Solution manual Fundamentals of Accounting by Cabrera Chapter 12 SM PDF

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Chapter 12Financial Statements AnalysisReview Questions A ratio is a mathematical expression of the relation of one figure to another. The purpose in computing a ratio is simply to draw attention to this relationship. The reader of a financial statement may observe, for example, that sales were P12 ...

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Chapter 12 Financial Statements Analysis Review Questions 1. A ratio is a mathematical expression of the relation of one figure to another. The purpose in computing a ratio is simply to draw attention to this relationship. The reader of a financial statement may observe, for example, that sales were P12 million and accounts receivable P1 million. If he or she states this relationship as a ratio—that is, that receivables turn over about 12 times per year—the information may become more useful. 2. Measures of liquidity include the following (three required): Current ratio (current assets divided by current liabilities). Quick ratio (quick assets divided by current liabilities). Working capital (current assets less current liabilities). Net cash provided by operating activities (appears in a statement of cash flows). 3. Current assets are expected to be converted into cash (or substituted for cash) within one year or an operating cycle, whichever is the longer period of time. The receivables of a company that regularly sells merchandise on 24- or 36month installment plans are current assets, because the collection of these receivables is part of the company’s operating cycle. 4. The quick ratio is quick assets (cash, marketable securities, and receivables) divided by current liabilities. Short-term creditors may consider the quick ratio more useful than the current ratio if inventories consist of slow-moving merchandise, or are unusually large in peso amount. 5. The debt ratio is computed by dividing total liabilities by total assets. It is considered a measure of the long-term safety of creditors’ claims, rather than a measure of short-term liquidity.

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6. Ratios and other measures used in evaluating profitability include (four required): Percentage change in net income from the prior year (peso amount of the change divided by the amount in the prior year). Gross profit rate (peso gross profit divided by net sales). Operating income (revenue from primary business activities less the cost of goods sold and operating expenses). Net income as a percentage of net sales (net income divided by net sales). Earnings per share (in the simplest case, net income divided by the number of shares of share capital outstanding). Return on assets (operating income divided by average total assets). Return on equity (net income divided by average equity). 7. A large corporation may have thousands or even millions of individual shareholders. The extent of each shareholder’s ownership of the business is determined by the number of shares that he or she owns. Thus, the earnings per share measurement helps shareholders relate the total earnings of the business to their ownership investments. 8. If the company’s earnings are very low, they may become almost insignificant in relation to share 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. 9. 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 riskfree and would pay a higher return. 10. The current ratio would probably be higher during July. At this time the amount of both current assets and current liabilities are likely to be at a minimum, and the ratio of current assets to current liabilities is thus likely to be larger. In general, it would be advisable for the company to end its fiscal year as of July 31. At this time inventories and receivables will be at a minimum; therefore, the chance of error in arriving at a valuation for these

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assets will be minimized, the work of taking inventories will be reduced, and a more accurate determination of net income is probable.

Exercises Exercise 1 (Pesos in Millions) a. (1) Quick assets: Cash and short-term investments ............................................... Receivables ................................................................................ Total quick assets ....................................................................

P 94.6 319.4 P414.0

(2) Current assets: Quick assets [part a (1)] ............................................................. Inventories .................................................................................. Prepaid expenses and other current assets .................................. Total current assets .................................................................

P414.0 144.6 64.0 P622.6

b. (1) Quick ratio: Total quick assets (part a) .......................................................... Current liabilities ........................................................................ Quick ratio (P414  P260.2) ...................................................

P414.0 260.2 1.6 to 1

(2) Current ratio: Total current assets (part a) ........................................................ Current liabilities ........................................................................ Current ratio (P622.6  P260.2) ..............................................

P622.6 260.2 2.4 to 1

(3) Working capital: Total current assets (part a) ........................................................ Less: Current liabilities .............................................................. Working capital.......................................................................

P622.6 260.2 P362.4

c. By traditional standards, Shin Toys seems to be quite solvent. Both its quick ratio and current ratio are well above rule-of-thumb levels, and its working capital balance is substantial. As a large and well-established company, it is quite possible that Shin Toys might be able to remain solvent even if its liquidity measures became lower than normal.

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Exercise 2 Requirement (a) (Pesos in thousands, except per share amounts) WANSO, INC. Statement of Earnings For the Year Ended December 31, 2007 Net sales ............................................................................................... P8,790,506 Less: Cost of goods sold....................................................................... 5,642,910 Gross profit........................................................................................... P3,147,596 Less: Operating expenses ..................................................................... 2,008,792 Operating income ................................................................................. P1,138,804 Nonoperating items: Interest revenue..................................................... P 31,594 Income taxes ......................................................... (462,320) (430,726) Net earnings ......................................................................................... P 708,078 Earnings per share ................................................................................

P3.16

Requirement (b) (1) Gross profit rate: Gross profit Net sales Gross profit rate (P3,147,596  P8,790,506) (2) Net income as a percentage of net sales: Net income Net sales Net income as a percentage of net sales (P708,078  P8,790,506) (3) Return on assets: Operating income Average total assets Return on assets (P1,138,804  P4,686,136) (4) Return on equity: Net income Average equity Return on equity (P 708,078  P3,280,874)

P3,147,596 P8,790,506 35.8% P 708,078 P8,790,506 8.1% P1,138,804 P4,686,136 24.3% P 708,078 P3,280,874 21.6%

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Requirement (c) The sale of retail clothing represents the company’s primary source of revenue from operations. Thus, interest revenue is a nonoperating source of revenue. To include interest revenue in the gross profit computation would overstate both gross profit and operating income. Exercise 3 a. Percentage change in earnings per share: In 2007: Peso change from prior year (P9.06 – P6.16) ..................................... +P2.90 Earnings per share in 2006.................................................................. P6.16 Percentage change (+P2.90  P6.16) .................................................. +47.1% In 2008: Peso change from prior year (P10.96 – P9.06) ................................... +P1.90 Earnings per share in 1987.................................................................. P9.06 +21.0% Percentage change (+P1.90  P9.06) .................................................. b. 2.5 to 1 (P27.50 market price divided by P10.96 earnings per share.) c. The low p/e ratio, especially in the face of rapidly accelerating earnings, indicates that investors expected Auto Max’s future earnings to decline from the 2008 levels. It appears that the market was right, as earnings per share levels for 2009 through 2013 were far below the 2008 level.

Note to instructor: All earnings per share figures shown in the problem have been adjusted to reflect the effect of a 2-for-1 share split which occurred subsequent to 2008.

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Exercise 4 Requirement (a) Return on assets

= =

Operating income Average total assets P4,844 = P4,844 = 16.3% P29,744 [(P29,096 + P30,392)  2]

Requirement (b) Return on equity

= =

Net income Average total equity P698 [(P9,124 + P9,348)  2]

P698 = 7.6% P9,236

Requirement (c) Equity figures shown in the balance sheet are reported at book value, not market value. Thus, the increase in Happy Talk’s total equity for the year did not result from an increase in the market value of the company’s shares. Exercise 5 a. (1) Gross profit percentage: 2007: 32% [(P1,200,000 − P816,000)  P1,200,000] 2008: 34% [(P1,500,000 – P990,000)  P1,500,000] (2) Inventory turnover: 2007: 4 times (P816,000  P204,000 average inventory) 2008: 4.5 times (P990,000  P220,000 average inventory) (3) Accounts receivable turnover: 2007: 6 times (P1,200,000  P200,000 average accounts receivable) 2008: 5 times (P1,500,000  P300,000 average accounts receivable) b. There are three highly favorable trends. First, the growth in net sales from P1,200,000 to P1,500,000. This represents an increase of 25% (P300,000 increase, divided by P1,200,000 in the prior year). Next, the gross profit rate increased from 32% in 2007 to 34% in 2008. Not only is Spectrum’s selling

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more, but it is selling its merchandise at a higher profit margin. Finally, the inventory turnover has increased, indicating that the company has increased its sales without having to proportionately increase its investment in inventories. There is only one negative trend. The accounts receivable turnover rate has declined. One question immediately should come to mind: Has Spectrum’s liberalized its credit policies as part of its strategy to increase sales? If so, the “slowdown” in the receivables turnover may have been expected and be no cause for concern. On the other hand, if the company has not changed its credit policies, it apparently is encountering more difficulty in collecting its accounts receivable on a timely basis. Exercise 6 a. b. c. d. e. f. g.

Current ratio: 3.6 to 1 (P1,080,000  P300,000) Quick ratio: 1.4 to 1 (P420,000  P300,000) Working capital: P780,000 (P1,080,000 – P300,000) Debt ratio: 40% (P960,000  P2,400,000) Accounts receivable turnover: 18 times (P5,580,000  P310,000) Inventory turnover: 6.2 times (P3,348,000  P540,000) Book value per share of capital stock: P24.00 (P1,440,000  60,000 shares)

Exercise 7 a.

Current assets: Cash 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

95,200 350,080 460,900 359,200 9,000 P1,274,380 P

P 140,000 250,860 15,140 29,200 20,000 P 455,200

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b. The current ratio is 2.8 to 1. It is computed by dividing the current assets of P1,274,380 by the current liabilities of P455,200. The amount of working capital is P819,180, computed by subtracting the current liabilities of P455,200 from the current assets of P1,274,380. 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. Exercise 8 (Pesos in Millions) a.

Current assets: Cash Receivables Merchandise inventories Prepaid expenses Total current assets Quick assets: Cash Receivables Total quick assets

b.

(1)

(2)

(3)

P 149.6 305.4 2,383.6 191.1 P3,029.6 P149.6 305.4 P455.0

Current ratio: Current assets (part a) Current liabilities Current ratio (P3,029.6  P3,878.0)

P3,029.6 P3,878.0 0.8 to 1

Quick ratio: Quick assets (part a) Current liabilities Quick ratio (P455  P3,878.0)

P455.0 P3,878.0 0.1 to 1

Working capital: Current assets (part a) Less: Current liabilities Working capital

P3,029.6 3,878.0 P(848.4)

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c.

No. It is difficult to draw conclusions from the above ratios. Makati’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 cash flows are able to operate successfully with current ratios lower than Makati’s.

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. Therefore, they are likely to reinvest their cash flows in business operations as quickly as possible.

e.

In evaluating Makati’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.

Exercise 9 Requirement 1

Net income ................................................. Less preference dividends .......................... Net income remaining for ordinary (a) ...... Average number of ordinary shares (b)...... Earnings per share (a) ÷ (b)........................

This Year P324,000 16,000 P308,000 50,000 P6.16

Last Year P240,000 16,000 P224,000 50,000 P4.48

Ordinary dividend per share (a)* ............... Market price per share (b) .......................... Dividend yield ratio (a) ÷ (b) .....................

P2.16 P45.00 4.8%

P1.20 P36.00 3.33%

a.

b.

*P108,000 ÷ 50,000 shares = P2.16; P60,000 ÷ 50,000 shares = P1.20

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c.

Ordinary dividend per share (a) ............... Earnings per share (b) .............................. Dividend payout ratio (a) ÷ (b) ................

This Year P2.16 P6.16 35.1%

Last Year P1.20 P4.48 26.8%

d.

Market price per share (a) ........................ Earnings per share (b) .............................. Price-earnings ratio (a) ÷ (b) ....................

P45.00 P6.16 7.3

P36.00 P4.48 8.0

Investors regard Metro Building Supply less favorably than other firms in the industry. This is evidenced by the fact that they are willing to pay only 7.3 times current earnings for a share of the company’s stock, as compared to 9 times current earnings for the average of all stocks in the industry. If investors were willing to pay 9 times current earnings for Metro Building Supply’s stock, then it would be selling for about P55 per share (9 × P6.16), rather than for only P45 per share.

Equity ........................................................ Less preference shares .............................. Ordinary equity (a) ....................................

This Year P2,150,000 200,000 P1,950,000

Last Year P1,950,000 200,000 P1,750,000

Number of ordinary shares (b) .................. Book value per share (a) ÷ (b)...................

50,000 P39.00

50,000 P35.00

e.

A market price in excess of book value does not mean that the price of a stock is too high. Market value is an indication of investors’ perceptions of future earnings and/or dividends, whereas book value is a result of already completed transactions and is geared to the past. Requirement 2 a. Net income ................................................ Add after-tax cost of interest paid: [P90,000 × (1 – 0.40)] ........................... Total (a) ..................................................... Average total assets (b).............................. Return on total assets (a) ÷ (b) .................. b.

This Year P 324,000

Last Year P 240,000

54,000 P 378,000

54,000 P 294,000

P3,650,000 10.4% This Year

P3,000,000 9.8% Last Year

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Net income ................................................ Less preference dividends ......................... Net income remaining for ordinary shareholders (a) .....................................

P 324,000 16,000

P 240,000 16,000

P 308,000

P 224,000

Average total equity*................................. Less average preference shares ................ Average ordinary equity (b) ......................

P2,050,000 200,000 P1,850,000

P1,868,000 200,000 P1,668,000

*1/2(P2,150,000 + P1,950,000); 1/2(P1,950,000 + P1,786,000). Return on ordinary equity (a) ÷ (b) ...........

16.6%

13.4%

c. Financial leverage is positive in both years, since the return on ordinary equity is greater than the return on total assets. This positive financial leverage is due to three factors: the preference shares, which has a dividend of only 8%; the bonds, which have an after-tax interest cost of only 7.2% [12% interest rate × (1 – 0.40) = 7.2%]; and the accounts payable, which may bear no interest cost. Requirement 3 We would recommend keeping the stock. The stock’s downside risk seems small, since it is selling for only 7.3 times current earnings as compared to 9 times earnings for the average firm in the industry. In addition, its earnings are strong and trending upward, and its return on ordinary equity (16.6%) is extremely good. Its return on total assets (10.4%) compares favorably with th...