears to be relatively liquid over the two-yearperiod, although all of the measures of liquidity declined in 2002, such asworking capital, the current ratio, the acid-test ratio and cash flow fromoperations to current liabilities and the two turnover ratios.

The companys debt-to-equity ratio increased slightly in 2002. The ratioof cash flows from operations to capital expenditures decreased dramaticallyin 2002, from 855.9% during 2001 to 298.6% in 2002, primarily as a result ofa decrease in cash flow from operations.

Asset turnover increased from 1.9 times in 2001 to 2.5 times in 2002.Winnebago Industries return on sales remained relatively unchanged, itsreturn on assets increased from 12.1% in 2001 to 16.3% in 2002, and its

return on common stockholders equity decreased from 20.6% in 2001 to30.4% in 2002.


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MAKING FINANCIAL DECISIONS

LO 4,5,6 DECISION CASE 13-5 ACQUISITION DECISION

1. Several measures give an indication as to the companys liquidity:

Working capital has nearly doubled over the two-year period, from$88,930,000 in 2003 to $161,820,000 in 2004.

Both the current ratio and the quick ratio have also increased:Current ratio = Current assets/Current liabilities

2004: $324,120/$162,300 = 2.00 to 12003: $215,180/$126,250 = 1.70 to 1

Quick ratio = (Cash + Marketable securities + Short-termreceivables)/Current liabilities

2004: ($48,500 + $3,750 + $128,420)/$162,300 = 1.11 to 12003: ($24,980 +0 + $84,120)/$126,250 = .86 to 1

The accounts receivable turnover for 2004 = Net credit sales/Averageaccounts receivable: $875,250/[($128,420 + $84,120)/2] = 8.24 times, oran average collection period of 360/8.24 = 44 days

Whether this is a reasonable number of days outstanding could bepartially determined by an examination of the companys credit terms.

The inventory turnover for 2004 = Cost of goods sold/Average inventory:$542,750/[($135,850 + $96,780)/2] = 4.67 times, or an average number ofdays sales in inventory of 360/4.67 = 77 days

The cash operating cycle for 2004 is 44 + 77 = 121 days

Conclusion: The company appears on the surface to be fairly liquid, buteach of the above measures of liquidity should be compared with industryaverages. One area of concern is the large increase in both receivablesand inventories from the prior year. The company could be experiencingcollection problems. The inventory should be examined more closely forpossible obsolescence and slow-moving items.

2. The companys solvency can be examined by looking at the followingfactors:

The debt-to-equity ratio has increased slightly from the prior year: Totalliabilities/Total stockholders equity

2004: ($162,300 + $275,000)/$532,710 = .82 to 12003: ($126,250 + $275,000)/$519,820 = .77 to 1

The times interest earned ratio = Operating income*/Interest expense:$68,140/$45,000 or 1.51 times

*The ratio is normally calculated as net income + income tax expense +interest expense, divided by interest expense. Because the company has


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an extraordinary gain to take into account, the easiest approach is to usethe income number before taking all of these items into account, i.e.,operating income.

Conclusion: The company is carrying a heavy debt burden even thoughthe bonds are not due until 2011. It will continue to have large interestpayments for the next seven years. Further information on the operatingcash flows is necessary to see whether funds will be available to service thedebt currently outstanding. Interest payments not only will be a significantcash drain but also will affect the companys profitability.

3. Profitability can be assessed by looking at a number of ratios for 2004. Theextraordinary gain should be ignored in assessing profitability for ourpurposes, because we are interested in the future performance of thecompany and this gain is not expected to recur in the future. Return on assets = (Net income + Interest expense, net of tax)/Average

total assets: [$13,890 + ($45,000)(1.40*)] divided by ($970,010 +

$921,070)/2 = $40,890/$945,540 = 4.3%

*The tax rate can be approximated by dividing income tax expense of $9,250by net income before taxes and extraordinary items of $23,140.

Return on sales = (Net income + Interest expense, net of tax)/Net sales:$40,890/$875,250 = 4.7%

Asset turnover = Net sales/Average total assets: $875,250/$945,540 = .93 times

Return on common stockholders equity = (Net income Preferreddividends)/Average common stockholders equity: $13,890/[($532,710 +

$519,820)/2] = $13,890/$526,265 = 2.6%

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