CHAPTER 12 – FINANCIAL STATEMENT ANALYSIS PROBLEM SOLUTIONS
Assessing Your Recall
12.1
A retrospective analysis is one in which historical data are used to analyze the
performance and liquidity of a company. A prospective analysis is one in which data are
used to forecast the future (performance and liquidity) of a company.
12.2
A time-series analysis is one in which financial statement data for a single
company is analyzed across time. A cross-sectional analysis is one in which financial
statement data from several companies are compared. The companies may be from the
same industry or they may be from various sectors of the economy. Another version of
the cross-sectional analysis would be to compare the company with industry average
statistics. The cross-sectional analysis could also be conducted over time for a
combined time-series, cross-sectional analysis. So time-series analyses are useful to
study the trends of a company over time while cross-sectional analyses are used to
compare one company to others.
12.3
The three major types of data that can be used in a time-series or a cross-sectional
analysis are:
Raw Data – The raw financial statement data can be used, such as sales revenues,
expenses, etc.
Common Size Data – common size data are obtained by comparing the raw data
components to some common denominator. For instance, a common size income
statement could be calculated by comparing each line item with the sales revenue for the
period. On the balance sheet the common denominator is usually the total assets.
Ratio Data. – Ratios that compare various components of the raw financial statement
data can be used as the inputs for these types of analyses.
12.4
The formula for each ratio is as follows:
a) ROA
ROA
=
Net Income + Interest Expense * (1 – Tax Rate)
Average Total Assets
=
Net Income + Interest Expense * (1 – Tax Rate)
Sales Revenue
x
=
Sales Revenue
Average Total Assets
Profit Margin Ratio x Total Asset Turnover
1
b) ROE
ROE =
Net Income – Preferred Dividends
Average Shareholders’ Equity
c) Accounts Receivable Turnover
Accounts Receivable
Turnover
=
Sales On Account
Average Accounts Receivable
d) Inventory Turnover
Inventory Turnover
=
Cost of Goods Sold
Average Inventory
=
Cost of Goods Sold
Average Accounts Payable
=
Current Assets
Current Liabilities
=
Current Assets – Inventories
Current Liabilities
e) Accounts Payable Turnover
Accounts Payable
Turnover
f) Current Ratio
Current Ratio
g) Quick Ratio
Quick Ratio
2
h) D/E (I)
D/E (I)
i)
=
Total Liabilities
Total Liabilities + Shareholders’ Equity
or
Total Liabilities
Total Assets
=
Total Liabilities
Total Shareholders’ Equity
D/E (II)
D/E(II)
j) D/E (III)
D/E(III)
=
Total Long-term Liabilities
Total Long-term Liabilities and Shareholders’ Equity
k) Times Interest Earned
Times Interest Earned
(TIE)
=
=
12.5
Income before Interest and Taxes
Interest Expense
Net Income + Taxes + Interest Expense
Interest Expense
The amount of cash produced from operations depends upon several factors. Three of
those factors are the accounts receivable, inventory, and accounts payable policies. The
leads and lags between the cash outflows for production and the cash inflows from
collections on sales are important in understanding the company’s cash generating
capabilities. The turnover ratios, when converted into the “number of days” form,
provide some insight into how long these lags are for a company. Changes in these ratios
also provide information about whether there have been significant changes in these
policies or in enforcing these policies. The accounts receivable turnover, for instance,
tells you how long, on average, it takes to collect an account receivable. Comparing this
ratio with a company’s stated receivables policy allows you to assess whether or not they
are doing a good job of collecting.
3
The shareholders of the company leverage their investment when they borrow some of
the money needed to invest in the assets of the company. This works to the advantage of
the shareholders if the cost to borrow the money is less than the return that they can earn
by investing in the assets of the company. It works to their disadvantage if the cost to
borrow exceeds the return on the assets invested. ROA provides a measure of the return
on the assets of the company. As long as this return is higher than the after tax cost of
the debt the shareholders’ return (ROE) should be higher than the ROA. This higher
return will be evidenced by a higher ROE for the company (higher than ROA). If the
after tax, cost of borrowing exceeds the ROA then ROE will be lower than ROA.
12.6
The ROA ratio can be broken down into two ratios: a profit margin ratio and a total
asset turnover ratio. The ratios are as follows:
ROA
= Net Income + Interest Expense * (1 – Tax Rate)
Average Total Assets
= Net Income + Interest Expense * (1 – Tax Rate)
Sales Revenue
x
=
Sales Revenue
Average Total Assets
Profit Margin Ratio x Total Asset Turnover
A retail clothing store could employ two different strategies of obtaining a particular
ROA. One strategy would be to set prices to achieve a relatively high profit margin.
Because of the high prices the total asset turnover might not be as high as it would
otherwise be because the company may have to invest more in its stores to attract the
kind of clientele that will pay the high prices. The volume of sales per dollar of
investment (total asset turnover) may, therefore, be lower. Another store in the same
industry may adopt a different strategy in which it charges lower prices (lower profit
margin ratio) but make up for it by not investing as much in its stores and, hopefully,
makes up for the lower profit margin with a higher volume per dollar of investment.
12.7
The advantage of common size statements are that they make it easy to make
proportionate comparisons that are not as easy using the raw data. For instance, in a
given year both the revenues and the cost of goods sold may increase, as evidenced by
the raw data. If, however, the cost of goods sold increases faster than the revenues the
profit margin of the company will decline. This decline could easily be seen in a
common size set of statements.
4
12.8
The current ratio is subject to manipulation because at year-end the company can adjust
its spending and payment patterns to produce a current ratio that is desired. Paying off
accounts payable with cash at year-end will improve the current ratio, for instance, but
may not be a sign of improved liquidity.
12.9
The accounts payable turnover ratio is ideally calculated as follows:
Accounts Payable
Turnover
=
Credit Purchases
Average Accounts Payable
The problem with this calculation is that credit purchases is not a readily available
number. As a surrogate for credit purchases the cost of goods sold number is often used.
How good a surrogate this is depends on the type of company and its credit policies. In a
retail company the cost of goods sold number will be a good surrogate for the credit
purchases if most goods are bought on credit and there is relatively little change in the
balance of accounts payable from the beginning of the period to the end. If not all goods
are purchased on credit this surrogate will tend to overstate the turnover. There is a
further problem with this ratio in a manufacturing company. In this case, the cost of
goods sold number includes many costs other than those associated with purchases
during the period. For example salaries, amortization, etc. Therefore, in a manufacturing
company this ratio tends to be overstated.
12.11
The earnings per share of a company is calculated by dividing the earnings of the
company by the average number of shares that were outstanding during the period. In
some companies there exists the possibility that more shares may be issued (other than
those currently outstanding) due to agreements such as stock option plans and
convertible securities (securities such as convertible debt or convertible preferred shares)
that can, at the option of the holder, be converted into common shares. Because of the
potential to issue more shares the calculated earnings per share based on the actual
number of shares outstanding may not truly reflect the earnings per share of the company
since it may be likely that some investors will exercise their options or convert their debt
or preferred shares into common shares. This will have the effect of diluting earnings
per share. The purpose of basic and fully diluted earnings per share is to give the reader
of the financial statement some idea of the effect that these conversions might have on
the earnings per share number. Basic earnings per share is a reflection of the current
earnings and fully diluted earnings per share is a reflection of the worst case scenario
assuming outstanding issuances or conversions occurred.
5
12.12
The lower the times interest earned ratio, the greater is the credit risk of the
company. This relationship exists because a company that is experiencing difficulties
meeting its interest payments on existing debt has a greater potential to default on an
additional loan. From the perspective of lenders, this greater default risk translates into a
higher assessed credit risk.
Applying Your Knowledge
12.13
a)
Year 1:
Year 2:
Year 3
Year 4
Current Ratio
$1,500 / $1,000 = 1.5
$2,000 / $1,250 = 1.6
$2,500 - $1,485 = 1.7
$3,000 / $1,500 = 2.0
Quick Ratio
($1,500 - $600) / $1,000 = 0.9
($2,000 - $1,100) / $1,250 = 0.7
($2,500 - $1,700) / $1,485 = 0.5
($3,000 - $2,200) / $1,500 = 0.5
b) The current ratio has shown an increasing trend over the four years and
can be considered respectable as seen in year 4. However, this 4 year upward trend has
been at the cost of stocking more inventory and this has resulted in a downward trend in
the quick ratio, which has become 0.5 in Year 4.
12.14
a)
Current Ratio
20x1
$300,991 / $239,789 = 1.3
20x2
$310,739 / $160,345 = 1.9
b)
Quick Ratio
20x1
($62,595 + $96,242) / $239,789
= 0.7
20x2
($67,834 + $98,666) / $160,345 = 1.0
c) Sundry incurred a net loss in 20x2 because the balance in retained earnings
decreased, although no dividends were declared. The amount of the net loss is equal to
the change in retained earnings from the prior year, or $1,461.
d)
Debt / equity
20x1
$532,764 / $866,036 = 62%
20x2
$549,130 / $885,194 = 62%
e) Declaring a dividend is possible because the company has a reasonable cash balance,
and is in a comfortable position regarding short-term liquidity. This can be seen from
the current and quick ratios. The debt to equity ratio is unchanged from the prior year,
and indicates that 62% of the company’s assets are financed through debt. However,
6
because long-term debt increased in 20x2, interest payments can be expected to rise in
the future. In addition, since the company incurred a net loss for the year, declaring a
dividend is not recommended.
12.15 a) Accounts receivable Turnover
Campton Electric:
$3,893,567 / [($542,380 + $628,132) / 2 ] = 6.65
Johnson Electrical:
$1,382,683 / [($168,553 + $143,212) / 2] = 8.87
b) Average number of days required to collect Accounts Receivable:
Campton: 365 / 6.65 = 55 days
Johnson: 365 / 8.87 = 41 days
c) Given that these companies are in the same industry, Johnson would appear to be
more efficient in collecting its accounts receivable.
d) In order to assess management’s handling of the collection of accounts receivable, it
would be helpful to know the credit terms that each company offers to its customers.
This could then be compared against the turnover in days to determine whether the credit
terms are being enforced.
12.16 a) Accounts receivable Turnover
20x0: $3,218,449 / $350,672 = 9.18
20x1: $3,585,391 / [($350,672 + $362,488) / 2] = 10.05
20x2: $3,988,432 / [($362,488 + $358,562) / 2] = 11.06
b) Average number of days required to collect Accounts Receivable:
20x0: 365 / 9.18 = 40 days
20x1: 365 / 10.05 = 36 days
20x2: 365 / 11.06 = 33 days
c) Accounts receivable turnover is increasing each year, and collection seems to be
occurring faster. To help understand these trends, information regarding changes in
credit terms, the sales mix, or the types of customers would be helpful.
7
12.17
a)
Year 1:
Year 2:
Year 3
Year 4:
Year 5:
Inventory Turnover
$463,827 / $65,537 = 7.08
$511,125 / $81,560 = 6.27
$593,350 / $110,338 = 5.38
$679,686 / $166,672 = 4.08
$708,670 / $225,895 = 3.14
Number of days
365 / 7.08 = 52 days
365 / 6.27 = 58 days
365 / 5.38 = 68 days
365 / 4.08 = 89 days
365 / 3.14 = 116 days
b) The inventory Turnover has decreased over the 5 year period suggesting a periodic
increase in the time that the inventory is held. This is not favorable. It is possible that
this change could be due to a change in the type of inventory that is being sold by the
company and, therefore, might not indicate a major problem. Information on such
changes is needed in order to comment on the management of inventories.
12.18 a) Inventory turnover:
Green Grocers:
$8,554,921 / [($582,633 + $547,925) / 2] = 15.13
Fast Lane Foods:
$2,769,335 / [($174,725 + $195,446) / 2] = 14.96
b) Average number of days inventory is held:
Green Grocers: 365 / 15.13 = 24 days
Fast Lane Foods: 365 / 14.96 = 24 days
c) The inventory turnover for a food store should be high because food is perishable,
and must be turned over frequently so that spoilage does not occur. Therefore,
considering that inventory for these companies is held for less than one month, this
appears to be reasonable. Both companies appear to be managing their inventory to more
or less the same degree, although Green Grocers has a slightly higher turnover.
d) Fast inventory turnovers could be an indication that not enough inventory is being
held. Because inventory is held in order to support the sales function, potential sales can
be lost or shortages might result in the loss of current customers if not enough inventory
is maintained.
8
12.19
a) Current liabilities are $664,892, using the current ratio to compute the amount:
Current ratio = Current assets / Current liabilities
Current ratio x Current liabilities = Current assets
Current liabilities = Current assets / Current ratio
Current liabilities = $1,462,763 / 2.20 = $664,892
b) Total debt is $2,073,399, using the debt to equity ratio (I) to compute the amount:
Debt to equity ratio (I) = Total debt / Total assets
Total debt = Debt to equity ratio (I) x Total assets
Total debt = .58 x $3,574,825 = $2,073,399
c) Total equity is, $1,501,426 using total assets minus total liabilities ($3,574,825 $2,073,399).
d) The company has a quick ratio of only 0.89 compared to a current ratio of 2.20. This
indicates that the company has a significant amount of inventory or prepaid assets as a
current asset on its balance sheet. Financial institutions tend to have larger balances in
cash and near cash items, which would tend to result in a higher quick ratio and normally
do not carry large balances of inventory. This would appear to rule out classifying the
company as a financial institution. It also appears that the company is not a service
organization. Service organizations normally do not have large amounts invested in
noncurrent assets. Since only $497,645 of the $1,431,123 increase in total assets is
attributable to an increase in current assets, $933,478 has been added to noncurrent
assets during the year. Because of the increase in noncurrent assets and the large
inventory balance, it appears the company is a merchandising or manufacturing
company.
e) Net income for the year was $247,530 (1,650,200 shares x $0.15 earnings per share).
f) The company’s liquidity is largely dependent upon the nature of the inventory it
holds, and the speed at which this inventory can be sold, and the cash collected. If the
inventory is liquid, then the current ratio of 2.20 indicates that the company is in good
shape for the short-term. If the inventory is not liquid, then the quick ratio of 0.89
suggests that cash might not be present to extinguish the current liabilities as these fall
due. The overall financial position of the company appears to be deteriorating. The
quick ratio and earnings per share have declined. The amount of debt relative to assets
and equity has increased, indicating a larger proportion of debt financing which increases
the riskiness of the company. A more thorough analysis would be necessary to
determine if the company is in serious financial trouble.
g) Significant changes from Year 1 to Year 2 include the discrepancy between the
current and quick ratios, the use of debt to finance total assets, the increase in noncurrent
assets, and the decline in earnings per share. The quick ratio declined although the
current ratio increased. This indicates that the company has increased its investment in
inventory or prepaids, also apparent from the large increase in current assets. The
company’s use of debt has also increased in Year 2 such that debt is being relied upon to
a greater extent than equity, which is not the case in Year 1. This is the result of
increased debt financing, and possible share redemptions. Noncurrent assets also
increased, and were likely financed through the issuance of additional debt. Finally,
earnings per share decreased. While the gross margin on sales did not change
significantly, the increased debt burden undoubtedly had a major impact, resulting in a
reduction in net income and earnings per share.
9
12.20 a) Return on Shareholders’ Equity:
Year 1:
Year 2:
Year 3:
Year 4:
ROE
$200 / $6,278 = 3.2%
$503 / $9,614 = 5.2%
$1,105 / $13,619 = 8.1%
$2,913 / $24,729 = 11.8%
b) Return on assets:
Year 1:
Year 2:
Year 3:
Year 4:
Profit Margin Ratio
[$200 + $50(0.6)] / $15,472 = 1.5%
[$503 + $55(0.6)] / $19,558 = 2.7%
[$1,105 + $96(0.6)] / $21,729 = 5.4%
[$2,913 + $89(0.7)] / $28,493 = 10.4%
Total Asset Turnover
$15,472 /$19,745 = .78
$19,558 / $25,227 = .77
$21,729/ $33,146 = .66
$28,493 / $67,185 = .42
ROA
1.17%
2.08%
3.56%
4.37%
c) ROA and ROE have been positive and increasing over the four year period. This
would indicate improved performance over time. The actual performance depends upon
what other companies in the same industry have been able to do in the same time period.
The improvement has come from improved profit margins for the four years, although
the asset turnover has been declining over the same period. The company has effectively
applied leverage since the ROE exceeds the ROA in all four years.
10
12.21 a) Return on Shareholders’ Equity:
ROE
$1,533 / $24,664 = 6.2%
$3,830 / $32,415 = 11.8%
$6,755 / $51,415 = 13.1%
Year 1:
Year 2:
Year 3:
b) Return on assets:
Year 1:
Year 2:
Year 3:
Profit Margin Ratio
[$1,533 + $896(0.75)] /
$42,798 = 5.2%
[$3,830 + $1,441(0.7)] /
$54,061 = 9.0%
[$6,755 + $2,112(0.7)] /
$76,023 = 10.8%
Total Asset Turnover
$42,798 / $48,744 = 0.88
ROA
4.6%
$54,061 / $65,258 = 0.83
7.5%
$76,023 / $98,654 = 0.77
8.3%
c) ROA and ROE have been positive and increasing over the three year period. This
would indicate improved performance over time. The actual performance depends upon
what other companies in the same industry have been able to do in the same time period.
The improvement has come from improved profit margins as evidenced from the change
in the profit margin ratio and the slightly declining asset turnover. The company is also
effectively applying leverage since the ROE exceeds the ROA.
ROE
=
ROA
Net Income
400,000
=
NI + [($200,000 x 0.08) x 0.7]
$600,000
$600,000 x NI
$600,000 x NI
$200,000 x NI
Net income
=
=
=
=
$400,000 x [NI + $11,200]
$400,000 x NI + $4,480,000
$4,480,000
$22,400
b) ROE = $22,400 / $400,000 = 5.6%
c) After tax income
= $22,400
Before tax income ($22,400 / 0.7)
Interest = $200,000 x 8%
Income before interest and taxes
d) ROA
=
0.056 =
NI + [($300,000 x 0.06) x 0.7]
$600,000
Net income
=
ROE =
$21,000 / $300,000 = 7.0%
=
=
$32,000
16,000
$48,000
NI + [Interest expense x (1 - tax rate)]
Average total assets
$21,000
11
e) Under the original assumptions, the ROA is 5.6%. In the second set of assumptions
the company can borrow at an after-tax interest cost of 4.2% (6% x 0.7). Because the
company is borrowing at a cost of 4.2% to invest in assets that generate a return of 5.6%,
the ROE climbed to 7.0%.
12.23a)
Year 1:
D/E (I)
$1,025 / $2,225 = 46%
D/E (II)
$1,025 / $1,200 = 85%
Year 2:
Year 3:
$1,525 / $3,325= 46%
$2,150 / $4,350 = 49%
$1,525 / $1,800 = 85%
$2,150 / $2,200 = 98%
Year 1:
Year 2:
Year 3:
D/E(III)
$600 / $1,800 =
33%
$1,000 / $2,800 = 36%
$1,400 / $3,600 = 39%
Times Interest Earned
$500 / $80 = 6.3
$800 / $100 = 8.0
$1,000 / $135 = 7.4
b) The company seems to be in a fairly comfortable position with regard to its long-term
debt/equity ratio (D/E III), which is increasing slightly over the years, but not at a
significant rate. There would be some concern if this trend continues and if it
accelerates. The times interest earned ratio also indicates that the company is earning a
sufficient amount of income to meet its interest obligations. There is no trend in either
direction with the TIE ratio.
12.24 a)
Year 1:
D/E (I)
$1,090 / $2,590 = 42%
D/E (II)
$1,090 / $1,500 = 73%
Year 2:
$1,530 / $3,030 = 51%
$1,530 / $1,500 = 102%
Year 3:
$1,720 / $3,520 = 49%
$1,720 / $1,800 = 96%
Year 1:
Year 2:
Year 3:
D/E(III)
$700 / $2,200 =
32%
$1,100 / $2,600 =
42%
$1,200 / $3,000 =
40%
Times Interest Earned
$1,000 / $120 = 8.3
$1,300 / $150 = 8.7
$1,600 / $165 = 9.7
b) The company seems to be in a fairly comfortable position with regard to its long-term
debt/equity ratio (D/E III), which has increased 10% in Year 2 and then decreased
slightly. There would be concern if the ratio continued to increase in future years as the
rate that it did in Year 2. The times interest earned ratio also indicates that the company
is earning a sufficient amount of income to meet its interest obligations. Since Year 1,
the TIE has increased to 9.7 in Year 3, the company can quite comfortably pay the
interest out of earnings.
12
12.25Key:
Decrease
Increase
No Effect
Transaction
1
2
3
4
5
6
7
+
NE
Current
Ratio
*
+
*
+
+
-
Quick
Ratio
Inventory
Turnover
+
*
+
+
+
+
NE
NE
NE
NE
+
ROE
D/E(I)
NE
+
NE
NE
+
-
+
+
+
* The ratio will be affected, but the direction of the effect cannot be
determined from the information given. Since the same amount will be added or
subtracted from the numerator as well as the denominator; the change in the ratio will
depend on what the ratio was to begin with.
12.26
Transaction
1
2
3
4
5
6
7
Current
Ratio
+
NE
*
+
NE
+
ROA
+
NE
NE
-
AR
Turnover
+
NE
NE
NE
NE
NE
ROE
+
NE
NE
NE
NE
-
D/E (I)
NE
+
+
+
NE
-
*The ratio will be affected but the direction of the effect cannot be determined from the
information given. Since the same amount will be added or subtracted from the
numerator as well as the denominator, the change in the ratio will depend on what the
ratio was to begin with.
12.27 a) The amount that should be reported as basic earnings per share for the
year is
Calculation of earnings per share:
Net income
Less preferred share dividends
[100,000 x $1.00]
Earnings available to common
Number of common shares
$720,000
(100,000)
$ 620,000
900,000
13
Earnings per share
$0.69
b) The convertibility of the preferred shares has relevance for reporting earnings per
share because the preferred shares might be converted to common shares. This means
that the company’s net income might have to be spread over more common shares. This
possible effect is called dilution of earnings per share. If all of the preferred shares
converted, net income would not need to be reduced by the preferred dividends and the
number of common shares would increase by 200,000. The fully diluted earnings per
share would be $0.65 ($720,000/1,100,000).
12.28 a) Net income for 2000 = $0.46 per share x 28,500 shares = $13,110
b) Earnings per share for 2001 = $14,800 / 28,500 = $0.52 per share
c) Earnings per share figures are usually included in the annual report on the face of the
income statement for each year reported. They are usually reported just below net
income. They could also be reported in the notes to the financial statements although
very few companies will report earnings per share in this manner.
d) If Signal decides to split its common shares 2 for 1, then the earnings per share must
also be split in 2, because the same net income must be spread out over twice as many
shares. The 2000 earnings per share amount is also affected, because the comparative
income statement must present both earnings per share figures as though the split had
occurred in 2000. This retroactive treatment is provided so that comparability is
maintained.
14
12.29a) Working capital = ($218,000 + $320,000 + $32,000) - $165,000 = $405,000
The working capital is quite high, and indicates that there are more than enough current
assets to satisfy current liabilities. In addition, since the company maintains a reasonably
high cash balance of $218,000, cash required to finance operations is not a concern.
b) Current ratio = $570,000 / $165,000 = 3.5
Quick ratio = ($218,000) / $165,000 = 1.3
The quick ratio assumes that the other assets are prepaid assets.
Both the current ratio and the quick ratio exceed the criteria of 2.0 and 0.8 respectively.
Based on these ratios, the company’s current asset position is strong, and short-term
liquidity is not a concern. In fact, these ratios suggest that perhaps the company’s
investment in current assets is more than what is required in order to support the sales
function and finance operations.
c) A change from cash to credit sales would not affect the current ratio or quick ratio if
previous cash sale customers now purchased on account. The cash balance would
decrease, and a receivable balance would be created. In reality, if the company starts to
sell on credit, its total sales are likely to increase as it attracts new customers who would
not buy before because of the cash only policy. This would cause both the current ratio
and the quick ratio to increase. The company will now have to manage collection of its
receivables, and establish credit terms for its customers. The accounts receivable
turnover ratio, which indicates how quickly accounts receivable are collected, will now
be affected.
d) If these balances existed following the completion of the primary business, then most
of the current assets held would be unnecessary, and reflect poor cash and inventory
management. Cash and inventory are short-term investments that a company must make
in order to facilitate sales to customers. If sales are decreasing, then the company should
decrease its current assets.
15
12.30a) Ratios for A-Tec and B-Sci:
A-Tech
(1)
(2)
(3)
(4)
(5)
(6)
Current ratios
Working capital
Rec. turnover
Inv. Turnover
Asset turnover
Total debt to
total assets
(7) Sh. Equity to
total assets
(8) Gross margin ratio
(9) Return on sales
(10) Return on assets
(11) Return on equity
Bi-Sci
2001
1.16
$11
31.7 times
16.6 times
2.4 times
2000
.95
($2)
45 times
22.5 times
3.2 times
2001
2.25
$30
30 times
15 times
3.6 times
2000
2.17
$28
30 times
15 times
3.8 times
86.9%
81.7%
14.2%
15.4%
13.1%
30%
10%
24.5%
186.3%
18.3%
33%
11.9%
38.5%
210.5%
85.8%
25%
10%
35.5%
41.4$
84.6%
25%
10%
38.5%
45.5%
Supporting calculations:
A-Tech:
(1) Current ratio (current assets/current liabilities)
(2) Working capital (current assets – current
Liabilities)
(3) Acc. receivables turnover (sales-net acc. rec.)
(4) Inventory turnover (cost of goods sold/inv.)
(5) Asset turnover (sales/total assets)
(6) Total debt to total assets (total liab./total assets)
(7) Sh. equity to total assets (Sh. equity/total assets)
(8) Gross margin ratio [(sales – cost of goods sold)
/sales]
(9) Return on sales (net income/sales)
(10) Return on assets (net income/total assets)
(11) Return on equity (net income/Sh. Equity)
2001
78/67
2000
38/40
78-67
950/30
665/40
950/388
337/388
51/388
(950-665)
/950
95/950
95/388
95/51
38-40
675/15
450/20
675/208
170/208
38/208
(675-450)
/675
80/675
80/208
80/38
Bi-Sci:
(1) Current ratio (current assets/current liabilities)
(3) Working capital (current assets – current
Liabilities)
(3) Acc. receivables turnover (sales-net acc. rec.)
(4) Inventory turnover (cost of goods sold/inv.)
(5) Asset turnover (sales/total assets)
(6) Total debt to total assets (total liab./total assets)
(7) Sh. equity to total assets (Sh. equity/total assets)
(8) Gross margin ratio [(sales – cost of goods sold)
/sales]
(9) Return on sales (net income/sales)
(10) Return on assets (net income/total assets)
(11) Return on equity (net income/Sh. Equity)
2001
54/24
2000
52/24
54-24
600/20
450/30
600/169
24/169
145/169
(600-450)
/600
60/600
60/169
60/145
52-24
600/20
450/30
600/156
24/156
132/156
(600-450)
/600
60/600
60/156
60/132
16
b) The following analysis is separated into liquidity, solvency, leverage and profitability
analysis.
Liquidity: Bi-Sci appears to be in a better liquidity position. Its current ratio is much
higher than A-Tech’s and its working capital is also higher. A-Tec’s current ratio and
working capital have improved but they are still lower. The accounts receivable turnover
and inventory turnover also measure liquidity because they measure the amount of time
before these items will be converted to cash in the operating cycle. Both of these ratios
remained constant for Bi-Sci in 2001. A-Tec’s ratios declined in 2001 and are now
closer to Bi-Sci’s. It may be that A-Tec’s ratios in 2000 were unusually high and are
now closer to those of other companies.
Solvency: Bi-Sci is in a much better solvency position as measured by the total debt to
total assets and total shareholders’ equity to total assets ratios. Bi-Sci is financed mostly
by shares while A-Tec is financed mostly by borrowing.
Leverage: A-Tec is using much more leverage than Bi-Sci. Since A-Tec is financed
mostly by debt, its return on equity (net income/shareholders’ equity) will be much
higher when the rate of earnings exceeds the interest rate on the debt. Leverage is best
measured by comparing the return on assets to the return on equity. With high leverage,
and a return on assets in excess of interest rates, the return on equity for a company like
A-Tec will be very high. The returns of the two companies are computed as follows:
Return on assets
Return on equity
A-Tech
2001
2000
24.5%
38.5%
186.3%
210.5%
Bi-Sci
2001
35.5%
41.4%
2000
38.5%
45.5%
Profitability: The companies are very similar in profitability measures. The return on
sales is about the same both years for both companies. While the return on assets is the
same in 2000, Bi-Sci is a little better in 2001. However, A-Tec increased its sales by
40% in 2001 to go along with the expansion in assets and Bi-Sci had no growth in 2001.
Determining which company is the better investment for a shareholder depends on the
amount of risk the shareholder is willing to absorb. The return on equity for A-Tec is
very high. As long as the return on assets stays high, there will be a good return to
shareholders. An important question is will the growth in sales continue. On the other
hand, the high leverage makes A-Tec much more risky for shareholders. Bi-Sci appears
to be a much better credit risk from a lender’s standpoint. It has a much better liquidity
and solvency position, less leverage, and less risk that debts will not be paid.
17
Management Perspective Problems
12.31
The debtholder is very interested in the ability of the company to pay off its
debts. The debt/equity ratios measure the extent to which the company utilizes debt to
finance its operations. The more debt it incurs the higher the risk of default on a
particular loan. The debtholder would be interested in restricting the level of debt in the
company to limit the risk of default. The current ratio measures short-term liquidity and
is a measure of the company’s ability to pay its debts in the short-term. The debtholder
would be very interested in assuring that this ratio is maintained at some minimum level
to insure that payments are made on a timely basis.
12.32
Perhaps the easiest way to influence the ratio is to try to increase net income. A change
in the revenue recognition method to recognize revenue earlier in the company’s cash to
cash cycle could have this impact. Accelerating the recognition of revenue under
existing methods could also cause an increase in net income. Companies might speed up
shipments of goods, for instance, if revenues are recognized at the time of shipment.
Management could also decide to delay the acquisition of new capital assets. When new
assets replace old ones, total assets usually increases which lowers the ROA.
12.33
From the perspective of a potential investor, the following four ratios might be helpful:
a) ROE: This ratio indicates the rate of return that the company is earning for its
common shareholders. Potential investors should compare the ROE for the company to
the rate of return that could be earned on a similar risk investment in another company.
b) Current ratio: This ratio tells potential investors whether the company is likely to
experience financial difficulties in the short-term.
c) Debt to equity (I): This ratio reflects the extent of debt in the company’s capital
structure. Debt use imposes additional risk on shareholders, because the company is
contractually committed to making fixed interest and principal repayments at definite
points in the future. Such commitments assume that the company is able to generate
sufficient cash from operations. In addition, as a potential investor, a large amount of
debt means that assets of the company must first be distributed to debtholders, creating
the potential that no assets remain to satisfy the claims of shareholders. On the other
hand, the use of debt can result in increased returns to shareholders through the use of
leverage.
d) Price earnings ratio: This ratio indicates the market price of a share per one dollar of
earnings that the company generates. For a potential investor, a high price-earnings ratio
means that the market price is based on future predicted earnings, rather than on current
earnings. Thus, the greater the price-earnings ratio, the higher earnings must be in the
future in order to justify the current market price.
18
12.34
From the perspective of an auditor, the following ratios might be helpful in
identifying abnormalities:
a) ROA: This ratio reflects the rate of return that a company earns on all assets. If this
ratio is significantly different from that of other companies in the same industry,
abnormalities or fraud might exist. This ratio should be examined through its
component parts - the profit margin ratio and the asset turnover.
b) Accounts receivable turnover: This ratio indicates the speed at which receivables are
collected. If the company has created fictitious sales, then turnover would be much
lower than expected, because the accounts receivable associated with the fake sales are
not collected. This can alert the auditor to fraud.
c) Accounts payable turnover: This ratio reflects the speed at which payables are paid. If
the company is creating fictitious sales, then this ratio would be much higher than
expected, because the cost of goods sold associated with the fake sales does not
correspond to a portion of accounts payable.
In general, auditors use both time-series analysis and cross-sectional analysis to alert
them to irregularities or fraud. Auditors focus on areas where significant changes
occurred from the prior year, and on those areas that differ materially from industry
averages.
12.35
Being a potential supplier that grants 30 day credit terms, you would be most interested
in the ability of the dealership to generate cash in the short-term to satisfy its current
liabilities. Thus, ratios that might be helpful include the current ratio, quick ratio, times
interest earned ratio, and accounts payable turnover.
12.36
Ratios that would help the decision maker in arriving at a decision or to identify areas for
further analysis include:
a) Decrease in net income from:
1. a decrease in sales or an increase in cost of sales:
Gross Profit Margin
2. an increase in total operating expenses:
Gross Profit Margin and Return on Sales
Horizontal and Vertical Analysis
3. an increase in an individual operating expense:
Horizontal and Vertical Analysis
b) Sufficient cash to pay dividends and make debt payments:
Dividends to Cash Flow from Operations
Current Ratio
Quick Ratio
c) Long-term debt higher than the industry as a whole:
Debt to Equity
Long-term Debt to Assets
19
d) Comparison of profitability in relation to invested capital:
Return on Equity
e) Whether the decline in economic activity affected accounts receivable collections:
Accounts Receivable Turnover
f) Whether the company was successful in reducing inventory investment:
Inventory Turnover
g) Determining which company provides more earnings per share:
Earnings Per Share
Price/earnings Ratio
h) Efficient management of inventory:
Inventory turnover
Reading and Interpreting Published Financial Statements
12.37 a)
ROA
=
Net income + [Interest expense x (1 - Tax Rate)]
Average Total Assets
=
Net income + [Interest expense x (1 - Tax Rate)]
Sales Revenue
X
Sales Revenue
Average Total Assets
=
{[$10,105 + $27,559(1-0.43)] / $354,125} X {$354,125 /
[($616,027 + $500,748) / 2]}
0.0729 x 0.6342
4.6%
=
=
ROE
=
Net Income - Preferred Dividends
Average shareholders’ equity
=
=
$10,105 / [($158,173 + $104,664) / 2]
7.7%
Inventory turnover = Cost of goods sold
Average inventory
=
=
Accounts receivable =
turnover
($300,935 x 50%) / [($116,770 + $87,477) / 2]
1.47
Sales
Average accounts receivable
=
=
$354,125 / [($74,812 + $56,292) / 2]
5.4
20
b)
1. Current ratio
2. Quick ratio
3. D/E (I)
4. Times interest
earned
1998
$233,793 / $141,614
= 1.65
($684 + $74,812) / $141,614
= 0.53
($616,027 - $158,173)/ $616,027
= 74%
$46,162 / $27,559
= 1.68
1997
$169,107 / $110,710
= 1.53
($883 + $56,292) / $110,710
= 0.52
($500,748 - $104,664) / $500,748
= 79%
$45,391 / $26,114
= 1.74
c) CHC is using leverage to its benefit, as reflected in the fact that its ROE exceeds its
ROA. This means that the after-tax cost of borrowing is less than the return it is able to
generate through investing in operating assets. The resulting benefit accrues to
shareholders in the form of a higher ROE.
d) The pros of investing in CHC include the fact that it is generating cash from
operations and net income has increased slightly from 1997. The cons are that it could
encounter financial difficulties in the short-term because of its weak quick ratio and low
inventory turnover. Combined, these ratios signal that because its inventory turns over
less than 1.5 times a year, the quick ratio is a better predictor of short-term liquidity.
Also, the debt to equity ratio is high which imposes additional long-term risk upon
shareholders. Although the company appears to be currently using leverage to the
benefit of shareholders, this could quickly change if its cost of borrowing increases or if
it is unable to generate enough of a return in order to meet debt obligations.
e) If the Canadian dollar continues to fall relative to other currencies, CHC can maximize
profits by paying expenses in Canadian dollars and earnings revenues in foreign
currencies. Similarly CHC should hold monetary assets in foreign currencies and owe
liabilities in Canadian dollars. Of course, financial institutions in other countries may
not want to have debt repaid in Canadian dollars. If CHC could achieve these holdings,
it would benefit from the falling Canadian dollar.
21
12.38 a)
ROA
=
Net income + [Interest expense x (1 - Tax Rate)]
Average Total Assets
=
Net income + [Interest expense x (1 - Tax Rate)]
Sales Revenue
X
Sales Revenue
Average Total Assets
=
$324 + [$21,189 x (1 - .251)] X
$1,552,272
$1,552,272
($783,124 + $734,080)/2
=
.01 x 2.0462
=
2%
1
Tax rate was calculated from 1997 at 25% ($11,325/$45,315)
ROE
=
Net Income - Preferred Dividends
Average shareholders’ equity
=
$324
($228,117 + $230,931)/2
=
0.14%
Inventory turnover = Cost of goods sold
Average inventory
=
$1,423,248
($237,312 + $182,157)/2
=
6.79
Accounts receivable =
turnover
Sales
Average accounts receivable
=
$1,552,272
($201,218 + $203,196)/2
=
7.68
b)
1. Current ratio
2. Quick ratio
3. D/E (I)
4. Times interest
earned
1998
$536,038 / $383,039
= 1.40
$286,385 / $383,039
= 0.75
$555,007/ $783,124
= 71%
$19,298 / $21,189
= 0.91
1997
$510,024 / $309,771
= 1.65
$316,246 / $309,771
= 1.02
$503,149 / $734,080
= 69%
$53,464 / $8,149
= 6.56
22
c) Western Star Trucks does not appear to be in particularly good financial condition. The
company incurred a net loss before taxes, compared to a net income of $33,990 and $36,523 in
1997 and 1996 respectively. The reasons for the sharp decline in income seem to be large selling
and administrative expenses and a large interest expense. The times interest earned ratio reflects
this increase in interest expense, and earnings before interest and taxes are insufficient to make
interest payments in 1998. The quick ratio has also declined in1998, serving as a further
indication of possible cash flow problems. This is also confirmed through an examination of the
cash flow statement, which reveals a net decrease in cash of $92,027.
d) Assuming a tax rate of 25%, the ROA is 2% whereas the ROE is .14%. The fact that
the ROE is lower than the ROA is an indication of negative leverage. Western Star
Trucks is earning 2% on its assets. Because its cost of borrowing is more than 2%, the
ROE is less than 2%.
e) If the Canadian dollar were to strengthen relative to the U.S. dollar, the Canadian
production with Canadian dollar costs would increase relative to foreign currencies. As
it exports much of its products, these products would tend to be priced higher and
Western Star could lose markets and sales. These trends would tend to be reduced by the
parts purchased outside Canada, and they would cost less in Canadian dollar terms. If
the Canadian dollar weakened relative to the U.S. dollar, the exact opposite would occur.
The Canadian production costs would be relatively cheaper and sales in foreign
currencies would be worth more. These trends would be reduced by the parts purchased
outside Canada.
23
12.39 a)
ROA
ROE
=
Net income + [Interest expense x (1 - Tax Rate)]
Average Total Assets
=
Net income + [Interest expense x (1 - Tax Rate)]
Sales Revenue
X
Sales Revenue
Average Total Assets
=
$6,754,540 + ($2,112,129 x .72) X $76,022,656
$76,022,656
($105,654,710 +$71,257,880)/2
=
0.1089 X 0.8594
=
9.4%
=
Net Income - Preferred Dividends
Average shareholders’ equity
=
$6,754,540
($51,414,975 + $32,460,890)/2
=
16.1%
Inventory turnover = Cost of goods sold
Average inventory
=
$34,574,580
($11,972,472 + $8,466,950)/2
=
3.38
Accounts receivable =
turnover
Sales
Average accounts receivable
=
$76,022,656
($10,298,798 + $10,341,943)/2
=
7.37
b)
1. Current ratio
2. Quick ratio
3. D/E (I)
4. Times interest
earned
1998
$23,573,581 / $24,774,714
= 0.95
$10,298,798 / $24,774,714
= 0.42
$54,239,735/ $105,654,710
= 51%
$11,448,881 / $2,112,129
= 5.42
1997
$19,281,998 / $18,131,277
= 1.06
$10,341,943 / $18,131,277
= 0.57
$38,796,990 / $71,257,880
= 54%
$6,182,659 / $1,441,847
= 4.29
c) Sleeman Breweries appears to be in very good financial condition. It is making high
profits and its net income nearly doubled from 1997 to 1998. Its risk from debt appears
24
to be quite moderate, since it is able to pay its interest expense 5.4 times from beforeinterest operating income in 1998. It is, however, operating without any cash. Instead, it
appears to be making use of a line of credit. It is generating a positive cash flow from
operations, $6,901,849 but it is spending more than that on acquisitions. Its debt has
therefore increased. To decide if we should invest in this company, we would want to
know the future prospects of its industry, including new products and competition.
d) Sleeman breweries uses leverage well, as its ROE is 16.1% compared to an ROA of
9.4%. This means that the company is able to borrow at a lower rate than it earns
through investing in operating assets. The resulting benefit accrues to shareholders in
the form of a higher ROE. The company’s average interest rate is 3.89% ($2,112,129 /
$54,239,735). Since it is able to earn 9.4% on its assets, it is beneficial for the company
to include debt in its financial structure.
25
e) Big Rock Brewery
ROA
=
Net income + [Interest expense x (1 - Tax Rate)]
Average Total Assets
ROE
=
Net income + [Interest expense x (1 - Tax Rate)]
Sales Revenue
X
Sales Revenue
Average Total Assets
=
($556,745) + ($661,640 x .554) X
$26,466,241
=
-0.0072 X 0.8665
=
-0.62%
=
Net Income - Preferred Dividends
Average shareholders’ equity
=
($556,745)
($16,447,657 + $17,731,383)/2
=
-3.3%
$26,466,241
($29,165,835 +$31,919,676)/2
Inventory turnover = Cost of goods sold
Average inventory
=
$7,691,231
($2,050,703 + $2,270,909)/2
=
3.56
Accounts receivable =
turnover
Sales
Average accounts receivable
=
$16,644,881
($1,548,486 + $1,302,336)/2
=
11.7
26
1. Current ratio
2. Quick ratio
3. D/E (I)
4. Times interest
earned
1999
$4,115,116 / $2,294,778
= 1.79
$1,630,628 / $2,294,778
= 0.71
$12,718,178/ $29,165,835
= 44%
($123,605) / $661,640
= -0.19
1998
$4,887,382 / $1,972,393
= 2.48
$2,213,275 / $1,972,393
= 1.12
$14,188,293 / $31,919,676
= 44%
$1,347,546 / $841,565
= 1.60
Because of the loss suffered by Big Rock in 1999, its ROE and ROA are both negative.
On this measure alone, Sleeman Breweries appears to be doing much better. The
inventory turnover for the two companies is very similar. Big Rock appears to be more
efficient in its collection of accounts receivable with a ratio of 11.7 compared to
Sleeman’s 7.37.
Big Rock’s short-term liquidity is better at 1.79 and .71 for its current and quick ratios
compared to Sleeman’s at .95 and .42. Both companies carry similar amounts of debt
with Big Rock at about 44% and Sleeman just over 50%. Sleeman’s times interest
earned ratio is much healthier than Big Rock’s although Big Rock has been trying to
remedy this situation by paying down its debt. Its interest expense dropped
approximately 25% in the last year.
At the time of the financial statements Sleeman Breweries was healthier. It had positive
earnings and a good use of leverage. Big Rock, because of its net loss for the year, needs
to do some financial rebuilding.
27
12.40 a)
ROA
ROE
=
Net income + [Interest expense x (1 - Tax Rate)]
Average Total Assets
=
Net income + [Interest expense x (1 - Tax Rate)]
Sales Revenue
X
Sales Revenue
Average Total Assets
=
$14,455 + ($4,045 x .554) X
$328,565
=
0.0508 X 1.1431
=
5.8%
=
Net Income - Preferred Dividends
Average shareholders’ equity
=
$14,455
($126,456 + $114,073)/2
=
12%
$328,565
($347,339 + $227,525)/2
Inventory turnover = Cost of goods sold
Average inventory
=
$254,441
($45,376 + $37,082)/2
=
6.17
Accounts receivable =
turnover
Sales
Average accounts receivable
=
$328,565
($81,394 + $56,966)/2
=
4.75
b)
1. Current ratio
2. Quick ratio
3. D/E (I)
4. Times interest
earned
1998
$137,914 / $119,398
= 1.16
$89,799 / $119,398
= 0.75
$220,883/ $347,339
= 64%
$29,503 / $4,045
= 7.29
1997
$110,722 / $53,432
= 2.07
$71,946 / $53,432
= 1.35
$113,452 / $227,525
= 50%
$23,556 / $1,311
= 17.97
28
c) Tritech appears to be in fairly good financial condition. It is earning 5.8% on total
assets, which, with good use of leverage, results in a return on shareholders’ equity of
12%. It does not appear to have high risk from liabilities as evidenced by the 7.29 times
interest earned ratio. Both the current and quick ratios are reasonable, and the operating
activities are producing a net inflow of cash. Tritech has a net cash shortage for1998
which appears to result from investing in fixed assets. We should learn more about the
company’s industry, its products, plans, markets, and competition before we decide to
invest.
d) Tritech currently has positive benefits from leverage, which increases its ROA of
5.8% to an ROE of 12%. The interest rate paid on long-term debt in 1998 appears to be
$3,652 / ($69,682 + $10,924) = 4.5%. Interest on current bank indebtedness appears to
be $393 / $39,257 = 1%.
e)
(i.) If the Canadian dollar strengthened against the US dollar by 5%, and if the product
prices remained the same, the effect would be to lower the Canadian value of the US
sales. The effect would be to lower sales and Income before Minority Interest and
Income Taxes by (75% x $328,565) x 5% = $12,321.
(ii) If the Canadian dollar weakened against the US dollar by 5%, and if the product
prices remained the same, the effect would be to increase the Canadian value of the US
sales. The effect would be to increase sales and Income before Minority Interest and
Income Taxes by (75% x $328,565) x 5% = $12,321.
29
12.41 a)
ROA
=
Net income + [Interest expense x (1 - Tax Rate)]
Average Total Assets
=
Net income + [Interest expense x (1 - Tax Rate)]
Sales Revenue
X
Sales Revenue
Average Total Assets
Note: Since interest expense is not disclosed separately, it is assumed to be zero for the
purposes of this calculation.
ROE
=
$22,568 x
$314,496
$314,496
($159,506 + $142,727)/2
=
0.0718 X 2.0811
=
15%
=
Net Income - Preferred Dividends
Average shareholders’ equity
=
$22,568
($100,056 + $86,965)/2
=
24%
Inventory turnover = Cost of goods sold
Average inventory
=
$244,065
($45,094 + $26,057)/2
=
6.86
Accounts receivable =
turnover
Sales
Average accounts receivable
=
$314,496
($54,125 + $66,096)/2
=
5.23
b)
1. Current ratio
2. Quick ratio
3. D/E (I)
1998
$99,219 / $43,190
= 2.30
$54,125 / $43,190
= 1.25
$59,450/ $159,506
= 37%
1997
$111,731 / $53,760
= 2.08
$85,674 / $53,760
= 1.59
$55,762 / $142,727
= 39%
30
c) Enerflex appears to be in strong financial condition. However, net income decreased
slightly from 1997 to 1998, which is attributable to a decline in revenues. Other than
this, the company is healthy. The current ratios and quick ratios are strong, indicating
that short-term liquidity is not a concern. The debt to equity ratios are also low, and
interest expense is more than offset from interest income on investments. The
company’s cash position is negative in 1998, mainly as the result of investments in
property, plant, and equipment. Before investing in Enerflex, we would want to know
more about its markets, products, and competitors. Furthermore, the reason for the
decline in revenues should be identified to determine whether this is a trend.
d) If Enerflex had used common shares rather than long-term debt, it would have issued
an additional 7,922,078 shares [Average issue price is $34,678,000 / 15,019,000 =
$2.31. Additional shares = $18,300,000 / $2.31 = 7,922,078]. Total common shares
would have been 7,922,078 + 15,019,000 = 22,941,078. New earnings per share would
be $22,568,000/22,941,078 = $0.98. This compares to the actual EPS of $1.50. With a
multiple of 20, the market price per share would have been reduced by ($1.50 - $0.98) x
20 = $10.40. Thus, Enerflex appears to have made a decision to use some long-term debt
financing instead of common shares and that decision results in a higher market price per
share of its stock.
31
12.42 a)
ROA
=
Net income + [Interest expense x (1 - Tax Rate)]
Average Total Assets
=
Net income + [Interest expense x (1 - Tax Rate)]
Sales Revenue
X
Sales Revenue
Average Total Assets
Note: Since interest expense is not disclosed separately, it is assumed to be zero for the
purposes of this calculation.
ROE
=
$5,211
$40,672
=
0.1281 X 0.7449
=
9.5%
=
Net Income - Preferred Dividends
Average shareholders’ equity
=
$5,211
($47,041 + $41,435)/2
=
11.8%
Accounts receivable =
turnover
X
$40,672
($60,751 + $48,456)/2
Sales
Average accounts receivable
=
$40,672
($9,489 + $11,250)/2
=
3.92
b) There is no Finished Goods Inventory as Mosaid designs for custom orders. Thus it
does not produce for inventory, it only produces for specific orders. As soon as the chips
are finished, they belong to the customer and become expenses. Thus inventory turnover
is not meaningful. Inventory turnover is meaningful only for companies that produce for
stockpiling for later sale.
c)
1. Current ratio
2. Quick ratio
3. D/E (I)
1998
$39,105 / $7,407
= 5.28
$33,117 / $7,407
= 4.47
$13,710/ $60,751
= 23%
1997
$38,309 / $6,308
= 6.07
$33,243 / $6,308
= 5.27
$7,021 / $48,456
= 14%
d) Mosaid uses very little leverage, as evidenced by the ROA being 9.5% and ROE
11.8%. In contrast, Enerflex has a relatively higher leverage, with ROA of 15% and
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ROE of 24%. Note that Mosaid does not need debt as it has substantial cash and shortterm marketable securities. Enerflex is in a cash deficit position. The comparison
between the two companies may not be appropriate because they are not manufacturing
the same products.
e)
(i.) If Mosaid will earn that same ROA, it cannot pay a higher interest rate than its ROA,
so it should not pay more than 9.5% after tax.
(ii.) To raise $10,000,000 from new shares, assuming a multiple of 20, it should be able
to sell these shares at 20 x $0.73 earnings per share = $14.60 each. Thus Mosaid would
need to sell $10,000,000 / $14.60 = 684,932 shares at $14.60.
(iii.) New net income would be 9.5% x (60,751 + 10,000) = $6,721 with shares and
$6,721 - [(10% x 10,000) x (1 - 3,012 / 8,560)] = $6,073 with 10% debt. New ROE
would be $6,721 / [(47,041 + 6,721 - 5,211 + 10,000) + 41,435] / 2 = $6,721 / $49,993 =
13.4% with shares and $6,073 / [(47,041 + 6,073 - 5,211) + 41,435] / 2 = $6,073 /
$44,669 = 13.6% with debt. Thus the new debt would increase the leverage to the
benefit of shareholders. To decide if new equity or debt should be used is not an easy
choice in this case. It appears to be slightly preferable to use debt to benefit from the
additional leverage.
12.43 a)
ROA
=
Net income + [Interest expense x (1 - Tax Rate)]
Average Total Assets
=
Net income + [Interest expense x (1 - Tax Rate)]
Sales Revenue
X
Sales Revenue
Average Total Assets
=
=
$13,525 + ($135,191 x .31) X
$783,800
.07 x 0.2774
=
1.9%
Accounts receivable =
turnover
$783,800
($3,201,224 + $2,450,201)/2
Sales
Average accounts receivable
=
$783,800
($59,632 + $45,550)/2
=
14.9
b) Inventory turnover would not be meaningful as Shaw Cable does not produce for
inventory. Its main business is distributing cable television signals. Inventory turnover
is meaningful only for companies that produce for stockpiling for later sale.
c)
1. Current ratio
1998
$116,838 / $306,143
1997
$62,582 / $261,123
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2. Quick ratio
3. D/E (I)
= 0.38
$85,686 / $306,143
= 0.28
$1,785,627/ $3,201,224
= 56%
= 0.24
$45,550 / $261,123
= 0.17
$1,870,825 / $2,450,201
= 76%
d) This company appears to be a risky investment from a short-term perspective because
its current and quick ratios are very poor, and indicate that the company might
experience cash flow problems when its current liabilities become due. In particular, the
total of its current assets are insufficient to cover either accounts payable and accrued
liabilities or the current portion of long-term debt. This means that additional short-term
financing must be obtained for the company to remain solvent. In addition, the return on
assets of 1.9% is unlikely to compensate debtholders and shareholders for the risk that
they bear. Finally, cash provided from operations of $128,737 does not even offset the
interest expense of $135,191, meaning that the company could have difficulty meeting its
contractual obligations relating to debt.
Beyond the Book
12.44
Answers to this question will depend on the company selected.
Critical Thinking Questions
12.45
General Comments
The purpose of this question is to increase the students’ awareness that the current
GAAP guidelines that allow alternative ways of recording transactions and reporting
elements reduce the comparability between entities. Students are asked to discuss the
prop and cons of comparability with reference to financial statement analysis.
Solution Outline
One of the benefits of the comparability occurs in ratio analysis. If you are analyzing the
financial statements of two or more companies by undertaking a ratio analysis, the ratios
will be comparable among the companies only if the original data are comparable. The
original data will be comparable only if they were produced using the same accounting
methods. Thus, for accounting information to be most useful to users, companies must
be forced to use the same set of accounting methods.
However, if all companies are forced to use the same accounting methods, the resulting
accounting numbers may not give an accurate portrayal of the underlying economic
events. No two companies have identical sets of economic transactions, so their
financial statements, which are intended to be summarized numeric portrayals of a
company’s activities, cannot be expected to be identical. Different economic
transactions require different accounting treatments, so restricting the accounting
methods that companies are permitted to use will inevitably result in some transactions
not being portrayed accurately in the financial statements. This situation would result in
comparable ratios that are misleading as the accounting information that produced the
ratios may not be properly portraying the underlying economic events.
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On the basis of this argument, regulators should not attempt to restrict the number or
types of accounting methods that companies can use.
12.46
General Comments
The purpose of this question is to require students to examine nonfinancial issues that
may impact the interpretation of the analysis of financial statement amounts. The
specific issue addressed in this question is the creation of captive finance subsidiaries
and their impact on the leverage that the company can achieve.
A major reason that a company forms a finance subsidiary is the potential for increasing
leverage at both the time of formation and in subsequent years. Upon forming a finance
subsidiary, the probability that a parent company will exceed the limits imposed by
existing debt covenants will be lessened. In fact, a parent company should be able to
borrow more because it is further from violating debt covenants than before the finance
subsidiary was formed. Furthermore, the initial increase in leverage from forming a
finance subsidiary is continued beyond the term of existing debt because the parent
company transfers much of its debt (usually only short-term) and high quality short-term
receivables to the subsidiary. The parent company reduces its debt/equity ratio in this
transfer and the subsidiary is able to sustain a “high” or higher than “normal” debt/equity
ratio because it now has higher quality assets dedicated solely to service that debt.
A captive finance subsidiary primarily finances its own parent company’s operations.
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