CHAPTER-07: CASH FLOW ANALYSIS

THEORY
1. What is cash flow statement?
2. Uses of cash flow statement.
3. Free cash flow and calculation of free cash flow
4. Different methods of cash flow statement and differences between them.
5. Reporting by activities and examples of items included in each activity.
6. Information provided for cash flow statement:
(i) Two balance sheets
(ii) Current year income statement
(iii) Additional information
MATHS
EXAMPLE:
Gould Corporation, whose balance sheet and income statement are presented respectively.

The following additional information about Gould for

Year 2 is available:
i. The company purchased a truck during the year at a cost of $30,000 that was financed in
full by the manufacturer.
 ii. A truck with a cost of $10,000 and a net book value of $2,000 was sold during the year
for $7,000. There were no other sales of depreciable assets.
iii. Dividends paid during Year 2 are $51,000.
Required:
Prepare cash flow statement by using both direct and indirect method.
SOLUTION:
First Method: Indirect Method

Gould Corporation
Cash flow statement [Indirect Method]
For the year ended 31st December year 2
Particulars Amount Amount
(1) Cash flow from operating activities:
Net income as per statement 84,000
Adjust of items to reconcile net income into cash flows:
Add: Depreciation and amortization 35,000
Less: Gain on sale of asset (5,000)
Less: Increase in accounts receivables (9,000)
Add: Decrease in inventories 6,000
Add: Decrease in prepaid expenses 3,000
Less: Decrease in accounts payable (5,000)
Add: Increase in prepaid expenses 4,000
Net cash flows from operating activities 1,13,000
(2) Cash flows from Investing activities:
Cash purchased of plant assets (70,000)
Cash receipt from sale of old truck 7,000
Net cash flows from investing activities (63,000)
(3) Cash flow from Financing Activities
Mortgage payable paid (1,50,000)
Sale of preferred stock 1,75,000
Dividend paid (51,000)
Net cash flows from financing activities (26,000)
Net increase in cash 24,000
Add: Beginning cash balance 51,000
Ending cash balance 75,000

Note-(1): Plant Assets

Ending plant assets 4,40,000
Add: Plant assets sold 10,000
4,50,000
Less: Plant asset purchased on credit 30,000
4,20,000
Less: Beginning balance 3,50,000
Plant assets purchased for cash 70,000
Note-2: If dividend is not given
 Beginning retained earnings 22,000
Add: Net income 84,000
1,06,000
Less: Ending retained earnings 55,000
Dividend paid 51,000

2nd Method: Direct Method

Working-(1): Cash collection from sales
Sales 6,60,000
Add: Beginning cash receivables 39,000
6,99,000
Less: Ending accounts receivables 48,000
Cash collection from customers 6,51000
Working-(2): Cash payments for purchases
Beginning inventory 60,000
Add: Purchases 3,57,000
Cost of goods available for sales 4,17,000
Less: Ending inventory 54,000
Cost of goods sold 3,63,000
Payments
Purchases 3,57,000
Add: Beginning accounts payable 56,000
4,13,000
Less: Ending accounts payable 51,000
Cash payments for purchases 3,62,000
Working-(3): Cash payments for Operating expenses
Operating expenses 1,83,000
Decrease in prepaid expenses 3,000
Increase in accrued expense 4,000
Cash payment for operating expenses 1,76,000

Gould Corporation
Cash flow statement [Indirect Method]
For the year ended 31st December year 2
Particulars Amount Amount
(1) Cash flow from operating activities:
Cash collection from customer (Working-1) 6,51,000
Cash payments for purchases (Working-2) (3,62,000)
Cash payments for operating expenses (1,76,000)
Net cash flows from operating activities 1,13,000
(2) Cash flows from Investing activities:
Cash purchased of plant assets (70,000)
Cash receipt from sale of old truck 7,000
Net cash flows from investing activities (63,000)
(3) Cash flow from Financing Activities
Mortgage payable paid (1,50,000)
Sale of preferred stock 1,75,000
Dividend paid (51,000)
Net cash flows from financing activities (26,000)
Net increase in cash 24,000
Add: Beginning cash balance 51,000
Ending cash balance 75,000
Note-(1): Plant Assets
Ending plant assets 4,40,000
Add: Plant assets sold 10,000
4,50,000
Less: Plant asset purchased on credit 30,000
4,20,000
Less: Beginning balance 3,50,000
Plant assets purchased for cash 70,000
Note-2: If dividend is not given
Beginning retained earnings 22,000
Add: Net income 84,000
1,06,000
Less: Ending retained earnings 55,000
Dividend paid 51,000
EXERCISE 7-3:
CASH FLOWS FROM OPERATIONS
Particulars Amount Amount
Cash flows from operating activities:
Net income 10,000
Add (Less) items to convert to cash basis:
Depreciation, depletion and amortization 8,000
Deferred income taxes 400
Undistributed earnings of unconsolidated affiliates (200)
Amortization of discount on bond payable 50
Amortization of premium on bonds payable (60)
Increase in accounts receivables (900)
Increase in accounts payable 1,200
Decrease in inventories 850
Cash flows from operations 19,340
Req-(b)(1)
The issuance of treasury stock for employee stock plans as compensation requires as add back to
net income because it is an expense not using cash.
Req-(b)(2):
The cash outflow for interest is not included in expense and must be included as cash outflow in
investing activities as part of outlays for property.
Req-(b)(3)
If the difference between pension expense and actual funding is an accrued liability, the unpaid
portion must be added back to income as an expense not requiring cash. If the amount funded
exceeds pension expense, then net income must be reduced by the excess amount.

EXERCISE 7-4:
Req-(a): Cash collection from sales during year 2
Net sales 19,37,000
Add: Beginning accounts receivables 3,05,000
Total potential receipts 22,42,000
Less: Ending accounts receivables 2,95,000
Cash collection from sales 19,47,000
Req-(b): Cash payments for accounts payable
Beginning inventory 4,31,000
Add: Purchases 12,68,000
Cost of goods available for sales 16,99,000
Less: Ending inventory 5,49,000
Cost of goods sold 11,50,000
Payments
Purchases 12,68,000
Add: Beginning accounts payable 5,63,000
Total potential payments 18,31,000
Less: Ending accounts payable 6,04,000
Cash payments for purchases 12,27,000
Req-(c): Cash receipts during Year 2 not provided by operations
Issuance of common share 81,000
Issuance of treasury stock 17,000
Cash receipts during year 2 not provided by operations 98,000
Req-(d): Cash payments for noncurrent assets purchased during Year 2.
Increase in land 1,50,000
Increase in plant and equipment 18,000
Total payments for non-current assets 1,68,000

PROBLEM 7-3:
Zett Company
Statement of Cash Flows [Indirect Method]
For the year ended 31st December……
Particulars Amount Amount
Cash flows from operating activities:
Net income 7,000
Add (Deduct) items to convert to cash basis:
Depreciation 5,000
Loss on sale of fixed assets 1,000
Gain on sale of investment (3,000)
Increase in accounts receivables (5,000)
Decrease in inventory 2,000
Decrease in accounts payable (7,000)
Net cash flows from operating activities 0
Cash flows from investing activities:
Sale of investment 9,000
Purchase of fixed assets (4,000)
Sale of fixed assets 6,000
Net cash flows from investing activities 11,000
Cash flows from financing activities:
Sale of common share 1,000
Purchase of treasury stock (11,500)
Net cash flows from financing activities (10,500)
Net increase in cash 500
Beginning cash balance 34,000
Ending cash balance 34,500
93,000+21,000-4,000-80,000= 30,000

CHAPTER-08: RETRUN ON INVESTED CAPITAL AND

PROFITABILITY ANALYSIS
THEORY
1. Use return on invested capital in several areas of our analysis, including (1) managerial
effectiveness, (2) level of profitability, and (3) planning and control.
2. Defining invested capital.
3. Components of RNOA and ROCE.
4. Operating and non-operating assets and liabilities with examples.
5. [8–1]. How is return on invested capital used as an internal management tool?
ANSWER:
The return that is achieved in any one period on the invested capital of a company consists of the
returns (and losses) realized by its individual segments and divisions. In turn, these returns are
made up of the results achieved by individual product lines and projects. A well-managed
company exercises rigorous control over the returns achieved by each of its profit centers and it
rewards the managers on the basis of such results. Specifically, when evaluating new
investments in assets or projects, management will compute the estimated returns it expects to
achieve and use these estimates as a basis its decisions to invest or not.
6. [8–2]. Why is return on invested capital one of the most relevant measures of company
performance? How do we use this measure in our analysis of financial statements?
ANSWER:
Profit generation is the first and foremost purpose of a company. The effectiveness of operating
performance determines the ability of the company to survive financially to attract suppliers of
funds, and to rewards them adequately. Return on invested capital is the prime measure of
company performance. The analyst uses it as an indicator of managerial effectiveness, and/or a
measure of the company’s ability to earn a satisfactory return on investment.
7. [8–3]. Why is interest expense ignored when computing return on net operating
assets (RNOA)?
ANSWER:
If the investment base is defined as comprising net operating assets, then net operating
profit (e.g. before interest) after tax (NOPAT) is the relevant income figure to use. The
exclusion of interest from income deductions is due to its being regarded as a payment
for the use of money from the supplier of debt capital. NOPAT is the appropriate amount
to measure against net operating assets.
8. 8–8. Company X’s NOPAT margin is 2% of sales. Company Y has a net operating asset
turnover of 12. Both companies’ RNOA are 6% and are considered unsatisfactory by
industry norms. What is the net operating asset turnover of Company X? What is the
NOPAT margin for Company Y? What strategic actions do you recommend to the
managements of the respective companies?
ANSWER:
Company X’s NOPAT margin= 2%
RNOA= 6%
Net operating assets turnover of Company X=?
RNOA= Margin x Turnover
Or, 6%= 2% x Turnover
Or, Turnover= 6%/2%= 3
Now
NOPAT margin for Company Y= 6%/12= 0.5%
Since both companies are from same industry, it is clear that Company X must concentrate on
improving its asset turnover. On the other hand, Company Y must concentrate on improving its
profit margin. More specific strategies depend on the product and industry.
9. 8–9. What is the purpose of measuring asset turnover for different asset categories?
ANSWER:
The sales to total assets (asset turnover) component of the return on invested capital measure
reflects the overall rate of asset utilization or it shows the effectiveness of management in
utilizing its total assets. It does not reflect the rate of utilization of individual asset categories that
enter into the overall asset turnover. To better evaluate the reasons for the level of asset turnover
or the reasons for changes in that level, it is helpful to compute the rate of individual asset
turnovers that make up the overall turnover rate.
MATHS
EXERCISE 8-1:
FIT Corporation’s return on net operating assets (RNOA) is 10% and its tax rate is 40%. Its net
operating assets ($4 million) are financed entirely by common shareholders’ equity. Management
is considering its options to finance an expansion costing $2 million. It expects return on net
operating assets to remain unchanged. There are two alternatives to finance the expansion:
1. Issue $1 million bonds with 12% coupon, and $1 million common stock.
2. Issue $2 million bonds with 12% coupon.
Required:
a. Determine net operating income after tax (NOPAT) and net income for each alternative.
b. Compute return on common shareholders’ equity for each alternative (use ending equity).
c. Calculate the assets-to-equity ratio for each alternative.
d. Compute return on net operating assets and explain how the level of leverage interacts with it
in helping determine which alternative management should pursue.
SOLUTION:
RNOA= 10%
Tax rate= 40%
NOA= $4 million
Expansion cost= $2 million
Req-(1):
Net operating income after tax (NOPAT)= ?
RNOA=
1st Alternative:
Or, 10%= NOPAT/60,00,000
Or, NOPAT= 60,00,000 x 10%= $6,00,000
NOPAT= $6,00,000
2nd Alternative
10%= NOPAT/60,00,000
Or, NOPAT= 60,000,000 X 10%= $6,00,000
NOPAT= $6,00,000
Net Income:
Net income= NOPAT - Interest expense (1- Tax rate)
1st Alternative:
Net income= 6,00,000- 10,00,000 x12% (1-40%)= 6,00,000- 72,000= $5,28,000
2nd Alternative
Net income= 6,00,000 – 20,00,000 x 12%x (1-40%)= $4,56,000
Req-(2): Return on common equity (ROCE):
ROCE=
1st Alternative:
ROCE=
2nd Alternative
ROCE=
Req-(3):
Assets-to-equity=
1st Alternative
Assets-to-equity =

2nd Alternative
Assets-to-equity =
Req-(4):
RNOA=
1st Alternative
RNOA=
2nd Alternative
RNOA=
Notice that the interest rate is 12% on the debt (bonds). The after-tax interest rate is 7.2% = 12%
x (1-40%), which is less than RNOA. Hence, the company earns more on its assets than it pays
for debt on after-tax basis. That is, it can successfully trade on the equity- use bondholders’ funds
to earn additional profit. Since, the second alternative uses more debt, as reflected in the assets-
to-equity ratio in requirement (c), the second alternative is probably preferred. The shareholders
would take on additional risk with the second alternative, but the expected returns are greater as
evidenced from computation in requirement-(b).

EXERCISE-8-2
Roll Corporation’s return on net operating assets (RNOA) is 10% and its tax rate is 40%. Its net
operating assets ($10 million) are financed entirely by common shareholders’ equity.
Management
is considering using bonds to finance an expansion costing $6 million. It expects return on net
operating assets to remain unchanged. There are two alternatives to finance the expansion:
1. Issue $2 million bonds with 5% coupon and $4 million common stock.
2. Issue $6 million bonds with 6% coupon.
Required:
(a) Compute Roll’s current net operating income after tax (NOPAT) and net income.
(b) Determine net income and net operating income after tax for each alternative financing
plan.
(c) Compute return on common shareholders’ equity for each alternative (use ending equity).
(d) Explain any difference in the ROCE for the alternative plans computed in (c). Include a
discussion of leverage in your response.
SOLUTION:
Req-(a):
Current net operating income after tax (NOPAT)= NOA x RNOA= 1,00,00,000 X 10%=
$10,00,000
Net Income= NOPAT – Interest (1-Tax rate)= 10,00,000- 0= $10,00,000
Req-(b):
1st alternative
NOPAT= 1,60,00,000 X 10%= $ 16,00,000
Net income= 16,00,000 – 20,00,000 x 5% [1-40%]= 15,40,000
2nd alternative
NOPAT= 1,60,00,000 X 10%= $ 16,00,000
Net income= 16,00,000 – 60,00,000 x 6% [1-40%]= 13,84,000
Req-(c): Return on common equity (ROCE):
ROCE=
1st Alternative:
ROCE=
2nd Alternative
ROCE=
Req-(d):
ROCE is higher under the second alternative due to successful use of leverage- that is,
successfully trading on the equity. We see from the assets-to-equity ratio for second alternative is
higher as shown below-
Assets-to-equity (1st Alternative)=
Assets-to-equity (2nd Alternative)=
The company should pursue the second alternative in the interest of shareholders (assuming
projected returns are consistent with current performance level.)
EXERCISE 8-3
Selected financial information from Syntex Corporation is reproduced below:
1. NOA turnover (average NOA equals ending NOA) is 2.
2. NOPAT margin equals 5%.
3. Leverage ratio (average NFO/average common equity) is 1.786, and the spread is 4.4%.
Required:
a. Compute return on net operating assets (RNOA).
b. Compute return on common equity using its three major components.
c. Analyze the disaggregation of return on common equity. What is the ―leverage advantage (in
percent return) accruing to common equity‖?
SOLUTION:
Req-(a):
Return on net operating assets (RNOA)= NOPAT margin x NOA turnover= 5% x 2= 10%
Req-(b):
Return on common equity (ROCE)= RNOA + Leverage x Spread= 10% + 1.786 x 4.4%=
17.86%
Req-(c):
Return on net operating assets 10%
Leverage advantage 7.86%
Return on common equity 17.86%
Due to leverage, return on common equity is 17.86% where 7.86% represents the leverage
advantage.
EXERCISE 8-5
Selected financial information for ADAM Corporation is reproduced below:
1. NOA turnover (average NOA equals ending NOA) is 3.
2. NOPAT margin is 7%.
3. Leverage ratio (average NFO to average common equity) is 1.667, and the spread is 8.4%.
Required:
a. Compute return on net operating assets (RNOA).
b. Compute return on common equity using its three major components.
c. Prepare an analysis of the composition of return on common equity describing the advantage
or disadvantage accruing to common shareholders’ equity from use of leverage.
SOLUTION:
Req-(a):
Return on net operating assets (RNOA)
RNOA= NOPAT margin x NOA turnover= 7% x 3= 21%
Req-(b): Return on common equity (ROCE)
ROCE= RNOA+ Leverage ratio x Spread= 21% + 1.667 x 8.4%= 35%
Req-(c):
RNOA 21%
Advantage of leverage 14%
ROCE 35%
Due to use of debt (leverage) net advantage to common equity holders is 14%.
EXERCISE 8-6:

SOLUTION:
We can justify whether the leverage benefits Rose’s shareholders or not by using ROCE with
and without leverage.
At the present level, there is an amount debt in the balance sheet.
ROCE with leverage=
ROCE without leverage:
In the absence of leverage, the non-current liabilities would be substituted with equity.
Accordingly, there would be no interest expense with all equity financing. Consequently, in this
case, net income would be as follows:
Net income with leverage 1,57,500
Add: Interest saved [6,75,000 x 8%] 54,000
Less: Tax effect of interest expense [54,000 x (27,000)
50%]
Net income without leverage 1,84,500

ROCE without leverage=

This means that leverage is beneficial to Rose’s shareholders since ROCE is 14% with leverage
but only 10.25% without leverage.
Req-(b):
NOPAT= Net income + Interest (1- Tax rate)= 1,57,500 + 6,75,000 x 8% x (1-50%)= 1,84,500
RNOA=
Req-(c):
The company is utilizing borrowed funds in its capital structure. Since ROCE is greater than
RNOA, the use of financial leverage is beneficial to stockholders. Specifically, the after cost of
debt is 4%= 8% (1-50%) and the financial leverage (NFO/Equity) is 6,75,000/11,25,000= 60%.
Therefore, ROCE= RNOA + LEV X SPREAD= 10.25% + 0.60 x (10.25%-4%)= 14%, as before.
The favorable effect of financial leverage is given by the term [0.60 x (10.25%-4%)]= 3.75%
which is equal to 14% -10.25%= 3.75%.
EXERCISE 8–7
1. Which of the following situations best correspond with a ratio of ―sales to average net tangible
assets‖ exceeding the industry norm? (Choose one answer.)
a. A company expanding plant and equipment during the past three years.
b. A company inefficiently using its assets.
c. A company with a large proportion of aged plant and equipment.
d. A company using straight-line depreciation.
2. A measure of asset utilization (turnover) is (choose one answer):
a. Sales divided by average long-term operating assets.
b. Return on net operating assets.
c. Return on common equity.
d. NOPAT divided by sales.
3. Return on net operating assets depends on the (choose one answer):
a. Interest rates and pretax profits.
b. Debt-to-equity ratio.
c. After-tax operating profit margin and NOA turnover.
d. Sales and total assets.

EXERCISE 8-10
A machine that produces hockey pucks costs $20,500 and produces 10 pucks per hour. Two
similar
companies purchase the machine and begin producing and selling pucks. The first company,
Northern Sales, is located in International Falls, Minnesota. The second company, Southern
Sales,
is located in Huntsville, Alabama. Northern Sales operates the machine 20 hours per day to meet
customer demand. Southern Sales operates the machine 10 hours per day to meet customer
demand. Sales data for the first month of operations are given below:
Northern Southern
Property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . $20,500 $20,500
Accumulated depreciation—Property, plant, and equipment . . $500 $500
Pucks sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 pucks 3,000 pucks
Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000 $6,000
Required:
Calculate the property, plant, and equipment turnover ratio (sales divided by average PPE) for
both Northern Sales and Southern Sales. Explain how this ratio impacts the return on net
operating assets of each company (assume the profit margin for each company is the same and
that there has been no change in PPE).
SOLUTION:
Property, plant and equipment turnover (PPE turnover) =

PPE turnover (Northern)=

PPE turnover (Southern)=
This implies that Northern generates $0.60 in sales per year for each $1 investment in PPE. In
contrast, Southern generates $0.30 in sales per year for each $1 investment in PPE. This shows
that Northern is able to generate twice the return for each $1 invested in PPE. Assuming equal
profit margin, Northern will report higher return on net operating assets because of the volume of
sales that the company is able to generate with its investment in PPE. As because, we can find
the return on net operating assets by multiplying asset turnover with profit margin, hence having
same profit margin, the company having higher asset turnover will produce more return on net
operating assets.

PROBLEM 8-3:
Req-(a):
Return on common equity (ROCE)
ROCE=

Req-(b):
Return on net operating assets (RNOA)=
NOPAT = Net income + Interest (1-Tax rate)= 1,650 + 10 (1-0.35)= 1,650+6.5= 1,656.5
Net operating assets = Operating assets – Operating liabilities= 7,250- 3,290= $3,960
RNOA=
The effect of financial leverage, thus, is only 42.7%-41.83%= 0.87%. this is because NFO to
NFE is insignificant. Most of the Merck’s ROCE in this year is derived from operating results.
Pre-tax income to sales= 0.36= 36%
Net income to sales= 23%
Sales /current assets= 1.47
Sales / fixed assets= 2.97
Sales /total assets= 0.98
Total liabilities/equity= 0.88
Long-term liabilities/ equity= 0.03
PROBLEM 8-5:
Return on common equity (ROCE)
Return on common equity (ROCE)
ROCE=
ROCE (year 5)= 14/125= 11.2%
ROCE (year 9)= 34/220= 15.5%

Return on net operating assets (RNOA)

RNOA=
RNOA (year 5)=
RNOA (year 9)=
ROCE= RNOA + LEV x Spread
Year 5: 10% + 1.2%= 11.2%
Year 9: 15.5% +0 = 15.5%
Req-(b):
Texas Telecom’s ROCE has increased from year 5 to year 9. The source in this increase,
however, has been an increase in RNOA as the leverage effect is zero in year 9 since its long-
term debt has been retired. Given the RNOA increase, additional leverage might be explored as a
way to increase shareholders’ returns.
CHAPTER 10: CREDIT ANALYSIS
THEORY:
1. Liquidity and working capital
2. Consequences of severe illiquidity
3. Ratios to measure liquidity
4. Solvency and capital structure and ratios to measure solvency
5. Capital structure ratios
6.
MATHS:
EXERCISE 10-1
Current ratio Quick ratio Working capital
1 No change No change No change
2 No change No change No change
3 Increase Increase Increase
4 Decrease No change Decrease
5 Decrease Decrease Decrease
6 Decrease Decrease Decrease
7 Increase Increase No change
8 Decrease Decrease No change
9 Increase Increase Increase
10 No change Decrease No change
EXERCISE 10-2:
(a) Accounts (b) Days’ Inventory Explanation
receivable sales in turnover
turnover receivables
1. NE NE D Cost of goods sold increases by 500,
average inventory increases 250, ratio ©
decreases.
2. I D NE Denominator will increase by half
amount of the numerator causing the (a)
ratio to increase. Denominator of ratio
(b) will increase causing the ratio to
decrease. There is no effect on the
components of ratio (c).
3. I D NE The numerator in ratio (a) would not
 change and the denominator will
decrease thus increasing the ratio.
Because ratio (a) will increase, ratio (b)
will decrease as the average accounts
receivable turnover increases. Ratio (c) is
unaffected.
4. I D NE Ratio (a) will increase due to the
decrease in the denominator. Ratio (b)
will decrease due to the increase in the
denominator, which is due to the increase
in ratio (a). ratio (c) is unaffected
5. NE NE I Only ratio (c) is affected. The numerator
increases while the denominator
decreases. Neither ratio (a) nor (b) are
affected.
6. NE NE I Average inventory will decrease by 50%
of the decrease in the numerator in ratio
(c) due to the averaging effect, thus
increasing the ratio.

EXERCISE 10-3:
(a) Accounts (b) Days’ Inventory Explanation
receivable sales in turnover
turnover [equals receivables [equals 4.0
4.0 prior to the prior to the
event] event]
1. NE NE NE Since we use the net accounts
receivables in computation of
ratio, there is no effect.
2. NE NE D Neither ratio (a) nor (b) is affected.
cost of goods sold increases by
and average inventory will
increase by $500 (due to the
averaging effect), thus decreasing
ratio (c).
3. NE NE I Only ratio (c) is affected. The
numerator increases while the
denominator decreases.
4. NE NE I Neither ratio (a) nor (b) is affected.
Average inventory will decrease
by $1,500 (half of $3,000),
increasing ratio (c).
5. NE NE I Neither ratio (a) nor (b) is affected.
average inventory will decrease by
of the decrease in the numerator.
6. I D NE Denominator of ratio (a) decreases
 by half the amount the numerator
decreases, causing ratio (a) to
increase. Denominator of ratio (b)
will increase, causing it to
decrease. There is no effect on
ratio (c).
EXERCISE 10-4:
The management of a corporation wishes to improve the appearance of its current
financial
position as reflected in the current and quick ratios.
Required:
a. Describe four ways in which management can window-dress the financial statements
to accomplish this objective.
b. For each technique you identify in (a), describe the procedures, if any, you can use in
your analysis to detect the window-dressing.
SOLUTION:
Req-(a) Methods to window dress financial statements to improve the current and quick
ratios:

(i) Pay off accounts payable with cash. This would have the effect of reducing
both current assets and current liabilities by the same amount thus increasing
the current ratio and quick ratio.
(ii) Invest additional capital funds at year-end. This would increase cash without
affecting current liabilities. [See note]
(iii) Sell fixed assets for cash or short-term notes. This would increase current
assets, but decrease only fixed assets. Thus, the current and quick ratios would
improve. [See note]
(iv) Borrow cash by incurring long-term liabilities (notes or bonds). This would
increase cash, but would not affect current liabilities, since the purpose is to
make them long-term liabilities. [See note]
(v) Defer incurring various expenses, such as advertising, research and
development, and marketing, along with reducing capital expenditures. [See
note]
(vi) Keep the cash receipts books open longer, in an effort to show higher
receivables or collections. This method is a highly irregular and manipulative
device. These procedures are normal business transactions that cannot usually
be considered manipulative device.

NOTE: These procedures are normal business transactions that cannot usually be
considered manipulative in character. They may become manipulative when they
have no sound business justification and are undertaken solely to influence the
measures used by outside analysts.
 Req-(b): The analyst could, if all underlying evidence and documents were available,
detect each of these methods. However, sufficient evidence, such as invoices and the
books of original entry, will most likely not be available for inspection. Moreover,
these methods may not be recognizable through the usual analysis of financial
statements of the company. If sufficient evidence were available, the following are
techniques that may be used to detect the methods described in req-(a)

(i) The analyst could determine the company's usual payment policies, and
compare them with those employed at year-end. S/he could look at the terms of
the liabilities, to see if they were paid at the most beneficial time-in other
words, if any economic benefit was derived by paying them earlier than due or
when normally paid. S/he could inspect the payments in the first month of the
following year, to see If liabilities were paid disproportionately to year-end,
taking into account due dates and normal requirements. An unusually low
inventory at year-end might also indicate failure to purchase merchandise at
year-end in an effort to improve the quick ratio.
(ii) The analyst could analyze the timing of investments and the use to which they
were put. If s/he sees large capital infusions at year-end, and that these
investments were represented by idle cash, or by marketable securities which
are not related to operations, and where there is little probability of such funds
being required for operations in the near future, the reason might be window
dressing.
(iii) Contracts and invoices might be examined to see when they were entered into
and when they were recorded.
(iv) The procedures for investigation of excessive borrowing at year-end are the
same as those for excessive investments of equity funds (ii. above) Also, the
contracts should be studied to determine if they are bonafide loans.
(v) The purchase journal and cash disbursements journal should be examined to
compare expenses incurred toward the end of the year with expenses at the
beginning of the following year, and the reasons for large differences.
(vi) To determine if the books are being kept open too long, the analyst would
study such documents as the underlying invoices and canceled checks to
determine their actual dates, and to compare this with the dates recorded. S/he
might also confirm material accounts with customers as of the year-end.

EXERCISE 10-5:
Transactions Total debt to Long-term debt to Earnings to fixed Cash flow to fixed
equity equity charges (exceeds 1.0 charges (exceeds 1.0
before transactions before transaction and
and events) events)
1. Increase in tax NE NE I/I= D I/I= D
rate
2. Retire bonds— D/NE= D D/NE=D D/D=I D/D=I
paid in cash.
3. Issue bonds to I/NE=I I/NE=I I/I=D I/I=D
 finance expansion
4. Issue preferred NE/I=D NE/I=D I/I=D I/I=D
stock to finance
expansion
5. Depreciation NE NE D/NE=D NE
expense increases
6. Collect accounts NE NE NE I/NE=I
receivable
7. Refinance debt NE NE I/I=D I/I=D
resulting in higher
interest cost
8. Capitalize higher NE NE D/D=I D/D=I
proportion of
interest expense
9. Convert D/I=D D/I=D NE NE
convertible debt
into common
stock
10. Acquire inventory I/NE=I NE NE NE
on credit

PROBLEM 10-1
Refer to the financial statements of Campbell Soup
Company in Appendix A.
Required:
a. Compute the following liquidity measures for Year 10:
(1) Current ratio.
(2) Acid-test ratio.
(3) Accounts receivable turnover (accounts receivable balance at end of Year 9 is
$564.1).
(4) Inventory turnover (inventory balance at end of Year 9 is $816.0).
(5) Days’ sales in receivables.
(6) Days’ sales in inventory.
(7) Conversion period (operating cycle).
(8) Cash and cash equivalents to current assets.
(9) Cash and cash equivalents to current liabilities.
(10) Days’ purchases in accounts payable.
(11) Net trade cycle.
(12) Cash flow ratio.
b. Assess Campbell’s liquidity position using results from (a).
c. For Year 10, compute ratios 1, 4, 5, 6, and 7 using inventories valued on a FIFO basis
(FIFO inventory at the end
of Year 9 is $904).
d. What are the limitations of the current ratio as a measure of liquidity?
e. How can analysis and use of other related measures (other than the current ratio)
enhance the evaluation of liquidity?
SOLUTION:
Req-(a) Short-term liquidity ratios for Campbell Soup:
(1) Current ratio= Current assets /Current liabilities= [36]/[45]= 1,665.5/1,298.1= 1.2
(2) Acid-test ratio= [31]+[32]+[33]/[45]= (80.7+22.5+624.5)/(1298.1)= 0.56
(3) Accounts receivable turnover = 6,205.8/[624.5+564.1]/2= 10.44
(4) Inventory Turnover=

PROBLEM 10-3:
What if analysis of proposed credit policy change-
RAM Corporation
Cash Forecast before policy changes
For the year ended December 31, Year 2
Particulars Amount Amount
Cash, January 1, Year 2 80,000
Cash collections:
Accounts receivables, Jan 1 1,50,000
Sales [8,00,000 x 110%] 8,80,000
Less: Accounts receivables, December 31 1,65,000
[1,50,000 x 110%]
Cash collection from sales 8,65,000
Total cash available 9,45,000
Less: Cash disbursements:
Accounts payable, Jan 1 1,30,000
Purchases [Note-2]

CHAPTER-10: FORECASTING FINANCIAL STATEMENT

THEORY
1. Financial statement forecasting.
2. Use/importance of financial statement forecasting.
3. General forecasting principles.
4. Seven-step forecasting game plan.