MANAGEMENT ACCOUNTING - Solutions Manual

CHAPTER 4

FINANCIAL STATEMENTS ANALYSIS - I

I. Questions

1. The objective of financial statements analysis is to determine the extent of

a firm’s success in attaining its financial goals, namely:
a. To earn maximum profit
b. To maintain solvency
c. To attain stability

2. Some of the indications of satisfactory short-term solvency or working

capital position of a business firm are:
1. Favorable credit position
2. Satisfactory proportion of cash to the requirements of the current
volume
3. Ability to pay current debts in the regular course of business
4. Ability to extend more credit to customers
5. Ability to replenish inventory promptly

3. These tests are:

1. Improvement in the financial position
2. Well-balanced financial structure between borrowed funds and
equity
3. Effective employment of borrowed funds and equity
4. Ability to declare satisfactory amount of dividends to
shareholders
5. Ability to withstand adverse business conditions
6. Ability to engage in research and development in an attempt to
provide new products or improve old products, methods or
processes

4. Some indicators of managerial efficiency are:

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1. Ability to earn a reasonable return on its investment of borrowed

funds and equity
2. Ability to control operating costs within reasonable limits
3. No overinvestment in fixed assets, receivables and inventories

5. The techniques used in Financial Statement Analysis are:

I. Vertical analysis which shows the relationships of the items in the
same year: also referred to as “static measure.”
a. Financial ratios
b. Common-size statements

II. Horizontal analysis which shows the changes or tendencies of an

item for 2 or more years; also referred to as “dynamic measure.”
a. Comparative statements - showing changes in absolute
amount and percentages
b. Trend percentages

III. Use of special reports or statements

a. Statements of Changes in Financial Position
b. Gross Profit / Net Income Variation Analysis

6. Refer to page 133 of the textbook.

7. Horizontal analysis involves the comparison of items on financial

statements between years. Analysis of comparative financial statements
or the increase/decrease method of analysis and trend percentages are the
two techniques that may be applied under horizontal analysis.

Vertical analysis involves the study of items on a single statement for a

single year, such as the analysis of an income statement for some given
year. Common-size statement and financial ratios are techniques used in
vertical analysis.

8. Trends can indicate whether a situation is improving, remaining the same

or deteriorating. They can also give insight to the probable future course
of events in a firm.

9. Trend percentages represent the expression of several years’ financial data

in percentage form in terms of a base year.

10. Refer to page 133 of the textbook.

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11. Observation of trends is useful primarily in determining whether a

situation is improving, worsening, or remaining constant. By comparing
current data with similar data of prior periods we gain insight into the
direction in which future results are likely to move.

Some other standards of comparison include comparison with other

similar companies, comparison with industry standards, and comparison
with previous years’ information. By comparing analytical data for one
company with some independent yardstick, the analyst hopes to determine
how the position of the company in question compares with some standard
of performance.

12. Trend percentages are used to show the increase or decrease in a financial
statement amount over a period of years by comparing the amount in each
year with the base-year amount. A component percentage is the
percentage relationship between some financial amount and a total of
which it is a part.

Measuring the change in sales over a period of several years would call
for use of trend percentages. The sales in the base year are assigned a
weight of 100%. The percentage for each later year is computed by
dividing that year’s sales by the sales in the base year.

13. Expenses (including the cost of goods sold) have been increasing at an
even faster rate than net sales. Thus Premiere is apparently having
difficulty in effectively controlling its expenses.

14. A corporate net income of P1 million would be unreasonably low for a

large corporation, with, say, P100 million in sales, P50 million in assets,
and P40 million in equity. A return of only P1 million for a company of
this size would suggest that the owners could do much better by investing
in insured bank savings accounts or in government bonds which would be
virtually risk-free and would pay a higher return.

On the other hand, a profit of P1 million would be unreasonably high for a

corporation which had sales of only P5 million, assets of, say, P3 million,
and equity of perhaps one-half million pesos. In other words, the net
income of a corporation must be judged in relation to the scale of
operations and the amount invested.

II. True or False

1. True 3. True 5. False 7. True 9. True

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2. False 4. True 6. False 8. False 10. True

III. Problems

Problem 1 (Percentage Changes)

a. Accounts receivable decreased 16% (P24,000 decrease  P150,000 =

16% decrease).
b. Marketable securities decreased 100% (P250,000 decrease  P250,000 =
100% decrease).
c. A percentage change cannot be calculated because retained earnings
showed a negative amount (a deficit) in the base year and a positive
amount in the following year.
d. A percentage change cannot be calculated because of the zero amount of
notes receivable in 2005, the base year.
e. Notes payable increased 7 ½% (P60,000 increase  P800,000 = 7 ½%
increase).
f. Cash increased 3% (P2,400 increase  P80,000 = 3% increase).
g. Sales increased 10% (P90,000 increase  P900,000 = 10% increase).

Problem 2 (Computing and Interpreting Rates of Change)

Requirement (a)
Computation of percentage changes:
1. Net sales increased 10% (P200,000 increase  P2,000,000 = 10%
increase).
2. Total expenses increased 11% (P198,000 increase  P1,800,000 = 11%
increase).

Requirement (b)
1. Total expenses grew faster than net sales. Net income cannot also have
grown faster than net sales, or the sum of the parts would exceed the size
of the whole.
2. Net income must represent a smaller percentage of net sales in 2006 than
it did in 2005. Again, the reason is that the expenses have grown at a
faster rate than net sales. Thus, total expenses represent a larger
percentage of total sales in 2006 than in 2005, and net income must
represent a smaller percentage.

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Problem 3 (Financial Statement Analysis using Comparative Statements

or Increase-Decrease Method)

Requirement 1

XYZ Corporation
Balance Sheet
As of December 31
Change
Peso %
2005 2006
Assets
Cash and equivalents 14,000 16,000 2,000 14.29%
Receivables 28,800 55,600 26,800 93.06%
Inventories 54,000 85,600 31,600 58.52%
Prepayments and others 4,800 7,400 2,600 54.17%
Total current assets 101,600 164,600 63,000 62.01%
Property, plant & equipment - net
of dep. 30,200 73,400 43,200 143.05%
Total assets 131,800 238,000 106,200 80.58%

Liabilities and Equity

Notes payable to banks 10,000 54,000 44,000 440.00%
Accounts payable 31,600 55,400 23,800 73.32%
Accrued liabilities 4,200 6,800 2,600 61.90%
Income taxes payable 5,800 7,000 1,200 20.69%
Total current liabilities 51,600 123,200 71,600 138.76%
Share capital 44,600 44,600 0 0.00%
Retained earnings 35,600 70,200 34,600 97.19%
Total equity 80,200 114,800 34,600 43.14%
Total liabilities and equity 131,800 238,000 106,200 80.58%

XYZ Corporation
Income Statement
Years ended December 31
(P thousands)
Change
Peso %
2005 2006
Net sales 266,400 424,000 157,600 59.16%
Cost of goods sold 191,400 314,600 123,200 64.37%
Gross profit 75,000 109,400 34,400 45.87%
Selling, general and administrative
expenses 35,500 58,400 22,900 64.51%
Income before income taxes 39,500 51,000 11,500 29.11%
Income taxes 12,300 16,400 4,100 33.33%

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Net income 27,200 34,600 7,400 27.21%

Requirement 2

Short-term financial position

1. Current Current
increased by 62.01% while increased by 138.76%
Assets Liabilities
 Unfavorable
2. Quick Current
increased by 62.40% while increased by 138.76%
Assets Liabilities
 Unfavorable
3. Net Accounts
increased by 59.16% while increased by 93.06%
Sales Receivable
 Unfavorable
4. Cost of Inventories
increased by 64.37% while increased by 58.52%
Goods Sold
 Favorable
Leverage
5. Total Total
increased by 80.58% while increased by 138.76%
Assets Liabilities
 Unfavorable
6. Total Total
increased by 138.76% while increased by 43.14%
Liabilities Equity
 Unfavorable
Profitability
7. Net Cost of
increased by 59.16% while increased by 64.37%
Sales Goods Sold
 Unfavorable

8. Net Selling,
Sales increased by 59.16% while General & increased by 64.51%
Administrative
Expenses
 Unfavorable
9. Net Net
increased by 59.16% while increased by 27.21%
Sales Income
 Unfavorable
10. Net Total
increased by 27.21% while increased by 80.58%
Income Assets
 Unfavorable

Problem 4 (Trend Percentages)

Requirement (1)

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The trend percentages are:

Year 5 Year 4 Year 3 Year 2 Year 1
Sales 125.0 120.0 110.0 105.0 100.0

Cash 80.0 90.0 105.0 110.0 100.0

Accounts receivable 140.0 124.0 108.0 104.0 100.0
Inventory 112.0 110.0 102.0 108.0 100.0
Total current assets 118.8 113.1 104.1 106.9 100.0

Current liabilities 130.0 106.0 108.0 110.0 100.0

Requirement (2)
Sales: The sales are increasing at a steady rate, with a particularly
strong gain in Year 4.

Assets: Cash declined from Year 3 through Year 5. This may have been
due to the growth in both inventories and accounts receivable.
In particular, the accounts receivable grew far faster than sales
in Year 5. The decline in cash may reflect delays in collecting
receivables. This is a matter for management to investigate
further.

Liabilities: The current liabilities jumped up in Year 5. This was probably

due to the buildup in accounts receivable in that the company
doesn’t have the cash needed to pay bills as they come due.

Problem 5 (Use of Trend Percentages)

a. 1. An unfavorable tendency could be observed in Receivables in relation

to Net Sales from 2003 – 2005 because receivables had been
increasing at a much faster rate than Net Sales. This could indicate
inefficiency in the collection of receivables or simply poor company
credit policy. The situation however, improved in 2006 and 2007
when sales started to move up at a faster rate than accounts
receivable. This would indicate improvement in the credit and
collection policy or more cash sales were being generated.
2. Unfavorable tendency in inventory persisted from 2003 to 2007
because it had been going up at a much faster rate than Net Sales. If

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this continues, the company will end up with over-investment in

inventory because the buying rate is faster than the selling price.
3. Favorable tendencies could be noted in Fixed Assets in relation to Net
Sales because inspite of the minimal additions to fixed assets made by
the company from 2003 through 2007, sales had been increasing at a
very encouraging rate.
4. Net Income had likewise been increasing at a much faster rate than
net sales. This is favorable because this would indicate that the
company had been successfully controlling the increases in Cost of
Sales and Operating Expenses.
b. Review computations of the Trend Percentages. It will be noted that the
Trend Percentages in Total Noncurrent Liabilities and Equity from 2005
to 2007 were interchanged. Correction should be made first before
interpretation is done.
1. The upward tendency in current assets had been accompanied by an
upward trend in current liabilities. It could be noted that current
assets had been moving up at a much faster rate than current
liabilities. This is favorable because the margin of safety of the short-
term creditors is widened.
2. Favorable tendencies could also be observed in noncurrent assets
which had been increasing and which increases had been accompanied
by downward trend in noncurrent liabilities. This would mean better
security on the part of creditors and stronger financial position.
3. There is an unfavorable tendency in Net Sales in relation to non-
current assets. Sales had not been increasing at the same rate as the
increases in fixed assets. This could indicate that more investments
are made in noncurrent assets without considering whether or not they
could sell the additional units of product they are producing.
c. The unfavorable trend in net income could be attributed to the following
tendencies:
1. Higher rates of increases in cost of sales as compared to sales.
2. Higher rates of increases in selling, general and administrative
expenses in relation to net sales.
3. Higher rates of increases in other financial expenses than the rates of
increases in net sales.

IV. Multiple Choice Questions

1. D 11. A, C, D

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2. A 12. B*
3. A 13. D
4. B
5. D
6. C
7. C
8. A
9. D
10. C

* (P400,000 – P160,000)  P160,000 = 150%

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