CHAPTER 12 – FINANCIAL STATEMENT ANALYSIS PROBLEM SOLUTIONS
Assessing Your Recall
12.1 A retrospective analysis is one in which historical data are used to analyze the performance and liquidity of a company. A prospective analysis is one in which data are used to forecast the future (performance and liquidity) of a company.
12.2 A time-series analysis is one in which financial statement data for a single
company is analyzed across time. A cross-sectional analysis is one in which financial statement data from several companies are compared. The companies may be from the same industry or they may be from various sectors of the economy. Another version of the cross-sectional analysis would be to compare the company with industry average statistics. The cross-sectional analysis could also be conducted over time for a combined time-series, cross-sectional analysis. So time-series analyses are useful to study the trends of a company over time while cross-sectional analyses are used to compare one company to others.
12.3 The three major types of data that can be used in a time-series or a cross-sectional analysis are:
Raw Data – The raw financial statement data can be used, such as sales revenues, expenses, etc.
Common Size Data – common size data are obtained by comparing the raw data components to some common denominator. For instance, a common size income statement could be calculated by comparing each line item with the sales revenue for the period. On the balance sheet the common denominator is usually the total assets.
Ratio Data. – Ratios that compare various components of the raw financial statement data can be used as the inputs for these types of analyses.
12.4 The formula for each ratio is as follows:
a) ROA
ROA = Net Income + Interest Expense * (1 – Tax Rate)
Average Total Assets
= Net Income + Interest Expense * (1 – Tax Rate)
Sales Revenue
x Sales Revenue
Average Total Assets
= Profit Margin Ratio x Total Asset Turnover
b) ROE
ROE = Net Income – Preferred Dividends
Average Shareholders’ Equity
c) Accounts Receivable Turnover
Accounts Receivable = Sales On Account
Turnover Average Accounts Receivable
d) Inventory Turnover
Inventory Turnover = Cost of Goods Sold
Average Inventory
e) Accounts Payable Turnover
Accounts Payable = Cost of Goods Sold
Turnover Average Accounts Payable
f) Current Ratio
Current Ratio = Current Assets
Current Liabilities
g) Quick Ratio
Quick Ratio = Current Assets – Inventories
Current Liabilities
h) D/E (I)
D/E (I) = Total Liabilities
Total Liabilities + Shareholders’ Equity
or Total Liabilities
Total Assets
i) D/E (II)
D/E(II) = Total Liabilities
Total Shareholders’ Equity
j) D/E (III)
D/E(III) = Total Long-term Liabilities
Total Long-term Liabilities and Shareholders’ Equity
k) Times Interest Earned
Times Interest Earned = Income before Interest and Taxes
(TIE) Interest Expense
= Net Income + Taxes + Interest Expense
Interest Expense
12.5 The amount of cash produced from operations depends upon several factors. Three of those factors are the accounts receivable, inventory, and accounts payable policies. The leads and lags between the cash outflows for production and the cash inflows from collections on sales are important in understanding the company’s cash generating capabilities. The turnover ratios, when converted into the “number of days” form, provide some insight into how long these lags are for a company. Changes in these ratios also provide information about whether there have been significant changes in these policies or in enforcing these policies. The accounts receivable turnover, for instance, tells you how long, on average, it takes to collect an account receivable. Comparing this ratio with a company’s stated receivables policy allows you to assess whether or not they are doing a good job of collecting.
The shareholders of the company leverage their investment when they borrow some of the money needed to invest in the assets of the company. This works to the advantage of the shareholders if the cost to borrow the money is less than the return that they can earn by investing in the assets of the company. It works to their disadvantage if the cost to borrow exceeds the return on the assets invested. ROA provides a measure of the return on the assets of the company. As long as this return is higher than the after tax cost of the debt the shareholders’ return (ROE) should be higher than the ROA. This higher return will be evidenced by a higher ROE for the company (higher than ROA). If the after tax, cost of borrowing exceeds the ROA then ROE will be lower than ROA.
12.6 The ROA ratio can be broken down into two ratios: a profit margin ratio and a total asset turnover ratio. The ratios are as follows:
ROA = Net Income + Interest Expense * (1 – Tax Rate)
Average Total Assets
= Net Income + Interest Expense * (1 – Tax Rate)
Sales Revenue
x Sales Revenue
Average Total Assets
= Profit Margin Ratio x Total Asset Turnover
A retail clothing store could employ two different strategies of obtaining a particular ROA. One strategy would be to set prices to achieve a relatively high profit margin. Because of the high prices the total asset turnover might not be as high as it would otherwise be because the company may have to invest more in its stores to attract the kind of clientele that will pay the high prices. The volume of sales per dollar of investment (total asset turnover) may, therefore, be lower. Another store in the same industry may adopt a different strategy in which it charges lower prices (lower profit margin ratio) but make up for it by not investing as much in its stores and, hopefully, makes up for the lower profit margin with a higher volume per dollar of investment.
12.7 The advantage of common size statements are that they make it easy to make proportionate comparisons that are not as easy using the raw data. For instance, in a given year both the revenues and the cost of goods sold may increase, as evidenced by the raw data. If, however, the cost of goods sold increases faster than the revenues the profit margin of the company will decline. This decline could easily be seen in a common size set of statements.
12.8 The current ratio is subject to manipulation because at year-end the company can adjust its spending and payment patterns to produce a current ratio that is desired. Paying off accounts payable with cash at year-end will improve the current ratio, for instance, but may not be a sign of improved liquidity.
12.9 The accounts payable turnover ratio is ideally calculated as follows:
Accounts Payable = Credit Purchases
Turnover Average Accounts Payable
The problem with this calculation is that credit purchases is not a readily available number. As a surrogate for credit purchases the cost of goods sold number is often used. How good a surrogate this is depends on the type of company and its credit policies. In a retail company the cost of goods sold number will be a good surrogate for the credit purchases if most goods are bought on credit and there is relatively little change in the balance of accounts payable from the beginning of the period to the end. If not all goods are purchased on credit this surrogate will tend to overstate the turnover. There is a further problem with this ratio in a manufacturing company. In this case, the cost of goods sold number includes many costs other than those associated with purchases during the period. For example salaries, amortization, etc. Therefore, in a manufacturing company this ratio tends to be overstated.
12.11 The earnings per share of a company is calculated by dividing the earnings of the company by the average number of shares that were outstanding during the period. In some companies there exists the possibility that more shares may be issued (other than those currently outstanding) due to agreements such as stock option plans and convertible securities (securities such as convertible debt or convertible preferred shares) that can, at the option of the holder, be converted into common shares. Because of the potential to issue more shares the calculated earnings per share based on the actual number of shares outstanding may not truly reflect the earnings per share of the company since it may be likely that some investors will exercise their options or convert their debt or preferred shares into common shares. This will have the effect of diluting earnings per share. The purpose of basic and fully diluted earnings per share is to give the reader of the financial statement some idea of the effect that these conversions might have on the earnings per share number. Basic earnings per share is a reflection of the current earnings and fully diluted earnings per share is a reflection of the worst case scenario assuming outstanding issuances or conversions occurred.
12.12 The lower the times interest earned ratio, the greater is the credit risk of the
company. This relationship exists because a company that is experiencing difficulties meeting its interest payments on existing debt has a greater potential to default on an additional loan. From the perspective of lenders, this greater default risk translates into a higher assessed credit risk.
Applying Your Knowledge
12.13 a)
Current Ratio / Quick RatioYear 1: / $1,500 / $1,000 = 1.5 / ($1,500 - $600) / $1,000 = 0.9
Year 2: / $2,000 / $1,250 = 1.6 / ($2,000 - $1,100) / $1,250 = 0.7
Year 3 / $2,500 - $1,485 = 1.7 / ($2,500 - $1,700) / $1,485 = 0.5
Year 4 / $3,000 / $1,500 = 2.0 / ($3,000 - $2,200) / $1,500 = 0.5
b) The current ratio has shown an increasing trend over the four years and
can be considered respectable as seen in year 4. However, this 4 year upward trend has been at the cost of stocking more inventory and this has resulted in a downward trend in the quick ratio, which has become 0.5 in Year 4.
12.14 a)
Current Ratio /20x1 / $300,991 / $239,789 = 1.3
20x2 / $310,739 / $160,345 = 1.9
b)
Quick Ratio
20x1 ($62,595 + $96,242) / $239,789 = 0.7
20x2 ($67,834 + $98,666) / $160,345 = 1.0
c) Sundry incurred a net loss in 20x2 because the balance in retained earnings decreased, although no dividends were declared. The amount of the net loss is equal to the change in retained earnings from the prior year, or $1,461.
d)
Debt / equity20x1 / $532,764 / $866,036 = 62%
20x2 / $549,130 / $885,194 = 62%
e) Declaring a dividend is possible because the company has a reasonable cash balance, and is in a comfortable position regarding short-term liquidity. This can be seen from the current and quick ratios. The debt to equity ratio is unchanged from the prior year, and indicates that 62% of the company’s assets are financed through debt. However, because long-term debt increased in 20x2, interest payments can be expected to rise in the future. In addition, since the company incurred a net loss for the year, declaring a dividend is not recommended.
12.15 a) Accounts receivable Turnover
Campton Electric:
$3,893,567 / [($542,380 + $628,132) / 2 ] = 6.65
Johnson Electrical:
$1,382,683 / [($168,553 + $143,212) / 2] = 8.87
b) Average number of days required to collect Accounts Receivable:
Campton: 365 / 6.65 = 55 days
Johnson: 365 / 8.87 = 41 days
c) Given that these companies are in the same industry, Johnson would appear to be more efficient in collecting its accounts receivable.
d) In order to assess management’s handling of the collection of accounts receivable, it would be helpful to know the credit terms that each company offers to its customers. This could then be compared against the turnover in days to determine whether the credit terms are being enforced.
12.16 a) Accounts receivable Turnover
20x0: $3,218,449 / $350,672 = 9.18
20x1: $3,585,391 / [($350,672 + $362,488) / 2] = 10.05
20x2: $3,988,432 / [($362,488 + $358,562) / 2] = 11.06
b) Average number of days required to collect Accounts Receivable:
20x0: 365 / 9.18 = 40 days
20x1: 365 / 10.05 = 36 days
20x2: 365 / 11.06 = 33 days
c) Accounts receivable turnover is increasing each year, and collection seems to be occurring faster. To help understand these trends, information regarding changes in credit terms, the sales mix, or the types of customers would be helpful.
12.17 a)
Year 1: / $463,827 / $65,537 = 7.08 / 365 / 7.08 = 52 days
Year 2: / $511,125 / $81,560 = 6.27 / 365 / 6.27 = 58 days
Year 3 / $593,350 / $110,338 = 5.38 / 365 / 5.38 = 68 days
Year 4: / $679,686 / $166,672 = 4.08 / 365 / 4.08 = 89 days
Year 5: / $708,670 / $225,895 = 3.14 / 365 / 3.14 = 116 days
b) The inventory Turnover has decreased over the 5 year period suggesting a periodic increase in the time that the inventory is held. This is not favorable. It is possible that this change could be due to a change in the type of inventory that is being sold by the company and, therefore, might not indicate a major problem. Information on such changes is needed in order to comment on the management of inventories.
12.18 a) Inventory turnover:
Green Grocers:
$8,554,921 / [($582,633 + $547,925) / 2] = 15.13
Fast Lane Foods:
$2,769,335 / [($174,725 + $195,446) / 2] = 14.96
b) Average number of days inventory is held:
Green Grocers: 365 / 15.13 = 24 days