Chapter 05 - Financial Statements Analysis - II PDF

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MANAGEMENT ACCOUNTING (VOLUME I) - Solutions ManualCHAPTER 5FINANCIAL STATEMENTS ANALYSIS - III. Questions By looking at trends, an analyst hopes to get some idea of whether a situation is improving, remaining the same, or deteriorating. Such analyses can provide insight into what is likely to happe...

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MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual

CHAPTER 5 FINANCIAL STATEMENTS ANALYSIS - II

I.

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

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Chapter 5 Financial Statement Analysis –II

5. Financial leverage, as the term is used in business practice, means obtaining funds from investment sources that require a fixed annual rate of return, in the hope of enhancing the well-being of the ordinary shareholders. If the assets in which these funds are invested earn at a rate greater that the return required by the suppliers of the funds, then leverage is positive in the sense that the excess accrues to the benefit of the ordinary shareholders. If the return on assets is less than the return required by the suppliers of the funds, then leverage is negative in the sense that part of the earnings from the assets provided by the ordinary shareholders will have to go to make up the deficiency. 6. How a shareholder would feel would depend in large part on the stability of the firm and its industry. If the firm is in an industry that experiences wide fluctuations in earnings, then shareholders might be very pleased that no interest-paying debt exists in the firm’s capital structure. In hard times, interest payments might be very difficult to meet, or earnings might be so poor that negative leverage would result. 7. No, the stock is not necessarily overpriced. Book value represents the cumulative effects on the balance sheet of past activities evaluated using historical prices. The market value of the stock reflects investors’ beliefs about the company’s future earning prospects. For most companies market value exceeds book value because investors anticipate future growth in earnings. 8. A company in a rapidly growing technological industry probably would have many opportunities to invest its earnings at a high rate of return; thus, one would expect it to have a low dividend payout ratio. 9. It is more difficult to obtain positive financial leverage from preference shares than from long-term debt due to the fact that interest on long-term debt is tax deductible, whereas dividends paid on preference shares are not tax deductible. 10. The current ratio would probably be highest during January, when both current assets and current liabilities are at a minimum. During peak operating periods, current liabilities generally include short-term borrowings that are used to temporarily finance inventories and receivables. As the peak periods end, these short-term borrowings are paid off, thereby enhancing the current ratio. 11. A 2-to-1 current ratio might not be adequate for several reasons. First, the composition of the current assets may be heavily weighted toward 5-2

Financial Statement Analysis –II Chapter 5

slow-turning inventory, or the inventory may consist of large amounts of obsolete goods. Second, the receivables may be large and of doubtful collectibility, or the receivables may be turning very slowly due to poor collection procedures. 12. Expenses (including the cost of goods sold) have been increasing at an even faster rate than net sales. Thus Sunday is apparently having difficulty in effectively controlling its expenses. 13. If the company’s earnings are very low, they may become almost insignificant in relation to stock price. While this means that the p/e ratio becomes very high, it does not necessarily mean that investors are optimistic. In fact, they may be valuing the company at its liquidation value rather than a value based upon expected future earnings. 14. From the viewpoint of the company’s shareholders, this situation represents a favorable use of leverage. It is probable that little interest, if any, is paid for the use of funds supplied by current creditors, and only 11% interest is being paid to long-term bondholders. Together these two sources supply 40% of the total assets. Since the firm earns an average return of 16% on all assets, the amount by which the return on 40% of the assets exceeds the fixed-interest requirements on liabilities will accrue to the residual equity holders – the ordinary shareholders – raising the return on equity. 15. The length of operating cycle of the two companies cannot be determined from the fact the one company’s current ratio is higher. The operating cycle depends on the relationships between receivables and sales, and between inventories and cost of goods sold. The company with the higher current ratio might have either small amounts of receivables and inventories, or large sales and cost of sales, either of which would tend to produce a relatively short operating cycle. 16. The investor is calculating the rate of return by dividing the dividend by the purchase price of the investment (P5  P50 = 10%). A more meaningful figure for rate of return on investment is determined by relating dividends to current market price, since the investor at the present time is faced with the alternative of selling the stock for P100 and investing the proceeds elsewhere or keeping the investment. A decision to retain the stock constitutes, in effect, a decision to continue to invest P100 in it, at a return of 5%. It is true that in a historical sense the investor is earning 10% on the original investment, but this is interesting history rather than useful decision-making information. 5-3

Chapter 5 Financial Statement Analysis –II

17. A corporate net income of P1 million would be unreasonably low for a large corporation, with, say, P100 million in sales, P50 million in assets, and P40 million in equity. A return of only P1 million for a company of this size would suggest that the owners could do much better by investing in insured bank savings accounts or in government bonds which would be virtually risk-free and would pay a higher return. On the other hand, a profit of P1 million would be unreasonably high for a corporation which had sales of only P5 million, assets of, say, P3 million, and equity of perhaps one-half million pesos. In other words, the net income of a corporation must be judged in relation to the scale of operations and the amount invested. II. True or False 1. True 2. True

3. True 4. False

5. True 6. True

7. True 8. True

9. False 10. False

III. Problems Problem 1 (Common Size Income Statements) Common size income statements for 2005 and 2006: 2006 2005 Sales................................................. 100% 100% Cost of goods sold............................ 66 67 Gross profit....................................... 34% 33% Operating expenses........................... 28 29 Net income....................................... 6% 4% The changes from 2005 to 2006 are all favorable. Sales increased and the gross profit per peso of sales also increased. These two factors led to a substantial increase in gross profit. Although operating expenses increased in peso amount, the operating expenses per peso of sales decreased from 29 cents to 28 cents. The combination of these three favorable factors caused net income to rise from 4 cents to 6 cents out of each peso of sales. Problem 2 (Measures of Liquidity) Requirement (a) Current assets: Cash

P 47,600 5-4

Financial Statement Analysis –II Chapter 5

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

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

Requirement (b) The current ratio is 2.8 to 1. It is computed by dividing the current assets of P637,280 by the current liabilities of P227,600. The amount of working capital is P409,680, computed by subtracting the current liabilities of P227,600 from the current assets of P637,280. The company appears to be in a strong position as to short-run debt-paying ability. It has almost three pesos of current assets for each peso of current liabilities. Even if some losses should be sustained in the sale of the merchandise on hand or in the collection of the accounts receivable, it appears probable that the company would still be able to pay its debts as they fall due in the near future. Of course, additional information, such as the credit terms on the accounts receivable, would be helpful in a careful evaluation of the company’s current position. Problem 3 (Common-Size Income Statement) Requirement 1

2006 2005 Sales........................................................................................................................ 100.0 % 100.0 % Less cost of goods sold........................................................................................... 63.2 60.0 Gross margin........................................................................................................... 36.8 40.0 Selling expenses...................................................................................................... 18.0 17.5 Administrative expenses......................................................................................... 13.6 14.6 Total expenses......................................................................................................... 31.6 32.1 Net operating income.............................................................................................. 5.2 7.9 Interest expense....................................................................................................... 1.4 1.0 Net income before taxes.......................................................................................... 3.8 % 6.9 % 5-5

Chapter 5 Financial Statement Analysis –II

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

Sales (net) Cost of goods sold Gross profit on sales Operating expenses: Selling General and administrative Total operating expenses Operating income Income taxes Net income.......................................

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

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

Requirement (b) Ms. Freeze’s operating results are significantly better than the average performance within the industry. As a percentage of sales revenue, Ms. Freeze’s operating income and net income after nearly twice the average for the industry. As a percentage of total assets, Ms. Freeze’s profits amount to an impressive 23% as compared to 14% for the industry. The key to Ms. Freeze’s success seems to be its ability to earn a relatively high rate of gross profit. Ms. Freeze’s exceptional gross profit rate (51%) probably results from a combination of factors, such as an ability to command a premium price for the company’s products and production efficiencies which lead to lower manufacturing costs. 5-6

Financial Statement Analysis –II Chapter 5

As a percentage of sales, Ms. Freeze’s selling expenses are five points higher than the industry average (21% compared to 16%). However, these higher expenses may explain Ms. Freeze’s ability to command a premium price for its products. Since the company’s gross profit rate exceeds the industry average by 8 percentage points, the higher-than-average selling costs may be part of a successful marketing strategy. The company’s general and administrative expenses are significantly lower than the industry average, which indicates that Ms. Freeze’s management is able to control expenses effectively. Problem 5 (Common-Size Statements) Requirement 1 The income statement in common-size form would be: Sales......................................................... Less cost of goods sold............................ Gross margin............................................ Less operating expenses........................... Net operating income............................... Less interest expense................................ Net income before taxes........................... Less income taxes (30%)......................... Net income...............................................

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

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

The balance sheet in common-size form would be: 2006 Current assets: Cash .......................................................... Accounts receivable, net .......................................................... Inventory .......................................................... Prepaid expenses .......................................................... Total current assets Plant and equipment................................. Total assets............................................... 5-7

2.0%

2005 5.1%

15.0

10.1

30.1

15.2

1.0

1.3

48.1

31.6

51.9 100.0%

68.4 100.0%

Chapter 5 Financial Statement Analysis –II

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

25.1% 20.1 45.1

12.7% 25.3 38.0

15.0

19.0

Ordinary shares, P5 par

10.0

12.7

Retained earnings

29.8

30.4

54.9

62.0

100.0%

100.0%

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

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

P

74.8 152.7 1,191.8 95.5 P1,514.8

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Financial Statement Analysis –II Chapter 5

Cash Receivables Total quick assets

P

74.8 152.7 P 227.5

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

P1,514.8 P1,939.0 0.8 to 1

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

P 227.5 P1,939.0 0.1 to 1

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

P1,514.8 P1,939.0 P(424.2)

Requirement (c) No. It is difficult to draw conclusions from the above ratios. Alabang Supermarket’s current ratio and quick ratio are well below “safe” levels, according to traditional rules of thumb. On the other hand, some large companies with steady ash flows are able to operate successfully with current ratios lower than Alabang Supermarket’s. Requirement (d) Due to characteristics of the industry, supermarkets tend to have smaller amounts of current assets and quick assets than other types of merchandising companies. An inventory of food has a short shelf life. Therefore, the inventory of a supermarket usually represents only a few weeks’ sales. Other merchandising companies may stock inventories representing several months’ sales. Also, supermarkets sell primarily for cash. Thus, they have relatively few receivables. Although supermarkets may generate large amounts of cash, it is not profitable for them to hold assets in this form. 5-9

Chapter 5 Financial Statement Analysis –II

Therefore, they are likely to reinvest their cash flows in business operations as quickly as possible. Requirement (e) In evaluating Alabang Supermarket’s liquidity, it would be useful to review the company’s financial position in prior years, statements of cash flows, and the financial ratios of other supermarket chains. One might also ascertain the company’s credit rating from an agency such as Dun & Bradstreet. Note to Instructor: Prior to the year in which the data for this problem was collected, Alabang Supermarket had reported a negative retained earnings balance in its balance sheet for several consecutive periods. The fact that Alabang Supermarket has only recently removed the deficit from its financial statements is also worrisome.

Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk) Requirement (a) (1) Quick assets: Cash Marketable securities (short-term) Accounts receivable Total quick assets

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

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

...