Chapter 13

CHAPTER 13
Financial Statement Analy

sis
OVERVIEW OF EXERCISES, PROBL EMS, AND CASES
Estimated
Time in
Learning Outcomes Exerc ises Minutes Level
1. Explain the various limitations and considerations in financial
statement analysis.
2. Use comparative financial statements to analyze a company 12* 45 Mod

over time (horizontal analysis). 13* 30 Mod
3. Use common-size financial statements to compare various 12* 45 Mod

financial statement items (vertical analysis). 13* 30 Mod
4. Compute and use various ratios to assess liquidity. 1 15 Mod

2 15 Mod
3 30 Mod
4 20 Mod
5 30 Mod
5. Compute and use various ratios to assess solvency. 6 20 Mod

7 20 Mod
6 . Compute and use various ratios to assess profitability. 8 20 Mod

9 20 Mod
10 15 Mod
11* 10 Mod
7. Explain how to report on and analyze other income statement 11* 10 Mod
items. (Appendix)
Exercise, problem, or case covers two or more learning outcomes

Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
13-1
13-2 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
Problems Estimated
and Time in
Learning Outcomes Alternates Minutes Level
statement analysis.
2. Use comparative financial statements to analyze a company

over time (horizontal analysis).
3. Use common-size financial statements to compare various

financial statement items (vertical analysis).
4. Compute and use various ratios to assess liquidity. 1 40 Mod

2 40 Mod
5* 30 Mod
7* 40 Mod
5. Compute and use various ratios to assess solvency. 1# 30 Mod

2# 30 Mod
5* 30 Mod
6* 40 Diff
7* 40 Mod
6. C ompute and use various ratios to assess profitability. 3 20 Mod

4 60 Diff
5* 30 Mod
6* 40 Diff
7* 40 Mod
7. Explain how to report on and analyze other income statement

items. (Appendix)

#Alterna te problem only
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
CHAPTER 13 FINANCIAL STATEMENT ANALYSIS 13-3
Estimated
Time in
Learning Outcomes Cases Minutes Level
statement analysis.
2. Use com parative financial statements to analyze a company 1 45

Mod
over time (horizontal analysis).
3. Use common-size financial statements to compare various 2 60 Mod

financial statement items (vertical analysis). 3 60 Mod
6 45 Mod
4. Compute and use various ratios to assess liquidity. 4* 45 Mod

5* 45 Mod
7* 45 Diff
8 20 Mod
5. Compute and use various ratios to assess solvency. 4* 45 Mod

5* 45 Mod
7* 45 Diff
6. Compute and use various ratios to assess profitability. 4* 45 Mod

5* 45 Mod
7. Explain how to report on and analyze other income statement 5* 45 Mod

items. (Appendix)

Level = Difficulty levels: Ea sy; Moderate (Mod); Difficult (Diff)
QUESTIONS
1. The inventory valuation method used by a company will have a significant effect on
many ratios. Depending on the relative movement of prices, the choice between
LIFO and FIFO will result in significantly different amounts reported for inventory. For
example, in a period of rising prices, the use of LIFO will reduce inventory (relative to
what it would have been under FIFO) and thus reduce the current ratio and the acid-
test ratio. The inventory turnover ratio will differ as well, because LIFO will result in
more cost of goods sold expense. Thus, all other things being equal, in a period of
rising prices, a LIFO company will report a higher turnover of inventory than a FIFO
company. The LIFO companys cash flow will be better because it will pay less in
taxes. Thus, the various ratios that involve cash from operations will be affected. Fi
nally, the profitability ratios will be affected by the choice of an inventory method. For
example, the LIFO company will report lower profits and thus have a lower profit
margin.
2. One of the difficulties in comparing a companys ratios with industry standards is t
hat the standards are an average for all companies surveyed. First, your company
may be much larger or smaller than the average company in the survey. Second,
many large companies today are conglomerates, and their operations cross over the
traditional boundaries of any one industry. This makes comparison with industry
standards difficult. Finally, your company may use different accounting methods than
most others in the survey. If your company uses straight-line depreciation but a ma
jority of the sample companies use accelerated depreciation, comparisons can be
difficult.
3. Published financial statements, as well as those often used by management, are b
ased on historical costs and have not been adjusted for inflation. Trend analysis is
one type of analysis that must be performed with particular caution if inflation is sig
nificant. An increase in sales, for example, may be due to an increase in prices, ra
ther than to an increase in the number of units sold. Inflation affects the various fi
nancial statements differently. Some period expenses, such as advertising, are usu
ally not seriously misstated in historical cost terms. However, depreciation based on
costs paid for assets that are fifty years old will be much different from depreciation
adjusted for the effects of inflation.
4. The analysis of financial statements over a series of years is called horizontal analy
sis. For example, by looking for trends in certain costs over a series of years (thus
the name trend analysis), the analyst is able to more accurately predict future costs.
Common-size financial statements are statements in which all amounts are stated
as a percentage of one selected item on the statement, such as net sales. Thus, ver
tical analysis of a single years income statement will help the analyst discern the
relative amounts incurred for various costs.
5. Rising costs to either manufacture or purchase inventory could be respons ible 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 a selling 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 $96 and the company sells another 1,000 units, sales will in
crease by 15% to $115,000, but gross profit will decrease to 1,000 ($115 $96),
or $19,000a decrease in gross profit of 5%.
6. The composition of current assets indicates the relative size of cash, accounts rec
eivable, inventory, and other short-term assets. A relatively large balance in invento
ry may indicate that a company is not turning over its products quickly enough. Simi
larly, a large accounts receivable balance could signal a problem in the collection
department. Finally, a large cash balance may be a sign that the company is not tak
ing advantage of short-term investment opportunities.
7. Ratios can be categorized according to their use in performing three types of analys
is: (1) liquidity analysis, (2) solvency analysis, and (3) profitability analysis.
8. The first stage in the operating cycle for a manufacturer is the purchase of raw mat
erial and its transformation into a final product. The second step is the sale of the
product, and the third is the collection of any receivable from credit granted to the
customer. The operating cycle differs for a retailer in that a finished product is pur
chased from a wholesaler and there is not the time involved in production.
9. Current assets are reported on a balance sheet in the order of their nearness to
cash, or liquidity. Cash is obviously presented first, followed by short-term invest
ments. Accounts receivable, one step removed from cash, are shown next, and then
inventory. Because prepaid assets, such as supplies or insurance paid for in ad
vance, will not be converted into cash, they are normally reported last in the current
asset section of the balance sheet.
10. A relatively low acid-test or quick ratio compared with the current ratio probably I
ndicates a large inventory balance. Large amounts of inventory may be normal for a
company, but on the other hand they could signal problems in moving obsolete
items. The inventory turnover ratio for the most recent period should be compared
with those of prior periods to determine whether there has been a decrease in the
number of turns per year. A less likely explanation for a low quick ratio compared
with the current ratio would be large balances in various prepayments, such as sup
plies and insurance.
11. All turnover ratios are a measure of the activity for a period compared with the inv
estment necessary to carry on that activity. For example, the inventory turnover ratio
measures the relationship between inventory sold, on a cost basis, and the average
amount of inventory on hand during that time period. The base is the average inven
tory because it is divided into an activity measure for the entire periodthat is, cost
of goods sold.
12. An accounts receivable turnover of nine times translates to an average n umber of

days in receivables of 40 (360/9). If the credit department extends terms of 2/10, net
30, investigation of the companys actual credit policies is warranted. For example,
the department may routinely give customers up to 40 or 50 days to pay. If this
policy does not create any cash flow problems, why have terms of 2/10, net 30?
Alternatively, the average time to collect may be an indication that the credit depart
ment is extending 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 inventory turnover may simply be a
seasonal phenomenon. For example, the ratio for the third quarter of the year should
be compared with that of the third quarter of the prior year. Problems in the sales
department may also partially explain a low turnover of inventory. Or, the company
may be pricing itself out of the market and need to consider lowering its prices to
meet the competition.
14. A manufacturers operating cycle runs from the purchase of raw materials, to the t
ransformation of the materials into a final product, to sale, to the collection of any re
ceivable. This differs from the operating cycle of a service business because the
latter does not technically sell a product. Service businesses must look for
alternative measures of efficiency. For example, an airline would be interested in the
average amount of time elapsed between the sale of a ticket and collection from the
passen ger. A public accounting firm might want to know the average length of time
that passes after an audit is finished before the client pays the bill.
15. Liquidity analysis is concerned with the ability of the company to pay its debts as t
hey are due and thus focuses on the current assets and liabilities. Solvency is the
ability to stay in business over the long run. The debt-to-equity ratio and the debt
service coverage ratio are two measures of the firms solvency.
16. The debt service coverage ratio is superior to the times interest earned ratio as a
measure of solvency for two reasons. First, the ratio considers the need to pay both
interest and principal, whereas the times interest earned ratio deals only with inter
est. Second, the necessary payments to service debt are compared with the cash
available to pay the debt, while the times interest earned ratio uses an accrual in
come number in its numerator.
17. Both are right. Many different ratios are used to assess the relative mix of a compan
ys capital structure. The debt-to-equity ratio measures the amount of outstanding
debt relative to the amount of stockholders equity. An alternative measure is to di
vide the same debt by the total assets of the company. A different ratio will obviously
result, but as long as the same measure is used consistently, either ratio is an indi
cator of solvency.
18. The debt service coverage ratio measures the amount of cash generated from ope
rating activities that is available to repay the interest and any maturing debt. A loan
officer is primarily concerned with the companys ability 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 expectation on the p
art of stockholders. Therefore, when computing the cash available to make capital
acquisitions, it is helpful to take into account the normal dividend requirements.
20. The numerator in any rate of return ratio must match the investment or base in the d
enominator. If total assets is the base, the numerator must be a measure of the in
come available to all providers of capital. Interest expense, net of tax, is added back
to net income because the creditors are one of the sources of capital, and we want
to consider the income available before any of the sources of funds are given a dis
tribution. Interest must be on a net or after-tax basis to be consistent with net in
come, which is on an after-tax basis.
21. A return on stockholders equity that is lower than the return on assets means that t
he company is not successfully using borrowed funds. Return on assets measures
the return to all providers of capital, whereas return on equity is concerned only with
common stockholders. The company has not been able to earn an overall return that
is as high as what is being paid to creditors and preferred stockholders. Leverage
deals with the use of someone elses money to earn a favorable return. Presently,
this company is not successfully employing financial leverage.
22. The price/earnings ratio is sometimes used as an indicator of the quality of a comp
anys earnings because it combines a measure of the companys performance,
based on its earnings, and the companys worth as measured by the market price of
its stock. The ratio of price to earnings is an indication of the markets assessment of
the companys performance. For example, the use of different accounting methods
can cause the market to value the price of one companys stock higher than another
companys stock, even though they report similar earnings. This could be the case if
one defers taxes by using LIFO whereas the other uses FIFO. This differing treat
ment of the two stocks is a statement by the market about the quality of the two
companies earnings.
23. Most of the liquidity ratios are primarily suited to use by management. For example,
t he investor would not normally place major emphasis on the turnover of either inv
entory or receivables. On the other hand, turnover ratios must be constantly moni
tored by management. The stockholder will be very interested in both the dividend
payout ratio and the dividend yield. A banker would rely partially on a companys
debt service coverage in the past 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 as a law firm
o r a public accounting firm. These firms do not sell a tangible product; instead, they
se ll their professional expertise and thus must rely on alternative measures of their
effi ciency in marketing their services. An accounting firm, for example, might keep
deta iled records on the number of clients served, the average annual billings to
each client, and the ratio of these billings to the average costs incurred on each
audit.
25. Separate reporting of discontinued operations, extraordinary items and the cum
ulative effect of a change in accounting principle assists the reader of the state
ments in making predictions about the future profitability of the business. For exam
ple, users of the income statement may want to ignore these items when assessing
the future prospects for the company because these items by their nature are not
likely to reoccur in the future.
BRIEF EXERCISES
LO1 BRIEF EXERCISE 13-1 LIMITATIONS IN RATIO ANALYSIS
Al though a current ratio of 0.50 is certainly low, other factors need to be considered
befor e making a decision on whether to extend credit. Has the company operated
successfu lly in the past with a low current ratio? How does this ratio compare with other
compan ies in the same industry? What is the composition of the companys current
assets?
LO2 BRIEF EXERCISE 13-2 HORIZONTAL ANALYSIS
A comparison of financial statement items within a single period is called vertical

analysis .
A c omparison of financial statement items over a period of time is called horizontal

analy sis.
LO3 BRIEF EXERCISE 13-3 VERTICAL ANALYSIS
A ccounts on the balance sheet should be stated as a percentage of total assets. All
acco unts on the income statement should be stated as a percentage of net sales.
LO4 BRIEF EXERCISE 13-4 LIQUIDITY ANALYSIS
C urrent ratio: Current

Assets
Acid-Test rati o: Cash + Marketable Securities + Current Receivables
Accounts Rec eivable Turnover: Net Credit Sales
Inventory Turn over: Cost of Goods Sold
LO5 BRIEF EXERCISE 13-5 SOLVENCY ANALYSIS
M eet its interest and principal payments: Debt service coverage ratio
Fin ance long-term asset acquisitions with cash from operations: Cash flow from
operation s to capital expenditures ratio
Mee t its interest payments: Times interest earned ratio
L O6 BRIEF EXERCISE 13-6 PROFITABILITY ANALYSIS
R eturn on assets: Interest Expense, Net of Tax (A)

Re turn on common stockholders equity: Preferred Dividends (D)
Ear
nings per share: Preferred Dividends (D)
Return on sales: Interest Expense, Net of Tax (D)
LO 7 BRIEF EXERCISE 13-7 OTHER INCOME STATEMENT ITEMS
Disposed of a segment of the business: Discontinued operations

Incurred a loss from an event that was unusual and infrequently occurring:
Extraordinary item
EXERCISES
LO 4 EXERCISE 13-1 ACCOUNTS RECEIVABLE ANALYSIS
1. Accounts receivable turnover:

Net credit sales/Average accounts receivable:
2008: $600,000/[($150,000 + $100,000)/2] = $600,000/$125,000 = 4.8 times
2007: $540,000/[($100,000 + $80,000)/2] = $540,000/$90,000 = 6 times
2. Number of days sales in receivables:

2008: 360/4.8 = 75 days
2007: 360/6 = 60 days
3. The average age of a receivable in 2007 was the same number of days as the
maximum credit period of 60 days. The average age in 2008 of 75 days, however, is
significantly in excess of the credit period. The company needs to investigate this in
crease and decide whether efforts are needed to speed up the collection process.
The company may decide that allowing customers more liberal payment terms has
had a positive effect on sales, as evidenced by the increase in sales, and not want to
press its customers for earlier payment. Conversely, the company may find that
allowing an extra 15 days for payment causes cash flow problems.
LO 4 EXERCISE 13-2 INVENTORY ANALYSIS
1. Inventory turnover:
Cost of goods sold/Average inventory:
2008: $7,100,000/[($200,000 + $150,000)/2] = $7,100,000/$175,000
= 40.57 times
2007: $8,100,000/[($150,000 + $120,000)/2] = $8,100,000/$135,000
= 60 times
2. Number of days sales in inventory:

2008: 360/40.57 = 8.9 days
2007: 360/60 = 6 days
3. Inventory turnover has declined dramatically from the prior year. Many different
explanations are possible for this decline, such as problems in the sales effort, over-
pricing of the products relative to the competition, or inferior produce. Management
needs to investigate the problem and decide who should be held responsible for the
slow movement. The company may find that no one department or individual is
totally responsible and that many different parts of the business need to work
together to improve the turnover of inventory.
LO 4 EXERCISE 13-3 ACCOUNTS RECEIVABLE AND INVENTORY ANALYSES FOR

COCA-COLA AND PEPSICO
1. Calculations (all dollar amounts in millions):

a. Accounts Receivable Turnover Ratio:
Coca-Cola Company
$24,088/[($2,587 + $2,281)/2] = $24,088/$2,434 = 9.90 times
PepsiCo, Inc.
$35,137/[($3,725 + $3,261)/2] = $35,137/$3,493 = 10.06 times
B . Number of Days Sales in Receivables:
Coca-Cola Company
360/9.90 = 36.4 days
PepsiCo, Inc.
360/10.06 = 35.8 days
c. Inventory Turnover Ratio:
Coca-Cola Company
$8,164/[($1,641 + $1,379)/2] = $8,164/$1,510 = 5.41 times
PepsiCo, Inc.
$15,762[($1,926 + $1,693/2] = $15,762/$1,809.5 = 8.71 times
d. Number of Days Sales in Inventory:
Coca-Cola Company
360/5.41 = 66.5 days
PepsiCo, Inc.
360/8.71 = 41.3 days
E . Cash to Cash Operating Cycle:
Coca-Cola Company
36.4 + 66.5 = 102.9 days
PepsiCo, Inc.
35.8 + 41.3 = 77.1 days
2. T he two companies accounts receivable turnover ratios are similar, and therefore
their numbers of days sales in receivables are about the same. PepsiCo, Inc. has a
higher inventory turnover ratio and, accordingly, a lower number of days sales in
inventory. The result is that PepsiCo, Inc. also has a lower cash to cash operating
cycle.
LO 4 EXERCISE 13-4 LIQUIDITY ANALYSES FOR COCA-COLA AND PEPSICO
1. Calculations (all dollar amounts in millions):

Coca-Cola Company PepsiCo, Inc.
a. Current ratio $8,441/$8,890 = 0.95 to 1 $9,130/$6,860 = 1.33 to 1
b. Quick assets $2,440 + $150 + $2,587 $1,651 + $1,171 + $3,725
= $5,177 = $6,547
Acid-test or
Quick ratio $5,177/$8,890 = 0.58 to 1 $6,547/$6,860 = 0.95 to 1
2. PepsiCos current and acid-test (or quick) ratios are higher than Coca-Colas. Based
on these measures, PepsiCo appears to be more liquid than Coca-Cola.
3. Other ratios that can be used to more fully assess the liquidity of these two
companies 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.
LO 4 EXERCISE 13-5 LIQUIDITY ANALYSES FOR MCDONALDS AND WENDYS
1. Calculations:
McDonalds Wendys
(In millions) (In thousands)
a. Working capital $3,625.3 $3,008.1 $656,732 $394,666
= $617.2 = $262,066
b. Current ratio $3,625.3/$3,008.1 $656,732/$394,666
= 1.21 = 1.66
c. Quick assets $2,136.4 + $904.2 $457,614 + $84,841
= $3,040.6 = $542,455
Acid-test or
Quick ratio $3,040.6/$3,008.1 $542,455/$394,666
= 1.01 = 1.37
2. Wen dys current and acid-test (or quick) ratios are higher than McDonalds. Based
on these measures, Wendys appears to be more liquid than McDonalds.
3. Calculations of cash flow from operations to current liabilities ratios:
McDonalds (in millions)
$4,341.5/[($3,008.1 + $4,107.7)/2] = $4,341.5/$3,557.9 = 122.0%
Wendys (in thousands)
$271,379/[($394,666 + $583,352)/2] = $271,379/$489,009 = 55.5%
This ratio overcomes the two limitations of the current and the quick ratios, because
it focuses on cash and cash flows. McDonalds cash flow from operations to current
liabilities ratio is higher than Wendys. On the basis of this ratio alone, McDonalds
appears to be the more liquid company.
LO 5 EXERCISE 13-6 SOLVENCY ANALYSES FOR IBM
1. 2006 2005
a. D ebt-to-equity ratio $74,728/$28,506 $72,650/$33,098
= 2.62 to 1 = 2.19 to 1
b. Times interest earned ($9,492 + $278 + ($7,934 + $220 +
$3,901)/$278 $4,232)/$220
= $13,671/$278 = $12,386/$220
= 49.2 to 1 = 56.3 to 1
c. Debt service
coverage ratio* ($15,019 + $278 + ($14,914 + $220 +
$3,901)/($278 + $3,400) $4,232)/($220 + $3,522)
= $19,198/$3,678 = $19,366/$3,742
= 5.2 times = 5.2 times
*The amounts for interest and taxes represent interest expense and income tax
expense rather than the amounts paid.
d. Cash flow from
operations to capital
expenditures ratio ($15,019 $1,683)/$4,362 ($14,914 $1,250)/$3,842
= $13,336/$4,362 = $13,664/$3,842
= 305.7% = 355.6%
2. IBMs debt-to-equity ratio increased during 2006, due to both an increase in the
amount of debt outstanding at the end of 2006 and a decrease in stockholders
equity. The other three ratios for the two years all indicate that the company is highly
solvent.
LO 5 EXERCISE 13-7 SOLVENCY ANALYSIS
1. a. Debt-to-equity ratio: Total liabilities/Total stockholders equity

At 12/31/08: ($350,000 + $600,000)/$1,650,000
= $950,000/$1,650,000 = 0.58 to 1
At 12/31/07: ($405,000 + $800,000)/$1,500,000
= $1,205,000/$1,500,000 = 0.80 to 1
b. Times interest earned for 2008 (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
c. De bt service coverage for 2008 (Cash flows from operations before interest 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, 12/31/07 $ 45,000
Add: Tax expense 111,000
Less: Taxes payable 12/31/08 60,000
Taxes paid during 2008 $ 96,000
**Principal payments:
a. Short-term notes payable $ 75,000
b. 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 serial bonds. The ratio at the
end of 2008 of almost 0.6 to 1 indicates a relatively conservative balance of debt to
stockholders equity. The times interest earned ratio indicates that Impacts profits
before interest and taxes were almost four times the amount of interest expense.
Two problems arise, however, in using the times interest earned ratio as the sole
measure of solvency. First, it considers the payment of only interest, not principal.
Second, principal and interest payments must be made with cash, not profits. The
debt service coverage ratio is a much better indication of the companys ability to
meet its obligations. A ratio of 1.02 times indicates that Impact generated just
enough cash from operations to meet its principal and interest payments in 2008.
LO 6 E XERCISE 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 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 = 0.36 times
*Total assets at end of year are the same as total liabilities and stockholders
equity (given).
c. Return on assets = (Net income + Interest expense, net of tax)/Average total
assets
$90,000 (from Part a.)/$1,800,000 (from Part b.) = 5%
d. Return on common stockholders equity = (Net income Preferred dividends)/
Average common stockholders equity
($ 60,000 $25,000*)/[($950,000 + $915,000**)/2]
= $35,000/$932,500 = 3.75%
*Preferred dividends: $250,000 par value 10%
**Stockholders equity at beginning of year:
Common stock $600,000
Retained 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 the return on
stockholders equity of 3.75% is less than the return to all providers 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 of borrowed 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 minus the tax rate, or 60%, translates to
an after-tax borrowing rate of 4.62%. The return paid to the preferred stockholders is
10%. Both of these rates exceed the return to the common stockholder of 3.75% and
indicate t hat Evergreen is not successfully employing leverage.
LO 6 EXERCISE 13-9 RELATIONS HIPS AMONG RETURN ON ASSETS, RETURN ON

SALES, AND ASSET TURNOVER
Case 1. Return on assets = Net income (assuming no interest expense)/Average

total assets = $10,000/$60,000 = 16.67%
Case 2. Return on sales = Net income/Net sales

2% = $25,000/X
Net sales = $1,250,000
Case 3. Return on assets = Return on sales Asset turnover

X = 6% 1.5
Return on assets = 9%
Case 4. Asset turnover = Net sales/Average total assets

1.25 = $50,000/X
Average total assets = $40,000
Return on assets = Net income (assuming no interest expense)/Average
total assets
10% = X/$40,0 00
Net income = $4,000
Case 5. Return on assets = Net income (assuming no interest expense)/Average

total assets
15% = $20,000/X
Average total assets = $133,333
LO 6 EXERCISE 13-10 EPS, P/E RATIO, AND DIVIDEND 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
= ($0.40 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 awar e of industry trends, the general economic

environment, the historical performance of the company, the investors attitudes
about risk, and any other relevant data needed to make an informed decision.
M U LTI C O N C E P T EXERCISES
LO 6,7 EXERCISE 13-11 EARNINGS PER SHARE AND EXTRAORDINARY ITEMS
1. Earnings per share before extraordinary items = (Net income before extraordinary
loss less preferred dividends)/Number of common shares outstanding:
[$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 preferred
dividends)/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 and thus, to
some extent, must be evaluated on the basis of the bottom line as measured by
the earnings per share after the extraordinary loss from the flood. In attempting to
forecast future profits, however, both management and a potential stockholder would
be much more concerned with EPS exclus ive of any extraordinary items, because
these gains and losses are unusual in nature and infrequent In occurrence.
LO 2,3 EXERCISE 13-12 COMMON-SIZE BALANCE SHEETS AND HORIZONTAL

ANALYSIS
1. FARINET COMPANY
COMMON-SIZE COMPARATIVE BALANCE SHEETS
DECEMBER 31, 2008 AND 2007
12/31/08 12/31/07
Dollars Percent Dollars Percent
Cash $ 16,000 1.7%* $ 20,000 2.5%*
Accounts receivable 40,000 4.3 30,000 3.8
Inventory 30,000 3.3 50,000 6.2
Prepaid 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
Accumulated depreciation (130,000) (14.1) (60,000) (7.5)
Total long-term assets $ 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 0.6 10,000 1.3
Short-term notes payable 70,000 7.6 50,000 6.2
Total current liabilities $ 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 stockholders equity $ 674,000 73.0%* $ 522,000 65.1%
Total liabilities and
stockholders equity $ 924,000 100.0% $ 802,000 100.0%
*Rounded to total.
2. Observations from Farinets common-size balance sheets:

a. Current assets as a percentage of total assets has decreased. At the same time,
current liabilities has accounted for about the same percentage of total equities in
the two years.
b. The relative mix of current assets has changed from one year to the next. Cash
now accounts for a smaller share of total assets, as does inventory, whereas
accounts receivable accounts for a slightly higher percentage of total assets.
c. Major investments in plant and equipment have been made in 2008. At the end of
2007, plant and equipment accounted for three-fourths of the total assets, and
now it accounts for over 86% of the total.
d. Bonds payable now make up a smaller share of the capital structure with the
retirement of $50,000 during 2008.
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%).
3. FARINET COMPANY
COMPARATIVE BALANCE SHEETS
DECEMBER 31, 2008 AND 2007
December 31 Increase (Decrease)
2008 2007 Dollars Percent
Cash $ 16,000 $ 20,000 $ (4,000) (20)%
Accounts receivable 40,000 30,000 10,000 33
Inventory 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
Accumulated depreciation (130,000) (60,000) (70,000) (117)
Total long-term assets $ 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 40
Total 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 stockholders equity $ 674,000 $ 522,000 $ 152,000 29%
Total liabilities and
stockholders equity $ 924,000 $ 802,000 $ 122,000 15%
4. Largest chan ges Refer to
a. Accumulated depreciation Fixed asset records, showing

additions to plant and equipment
and depreciation calculations
b. Prepaid rent Rental agreements
c. Inventory Purchase orders, sales records
d. Income tax payable Income tax return and
supporting records
e. Short-term notes payable Loan agreements
LO 2,3 EXERCISE 13-13 COMMON-SIZE INCOME STATEMENTS AND HORIZONTAL

ANALYSIS
1. MARINERS CORP.
COMMON-SIZE COMPARATIVE INCOME STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2008 AND 2007
(IN THOUSANDS OF DOLLARS)
2008 2007
Sales 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 administrative
expense 9,000 15.0 5,000 10.0
Operating income $ 9,000 15.0% $15,000 30.0%
Interest expense 2,000 3.3 2,000 4.0
Income before tax $ 7,000 11.7% $13,000 26.0%
Income tax expense 2,000 3.3 4,000 8.0
Net 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 percentage has
decreased significantly because of a higher ratio of cost of goods sold to sales:
from 60% to 70%.
b. Selling and administrative expenses have increased both in absolute dollars and
as a percentage of sales. An in crease from 10% to 15% of sales is a drastic
increase in the importance of this cost relative to sales.
c. Interest expense remained the same in absolute dollars, but because sales
increased, it decreased slightly from 4% to 3.3% of sales.
d. The bottom line net income decreased both in absolute dollars and as a
percentage of sales. The solid increase in sales is more than offset by the large
increases in both product costs and selling and administrative expenses.
3. MARINERS CORP.
COMPARATIVE STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 2008 AND 2007
December 31 Increase (Decrease)
2008 2007 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 administrative
expense 9,000 5,000 4,000 80
Operating income $ 9,000 $15,000 $ (6,000) (40)%
Interest expense 2,000 2,000 0 0
Income 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 to

Selling and administrative Individual records, for the
expenses various expenses
Income tax expense Income tax return and supporting
records
PROBLEMS
LO 4 PROBLEM 13-1 EFFECT OF TRANSACTIONS ON WORKING CAPITAL, CURRENT

RATIO, AND QUICK RATIO
1. Calculation of working capital, current ratio, and quick ratio (dollar amounts in
thousands):
Working capital
($70 + $60 + $80 + $100 + $10) ($75 + $25 + $40 + $60)
= $320 $200 = $120
Current ratio
$320/$200 = 1.600 to 1
Quick ratio
($70 + $60 + $80)/$200 = $210/$200 = 1.050 to 1
PROBLEM 13-1 (Concluded)
2. Effect of transactions on working capital, current ratio, and quick ratio:

Working Effect Effect Effect
Capital of of of
(in Thou- Trans- Current Trans- Quick Trans-
Transaction sands) action Ratio action Ratio action
a. Purchased inventory
on account for
$20,000 $120 none 1.545 decrease 0.955 decrease
b. Purchased inventory
for cash, $15,000 $120 none 1.600 none 0.975 decrease
c. Paid suppliers on
account, $30,000 $120 none 1.706 increase 1.059 increase
d. Received cash on
account, $40,000 $120 none 1.600 none 1.050 none
e. Paid insurance for
next year, $20,000 $120 none 1.600 none 0.950 decrease
f. Made sales on
account, $60,000 $180 increase 1.900 increase 1.350 increase
g. Repaid short-term
loans at bank,
$25,000 $120 none 1.686 increase 1.057 increase
h. Borrowed $40,000
at bank for 90 days $120 none 1.500 decrease 1.042 decrease
i. Declared and paid
$45,000 cash
dividend $ 75 decrease 1.375 decrease 0.825 decrease
j. Purchased $20,000
of short-term
investments $120 none 1.600 none 1.050 none
k. Paid $30,000 in
salaries $ 90 decrease 1.450 decrease 0.900 decrease
l. Accrued additional
$15,000 in taxes $105 decrease 1.488 decrease 0.977 decrease
LO 4 PROBLEM 13-2 EFFECT OF TRANSACTIONS ON WORKING CAPITAL, CURRENT

RATIO, AND QUICK RATIO
1. Calculation of working capital, current ratio and quick ratio (dollar amounts in
thousands):
Working capital
($70 + $60 + $80 + $100 + $10) ($75 + $25 + $40 + $210)
= $320 $350 = $(30)
Current ratio
$320/$350 = 0.914 to 1
Quick ratio
($70 + $60 + $80)/$350 = $210/$350 = 0.600 to 1
2. Effect of transactions on working capital, current ratio, and quick ratio:

Working Effect Effect Effect
Capital of of of
(in Thou- Trans- Current Trans- Quick Trans-
Transaction sands) action Ratio action Ratio action
a. Purchased inventory
on account for
$20,000 $(30) none 0.919 increase 0.568 decrease
b. Purchased inventory
for cash, $15,000 $(30) none 0.914 none 0.557 decrease
account, $30,000 $(30) none 0.906 decrease 0.563 decrease
d. Received cash on
account, $40,000 $(30) none 0.914 none 0.600 none
e. Paid insurance for
next year, $20,000 $(30) none 0.914 none 0.543 decrease
f. Made sales on
account, $60,000 $30 increase 1.086 increase 0.771 increase
g. Repaid short-term
loans at bank,
$25,000 $(30) none 0.908 decrease 0.569 decrease
h. Borrowed $40,000
at bank for 90 days $(30) none 0.923 increase 0.641 increase
$45,000 cash
dividend $(75) decrease 0.786 decrease 0.471 decrease
j. Purchased $20,000
of short-term
investments $(30) none 0.914 none 0.600 none
k. Paid $30,000 in
salaries $(60) decrease 0.829 decrease 0.514 decrease
$15,000 in taxes $(45) decrease 0.877 decrease 0.575 decrease
LO 6 PROBLEM 13-3 GOALS FOR SALES AND RETURN ON ASSETS
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%
= $60,000,000/$40,000,000 = 1.5 times
c. Return on assets = Return on sales Asset turnover
= 8.33% 1.5 = 12.5%
2. Asset turnover = ($60,000,000 120%)/($40,000,000 112.5%)

= $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 on assets, 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 president has set a goal for an
increase in sales of only 20%. To increase income by a larger percentage than the
increase in sales will require cost cutting in the various departments of the business.
The company may want to look for cheaper sources of supply for its materials, as
long as the quality of the product 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):

2011 2010 2009
1. Sales* 266.200 242.00 220.0
2. Net income (sales 3%)* 7.986 7.26 6.6
3. Dividends declared and paid (greater of
$3,000,000 or 50% of net income) 3.993 3.63 3.3
4. Owners equity, December 31 balance
(prior years balance + net income
less dividends) 80.923 76.93 73.3
5. Debt, Dec. 31 balance** 52.177 44.07 36.7
Selected 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 20062008 are
based on year-end owners equity rather than the average for each year.
Therefore, to be consistent, year-end balances are used for 20092011.
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 $110.0
Less: Owners equity (Item 4) 80.923 76.93 73.3
Debt $ 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 assumptions that the net income to
sales ratio be maintained at 3% with annual sales growth of 10%, and the asset
turnover ratio be maintained at 2, the goal of holding debt to 35% of total assets will
be met only in 2009. The debt will increase to 36.4% of total assets in 2010 and to
39.2% of total assets in 2011 under the proposed plan. The calculations assume that
all other factors remain constant. Because some of the factors that affect stock
prices are outside the companys control, it cannot be determined whether the main
requirement of improving the stock price can be met if the expected performance is
accomplished.
3. Alternative actions to be considered to improve the return on equity and support 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 subsidiary or 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.
4. The CEO is probably concerned with the potential impact that greater debt would
have on the companys cost of capital. Increasing debt relative to owners equity
creates added risk, which translates to higher returns required by investors in the
companys stocks and bonds. If investors perceive that the companys financial risks
have increased, the market prices for its long-term debt issues will fall (interest rates
will rise), and greater dividend payments will be necessary to maintain the market
price of the stock.
M U LTI C O N C E P T P R O B L E M S
LO 4,5,6 PROBLEM 13-5 BASIC FINANCIAL RATIOS
1. Financial ratios for 2008 for CCB Enterprises (thousands omitted):
a. Times interest earned = (Net income + Income tax expense + Interest

expense)/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 of tax)/Average total
assets
= {$72,000 + [$20,000 (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 Preferred dividends)/
= $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
e. Current ratio = Current assets/Current liabilities
= $144,000/$120,000 = 1.2 to 1
f. Quick (acid-test) ratio = (Cash + Marketable securities + Short-term receivables)/
Current liabilities
= ($26,000 + $48,000)/$120,000
= $74,000/$120,000 = 0.62 to 1
g. Accounts receivable turnover ratio = Net credit sales/Average accounts
receivable
= $800,000/[($48,000 + $50,000)/2]
= $800,000/$49,000 = 16.3 times
h. Number of days sales in receivables = Number of days in period/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/Inventory turnover

k. Number of days in cash operating cycle = Days sales in inventory + Days sales
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 the significantly
smaller quick ratio may signal a problem with excess inventory. Whether or not the
quick ratio is indicative of a liquidity problem could be determined more accurately
by comparing this ratio with prior years, as well as with an industry average.
Inventory turnover of 8.5 times may not be a problem area (see discussion of
quick ratio above), but it should be compared with those of prior years and with an
industry averageturning over inventory every 42 days may be normal for the
industry.
The length of time that receivables are outstanding, 22 days, appears to be
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 credit terms are too
stringent, the company may be losing good customers. Comparison of this statistic
with those of other companies in the same line of business would help to determine
whether there is a problem in the credit department.
The company appears to be successfully using outside capital, as is evidenced
by a return on assets of 16%, but a return on stockholders equity of almost double
this30.2%. Further evidence of the companys use of leverage could be found by
examining the exact cost of each individual source of capital. For example, what are
the terms of the instruments that make up long-term debt, and what is the effective
interest cost of each?
The times interest earned ratio indicates that earnings are seven times the
amount of interest expensewhat appears to be excellent coverage. However, how
much cash is generated from operations? Is this cash sufficient to cover not only
interest payments but also maturing principal amounts? Calculation of the debt
service coverage ratio, with information found on a cash flows statement, would
provide further evidence of the companys solvency.
Finally, to fully evaluate the companys financial health, it would be necessary to
know more about its plans for the long run. Does it plan to expand plant and
equipment? Are there any plans to take on additional products or acquire another
company? Are any additional debt issues being contemplated?
LO 5,6 PROBLEM 13-6 PROJECTED RESULTS TO MEET CORPORATE OBJECTIVES
1. Projected results for the four objectives for Tablon Inc. (in thousands of dollars):
Sales growth of 20% will be achieved:
Sales increase for the year $30,000 $25,000

= = 20%
Sales for 2008 $25,000
Return on stockholders equity of 15% will not be met:

Net income preferred dividends $1,200 $0 *
Average stockholders' equity
= = $1,200/$9,000 =
($9,300 + $8,700)/2
13.3%
*No preferred stock
Long-term debt-to-equity ratio of not more than 1 will not be achieved:
Long - term debt at 5/31/09 $10,000

Stockholde rs' equity at 5/31/09
= = $10,000/$9,300 = 1.08 to 1
($5,000 + $4,300)
A cash dividend of 50% of net income, with a minimum payment of at least

$400,000 will be met:
50% 2009 net income = 0.50 $1,200 = $600
($600 is the forecasted dividend payment)
2. Contributing factors to Tablons failure to meet all its objectives include the following:
Each of the three expenses, cost of goods sold, selling expenses, and
administrative expenses and interest, as a percentage of sales, are expected to
increase in 2009 from 2008:
2008 2009
Cost 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 could cause a
cash flow problem and possibly an increase in bad debts.
Production will exceed sales needs, as is evidenced by the 23% expected
increase in the amount of inventory. This will result in additional carrying costs for
the year.
Long-term borrowing increased by 50% in the first six months of 2008, and for
the full year it is expected to be up by 66.67% from the beginning of the year.
3. Possible actions that the controller could recommend to the president in response to
the problems cited above include the following:
Review the accounts receivable collection process to determine ways to speed
up collection and to determine whether credit is being extended to high-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 to sales.
Review the selling and administrative expenses to determine whether certain
areas can be cut back and still provide necessary services.
Review the continuing increases in long-term debt and decide whether they are
necessary. Consider the issuance of preferred stock as an alternative form of
financing.
LO 4,5,6 PROBLEM 13-7 COMPARISON WITH INDUSTRY AVERAGES
1. Industry
Ratio Average Heartland Inc.
Current ratio 1.23 0.92
Acid-test (quick) ratio 0.75 0.53
Accounts receivable turnover 33 times 39 times
Inventory turnover 29 times 31 times
Debt-to-equity ratio 0.53 0.69
Times interest earned 8.65 times 4.43 times
Return on sales 6.57% 4.54%
Asset turnover 1.95 times 1.98 times
Return 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 = 0.92 to 1
Acid-test ratio = (Cash + Marketable securities + Accounts receivable)/Current
liabilities
($1,135 + $1,250 + $15,650)/$33,945 = $18,035/$33,945 = 0.53 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 = 0.69 to 1
Times interest earned = (Net income + Interest expense + Income tax
expense)/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 0.40*)]/$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 total assets
$24,660 (above)/$274,810 (above) = 8.97%
Return on common stockholders equity = (Net income Preferred dividends)/
$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 is evidenced by

its lower current and quick ratios. The inventory turnover ratio is very close to the
industry average, whereas the accounts receivable turnover is significantly better.
Note, however, that the industry has a very high turnoverin fact, the average
number of days in receivables for the industry is 360/33, or 11 days. Heartlands
accounts payable has increased significantly during a year in which inventory has
actually decreased.
The company is not as solvent as the rest of the industry, either, as is indicated
by its higher debt-to-equity ratio and lower times interest earned ratio. The heavy
reliance on outside funds is also reflected in the profitability of the company. Even
though Heartlands return on equity is higher than its return on assets, both ratios
are significantly lower than the comparable industry averages. Its asset turnover is
slightly higher than the industry norm.
3. If the banks primary consideration in making the loan decision is the companys
relative performance compared with that of the competition, it probably will not
approve the loan. Heartland is already more highly leveraged than the average
company in the industry, and it is not nearly as profitable. However, the loan decision
will depend on other factors in addition to the companys relative standing in its
industry. For example, the bank will look at how Heartlands ratios this year compare
with those of prior years. Maybe the company is smaller than others in the industry
and has always performed at its current level. If the bank approves the loan, it will
probably require a higher interest rate to compensate for any perceived additional
risk.
A L T E R N AT E P R O B L E M S
LO 5 PROBLEM 13-1A EFFECT OF TRANSACTIONS ON DEBT-TO-EQUITY RATIO
1. Calculation of debt-to-equity ratio (000s omitted):

($150 + $375)/$400 = $525/$400 = 1.313 to 1
2. Effect of transactions on debt-to-equity ratio:
Debt-to-Equity Effect of
Transaction Ratio Transaction
a. Purchased inventory on
account for $20,000 1.363 increase
b. Purchased inventory for
cash, $15,000 1.313 none
account, $30,000 1.238 decrease
d. Received cash on
account, $40,000 1.313 none
e. Paid insurance for next
year, $20,000 1.313 none
f. Made sales on account,
$60,000 1.141 decrease
g. Repaid short-term loans
at bank, $25,000 1.250 decrease
h. Borrowed $40,000 at
bank for 90 days 1.413 increase
$45,000 cash dividend 1.479 increase
j. Purchased $20,000 of
short-term investments 1.313 none
k. Paid $30,000 in salaries 1.419 increase
$15,000 in taxes 1.403 increase
LO 5 PROBLEM 13-2A EFFECT OF TRANSACTIONS ON DEBT-TO-EQUITY RATIO
1. Calculation of debt-to-equity ratio (000s omitted):

($25 + $125)/$400 = $150/$400 = 0.375 to 1
2. Effect of transactions on debt-to-equity ratio:
Debt-to-Equity Effect of
Transaction Ratio Transaction
a. Purchased inventory on
account for $20,000 0.425 increase
b. Purchased inventory for
cash, $15,000 0.375 none
account, $30,000 0.300 decrease
d. Received cash on
account, $40,000 0.375 none
e. Paid insurance for next
year, $20,000 0.375 none
f. Made sales on account,
$60,000 0.326 decrease
g. Repaid short-term loans
at bank, $25,000 0.313 decrease
h. Borrowed $40,000 at
bank for 90 days 0.475 increase
$45,000 cash dividend 0.423 increase
j. Purchased $20,000 of
short-term investments 0.375 none
k. Paid $30,000 in salaries 0.405 increase
$15,000 in taxes 0.429 increase
LO 6 PROBLEM 13-3A GOALS FOR SALES AND RETURN ON ASSETS
1. a. Return on sales = Net income after adding back interest expense, net of tax/
Net sales
= $60,000/$750,000 = 8%
= $750,000/$400,000 = 1.88 times
c. Return on assets = Return on sales Asset turnover
= 8% 1.88 = 15.04%
PROBLEM 13-3A (Concluded)
2. Asset turnover = ($750,000 115%)/($400,000 110%)

= $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.
4. Income will have to increase by 47%, ($88,000 $60,000)/$60,000, to achieve the
goal of a 20% return on assets. The president has set a goal for an increase in sales
of only 15%. To increase income by a larger percentage than the increase in sales
will require cost cutting in the various departments of the business. The company
may want to look for cheaper sources of supply for its materials as long as the
quality of the product is maintained. Efforts will need to be made to cut selling,
general, and administrative expenses as well.
LO 6 PROBLEM 13-4A GOALS FOR SALES AND INCOME GROWTH
1. Selected financial data (in millions of dollars):

2011 2010 2009
1. Sales* 133.1000 121.000 110.0
2. Net income (sales 3%)* 3.9930 3.630 3.3
3. Dividends declared and paid
(greater of $2,000,000
or 60% of net income) 2.3958 2.178 2.0
4. Owners equity, December 31
balance (prior years
balance + net income less
dividends) 44.3492 42.752 41.3
5. Debt, Dec. 31 balance** 22.2008 17.748 13.7
Selected 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 20062008 are
based on year-end owners equity rather than the average for each year.
Therefore, to be consistent, year-end balances are used for 20092011.
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 41.3
Debt $22.2008 $17.748 $13.7
2. No, the CEO will not be able to meet all his requirements if a 10% per year growth in
income and sales is achieved. If under the stated assumptions that the net income to
sales ratio be maintained at 3% with annual sales growth of 10%, and the asset
turnover ratio be maintained at 2, the goal of holding debt to 25% of total assets will
only be met in 2009. The debt will increase to 29.3% of total assets in 2010 and to
33.36% of total assets in 2011 under the proposed plan. The calculations assume
that all other factors remain constant. Because some of the factors that affect stock
prices are outside the companys control, it cannot be determined whether the main
requirement of improving the stock price can be met if the expected performance is
accomplished.
3. Alternative actions to be considered to improve the return on equity and support 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 subsidiary or 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.
A L T E R N AT E M U L T I C O N C E P T P R O B L E M S
LO 4,5,6 PROBLEM 13-5A BASIC FINANCIAL RATIOS
1. Financial ratios for 2008 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 of tax)/Average total
assets
= {$60,000 + [$15,000 (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 Preferred dividends)/
= $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 = 0.67 to 1
e. Current ratio = Current assets/Current liabilities
= $100,000/$105,000 = 0.95 to 1
f. Quick (acid-test) ratio = (Cash + Marketable securities + Short-term receivables)/
Current liabilities
= ($27,000 + $36,000)/$105,000
= $63,000/$105,000 = 0.6 to 1
g. Accounts receivable turnover ratio = Net credit sales/Average accounts
receivable
= $600,000/[($36,000 + $37,000)/2]
= $600,000/$36,500 = 16.4 times
h. Number of days sales in receivables = Number of days in period/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/Inventory turnover
k. Number of days in cash operating cycle = Days sales in inventory + Days sales
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 smaller quick ratio
may signal a problem with excess inventory. Whether or not the quick ratio is
indicative of a liquidity problem could be determined more accurately by comparing
this ratio with those of prior years, as well as with an industry average.
Inventory turnover of 10.52 times may not be a problem area (see discussion of
quick ratio above), but it should be compared with those of prior years and with an
industry averageturning over inventory every 34 days may be normal for the
industry.
The length of time that receivables are outstanding, 22 days, appears to be
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 the credit terms are too
stringent, the company may be losing good customers. Comparison of this statistic
with other companies in the same line of business would help to determine whether
there is a problem in the credit department.
The company appears to be successfully using outside capital, as is evidenced
by a return on assets of 23.65% but a much higher return on stockholders equity of
34.78%. Further evidence of the companys use of leverage could be found by
examining the exact cost of each individual source of capital. For example, what are
the terms of the instruments that make up long-term debt and what is the effective
interest cost of each?
The times interest earned ratio indicates that earnings are nearly seven times the
amount of interest expensethat would appear to be excellent coverage. However,
how much cash is generated from operations? Is this cash sufficient to cover not
only interest payments but also maturing principal amounts? Calculation of the debt
service coverage ratio, with information found on a cash flows statement, would
provide further evidence of the companys solvency.
Finally, to fully evaluate the companys financial health, it would be necessary to
know more about its plans for the long run. Does it plan to expand plant and
equipment? Are there any plans to take on additional products or acquire another
company? Are any additional debt issues being contemplated?
LO 5,6 PROBLEM 13-6A PROJECTED RESULTS TO MEET CORPORATE OBJECTIVES
1. Projected results for the four objectives for Grout Inc. (in thousands of dollars):
Sales growth of 10% will be exceeded:

Sales increase for the year $12,000 $10,000
= = 20%
Sales for 2008 $10,000
Return on stockholders equity of 20% will not be met:

Net income Preferred dividends $400 $0 *
Average stockholde rs' equity
= = $400/$5,000 = 8%
($5,000 + $5,000)/2
*No preferred stock.
Long-term debt-to-equity ratio of not more than 1 will not be achieved:

Long - term debt at 9/30/09 $5,500
Stockholde rs' equity at 9/30/09
= = $5,500/$5,000 = 1.1 to 1
($4,000 + $1,000)
A cash dividend of 50% of net income will be met (dividends of 100% of net
income are projected), but a minimum dividend payment of $500,000 will not be
met (the projected dividends are only $400,000).
2. Contributing factors to Grouts failure to meet all its objectives include the following:
Cost of goods sold, as a percentage of sales, is expected to increase in 2009

from 2008, and the other two operating expenses are expected to remain the
same:
2008
Cost 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 an increase in bad
debts will need to be monitored.
Production will exceed sales needs, as is evidenced by the 20% expected
increase in the amount of inventory. This will result in additional carrying costs for
the year.
Long-term borrowing increased by 37.5% in the first six months of 2009, 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 in response to
the problems cited above include the following:
Review the accounts receivable collection process to determine ways to speed

up collection and to determine whether or not credit is being extended to high-
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 to sales.
Review the continuing increases in long-term debt and decide whether or not
they are necessary. Consider the issuance of preferred stock as an alternative
form of financing.
LO 4,5,6 PROBLEM 13-7A COMPARISON WITH INDUSTRY AVERAGES
1. Industry
Ratio Average Midwest, Inc.
Current ratio 1.20 1.26
Acid-test (quick) ratio 0.50 0.34
Inventory turnover 35 times 37.27 times
Debt-to-equity ratio 0.50 0.69
Times interest earned 25 times 4.13 times
Return on sales 3% 4.68%
Asset turnover 3.5 times 3.82 times
Return on common stockholders equity 20% 23.19%
Calculations for Midwests ratios (thousands omitted):

$12,440/$9,900 = 1.26 to 1
Acid-test ratio = (Cash + Marketable securities + Accounts receivable)/Current
liabilities
($1,790 + $1,200 + $400)/$9,900 = $3,390/$9,900 = 0.34 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 = 0.69 to 1
Times interest earned = (Net income + Interest expense + Income tax expense)/
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 0.446*)]/$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 = 3.82 times
$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 is

evidenced by its lower quick ratio. The inventory turnover ratio is very similar to the
industry average. Midwests accounts payable has decreased during the year,
although this is offset by increases in each of the other three current liabilities.
The company is not as solvent as the rest of the industry either, as is indicated by
its higher debt-to-equity ratio and lower times interest earned ratio. The heavy
reliance on outside funds, however, has not been a detriment to the companys
profitability. Midwests return on equity is higher than the industry average.
3. Midwest is already more highly leveraged than the average company in the industry,
but as was indicated earlier, has used borrowed money effectively. However, the
loan decision will depend on other factors in addition to the companys relative
standing in its industry. For example, the bank will look at how Midwests ratios this
year compare with those of prior years. Maybe the company is smaller than others in
the industry and has always performed at its current level. If the bank approves the
loan, it will probably require a higher interest rate to compensate for any perceived
additional risk.
D E C IS ION C AS E S
READING AND INTERPRETING FINANCIAL STATEMENTS
LO 2 DECISION CASE 13-1 HORIZONTAL ANALYSIS FOR KELLOGGS
1. and 2. (In millions of dollars)

Increase (Decrease) from:
2005 to 2006 2004 to 2005
Income Statement Accounts Dollars Percent Dollars Percent
Net sales $729.5 7.2% $563.3 5.9%

Cost of goods sold 469.9 8.4 312.9 5.9
Selling, general, and administrative
expense 244.1 8.7 181.2 6.9
Operating profit 15.5 0.9 69.2 4.1
Interest expense 7.1 2.4 (8.3) (2.7)
Other income (expense), net 38.1 153.0 (18.3) 277.3
Earnings before income taxes 46.5 3.3 59.2 4.3
Income taxes 21.8 4.9 (30.6) (6.4)
Earnings (loss) from joint venture (1.0) 0.0 0.0 0.0
Net earnings 23.7 2.4 89.8 10.1
Note: Answers may differ slightly due to rounding.
3. Net sales has increased in each of the last two years; however the two major
expenses have increased at either the same or higher rates. The result is that
operating profit increased in each of the two years but not at a rate not as high as
the increase in net sales. The increase in net earnings is higher in 2005 than in
2006, primarily due to the decrease in income taxes in 2005. Overall, the company
profitability has improved over the three-year period.
LO 3 DECISION CASE 13-2 VERTICAL ANALYSIS FOR KELLOGGS
1. Common-size comparative income statements:
KELLOGGS
COMMON-SIZE CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 30, 2006 AND DECEMBER 31, 2005
(IN MILLIONS OF DOLLARS)
2006 2005
Net sales $10,906.7 100.0% $10,177.2 100.0%

Cost of goods sold 6,081.5 55.8 5,611.6 55.1
Selling, general, and administrative
expense 3,059.4 28.0 2,815.3 27.7
Operating profit $ 1,765.8 16.2 $ 1,750.3 17.2
Interest expense 307.4 2.8 300.3 3.0
Other income (expense), net 13.2 0.1 (24.9) (0.2)
Earnings before income taxes $ 1,471.6 13.5 $ 1,425.1 14.0
Income taxes 466.5 4.3 444.7 4.4
Earnings (loss) from joint venture (1.0) 0.0 0.0 0.0
Net earnings $ 1,004.1 9.2 $ 980.4 9.6
2. Cost of goods sold as a percentage of net sales increased slightly in 2006, which
would result in a decrease in the gross profit ratio. Similarly, selling, general, and
administrative expenses as a percentage of net sales increased slightly in 2006,
resulting in a decline in the operating profit percentage by one percentage point. The
decrease in the profit margin ratio from 9.6% to 9.2% was minimal.
3. Common-size comparative balance sheets:
KELLOGGS
COMMON-SIZE CONSOLIDATED BALANCE SHEETS
AT DECEMBER 30, 2006 AND DECEMBER 31, 2005
2006 2005
Cash and cash equivalents $ 410.6 3.8 $ 219.1 2.1
Accounts receivable, net 944.8 8.8 879.1 8.3
Inventories 823.9 7.7 717.0 6.8
Other current assets 247.7 2.3 381.3 3.6
Total current assets $ 2,427.0 22.6 $ 2,196.5 20.8
Property, net 2,815.6 26.3 2,648.4 25.0
Other assets 5,471.4 51.1 5,729.6 54.2
Total assets $ 10,714.0 100.0 $ 10,574.5 100.0
Current maturities of long-term debt $ 723.3 6.8 $ 83.6 0.8
Notes payable 1,268.0 11.8 1,111.1 10.5
Accounts payable 910.4 8.5 883.3 8.3
Other current liabilities 1,118.5 10.4 1,084.8 10.3
Total current liabilities $ 4,020.2 37.5 $ 3,162.8 29.9
Long-term debt $ 3,053.0 28.5 $ 3,702.6 35.0
Other liabilities $ 1,571.8 14.7 $ 1,425.4 13.5
Common stock, $0.25 par value $ 104.6 1.0 $ 104.6 1.0
Capital in excess of par value 292.3 2.7 58.9 0.5
Retained earnings 3,630.4 33.9 3,266.1 30.9
Treasury stock, at cost (912.1) (8.5) (569.8) (5.4)
Accumulated other comprehensive
Income (loss) (1,046.2) (9.8) (576.1) (5.4)
Total shareholders equity $ 2,069.0
19.3 $ 2,283.7 21.6
Total liabilities and shareholders
equity $ 10,714.0 100.0 $ 10,574.5 100.0
4. Within the current asset category, cash increased in relative importance from the
prior year, 3.8% in 2006 versus 2.1% in 2005. Overall, there were small increases in
both current assets and property as percentages of total assets. These were
counterbalanced by a small decrease in other assets as a percentage of total
assets.
Current liabilities increased in importance in 2006, increasing from about 30% of
the total right side of the balance sheet to over 37%. This was due primarily to an
increase in current maturities of long-term debt. As a result, long-term debt
decreased by a similar percentage. Total shareholders equity decreased in relative
importance, due mainly to increases in the relative percentages of the two contra-
equity accounts, treasury stock and accumulated other comprehensive loss.
LO 3 DECISION CASE 13-3 COMPARING TWO COMPANIES IN THE SAME INDUSTRY:

KELLOGGS AND GENERAL MILLS
1. Common-size comparative income statements:
GENERAL MILLS
COMMON-SIZE CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED MAY 28, 2006 AND MAY 29, 2005
2006 2005
Net sales $11,640 100.0% $11,244 100.0%

Cost of sales 6,966 59.9 6,834 60.8
Selling, general, and administrative 2,678 23.0 2,418 21.5
Interest, net 399 3.4 455 4.1
Restructuring and other exit costs 30 0.2 84 0.7
Divestitures (gain) 0 0.0 (499) (4.4)
Debt repurchase costs 0 0.0 137 1.2
Total costs and expenses $10,073 86.5 $ 9,429 83.9
Earnings before income taxes and
after-tax earnings from joint ventures 1,567 3.5 1,815 16.1
Income taxes 541 4.6 664 5.9
After-tax earnings from joint venture 64 0.5 89 0.8
Net earnings $ 1,090 9.4 $ 1,240 11.0
2. General Millss cost of sales is a higher percentage of net sales in each year
compared to these ratios for Kelloggs. Conversely, selling, general and
administrative expenses are a lower ratio in each year for General Mills compared to
Kelloggs. Kelloggs profit margin averaged 9.4% over the two-year period compared
to an average profit margin for General Mills of 10.2%.
3. Common-size comparative balance sheets:
GENERAL MILLS
COMMON-SIZE CONSOLIDATED BALANCE SHEETS
AT MAY 28, 2006 AND MAY 29, 2005
2006 2005
Cash and cash equivalents $ 647 3.6 $ 573 3.2

Receivables 1,076 5.9 1,034 5.7
Inventories 1,055 5.8 1,037 5.7
Prepaid expenses and other current
assets 216 1.2 203 1.1
Deferred income taxes 182 1.0 208 1.2
Total current assets $ 3,176 17.5 $ 3,055 16.9
Land, buildings and equipment 2,997 16.5 3,111 17.2
Goodwill 6,652 36.5 6,684 37.0
Other intangible assets 3,607 19.8 3,532 19.6
Other assets 1,775 9.7 1,684 9.3
Total assets $ 18,207 100.0 $ 18,066 100.0
Accounts payable $ 1,151 6.3 $ 1,136 6.3
Current portion of long-term debt 2,131 11.7 1,638 9.1
Notes payable 1,503 8.3 299 1.7
Other current liabilities 1,353 7.4 1,111 6.1
Total current liabilities $ 6,138 33.7 $ 4,184 23.2
Long-term debt 2,415 13.3 4,255 23.6
Deferred income taxes 1,822 10.0 1,851 10.2
Other liabilities 924 5.1 967 5.3
Total liabilities $ 11,299 62.1 $ 11,257 62.3
Minority interests $ 1,136 6.2 $ 1,133 6.3
Common stock $ 50 0.3 $ 50 0.3
Additional paid-in capital 5,737 31.5 5,691 31.5
Retained earnings 5,107 28.1 4,501 24.9
Common stock in treasury, at cost (5,163) (28.4) (4,460) (24.7)
Unearned compensation (84) (0.5) (114) (0.6)
Accumulated other comprehensive
income (loss) 125 0.7 8 0.0
Total stockholders equity $ 5,772 31.7 $ 5,676 31.4
Total liabilities and stockholders equity $ 18,207 100.0 $ 18,066 100.0
4. Kelloggs has a higher percentage of its total assets invested in current assets,
compared to General Mills. Long-term tangible assets also make up a higher
percentage of total assets for Kelloggs. Other long-term assets, including goodwill
and other intangible assets are a higher percentage for General Mills. Current
liabilities are a higher percentage of the total liabilities and shareholders equity for
Kelloggs. In fact, total liabilities make up a higher percentage of the right side of the
balance sheet, as evidenced by the lower percentage of total shareholders equity to
the total of the right side for Kelloggs compared to General Mills. The conclusion is
that Kelloggs relies more heavily on outside funds to finance its business.
LO 4,5,6 DECISION CASE 13-4 RATIO ANALYSIS FOR GENERAL MILLS
1. Ratios and other amounts for General Mills (all dollar amounts in thousands):
a. Working capital = Current assets Current liabilities

2006: $3,176 $6,138 = $(2,962)
2005: $3,055 $4,184 = $(1,129)
b. Current ratio = Current assets/Current liabilities
2006: $3,176/$6,138 = 0.517 to 1
2005: $3,055/$4,184 = 0.730 to 1
c. Acid-test ratio = (Cash and cash equivalents + Receivables)/Current liabilities
2006: ($647 + $1,076)/$6,138 = $1,723/$6,138 = 0.281 to 1
2005: ($573 + $1,034)/$4,184 = $1,607/$4,184 = 0.384 to 1
d. Cash flow from operations to current liabilities = Net cash provided by operating
activities/Current liabilities
2006: $1,771/$6,138 = 0.289 to 1
2005: $1,711/$4,184 = 0.409 to 1
e. Debt-to-equity ratio = Total liabilities/Total stockholders equity
2006: $11,299/$5,772 = 1.958 to 1
2005: $11,257/($5,676 = $1.983 to 1
f. Cash flow from operations to capital expenditures = (Net cash provided by

operating activities Total dividends paid)/Cash paid for acquisitions
2006: ($1,771 - $485)/$360 = $1,286/$360 = 3.572 to 1
2005: ($1,711 - $461)/$434 = $1,250/$434 = 2.880 to 1
g. Asset turnover = Net sales/Total assets
2006: $11,640/$18,207 = 0.639 times
2005: $11,244/$18,066 = 0.622 times
h. Return on sales = (Net income + Interest expense* net of tax**)/Net sales

2006: [$1,090 + $367(1 0.35)]/$11,640 =
$1,329/$11,640 = 11.4%
2005: [($1,240 + $449(1 0.37)]/$11,244 =
$1,523/$11,244 = 13.5%
*Interest, net on the income statement includes interest expense; amount of
interest expense disclosed on page 47 of the 2006 annual report).
**Tax rates: 2006: $541/$1,567 = 0.35
2005: $664/$1,815 = 0.37
i. Return on assets = (Net income + Interest expense, net of tax)/Total assets

2006: $1,329 (from h.)/$18,207 = 7.3%
2005: $1,523 (from h.)/$18,066 = 8.4%
j. Return on common stockholders equity = (Net income preferred dividends)/
Common stockholders equity
2006: $1,090/$5,772 = 18.9%
2005: $1,240/$5,676 = 21.8%
2. General Mills has been able to operate successfully with a relatively low current ratio
and acid-test ratio, although both ratios declined in 2006. The company operates
with a debt to equity ratio approaching 2 to 1. General Mills has used its borrowed
funds to its advantage, as evidenced by a return on common equity that exceeded
the return on assets each year. However, both ratios did decline in 2006 from the
prior year.
MAKING FINANCIAL DECISIONS
LO 4,5,6,7 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 2007 to $161,820,000 in 2008.
Both the current ratio and the quick ratio have also increased:
2008: $324,120/$162,300 = 2.00 to 1
2007: $215,180/$126,250 = 1.70 to 1
Quick ratio = (Cash + Marketable securities + Short-term receivables)/
Current liabilities
2008: ($48,500 + $3,750 + $128,420)/$162,300 = 1.11 to 1
2007: ($24,980 +0 + $84,120)/$126,250 = 0.86 to 1
The accounts receivable turnover for 2008 = Net credit sales/Average accounts
receivable: $875,250/[($128,420 + $84,120)/2] = 8.24 times, or an average
collection period of 360/8.24 = 44 days
Whether this is a reasonable number of days outstanding could be partially
determined by an examination of the companys credit terms.
The inventory turnover for 2008 = Cost of goods sold/Average inventory:
$542,750/[($135,850 + $96,780)/2] = 4.67 times, or an average number of days
sales in inventory of 360/4.67 = 77 days
The cash operating cycle for 2008 is 44 + 77 = 121 days
Conclusion: The company appears on the surface to be fairly liquid, but each of the
above measures of liquidity should be compared with industry averages. One area
of concern is the large increase in both receivables and inventories from the prior
year. The company could be experiencing collection problems. The inventory should
be examined more closely for possible obsolescence and slow-moving items.
2. The companys solvency can be examined by looking at the following factors:
The debt-to-equity ratio has increased slightly from the prior year: Total liabilities/
Total stockholders equity
2008: ($162,300 + $275,000)/$532,710 = 0.82 to 1
2007: ($126,250 + $275,000)/$519,820 = 0.77 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 an extraordinary
gain to take into account, the easiest approach is to use the income number before
taking all of these items into account, i.e., operating income.
Conclusion: The company is carrying a heavy debt burden even though the bonds
are not due until 2015. It will continue to have large interest payments for the next
seven years. Further information on the operating cash flows is necessary to see
whether funds will be available to service the debt currently outstanding. Interest
payments not only will be a significant cash drain but also will affect the companys
profitability.
3. Profitability can be assessed by looking at a number of ratios for 2008. The

extraordinary gain should be ignored in assessing profitability for our purposes,
because we are interested in the future performance of the company 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 0.40*)] 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 $9,250 by 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 = 0.93
times
Average common stockholders equity: $13,890/[($532,710 + $519,820)/2] =
$13,890/$526,265 = 2.6%
The average cost of borrowed funds can be approximated: $45,000 in interest
expense divided by an average of short-term notes and bonds combined of
[($80,000 + $275,000) + ($60,000 + $275,000)]/2 = $45,000/$345,000 = 13%.
The after-tax cost of these borrowed funds is 13% (1 0.40) = 7.8%.
4. It would be difficult to recommend to the vice-president of acquisitions that Heavy

Duty be acquired. It has not demonstrated the ability to be a profitable member of
the Diversified family over the long run. Disregarding the extraordinary gain, the
profit margin before interest and taxes was only 7.8%. Heavy Duty relies on a
considerable amount of outside debt for funding, but it is proving to be too costly at
an after-tax cost of 7.8%. This is further evidenced by an overall return on assets,
4.3%, which is higher than the return to the stockholder of only 2.6%. While Heavy
Duty is at least profitable, it is unlikely that the president and board of directors of
Diversified will be satisfied with a company that yields such a low return. In addition,
it may prove very difficult for Heavy Duty to generate the necessary funds to repay
the bonds in 2015.
LO 3 DECISION CASE 13-6 PRICING DECISION
1. BPO
COMMON-SIZE COMPARATIVE INCOME STATEMENTS
FOR YEARS 13
(IN THOUSANDS OF DOLLARS)
Year 3 Year 2 Year 1
$ % $ % $ %
Sales $125 100.0% $110 100.0% $100 100.0%
Cost of goods sold 62 49.6 49 44.5 40 40.0
Gross profit $ 63 50.4% $ 61 55.5% $ 60 60.0%
Operating expenses 53 42.4 49 44.5 45 45.0
Net income $ 10 8.0% $ 12 11.0% $ 15 15.0%
2. Net income has decreased while sales have increased because BPO has not held
the line on its product costs. The gross profit ratio has declined significantly, because
of the increase in cost of goods sold relative to sales, from 40% to nearly 50%.
3. BPO
INCOME STATEMENT
YEAR 4
Sales: $125,000 1.10 $ 137,500
Cost of goods sold: $62,000 1.08 66,960
Gross profit $ 70,540
Operating expenses $53,000 1.08 57,240
Net income $ 13,300
4. With a 10% increase in volume, BPO will not need to increase its prices. On the
basis of the projections, it will report an increase in net income of 33%.
ETHICAL DECISION MAKING
LO 4,5 DECISION CASE 13-7 PROVISIONS IN A LOAN AGREEMENT
1. No, Midwest is not in violation of its existing loan agreement. The current ratio is
$16/$10, or 1.6 to 1, which is above the minimum requirement of 1.5. The debt-to-
equity ratio is $25/$55, or 0.45 to 1, which is below the maximum of 0.5.
2. Jackson has handled each of the two items incorrectly, and the controller has the
responsibility to make corrections before the statements are released. The treatment
of both items is in violation of accounting standards. First, the $5 million note should
be included in current liabilities, since it is due in six months. The mere intent of the
company to roll over or refinance the note does not by itself justify the exclusion of it
from current liabilities. [Note: The instructor may want to use this opportunity to point
out that an accounting standard (SFAS No. 6) requires a company to demonstrate
the ability to refinance an obligation before classifying it as long-term.] Second, the
controller should not have recorded the deposit from the state as revenue. Instead, it
is a liability until the work is completed.
3. Revised balance sheet:

Current assets $16 Current liabilities $17
Long-term assets 64 Long-term debt 10
Stockholders equity 53
Total $80 Total $80
Current liabilities should be $10, as reported, plus $5 for the note due in six months
and $2 for the deposit from the state. Long-term debt is reduced by $5 for the note
that is reclassified as short-term. Stockholders equity is reduced by $2 because the
deposit should be included in current liabilities rather than revenue as recorded by
Jackson.
Revised ratios:
Current ratio: $16/$17 = 0.94 to 1
Debt-to-equity ratio: $27/$53 = 0.51 to 1
These revisions will put Midwest in violation of its loan agreement with Southern
National Bank. The current ratio is significantly below the minimum level of 1.5, while
the debt-to-equity ratio is slightly above the maximum of 0.5.
LO 4 DECISION CASE 13-8 INVENTORY TURNOVER
1. The president calculated the inventory turnover ratio of 90 times by dividing sales
revenue of $3,690,000 by the average inventory balance of $41,000 (the average of
$40,000 at the end of 2008 and $42,000 at the end of 2007).
2. The president has erroneously used sales rather than cost of goods sold to calculate
inventory turnover. Because inventory is stated at cost, cost of goods sold must be
used in the numerator, not sales. The correct calculation is
($3,690,000 1 0.40*)/$41,000 = $2,214,000/$41,000 = 54 times
*The gross profit ratio is 40%. Therefore, cost of goods sold is 1 40%, or 60% of
sales.
3. It is understandable why the president would prefer to report an inventory turnover of

90 times, rather than 54 times. In the fruits and vegetables business, the company
needs to be able to show that it turns the inventory frequently to maintain freshness.
As controller, you have a responsibility to the public not to intentionally misrepresent
the company. You must tell the president that his calculations are incorrect and
explain to him how the ratio should be computed.
REAL WORLD PRACTICE 13.1
Wrigleys gross profit ratio for each year is as follows:

2006: 51.9% 2001: 57.1%
2005: 54.2% 2000: 56.1%
2004: 55.7% 1999: 54.8%
2003: 56.9% 1998: 55.0%
2002: 56.8% 1997: 53.6%
1996: 53.2%
Over this time period, the ratio has seen some variation, from a low of 51.9% in 2006 to
a high of 57.1% in 2001.
REAL WORLD PRACTICE 13.2
Gross profit ratio:

2006: ($10,906.7 $6,081.5)/$10,906.7 = $4,825.2/$10,906.7 = 44.2%
2005: ($10,177.2 $5,611.6 )/$10,177.2 = $4,565.6/$10,177.2 = 44.9%
2004: ($9,613.9 $5,298.7)/$9,613.9 = $4,315.2/$9,613.9 = 44.9%
Profit margin ratio:

2006: $1,004.1/$10,906.7 = 9.2%
2005: $980.4 /$10,177.2 = 9.6%
2004: $890.6/$9,613.9 = 9.3%
Percentage increases (decreases):

Gross profit ratio:
From 2005 to 2006: (44.2 44.9)/44.9 = (0.7)/44.9 = (1.6%)
From 2004 to 2005: 0%
Profit margin ratio:
From 2005 to 2006: (9.2 9.6)/9.6 = (0.4)/9.6 = (4.2%)
From 2004 to 2005: (9.6 9.3)/9.3 = 0.3/9.3 = 3.2%
This analysis indicates that Kelloggs gross profit ratio and profit margin ratio have both
remained very stable over the three-year period.
THIS PAGE IS INTENTIONALLY LEFT BLANK

SOLUTIONS TO INTEGRATIVE PROBLEM
1. GALLAGHER, INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2008
Cash Flows from Operating Activities
Net income $ 3,440
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense 700
Increase in accounts receivable (3,500)
Increase in inventories (2,500)
Decrease in prepaid insurance 300
Increase in accounts payable 2,300
Increase in taxes payable 400
Net cash provided by operating activities $ 1,140
Cash Flows from Investing Activities
Acquisition of buildings and equipment $(3,000)
Net cash used by investing activities $(3,000)
Cash Flows from Financing Activities
Issuance of additional notes payable $ 800
Payment of cash dividends (600)
Payment of bonds (200)
Net cash provided by financing activities $ 0
Net decrease in cash $(1,860)
Cash balance, December 31, 2007 2,700
Cash balance, December 31, 2008 $ 840
2. a. Current ratio = Current assets/Current liabilities

= $21,440/$14,500 = 1.48 to 1
b. Acid-test ratio = (Cash + Accounts receivable)/Current liabilities
= ($840 + $12,500)/$14,500 = $13,340/$14,500 = 0.92 to 1
c. Cash flow from operations to current liabilities ratio = Net cash provided by
operating activities/Average current liabilities
= $1,140/[($14,500 + $11,000)/2] = $1,140/$12,750 = 9%
d. Accounts receivable turnover ratio = Net credit sales/Average accounts
receivable
= $48,000/[($12,500 + $9,000)/2] = $48,000/$10,750 = 4.47
e. Number of days sales in receivables = Number of days in the period/Accounts
receivable turnover ratio = 360/4.47 = 80.54
f. Inventory turnover ratio = Cost of goods sold/Average inventory

= $36,000/[($8,000 + $5,500)/2] = $36,000/$6,750 = 5.33
g. Number of days sales in inventory = Number of days in period/Inventory turnover
ratio = 360/5.33 = 67.54
h. Debt-to-equity ratio = Total liabilities/Total stockholders equity
= $15,900/$17,840 = 0.9 to 1
i. Debt service coverage ratio = Cash flow from operations, before interest and tax
payments/Interest and principal payments
= ($1,140 + $280 + $2,280 $400*)/($280 + $200) = $3,300/$480 = 6.88 to 1
*Increase in taxes payable account.
j. Cash flow from operations to capital expenditures ratio = (Cash flow from
operations Total dividends paid)/Cash paid from acquisitions
= ($1,140 $600)/$3,000 = $540/$3,000 = 18%
3. Gallaghers current ratio decreased from 1.6 in 2007 to 1.48 in 2008 and its acid-test
ratio also decreased from 1.06 in 2007 to 0.92 in 2008. For many companies, an
acid-test ratio below 1 is not desirable because it may signal the need to liquidate
marketable securities to pay bills, regardless of the current trading price of the
securities. Gallagher currently doesnt own marketable securities and therefore it
may have difficulty in paying its bills. Its cash flow from operations to current
liabilities ratio is low also. The number of days sales in receivable indicates it should
increase collection efforts while the number of days sales in inventory may indicate
a large amount of obsolete inventory or problems in the sales department.
Gallaghers debt-to-equity ratio indicates that for every $1 of capital that
stockholders provided, creditors provided $0.90. Gallagher generated almost $7 of
cash from operations during 2008 to cover every $1 of required interest and
principal payments. The cash flow from operations to capital expenditures ratio
(18%) of less than 100% indicates that it is not able to finance all of its capital
expenditures from operations and cover its dividend payments. Overall, Gallagher
appears to have low liquidity and solvency ratios. However, these ratios should be
compared to ratios in its industry as well as to ratios from prior years to get a better
idea of how it is doing. Its credit policies should also be examined to determine its
policy on collections. It should consider putting off future dividend payments until it
gets its liquidity problems under control.

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CHAPTER 13

Financial Statement Analy

2. Use comparative financial statements to analyze a company 12* 45 Mod

3. Use common-size financial statements to compare various 12* 45 Mod

4. Compute and use various ratios to assess liquidity. 1 15 Mod

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

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

Exercise, problem, or case covers two or more learning outcomes

2. Use comparative financial statements to analyze a company

3. Use common-size financial statements to compare various

4. Compute and use various ratios to assess liquidity. 1 40 Mod

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

6. C ompute and use various ratios to assess profitability. 3 20 Mod

7. Explain how to report on and analyze other income statement

Exercise, problem, or case covers two or more learning outcomes

2. Use com parative financial statements to analyze a company 1 45

3. Use common-size financial statements to compare various 2 60 Mod

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

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

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

7. Explain how to report on and analyze other income statement 5* 45 Mod

Exercise, problem, or case covers two or more learning outcomes

12. An accounts receivable turnover of nine times translates to an average n umber of

LO1 BRIEF EXERCISE 13-1 LIMITATIONS IN RATIO ANALYSIS

LO2 BRIEF EXERCISE 13-2 HORIZONTAL ANALYSIS

A comparison of financial statement items within a single period is called vertical

A c omparison of financial statement items over a period of time is called horizontal

LO3 BRIEF EXERCISE 13-3 VERTICAL ANALYSIS

LO4 BRIEF EXERCISE 13-4 LIQUIDITY ANALYSIS

C urrent ratio: Current

LO5 BRIEF EXERCISE 13-5 SOLVENCY ANALYSIS

L O6 BRIEF EXERCISE 13-6 PROFITABILITY ANALYSIS

R eturn on assets: Interest Expense, Net of Tax (A)

LO 7 BRIEF EXERCISE 13-7 OTHER INCOME STATEMENT ITEMS

Disposed of a segment of the business: Discontinued operations

LO 4 EXERCISE 13-1 ACCOUNTS RECEIVABLE ANALYSIS

1. Accounts receivable turnover:

2. Number of days sales in receivables:

LO 4 EXERCISE 13-2 INVENTORY ANALYSIS

2. Number of days sales in inventory:

LO 4 EXERCISE 13-3 ACCOUNTS RECEIVABLE AND INVENTORY ANALYSES FOR

1. Calculations (all dollar amounts in millions):

LO 4 EXERCISE 13-4 LIQUIDITY ANALYSES FOR COCA-COLA AND PEPSICO

1. Calculations (all dollar amounts in millions):

LO 4 EXERCISE 13-5 LIQUIDITY ANALYSES FOR MCDONALDS AND WENDYS

LO 5 EXERCISE 13-6 SOLVENCY ANALYSES FOR IBM

LO 5 EXERCISE 13-7 SOLVENCY ANALYSIS

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

LO 6 E XERCISE 13-8 RETURN RATIOS AND LEVERAGE

LO 6 EXERCISE 13-9 RELATIONS HIPS AMONG RETURN ON ASSETS, RETURN ON

Case 1. Return on assets = Net income (assuming no interest expense)/Average

Case 2. Return on sales = Net income/Net sales

Case 3. Return on assets = Return on sales Asset turnover

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

Case 5. Return on assets = Net income (assuming no interest expense)/Average

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

2. An investment advisor needs to be awar e of industry trends, the general economic

LO 6,7 EXERCISE 13-11 EARNINGS PER SHARE AND EXTRAORDINARY ITEMS

LO 2,3 EXERCISE 13-12 COMMON-SIZE BALANCE SHEETS AND HORIZONTAL

2. Observations from Farinets common-size balance sheets:

4. Largest chan ges Refer to

a. Accumulated depreciation Fixed asset records, showing

LO 2,3 EXERCISE 13-13 COMMON-SIZE INCOME STATEMENTS AND HORIZONTAL

Sales revenue $60,000 100.0% $50,000 100.0%