MANAGEMENT ACCOUNTING (VOLUME I) - Solutions ManualCHAPTER 5 FINANCIAL STATEMENTS ANALYSIS - II I. Questions 1. By looking at trends, an analyst hopes to get some idea of whether a situation is improving, remaining the same, or deteriorating. Such analyses can provide insight into what is likely to happen in the future. Rather than looking at trends, an analyst may compare one company to another or to industry averages using common-size financial statements. 2. Ratios highlight relationships, movements, and trends that are very difficult to perceive looking at the raw underlying data standing alone. Also, ratios make financial data easier to grasp by putting the data into perspective. As to the limitation in the use of ratios, refer to page 129. 3. Price-earnings ratios are determined by how investors see a firm’s future prospects. Current reported earnings are generally considered to be useful only so far as they can assist investors in judging what will happen in the future. For this reason, two firms might have the same current earnings, but one might have a much higher price-earnings ratio if investors view it to have superior future prospects. In some cases, firms with very small current earnings enjoy very high price-earnings ratios. This is simply because investors view these firms as having very favorable prospects for earnings in future years. By definition, a stock with current earnings of P4 and a price-earnings ratio of 20 would be selling for P80 per share. 4. A manager’s financing responsibilities relate to the acquisition of assets for use in his or her company. The acquisition of assets can be financed in a number of ways, including through issue of ordinary shares, through issue of preference shares, through issue of long-term debt, through leasing, etc. A manager’s operating responsibilities relate to how these assets are used once they have been acquired. The return on total assets ratio is designed to measure how well a manager is discharging his or her operating responsibilities. It does this by looking at a company’s income before any consideration is given as to how the income will be distributed among capital resources, i.e., before interest deductions. 5-1 Chapter 5 Financial Statement Analysis –II 5. Financial leverage, as the term is used in business practice, means obtaining funds from investment sources that require a fixed annual rate of return, in the hope of enhancing the well-being of the ordinary shareholders. If the assets in which these funds are invested earn at a rate greater that the return required by the suppliers of the funds, then leverage is positive in the sense that the excess accrues to the benefit of the ordinary shareholders. If the return on assets is less than the return required by the suppliers of the funds, then leverage is negative in the sense that part of the earnings from the assets provided by the ordinary shareholders will have to go to make up the deficiency. 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. 8. A company in a rapidly growing technological industry probably would have many opportunities to invest its earnings at a high rate of return; thus, one would expect it to have a low dividend payout ratio. 9. It is more difficult to obtain positive financial leverage from preference shares than from long-term debt due to the fact that interest on long-term debt is tax deductible, whereas dividends paid on preference shares are not tax deductible. 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 slow5-2 In fact. From the viewpoint of the company’s shareholders. If the company’s earnings are very low. the amount by which the return on 40% of the assets exceeds the fixed-interest requirements on liabilities will accrue to the residual equity holders – the ordinary shareholders – raising the return on equity. or large sales and cost of sales. 15. Second. While this means that the p/e ratio becomes very high. is paid for the use of funds supplied by current creditors. Together these two sources supply 40% of the total assets. and only 11% interest is being paid to long-term bondholders. Since the firm earns an average return of 16% on all assets. The length of operating cycle of the two companies cannot be determined from the fact the one company’s current ratio is higher. The company with the higher current ratio might have either small amounts of receivables and inventories. the receivables may be large and of doubtful collectibility. at a return of 5%. It is true that in a historical sense the investor is 5-3 . Thus Sunday is apparently having difficulty in effectively controlling its expenses. 13. either of which would tend to produce a relatively short operating cycle. 16. The operating cycle depends on the relationships between receivables and sales. this situation represents a favorable use of leverage. in effect. they may be valuing the company at its liquidation value rather than a value based upon expected future earnings. A decision to retain the stock constitutes.Financial Statement Analysis –II Chapter 5 turning inventory. they may become almost insignificant in relation to stock price. and between inventories and cost of goods sold. It is probable that little interest. or the inventory may consist of large amounts of obsolete goods. 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. it does not necessarily mean that investors are optimistic. if any. A more meaningful figure for rate of return on investment is determined by relating dividends to current market price. Expenses (including the cost of goods sold) have been increasing at an even faster rate than net sales. 14. The investor is calculating the rate of return by dividing the dividend by the purchase price of the investment (P5 P50 = 10%). 12. a decision to continue to invest P100 in it. or the receivables may be turning very slowly due to poor collection procedures. ... the operating expenses per peso of sales decreased from 29 cents to 28 cents.Chapter 5 Financial Statement Analysis –II earning 10% on the original investment............ Sales increased and the gross profit per peso of sales also increased... True 8....... These two factors led to a substantial increase in gross profit... with.. say... 28 29 Net income...... True or False 1.. 6% 4% The changes from 2005 to 2006 are all favorable... and P40 million in equity............. 100% 100% Cost of goods sold........................... but this is interesting history rather than useful decision-making information.............. 66 67 Gross profit. In other words.. 17.......... the net income of a corporation must be judged in relation to the scale of operations and the amount invested..... Although operating expenses increased in peso amount. True 2.. a profit of P1 million would be unreasonably high for a corporation which had sales of only P5 million.... P50 million in assets... 34% 33% Operating expenses.. P100 million in sales.. Problems Problem 1 (Common Size Income Statements) Common size income statements for 2005 and 2006: 2006 2005 Sales.......... and equity of perhaps one-half million pesos..... assets of... False 5..... False III...... True 4...... False 10... A return of only P1 million for a company of this size would suggest that the owners could do much better by investing in insured bank savings accounts or in government bonds which would be virtually risk-free and would pay a higher return.. On the other hand.... II. True 7........ True 9... True 3... Problem 2 (Measures of Liquidity) Requirement (a) 5-4 .. A corporate net income of P1 million would be unreasonably low for a large corporation.. True 6... The combination of these three favorable factors caused net income to rise from 4 cents to 6 cents out of each peso of sales. say............. P3 million.......... ........ It is computed by dividing the current assets of P637........600 10......... 13...................540 179..600 175......................0 Gross margin...............600 from the current assets of P637......... The company appears to be in a strong position as to short-run debt-paying ability........................... The amount of working capital is P409........680.......................................600.............570 14. Of course.........040 230.......5 Administrative expenses................000 P227.......................... would be helpful in a careful evaluation of the company’s current position................... 63..................................280...280 by the current liabilities of P227..... 5.....................2 60..... 36............................................6 Total expenses...............................0 17...........................................9 Interest expense...............................................................................600 Requirement (b) The current ratio is 2. 100.......6 32...............430 7... 31.....Financial Statement Analysis –II Chapter 5 Current assets: Cash Marketable securities Accounts receivable Inventory Unexpired insurance Total current assets Current liabilities: Notes payable Accounts payable Salaries payable Income taxes payable Unearned revenue Total current liabilities P 47............4 1..................8 to 1.................... Even if some losses should be sustained in the sale of the merchandise on hand or in the collection of the accounts receivable.............. it appears probable that the company would still be able to pay its debts as they fall due in the near future........................0 5-5 ...8 40.....0 % Less cost of goods sold.0 % 100.000 125....600 4..................2 7.... It has almost three pesos of current assets for each peso of current liabilities................................... 18..500 P637........................................... Problem 3 (Common-Size Income Statement) Requirement 1 2006 2005 Sales.................0 Selling expenses.....1 Net operating income............... additional information......... such as the credit terms on the accounts receivable.... computed by subtracting the current liabilities of P227........... 1...........................6 14...........280 P 70...... Ms........ Problem 4 (Comparing Operating Results with Average Performance in the Industry) Requirement (a) Sales (net) Cost of goods sold Gross profit on sales Operating expenses: Selling General and administrative Total operating expenses Operating income Income taxes Net income..... Freeze.. This suggests that the company is not passing the increases in costs of its products on to its customers... Freeze’s operating income and net income after nearly twice the average for the industry... Selling expenses and interest expense have both increased slightly during the year... As a percentage of sales revenue........... which increased from 60........ which suggests that costs generally are going up in the company......... Freeze’s success seems to be its ability to earn a relatively high rate of gross profit.. such as an ability to command 5-6 ...... which have decreased from 14..6% of sales in 2005 to 13.6% of sales in 2006.8 % 6....Chapter 5 Financial Statement Analysis –II Net income before taxes. Ms..... As a percentage of total assets..... Ms. Freeze’s operating results are significantly better than the average performance within the industry... Inc..... cost of goods sold as a percentage of sales has increased and gross margin has decreased....2% of sales in 2006.......0% of sales in 2005 to 63. As a result........9 % Requirement 2 The company’s major problem seems to be the increase in cost of goods sold.... Freeze’s profits amount to an impressive 23% as compared to 14% for the industry................. The only exception is the administrative expenses. Ms... 3........... Freeze’s exceptional gross profit rate (51%) probably results from a combination of factors....... The key to Ms... This probably is a result of the company’s efforts to reduce administrative expenses during the year. 100% 49 51% 21% 17 38% 13% 6 7% Industry Average 100% 57 43% 16% 20 36% 7% 3 4% Requirement (b) Ms........ ...... Total current assets 5-7 2.. Net income.....0 10..... Net income before taxes.1% 15............................... However........ The company’s general and administrative expenses are significantly lower than the industry average..................................... the higher-than-average selling costs may be part of a successful marketing strategy.0% 2005 5............ which indicates that Ms...........1 15..........................4 9...............5 2............ Net operating income...... As a percentage of sales...0% 65...........................6 8..........1 30.............7 1.............6% The balance sheet in common-size form would be: 2006 Current assets: Cash ................. Inventory ... Since the company’s gross profit rate exceeds the industry average by 8 percentage points........ Less interest expense.......3 48...............0 30.........4 5.....3% 2005 100.........3 5....... these higher expenses may explain Ms.6 ........ Freeze’s management is able to control expenses effectively.0 35.....................................................0 2................... Less operating expenses.....2 1...Financial Statement Analysis –II Chapter 5 a premium price for the company’s products and production efficiencies which lead to lower manufacturing costs............. Prepaid expenses .......0 40........ Problem 5 (Common-Size Statements) Requirement 1 The income statement in common-size form would be: Sales.....1 31.........0 26.............0 1............2 7....... Less cost of goods sold......0% 60.... Gross margin. Ms..... Freeze’s ability to command a premium price for its products.................6 1........3 8.... Less income taxes (30%)........... net ........................... Freeze’s selling expenses are five points higher than the industry average (21% compared to 16%).......... Accounts receivable........ 2006 100........ . Problem 6 (Solvency of Alabang Supermarket) Requirement (a) (Pesos in Millions) Current assets: Cash Receivables Merchandise inventories Prepaid expenses Total current assets P 74...8 5-8 ..8 30..1 45.........1 12..................0 Ordinary shares.... This appears to be the major reason the company’s profits showed so little increase between the two years....0 12..0 100.............1% 20....... P5 par 10. 51..................... Total assets......7% 25..........0% 25...0% 100. the company’s net income declined from 5.9 100...0% Liabilities: Current liabilities....... as evidenced by the fact that operating expenses were only 26....9 62..3 percent of sales in 2006..... 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...... Unfortunately... Total liabilities........ this reduction in operating expenses was not enough to offset the increase in cost of goods sold..191..8 152...7 1...6 percent of sales in 2005 to 5.4 percent in 2005.. P10 par Total equity Total liabilities and equity......514. As a result.. Bonds payable..8 95...0 19.5 P1..3 percent of sales in 2006 as compared to 30. Note: Columns do not total down in all cases due to rounding differences.Chapter 5 Financial Statement Analysis –II Plant and equipment.......3 38.. Equity: Preference shares.......4 100...7 Retained earnings 29..............0% 68.......4 54....0 15.. 8%.. 12%......... Some benefits were realized from the company’s cost-cutting efforts.. 0 P(424. a) Current liabilities Quick ratio (P227. according to traditional rules of thumb. a) Less: Current liabilities Working capital P1.Financial Statement Analysis –II Chapter 5 Quick assets: Cash Receivables Total quick assets P 74.0 0.8 152.514. Requirement (d) Due to characteristics of the industry. It is difficult to draw conclusions from the above ratios.8 P1. some large companies with steady ash flows are able to operate successfully with current ratios lower than Alabang Supermarket’s. a) Current liabilities Current ratio (P1. Therefore.0 0. supermarkets tend to have smaller amounts of current assets and quick assets than other types of merchandising companies. An inventory of food has a short shelf life. On the other hand.5 P1.2) Requirement (c) No.5 Requirement (b) (1) Current ratio: Current assets (Req. the inventory of a supermarket usually represents only a few weeks’ sales.939.0) P 227.939. Also. Other merchandising companies may stock inventories representing several months’ sales.8 P1.939.939.939.8 P1.0) P1. Thus. Alabang Supermarket’s current ratio and quick ratio are well below “safe” levels.1 to 1 (3) Working capital: Current assets (Req.7 P 227. supermarkets sell primarily for cash.514.514.5 P1. they have relatively 5-9 .8 to 1 (2) Quick ratio: Quick assets (Req. it would be useful to review the company’s financial position in prior years.736 P164.926 23. Note to Instructor: Prior to the year in which the data for this problem was collected.553 P127. and the financial ratios of other supermarket chains.949 (3) Current liabilities: 5-10 . Therefore. Requirement (e) In evaluating Alabang Supermarket’s liquidity. it is not profitable for them to hold assets in this form.553 32. Alabang Supermarket had reported a negative retained earnings balance in its balance sheet for several consecutive periods.210 5.003 (2) Current assets: Cash Marketable securities (short-term) Accounts receivable Inventories Prepaid expenses Total current assets P 47.524 55.926 23.Chapter 5 Financial Statement Analysis –II few receivables. Although supermarkets may generate large amounts of cash. One might also ascertain the company’s credit rating from an agency such as Dun & Bradstreet. The fact that Alabang Supermarket has only recently removed the deficit from its financial statements is also worrisome. they are likely to reinvest their cash flows in business operations as quickly as possible.524 55. statements of cash flows. Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk) Requirement (a) (1) Quick assets: Cash Marketable securities (short-term) Accounts receivable Total quick assets P 47. If Bonbon Sweets’ were to go out of business and liquidate 5-11 .643 (4) Debt ratio: Total liabilities (given) Total assets (given) Debt ratio (P81. Not only is the company highly liquid.424 21.Financial Statement Analysis –II Chapter 5 Notes payable to banks (due within one year) Accounts payable Dividends payable Accrued liabilities (short-term) Income taxes payable Total current liabilities P 20. a) Working capital P164.630 P353. a) Quick ratio (P127.949 P55.816) P 81.306 2.532 6.438 P 55. Its quick and current ratios are well above normal rules of thumb. Bonbon Sweets’ appear highly liquid.949 P 55.912 1.306) P164.949 55.1% of total assets.003 P 55.0 to 1 (3) Working capital: Current assets (Req.306 3. and the company’s cash and marketable securities alone are almost twice its current liabilities.306 P109.630 P353. a) Current ratio (P164.1% Requirement (c) (1) From the viewpoint of short-term creditors.000 5.003 P55. (2) Long-term creditors also have little to worry about.306 Requirement (b) (1) Quick ratio: Quick assets (Req. a) Less: Current liabilities (Req. but creditors’ claims amount to only 23. a) Current liabilities (Req.306) P127.3 to 1 (2) Current ratio: Current assets (Req.816 23. a) Current liabilities (Req. .200........ P1..9 to 1 (rounded) ...........000 = 1.000 + P10........04 to 1 (rounded) Requirement 3 a...000 – P100.........300...... it would have to raise only 23 cents from every peso of assets for creditors to emerge intact.000 Current liabilities (P1................... Problem 8 (Selected Financial Measures for Short-term Creditors) Requirement 1 Current assets (P80...............000 + P0 + P460.........000 Problem 9 (Selected Financial Ratios) 5-12 = 2. This should be of concern to shareholders.........200.......................................000 + P750....... Current assets generally do not generate high rates of return.................................. P 780............... (3) From the viewpoint of shareholders.. If Bonbon Sweets is unable to invest its highly liquid assets more productively in its business..... 420........... Working capital would not be affected: Current assets (P1...... the company’s relatively large holdings of current assets dilutes its return on total assets..300.........000 Working capital.......................000 Current liabilities (P520............... Thus..................000 – P100...000 Working capital.... P1...000 ÷ 2...000 + P460....................................... shareholders probably would like to see the money distributed as dividends.............................. Requirement 2 Acid-test ratio = Cash + Marketable securities + Accounts receivable Current liabilities Acid-test ratio = P80...........000).........000).......000 b.................000 P 780.. The current ratio would rise: Current ratio = Current rate = Current assets Current liabilities P1.......... 520....000)......... Bonbon Sweets’ appears overly liquid...300..5)....000 P420...000 P520.............Chapter 5 Financial Statement Analysis –II its assets.......................................................................................... 000 P280.1 days (rounded) 5. Debt-to-equity ratio: Total liabilities Total equity = P500.Financial Statement Analysis –II Chapter 5 1.000 P30.63 to 1 (rounded) 7.260. Inventory turnover: Cost of goods sold Average inventory = 365 days 4.100. Times interest earned: Earnings before interest and income taxes Interest expense = 5-13 P180. Accounts receivable turnover: Sales Average accounts receivables = 365 days 14 times P2.000 P200.000 P800.5 times = 81.000 = 2. Current ratio: Current assets Current liabilities = 40% P490.0 times .000 = 4.100.000 = = 0.000 P2. Gross margin percentage: Gross margin Sales P840.000 P200.000 = 6.000 = 14 times = 26. Acid-test ratio: Quick assets Current liabilities P181.5 times P1.000 = = 2.000 = 0.000 P150.91 to 1 (rounded) 4.45 to 1 3.1 days to turn (rounded) 6. 000 P1.15 P63.0 Problem 11 (Selected Financial Ratios for Ordinary Shareholders) 1.00 P5. Dividend payout ratio: Dividends paid per share Earnings per share 3.25 = 60% = P3.25 = 12.000 5-14 = 10. Earnings per share: Net income to ordinary shares Average ordinary shares outstanding 2. Price-earnings ratio: Market price per share Earnings per share = P105.300. Dividend yield ratio: Dividends paid per share Market price per share 4. Book value per share: Equity Ordinary shares outstanding = P800.000 shares = P5.30)] ½ (P1.000) P126.Chapter 5 Financial Statement Analysis –II 8.100.000 + P1. Return on total assets: Return on total = assets = = Net income + [Interest expense x (1 – Tax rate)] Average total assets P105.000 x (1 – 0.25 per share = P3.15 P5.200.000 20.000 20.000 + [P30.000 shares* = P40 per share * P100.00 = 5% = P63.5% .000 total par value ÷ P5 par value per share = 20.000 shares Problem 10 (Selected Financial Ratios for Ordinary Shareholders) 1. 000 ½ (P725. which may carry no interest cost.060. 10% interest rate × (1 – 0.67 to 1 P650.000 0.470.000 P1. Current assets Current liabilities Working capital 5-15 . This positive leverage is traceable in part to the company’s current liabilities. Quick assets (a) Current liabilities (b) Acid-test ratio (a) ÷ (b) P740.000 P600.000 P 870.5%).100.000 P762.08 to 1 d. Return on ordinary shareholders’ equity: Return on ordinary shareholders’ equity = Net income – preference dividends Average ordinary shareholders’ equity P105. Cases Case 1 (Common-Size Statements and Financial Ratios for Creditors) Requirement 1 This Year P2. which have an after-tax interest cost of only 7%.000 P525.3 times P6.000 P600.500 = 13. IV.000 b.87 to 1 P1.000. Current assets (a) Current liabilities (b) Current ratio (a) ÷ (b) P2.000 P1.470.000 Last Year P1.000) = = P105.100.000 1.000 P 960.000 1.000 P375. Sales on account (a) Average receivables (b) Turnover of receivables (a) ÷ (b) P7. and to the bonds payable.000 16.8% (rounded) 3.0 times a.000 1.45 to 1 c.30) = 7% after-tax cost.000 600.000 2.000.060.Financial Statement Analysis –II Chapter 5 2.100. Financial leverage was positive.000 + P800.000 13. since the rate of return to the ordinary shareholders (13.8%) was greater than the rate of return on total assets (10. 000 P1.6 days P1. 12% Total liabilities Equity: Preference shares.1 100.000 5.1 times P4. Net income before interest and taxes (a) Interest expense (b) Times interest earned (a) ÷ (b) Requirement 2 a.9 5.9 days P1.000 P2.000 0.2 % 22.0 16.000 7.000 P90. 8% Ordinary shares.0 % 6.0 % 27.3 times 71. P50 par.6 44.5 100.5 51.0 % .5 0.000 P1.2 0.4 times f.4 days 22.950.7 40.5 100.850.9 59.3 18.3 % 0.8 46.1 % 1.5 55. METRO BUILDING SUPPLY Common-Size Balance Sheets Current assets: Cash Marketable securities Accounts receivable.000 P90. net Inventory Prepaid expenses Total current assets Plant and equipment.0 times P490.5 12.5 48.8 days e. net Total assets Liabilities: Current liabilities Bonds payable.150.86 to 1 57.5 % 18. Cost of goods sold (a) Average inventory (b) Inventory turnover (a) ÷ (b) P5.000 5.5 36.400.69 to 1 P630.0 12.0 % 6.050.3 53.350.8 100.2 37.3 32.1 15.000 0.000 P760.000 6.800.Chapter 5 Financial Statement Analysis –II Average age of receivables: 365 ÷ turnover 27. P10 par Retained earnings Total equity Total liabilities and equity 5-16 This Year Last Year 2. Turnover in days: 365 ÷ turnover Total liabilities (a) Equity (b) Debt-to-equity ratio (a) ÷ (b) g.1 24. which is offset somewhat by an increase in operating expenses.Financial Statement Analysis –II Chapter 5 Note: Columns do not total down in all cases due to rounding. it soon will be impossible for the company to pay its bills as they come due.7 4.3 7.9 13.0 20.0 % 80. its current position actually has deteriorated significantly since last year. This is attributable to an increase in gross margin.0 % 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.2 1.0 11. (This shows the importance of not just looking at the working capital in assessing the financial strength of a company. since the average collection period is 27 days and collection terms are 2/10. Although the company’s working capital has increased.5 6.6 % Sales Less cost of goods sold Gross margin Less operating expenses Net operating income Less interest expense Net income before taxes Less income taxes Net income Last Year 100.7 2. n/30. Both the current ratio and the acid-test ratio are well below the industry average. The drain on the cash account seems to be a result mostly of a large buildup in accounts receivable and inventory. and that it is now 9 days over the industry average.0 1. 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.9 9. In both years the company’s net income as a percentage of sales equals or exceeds the industry average of 4%.1 4.8 8. METRO BUILDING SUPPLY Common-Size Income Statements This Year 100.1 22.0 % 77. b. Many of the company’s customers are not taking their discounts.) Given the present trend.7 3. This suggests financial weakness on the part of these 5-17 . and both are trending downward. ..........000 Earnings per share (a) ÷ (b) 50....000 shares = P1............00 4............48 b..... Perhaps the company has been too aggressive in expanding its sales...000 Last Year P240................... It would also mean a sharp reduction of inventory levels to a more manageable size.............. 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)......... P45.16 50...........................20 P36.......8% d...... it appears that sufficient funds could be generated to repay the loan in a reasonable period of time...................000 ÷ 50...... the loan should be approved on the condition that the company take immediate steps to get its accounts receivable and inventory back under control..33% Net income Less preference dividends Net income remaining for ordinary (a) Average number of ordinary shares (b) *P108. In the authors’ opinion....... Case 2 (Financial Ratios for Ordinary Shareholders) Requirement 1 a.............. P6..........000 P224...1% 26...16 P1.... Ordinary dividend per share (a)..16 P45.000 16......00 3...20 Earnings per share (b)......000 P308........................16......... If these steps are taken.......... This Year P324..........00 5-18 ...16 P4. The inventory turned only 5 times this year as compared to over 6 times last year........ P2..........000 P6..48 Dividend payout ratio (a) ÷ (b)......000 P4....... This suggests that inventory stocks are higher than they need to be...000 ÷ 50... or sales to customers who are poor credit risks.......... Ordinary dividend per share (a)* Market price per share (b) Dividend yield ratio (a) ÷ (b) P2...000 16........... Market price per share (a)................ P60.. 35...000 shares = P2..00 P36...20 c.8% P1.....Chapter 5 Financial Statement Analysis –II customers............. This would mean more rigorous checks of creditworthiness before sales are made and perhaps paring out of slow paying customers...... ........................... 54.......... as compared to 9 times current earnings for the average of all stocks in the industry....000 Ordinary equity (a)...000 P 240............................... P3.............................000 P1.....150.............................................. whereas book value is a result of already completed transactions and is geared to the past....................16)...................000.........950........................0 Investors regard Metro Building Supply less favorably than other firms in the industry.................000 P1..... This is evidenced by the fact that they are willing to pay only 7...........000 Net income......................000 Number of ordinary shares (b)....................................................950..............000 200.. 200........................................000 54..........000 P 224......000 Less preference shares...................... P2.... P 378...................................................................................000 Return on total assets (a) ÷ (b).................... rather than for only P45 per share...... Add after-tax cost of interest paid: [P90............................. This Year Last Year P 324.....8% b......3 times current earnings for a share of the company’s stock...........................000 16...........000 P3.................. P1......... If investors were willing to pay 9 times current earnings for Metro Building Supply’s stock.......000 Net income.........00 A market price in excess of book value does not mean that the price of a stock is too high................000 P 294...000 50...............000 Book value per share (a) ÷ (b)....16 P4........................................ This Year Last Year Equity.................................................00 P35........ P39.................000 × (1 – 0.....................................000 5-19 .........................3 8...............000 Total (a)............. This Year Last Year P 324...................................000 Net income remaining for ordinary P 308..650.................. Requirement 2 a. 10.............................48 Price-earnings ratio (a) ÷ (b)..................................000 Average total assets (b).. 50................................................................ then it would be selling for about P55 per share (9 × P6............................................................................. Market value is an indication of investors’ perceptions of future earnings and/or dividends..000 P 240.........................................................Financial Statement Analysis –II Chapter 5 Earnings per share (b)........ 7..................................................4% 9........ e.................... 16..............40)]............................... Less preference dividends...............750... P6.......... .............. leading to an eventual reduction in profits through inability to operate......... which have an after-tax interest cost of only 7.... This does not seem likely.......000 P 168........ since the company can easily control its cash problem through more careful management of accounts receivable and inventory...... the cash problem could worsen................000 a..000 P1...................... the price of the stock could rise sharply over the next few years..... the bonds. Financial leverage is positive in both years.000 5-20 ................ which has a dividend of only 8%. Return on ordinary equity (a) ÷ (b) 16...150................ The risk..................... Its return on total assets (10. Requirement 3 We would recommend keeping the stock........... The stock’s downside risk seems small..000 + P1...........000 + P1......... and its return on ordinary equity (16...........668.....000 200...........2% [12% interest rate × (1 – 0.....000)...000 × (1 – 0.............000)...... and a precipitous drop in the market price of the company’s stock............... This positive financial leverage is due to three factors: the preference shares.......868. Conceivably...........950...40) = 7...... P1...........................000 P1....... Net income.... 84...000 Average ordinary equity (b)..... is whether the company can get its cash problem under control......000 Less average preference shares........... 1/2(P1................... In addition......................6% 13... a reduction in dividends...................... If this problem is brought under control.............6%) is extremely good........ Add after-tax cost of interest: P120.... its earnings are strong and trending upward................850. Case 3 (Comprehensive Ratio Analysis) Requirement 1 This Year Last Year P 280..4% c..................3 times current earnings as compared to 9 times earnings for the average firm in the industry........ P2................. which may bear no interest cost.................950....000 *1/2(P2.... of course............... Average total equity*...Chapter 5 Financial Statement Analysis –II shareholders (a).. and the accounts payable....4%) compares favorably with that of the industry... 200... however..............2%]....050.. since the return on ordinary equity is greater than the return on total assets.......30).. since it is selling for only 7.................786.................... making it an excellent investment... ..........000 P 364........000 Average ordinary equity (b)....8 P20......00 P2.................000 P 120.............................................120..9%) is less than the return on total assets (5.......... Less preference dividends....................... For last year..640..................6% c............... Net income remaining for ordinary (a) Average number of ordinary shares (b) Earnings per share (a) ÷ (b) d................................... leverage is negative since the return on the ordinary equity (4.......................8%)..30).............. Ordinary dividend per share (a) Earnings per share (b) Dividend payout ratio (a) ÷ (b) This Year P1...............44 P4...............520.3 a...000 b...000 Return on ordinary equity (a) ÷ (b).....1% P 280.40 8................. P5.72 P2..... Leverage is positive for this year................000 48. 70.. Market price per share (a) Earnings per share (b) Price-earnings ratio (a) ÷ (b) Notice from the data given in the problem that the average P/E ratio for companies in Helix’s industry is 10...........................................................000 P2.......000 P3...........Financial Statement Analysis –II Chapter 5 P100...........000 600................................................000 P 168.330................. Since Helix Company presently has 5-21 ....000 × (1 – 0.00 3.......64 7...............000 P 232.............000 50................000 Less average preference shares.............................000 P 238...00 P4................................000 Net income remaining for ordinary (a)...40 b..............000 50.000 P2....... Requirement 2 P 232.......40 30.2%) is greater than the return on total assets (6.028..... P2...................000 Return on total assets (a) ÷ (b)...... Ordinary dividend per share (a) Market price per share (b) Dividend yield ratio (a) ÷ (b) P1...0% Last Year P0....... 600.0% P0...........64 31..............44 P36...............8% 5..................000 P4............... 48......................1%). P3.. 6...................... Net income..........428...................000 Total (a)............................00 4............................. 9..2% 4...... Average total equity.....0% P36....................................000 P4........................64 P 120.. since the return on ordinary equity (9.......................... Average total assets (b)...........................................72 P20................9% c.............. Sales on account (a) P5.300.000 2.000 P52.000 600.000 P920.120. This does not necessarily indicate that the stock is selling at a bargain price. whereas book value is a result of already completed transactions and is geared to the past.000 Requirement 3 a.980.000 P1.000 600. as compared to 10 times current earnings for a share of stock for the average company in the industry. Current assets Current liabilities Working capital 5-22 . That is. Current assets (a) Current liabilities (b) Current ratio (a) ÷ (b) P2.000 b.80 Note that the book value of Helix Company’s stock is greater than the market value for both years.000 P48.000 P2.000 P920.000 50.000 P4.060.600. e.000 P2.220.600.000 20.22 to 1 d. Equity Less preference shares Ordinary equity (a) Number of ordinary shares (b) Book value per share (a) ÷ (b) P3. investors appear to regard it less well than they do other companies in the industry.Chapter 5 Financial Statement Analysis –II a P/E ratio of only 7. Quick assets (a) Current liabilities (b) Acid-test ratio (a) ÷ (b) P1.000 Last Year P1.0 to 1 P1.94 to 1 P1.160.0% P860. f.00 50.000 2.250.000 920.160.000 0.440.300.000 P1. Gross margin (a) Sales (b) Gross margin percentage (a) ÷ (b) P1.000 1.200.050.000 P5. investors are willing to pay only 7.000 1.7% This Year P2.15 to 1 c.000 P4. Market value is an indication of investors’ perceptions of future earnings and/or dividends.300.000 P3.600.8 times current earnings for a share of Helix Company’s stock.000 P1.040.250.8.000 P1.980.000 20.300. 000 4.000 P720.000 0.1% last year to 6. The company should be encouraged to make another issue of ordinary stock in order to provide a broader equity base on which to operate.4 times Total liabilities (a) Equity (b) Debt-to-equity ratio (a) ÷ (b) g.000 3.000 P3.500.200.040.8% this year. Net income before interest and taxes (a) Interest expense (b) Times interest earned (a) ÷ (b) Requirement 4 As stated by Meri Ramos.200. Also notice that the debt-to-equity ratio is rising rapidly.920. 5-23 . the gross margin percentage has declined.300.2% from 4. Cost of goods sold (a) Average inventory (b) Inventory turnover (a) ÷ (b) Number of days to turn inventory. while not large.4 times 52 days 49 days e. However. One wonders if the increase in sales was obtained at least in part by extending credit to high-risk customers.78 to 1 P1. The return on total assets has improved from 5. which should ordinarily result in an improvement in the gross margin percentage as fixed costs are spread over more units.000 P1. 365 days ÷ turnover (rounded) P4.63 to 1 P520. the loan should not be approved.000 P3. The deterioration in the gross margin percentage. and.000 7. more important.0 times P3.050.000 loan is granted.9% the year before.000 0.000. both net income and sales are up from last year. If the P1.09 to 1. Virtually all other ratios are below the industry average. the ratio will rise further to 1.0 times P560. 365 ÷ turnover P750. P2. Sales and inventories have increased substantially. In the author’s opinion.3 times P340. what the company needs is more equity—not more debt.000 4.000 7. is worrisome.000 4. and the return on ordinary equity is up to 9.Financial Statement Analysis –II Chapter 5 Average receivables (b) Accounts receivable turnover (a) ÷ (b) Average age of receivables. Notice particularly that the average age of receivables has lengthened to 52 days—about three weeks over the industry average—and that the inventory turnover is 50% longer than the industry average. they are trending downward.000 P100.000 P120.6 times 91 days 79 days f. But this appears to be the only bright spot in the company’s operating picture. Therefore. 000 Bulacan Company Balance Sheet December 31.160 21.320 P 10.720 28.000 .800 84.000 55.000 P132.Chapter 5 Financial Statement Analysis –II Case 4 (Statement Reconstruction Using Ratios) Bulacan Company Income Statement For the Year Ended December 31.000 P40.120 P 77. 2005 Sales Less: Cost of Sales (4) Gross Profit Less: Expenses Net Income (1) P140.000 P132.480 P 56. 2005 As s e t s Current Assets: Cash Accounts Receivable (5) Merchandise Inventory (3) Total Current Assets (2) Fixed Assets (8) Total Assets P 27.320 46.000 Liabilities and Equity Current Liabilities: Accounts Payable (2) Equity: Share Capital (issued 20.000 48.000 shares) (6) Retained Earnings Total Liabilities and Equity P 44.000 5-24 88. 800 P21.Financial Statement Analysis –II Chapter 5 Supporting Computations: (1) Earnings Per Share = Net Income Ordinary Shares Outstanding P0.120 (4) Inventory turnover = 4 = X (Cost of Sales) = 5-25 Cost of Sales Ave.75 1 0.000 55.880 Quick Ratio Current Assets Quick Assets Inventory P77.000 = Quick Assets Current Liabilities 1.27 = X 44.000 (2) Current Assets Pxx Current Liabilities xx Working Capital P33.000 1.75 Current Liabilities (3) Current Ratio = P33. Inventory X P21.50 = X 20.120 P84.000 1.000 X (Current Assets) = P55.27 = X (Current Assets) = P77.000 X (Net Income) = P10.000 Current Assets Current Liabilities X 44.000 0.75 = = P44.480 . 800 X (Fixed Assets) = 0.625 = P55.000 X = P88.000 5-26 .800 X = 5 X (Receivables) = P28.375X = P33.000 = 25% Share Capital Share Capital = P40.000 + 0.Chapter 5 Financial Statement Analysis –II (5) Average age of outstanding Accounts Receivable Quick Assets Current Liabilities = 365 5 = 73 days (Average age of receivables) Net Sales Average Receivables = 5 P140.625X = P44.160 Accounts receivable (6) Earnings for the year as a percentage of Share Capital P10.800 365 = 73 days = P28.000 Equity (7) Current Assets + (8) Fixed Assets to Equity Fixed Assets Equity X P140.000 + X 0.625 = 0.160 Another Method: P140.000 Fixed Assets = Current Liabilities + Equity P77. 000 Even if this tactic had succeeded in qualifying the company for the loan.000 = 0.10 x (6/12) = 5.000 x 0. This happens because inventory is considered to be a current asset but is not included in the numerator when computing the acid-test ratio. These ratios are computed below: Current ratio Current rate Acid-test ratio = = Current assets Current liabilities P290.70 (rounded) P164. the current ratio would improve.Financial Statement Analysis –II Chapter 5 Case 5 (Ethics and the Manager) Requirement 1 The loan officer stipulated that the current ratio prior to obtaining the loan must be higher than 2.000 + P0 + P50. but there would be no effect on the acid-test ratio. and the interest on the loan must be no more than four times net operating income.000 Cash + Marketable securities + Accounts receivable Current liabilities = P70.000 + P0 + P50.70 (rounded) P164.0. Current ratio = Current rate = Acid-test ratio = Current assets Current liabilities P290.0 (rounded) P164.000 + P45. we Acid-test ratio = 5-27 . Requirement 2 By reclassifying the P45 thousand net book value of the old machine as inventory.000 = 2.0 Interest on the loan Acid-test ratio = The company would fail to qualify for the loan because both its current ratio and its acid-test ratio are too low.0.000 Net operating income P20.000 = 0.8 (rounded) P164. the acid-test ratio must be higher than 1.000 = P80.000 Cash + Marketable securities + Current receivables Current liabilities P70.000 = 1. If this were done. 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. 17. Rome would only have to sell the machine if he would otherwise be unable to pay back the loan. 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. 34.000 = 2. In that case. 8. 15. doing so would be intentionally misleading. 33. 24. B D A C A C D A 31.000 + P0 + P50. 18. the old equipment is an asset that could be turned into cash.000 + P45. A C D B A D C D 11.0 (rounded) P164. After all. 27. 12. 36. V. Inventories are assets the company has acquired for the sole purpose of selling them to outsiders in the normal course of business. 28. 37. Multiple Choice Questions 1.000 = 1. 38.000 P164. 6. We would advise Rome to fully and honestly explain the situation to the loan officer.Chapter 5 Financial Statement Analysis –II strongly advise against it. 26. C . 16. Current ratio = Current rate = Current assets Current liabilities P290. 14.000 Acid-test ratio = Cash + Marketable securities + Current receivables Current liabilities Acid-test ratio = P70.000 + P45. 25. 4. 35. 23. 32. Or he may approve the loan on the condition that the equipment is pledged as collateral. 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. The loan officer might insist that the machine be sold before any loan is approved. Nevertheless. Used production equipment is not considered to be inventory—even if there is a clear intention to sell it in the near future. 3. C A C B D B A C 21.00 (rounded) However. 5-28 C D C A A C A A 41. Since the loan officer would not expect used equipment to be included in inventories. 13. 5. 2. other options may be available. 22. 7. A 10. D 30. A 20.Financial Statement Analysis –II Chapter 5 9. C 40. C 29. C 5-29 . B 19. A 39.
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