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Financial Ratios For Chico Electronics
Financial Ratios For Chico Electronics
Financial Ratios For Chico Electronics
e. Gross profit margin:(Net sales - Cost of goods sold) Net sales($12,065 - $8,048)
$12,065 = 33.3%
Interpretation: Gross profit for each dollar of net sales (difficult to assess this value in
isolation)
g. Days to sell inventory: Average inventory (Cost of goods sold 360)[($2,423 + $1,415)
2] [$8,048 360] = 85.8 days
Interpretation: Time it would take to dispose of inventory (difficult to assess the value in
isolation)
i.Total debt to total equity: Total liabilities Total shareholders' equity$4,255 $3,803 =
1.12
Interpretation: Total no owner financing relative to owner financing
j. Sales to end-of-year working capital: Net sales Working capital$12,065 ($6,360 -
$3,945) = 5
Interpretation: Sales as a multiple of working capital – measure of efficiency and safety
2-13
As per the words of Marsh in management's discussion and analysis, the company
decided to "take a big bath" in conjunction with the recgnition of large charge related to
the implementation of FAS 121. Marsh believes that the additional charges taken in the
quarter will be perceived less unfavorably by the market than if they had each been
recorded in separate quarters. Now the company has recognized all of its losses. These
items are no longer looming as losses that need to be recognized. Thus, in the future, net
income will be higher.
1-3
Chapter 4
Question
3 a. The two most important questions facing the financial analyst with respect to
receivables are: (1) Is the receivable genuine, due, and enforceable?, and (2) Has the
probability of collection been properly assessed? While the unqualified opinion of an
independent auditor lends some assurance with regard to these questions, the financial
analyst must recognize the possibility of an error of judgment as well as the lack of
complete independence.
c. When receivables are sold with recourse, the balance sheet reports the cash received
from the sale of the receivable. However, the balance sheet may or may not report the
contingent liability to the receivables purchaser for uncollectible receivables purchased
with recourse—this depends on who assumes the risk of ownership.
7. The major objective of the LIFO method of inventory accounting is to charge cost of
goods sold with the most recent costs incurred. When the price level is stable, the results
under either the FIFO or the LIFO method will be the same. When price levels change, the
use of these different methods can yield significantly different financial results. One of
the primary aims of LIFO is to obtain a better matching of costs and revenues in times of
inflation. Under the LIFO method, the income statement is given priority over the balance
sheet. This means that while a matching of more current costs with revenues occurs in
times of price inflation (deflation), the inventory carrying amounts in the balance sheet
will be unrealistically low (high). Note that use of the LIFO method is encouraged by its
acceptance for tax purposes. The tax law stipulates that its use for tax purposes makes
mandatory its adoption for financial reporting.
8. In most annual reports, insufficient information is given to allow the analyst to convert
inventories accounted for under one method to a figure reflecting a different method of
inventory accounting. Most analysts want such information to better compare the
financial statements of companies that use different inventory accounting methods.
Converting an inventory figure from one method to another is made even more difficult
by the use of different methods for various components of inventory. Still, analysts must,
in most cases, make an overall assessment of the impact of different inventory methods
on the comparability of inventory figures. Such an assessment should be based on a
thorough understanding of the inventory methods in use and the effect they are likely to
have on inventory values. The differences that arise between informed approximations
and exact figures using additional data generally are not materially different.
10. LIFO tends to yield lower reported earnings when prices rise as compared to FIFO.
The following illustration highlights these effects:
Period 3……………… 5 15 75
Under LIFO, if 10 units are sold, then cost of goods sold is $125, computed as (5 x $15)
+ (5 x $10). Also, the LIFO inventory value is $25, computed as 5 x $5. If units are sold
for $20, then gross profit is $75, computed as (10 x $20) - $125. Under FIFO, if 10
units are sold, then cost of goods sold is $75, computed as (5 x $5) + (5 x $10). Gross
profit would be $125, computed as $200 - $75. Inventory would be valued at $75,
computed as 5 x $15—inflating the balance sheet. This shows that FIFO tends to
increase income and taxes in inflationary periods.
12. The observation is correct in pointing out that an analyst must subject the data
regarding an entity's depreciation policies to critical analysis and scrutiny. The
company can choose among several acceptable but vastly different depreciation
methods. The reasons a particular choice(s) is made by the company and the effect
on reported depreciation expense and accumulated depreciation should be assessed.
15. One of the more common solutions applied by analysts to the analysis of goodwill
is to simply ignore it. That is, they ignore the asset shown on the balance sheet. As for
the income statement, under current accounting standards, goodwill is no longer
amortized, but is subjected to an impairment test annually and written down if
required. Often, however, the write-down expense is treated with skepticism and is
frequently ignored. By ignoring goodwill, analysts ignore investments of very
substantial resources in what may often be a company's most important and valuable
asset. Ignoring the impact of goodwill on reported income is no solution to the
analysis of this complex item. Even considering the limited information available, an
analyst is better off evaluating the accounting numbers for goodwill rather than
dismissing them altogether.
Goodwill is measured by the excess of cost over the fair market value of tangible
net assets acquired in a transaction accounted for as a purchase. It is the excess of the
purchase price over the fair value of all the tangible assets acquired, arrived at by
carefully ascertaining the value of such assets—at least in theory. The analyst must be
alert to the makeup and the method of valuation of Goodwill as well as to the
method of its ultimate disposition. One way of disposing of the Goodwill account,
frequently preferred by management, is to write it off at a time when it would have
the least impact on the market's assessment of the company's performance. (for
example, in a period of losses or reduced earnings).
Exercises
4;a. (i) The average cost method is based on the assumption that the average
costs of the goods in the beginning inventory and the goods purchased during the
period should be used for both the inventory and the cost of goods sold computation.
(ii) The FIFO (first-in, first-out) method is based on the assumption that the first goods
purchased are the first sold. As a result, inventory is reported at the most recent
purchase prices, while cost of goods sold is at older purchase prices. (iii) The LIFO
(last-in, first-out) method is based on the assumption that the latest goods purchased
are the first sold. As a result, the inventory is at the oldest (less recent) purchase
prices, while cost of goods sold is at more recent purchase prices.
c. Where there is evidence that the value of inventory to be disposed of in the ordinary
course of business will be less than cost, the difference should be recognized as a loss
in the current period. This is done by restating inventory to its market value in the
financial statements. The concept of conservatism, yielding inventory reported at the
lower of cost or market, is the primary justification of this approach.
Exercise 4-4
a. The inventory asset is more meaningful for analysis purposes when calculated using
the FIFO cost flow assumption. This is because the costs assigned to units remaining
in ending inventory are the more recent costs.
b. Cost of goods sold is usually more meaningful for analysis purposes when calculated
using the LIFO cost flow assumption. This is because the costs assigned to units sold
are the costs from the more recently purchased units.
c. When a company uses LIFO, the costs assigned to units in ending inventory are the
costs from older (less recent) units. As a result, analysts would prefer to calculate
what ending inventory would have been had FIFO been used. This can be
accomplished by adding the LIFO reserve value to the LIFO ending inventory value.
Exercise 4-7
The analyst must remember that book values are only the starting point for
accounting-based valuation. If unrecorded assets have economic value, they will
eventually be recognized through higher future abnormal earnings (residual income).
This means the analyst must consider the impact of unrecorded assets when
projecting future profitability for valuation purposes.
Exercise 4-9
$329b
$329a
$329b
b. Generally, these ratios can be used to assess a company's depreciation policies both
over time (temporal) and for comparative purposes with other companies in the
same industry. An analyst must take care whenever comparisons are made between
companies. There often are economic reasons for different depreciation methods and
assumptions, which can be obscured in a simple restatement of results. For example,
Colgate uses straight-line depreciation for plant and equipment; another company
may use an accelerated method such as double-declining-balance. The selection of
different methods may reflect fundamental differences in management philosophy
and action toward capital financing and maintenance. Also, with capital intensive
companies, profit margins may not reflect the higher costs that may be expended to
replace existing plant assets.
Problem 4-3
= $246,586
= $266,254
b. Net Income as Adjusted from LIFO to FIFO:
Year ended Jan. 29, 1999: = LIFO Income + After-Tax Change in LIFO Reserve
= $31,185 + [ ($26,900 – $25,100) x (1 - .37) ]
= $32,319
c. The primary analysis objective when making a LIFO to FIFO restatement is to (1)
achieve better comparability between firms using different inventory methods, and
(2) obtain better measures, using more recent costs, of the value of inventory on the
balance sheet.