Using Financial Statement Information

CHAPTER 5

USING FINANCIAL STATEMENT INFORMATION

EXERCISES

E5–5 a. Current Ratio = Current Assets ÷ Current Liabilities 2004: $6,304 ÷ $2,242 = 2.81 2005: $5,239 ÷ $1,942 = 2.70 2006: $5,029 ÷ $2,272 = 2.21 b. Gross Profit as a % of Sales = Gross Profit ÷ Net Sales 2004: $6,381 ÷ $16,267 = .39 2005: $5,869 ÷ $16,023 = .37 2006: $5,649 ÷ $15,943 = .35 c. Inventory Turnover = Cost of Goods Sold ÷ Average Inventory 2005: $10,154 ÷ [($1,814 + $1,696) ÷ 2] = 5.79 2006: $10,294 ÷ [($1,696 + $1,796) ÷ 2] = 5.90

Average Days Supply of Inventory = 365 ÷ Inventory Turnover

2005: 365 ÷ 5.79 = 63 days 2006: 365 ÷ 5.90 = 62 days d. Over the three-year period, solvency has deteriorated, as has the profitability per sale. Inventory turnover has improved slightly, reducing the average shelf time of the inventory by one day.

E5–7 a. (1) Current Ratio = Current Assets ÷ Current Liabilities

2008: $385,000 ÷ $170,000 = 2.26 2009: $400,000 ÷ $460,000 = 0.87

(2) Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) ÷ Current Liabilities

2008: ($30,000 + $10,000 + $95,000) ÷ $170,000 = 0.794 2009: ($15,000 + $225,000+ $90,000) ÷ $460,000 = 0.717 b. Receivables Turnover = Net Credit Sales ÷ Average Accounts Receivable

2008: $780,000 ÷ [($100,000 + $95,000) ÷ 2] = 8.00 2009: $800,000 ÷ [($95,000 + $90,000) ÷ 2] = 8.65

Number of Days Outstanding = 365 ÷ Receivables Turnover 1 2008: 365 ÷ 8.00 = 45.625 2009: 365 ÷ 8.65 = 42.197 c. Solvency refers to a company's ability to meet its debts as they come due. Current liabilities represent the debts that are expected to come due first. Therefore, to be solvent, a company must have sufficient cash or near-cash assets to meet these current liabilities. Total current assets is one measure of near-cash assets. As indicated by the change in the company's current ratio, the company has insufficient current assets available to settle its current liabilities. The company's quick ratio worsened during 2009. Given that the company has insufficient current assets and insufficient cash, marketable securities, and accounts receivable to meet its debts, it can probably be concluded that the company's overall solvency position is not strong.

E5–9 a. Current Ratio = Current Assets ÷ Current Liabilities

2006: $20,000 ÷ $8,000 = 2.500 2007: $24,000 ÷ $13,000 = 1.846 2008: $31,000 ÷ $25,000 = 1.240 2009: $35,000 ÷ $30,000 = 1.167

Debt/Equity Ratio = Total Liabilities ÷ Total Stockholders' Equity

2006: ($8,000 + $15,000) ÷ ($20,000 + $10,000) = 0.767 2007: ($13,000 + $35,000) ÷ ($20,000 + $20,000) = 1.200 2008: ($25,000 + $40,000) ÷ ($20,000 + $32,000) = 1.250 2009: ($30,000 + $40,000) ÷ ($20,000 + $38,000) = 1.207

Return on Assets = (Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Average Total Assets

2006: ($13,000 + [$2,000 (1 - .3)]) ÷ [($53,000] = 0.272 2007: ($14,000 + [$4,000 (1 - .3)]) ÷ [($53,000 + $88,000) ÷ 2] = 0.238 2008: ($21,000 + [$5,000 (1 - .3)]) ÷ [($88,000 + $117,000) ÷ 2] = 0.239 2009: ($24,000 + [$5,000 (1 - .3)]) ÷ [($117,000 + $128,000) ÷ 2] = 0.224 b. 2009 2008 2007 2006 Current assets 27.34% 26.50% 27.27% 37.74% Noncurrent assets 72 .66 73 .50 72 .73 62 .26 Total assets 100 .00% 100 .00% 100 .00% 100 .00%

Current liabilities 23.44% 21.37% 14.77% 15.09% Long-term liabilities 31.25 34.19 39.77 28.30 Capital stock 15.62 17.09 22.73 37.74 Retained earnings 29 .69 27 .35 22 .73 18 .87 Total liabilities and stockholders' equity 100 .00% 100 .00% 100 .00% 100 .00% c. Solvency measures a company's ability to meet its debts as they come due. The current ratio provides one measure of a company's solvency. Based upon this ratio, Lotechnic has sufficient current assets to meet its current obligations. However, the trend in its current ratio indicates that the company's excess of current assets over current liabilities is decreasing. Therefore, the company has relatively fewer current assets available to meet its current

2 obligations. This trend indicates that Lotechnic Enterprises' solvency position may be worsening. The debt/equity ratio provides an indication of a company's capitalization, which, in turn, indicates how risky a company is. Lotechnic is relying increasingly on debt relative to stockholders' equity to finance operations. At some point in time, the company will have to repay this debt. The company will either have to repay this debt by (1) generating cash from operations, (2) selling assets, (3) borrowing additional cash, or (4) acquiring cash by issuing stock. From the statement of cash flows, the cash generated from operations has been decreasing and is now negative; therefore, it appears that the company cannot rely on operations to generate cash. The statement of cash flows also indicates that the company has been using cash for investment purposes every year. This implies that the company may have some assets that it could sell. But if these assets are used in operations, the company's operations may be adversely affected by selling them. Since total assets equal the sum of total liabilities and stockholders' equity, the proportion of total liabilities to the sum of total liabilities and stockholders' equity reported on the common- size balance sheet equals the proportion of total liabilities to total assets. This measure indicates the proportion of total assets (based upon book value) that would have to be sold to satisfy all the company's obligations. To meet its obligations, Lotechnic Enterprises would have to sell approximately 55% of its total assets, which would virtually decimate its asset base. Based upon the trend in the current ratio, the debt/equity ratio, cash flows from operations, and the proportion of total liabilities to total assets, it appears that Lotechnic Enterprises may face severe solvency problems as its long-term debt matures.

Earning power is defined as a company's ability to increase its wealth through operations and to generate cash from operations. Earning power and solvency are closely related. A company must have adequate resources to generate wealth. If a company experiences solvency problems, it will most likely have to divert its resources to paying its obligations. Therefore, due to its solvency problems, Lotechnic Enterprises may not have strong earning power. Although Lotechnic's net income has increased every year, the company's effectiveness at managing capital, as indicated by ROA, has decreased every year. This trend indicates that the company may have limited earning power. This conclusion is also supported by the trend in the company's cash flows from operations. It must be remembered, however, that this analysis is based on very limited information. To adequately analyze a company, additional information would be needed. Complete financial statements, financial information for similar companies, and general economic information should all be considered when analyzing a company's earning power and solvency position.

E5–10 Transaction Quick Ratio Current Ratio Debt/Equity Ratio

(1) – – + (2) N E N E + (3) – – – (4) – – +a (5) + + –b (6) + + – ______a Wage Expense would be closed into Retained Earnings at the end of the accounting period as part of the closing process. Thus, recording wage expense would decrease stockholders' equity, and thereby increase the debt/equity ratio.

3 b This transaction would increase both Sales and Cost of Goods Sold. Both of these accounts would be closed into Retained Earnings as part of the closing process. Since the sales price exceeds the cost of the inventory, the net effect of this transaction would be to increase Retained Earnings. Thus, total stockholders' equity would increase, and thereby decrease the debt/equity ratio.

PROBLEMS

P5–6 In order to consider an investment in Goodyear, let us first compute the following ratios:

1. Return on Equity = Net Income ÷ Average Stockholders’ Equity

2005: $ 228 ÷ [($73 + $74) ÷ 2] = 310.2% 2006: $(330) ÷ [($(758) + $73) ÷ 2] = (96.35%)

2. Return on Sales = (Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Net Sales 2005: ($228 + [$411 (1 – 0.30)]) ÷ $19,723 = 2.61% 2006: ($(330) + [$451 (1 – 0.30)]) ÷ $20,258 = (0.07%)

3. Current Ratio = Current Assets ÷ Current Liabilities 2005: $ 8,616 ÷ $5,441 = 1.58 2006: $10,179 ÷ $4,666 = 2.18

4. Debt/Equity Ratio = Total Liabilities ÷ Total Stockholders’ Equity 2005: $15,532 ÷ $73= 212.77 2006: $17,787 ÷ ($758) = NA

Generally, an equity investor would have much more information available to make a decision than what is provided by Goodyear. However, based on the information provided, an equity investment in Goodyear would be unwise. The company is showing a net loss on its income statement and has negative equity on its balance sheet and is producing a decreasing amount of cash from opeations. Until Goodyear can turn around its operations, it is not an attractive opportunity.

P5–11 As a loan officer, I would be concerned with whether a potential borrower has the ability to meet its debts as they come due. Since both companies are requesting only nine-month loans, I would be interested in the potential borrowers' short-term solvency. Therefore, I would examine their current ratios and quick ratios. Further, I would consider the effect of the potential loan on these ratios. The current ratio is calculated as current assets divided by current liabilities.

Selig Equipment: $715,000 ÷ ($285,000 + $125,000) = 1.74 Mountain Bike: $835,000 ÷ ($325,000 + $125,000) = 1.86

It appears that both companies have more than sufficient current assets to meet their current obligations, including the new loan. However, some current assets, such as prepaid expenses and

4 inventory, are not near-cash assets. Thus, a better measure of a potential borrower's ability to meet its current obligations is the quick ratio. This ratio is calculated as the sum of cash, marketable securities, and accounts receivable divided by current liabilities. Again, the effect of the new loan should be considered.

Selig Equipment: ($15,000 + $215,000) ÷ ($285,000 + $125,000) = .561 Mountain Bike: ($160,000 + $470,000) ÷ ($325,000 + $125,000) = 1.400

Based on the quick ratio, Mountain Bike, Inc. appears to be a much better risk than Selig Equipment. Mountain Bike has approximately 2.5 times more near-cash assets available than Selig Equipment to meet its current obligations. Therefore, Mountain Bike does not have to rely as heavily on converting other assets to cash as Selig does to meet its obligations. The company that can most readily convert its inventory and receivables to cash might be the better risk. Two possible measures of a company's ability to generate cash from its receivables and inventory are the turnover and number-of-days ratios. Receivables turnover is calculated as net credit sales divided by average accounts receivable, and the number of days for receivables is calculated as 365 divided by the receivables turnover.

Receivables turnover: Selig Equipment: $1,005,000 ÷ $215,000 = 4.67 Mountain Bike: $1,625,000 ÷ $470,000 = 3.46

Number of days: Selig Equipment: 365 ÷ 4.67 = 78.16 Mountain Bike: 365 ÷ 3.46 = 105.49

These ratios indicate that Selig Equipment, on average, collects its receivables 27 days quicker than Mountain Bike. Therefore, Selig Equipment can more easily convert its receivables to cash than Mountain Bike can. Inventory turnover is calculated as cost of goods sold divided by average inventory, and the number of days is calculated as 365 divided by inventory turnover.

Inventory turnover: Selig Equipment: $755,000 ÷ $305,000 = 2.48 Mountain Bike: $960,000 ÷ $195,000 = 4.92

Number of days: Selig Equipment: 365 ÷ 2.48 = 147.18 Mountain Bike: 365 ÷ 4.92 = 74.19

These ratios bode well for Mountain Bike. Mountain Bike sells its inventory, on average, 73 days sooner than Selig Equipment sells its inventory. This difference implies that Mountain Bike generates more sales which, in turn, implies that it generates more accounts receivable. Although Mountain Bike does not turn over its receivables as often as Selig Equipment, it has a larger amount of receivables to turn over. Thus, Mountain Bike potentially has more assets that can easily be converted into cash than Selig Equipment. Based upon Mountain Bike's superior quick ratio and potential ability to generate cash from its larger receivables base, I would recommend that the bank grant the loan to Mountain Bike, Inc.

5 P5–12 a. Watson Metal Products' 2010 income statements under the different financing alternatives would be as follows.

Alternative 1 Alternative 2 Alternative 3 Income from operations* $ 16,500,000 $ 16,500,000 $ 16,500,000 Interest expense 4,000,000 4,750,000 4,375,000 Net income before taxes $ 12,500,000 $ 11,750,000 $ 12,125,000 Income taxes 5,000,000 4,700,000 4,850,000 Net income $ 7,500,000 $ 7,050,000 $ 7,275,000

* $16,500,000 = $15,000,000 2010 income from operations from non-French operations per the 2009 income statement + $1,500,000 2010 income from operations from French operations.

The formulas for the requested ratios are:

Earnings per Share = Net Income ÷ Average Number of Common Shares Outstanding Return on Equity = Net Income ÷ Average Stockholders' Equity Return on Assets = (Net Income + [Interest Expense (1– Tax Rate)]÷ Average Total Assets Financial Leverage = Return on Equity – Return on Assets Debt/Equity Ratio = Total Liabilities ÷ Total Stockholders' Equity

Note: Although several of the ratios use averages, ending balances were used as specified in the problem.

Alternative 1 EPS: $7,500,000 ÷ (2,000,000 shares* + 200,000 shares) = $3.41

* 2,000,000 shares = $6,600,000 2009 net income ÷ $3.30 2009 earnings per share

ROE: $7,500,000 ÷ ($45,000,000 + $5,000,000a + $7,500,000b) = .1304

a $5,000,000 = 200,000 shares  $25 per share b $7,500,000 = 2010 net income

ROA: ($7,500,000 + [$4,000,000 (1 – .4)]) ÷ ($35,000,000 + $45,000,000 + $5,000,000 + $7,500,000) = .1070

Leverage: .1304 – .1070 = .0234

Debt/Equity: $35,000,000 ÷ ($45,000,000 + $5,000,000 + $7,500,000) = .609

6 P5–12 Continued Alternative 2 EPS: $7,050,000 ÷ 2,000,000 shares = $3.53

ROE: $7,050,000 ÷ ($45,000,000 + $7,050,000) = .1354

ROA: ($7,050,000 + [$4,750,000 (1 - .40]) ÷ ($35,000,000 + $45,000,000 + $5,000,000 + $7,050,000) = .1076

Leverage: .1354 – .1076 = .0278

Debt/Equity: ($35,000,000 + $5,000,000) ÷ ($45,000,000 + $7,050,000) = .768

Alternative 3 EPS: $7,275,000 ÷ (2,000,000 shares + 100,000 shares) = $3.46

ROE: $7,275,000 ÷ ($45,000,000 + $2,500,000* + $7,275,000) = .1328

* $2,500,000 = 100,000 shares  $25 per share

ROA: ($7,275,000 + [$4,375,000 (1 - .4)]) ÷ ($35,000,000 + $45,000,000 + $5,000,000 + $7,275,000) = .1073

Leverage: .1328 – .1073 = .0255

Debt/Equity: ($35,000,000 + $2,500,000) ÷ ($45,000,000 + $2,500,000 + $7,275,000) = .685 b. Alternative 2 prevents a dilution of the stockholders' position. Since this alternative did not require any additional shares of stock to be issued, it provides the largest earnings per share. Alternative 2 allows the company to more effectively manage its stockholders' investment, as evidenced by return on equity, and all investments, as evidenced by return on assets. The only potentially serious drawback of this alternative is that it makes the company more risky, as evidenced by it having the largest debt/equity ratio. Further, Alternative 2 allows the company to use debt to benefit stockholders more effectively than is allowed with either of the other two alternatives. Under Alternative 3, stockholders earn a slightly smaller return on their equity, but incur fewer risks, since the company has issued less debt. Alternative 1 provides a marginally lower return to stockholders, but imposes even less risk on them. Stockholders must trade off the risk from issuing debt against the benefits of issuing debt. If the company is close to violating debt covenants or projects weak future cash flows, then Alternatives 1 or 3 would probably be preferable. Otherwise, Alternatives 2 or 3 would probably be preferable.

7 P5–12 Concluded c. Alternative 1 $3.30 = ($6,600,000 + Net income from expansion project) ÷ (2,000,000 shares + 200,000 shares)

Net income from expansion project = $660,000

Alternative 2 $3.30 = ($6,600,000 + Net income from expansion project) ÷ 2,000,000 shares

Net income from expansion project = $0

Alternative 3 $3.30 = ($6,600,000 + Net income from expansion project) ÷ (2,000,000 shares + 100,000 shares)

Net income from expansion project = $330,000

ISSUES FOR DISCUSSION

ID5–15 Profile #1 – EchoStar Profile #2 – US Airways Profile #3 – Wal-Mart

EchoStar is a relatively new company with a relatively new product. The company has been growing, as more consumers switch from traditional and cable television services to satellite television. The growth of the company has generated positive cash from operations. However, the company has had to take that cash and invest it back into its business; the negative cash from investing in all three years shows that the company is growing its business by investing in long- term assets. The growth is not sufficiently funded by operations, so the company is raising money from debt and equity sources (financing activities) to fund its business. At the present time, the company is not returning cash to its shareholders or repaying debt. It is borrowing additional funds and raising additional equity to fund its growth.

US Airways operates in a difficult industry. The company has been unable to generate a positive cash flow from its operations, a definite red flag for any business. The cash outflow from operations has been paired with negative cash from investing activities, as the company must reinvest in long term assets (aircraft) to remain competitive in its industry. The only source of cash to fund the negative operations and the investments is financing (issuing debt and selling equity). The long term prospects for the company do not look healthy. No business can sustain itself through endless financing activities to fund cash; if the company is going to survive, it will eventually have to generate cash from its operations so that it can eventually repay debt and return some cash to shareholders.

Wal-Mart is an excellent example of a successful company that has reached the stage in its maturity that its operations throw off enough cash to fund the company’s still-impressive growth (investing activities) AND to return cash to shareholders and/or repay debt (financing activities). The company can rely on its daily operations to generate cash, which is then used to add more stores and fund dividends and debt reduction.