➢  Through the use of turnover rates, explain why a firm might seek to increase the volume of its sales even though such an increase can be secured only at reduced prices.

➢  Indicate which of the relationships illustrated in the chapter would be best to judge:

• The short-term debt-paying ability of the firm.
• The overall efficiency of the firm without regard to the sources of assets.
• The return to owners (stockholders) of a corporation.
• The safety of long-term creditors’ interest.
• The safety of preferred stockholders’ dividends.

➢  Indicate how each of the following ratios or measures is calculated:

• Payout ratio.
• Earnings per share of common stock.
• Price-earnings ratio.
• Earnings yield on common stock.
• Dividend yield on preferred stock.
• Times interest earned.
• Times preferred dividends earned.
• Return on average common stockholders’ equity.
• Cash flow margin.

➢  How is the rate of return on operating assets determined? Is it possible for two companies with operating margins of 5 per cent and 1 per cent, respectively, to both have a rate of return of 20 per cent on operating assets? How?

➢  Cite some of the possible deficiencies in accounting information, especially regarding its use in analyzing a particular company over a 10-year period.

Exercises

Exercise A Income statement data for Boston Company for 2009 and 2010 follow:

Prepare a horizontal and vertical analysis of the income data in a form similar to Exhibit 2. Comment on the results of this analysis.

Exercise B A company engaged in the following three independent transactions:

• Merchandise purchased on account, $ 2,400,000.
• Machinery purchased for cash, $ 2,400,000.
• Capital stock issued for cash, $ 2,400,000.

1. Compute the current ratio after each of these transactions assuming current assets were $ 3,200,000 and the current ratio was 1:1 before the transactions occurred.
2. Repeat part (a) assuming the current ratio was 2:1.
3. Repeat part (a) assuming the current ratio was 1:2.

Exercise C A company has sales of $ 3,680,000 per year. Its average net accounts receivable balance is $ 920,000.

1. What is the average number of days accounts receivable are outstanding?
2. By how much would the capital invested in accounts receivable be reduced if the turnover could be increased to 6 without a loss of sales?

Exercise D Columbia Corporation had the following selected financial data for 2009 December 31: Net cash provided by operating activities

Compute the cash flow margin.

Exercise E From the following partial income statement, calculate the inventory turnover for the period.

Exercise F Eastern, Inc., had net sales of $ 3,520,000, gross margin of $ 1,496,000, and operating expenses of $ 904,000. Total assets (all operating) were $ 3,080,000. Compute Eastern’s rate of return on operating assets.

Exercise G Nelson Company began the year 2010 with total stockholders’ equity of $ 2,400,000. Its net income for 2010 was $ 640,000, and $ 106,800 of dividends were declared. Compute the rate of return on average stockholders’ equity for 2010. No preferred stock was outstanding.

Exercise H Rogers Company had 60,000 shares of common stock outstanding on 2010 January 1. On 2010 April 1, it issued 20,000 additional shares for cash. The amount of earnings available for common stockholders for 2010 was $ 600,000. What amount of EPS of common stock should the company report?

Exercise I Smith Company started 2011 with 800,000 shares of common stock outstanding. On March 31, it issued 96,000 shares for cash, and on September 30, it purchased 80,000 shares of its own stock for cash. Compute the weighted-average number of common shares outstanding for the year.

Exercise J A company reported EPS of $ 2 (or ) for 2009, ending the year with 1,200,000 shares outstanding. In 2010, the company earned net income of $ 7,680,000, issued 320,000 shares of common stock for cash on September 30, and distributed a 100 per cent stock dividend on 2010 December 31. Compute EPS for 2010, and compute the adjusted earnings per share for 2009 that would be shown in the 2010 annual report.

Exercise K A company paid interest of $ 32,000, incurred federal income taxes of $ 88,000, and had net income (after taxes) of $ 112,000. How many times was interest earned?

Exercise L John Company had 20,000 shares of $ 600 par value, 8 per cent preferred stock outstanding. Net income after taxes was $ 5,760,000. The market price per share was $ 720.

1. How many times were the preferred dividends earned?
2. What was the dividend yield on the preferred stock assuming the regular preferred dividends were declared and paid?

Exercise M A company had 80,000 weighted-average number of shares of $ 320 par value common stock outstanding. The amount of earnings available to common stockholders was $ 800,000. Current market price per share is $ 720. Compute the EPS and the price-earnings ratio.

Problems

Problem A Loom’s comparative statements of income and retained earnings for 2010 and 2009 are given below.

Loom

Consolidated statement of earnings

For the years ended 2010 December 31, and 2009

(USD thousands, except per data share)

Loom

consolidated balance sheet

As of 2010 December 31, and 2009

(USD thousands)

Perform a horizontal and vertical analysis of Loom’s financial statements in a manner similar to those illustrated in this chapter. Comment on the results of the analysis in (a).

Problem B Deere & Company manufactures, distributes, and finances a full range of agricultural equipment; a broad range of industrial equipment for construction, forestry, and public works; and a variety of lawn and grounds care equipment. The company also provides credit, health care, and insurance products for businesses and the general public. Consider the following information from the Deere & Company 2000 Annual Report:

1. Prepare a statement showing the trend percentages for each item using 1997 as the base year.
2. Comment on the trends noted in part (a).

Problem C The following data are for Toy Company:

1. Compute the amount of working capital at both year-end dates.
2. Compute the current ratio at both year-end dates.
3. Compute the acid-test ratio at both year-end dates.
4. Compute the cash flow liquidity ratio at both year-end dates.
5. Comment briefly on the company’s short-term financial position.

Problem D On 2011 December 31, Energy Company’s current ratio was 3:1 before the following transactions were completed:

• Purchased merchandise on account.
• Paid a cash dividend declared on 2011 November 15.
• Sold equipment for cash.
• Temporarily invested cash in trading securities.
• Sold obsolete merchandise for cash (at a loss).
• Issued 10-year bonds for cash.
• Wrote off goodwill to retained earnings.
• Paid cash for inventory.
• Purchased land for cash.
• Returned merchandise that had not been paid for.
• Wrote off an account receivable as uncollectible. Uncollectible amount is less than the balance in the Allowance for Uncollectible Accounts.
• Accepted a 90-day note from a customer in settlement of customer’s account receivable.
• Declared a stock dividend on common stock.

Consider each transaction independently of all the others.

1. Indicate whether the amount of working capital will increase, decrease, or be unaffected by each of the transactions.
2. Indicate whether the current ratio will increase, decrease, or be unaffected by each of the transactions.

Problem E Digital Company has net operating income of $ 500,000 and operating assets of $ 2,000,000.

Its net sales are $ 4,000,000.

The accountant for the company computes the rate of return on operating assets after computing the operating margin and the turnover of operating assets.

1. Show the computations the accountant made.
2. Indicate whether the operating margin and turnover increase or decrease after each of the following changes. Then determine what the actual rate of return on operating assets would be. The events are not interrelated; consider each separately, starting from the original earning power position. No other changes occurred.

(a)Sales increased by $ 160,000. There was no change in the amount of operating income and no change in operating assets.

(b)Management found some cost savings in the manufacturing process. The amount of reduction in operating expenses was $ 40,000. The savings resulted from the use of less materials to manufacture the same quantity of goods. As a result, average inventory was $ 16,000 lower than it otherwise would have been. Operating income was not affected by the reduction in inventory.

(c)  The company invested $ 80,000 of cash (received on accounts receivable) in a plot of land it plans to use in the future (a nonoperating asset); income was not affected.

(d)The federal income tax rate increased and caused income tax expense to increase by $ 20,000. The taxes have not yet been paid.

(e)The company issued bonds and used the proceeds to buy $ 400,000 of machinery to be used in the business. Interest payments are $ 20,000 per year. Net operating income increased by $ 100,000 (net sales did not change).

Problem F Polaroid Corporation designs, manufactures, and markets worldwide instant photographic cameras and films, electronic imaging recording devices, conventional films, and light polarizing filters and lenses. The following information is for Polaroid:

Compute the following for both 2000 and 1999. Then compare and comment.

1. EPS of common stock.
2. Net income to net sales.
3. Net income to average common stockholders’ equity.
4. Times interest earned ratio.

Problem G The Walt Disney Company operates several ranges of products from theme parks and resorts to broadcasting and other creative content. The following balance sheet and supplementary data are for The Walt Disney Company for 2000.

The Walt Disney Company

Consolidated balance sheet

For 2000 September 30

(USD millions)

• Net income, $ 920.
• Income before interest and taxes, $ 3,231.
• Cost of goods sold, $ 21,321.
• Net sales, $ 25,402.
• Inventory on 1999 September 30, $ 796.
• Total interest expense for the year, $ 598.

Calculate the following ratios and show your computations. For calculations normally involving averages, such as average stockholders’ equity, use year-end amounts unless the necessary information is provided.

1. Current ratio.
2. Net income to average common stockholders’ equity.
3. Inventory turnover.
4. Number of days’ sales in accounts receivable (assume 365 days in 2000).
5. EPS of common stock (ignore treasury stock).
6. Times interest earned ratio.
7. Equity ratio.
8. Net income to net sales.
9. Total assets turnover.
10. Acid-test ratio.

Problem H Cooper Company currently uses the FIFO method to account for its inventory but is considering a switch to LIFO before the books are closed for the year. Selected data for the year are:

1. Compute the current ratio, inventory turnover ratio, and rate of return on operating assets assuming the company continues using FIFO.
2. Repeat part (a) assuming the company adjusts its accounts to the LIFO inventory method.

Alternate problems

Alternate problem A Steel Corporation’s comparative statements of income and retained earnings and consolidated balance sheet for 2010 and 2009 follow:

Steel Corporation

Consolidated statement of Earnings

For the years ended 2010 December 31, 2009

(USD thousands)

Steel Corporation

Consolidated balance sheet

As of 2010 December 31, and 2009

2. Perform a horizontal and vertical analysis of Steel’s financial statements in a manner similar to Exhibit 1 and Exhibit 2.
3. Comment on the results obtained in part (a).

Alternate problem B Ford Motor Company is the world’s second-largest producer of cars and trucks and ranks among the largest providers of financial services in the United States. The following information pertains to Ford: (in millions)

1. Prepare a statement showing the trend percentages for each item, using 1998 as the base year.
2. Comment on the trends noted in part (a).

Alternate problem C The following data are for Clock Company: Allowance for uncollectible accounts

1. Compute the amount of working capital at both year-end dates.
2. Compute the current ratio at both year-end dates.
3. Compute the acid-test ratio at both year-end dates.
4. Compute the cash flow liquidity ratio at both year-end dates.
5. Comment briefly on the company’s short-term financial position.

Alternate problem D Tulip Products, Inc., has a current ratio on 2010 December 31, of 2:1 before the following transactions were completed:

• Sold a building for cash.
• Exchanged old equipment for new equipment. (No cash was involved.)
• Declared a cash dividend on preferred stock.
• Sold merchandise on account (at a profit).
• Retired mortgage notes that would have matured in 2011.
• Issued a stock dividend to common stockholders.
• Paid cash for a patent.
• Temporarily invested cash in government bonds.
• Purchased inventory for cash.
• Wrote off an account receivable as uncollectible. Uncollectible amount is less than the balance of the Allowance for Uncollectible Accounts.
• Paid the cash dividend on preferred stock that was declared earlier.
• Purchased a computer and gave a two-year promissory note.
• Collected accounts receivable.
• Borrowed from the bank on a 120-day promissory note.
• Discounted a customer’s note. Interest expense was involved.

Consider each transaction independently of all the others.

1. Indicate whether the amount of working capital will increase, decrease, or be unaffected by each of the transactions.
2. Indicate whether the current ratio will increase, decrease, or be unaffected by each of the transactions.

Alternate problem E The following selected data are for three companies:

1. Determine the operating margin, turnover of operating assets, and rate of return on operating assets for each company.
2. In the subsequent year, the following changes took place (no other changes occurred):

Company 1 bought some new machinery at a cost of $ 156,000. Net operating income increased by $ 12,480 as a result of an increase in sales of $ 249,600.

Company 2 sold some equipment it was using that was relatively unproductive. The book value of the equipment sold was $ 624,000. As a result of the sale of the equipment, sales declined by $ 312,000, and operating income declined by $ 6,240.

Company 3 purchased some new retail outlets at a cost of $ 6,240,000. As a result, sales increased by $ 9,360,000, and operating income increased by $ 499,200.

• Which company has the largest absolute change in:

1. Operating margin ratio?
2. Turnover of operating assets?
3. Rate of return on operating assets?

• Which one realized the largest dollar change in operating income? Explain this change in relation to the changes in the rate of return on operating assets.

Alternate problem F One of the largest spice companies in the world, McCormick & Company, Inc., produces a diverse array of specialty foods. The following information is for McCormick & Company, Inc.:

Assume average common shares outstanding for 2000 and 1999 are 69,600 and 72,000 (in thousands), respectively.

Compute the following for both 2000 and 1999. Then compare and comment. Assume stockholders’ equity for 1998 was $ 388,100.

1. EPS of common stock.
2. Net income to net sales.
3. Return on average common stockholders’ equity.
4. Times interest earned ratio.

Alternate problem G Parametric Technology Corporation is in the CAD/CAM/CAE industry and is the top supplier of software tools used to automate a manufacturing company. The following consolidated balance sheet and supplementary data are for Parametric for 2003:

Parametric Technology Corporation

Consolidated balance sheet

For 2003 September 30 (in thousands)

• Net loss, ($ 3,980).
• Loss before interest and taxes, ($ 4,700).
• Cost of goods sold, $ 244,984.
• Net sales, $ 928,414.
• Total interest expense for the year, $ 367.
• Weighted-average number of shares outstanding, 273,081.

Calculate the following ratios and show your computations. For calculations normally involving averages, such as average accounts receivable or average stockholders’ equity, use year-end amounts if the information is not available to use averages.

1. Current ratio.
2. Net income to average common stockholders’ equity.
3. Number of days’ sales in accounts receivable (assume 365 days in 2003).
4. EPS of common stock.
5. Times interest earned ratio.
6. Equity ratio.
7. Net income to net sales.
8. Total assets turnover.
9. Acid-test ratio.

Alternate problem H Paper Company is considering switching from the FIFO method to the LIFO method of accounting for its inventory before it closes its books for the year. The January 1 merchandise inventory was $ 864,000. Following are data compiled from the adjusted trial balance at the end of the year:

If the switch to LIFO takes place, the December 31 merchandise inventory would be $ 900,000.

1. Compute the current ratio, inventory turnover ratio, and rate of return on operating assets assuming the company continues using FIFO.
2. Repeat (a) assuming the company adjusts its accounts to the LIFO inventory method.

Beyond the numbers – Critical thinking

Business decision case A The comparative balance sheets of the Darling Corporation for 2011 December 31, and 2010 follow:

Darling Corporation

Comparative balance sheets

2011 December 31, and 2010

(USD millions)

Based on your review of the comparative balance sheets, determine the following:

1. What was the net income for 2011 assuming there were no dividend payments?
2. What was the primary source of the large increase in the cash balance from 2010 to 2011?
3. What are the two main sources of assets for Darling Corporation?
4. What other comparisons and procedures would you use to complete the analysis of the balance sheet?

Business decision case B As Miller Manufacturing Company’s internal auditor, you are reviewing the company’s credit policy. The following information is from Miller’s annual reports for 2008, 2009, 2010, and 2011:

Management has asked you to calculate and analyze the following in your report:

1. If cash sales account for 30 per cent of all sales and credit terms are always 1/10, n/60, determine all turnover ratios possible and the number of days’ sales in accounts receivable at all possible dates. (The number of days’ sales in accounts receivable should be based on year-end accounts receivable and net credit sales.)
2. How effective is the company’s credit policy?

Business decision case C Wendy Prince has consulted you about the possibility of investing in one of three companies (Apple, Inc., Baker Company, or Cookie Corp.) by buying its common stock. The companies’ investment shares are selling at about the same price. The long-term capital structures of the companies alternatives are as follows:

Prince has already consulted two investment advisers. One adviser believes that each of the companies will earn $ 300,000 per year before interest and taxes. The other adviser believes that each company will earn about $ 960,000 per year before interest and taxes. Prince has asked you to write a report covering these points:

1. Compute each of the following, using the estimates made by the first and second advisers.

(a)Earnings available for common stockholders assuming a 40 per cent tax rate.

(b)EPS of common stock.

(c)  Rate of return on total stockholders’ equity.

1. Which stock should Prince select if she believes the first adviser?
2. Are the stockholders as a group (common and preferred) better off with or without the use of long-term debt in the companies?

Annual Report analysis D The following selected financial data excerpted from the annual report of Appliance Corporation represents the summary information which management presented for interested parties to review:

Appliance Corporation

Selected Financial Data

(USD thousands except per share data)

1. As a creditor, what do you believe management’s objectives should be? Which of the preceding items of information would assist a creditor in judging management’s performance?
2. As an investor, what do you believe management’s objectives should be? Which of the preceding items of information would assist an investor in judging management’s performance?
3. What other information might be considered useful?

Group project E Choose a company the class wants to know more about and obtain its annual report. In groups of two or three students, calculate either the liquidity, equity, profitability, or market test ratios. Each group should select a spokesperson to tell the rest of the class the results of the group’s calculations. Finally, the class should decide whether or not to invest in the corporation based on the ratios they calculated.

Group project F In a group of two or three students, go to the library and attempt to locate Dun & Bradstreet’s Industry Norms and Key Business Ratios. You may have to ask the reference librarian for assistance to see if this item is available at your institution. If it is not available at your institution, ask if it is available through an interlibrary loan. (Obviously, if you cannot obtain this item, you cannot do this project.) Then select and obtain the latest annual report of a company of your choice. Determine the company’s SIC Code (a code that indicates the industry in which that company operates). SIC Codes for specific companies are available on COMPACT DISCLOSURE, an electronic source that may be available at your library. As an alternative, you could call the company’s home office to inquire about its SIC Code. The annual report often contains the company’s phone number. From the annual report, determine various ratios for the company, such as the current ratio, debt to equity ratio, and net income to net sales. Then compare these ratios to the industry norms for the company’s SIC Code as given in the Dun & Bradstreet source. Write a report to your instructor summarizing the results of your investigation.

Group project G In a group of two or three students, obtain the annual report of a company of your choice Identify the major sections of the annual report and the order in which they appear. Would you recommend the order be changed to emphasize the most useful and important information? If so, how? Then describe some specific useful information in each section. Comment on your perceptions of the credibility that a reader of the annual report could reasonably assign to each section of the report. For instance, if such a discussion appears in the annual report you select, would you assign high credibility to everything that appears in the Letter to Stockholders regarding the company’s future prospects? Write a report to your instructor summarizing the results of your investigation.

Using the Internet—A view of the real world

Visit the following website for Eastman Kodak Company:

http://www.kodak.com

By following choices on the screen, locate the income statements and balance sheets for the latest two years. Calculate all of the ratios illustrated in the chapter for which the data are available. Compare the ratios to those shown for Synotech as presented in the chapter. Write a report to your instructor showing your calculations and comment on the results of your comparison of the two companies.

Visit the following website for General Electric Company:

http://www.ge.com

By following choices on the screen, locate the income statements and balance sheets for the latest two years. Calculate all of the ratios illustrated in the chapter for which the data are available. Compare the ratios to those shown for Synotech as presented in the chapter. Write a report to your instructor showing your calculations and comment on the results of your comparison of the two companies.

Answers to self-test

True-false

True. Financial statement analysis consists of applying analytical tools and techniques to financial statements and other relevant data to obtain useful information.

False. Horizontal analysis provides useful information about the changes in a company’s performance over several periods by analyzing comparative financial statements of the same company for two or more successive periods.

False. Common-size statements show only percentage figures, such as percentages of total assets and percentages of net sales.

True. Liquidity ratios such as the current ratio and acid-test ratio indicate a company’s short-term debt-paying ability.

True. The accrual net income shown on the income statement is not cash basis income and does not indicate cash flows.

True. Analysts must use comparable data when making comparisons of items for different periods or different companies.

Multiple-choice

1. b. Current assets: $ 136,000 + $ 64,000 + $ 184,000 + $ 244,000 + $ 12,000 = $ 640,000

Current liabilities: $ 256,000 + $ 64,000 = $ 320,000

Current ratio:

1. c. Quick assets:

$ 136,000 + $ 64,000 + $ 184,000 = $ 384,000

Current liabilities:

256,000 + $ 64,000 = $ 320,000

Acid-test ratio:

1. Net sales:

$ 4,620,000

Average accounts receivable:

Accounts receivable turnover:

1. Cost of goods sold:

$ 3,360,000

Average inventory:

Inventory turnover:

1. Income before interest and taxes, $ 720,000

Interest on bonds, 192,000

Times interest earned ratio: $ 720,000/$ 192,000 = 3.75 times