20 Analysis and. ne nd tnterpretation of Financial Statements n preceding chapters we have explained how decision makers analyze, interpret, and use various types of accounting informa- tion, Now we are ready to ‘examine a complete set of financial statements, and to see how investors and creditors may use these statements in evaluating the profitability, solvency, and future prospects of a business. A major goal of this chapter is to. temonstrate how different types of investors select the account- 1 ae anformation that is most relevant to their decisions. ‘ante studying this chapter you should be able to mept these Learn ing Objectives: : 1 pill a company's net income Into perspective by relating It fo 7 Gales, assets, and stockholders’ equity. ge +S Deseribe several sources of financial Information about @ busl- ness. ° 3. Explain the uses of dollar and percentage changes, trend per- centages, component percentages, 1d ratios. 4 ‘Discuss the “quallty” of a company’s earnings, assets, and working capital, 5: Analyze financlal statements from the viewpoints of common . stockholders, creditors, and others. . 6 Compute the ratios widely used In financlal statement analysis and explain the significance of each. Ra cin _OBE C TIVE } Put acon. any’s net income into Perspective by relating it to sates assets, and stockhold- ers? equity, CASE IN POINT. General Motore in an annual teport'a'few years, ago “received as revenue, only 4 cent represented Profit for GM, On a $10,000 923 ‘ancial: State, m 5 ne cont ments tre the matrument pancl of a business enterprise, tics, T ean or failure and nan ceerial Performanco, attesting to manago- Tead a co; i 'shing warning signals of impending difficul- and theiy calibrate instrumont Panel, one must understand the gauges imilatly, ony must ue) Mak© sense out of the array of data they convey, tem and ¢ jenifigg etStand the inner Workings of the accounting sys, Hata app, ing j fae Various financial relationships to interpret the counting, 8 tof nancial statements, ‘Te reader with a knowledge of enterp, offinancial statements tells'a great deal about a business spread public belief that profits are six times the actual rate may lead to Some unwise legislation showed @ net income of $821 million This profit may soiind like a huge" \ amount, but it was only one-half of 1% of GM's sales, Thus; of every ‘dollar: far, this was a profit of $50, Actually, earning only $821 million in a year \ Tiust be regarded as very poor performance for t corporation the size of \ General Motors. Shortly afterward, however, GM ace new records for both sales and earnings. Net income was $4.5 billion any represented about 5} cents profit on each dolla of sales, ‘That was 8 profit of $550 on a $10,000 automobile. : i : veidasin-ddpth Imowledge of accounting does not enable you to say at what level corporate earnings should be; however, a knowledge of accounting Goes enable you to read audited financial statemente thee show what the level of corporate earnings actually is; Moreover, you are'aware the infor.eng Bn OBJECTIVI Describe sev- eral sources of financial information about a business. spose REPORTS AND FINANCIAL STATEMENT ANALYSIS: PART SIX in these pOkl) hoe Ane veto! statements are reasonably reliable; they ba Hoon deteray had 1A odeardonce W generally accepted accounting priri ples and verified ly indepeniont experts. _. and Losses ovations carn @ P +, For the ten years 1990, Pan Americal et ioss each ‘Am_—America’s “flagship” “Prjine—ceased opera- ae bad year in 1991. Bach of the Even IBM sus- Some S2citie Exampios of Corporate Earnings - Not all tea from 1981 t's year. Late 0 1sg1 Pan Hons. Many American corporations SBig Thive” American automakers reported huge losse: tained a net Joss—the first in the company’s g0-vear histor} The oil companies have been particularly suLjec called excessive profits, 'y look at the Pr’ g0 let us briefl cansa’s largest oil company. A recent annual report of Price Waterhouse) shows that profits amounted to 2 little ever 3.6 Standing alone, that figure seems ts arous_—but we: newd to 190k & little > net income farther. The total revenue of Exxor $95 billion, 80 ales, On the other hance. excise meome taxes, mounted to less than 4% of taxes, and other taxes and d Jevied upon Exxon amounted to more than $27 billion, or about 7) times as rovch a the company’s profit. T' ‘cost of a gallon of gas’: taxation represents @ {ker joes the oil company’s Profit. ‘There are many ways of appraising the adequacy of corporate carn no cortainly, earnings should be compared with total assets and wit) Veated capital as well as with cee ain this chapter we shall looks a a weather of ways of evaluating corporate profits and solvency. Sources of Financial Information For the most part, our discussion will be limited to the kind of analysis thet. For pe made by “outsiders” who do vot have access to internal accounting records. Investors must rely to, @ ‘condiderable extent on financial state rents in published annual and ‘quarterly reports. In the case of largely publicly owned corporations, additional information is filed with the SEC and is available to the public. ‘The SEC requires large corporations to include in their annual reports ¢ discussion and analysis by top management of the results of the compa ny’s operations and of its current financial position. In this section of th panual report, management is required to highlight favorable and unfavo oe trends, and to identify significant event ‘and existing uncertaintie affecting the company’s financial condition. (This element of an annvi report is illustrated in Comprehensive Problem 5, on pages 974-975.) or nancial analysts also study the financial position and futu prospects of publicly owned corporations and sell their analyses, conel siong, and investment recommendations for a fee. For example, “aetail sion ial analyses of most large corporations are publish a week! Moodie Investors Service, Standard & Poor's, and The Value Lite Inve e urvey. one may sul il i * i Wenkers and major LE eee eally are investment advisory sor ly are able to obtain detailed find cial information from borrowers simply by requesting it as a conditionMO WTEHPME DA TION OF FIMANCIAL STATEMENTS 925 ranting 4 lo Panel an, 8 clon, nes rage Pele aly ther trade creditors may obtain some fi- Dunn ge Dragnet an: business from credit-rating agen- Tet, Compa, ative py Sieniticans iManetal Statomong chan, ; ment amouske fer! financial data sre casy to see when financial state- Them. § more years are placed side by side in adjacent am 4 Stateme; 2 ‘Ounty nt is called a comparative financial statement. ima she moat recent yen usually placed in the left-hand pach ated in the fot the balanee sheet ons the ineome statement are often Parative income BtatemenriPatative statements, A highly condensed com- covering three years is shown below. CoBENSON CORPORATION mparative Income Statement For the Years ¢naca December 31, 1994, 1993, and 1992 (in thousands of dollars} 1994 1993 1902 $800 $500 $400 370 300 235 $230 3200 3165 160 115 $40 $50 ifying changes and trends, Four Widely used analytical techniques are (1) dollar and pereentase changes, (2) trend percentages, (3) component percentages, and (4) rate, Dollar and Percentage Changes t of change from year to year is significant, but express- The ee earcentaes forms adds perspective. For example, if asles ing the ¢} eee increased by $100,000, the fact that this is an increase of is year last year’s sales of $1 million puts it in a different Perspective ao eters sented a 1% increase over sales of $10 million for the prior jan if it year. int of any change is the difference between the amount The Cee and for a base year. The percentage change is for a compar tying the amount of the change between years by the computed Ps base year. This is illustrated in the tabulation below, using amount for ji me statement above, parative incor data from the92 we 6 Bh PART 61X°/: SPECIAL PURPODE REPORTS AND FINANCIAL STATEMENT ANALYSIS: i ®, ; ; Increase or In Thot de 1994 over " t Year Year Your Ee ee 1994 1999 1992 Amount % Amount % changes $600 $600: $400 ‘$100 20% ‘$100 25% 96. 40° 60 (90%) (10) (20%). “Although net sales increased §100,000 in both 1993 and 1994, the per- centage of change differs because of the shift in the base from 1992 to 1993. hen the figures for the base year i : These calculations present no problems wi are positive amounts. Ifa negative amount or a zero amount appears inthe base year, however, a percentage change cannot be computed. Thus if Ben- son Corporation had incurred a net loss in 1993; the percentage change in, net income from 1993 to 1994 could not have been calculated. 7 Evaluating Percentage Changes In Sales and Earnings Computing the pércentage changes in sales, gross profit, and net income from one year to Tho next gives insight into a company’s rate of growth, If a company is noes _ experiencing growth in its economic activities, sales and earnings should 2 \ “Gnerease at more than the rate of inflation. Assume, for example, that a company’s sales increase by 6% while the general price level rises by 10%. It is probable that the entire increase jn the dollar amount of sales may be explained by inflation, rather than by an increase jn sales volume (the . ART SIX 1 SPECIAL PURPOSE REPORTS AND FINANCIAL STATENENT ANALYSIS when net income declined despite a solid increase in sales. This variation ATE have vovulted from an unfavorable change in the EFOSs Prot’ margin or from unusual expenses. However, the problem wi overcome in 4994 with a sharp rise in net income. Overall the ‘trend percentages give & pic- ture of a profitable growing enterprise. ‘As another example, assume that sales are increasing each year but that the cost of goods sold is increasing at a faster rate, This means that the gross profit margin is shrinking. Perhaps the increases 1) sales are being achieved through excessive price cutting. ‘The company’s net income may be declining even though sales are rising Component Percentages Component percentages indicate the relative size of each item included in a total. For example, each item on @ balance sheet could be expressed a5 & » percentage of total assets. This shows quickly the relative importance © current and noncurrent assets as ‘well as the relative amount of financing obtained from current creditors, long-term creditors, ‘and stockholders. By computing component percentages for ‘Taveral successive balance sheets, soo can see which items are increasing in importance ‘and which are becom- ing less significant. Common SIze Income Statement Another application of component per- centages is to express all items in an income statement as a percentage of net sales. Such a statement is called a common size income statement. A condensed income statement in dollars and in common size form is illus- trated below. Income Statement “ Component Dollars: Percentages 1994 1993 1994 1993 Net ‘$1,000,000 $600,000 100.0% 100.0% 70.0. 60.0 __700,000 _360,000 $ 300,000 $240,000 30.0% 40.0% 250,000 __180,000 _25.0_ _30.0 550,000 _$ 60,000 _ 5.0% _10.0% Cost of goods sold. Gross profit on sales “Expenses (Including Income taxes). Net Income. Looking only at the component percentages, we see that the decline i ne eating trate from 40% to 90% was only partially offset ards the gross Dxpenses as a percentage of net sales, eausi i Grenease from 10% to 6% of net sales. aa Ratios Aratio is a simple mathematical expression of the relationshi, mshi i to another. Every percentage may be viewed as a at thet ta one eo ber expressed as a percentage of another. mame Ratios may be stated in several ways. To illustrate, I i caine mato which expresses the relationship between cuovent ano adLysis Aho TERPAE, A7ON OF Fmanciat srarcuents El 929 Curre, ®2y either gees! Are $100,000 and current liabilities are t assets at the current ratio is 2 to 1 (which is written atizeg shov° 200% of current liabilities. Either state- 88 current Tiatsationship—that is, that current assets, hy e ilities, of the ulated. Our jnrctuh the two amounts being compared must be Stlying data. “"PPetation of a ratio often requires investigation Comp, arative p, ata i ; The ann, ‘” Annual Reports of Major Corporations ual rey . tee Sheets oa ra of major corporations usually contain comparative bal- TS. Supple oY Years and comparative income statements for ther key amore ™entary schedules showing sales, net income, and Shown below anes 0% often presented for periods of five to 10 years. ny Selected items from an annual report of The Coca-Cola Company \y she 5 4 low:ng some interesting trends for a five-year period. THE COCA-COLA COMPANY (Dollars in millions, except per share data) 1989 1988 1987 1986 1985 $8,965 $8,938 $7,658 $6,977 $5,879 1724 1045916834722 492 285° 2492421. 136-1200 «1.12 1.0899 7F25 4463 98.13 97.75 26.17 Standards of Comparison In using dollar and percentage changes, trend percentages, component per- centages, and ratios, financial analysts constantly search for some stan- dard of comparison against which to judge whether the relationships that they have found are favorable or unfavorable. Two such standards are (1) the past performance of the company and (2) the performance of other ‘companies in the same industry. cE past Perforriance of the Company Comparing analytical data for a cur- rent period with similar computations for prior years affords some basis for judging whether the condition of the business is improving or worsening. ‘hie comparison of data over time is sometimes called horizontal ov trend analysis, to express the idea of reviewing data for a number of con~ Teutive periods. It is distinguished from vertical or static analysis which refers to the review of the financial information for only one account. Jog period. ni a ing per ition to determining whether the situation is improving or becom ing worse, horizontal analysis may aid in making estimates of future pros. pects. s may reverse their direction at any tii rise changes e nn at any time, however, pro- seating past trends into the future is always a somewhat risky statistical j : pastime.930 «ff OBJECTIVE 4 Discuss the “quality” of a company’s earnings, assets, and * working capital. LNT ANALYSIS: PART SIX / SPECIAL PURPCSE REPORTS ANO FINANCIAL STATEME! rison with the past docs rms, The fact that net Jes this year indicates should be 7% of A weakness of horizontal analysis is that com! not afford any basis for evaluation in absolute te! income was 2% of sales last year and is 3% of sal improvement, but if there is evidence that net income © sales, the record for both years is unfavorable. Industry Standard The limitations of horizontal analysis ay cue to some extent by finding an appropriate “yardstick” against cf ee sure a particular company’s performance. The yardsticke most WiG0ly heed by most analysts are the performance of comparable companies and the average performance of several companies in the same industry. 7 Assume, for example, that the revenue of Alpha Airlines drops by 5% during the current year. If the revenue for the airlines industry had dropped an average of 15% during this year, Alpha’s 5% decline might be viewed as a favorable performance. As another example, assume that Omega Co, earns a net income equal to 2% of net sales. This would be substandard if Ornega were a manufacturer of comimercial aircraft, but it would be satisfactory performance if it were a grocery chain, When we compare a given company with its competitors or with indus- try averages, our conclusions will be valid only if the companies in question are reasonably comparable. Because of the large number of diversified companies formed in recent years, the term industry is difficult to define, and companies that fall roughly within the same industry may not be com- parable in many respects. For example, one company may engage only in the marketing of oil products; another may be a fully integrated producer from the well to the gas pump, yet both are said to be in the “oil industry.” Quality of Earnings Profits are the lifeblood of a business entity. No entity can survive for long and accomplish its other goals unless it is profitable. On the other hand, continuovs losses will drain assets from the business, consume owners’ equity, and leave the company at the mercy of creditors. In assessing the prospects of a company, we are interested not only in the total amount of earnings but also in the rate of earnings on sales, on total assets, and on ow-er’s equity. In addition, we must look at the stability and source of ings, An erratic earnings performance over a period of years, for exam- ple, is less desirable than a steady level of earnings. A history of increasing earnings is preferable to a “flat” earnings record. ‘A breakdown of sales and earnings by major product lines is useful in evaluating the future performance’of a company. Publicly owned comps nies include with their financial ‘statements supplementary schedules showing sales and profits by product line and by geographical area. These schecules assist financial analysts in forecasting the effect upon the com: ear: + pany of changes in consumer demand for particular types of products. T~ndustry data are evailable from a number of sources. For exay t s Fe tutti een es Fr aml ker Mais its grouped into several hundred industry clasifiations. Industry clavstfcatons es cee ed UF Eve ime gy cn anya uc than 800 lines of business.CHAPTER / ANALys ‘SIS AND inrenpaer, a MON OF FWANCAL srarchents ml 937 compan; nalysts ofte, This ensocts higher quakeg wees (Be oinon that the earnings of one agement ere of Mality of ear than earnings of other similar companies. all of which °°8 from a variety te eet ‘each company man- often Wit? Bre considered go riety of accounting principles and methods, policies @tnder heavy press erally acceptable. A company's management the eS MAY be tailored toward to report rising earnings, and accounting impact on cures toward this objective, We havo already pointed out and FIFO mothonent eorted earnings of the choice between the LIFO policies, In judging of inventory valuation and the choige of depreciation consider whether th the quality of earnings, the financial analyst shoul agement lead to a ome eating Principles and ‘methods selected by man- reported earnings onservative mensurement of earnings or tend to inflate Q ality of Assets and the Relative Amount of Debt good indication of the Although a satisfactory level of earnings may be & fends, we must also any s long-run ability to pay its debis and divid a look at the composition of assets, their condition and liquidity, the relation- ship between current assets and current liabilities, and the total amount of debt outstanding, A company may be profitable and yet be ‘unable to pay its liabilities on time; sales and earnings may appear satisfactory, but plant and equipment may be deteriorating because of poor maintenance policies; Valuable patents may be expiring; substantial losses may be imminent due to slow-moving inventories and past-due receivables. Companies with large amounts of debt often are vulnerable to increases in interest rates and to even temporary reductions in cash inflows. Impact of Intlation . During a period of significant inflation, financial statements prepared in terms of historical costs do not reflect fully the economic resources or the seal ineome (in terms of purchasing power) of a business enterprise. The FASB recommends that companies include in their annual reports supple- eentary schedules showing the effects of inflation upon their financial Miatements, Inclusion of these supplementary disclosures is voluntary, not srandatory. Most companies do not include these supplementary sched- Ties because of the high cost of developing this information. mustrative Analysis for Seacliff Company Keep in mind the above discussion of analytical principle dnalysis is contained in a set of condensed two-year comparative financial a yet ite for Seacliff Company shown below and on tae following pages gatemenzed statement data, together with computations of doilar in. ereases and decreases, and component percentages where applicable; a been compiled. For convenience in this illustration, relatively small ‘dollar amounts have been used in the Seacliff Company financial statements. —_——932 BL PART 1X / SPECIAL PURPOSE REPORTS AND FINANCIAL STA Using the information in these statement analysis that might be of particular interest to ( kholders, an (2) long-term creditors, (3) preferred sto tors, SEACLIFF COMPANY Comparative Income Statem 1 + For the Years Ended December 31, 1994 ani ent id December 31, 1993 Increase or (Decrease) 1994 1993 -—~Dollars % Net sales .. Cost of goods sold . Gross profit on sal Operating expen ‘Selling expenses: General and administrative expenses .. Total operating expenses..... Operating Income |....+ Intorest expense . Income before Income taxes Income taxes ..... Net income Earnings per share of common stock. 28,000 SEACLIFF. COMPANY $117,000 $ 75,000 $ 42,000 126,000 _ 95,000 _31,000 $243,000 $170,000 $ 73,000 ‘$127,000 $160,000 $(33,000) 24000 _ 90,000 __(6,000) ‘s¥03,000 $130,000 $(27,000) $800,000 $750,000 $150,000 20.0 530,000 420,000 110,000 26.2 $370,000 $330,000 $ 40,000 121 (12,000) '$(15,000) Statement of Retained Earnings For the Years Ended December 31, 1994 and December 31, 1993 Retained earnings, beginning of year . Net income ... Less: Dividentis 6n. common stock ($5.00 per share in 1991, $4.80 per stiaro in 1992).. Dividends on preferred stock ($9 per share).. Retained earnings, end of year ».. 1994 1993 $176,000 $115,000 98,000 $205,000 $ 20,000. 9,000 29, ‘$176,000 3 (16.7) '$(7.05) (34.8) \TEMENT ANALYSIS. Percentage of Net Sales 1994 1993 100.0 100.0 589 _56.0 Alt 44.0 10.0 127 227 2nd 49 173 53 720 Increase or (Decrease) Dollars % $61,000 530 (15,000) - (16.7) $46,000 224 200 138 23.9 jet us consider the kind of ts, MC) common stockholders, d (4) short-term cred. ~~ wre ianciat. STATEME! CHApreE Aero, 3 ANALYSIB. LYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS os 933 SEACLIFF ci Condensad Ci SOMPANY De omm~grative Balance Shoot" : jecembor 31, 10bsand Hecambor 91, 1009 Porcentage Inoreaso oF ‘of Total (Decrease) _“——_ % «1994 «1093 wea att 998 1904 1999. .Dollare ‘$390,000 $289,000 $102,000 ‘sooo 467,000 «93000 Tt ‘so.000 105,000 (48,000) (428) _o3 700.0 Fsr000 $060,000 $90,000, 106 700.0 Current assets... Plant and equipment (nat) Other assots (iar ns to Total ws f0 officers). Liabilities . Luise oes eather! Ewuty Current tabiities «.. 12%% long-term note payable. | g112.000 $ 04,000 $ 10,000 19-4 11 0. * SToaoo0 260,000 _(80,000) (200) 21. , Total labilt 1 ‘Stockholders’ a ty Gawaon0 3(9a000) (0.9) 228 8% preferred stock, $100 par, callable oe vis eonenaven $100,000 $100,000 10.56 146 Common stock, $50 par. rane Stopeco $6000 76.0 20.2 34 Aacnicen Pelt Seene. 70,000 40,000 30,000 75.0 74 47 Cee eee *pye000 176,000 _ 42,000, 299 229 208 Scene ZAMS grteoon $inz.000, 226 EL EE 70 Total liabilities & stockholders’ equity $as0,000 $060,000 $ 90,000 105 | + inorder to focus attention on important subtotals, ti statement Mia ‘andonsed and doesnot how adiigua sot and ato orl ierstocn tarda an ngrar si ret dacasn Far anon at of Sea Company® urront aesots 603 ‘current Habilies appears on page G41, ‘SEACLIFF COMPANY ” Condensed Comparative Statement of Cash Flows For the eure Ended December 31, 1994 and December 31, 1999 Increase or + (Dacrease) 1994 ©1993 Dollars % Cash flows from operating activities: ‘Net cash flow from operating activities .. cash flows from Investing activities: Purchases of plant assots. Collections of loans from officers «.» ‘Net cash used by Investing activities .. cash flows from financing activities: Dividends pald... Repayment of long-term debt. Proceeds trom Issuing cepltal stock . | Not cash used by financing activites Not increase (decrease) In cash and cash equive ‘Cash and cash equivalents, beginning of the year. ‘Cash and cash equivalents, end of the year. |. $19,000 $95,000 (76,000) (80.0) (63,000) (28,000) (95,000) 125.0 45,000 _(35,000) __80,000 N/A" $18,000) $63,000) $45,000 (71.4) (93,000) (29,000) $ (4,000) 13.7 (0,000), -0- (50,000). N/A 80,000 _-0- 80,000 N/A $ (3,000) $(29,000) $26,000 (89.6 $ (2,000) $ 9,000 $ (5,000) — N/A‘me 40,000 _-<_ $7,000 $38,000 $49,000 te ee ahaa erga a poo oman ak934 a statements from the viewpoints of common stockholders, creditors, and others, Earnings ra- lated to num- ber of common shares out- standing Less: Preferred dividend requirements PART SIX / SPECIAL PURPOSE REPORFS AND FINANCIAL STATEMENT ANALYSIS Analysis by Common Stock 10i+4¢ Common stockholders and potential investors in a company’s earnings record. Their investment i earnings per share and dividends per share are of parti Earnings per Share of Common Stock As indicated in Chapter 15, earn- uted by dividing the income appli- ings per share of common stock are com) cable to the common stock by the wweighted-average number of shares of common stock outstanding during the preferred dividend re- quirements must be subtracted from ne! ‘rmine income ap- plicable to common stock, as shown in ions for common stock look first at is in shares of stock, so icular interest. year: Any ¢ income to dete: the following computat Seacliff Company: Earnings per Share of Common ‘Stock —_ 1994 1993 Net Income. $75,000 $90,000 9,000 9,000 (a) $66,000 $81,000 (e) 5,000 - 4000 $13.20 $20.25 Income applicable to common stock Shares of common stock outstanding, during the year Earnings per share of common stock (2+ bd). share have decreased by $7.05 in 1994, repre ‘ir level in 1993 ($7.05 + $20.25 = ‘decline in earnings per share to ‘A decline in earnings per share and cre- Notice that earnings per senting a decline of nearly 35% from th 34.8%). Common stockholders consider a be an extremely unfavorable development. génerally represents a decline in the profitability of the company, ates doubt as to the company’s prospects for future growth. With such a significant decline in earnings per shere, we should expect toseea substantial decline in the market vale of Seacliff's common stock during 1994. [For purposes of our illustration, we will assume the common creck had a market value of $760 at December 31, 1993 and of $132 at the Set 994, This drop of $28 per share represents a 174% decline in the ona ott value of every common stockholder’s investment ($28 decline = $160 = 17.5%).] price-Earnings Ratio’ The relationship between the market price of com Pricevtock and earnings per share is so widely recognized that it is e%- pressed as a ratio, called the price-earnings ratio (or ple ratio). The pe ereeets determined by dividing the market price per share by the annual earnings per share. Thesverage ple ratio of the 30 stocks included in the Dow-Jones Indus- trigl Average has varied widely i zecent years, ranging from a low of about Wo\to s high of about 12, The outlook for future earnings is the major facto# soo ding a company’s ple ratio. Companies with track records of rapid growth may sell at ple ratios of perhaps 20 to 1, or even higher. Companies ao lat” earnings or earnings expected to decline in future years often ell at price-earnings ratios below, say, 10 to 1. 'At the end of 1993, Seacliff’ p/e ratio was approximately 8 to 1 ($160 + re expecting earnings to de- $20.25 = 7.9), suggesting that investors wel in 1994. At December 31, 1994, the price earnings ratio was 10 to 1CHapy EA 2 oF Ana “YSI8 AND INTERPRETATION OF FINANCIAL STATEMENTS — I 935 ($192 13,20 = PPect futy, 10.0). A pie ratio in this renge suggests that investors re ‘arnings to stabilize around the current level. Dlvideng : : ut second Dividends are of prime importanée to some stockholders Y factor to others. In other words, some stockholders invest Principally eee regular cash income, while others invest in stocks Prices, If a ¢0 the hope of securing capital gains through rising market Of the busines Poration is profitable and retains its earnings for expansion net income of; there expanded operations should produce an increase in the valuable, '¢ company and thus tend to make each share of stock more h . should eee the merits of alternative investment opportunities, we stock. Divides armine® and dividends per share to the market value of the the yield nerd Pet share divided by market price per share determine to those int@ oF company’s stock. Dividend yield is especially important from they St2°8 whose objective is to maximize the dividend revenue r investments, aunmary of Earnings and Dividend Daia for Seacliff The relationships of acliffs per-share earnings and dividends to its year-end stock prices arek summarized below: Earnings and Dividends per Share of Common Stock Assumed Earnings Market Earnings _Price- Dividends dividends Value per per. Earnings ~——_per_——Diividend Inted to market Date Share Share ‘Ratlo Share Yield, % price of com- Dee. 31, 1993. S160 $20.25 e $5.00 a4 192 13.20 10 4.80 36 mon stock Dec. 31, 1994.. The decline in market value during 1994 presumably reflects the de- creases in both earnings and dividends per share. Investors appraising this stock at December 31, 1994, should consider whether a price-earning ratio of 10 and a dividend yield of 3.6% represent a satisfactory situation in the light of alternative investment opportunities. These investors will also place considerable weight on estimates of the company’s prospective future earnings and the probable effect of such estimated earnings on the market price of the stock and on dividend payments. Book Value per Share of Common Stock The procedures for computing book value per share were fully described in Chapter 14 and will not be repeated here. We will, however, determine the book value per share of common stock for the Seacliff Company: Book Value per Share of Common Stock . 1994 1993 $638,000 $516,000 Why did book ~ Total stockholders’ equity value per Loss: Equity of preferred stockholders (1,000 shares at share Increase? ay price of $105) .. Equity of common stockholders, Shares of common stock outstanding Book vaiue per share of common stock {a + b). 105,000 (a) £33,000 $411,009 (%) 5.090 4.4000 $106.60. $102.75 ee936 a oes a higher ‘operating ex- pense ratio Indizaic higher vost ince? PART SIX / SPECIAL PURPOSE REPOATS .« JP SINANCIAL STATEMENT ANALYSIS Book value indicates the net assets represented by each share of stock, This statistic is often helpful in estimating a reasonable price for a compa. ny’s stock, especially for small corporations whose shares are not publicly traded. However, if a company's future earnings prospects are unusually good or unusually poor, the market price of its shares may differ signifi. cantly from their book value. Revenue and Expense Analysis. The trend of earnings of Seacliff Com. pany is unfavorable, and stockholders will want to know the reasons for the decline in net income. The comparative income statement on page 932 shows that despite a 20% increase in net sales, net income fell from $90,000 in 1993 to $75,000 in 1994, a decline of 16.7%, As a percentage of net sales, net income fell from 12% to only 8.3%, The primary causes of this decline were the increases in sellirig expenses (56.0%), in general and ad. ministrative expenses.(32.6%), and in the cost of goods sold (26.2%), all ot ~ which exceeded the 20% increase in net sales. Let us assume that further investigation reveals Seacliff Company de. cided in 1994 to reduce its sales prices in an effort to generate greater sales volume, This would explain the decrease in gross profit rate from 44% to 41.1% of net sales, Since the dollar amount of gross profit increased $40,000 in 1994, the strategy of reducing sales prices to increase volume would have been successful if there had been little or no increase in operat- ing expenses. However, operating expenses rose by $73,000, resulting in a $83,000 decrease in operating income. ‘The next step is to find which expenses increased and why. An investor may be handicapped here, because detailed operating expenses are not usually shown in published financial statements. Some conclusions, how- ever, can be reached on the basis of even the condensed information avail- able in the comparative income statement for Seacliff Company shown on page 932. . ‘The substantial incredse in selling expenses presumably reflects greater selling effort during 1994 in an attempt to improve sales volume. However, the fact that selling expenses increased $42,000. while gross . profit increased only $40,000 indicates that the cost of this increased sales effort was not justified in terms of results. Even more disturbing is the increase in general and administrative expenses. Some growth in adminis- __ trative expenses might be expected to accompany increased sales volurie, but because some of the expenses are fixed, the growth generally should be less than proporticnal to any increase in sales, The increase in general and administrative expenses from 12,7 to 14% of sales would be of serious concern to informed investors. ‘Management generally has greater control over operating expenses than over revenue, The operating expense ratio is often used as a mea- sure of management's ability to control its operating expenses, The unfa- vorable trend in this ratio for Seacliff Company is shown below: Operating Expense Ratlo : 1994 1993 (a) $243,060 $170,000 (®) $900,000. $750,000 27.0% 22.7% Operating expenses Operating expense ratlo (a+ b)CHAPTE vi 20-7 ANALYSI AND INTENPRETATION OF FINANCIAL OTATEMUHTO Mil 097 sans Managomont wore able to ineronae tho nalon volume whilo nt the pales 10 incronaing tho grou profit rato and decreasing the operating pense rato, ho aft on not income cal bo lle dvamatie, Por oxame if in 1999 Soaclif? Company ean incrvano Ite anton by 11% to $1,000,000, cvenso itn grons profil rate from 41,1 to 44%, and reduce the perating expense ratio from 27 to 24%, itv operating, income will inereane $240,000), an Ine from $127,000 to $200,000 (1,000,000 ~ $500,000 ~ crease of over 57%, Return on Investment (ROI) ‘The rato of return on investment (often eallod ROI) iv a measure of man- agement’s officioncy in using available resources, Regardless of the nize of tho organization, capital is a searco resource and must bo used officiently, In judging tho performance of branch managers or of ‘companywide man- agement, it is reasonable to raiso tho question: What rate of return have you earned on the resources undor your control? Tho concept of return on yevostment ean be applied to a number of situations: for example, evaluat- ing a branch, a total business, a product line, or an individual investment, ‘A number of differant ratios have boon developed for the ROI concept, ea.h ell suited to a particular situation, We shall consider the return on aa. aye and the return on common stackholders’ equity as examples of the return on investment concept. t test of management's ability to earn a Return on Assets An importan the rate of return on total return on funds supplied from all sources is tl assets. "The income figure used in computing this ratio should be operating income, since interest expense and income taxes are determined by factors Uiher than the efficient use of resources,, Operating income is earned throughout the year and therefore should be related to the average invest- ment in assets during the year. The computation of this ratio of Seacliff Company is shown below: . Percentage Return on Assets 1994-1993 (a) $127,000 $160,000 (2) $860,000 $820,000 (c) $950,000. $860,900 (a) $905,000 —$640,090-~ 14% 19% Operating Income . Total assets, beginning of year. * Total assete, ond of yoar ‘Average Investment In assets [(b + ¢) + 2]. Return on assats (a+ 0). ‘This ratio shows that the rate of'return earned on the company’s assets has fallen off in 1994. Before drawing conclusions as to the effectiveness of Seaclif's management, however, we should consider the trend in the re-" turn on assets earned by other companies of similar kind and size. Return on Common Stockholders’ Equity Because interest and dividends . paid to creditors and preferred stockholders are fixed in amount, a com- pany may earn a greater or smaller return on the common stockholders’938 Dogs the use of levenige benefit. com- mon stach> holders? un Matt Oh pant 61x 1 BHeCIA, HUAPOGE HEFONT 4 4 AMD 0 OLA hay equity than on te ata want, ha cng Ls : equity for Bencliff Company b4 #hoWl la Enis a yitiia® ' Return on Gominon M7 {Hs i inn STO Vay Het income, parents wf Less: Preferred dividend raqulremsnty rrr?” Net income,eppliceble to common ataeh v+000?"! eA Common atackholders’ equity, baylinirg 1 1 (GVA Hayy Common stockholders" uquity, nd of YO6F 70077" GYM Vi ‘Average comman stockholders’ ayulty {th + 0) % A) veer" ite Return on common atocthclders! ayuity (a A) vvrveee0ee 00 In both years, the rate of revuen on watntne MEDLEY, higher than the 12% rate uf invezost y2id 1p Wana“ LTS © dividend rate pald to preferred sxicholders, Tinie 1% sissoug through the favorable uve of leverase WIABME tiny i SELEY DKY, Leverage ‘The teria leverage means operating 2 bus the borrowed capital can be used in the than the cust of borrowing, then the ns stockholders’ equity will increase. In oth money at 12% and use it earn QV, y ever, leverage van act 22 2 “double-ciged ev able or unfavorable to the holders of If the rate of return on tal zene interest on borrowed capital, leverag turn on common stuckbolders’ equi that carry high interest rates would appear to be 2 logics, move, Howe, most companice do not have enoagh cath to resize | notice. Therefore, the common etuckholders zazy b unfavorable effects of leverage, In deciding how much leveraze is appropricts, the execan 4s should consider the stability of the coupenye cree the relationship of this return t the averege cost business incurs 20 much debt that it becomes ures on cases oa wel 3 borrowed zpitel Ts interest and principal ai ee meet the ree a a tae ei nye ace > Equity Ratio One indicator of the ammmant ee the equity ratio, Tis ratio meznaree the poreseee A financed by stockholders, as distingwiches fry ion by dividing total tzckbcldere enc wr ase india an xen te cf leverage, hat provided by creditors. A high ans el the bosineas is making eeeCHAPTER 20 1 ANALYEID AUD IITERPRETATION OF FMANCIAL BTATEMENTO Ry 939 Equity Ratio ! Proportion of Total stockholders’ equity . i004 1989 assets financed Total assets (or total Hlabllitios & (2) $638,000 $516,000 stockhodors’ : by stockholder Eouny ratio (a> - jolders’ oqulty). (©) $960,009 $460,000 672% 60.0% Seucliff Company has a hig! tol oucabier pen eel igh equity ratio in 1994 than in 1993. Is this From the viewpoint of the common stockhol it io wii produce maximum benefits if management ie able to earn gate cha on assets greater than the rate of interest paid to creditors. However, a low equity ratio can be very unfavorable if the return on assets falls below the rate of interest paid to creditors, Since the return on total assets earned by Seacliff Company has declined from 19% in 1993 to a relatively ° low 14% in 1994, the common stockholders probably would not want to risk a low equity ratio. The action by management in 1994 of retiring $50,000 in long-term liabilities will help to protect the common stockhold- ers from the unfavorable effects of leverage if the rate of return on assets continues to decline. Analysis by Long-Term Creditors Bondholders and other long-term creditors are primarily interested in three factors: (1) the rate of return on their investment, (2) the firm's abil- ity to meet its interest requirements, and (8) the firm's ability to repay the principal of the debt when it falls due. Vield Rate on Bonds The yield rate on bonds or other long-term indebted- hess cannot be computed in the eame manner as the yield rate on shares of Tock, because bonds, unlike stocks, have a definite maturity date and aaoexint, The ownership of 12%, 10-year, $1,000 bond represents the right arn oative $120 cach year for 10 years plus the right to receive $1,000 at the to rof 10 years. Ifthe market price ofthis bond is $950, the yield rate on an, gre ot mect in the bond is the rate of interest that will make the present investmiCthese two contractual rights equal to $960, When bonds eell at yalne {iy value, the yield rate is equal tothe bond interest rate, The yield aaatty yn versely with changes in the market price of the bond. If coe eri ee igo, the market prive of existing bonds will fall if interest interett line, the price of bonds will rise. Ifthe price of a bond is above rats Ay valae, the yield rate is less than the bond interest rate; if the seria bond is below maturity value, the yield rate is higher than the bond interest rate. ‘overage Ratio Bondholders feel that their investments are rela- cl gore tthe issuing company ens enough income tocover its annual a igations by a wide margin. eee ee rie tors! aafety is the ratio of operating income, ‘A common measure of cred x available for the payment of interest to the annual interest expanse, called the interest coverage ratio. ‘This. computation for Seacliff Company’. would be:940 a Long;term creditors watch this ratio «ls the preferred dividend safe? yaTeme” sancial 87 PANT 81x 7 apeciat punpose REPORTS AND IN ‘erage Ratio 994 (1903 1 coverage 1 interes! (a) $127,000 ee 24,000 1,000 Operating Income (botore Interest and incom (o) el ‘ino 53 tray Annual interest expene, Intoreat coverage (a + b) ang 1994. A ratio uring y industries, Nige ratio for tios of indi- di Tho ratio remai sat i oto tins ear conned TE cer Tn the electric utilities industry, for example, the in' ‘vith the 72! the leading companies presently averages about & vidual companies varying from 2 to 6. : age of total Debt Ratio Long-torm ereditors are interested in the percenttmenced by assets financed by debt, ae distinguished from the Pete". i measured stockholders, The percentage cf total assets financed BY Fo tieg by total by the debt ratio. This ratios computed by dividing total assets, shown below for Seacliff Company. Debt Ratio oe (a) $312,000 $944,000 (0) $950,000 $860,000 (or total tabi Laoag ape Debt ratio (a+ b).. From a creditor’s viewpoint, the lower the deb ft equity ratio) the better, since this means that stockholders have contrib- uted the bulk of the funds to the business, and therefore the margin of prétection to creditors against a shrinkage bf the assets 15 high. & stockholders" equi t ratio (or the higher the Analysis by Preferred Stockholders ‘Some preferred stocks are convertible into common stock at the option of the holder. However, many preferred stocks do not have the conversion privilege. If a preferred stock is convertible, the interests of the preferred stockholders are similar to those of common stockholders. If a preferred stock is not convertible, the interests of the preferred stockholders are more like thoze of long-term creditors. Preferred stockholders are interested in the yield on their investment. ‘The yield is computed by dividing the dividend per share by the market value per share. The dividend per share of Seacliff Company preferred stock is $9. If we assume that the market value at December 81, 1994, is $75 per share, the yield rate at that time would be 12% ($9 + $75). 'e primary measurement of the safety of an investment in preferred stock is the ability of the firm to meet its preferred dividend requirements. . The beat test of this ability is the ratio of the net income to the amount of tho ennual preferced dividends, as follows: Preferred Dividends Coverage Ratio 19941999 (a) $75,000 $90,000 (0) $ 9,000 § 9.000 8.3 times 10 times | | Net Incoms... ‘Annual preferred dividend requirements . Profarred dividend coverage (a +).cuae TER 20 / ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS — Ell 941 Although tho margin of protection declined in 1994, the annual preferred UF requirement still appears well protected. prefertes lously discussed in Chapter 14 (page 663) the market price of a preferred stock tonds to vary inversely with intorest rates. When interest rates are moving up, proferred stock prices tond to decline, when interest tes are dropping, preferred stock prices rise. Analysis by Short-Term Credltors ee and other short-term creditors share the interest of stockholders - bondholders in the profitability and long-run stability of a business. ieir primary interest, however, is in the current position of the firm—its ability to generate sufficient funds (working capital) to meet current oper- ating needs and to pay curreat debts promptly. Thus the analysis of finan- cial statements by a banker considering a short-term loan, + by a trade creditor investigating the credit status of a customer, is likely to center on the working capital position of the prospective debtor. Q : Amount of Working Capital The details of the working capital of Seacliff Company are shown below: SEACLI7F COMPANY Comparative Schedule of Working Capita! As of Docember 31, 1994 and December 31, 1993 Percentage Increase or of Total (Decrease) Gixrent faire 1994 1993 Dollars % «1994 1993 $ 40,000 $ (2,000) (5.0). a7 13.9 86,000 31,000 \ 96.0 | 30.0 29.9 120,000. © 60,000 50.0) 46.2 41.8 42,000 19,000 Js s41 146 $990,000 $288,000 $102,000 35.4 100.0 100.0, Notes payablo to creditors $ 14,600 $ 10,000 $ 4600 460 13.1 10.7 66,000 -° 30,000 36,000" 120.0 58.9 31.9 31,400 _ “54,000 ,_ (22,600) (41.9) _28.0 »_57.4 $112,000 $ 94,000 $ 18,000 _19.1 100.0 100.0 $278,000 $194,000 $64,000 ; nt of working capital, is measured by the excess of current cone ame rcent Habllites. Thus, working capital represents the,» aasernt of cash, near-cash items, and cash substitutes (prepayments) hand after providing for payment of all current liabilities. ne ae chedut@ shows that current assets increased $102,000, while cur. rent liabilities rose by only $18,000, with the result that working capital incre: 84, *3420 «i Are customers paying promptly? ANALYSIS PART SIX /°SPECIAL PURPOSE REPORTS AND FINANCIAL STATEMENT t Quality of Working Capital In evaluating the debt-p* ness, short-term creditors should a#sider the quality © well as the total dollar amount, (Pr principal factors a of working capital are (1) the nature of the current asset of time required to convert these assets into cash. ing ability of a busi. evi working capital ag ffecting the quality s and (2) the length, of Seacliff Company's working capital during 1994; cas 13.9% to 9.7% of eurrent ansete, aaa inwentery rose from 41.6% to nea Inventory is a less liquid resource than cash. Therefore, the quality of working capital is not as liquid as in 1993, Turnover. rates (or re jos ae be used to assist short-term creditors in estimating the time required to turn assets such as receivables and inventory into cash. Accounts Recelvable Turnover Rate As explained in Chapter 8, the ac. counts receivable turnover rate indicates how quiekly a company converts its accounts receivable into cash. The accounts receivable turnover rate is determined by dividing net sales by the average balance of accounts receiy. able.? The number of days required (on average) to collect accounts receiv. able then may be determined by dividing the number of days in a year (365) by the turnover rate. These computations are shown below using the data in our Seacliff example: ‘Accounts Receivable Turnover 1994 1993 (a) $900,000 $750,000 $ 86,000 $ 80,000 $117,000 $ 86,000 () $101,500 § 89,000 8.9 times 9.0 tins Recaivables, beginning of year. Recoivables, end of year. Average recelvaxios Aaculvablo turnover per yoar (a = b) i Average numbér of days to collect receivables (divide 365 daya by recelvable turnover)... 41 days 41 days There has been no significant change in the average time required to collect receivables. The interpretation of the average age of receivables depends upon the company’s credit terms and the seasonal activity imme- diately before year-end. For example, if the company grants 30-day credit terms to its customers, the above analysis indicates that accounts receiva- ble collections are lagging. If the terms are for 60 days, however, collection’ are being made ahead of schedule. Inventory Turnover Rate The inventory turnover rate indicates how many times during the year the company is able to sell a quantity of goods equal to its average inventory. Mechanically, this rate is determined by dividing the cost of goods sold for the year by the average amount of inventory on hand during the year. The number of days required to sell this amount of inventory may be determined by dividing 365 days by the turnaver rate. F Tdeally, the accounts receivable turnover is computed by dividing net eredit sales by tht” monthly average of receivables. Such detailed information, havens oe nee aided i annual financial statements. ‘ver, generally is not provideCHAPTER 20 / AMLYSIS AND WTERPRETATION oF pmaNowL svaTeweNTS HM) = 943 These computatio is ns Were explained i nstrated below using the data of Scadift Conposeet 8, and are demonstrat Inventory Turnover 1994. 1993 Cost of goods sold... (a) $530,000 $420,000 pie paepiied of yoar $120,000 * $100,000 oan $180,000, $120,000 ieee eee (&) $150,000 $110,000 Averago inventory turnover por year (a+ b) eee 3.5 times 3.8 times Average numbor of days to sell Inventory (divide 365 days by Inventory turnover) 404 days 96 days __ The trend indicated by this analysis is unfavorable, since the length of time required for Seacliff to turn over (sell) its inventory is increasing. Companies that have low gi%ss profit rates often need high inventory turnover rates in order to operate profitably. This is merely another way of saying that if the gross profit rate is low, a high volume of transactions is necessary to prodiice a satisfactory amount of profits. Companies that sell ‘high markup” items, such as jewelry stores and art galleries, can operate successfully with much lower inventory turnover rates. Operating Cycle In Chapter 6 we dofined the term operating cycle as the average time period between tho purchase of merchandise and the conversion of this merchandise back into cash. In other words, the mer- ‘chandise acquired for inventory is gradually converted into accounts re- ceivable by selling goods to customers vn credit, and these receivables are converted into cash through the process of collection. The word cycle refers to the circular flow of assets from cash to inventory to receivables and back into cash. Seacliff’s operating cycle in 1994 was approximately 145 days, com- puted by adding the 104 days required to turn over inventory and the average 41 days required to collect receivables. This compares to an operat- ing cycle of only 137 days in 1993, computed as 96 days to dispose of the inventory plus 41 days to collect the resulting receivables. From the view; point of short-term creditors, the shorter the operating cycle, the higher the quality of the borrower's working capital. Therefore, these crejlitors would regard the lengthening of Seacliff Company's operating cycle as an unfavorable trend. : . Current Ratio The current ratio (current assets divided by current liabili- ties) expresses the relationship between current assets and current liabili- ties, As debts come due, they must be paid out of current assets, Therefore, ‘short-term creditors frequently compare tho amount of turrent assets with, the amount of current liabilities. The current'ratio indicates a company’s Ishort-run, debt-paying ability. It is a measure of liquidity and of solvency. Astrong current ratio provides considerable assurance that a company will be able to meet its obligations coming due in the near future. The current > - ratio for Seacliff Company is computed as follows: .944 PART 8IX / SPECIAL PURPOSE REPORTS AND FINANCIAL STATEMENT ANALYSIS Current Ratlo 199 Does this Indl 1994 a cate satistace (a) $390,000 $288,000 tory debt: (b) $112,000 $ 94,000 paying ability? — Current ratio (a+ b) a at A widely used rule of thumb is that a current ratio of 2 to 1 or better is satisfactory. By this standard, Seacliff Company's current ratio appears quite strong. Creditors tend to feel that the higher the current ratio the better. From a managerial point of view, however, there is an upper limit, Too high a current ratio may indicate that capital is not being used produc- tively in the business. Use of both the current ratio and the amount of working capital helps to " place debt-paying ability in its proper perspective. For example, if Com- pany X has current assets of $200,000 and current liabilities of $100,000 and Company Y has current assets of $2,000,000 and current liabilities of $1,900,000, each company has $100,000 of working capital, but the current . position of Company X is clearly superior to that of Company Y. The cur- rent ratio for Company X is quite satisfactory at 2 to 1, but Company Y's current ratio is very low—only slightly above 1 to 1. As another example, assume that Company A and Company B both have current ratios of3 to 1. However, Company A has working capital of $50,000 and Company B has working capital of $500,000. Although both companies appear to be good credit risks, Uompany B would no doubt be able to qualify for a much larger bank loan’ than would Company A. Quick Ratlo Because inventories and prepaid expenses are further re- moved from conversion into cash than other current assets, a statistic known as the quick ratio is sometimes computed as a supplement to the current ratio, The quick ratio compares the highly liquid current assets (cash, marketable securities, and receivables) with current liabilities. Seacliff Company has no marketable securities; its quick ratio:is computed as follows: * = Quick Ratlo 19941993 (0) $155,000 $126,000, (b) $112,000 $ 94,000" 14 13 Ameasure of Quick assets (cash and recolvables) Mquicity Current llabllitios Quick ratio (a+ b) Here again the analysis reveals a favorable trend and a strong position. If the credit periods extended to customers and granted by creditors are roughly equal, a quick ratio of 1.0 or better is considered satisfactory. Unused Lines of Credit From the viewpoint of a short-term creditor, a company’s unused lines of credit ropresent 1 “resourco” almost as liquid as - gash. An unused line of credit means that a bank has agreed in advance to * Jend the company any amount, up to the specified limit. As long as this line of eredit remains available, creditors know that the business can borrow cath quickly and easily for any purpose, including payments of creditors’ claims,945 CHaprT €R 207 ANALYSIS ano INTERPRETATION OF FINANCIAL STATEMENTS Ell Existing unnsed lines i : ing of accompanying the financial staternanes Of credit are disclosed in notes Cash Flow Analysis In Chapter 19 we stressed the importance of a company being able to gen- crate sufficient cash flow from its operations, In 1993, Seacliff generated a net eash flow of $95,000 from its operating activities—a relatively “nor- mal” amount, considering that net income for the Year was $90,000. This $95,000 net cash flow remained after payment of interest to creditors and mounted to more than three times the dividends paid to stockholders. Thus, in 1993 the net cash flow from operating activities appeared quite ( Suflicient to ensure that Seacliff could pay its interest obligations and also pay dividends, In, 1994, however, net cash flow from operating activities declined to only $19,000, an amount far below the company’s $75,000 net income and less than one-half of the amount of dividends paid. Stockholders and credi- tors alike would view this dramatic decline in cash flow as a negative and Potentially dangerous development. A reconciliation of Seacliff’s net income in 1994 with its net cash flow from operating activities is shown below: ‘Why was the ‘Net income... $ 75,000 cash flow trom agg; ‘ Sparaions 30 pepreclton expen ss0000 Increase in notes payable to suppliers . 4,600 Increase in nccounts payable ... 35,000 __70,600 5145600 Less: Increase in accounts recovabe. 9,000 Increasia in inventories 60,000. increas In propa expen 19,000 Decreasa in acorved labitiae 500 12,600 Not cash flow trom operating activitie 519,000 (As explained in Chapter 19, the FASB requires companies to provide this type of reconciliation either in the statement of cash flows or ig.a supple. mental schedule.) The primary reasons for Seacliff’ low net operating cash flow appear to be the growth in uncollected accounts receivable and inventories, and the substantial reducticn in acersed liabilities. Given the significant increase in Sales during 1994, the increase in accounts receivable is to be expected, The larg2 reduction in accrued liabilities probably is a one-time event, mot” likely ta recur next year. The large increase in inventory, however, may. have reduced Seacliffs liquidity unnecessarily. o. Seacliff's financial position would appear considerably stronger if its increased sales volume were supplied by a higher inventory turnover rate, instead of a larger inventory. 4946 a OnJECTIVE 6 Compute the ratios widely used in finan- cial statement analysis and explain the nificance Al uL STATEMENT: pany 1X / sPEGuL PuRPosE ReronTs AND FINANC Usefulness of the Notes to Financial Statements A set of financial statements normally is & tation notes, disclosing information useful in interpr® Users should view these notes as an integral POT hich Ute items which are Tn our preceding chapters, we have identified snany most useful dis. disclosed in notes te the financial statements. AMONE S”.0, (b) material closures are (a) a summary of the aceounting MEDC a} instruments loss contingencies, (c) current market value of a liabilities, (e) ma- (a) identification ofthe assets pledged to secure SPEC dit, and (g) pre. turity dates of significant liabilities, (unused lines 01 th financial ferred stock dividonds in arrears. The notes also supp! on as extraordi- statements by providing further explanation of such HT ray ge nary gains and losses, changes in accounting Pr te nancial events occurring r the balance shee! ssenti Tea eae ee ronan information essential 19 © Frets interpretation'ef the sorppany’s financial position, operating Tests 2 future prospects, Ot : several pages of ecompanie n a the statements, the financial state- Summary of Analytical Measurements ‘The basic ratios and other measurements discuss! their significance are summarized below. ao ‘The student should keep in mind the fact that the full significance of any of these ratios or other measurements depends on the direction of its trend and its relationship to some predetermined standard or indus- ed in this chapter and of each. try average. , Ratlo or Other . Measurement Method of Computation Significance 1 Earnings per share of et nc Indicates the amount of earnings common stock* ' eee applicable to a share of common stock. “Market prico per share 2 Price-earnings 3 Dividend yleld 4 Book value per sharo of Indicates If price of stock Is In line with earnings. ratio. Earn ‘share — - ‘Shows the rate of return earned by stockholders based on current price for a share of stock. Dividend por share Markel price per staré Measures the recorded value of comson stock net assots behind each share . of common stock. 2 : Operating expenses 5 Operating expense ratio. © iat salon Indicates management's ablily to control expenses. Operating Incomo, 6 Roturn on assotd “Fowage total aas0ts Measures the productivity of issets regardless of capital structure.stockholders” equity e-Equly ratio. / 9 Debt ratio 10 Interest coverag ratio 11 Preferred dividends coverage ratio. 12 Working capital .// v 19 Inventory turnover rate / 14 Accounts recelvable turnover rate 15-Curront ratio, 16 Quick ratio 7 Net income ~ preferred dividends Average common stockholders” ‘equity Total stockholders’ equity Total assets Total abilities Total sets Operating Income ‘Annual interest expense Net Income Annual preferred dividends Current assets ~ current liabilities Cost of goods sold ‘Average inventory Net sales ‘Average recelvables Current assets Current liabilities Cig Roem ee Licht Quick assets Current liabilities sommes END-OF-CHAPTER REVIEW Indicates the earning power of common stock equity, ‘Shows the protection to ereditors and the extent of leverago being ‘used, Indicates the percentage of ts financed through borrowing; It shows the extent of levefage being used ‘Measures the coverage of Interest requirements, Particularly on long-term debt, ‘Shows the adequacy of current earnings to cover dividends on Preferred stocks, ‘Measures short-run debt: paying ability, Indicates marketability of Inventory and reasonableness of quantity on hand, Indleates reasonableness of accounts receivable balance 4nd effectiveness of collections. ‘Measures short-run debt paying ability. ‘Measures the'short-term liquidity of a tiem, SUMMARY OF CHAPTER LEARNING OBJECTIVES 1 Put a company’s net income into perspective by relating it to sales, assets, and stockholders’ equity. : ‘To judge the adequacy of a corporation's net income, we need to rélate the dollar amount of nét income to the company’s annual sales, to the ameunt of its assets, and to the stockholders’ equity. A net. income of $1 million may represent very good earnings or very poor earnings de- pending upon the size of operations and amounts invested. 2 Deseribe several sources of financial information about a busi- nés Sources of information about a business include the company’s annual report, quarterly reports, and data available from financial investment services and credit rating agencies. :gag PART SIE! gpECIAL PURPOSE REPORTS AND FINANGIAL STATEMENT ANALYSIS 3 Explain the uses of dollar and percentage changes, trend per. centages, component percentages, and ratios. Analysis of financial statements should indicate whether a company’s earnings and colv 1cy ar on the upgrade or are siorating. The dol. lar change in any item is the difference bets en the amount for a com parison yest and for a base yoar. The percentage change is computed by dividing the change between years by the amount for the base year, Trend percentages are useful to compere performance in each of a series of yours with a selected base year. Thus, the rate of growth in sales is revealed by trend percentages. — Component percentages indicate the relative size of each item in- cluded in a total. Thus, each item on a balance sheet may be expressed as a percentage of total assets. Each item on an income statement may be expressed as a percentage of net sales. 4 Discuss the “quality” of a company’s earnings, assets, and work. ing capital. The concept of “quality” of earnings exists because each company mane agement. can chaoze from a variety of accounting principles and meth- ‘nich ain concitered generally accepted. For exarapls, the fer, stvaigh*-line depreciation and accelerated depreciation Ieads ta different reported earnings. In judging the que! i the financial analyst considers whether the accounting principles and methods selected by management lead to a conservative measurement of earnings or tend to inflate earnings. The trend of earnings, their stability, and source are also significant in judging quality of earnings, ‘The quality of assets and of working capital are affected by such factors as the nature and liquidity of assets and the maturity dates of liabilities. 7 5 Analyze financial statements from the viewpoints of common stockholders, creditors, and others. Investors in common stocks are interested primarily in future profit- ability, dividends, and the market price of the common shares. these invoutora look at the trend in such measures of profit- turn on assets, return on equity, and earnings per share, + trend in dividend payments and cash flow from operating also are interested in measures which place stock price much aa the price-carninge ratio and dividend yield. Long term ereclitors ore interested primarily in the yield on their ventracnt and in the borrower's ability to make its principal and vat puyinents an achedule, shorl-ierm creditors are primarily interested in the borrower's li- quidliy 2x indicated by uch measurements as cash flow from operat: ing activities, unused lines of credit, the current ratio, quick ratio, and inventory and receivables turnover ratios. , 6 Compute the ratios widely used in financii ce al sta ana explain the significance of each. ee retion widely used in financial staternent analysis, the methods of coraputation, and the signi : metine table on pazen ee significance of each ratio are summarized in theCMAPTEN 20 / AvALveis Ano wrenPneranion oF rmanciaL oraremens a 949° This chapter concludes our emphasis upon financial accounting —the preparation and interpretation of the accounting information included in financial statements, In the remaining chapters of this text, we will shift our emphanis to managerial accounting-—the use of accounting informa- tion by managers in planning and controlling business operations, In these chapters you will encounter many new terms and concepts; however, you will find your background in financial accounting to be extremely useful, KEY TERMS INTRODUCED OR EMPHASIZED IN CHAPTER 20 Comparative financlal stateme: successive yoars placed aide by a changes, nts Financial statement data for two or more ide in adjacent columns to facilitate study of Component Percentage The percentage relationship of any financial state- ment item to a total including that item, For example, each type of assct as a Percentage of total ussete, Horizontal analysin Comparlaon of the change in a finanelal statement item auch ay inventories during two or more accounting porlods, Levarage Refers to the practice of financing ansets with borrowed capltal, Rx tensive leverage creiics the posnibility for the rate of return on con:mon stockhold- ara’ equity to he aul mtantially ubive or below the rata of return on total wssuty, When the rate of return on total asncta excveds the Average cost of burrowed capi tal, loveraye increases net income and the return on euanon atockholders! equity, However, when the return on total aencts is leas than the average cost of borrowed _= leverage reduces net income and the return on common stockholders’ eq- uity, Quality of asuets The concept that sume corapanies have avaets of better quality than others, such aa well-balanced composition af asuetn, well-maintained lant and equipment, und receivables that are all current. A lower quality of assets ralght be indicated by poor maintonance of plant and equipment, slow-moving in- ventories with high danger of chrolescence, Past-due receivables, and patents ap- Pronciiag an expiration date, Quality of earnings Earnings are said to be of high quality if they are stable, the source aeems assured, and the methods used in measuring income are conten, vative. The existence of this concept suggests that the range of alternative but accoptable accounting principles may still be too wide to produce financial state- ments that are comparable, Hate of return on investment (ROI) A measure of management's ability to earn a satisfactory return on the assets under its control, Numerous variations of the ROI concept are used, such as return on total euseta, return on total rtockhold. ers’ equity, and return on common stockholders equity. Ratlow Bee pages 946-947 for list of ratios, methods of computation, and signifi- cance, ‘Trend percentages The purpose of computing trend percentages is to measure the increase or decrease in financial items (such as sales, net income, cash, ete) from a selected base year to a serios of following years, For example, the dollar amount of net income each year 1s divided by the base year net income to deter. mine the trend percentage. Vertical analysis Comparison of a particular financial statement item to a total including that item, such as inventories as a percentage of current assets, or oper-— ating expanses in relation to net gales,g50 oman RIE! sree punecst PY pf on vou! DEMONSTRATION PROBLEM geet sign ‘The accounting records of King Cope end of 1993 and 1994: ‘Accounts payabla .. Income taxes payable Bonds payatie—8% -- Premium en bonds payeble Capital stock, $5 par. Retaired earnings « Total liabilities end stockholders" equity. Sales (et ofelscounts and allowances Gost of goods sold. aE Gross profit on sales 5 esos . Expenses (Including $22,400 Interest expense). (35520) Income taxes. eee $166 400 stock dividend $40,000 were paid and 2 50% credit at a relatively uniform rete Cash dividends of ‘early in 1904, All sales were made on ivables did not fluctuate ‘The market | year. Inventory and recei Pear pany’ stock on December 31, 1994, was S56 PEE share; 02 $43.50 (before the 50% stock dividend distributed in insTAUCTIO[ Compute the following for 1994 and 1993: ie ie ef <4 Quick ratio. a he a Current ratio. oA SESION oss LG 4 ratio, CR GeO Book value per share of capital stock (based on shares i fer 50 tock dividend in 1998) on shares outstanding after SO PG | ar est cos es 7 Price-earnings ratio. wssfance MH - > Gross profit percentage. Be ol gre ty 6 Operating expense ratio. 19 Net income as a percentage of net sales.CHAPTER 20 /- ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS 11 Inventory turnover, (Assume m 957 12 Accounts receival 4n average inventory of $160,000 for both years.) ible turnover. (Assume average accounts receivable for $90,000 13 Interest coverage ratio, 1 . SOLUTION TO DEMONSTRATION PROBLEM (1) Quiek ratio: = $126,009 + $145,000. $116,000 + $71,000. (2) Current ratio: $290,000 + $145,000. $260,000 + $71,000... (9) Equity ratio: $571,400 + $1,000,000... $445,000 + $800,000... (4) Dott ratio: $426,600 + $1,000,000. $385,000 + $900,000. (8) Book value por shero of capital stock: {$571,400 + 33,000 shares. $445,000 = 33,00¢* shares .. : (6) Earnings per share of capital stock: {$166,400 + 33,000 shares. ‘$80,000 + 33,000" shares () Price-earnings ratio: $08 + $5.04 cee $43.50 + 1.5*= $29, adjusted market price; $294 $2.42 (®) Gross protit percentage: ‘$594,000 + $2,200,000 .. $480,000 + $1,600,000 .. + (9) Operating expense ratio: ($336,600 - $22,400) + $2,200,000. ($952,000 - $22,400) + $1,600,000. (10) Net income as a percentage of net sales: $166,400 + $2,200,000... $80,000 + $1,600,000... (11) Inventory turnover: ‘$1,606,000 + $150,000 {$1,120,00 +.$150,000 ..... (12) Accounts receivable turnover: $2,200,000 + $90,500 .. ‘$1,800,000 + $90,000 . (13) Interest coverage ratio: (8166,400 + $22,400 + $91,000) + $22,400 . ($80,000 + $22,400 + $48,000) + $22,400.. * Adjusted retroactively for 50% stock dvdend, 2to4 43% ses 17 times 27% 14% 7.6% tess 10.7 tmes 24.3 times 12% times es 1993 “16 tor 37 104 56% 48% $13.48 12 times 30% 20.6% 8% 75 times 17.8 times: 6.7 timesIUANCIAL STATEMENT ANALYSIS 952 MPA aT S1x 1 SPECAL PURPOSE REPORTS AND di SELF-TEST QUESTIONS Answers to these questions appear on page 967. 1 Which of the following is nof an accurate statement? a Expressing the various items in the income statement as @ percentage of, sales illustrates the use of component percentages: & An increase in the market price of bonds causes the yield rate to deci, ‘A high debt ratio is viewed favorably by long-term ereditors as long as y, number of times interest earned is at least 1. , ¢ Inmeasuring the dollar or percentage change in quarterly sales or earning it is appropriate to compere the results of the current quarter with those the seme quarter in the preceding year. Which of the following actions will improve the “quality” of earnings, evey though the total dollar amount of earnings may not increase? a Increasing the uncollectible accounts expense from 1% to 2% of net credit sales to reflect current conditions. b Switching from en accelerated method to the straight-line method for ds, preciating assets. © Changing from LIFO to the FIFO method of inventory valuation during peried of rising prices. @ Lengthening the estimated useful lives of depreciable assets Hunter Corporation's net income was $400,000 in 1993 and $160,000 in 1994, What percentage increase in net income must Hunter achieve in 1995 to offset the decline in profits in 1994? . 2 60% b150% c600% d 67% Of the following situations, which would be considered the most favorable for the common stockholders? ‘The company stops paying dividends on its cumulative preferred stock; the price-earnings ratio of common stock is low. b Equity ratio is high; return on assets exceeds the cost of borrowing. ¢ Book value per share of common stock is substantially higher than market value per share; return on common stockholders’ equity is less than theat#, of interest paid to creditors. Equity ratio is low; return on assets exceeds the cost of borrowing. é 5 During 1994, Ganey Corporation had sales of $4,000,000, all on credit. At counta receivable averaged $400,000 and inventory levels averaged $250,000 throughout the year. If Ganey’s gross profit rate during 1994 was 25% of n*t seles, which of the following statements are correct? (More than one statement may be correct. Assume 360 days in a year.) Ganey “turns over” ite accounts receivable more times per year than it turt* over its average inventory. b Ganey collects the amount of its average accounts receivable in about 96° ) BT days. ¢ Ganey’s operating cycle is 66 day ‘The quality of Ganey’s working capital would improve if the company 4! reduce ita inventory and receivables turnover rates,CHAPTER 20 / ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS a 953 == ASSIGNMENT MATERIAL DISCUSSION QUESTIONS ta Whet groupe are interested in tho financial affairs of publicly owned corpo- b bel Some of the more important sources of financial information for inves- 2 In financial statement analysis, what is the basic objective of observing trends in data and ratios? Suggest some other standards of comparison. 3 In financial statement analysis, what information is produced by computing a ratio that is not available in a simple observation of the underlying data? 4 Distinguish between trend percentages and component percentages. Which would be better suited to analyzing the change in sales over a term of several years? 5 “Although net income declined this year as compared with last year, it in- creased from 8% to 5% of net sales,” Are sales increasing or decreasing? 6 Differentiate between horizontal and vertical analysia, 7 Assume that Chemco Corporation is engaged in the manufacture and distribu- tion of a variety of chemicals, In analyzing the financial statements of this corporation, why would you want to refer to the ratios and other measurements of companies in the chemical industry? In comparing the financial results of Chemco Corporation with another chemical company, why would you be inter- eated in the accounting practices used by the two companies? 8 Explain how the following accounting practices will tend to raise or lower the quality of a company’s earnings, (Assume the continuance «.’ inflation.) @ Adoption of an accelerated depreciation method rather than straight-line + depreciation, b Adoption of FIFO rather than LIFO for the valuation of inventories, ¢ Adoption of a 7-year life rather than a 10-year life for the depreciation of equipment, © What single ratio do you think should be of greatest interest to: 4 A banker considering a short-term loan? b A common stockholder? © An insurance company considering a long-term mortgage loan? 10 Modern Company earned a 16% return on its total assets, Current liabilities 7 are 10% of total assets. Long-term bonds carrying a 18% coupon rate are equal to 30% of total assets, There is no preferred stock, Is this application of leverage” favorable or unfavorable from the viewpoint of Modern Company's stockhold- : era? . 11. In deciding whether a company’s equity ratio is favorable or unfavorable, credi- tors and stockholders may have different views, Why? 12 Ahi Co, has a current ratio of 3 to 1, Ono Corp. has a current ratio of 2 to 1.Does this mean that Ahi’s operating cycle is longer than Ono's? Why?EXERCSE 2041 ‘Terminclosy ART SIX / SPECIAL PURPOSE REPORTS AND FINANCIAL STATEMENT ANALYSIS wars ago and (tnow fock for $60 sevoral ye! T'm earning 14;% on 43 An investor states, “I bought this st ividends Inat year 80 sells for $100. Tt paid $5 per share in di my investment.” Criticize this statement, 44 Alpine Products experiences a considerable seasonal variation in ite business, ‘The high point in the year’s activity comes in ‘Novembor, the low point in July, juring which month would you ‘expect the company’s current ratio, te higher? If the company were choosing a fiscal year for accounting, Pit o8e8, how would you advise them? 15 Auto Parts’ inventory turnover and accounts receivab! aa ed from 1993 to 1994, but net income decrensed. Can yor ble reasons for this? 46 Is the rate of return on investment (RON) intended primarily to measure Jiquid- ity, solvency, or some other aspect of business operations? Explain. 47 Mention three financial amounts to which corporate profits can logica'ly be compared in judging their adequacy or reasonableness. wuld you consider a corporate net income of $. mile “sonably low? Under what ciroumstances would W ‘ilion as being unreasonebly high? Je turnover both 11 offer some pos 18 Under what circumstances wor lion for the year as being unre you consider a corporate profit of $1 EXERCISES Listed below are nine technic chapter. ‘al accounting terms introduced or emphasized in this Leverage Yield Quick ratio Trend percentages Vertical analysis Return on assets Inventory turnover Operating cycle Price-eaming rato Bach of the following statements may (or may not) describe one of these tetfinical Bach offor each statement, indicate the accounting fer? described, or answer terms. ihe statement docs not correctly describe any of the terms. a The proportion of total assets financed by stockholders, as distinguished from creditors. Market price per common share divided by earnings per ‘common share. Changes in financial statement items from & bast veer to following years ex- Trine base year amount and designed to show the pressed as a percentage 0 Petent and direction of change. ded by market price per share. 4 Dividends per share divi Average time period between the purchase of merchandise and the conversion 7 of this merchandise back into cash. {Study of relationships among the data of a single accounting period. 4g. Not sales divided by averqge inventory. hh Comparison of highly liquid current assets (cash, marketable securities, and receivables) with current liabilities. Buying assets with money raised by borrowing. ny for two 93 10 elected information taken from financial statements of Lopez Compai successive years follows. You te the percentage change from 19 ible. are to computcH EXERCISE 203 Intuition ver- sus Calculation INSTRUCTIONS - EXERCISE 204 Trend Percentages EXERCISE 20.5 ‘Common Size Income State- ments EXERCISE 20.6 Ratlos for a Retall Store INSTRUCTIONS APTER 20 / ANALYSIS AND INTERPRETATION OF FIANCIAL STATEMENTS 955 1994 «Account rece, 5126000 stan “o asoo ‘nooo ‘eo.cw) roo ~ Wo 860,000 800,000 62,400 80,000 990,000 900,000 Tait Corporation had net income of $4 million in its first year. In the second year, net income decreased by 75%. In the third year, due to an improved business envi. . ronment, net income increased by 250%. a Prior to making any computations, do you think Tait's net income was higher or lower in the third year than in the first year? b Compute Tait’s net income for the second year and for the third year, Do your computations support your initial response in part a? Compute trend percentages for the following items taken from the financial statements of Water-Wise Plumbing Fixtures over a five-year period. Treat 1990 as. the base year. State whether the trends are favorable or unfavorable. (Dollar amounts are stated in thousands.) tcos 1993 1992-1991 1990 $85,000 $74,000 $61,500 $£9,000 $50,000 $58,500 $48,000 $40,500 $36,000 $30,000 Sales . Cost of goods sold... Prepare common size income statements for Toyoda Company, a sole proprietor- ship, for the two years shown below by converting the dollar amounts into percent- ages. For each year, sales will appear as 100% and other items will be expressed as a percentage of sales. (Income taxes are not involved as the business is not incorpo- rated.) Comment on whether the changes from 1993 to 1994 are favorable or unfit” vorable, 1994 1993 ‘$500,000 $400,000 Sales .. eae Cost of goods sold. 930,000 _268,000 Gross prottt.. $170,000 $132,000 Operating expenses 140,000 _116,000 Net income. ... $30,000 § 16,000 Selected financial data for Vashon’s, a retail store, appear below. Since monthly figures are not available, the average amounts for inventories and’ for accounts ceivable should be based on the amounts shown for the beginning and end of 1994, 1994 1993 $750,000 $600,000 495,000" 408,000 85,500 ° 94,500 87,500. 100,000 Sales (torms 2/10, 1130)... Cost of goods sold. Inventory at and of yoar . Accounts recelvable at and of yer... Compute the following for 1994: @ Gross profit percentage b Inventory turnover F © Accounts receivable turnover956 a EXERCISE 207 Computing Ratlos INSTRUCTIONS rERCISE 208 Current Ratlo, Dobt Ratio, and Esrnings per Share INSTRUCTIONS EXERCISE 20-0 Ratio Analysis for Two similar Companies. e-en008 paar SIX / SPECIAL PURPOSE REPORTS AND FINANCIAL STATEMENT ANALYSIS ‘Acondensed belance sheet for Durham Corporation propared at the end of the year appears below. Lieblitios & Stockholdera’ Equity Assets 's 65,000 Notes payable (due In Cath. soe Accounts receivable "465,000 months) veeseseess $40,000 Inventory. 270,000 Aecounts payable, 110,0%0 Prepald oxpaneos «- 60,000 Longrterm Hable 330,003 Plant & equipment (ne!) 70,000 “Apltal stock, $5 par ‘300,009 ‘9,000 Retained earnings. 420,000 Total » $4,200,000 Aas $1,200,000 25 profit of $1,116,000 on sales of During the year the company earned a gro d plant assets remained almost con- $2,790,000, Accounts receivable, inventory, an stant in amount throughout the year, Compute the following: Current ratio Quick ratio Working capital Equity ratlo Accounts receivable turnover (all gales were on ers Inventory turnover Book value per share of eapital stock . -edit) ve annual reports of Hastings, Inc., appear below, 1994 1999 $400,000 $325,000 '$ 60,000 $100,000 100,000 $0,000 700,000 100,000 120,000 _75,000 ‘$400,000 $925,000 Selected items from succesai Total assots (40% of whieh are current) » Current labillties « Bonds payable, 12% Capital stock, $5 per value. Retained earnings » Total liabilities & stockholders" equity Dividends of $26,000 were declared and paid in 1994, Compute the following: a Current ratio for 1994 and 1993 b Debt ratio for 1994 and 1993 c Barnings per share for 1994 Selected data from the financial statements of Italian Marble Co, and Toro Stone Products for the year just ended follow. Assume that for both companies dividends declared were ‘equal in amount to net earnings during the year and thérefore stock- holders’ equity did not change. The two companies are in the same line of business.EHARTED 20 °/ QUALYSIS AMD MTERPRETATON OF FMANCINLcrareuENTS INSTRUCTIONS PROBLEM 20-1 Analysis to Identity Favor. able and Unfa- vorable Trends INSTRUCTIONS 957 ‘ Mtollan ‘Toro Stone Total liatslita Marble Co. Products re : $ 200,000 $ 100,000 Fotal assets......, z Sains (oll on ci 600,000 400,000 a8 (all on credit). z Sere 1,800,000 1,200,000 Average Inventory , 10 J Avarageraclables Ea cota Toro Gross profit as a porcentag> of sales 4 , 40% 30% Operating expensos a8 a pertentage of salon, 36% 25% Not income as a parcentage of salgs , 4% 5% Compute the following for each sompany: a Net income ~ b Net income as a percentage of stackholders' equity ¢ Accounts receivable turnover d Inventory turnover PROBLEMS Note: In this chapter, we provide an unusually wide variety of problem assign- ments. In order to make the full range of these assgnments available to all users of the text, we present them in one consecutive series,xather than splitting them into A and B groups. This entire series is supported in beh the Group A and Group B accounting work sheets, The following information was developed from the financialstatements of Custom Logos, Inc. At the beginning of 1994, the company’s former supplier went bank- rupt, and the company began buying merchandise from ariother supplier. 194 1983 $1,008n00 $1,134,000 230,49 252,000 172,800 189,000 6.0% 7.5% Gross profit on sales... Income before Income t Mot IncOme..+.+++00+ ‘Net Income as a percentago of net sales . @ Compute the net sales for each year. b Compute the cost of goods sold in dollars and as a percentage of net sales for each year. . . Compute operating expenses in dollars and as a percentage of net sales for each year, (Income taxes expense is not an operating expense.) a condensed comparative income statement for 1993 and 1994. Include © Travillowing Meme: net sales, coet of goods wold, gross pro. operating re penses, income before income taxes, income taxes expense, and net, income. Omit earnings per ehare statistics. ify the significant favorable trends and unfavorable trends in the perform- rico ef Custom Logos, Ine, Comment on any unusual changes.958 a PROBLEM 203 Comparing ‘Operating Re- sults with Av- rage Perform ance In the Industry INSTRUCTIONS PROBLEM 203 Ratios Based on Balance Sheet and In- come State- ment Data INSTRUCTIONS part SIX? ‘SPECIAL PURPOSE REPCATS AND FINANCIAL STATEMENT ANALYSIS rat, Shown below for the current in size summary for ntages in the rages for the ‘ufactures camping equipme! ment for the company tes, (Notice that the perce! are average percents Sub Zero, Inc., man year are the income state the industry in which the company opera! Hightchand column are rot for Sub Zero, Inc.» but industry.) ‘sub Zero, Industry Inc. Average {$20,000,000 —100%exe “9,800,000 _57 ‘$10,200,000 43% Saies (net) Cost of goods sold. Gross profit an sales « 16 3,400,000 __20 wating expense: eae — ‘$ 4,200,000 9% General end administrative ie Total operating expenses «+++ $7,600,000 __36% Operating income . ‘$ 2,600,000 7% Income taxes. 1,200,000 __3 Net income '$ 1,400,000 _* 23% 14% Return on assets 7 a_ Prepare a two-column co show for Sub Zero, Inc., ymmon size income statement. The first column should ‘all items expressed as & percentage of net sales. The second column should show as an iadustry average the percentage data givenin secondGiem, The purpose of this eommon size statement js tf Pepare the operating results of Sub Zero, Inc., with the average for the industry. b Comment specifically on differences between Sub Zero, Inc., and the industry corre with respect to gross profit on sales, selling expenses, general and ad- yperating income, net income, and return on assets. ministrative expenses, 0) Baggest possitle reasons for the more important disparities. Barnum Corporation has issued common stock only. The company has been so Baral and had a gross profit rate of 25%. The information shown below was de- rived from the company’s financial statements. ++ $ 700,000 Beginning Inventory Ending Inventory 800,000 ‘Average accounts receivable. 250,000 ‘Average commion stockholders’ equity 1;800,000 Sales (80% on credil)..+++++ 4,090,000 225,000 Net Income oe On the basis fhe aor information, compute the following (assume 365 days in a year): a Accounts receivable turnover and the average numb i lect the accounts receivable ee umber of daye regeized fo ot : : To ventay turnover and th average number of days required to turn over ¢ Length of Barnum Corporation's operating eycle d- Return on common stockholders’ equityINsTAUCTIONS PROBLEM 20-5 Ratios; Consider Advisebilty of Jncurting Long- Term Debt— ‘Second Problem ‘sTRUCTIONS TS CEEINANCIAL STATEMENTS 959 At the ond af the year, the following j ‘ recor of Catton Orice erefin€Nfrmation was obtained from the accounting ‘Sales (all on credit), Cost of goods sold........... erence lavorage Inventory . pean Average accounts receivable poo Interest expense, wee Income taxes... pee ‘Nat Income. am Average Investment In assets ...... bara ‘Average stockholders’ equity... toman 795,000 a From the information given, compute the following: 1 Inventory turnover 2 Accounts receivable turnover 3 Total operating expenses 4 Gross profit percentage 5 Return on average stockholders’ equity 6 Return on average assets 5 Carleton has an opportunity to obtain a long-term loan-at an annual interest rate of 12% and could use this additional capital at the same rate of profitability At the end of the year, the following information was obtained from the accounting records of Santa Fe Boot Co. Sales (all on credit) coors $800,000 Cost of goods sold.. 480,000 Average Inventory . 120,000 Average accounts receivable. 80,000 Interest expense..... 6,000 Income taxes... 8,000 ‘Net income for the year. 96,000 Average Investment in assets .. 500,000 400,000 Average stockholders’ equity .. ‘The company declared no dividends of any kind during the year and did not issue or retire any capital stock. From the information given, compute the following for the year: 1 Inventory turnover 2 Accounts receivable turnover 8 Total operating expenses 4 Gross profit percentage 5 Return on average stockholders’ equity 6 Return on average assets 3960 a PROBLEM 205 Analysis and + Interpretstion from Viewpaint of Short-Term Creditor INSTRUCTIONS PROBLEM 20-7 “Ratios: Evalua- tlon of Two Companies INSTRUCTIONS pART SIX / SPECIAL PURPOSE REPORTS AND FINANCIAL STATEMENT ANAND b Sania Fe Boot Co. has an opportunity to obtain a long-term loan at an annyay interest rate of 12% ard could use this ‘additional capital at the same rate of profitability as indicated above. Would ‘obtaining the loan be desirable from the Viewpoint of the stockholders? Explain. ‘Shown below are selected financial data for Mondo Corporation and Global, Inc., at, the end of the current year Mondo Qlobay, Ine, . Corporation Net sales (all on credit). . $1,440,000 $1,190,000 Cost of goods sold 1,260,000 825,009 36,000 70,000 Caste eeeee Accounts receivable (net). 180,000 140,090 Inventory. fea 504,000 165,009 Current Hebi ties .. aooseneen 240,000 180,009 nts receivable and for inven. ‘Assume that the year-end balances shown for accou ‘counts throughout the year, tory also represent the average balances of these ae ‘a For each company, compute the following: 4 Working capital. 2 Current ratio. B 3 Quick ratio. 4 Number of times inventory turned over during the year and the average num- ber of days required to turn aver inventory. — 7 eivable turned over during the year and the 5 Number of times accounts rec ‘d to collect accounts receivable. (Round to the average number of days reauire nearest day.) 6 Operating cycle. b From the viewpoint of a short-term creditor, cropany’s working capital. To which company would you {n merchandise on a 30-day open account? comment upon the quality of exch prefer to sell $50,000 ‘Shown below are selected financial data for ‘Another World and Imports, Inc,, at the end of the current year: ! : Another — Imports, World: $675,000 $560,000 a 504,000 480,000 Net credit sales Cost of goods sold..+:+++ Cash. ferece . 81,000. 20,000 Accounts receivable (net)... + 75,000 70,000 “Inventory. .++++ eeee 84,000. - 160000 105,000 100,000 Current abilities ‘Assume that the year-end balances shown for accounts receivable and for inven tory also represent the average balances of these items throughout the year. a For each of the two companies, compute the following: 1 Working capital. 2 Current ratio.CHAPTER 20 / ANALYSIS AND INTERPRETATION OF FINANCIAL STATEMENTS 961 PROBLEM 208 Evaluating Short-Term Debt-Paying Ability, WSTRUCTIONS 3 Quick ratio, 4 Number of times invontory turned over during the year and the average num- er of days required to turn over inventory, (Round computation to theggenr- est day.) ye 5 Number of times accounts receivable turned over during the year and the average number of days required to collect accounts receivable, (Round com- putation to the nearest day.) . 6 Operating cycle, ft n A b From the ‘viewpoint of a short-term creditor, comment upon the quality of each company's working capital. To which company would you prefer to sell $20,000 in mefchandise on a 80-day open account? Listed below is the working capital information for Imperial Products, Iinc., at the beginning of the year, . CASH. eeeesesee ore a ‘$405,000 Temporary Investments In marketable securities ... 216,000 Notes receivable—current 924,000 Accounts receivable .......... 540,000 Allowance for doubtful accounts 27,000 Inventory...+s++.++ 492,000 Prepaid expenses . _ 4,000 Notes payable within one year ... 162,000 Accounts payable . 445,500 40,500 Accrued liabilities . The following transactions are completed during the year: 0 Sold on account inventory costing $72,000 for $65,000. 1 Issued additional shares of capital stock for cash, $800,000. 2 Sold temporary investments costing $60,000 for $64,000 cash. 3 Acquired temporary investments, $105,000. Paid cash. 4 Wrote off uncollectible accounts, $18,000. 5 Sold on account inventory costing $75,000 for $90,000. 6 Acquired plant and equipment for cash, $480,000. , 7 Declared a cash dividend, $240,000. 8 Declared 4 10% stock dividend. 9 Paid accounts payable, $120,000. . 10 Purchased goods on account, $90,000. Sanit? 11 Collected cash on accounts receivable, $180,000. 12 Borrowed cash from a bank by issuing a short-term note, $250,000. a Compute the amount of quick assets, current assets, and current liabilities at the beginning of the year as shown by the above account balances. b Use the data compiled in part a to compute: (1) current ratio; (2) quick ratio; and (3) working capital. © Indicate the effect (Increase, Decrease, and No Effect) of each independent \ transaction listed above on the current ratio, quick ratio, working capital, and: net cash flow from operating activities. Use the following four-column forsaat (tem 0 is given as an example): . con