CHAPTER 5
I. Questions
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Chapter 5 Financial Statement Analysis –II
6. How a shareholder would feel would depend in large part on the stability
of the firm and its industry. If the firm is in an industry that experiences
wide fluctuations in earnings, then shareholders might be very pleased that
no interest-paying debt exists in the firm’s capital structure. In hard
times, interest payments might be very difficult to meet, or earnings might
be so poor that negative leverage would result.
7. No, the stock is not necessarily overpriced. Book value represents the
cumulative effects on the balance sheet of past activities evaluated using
historical prices. The market value of the stock reflects investors’ beliefs
about the company’s future earning prospects. For most companies
market value exceeds book value because investors anticipate future
growth in earnings.
10. The current ratio would probably be highest during January, when both
current assets and current liabilities are at a minimum. During peak
operating periods, current liabilities generally include short-term
borrowings that are used to temporarily finance inventories and
receivables. As the peak periods end, these short-term borrowings are paid
off, thereby enhancing the current ratio.
11. A 2-to-1 current ratio might not be adequate for several reasons. First, the
composition of the current assets may be heavily weighted toward slow-
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Financial Statement Analysis –II Chapter 5
12. Expenses (including the cost of goods sold) have been increasing at an
even faster rate than net sales. Thus Sunday is apparently having
difficulty in effectively controlling its expenses.
13. If the company’s earnings are very low, they may become almost
insignificant in relation to stock price. While this means that the p/e ratio
becomes very high, it does not necessarily mean that investors are
optimistic. In fact, they may be valuing the company at its liquidation
value rather than a value based upon expected future earnings.
15. The length of operating cycle of the two companies cannot be determined
from the fact the one company’s current ratio is higher. The operating
cycle depends on the relationships between receivables and sales, and
between inventories and cost of goods sold. The company with the higher
current ratio might have either small amounts of receivables and
inventories, or large sales and cost of sales, either of which would tend to
produce a relatively short operating cycle.
16. The investor is calculating the rate of return by dividing the dividend by
the purchase price of the investment (P5 P50 = 10%). A more
meaningful figure for rate of return on investment is determined by
relating dividends to current market price, since the investor at the present
time is faced with the alternative of selling the stock for P100 and
investing the proceeds elsewhere or keeping the investment. A decision to
retain the stock constitutes, in effect, a decision to continue to invest P100
in it, at a return of 5%. It is true that in a historical sense the investor is
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Chapter 5 Financial Statement Analysis –II
III. Problems
Requirement (a)
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Financial Statement Analysis –II Chapter 5
Current assets:
Cash P 47,600
Marketable securities 175,040
Accounts receivable 230,540
Inventory 179,600
Unexpired insurance 4,500
Total current assets P637,280
Current liabilities:
Notes payable P 70,000
Accounts payable 125,430
Salaries payable 7,570
Income taxes payable 14,600
Unearned revenue 10,000
Total current liabilities P227,600
Requirement (b)
Requirement 1
2006 2005
Sales........................................................................................................................
100.0 % 100.0 %
Less cost of goods sold............................................................................................
63.2 60.0
Gross margin...........................................................................................................
36.8 40.0
Selling expenses.......................................................................................................
18.0 17.5
Administrative expenses..........................................................................................
13.6 14.6
Total expenses.........................................................................................................
31.6 32.1
Net operating income...............................................................................................
5.2 7.9
Interest expense.......................................................................................................
1.4 1.0
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Chapter 5 Financial Statement Analysis –II
Requirement 2
The company’s major problem seems to be the increase in cost of goods sold,
which increased from 60.0% of sales in 2005 to 63.2% of sales in 2006. This
suggests that the company is not passing the increases in costs of its products
on to its customers. As a result, cost of goods sold as a percentage of sales
has increased and gross margin has decreased. Selling expenses and interest
expense have both increased slightly during the year, which suggests that costs
generally are going up in the company. The only exception is the
administrative expenses, which have decreased from 14.6% of sales in 2005 to
13.6% of sales in 2006. This probably is a result of the company’s efforts to
reduce administrative expenses during the year.
Requirement (a)
Ms. Freeze, Industry Average
Inc.
Sales (net) 100% 100%
Cost of goods sold 49 57
Gross profit on sales 51% 43%
Operating expenses:
Selling 21% 16%
General and administrative 17 20
Total operating expenses 38% 36%
Operating income 13% 7%
Income taxes 6 3
Net income........................................ 7% 4%
Requirement (b)
Ms. Freeze’s operating results are significantly better than the average
performance within the industry. As a percentage of sales revenue, Ms.
Freeze’s operating income and net income after nearly twice the average for
the industry. As a percentage of total assets, Ms. Freeze’s profits amount to
an impressive 23% as compared to 14% for the industry.
The key to Ms. Freeze’s success seems to be its ability to earn a relatively
high rate of gross profit. Ms. Freeze’s exceptional gross profit rate (51%)
probably results from a combination of factors, such as an ability to command
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Financial Statement Analysis –II Chapter 5
a premium price for the company’s products and production efficiencies which
lead to lower manufacturing costs.
As a percentage of sales, Ms. Freeze’s selling expenses are five points higher
than the industry average (21% compared to 16%). However, these higher
expenses may explain Ms. Freeze’s ability to command a premium price for
its products. Since the company’s gross profit rate exceeds the industry
average by 8 percentage points, the higher-than-average selling costs may be
part of a successful marketing strategy. The company’s general and
administrative expenses are significantly lower than the industry average,
which indicates that Ms. Freeze’s management is able to control expenses
effectively.
Requirement 1
2006 2005
Current assets:
Cash 2.0% 5.1%
..........................................................
Accounts receivable, net 15.0 10.1
..........................................................
Inventory 30.1 15.2
..........................................................
Prepaid expenses 1.0 1.3
..........................................................
Total current assets 48.1 31.6
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Chapter 5 Financial Statement Analysis –II
Note: Columns do not total down in all cases due to rounding differences.
Requirement 2
The company’s cost of goods sold has increased from 60 percent of sales in
2005 to 65 percent of sales in 2006. This appears to be the major reason the
company’s profits showed so little increase between the two years. Some
benefits were realized from the company’s cost-cutting efforts, as evidenced by
the fact that operating expenses were only 26.3 percent of sales in 2006 as
compared to 30.4 percent in 2005. Unfortunately, this reduction in operating
expenses was not enough to offset the increase in cost of goods sold. As a
result, the company’s net income declined from 5.6 percent of sales in 2005 to
5.3 percent of sales in 2006.
Requirement (a)
(Pesos in
Millions)
Current assets:
Cash P 74.8
Receivables 152.7
Merchandise inventories 1,191.8
Prepaid expenses 95.5
Total current assets P1,514.8
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Financial Statement Analysis –II Chapter 5
Quick assets:
Cash P 74.8
Receivables 152.7
Total quick assets P 227.5
Requirement (b)
Requirement (c)
Requirement (d)
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Chapter 5 Financial Statement Analysis –II
Requirement (e)
Note to Instructor: Prior to the year in which the data for this problem was
collected, Alabang Supermarket had reported a negative retained earnings
balance in its balance sheet for several consecutive periods. The fact that
Alabang Supermarket has only recently removed the deficit from its financial
statements is also worrisome.
Requirement (a)
Requirement (b)
Requirement (c)
(2) Long-term creditors also have little to worry about. Not only is the
company highly liquid, but creditors’ claims amount to only 23.1% of
total assets. If Bonbon Sweets’ were to go out of business and liquidate
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Chapter 5 Financial Statement Analysis –II
its assets, it would have to raise only 23 cents from every peso of assets
for creditors to emerge intact.
Requirement 1
Requirement 3
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Financial Statement Analysis –II Chapter 5
2. Current ratio:
Current assets P490,000
= P200,000 = 2.45 to 1
Current liabilities
3. Acid-test ratio:
Quick assets P181,000
Current liabilities = P200,000 = 0.91 to 1 (rounded)
Sales P2,100,000
Average accounts receivables = P150,000 = 14 times
365 days
14 times = 26.1 days (rounded)
5. Inventory turnover:
Cost of goods sold P1,260,000
Average inventory = P280,000 = 4.5 times
365 days
4.5 times = 81.1 days to turn (rounded)
6. Debt-to-equity ratio:
Total liabilities P500,000
Total equity = P800,000 = 0.63 to 1 (rounded)
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Chapter 5 Financial Statement Analysis –II
* P100,000 total par value ÷ P5 par value per share = 20,000 shares
4. Price-earnings ratio:
Market price per share P63.00
= = 12.0
Earnings per share P5.25
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Financial Statement Analysis –II Chapter 5
= P105,000
½ (P725,000 + P800,000)
P105,000
= = 13.8% (rounded)
P762,500
3. Financial leverage was positive, since the rate of return to the ordinary
shareholders (13.8%) was greater than the rate of return on total assets
(10.5%). This positive leverage is traceable in part to the company’s
current liabilities, which may carry no interest cost, and to the bonds
payable, which have an after-tax interest cost of only 7%.
10% interest rate × (1 – 0.30) = 7% after-tax cost.
IV. Cases
Requirement 1
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Chapter 5 Financial Statement Analysis –II
Requirement 2
Liabilities:
Current liabilities 27.5 % 18.2 %
Bonds payable, 12% 18.8 22.7
Total liabilities 46.3 40.9
Equity:
Preference shares, P50 par, 8% 5.0 6.1
Ordinary shares, P10 par 12.5 15.2
Retained earnings 36.3 37.9
Total equity 53.8 59.1
Total liabilities and equity 100.0 % 100.0 %
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Financial Statement Analysis –II Chapter 5
Requirement 3
The following points can be made from the analytical work in parts (1) and (2)
above:
The company has improved its profit margin from last year. This is
attributable to an increase in gross margin, which is offset somewhat by an
increase in operating expenses. In both years the company’s net income as a
percentage of sales equals or exceeds the industry average of 4%.
Although the company’s working capital has increased, its current position
actually has deteriorated significantly since last year. Both the current ratio
and the acid-test ratio are well below the industry average, and both are
trending downward. (This shows the importance of not just looking at the
working capital in assessing the financial strength of a company.) Given the
present trend, it soon will be impossible for the company to pay its bills as
they come due.
The drain on the cash account seems to be a result mostly of a large buildup in
accounts receivable and inventory. This is evident both from the common-size
balance sheet and from the financial ratios. Notice that the average age of the
receivables has increased by 5 days since last year, and that it is now 9 days
over the industry average. Many of the company’s customers are not taking
their discounts, since the average collection period is 27 days and collection
terms are 2/10, n/30. This suggests financial weakness on the part of these
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Chapter 5 Financial Statement Analysis –II
customers, or sales to customers who are poor credit risks. Perhaps the
company has been too aggressive in expanding its sales.
The inventory turned only 5 times this year as compared to over 6 times last
year. It takes three weeks longer for the company to turn its inventory than the
average for the industry (71 days as compared to 50 days for the industry).
This suggests that inventory stocks are higher than they need to be.
In the authors’ opinion, the loan should be approved on the condition that the
company take immediate steps to get its accounts receivable and inventory
back under control. This would mean more rigorous checks of
creditworthiness before sales are made and perhaps paring out of slow paying
customers. It would also mean a sharp reduction of inventory levels to a more
manageable size. If these steps are taken, it appears that sufficient funds
could be generated to repay the loan in a reasonable period of time.
Requirement 1
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Financial Statement Analysis –II Chapter 5
Investors regard Metro Building Supply less favorably than other firms in
the industry. This is evidenced by the fact that they are willing to pay only
7.3 times current earnings for a share of the company’s stock, as
compared to 9 times current earnings for the average of all stocks in the
industry. If investors were willing to pay 9 times current earnings for
Metro Building Supply’s stock, then it would be selling for about P55 per
share (9 × P6.16), rather than for only P45 per share.
A market price in excess of book value does not mean that the price of a
stock is too high. Market value is an indication of investors’ perceptions
of future earnings and/or dividends, whereas book value is a result of
already completed transactions and is geared to the past.
Requirement 2
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Chapter 5 Financial Statement Analysis –II
shareholders (a)...................................................................................................
Requirement 3
We would recommend keeping the stock. The stock’s downside risk seems
small, since it is selling for only 7.3 times current earnings as compared to 9
times earnings for the average firm in the industry. In addition, its earnings
are strong and trending upward, and its return on ordinary equity (16.6%) is
extremely good. Its return on total assets (10.4%) compares favorably with
that of the industry.
The risk, of course, is whether the company can get its cash problem under
control. Conceivably, the cash problem could worsen, leading to an eventual
reduction in profits through inability to operate, a reduction in dividends, and
a precipitous drop in the market price of the company’s stock. This does not
seem likely, however, since the company can easily control its cash problem
through more careful management of accounts receivable and inventory. If
this problem is brought under control, the price of the stock could rise sharply
over the next few years, making it an excellent investment.
Requirement 1
This Year Last Year
P 280,000 P 168,000
a. Net income..............................................................................................................
Add after-tax cost of interest:
P120,000 × (1 – 0.30).........................................................................................
84,000
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Financial Statement Analysis –II Chapter 5
P100,000 × (1 – 0.30).........................................................................................
70,000
P 364,000 P 238,000
Total (a)...................................................................................................................
P 280,000 P 168,000
b. Net income..............................................................................................................
Less preference dividends........................................................................................
48,000 48,000
P 232,000 P 120,000
Net income remaining for ordinary (a).....................................................................
c. Leverage is positive for this year, since the return on ordinary equity
(9.2%) is greater than the return on total assets (6.8%). For last year,
leverage is negative since the return on the ordinary equity (4.9%) is less
than the return on total assets (5.1%).
Requirement 2
Notice from the data given in the problem that the average P/E ratio for
companies in Helix’s industry is 10. Since Helix Company presently has
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Chapter 5 Financial Statement Analysis –II
a P/E ratio of only 7.8, investors appear to regard it less well than they do
other companies in the industry. That is, investors are willing to pay only
7.8 times current earnings for a share of Helix Company’s stock, as
compared to 10 times current earnings for a share of stock for the average
company in the industry.
Note that the book value of Helix Company’s stock is greater than the
market value for both years. This does not necessarily indicate that the
stock is selling at a bargain price. Market value is an indication of
investors’ perceptions of future earnings and/or dividends, whereas book
value is a result of already completed transactions and is geared to the
past.
Requirement 3
This Year Last Year
a. Current assets P2,600,000 P1,980,000
Current liabilities 1,300,000 920,000
Working capital P1,300,000 P1,060,000
Requirement 4
As stated by Meri Ramos, both net income and sales are up from last year.
The return on total assets has improved from 5.1% last year to 6.8% this year,
and the return on ordinary equity is up to 9.2% from 4.9% the year before.
But this appears to be the only bright spot in the company’s operating picture.
Virtually all other ratios are below the industry average, and, more important,
they are trending downward. The deterioration in the gross margin percentage,
while not large, is worrisome. Sales and inventories have increased
substantially, which should ordinarily result in an improvement in the gross
margin percentage as fixed costs are spread over more units. However, the
gross margin percentage has declined.
In the author’s opinion, what the company needs is more equity—not more
debt. Therefore, the loan should not be approved. The company should be
encouraged to make another issue of ordinary stock in order to provide a
broader equity base on which to operate.
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Chapter 5 Financial Statement Analysis –II
Bulacan Company
Income Statement
For the Year Ended December 31, 2005
Sales P140,800
Less: Cost of Sales (4) 84,480
Gross Profit P 56,320
Less: Expenses 46,320
Net Income (1) P 10,000
Bulacan Company
Balance Sheet
December 31, 2005
As s e t s
Current Assets:
Cash P 27,720
Accounts Receivable (5) 28,160
Merchandise Inventory (3) 21,120
Total Current Assets (2) P 77,000
Fixed Assets (8) 55,000
Total Assets P132,000
Current Liabilities:
Accounts Payable (2) P 44,000
Equity:
Share Capital (issued 20,000
shares) (6) P40,000
Retained Earnings 48,000 88,000
Total Liabilities and Equity P132,000
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Financial Statement Analysis –II Chapter 5
Supporting Computations:
Net Income
(1) Earnings Per Share =
Ordinary Shares Outstanding
X
P0.50 =
20,000
X (Net Income) = P10,000
= P44,000
Current Assets
(3) Current Ratio =
Current Liabilities
X
1.27 =
44,000
X (Current Assets) = P77,000
Quick Assets
Quick Ratio =
Current Liabilities
X
1.27 =
44,000
X (Current Assets) = P55,880
Cost of Sales
(4) Inventory turnover = Ave. Inventory
X
4 =
P21,120
X (Cost of Sales) = P84,480
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Chapter 5 Financial Statement Analysis –II
Quick Assets
(5) Average age of outstanding =
Accounts Receivable Current Liabilities
365
= 73 days (Average age of
5 receivables)
Net Sales
Average Receivables = 5
P140,800
X = 5
X (Receivables) = P28,160
Another Method:
P140,800
365 = 73 days = P28,160 Accounts receivable
0.375X = P33,000
X = P88,000 Equity
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Financial Statement Analysis –II Chapter 5
Requirement 1
The loan officer stipulated that the current ratio prior to obtaining the loan
must be higher than 2.0, the acid-test ratio must be higher than 1.0, and the
interest on the loan must be no more than four times net operating income.
These ratios are computed below:
Current assets
Current ratio = Current liabilities
P290,000
Current rate = P164,000 = 1.8 (rounded)
Cash + Marketable securities + Accounts receivable
Acid-test ratio =
Current liabilities
P70,000 + P0 + P50,000
Acid-test ratio = = 0.70 (rounded)
P164,000
Net operating income P20,000
= P80,000 x 0.10 x (6/12) = 5.0
Interest on the loan
The company would fail to qualify for the loan because both its current ratio
and its acid-test ratio are too low.
Requirement 2
By reclassifying the P45 thousand net book value of the old machine as
inventory, the current ratio would improve, but there would be no effect on the
acid-test ratio. This happens because inventory is considered to be a current
asset but is not included in the numerator when computing the acid-test ratio.
Current assets
Current ratio = Current liabilities
P290,000 + P45,000
Current rate = P164,000 = 2.0 (rounded)
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Chapter 5 Financial Statement Analysis –II
strongly advise against it. Inventories are assets the company has acquired for
the sole purpose of selling them to outsiders in the normal course of business.
Used production equipment is not considered to be inventory—even if there is
a clear intention to sell it in the near future. Since the loan officer would not
expect used equipment to be included in inventories, doing so would be
intentionally misleading.
Nevertheless, the old equipment is an asset that could be turned into cash. If
this were done, the company would immediately qualify for the loan since the
P45 thousand in cash would be included in the numerator in both the current
ratio and in the acid-test ratio.
Current assets
Current ratio =
Current liabilities
P290,000 + P45,000
Current rate = = 2.0 (rounded)
P164,000
However, other options may be available. After all, the old machine is being
used to relieve bottlenecks in the plastic injection molding process and it
would be desirable to keep this standby capacity. We would advise Rome to
fully and honestly explain the situation to the loan officer. The loan officer
might insist that the machine be sold before any loan is approved, but he might
instead grant a waiver of the current ratio and acid-test ratio requirements on
the basis that they could be satisfied by selling the old machine. Or he may
approve the loan on the condition that the equipment is pledged as collateral.
In that case, Rome would only have to sell the machine if he would otherwise
be unable to pay back the loan.
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