CHAPTER 5
USING FINANCIAL STATEMENT INFORMATION
BRIEF EXERCISE
BE5–1
(a)
Coke
Pepsi
ROE = Net Income/Average Stockholders’ Equity
ROA = (Net Income +[Interest Expense (1-Tax Rate)])/
Average Total Assets
11.2%
9.3%
Common Equity Leverage = Net Income/(Net Income +
[Interest Expense(1-Tax Rate)])
90.4%
Capital Structure Leverage = Average Total Assets/
Average Stockholders’ Equity
3.41
Return on Sales = Net Income + [Interest Expense
(1- Tax Rate)]/Net Sales
10.4%
Asset Turnover = Sales/Average Total Assets
27.7%
28.5%
96.7%
2.55
19.4%
.58
.89
Pepsi earns slightly more relative to its equity base and slightly less relative to its assets. Coke,
however, has a higher return on sales (profits relative to sales). Pepsi shows higher use of
leverage (Capital Structure Leverage ratio) and is much more efficient generating sales from its
asset base (Asset Turnover ratio).
(b)
ROA x Common Equity Leverage x Capital Structure Leverage = ROE
Coke: .112 x
Pepsi: .093 x
(c)
.967 x 2.55
.904 x 3.41
Return on Sales x Asset Turnover
= .277 (rounding)
= .285 (rounding)
= ROA
Coke: .194 x .58 = .112
Pepsi: .104 x .89 = .093
(d) Pepsi’s advantage in producing a return for shareholders’ equity investment is driven by more
aggressive use of leverage. Coke’s advantage in ROA is driven by its profitability for each dollar
of sales. Given the higher returns on equity and the companies’ respective costs of capital, both
companies are creating value for their shareholders.
E5–3
Based on the information provided by Ginny’s Fashions, we can compute the following ratios:
1. Return on Equity = Net Income ÷ Average Stockholders’ Equity*
2014: $17,000 ÷ $31,000 = .548
2015: $18,000 ÷ $35,500 = .507
*2013 numbers needed for averages, so the above ratios use the ending number from the balance
sheet
2. Return on Sales = (Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Net Sales
2014:
2015:
$17,000 + [2,000 (1 - .3)] ÷ $70,000 = .263
$18,000 + [2,000 (1 - .3)] ÷ $74,000 = .262
3. Current Ratio = Current Assets ÷ Current Liabilities
2014:
2015:
$14,000 ÷
$21,000 ÷
$7,000
$9,000
=
=
2.0
2.33
4. Debt/Equity Ratio = Total Liabilities ÷ Total Stockholders’ Equity
2014:
2015:
$33,000 ÷
$33,000 ÷
$31,000
$40,000
=
=
1.065
.825
Generally, a lot more information is available to a bank loan officer to decide upon a long-term loan.
However, given the limited information, I would support only a short-term loan rather than a longterm loan. The return on equity has declined while the return on sales has remained stable,
indicating that the company is not making any gains in its profitability. The current ratio is
encouraging, indicating the company’s short-term solvency is not in question. In terms of cash flows,
the company’s cash flow from operating activities is positive but declining considerably. It seems it is
financing its asset base partly from long-term loans and partly from its own operations. Overall, as a
bank loan officer, my bank’s interest will be safely protected if I approve only a short-term loan and
not a long-term loan.
E5–4
a.
Profitability Ratios:
Return on Equity
=
=
=
Net Income ÷ Average Stockholders' Equity
$16,500 ÷ [($29,000 + $36,500) ÷ 2]
.504
Return on Assets
=
=
=
(Net Income + [Interest Expense (1–Tax Rate)]) ÷ Average Total Assets
($16,500 + [$5,000 x (1- .34)]) ÷ [($81,000 + $99,000) ÷ 2]
.22
Earnings per Share =
=
=
Net Income ÷ Average Number of Common Shares Outstanding
$16,500 ÷ [(2,000 shares + 2,000 shares) ÷ 2]
$8.25
Return on Sales
=
=
=
(Net Income + [Interest Expense (1 – Tax Rate)])÷ Net Sales
($16,500 + [$5,000 x (1 - .34)]) ÷ $72,000
.275
Interest Coverage
=
=
=
(Net Income Before Taxes and Interest Expense) ÷ Interest Expense
$30,000 ÷ $5,000
6.00
Solvency Ratios:
Current Ratio
=
=
=
Current Assets ÷ Current Liabilities
($9,000 + $12,000 + $18,000) ÷ $16,500
2.36
Quick Ratio
=
=
=
(Cash + Marketable Securities + Accounts Receivable) ÷ Current Liabilities
($9,000 + $12,000) ÷ $16,500
1.27
Activity Ratios:
Receivables Turnover
Inventory Turnover
=
=
=
=
=
=
Net Credit Sales ÷ Average Accounts Receivable
$72,000 ÷ [($9,000 + $12,000) ÷ 2]
6.86
Cost of Goods Sold ÷ Average Inventory
$30,000 ÷ [($15,000 + $18,000) ÷ 2]
1.82
Capitalization Ratios:
Financial Leverage
Debt/Equity
=
=
=
Return on Equity – Return on Assets
.504 – .22
.284
=
=
=
Total Liabilities ÷ Total Stockholders' Equity
($16,500 + $46,000) ÷ ($20,000 + $5,000 + $11,500)
1.71
Market Ratios:
Price/Earnings Ratio
Dividend Yield
=
=
=
Return on Investment
=
=
=
Market Price per Share ÷ Earnings per Share
$36 ÷ $8.25
4.36
Dividends per Share ÷ Market Price per Share
($9,000 ÷ 2,000 shares) ÷ $36
.125
=
=
=
(Market Price1 – Market Price0 + Dividends per Share) ÷
Market Price0
($36 – $30 + $4.50) ÷ $30
.35
E5–4
Concluded
b.
Balance Sheet
Cash
Accounts receivable
Inventory
Long-lived assets (net)
Total assets
2015
2014
9%
12%
18%
61%
100%
9%
11%
19%
61%
100%
Accounts payable
Long-term liabilities
Common stock
Additional paid-in capital
Retained earnings
Total liabilities & stockholders' equity
17%
46%
20%
5%
12%
100%
15%
49%
25%
6%
5%
100%
Income Statement
Sales
100%
Cost of goods sold
42%
Gross profit
58%
Operating expenses
17%
Income from operations
41%
Interest expense
7%
Income from continuing operations (before taxes) 34%
Income taxes
12%
Net income
22%
c.
The company is making a handsome return of 27.5% on sales. Its return on equity is more
than 50%. Since the return on equity measures a company’s ability to use equity investor’s
capital to generate net assets through operations, a return of more than 50% indicates that
Ken’s Sportswear has exceptional earning power.
The current ratio of Ken’s Sportswear has gone down from 2.58 for the year 2014 to 2.36 for
the year 2015, but it is still very good. It is indicative of the fact that the company has more
than twice the current assets to meet its short-term obligations. Just as the current ratio
provides information about the short-term solvency position of the company, the debt/equity
ratio provides information about the long-term solvency of the company. Ken’s Sportswear has
a debt/equity of 1.79 in 2014 and 1.71 in 2015. This means that the company has more debt
than equity. A ratio of 1 would indicate that 50% of the company is financed by the
stockholders and the remaining 50% is financed by the creditors. Therefore, a ratio of more
than 1 indicates that the company has more debt than equity, which often can be a cause for
concern. In summary, the company does not have any solvency problems in the short run but
could face solvency problems in the future if its return on equity, financial leverage, and other
activity ratios decline.
E5–6
a. 2013
2013 Ending Cash Balance
=
=
=
2013 Beginning Cash Balance + Change in Cash
$0 + $78
$78
Change in Cash = Cash from Operating Activities + Cash from Investing
Activities + Cash from Financing Activities
$78 = Cash from Operating Activities – $400 + $800
Cash from Operating Activities = $(322)
2014
2014 Ending Cash Balance =
$76 =
2014 Beginning Cash Balance =
2014 Beginning Cash Balance + Change in Cash
Beginning Cash Balance – $2
$78
or
2014 Beginning Cash Balance
=
=
Change in Cash =
$(2) =
Cash from Investing Activities =
2013 Ending Cash Balance
$78
Cash from Operating Activities + Cash from Investing
Activities + Cash from Financing Activities
$(252) + Cash from Investing Activities + $400
$(150)
2015
2015 Ending Cash Balance
$156
Change in Cash
= 2015 Beginning Cash Balance + Change in Cash
= $76 + Change in Cash
= $80
Change in Cash =
$80 =
Cash from Operating Activities =
Cash from Operating Activities + Cash from Investing
Activities + Cash from Financing Activities
Cash from Operating Activities + $150 – $200
$130
Beecham was using debt and/or equity during 2013 and 2014 to finance the acquisition of
productive assets (i.e., investing activities) and to cover cash outflows from operating activities.
During 2015, the company started generating cash from operating activities and used this
cash—along with selling productive assets—to reduce its debt and/or equity and to build a cash
reserve.
E5–6
Concluded
b. Other than at the beginning of 2013, the company always had a positive cash balance. From
that standpoint the company was solvent throughout the three-year period. A more detailed
analysis of Beecham's solvency, however, requires an analysis of the company's operating
performance, financial flexibility, and liquidity. During 2013 and 2014, Beecham did not generate
cash flows from operating activities. The company remained solvent by issuing additional debt
or equity. Since the company was able to acquire additional debt or equity financing in 2013 and
2014 and was able to sell off assets during 2015, it appears that Beecham does have some
financial flexibility. However, without having the associated balance sheets, it is not possible to
adequately assess Beecham's financial flexibility and liquidity. Based upon the limited
information provided, it appears that Beecham faced some potential solvency problems in 2013
and 2014, but was able to overcome these problems by issuing additional debt or equity.
E5–7
a. (1) Current Ratio = Current Assets ÷ Current Liabilities
2014: $385,000 ÷ $170,000 = 2.26
2015: $400,000 ÷ $460,000 = 0.87
(2) Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) ÷ Current Liabilities
2014: ($30,000 + $10,000 + $95,000) ÷ $170,000 = 0.794
2015 ($15,000 + $225,000+ $90,000) ÷ $460,000 = 0.717
b. Receivables Turnover = Net Credit Sales ÷ Average Accounts Receivable
2014: $780,000 ÷ [($100,000 + $95,000) ÷ 2] = 8.00
2015: $800,000 ÷ [($95,000 + $90,000) ÷ 2] = 8.65
Number of Days Outstanding = 365 ÷ Receivables Turnover
2014: 365 ÷ 8.00 = 45.625
2015: 365 ÷ 8.65 = 42.197
c. Solvency refers to a company's ability to meet its debts as they come due. Current liabilities
represent the debts that are expected to come due first. Therefore, to be solvent, a company
must have sufficient cash or near-cash assets to meet these current liabilities. Total current
assets is one measure of near-cash assets. As indicated by the change in the company's
current ratio, the company has insufficient current assets available to settle its current liabilities.
The company's quick ratio worsened during 2015. Given that the company has insufficient
current assets and insufficient cash, marketable securities, and accounts receivable to meet its
debts, it can probably be concluded that the company's overall solvency position is not strong.
E5–8
a. Return on Equity = Net Income ÷ Average Stockholders' Equity
2012:
2013:
2014:
2015:
$510,000 ÷ [($100,000 + $100,000) ÷ 2] = 5.10
$490,000 ÷ [($100,000 + $290,000) ÷ 2] = 2.51
$515,000 ÷ [($290,000 + $315,000) ÷ 2] = 1.70
$505,000 ÷ [($315,000 + $510,000) ÷ 2] = 1.22
It appears that the additional capital provided by the owners has not been used to generate net
income. The company's net income has been relatively constant from 2012 to 2015. If the
company had been effective at using the additional capital, the company's net income should
have increased, and return on equity should have been relatively constant or increasing over
time. However, if the company has used the additional capital for long-term projects, such as a
new product, these projects may not generate any net income for several years. Once these
projects begin generating income, the company's return on equity may increase to more
appropriate levels. Therefore, the effectiveness of the company at using the owners' capital
cannot be adequately evaluated without additional information.
b. It appears that the company has overinvested in inventory. The inventory turnover and the days'
supply of inventory for each year are:
Inventory turnover
Days' supply
2012
2013
2014
2015
12.00
30.42
5.93
61.55
4.85
75.26
4.09
89.24
These ratios indicate that the company went from having one month's supply of inventory on
hand to having almost three months of inventory on hand. It appears that the company has
more inventory on hand than is warranted, given demand for the inventory. The company could
reduce inventory on hand and invest the proceeds in income-producing assets such as
marketable securities. Such a move would make the company more profitable and provide
owners a greater return on their investments. This change in investment policy would increase
the company's return on equity.
E5–9
a. Current Ratio = Current Assets ÷ Current Liabilities
2012:
2013:
2014:
2015:
$20,000 ÷ $8,000 = 2.500
$24,000 ÷ $13,000 = 1.846
$31,000 ÷ $25,000 = 1.240
$35,000 ÷ $30,000 = 1.167
Debt/Equity Ratio = Total Liabilities ÷ Total Stockholders' Equity
2012:
2013:
2014:
2015:
($8,000 + $15,000) ÷ ($20,000 + $10,000) = 0.767
($13,000 + $35,000) ÷ ($20,000 + $20,000) = 1.200
($25,000 + $40,000) ÷ ($20,000 + $32,000) = 1.250
($30,000 + $40,000) ÷ ($20,000 + $38,000) = 1.207
E5–9
Continued
Return on Assets = (Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Average Total Assets
2012:
2013:
2014:
2015:
($13,000 + [$2,000 (1 - .3)])
($14,000 + [$4,000 (1 - .3)])
($21,000 + [$5,000 (1 - .3)])
($24,000 + [$5,000 (1 - .3)])
b.
÷
÷
÷
÷
[($53,000]
= 0.272
[($53,000 + $88,000) ÷ 2] = 0.238
[($88,000 + $117,000) ÷ 2] = 0.239
[($117,000 + $128,000) ÷ 2] = 0.224
2015
Current assets
Noncurrent assets
Total assets
Current liabilities
Long-term liabilities
Capital stock
Retained earnings
Total liabilities and
stockholders' equity
2014
2013
2012
27.34%
72.66
100.00%
26.50%
73.50
100.00%
27.27%
72.73
100.00%
37.74%
62.26
100.00%
23.44%
31.25
15.62
29.69
21.37%
34.19
17.09
27.35
14.77%
39.77
22.73
22.73
15.09%
28.30
37.74
18.87
100.00%
100.00%
100.00%
100.00%
c. Solvency measures a company's ability to meet its debts as they come due. The current ratio
provides one measure of a company's solvency. Based upon this ratio, Lotechnic has sufficient
current assets to meet its current obligations. However, the trend in its current ratio indicates
that the company's excess of current assets over current liabilities is decreasing. Therefore, the
company has relatively fewer current assets available to meet its current obligations. This trend
indicates that Lotechnic Enterprises' solvency position may be worsening.
The debt/equity ratio provides an indication of a company's capitalization, which, in turn,
indicates how risky a company is. Lotechnic is relying increasingly on debt relative to
stockholders' equity to finance operations. At some point in time, the company will have to repay
this debt. The company will either have to repay this debt by (1) generating cash from
operations, (2) selling assets, (3) borrowing additional cash, or (4) acquiring cash by issuing
stock. From the statement of cash flows, the cash generated from operations has been
decreasing and is now negative; therefore, it appears that the company cannot rely on
operations to generate cash. The statement of cash flows also indicates that the company has
been using cash for investment purposes every year. This implies that the company may have
some assets that it could sell. But if these assets are used in operations, the company's
operations may be adversely affected by selling them.
Since total assets equal the sum of total liabilities and stockholders' equity, the proportion of total
liabilities to the sum of total liabilities and stockholders' equity reported on the common-size
balance sheet equals the proportion of total liabilities to total assets. This measure indicates the
proportion of total assets (based upon book value) that would have to be sold to satisfy all the
company's obligations. To meet its obligations, Lotechnic Enterprises would have to sell
approximately 55% of its total assets, which would virtually decimate its asset base.
Based upon the trend in the current ratio, the debt/equity ratio, cash flows from operations, and
the proportion of total liabilities to total assets, it appears that Lotechnic Enterprises may face
severe solvency problems as its long-term debt matures.
E5–9
Concluded
Earning power is defined as a company's ability to increase its wealth through operations and to
generate cash from operations. Earning power and solvency are closely related. A company
must have adequate resources to generate wealth. If a company experiences solvency
problems, it will most likely have to divert its resources to paying its obligations. Therefore, due
to its solvency problems, Lotechnic Enterprises may not have strong earning power. Although
Lotechnic's net income has increased every year, the company's effectiveness at managing
capital, as indicated by ROA, has decreased every year. This trend indicates that the company
may have limited earning power. This conclusion is also supported by the trend in the
company's cash flows from operations.
It must be remembered, however, that this analysis is based on very limited information. To
adequately analyze a company, additional information would be needed. Complete financial
statements, financial information for similar companies, and general economic information
should all be considered when analyzing a company's earning power and solvency position.
E5–10
Transaction
Quick Ratio
Current Ratio
Debt/Equity Ratio
(1)
–
–
+
(2)
NE
NE
+
(3)
–
–
–
(4)
–
–
+a
b
(5)
+
+
–
(6)
+
+
–
__________________
a Wage Expense would be closed into Retained Earnings at the end of the accounting period as
part of the closing process. Thus, recording wage expense would decrease stockholders' equity,
and thereby increase the debt/equity ratio.
b
This transaction would increase both Sales and Cost of Goods Sold. Both of these accounts
would be closed into Retained Earnings as part of the closing process. Since the sales price
exceeds the cost of the inventory, the net effect of this transaction would be to increase Retained
Earnings. Thus, total stockholders' equity would increase, and thereby decrease the debt/equity
ratio.
E5–12
a.
2010:
2011:
2012:
$2,408 ÷ $4,946 = 48.7%
$2,610 ÷ $5,503 = 47.4%
$2,897 ÷ $5,465 = 53.0%
b. Price Earnings Ratio
2011:
2012:
=
=
Market Price per Share ÷ Earnings per Share
Market Price per Share ÷ (Net Income ÷ Average Number of
Common Shares Outstanding)
$100.33 ÷ {$5,503 ÷ [(1,066 + 1,032) ÷ 2]} = 19.11
$ 88.21 ÷ {$5,465 ÷ [(1,032 + 1,010) ÷ 2]} = 16.49
Dividend Yield = Dividends per Share ÷ Market Price per Share
2010:
2011:
($2,408 ÷ 1,066 shares) ÷ $ 76.76 = .0294
($2,610 ÷ 1,032 shares) ÷ $100.33 = .0252
2012:
($2,897 ÷ 1,010 shares) ÷ $ 88.21 = .0325
Stock Price Return
2011:
2012:
=
(Market Price1 – Market Price0 + Dividends per Share) ÷
Market Price0
($100.33 – $76.76 + $2.53) ÷ $76.76 = 34.0%
($88.21 – $100.33 + $2.87) ÷ $100.33 = - 9.22%
c. An investment in McDonald’s stock from 2010 to 2012 would have provided a very good return
for investors in 2011, but a loss in 2012. The dividend yield was solid over this time period but
the capital appreciation from the stock price was strong in the first year but negative in the
second.
E5–14
a. Based on the 2012 numbers the Medical devices unit generated the highest operating profits
as a percentage of sales at 26.2%, slightly ahead of the Pharmaceutical unit at 24.0%
b. All three areas experience a drop in the total dollars of operating profits, but the percentage
drop was the smallest in the Medical devices unit.
P5–3
a.
Dollar
Change
Assets
Current assets:
Cash
Short-term marketable
securities
Accounts receivable
Inventory
Other current assets
Total current assets
Property, plant, & equipment
Other assets
Total assets
Percentage
Change
$
(1,904)
(32.2%)
$
691
(262)
344
(78)
(1,209)
0
1,948
738
70.9%
(7.3%)
15.0%
(5.4%)
(8.5%)
0.0%
16.7%
2.2%
(1,510)
63
135
(1)
(118)
890
(541)
43
47
1,189
(99.2%)
5.6%
16.8%
(0.2%)
(45.0%)
19.0%
(6.1%)
0.4%
3.5%
8.0%
Liabilities and Stockholders' Equity
Current liabilities:
Short-term borrowings
$
Accounts payable
Wages payable
Dividend payable
Income taxes payable
Other current liabilities
Total current liabilities
$
Long-term debt
Contributed capital
Retained earnings
Total liabilities and
stockholders' equity
$
738
2.2%
P5–3
Concluded
b.
2012
2011
Change
Assets
Current assets:
Cash
Short-term marketable securities
Accounts receivable
Inventory
Other current assets
Total current assets
Property, plant, and equipment
Other assets
Total assets
11.68%
4.84%
9.70%
7.69%
3.99%
37.90%
22.56%
39.54%
100.00%
17.60%
2.90%
10.69%
6.83%
4.31%
42.33%
23.05%
34.62%
100.00%
(33.64%)
66.90%
(9.26%)
12.59%
(7.43%)
(10.44%)
(2.13%)
14.21%
Liabilities and Stockholders' Equity
Current liabilities:
Short-term borrowings
Accounts payable
Wages payable
Dividend payable
Income taxes payable
Other current liabilities
Total current liabilities
Long-term debt
Contributed capital
Retained earnings
Total liabilities and stockholders' equity
00.03%
3.45%
2.73%
1.57%
0.42%
16.18%
24.39%
32.66%
(3.82%)
46.77%
100.00%
4.52%
3.34%
2.39%
1.61%
0.78%
13.90%
26.54%
33.25%
(4.05%)
44.26%
100.00%
(99.34%)
3.29%
14.23%
(2.48%)
(46.15%)
16.49%
(8.07%)
(1.77%)
(5.68%)
5.67%
(Other Current Assets and Other Current Liabilities are rounded to result in a value of 100% in
column addition.)
c. Common-size financial statements provide relative comparisons of account balances rather than
absolute comparisons of account balances. Absolute comparisons only provide information
about whether an account balance has increased or decreased. Alternatively, relative
comparisons provide information about whether an account balance has increased or decreased
relative to a benchmark measure. This relative comparison allows financial statement users to
determine more easily if a company is altering the composition of its assets, liabilities, or
stockholders' equity. Relative comparisons of account balances may also provide users with
insights into why account balances are changing.
P5–4
(1)
Return on equity measures a company's effectiveness at managing equity investments.
Return on equity is calculated as net income divided by average stockholders' equity.
2014:
2015:
$515,000 ÷ [($450,000 + $755,000) ÷ 2] = .855
$510,000 ÷ [($755,000 + $795,000) ÷ 2] = .658
The company generated returns on its owners' investments in excess of 65%, which appears
to be rather substantial. However, without being able to compare Gidley Electronics'
performance to industry averages, it is difficult to conclude whether the company is really
effective in managing the owners' capital.
P5–4
(2)
Continued
Return on equity measures a company's effectiveness at managing owners' investments, while
return on assets measures a company's effectiveness at managing all investments, both debt
and equity. The excess of return on equity over return on assets indicates a company's
effectiveness at using debt to generate returns for the owners. This measure is called financial
leverage. Since financial leverage is calculated using return on assets, the first step is to
calculate return on assets. Return on assets is calculated as the sum of net income and
[interest expense x (1- tax rate)] divided by average total assets. Gidley's return on assets for
2014 and 2015 is:
2014:
2015:
($515,000 + [$165,000 (1 - .40)]) ÷ [($1,450,000 + $1,470,000) ÷ 2] = .421
($510,000 + [$150,000 (1 - .40)]) ÷ [($1,470,000 + $1,465,000) ÷ 2] = .409
Gidley's financial leverage for 2014 and 2015 is, therefore:
2014:
2015:
.855 – .421 = .434
.658 – .409 = .249
The company is using debt to the benefit of its equity owners. The positive leverage indicates
that proceeds from debt are generating sufficient profits to provide a return for the equity
owners. In other words, the return from using debt exceeds its cost.
(3)
The current ratio measures whether a company has sufficient current assets to meet its current
liabilities. The current ratio equals current assets divided by current liabilities. Gidley's current
ratio for 2014 and 2015 is:
2014:
2015:
$1,010,000 ÷ $275,000 = 3.673
$980,000 ÷ $290,000 = 3.379
Gidley Electronics' current assets are over three times greater than its current liabilities. The
company therefore appears to have no solvency problems. However, the company may be
unable to convert some of its current assets to cash quickly enough to meet some of its current
liabilities. Another measure of solvency that compares near-cash assets to current liabilities is
the quick ratio. The quick ratio equals the sum of cash, marketable securities, and accounts
receivable divided by current liabilities. Gidley's quick ratio for 2014 and 2015 is:
2014:
2015:
($115,000 + $220,000 + $400,000) ÷ $275,000 = 2.673
($110,000 + $175,000 + $350,000) ÷ $290,000 = 2.190
Gidley Electronics appears to have sufficient cash and near-cash assets available to meet its
current obligations. Therefore, the company should have no significant short-term solvency
problems.
P5–4
(4)
Concluded
The price/earnings ratio measures the sensitivity of stock prices to changes in earnings. This
ratio is calculated by dividing the market price per share by earnings per share. Since this
ratio uses earnings per share in the calculations, the first step is to calculate earnings per
share. Earnings per share is calculated by dividing net income by the average number of
common shares outstanding during the year. Gidley's earnings per share for 2014 and 2015
are:
2014:
2015:
$515,000 ÷ [(17,000 + 17,000) ÷ 2] = $30.29
$510,000 ÷ [(17,000 + 22,000) ÷ 2] = $26.15
Gidley's price/earnings ratio for 2014 and 2015 is:
2014:
2015:
$69.00 ÷ $30.29 = 2.278
$54.00 ÷ $26.15 = 2.065
It appears that the price of Gidley Electronics' stock is rather sensitive to changes in earnings.
A change in earnings per share should cause the market price to change by approximately
twice the change. To obtain a better idea of how sensitive the company's stock is to changes
in earnings, the company's price/earnings ratio should be compared to industry averages.
(5)
The average number of days accounts receivable are outstanding is calculated as 365 days
divided by accounts receivable turnover. The accounts receivable turnover is, in turn,
calculated by dividing net credit sales by average accounts receivable. Gidley's accounts
receivable turnover for 2014 and 2015 is:
2014:
2015:
$3,010,000 ÷ [($400,000 + $400,000) ÷ 2] = 7.525
$2,450,000 ÷ [($400,000 + $350,000) ÷ 2] = 6.533
The number of days outstanding for receivables during 2014 and 2015 is:
2014:
2015:
365 ÷ 7.525 = 48.505 days
365 ÷ 6.533 = 55.870 days
The average number of days accounts receivable are outstanding increased slightly.
Therefore, customers are not paying their open receivables as quickly as before. If this
problem persists, Gidley may have to consider more stringent credit and/or collection policies.
P5–5
a. Return on equity provides a measure of a company's effectiveness at managing the owners'
capital. The formula for calculating return on equity is net income divided by average
stockholders' equity. The 2015 return on equity for Hathaway Toy Company and Yakima
Manufacturing would be:
Hathaway:
Yakima:
$875,000 ÷ [($1,585,000 + $2,460,000) ÷ 2] = .433
$755,000 ÷ [($70,000 + $825,000) ÷ 2] = 1.687
Note: Beginning Stockholders' Equity = Ending Stockholders' Equity – Net Income
Based on return on equity, Yakima Manufacturing has been almost four times more efficient than
Hathaway Toy Company at managing owners' capital.
P5–5
Concluded
b. Return on assets provides a measure of a company's effectiveness at managing all investors'
capital. The formula for calculating return on assets is the sum of net income and tax-adjusted
interest expense divided by average total assets. The 2015 return on assets for Hathaway Toy
Company and Yakima Manufacturing would be:
Hathaway:
Yakima:
($875,000 + $0) ÷ [($1,825,000 + $2,700,000) ÷ 2] = .387
($755,000 + $195,000[1 – 0.00]) ÷ [($1,945,000 + $2,700,000) ÷ 2] = .409
Note: Beginning Total Assets
=
=
Ending Total Assets – Net Income
Total Liabilities and Stockholders' Equity – Net Income
Based on return on assets, Yakima Manufacturing and Hathaway Toy Company are essentially
equal in their abilities to manage all investors' capital.
c. Earnings per Share = Net Income ÷ Average Number of Common Shares Outstanding
Hathaway:
Yakima:
$875,000 ÷ [(80,000 + 80,000) ÷ 2] = $10.94
$755,000 ÷ [(35,000 + 35,000) ÷ 2] = $21.57
Note: The number of shares outstanding equals the balance in Common Stock divided by $10
par value per share.
d. Yes, stockholders are realizing a return on their capital of 168.7% (from Part [a]), while
debtholders are realizing only a return on their capital of approximately 10.5% ($195,000 of
interest expense ÷ $1,850,000 balance in mortgage payable). This difference in returns is
due to the company using debt rather than equity to finance operations. Since the
debtholders are only entitled to interest, any earnings from operations in excess of interest
accrues to the stockholders. Thus, Yakima Manufacturing has efficiently used debt to benefit
its stockholders.
P5–6
In order to consider an investment in Goodyear, let us first compute the following ratios:
1. Return on Equity
=
Net Income ÷ Average Stockholders’ Equity
2011: $ 321 ÷ [($1,505 + $1,624) ÷ 2] = 20.5%
2012: $183 ÷ [($1,624 + $1,159) ÷ 2] = 13.2%
2. Return on Sales
=
(Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Net Sales
2011: ($321 + [$330 (1 – 0.30)]) ÷ $22,767 = 2.4%
2012: ($183 + [$357 (1 – 0.30)]) ÷ $20,992 = 2.1%
P5–6
Concluded
3. Current Ratio
=
Current Assets ÷ Current Liabilities
2011: $9,812
2012: $8,498
4. Debt/Equity Ratio
÷
÷
=
2011: $16,005
2012: $15,814
$5,929
$5,322
=
=
1.65
1.60
Total Liabilities ÷ Total Stockholders’ Equity
÷
÷
$1,624
$1,159
=
=
9.86
13.64
Generally, an equity investor would have much more information available to make a decision
than what is provided by Goodyear. However, based on the information provided, an equity
investment in Goodyear would be unwise. The company is showing a lower ROE and return on
sales, has high leverage on its balance sheet and is generating a drop in cash balances. Until
Goodyear can turn around its operations, it is not an attractive opportunity.
P5–7
a. Return on Equity = Net Income ÷ Average Stockholders' Equity
Robotronics:
Technology:
$610,000 ÷ [($1,005,000 + $1,005,000) ÷ 2] = .607
$1,675,000 ÷ [($1,440,000 + $1,440,000) ÷ 2] = 1.163
Based on return on equity, Technology is almost twice as efficient as Robotronics at managing
the stockholders' capital. If unusual items were not considered, return on equity for each
company would be:
Robotronics:
Technology:
$610,000 ÷ [($1,005,000 + $1,005,000) ÷ 2] = .607
($1,675,000 – $1,300,000) ÷ [($1,440,000 + $1,440,000) ÷ 2] = .260
Technology now appears to be considerably worse than Robotronics at managing the
stockholders' capital. Including unusual items in calculating return on equity does provide a
more complete measure of how efficiently a company managed its stockholders' equity in the
current year. However, since unusual items are, by definition, items that occur infrequently,
these items do not indicate a company's continued ability to efficiently manage the stockholders'
capital. Thus, unusual items probably should not be used to calculate return on equity.
P5–7 Concluded
b. Financial leverage indicates how effectively a company uses debt for the benefit of stockholders.
Financial leverage equals return on equity less return on assets. Thus, return on assets must be
calculated before calculating financial leverage.
Return on Assets = (Net Income + Interest Expense (net of tax)) ÷ Average Total Assets
Robotronics:
Technology:
($610,000 + $100,000) ÷ [($3,360,000 + $3,360,000) ÷ 2] = .211
($1,675,000 + $175,000) ÷ [($1,870,000 + $1,870,000) ÷ 2] = .989
Financial Leverage = Return on Equity – Return on Assets
Robotronics:
Technology:
.607 – .211 = .396
1.163 – .989 = .174
From this analysis, Robotronics is approximately twice as effective as Technology at using debt
to generate returns for its stockholders. If unusual items are not considered, the return on assets
for each company would be:
Robotronics:
Technology:
($610,000 + $100,000) ÷ [($3,360,000 + $3,360,000) ÷ 2] = .211
[($1,675,000 – $1,300,000) + $175,000] ÷ [($1,870,000 +
$1,870,000) ÷ 2] = .294
Therefore, the financial leverage of the two companies would be:
Robotronics:
Technology:
.607 – .211 = .396
.260 – .294 = –.034
If unusual items are not considered, Technology has negative financial leverage. That means
that Technology is not generating a large enough return on its debt to even cover the interest
expense. Thus, Technology is using debt to the detriment of its stockholders. It appears,
therefore, that unusual items can affect the conclusions one draws when analyzing a company.
P5–8
Return on Sales
.08
Net Sales
=
=
Net Income ÷ Net Sales
$25,000 ÷ Net Sales
=
$312,500
Cost of Goods Sold
=
=
=
Net sales x (1 – Gross Margin Percentage)
$312,500 x (1 – 40%)
$187,500
Net Income
$25,000
Expenses
=
=
=
Net Sales – Cost of Goods Sold – Expenses
$312,500 – $187,500 – Expenses
$100,000
Inventory Turnover
5
Ending Inventory
=
=
=
Cost of Goods Sold ÷ Average Inventory
$187,500 ÷ [($0 + Ending Inventory) ÷ 2]
$75,000
Receivables Turnover
8
Accounts Receivable
=
=
Net Credit Sales ÷ Average Accounts Receivable
$312,500 ÷ [($0 + Ending Accounts Receivable)÷2) Ending
$78,125
Quick Ratio
=
.5
Cash
=
=
(Cash + Accounts Receivable + Marketable Securities) ÷
Current Liabilities
(Cash + $78,125 + $0) ÷ $200,000
$21,875
=
Tumwater Canyon Campsites
Income Statement
For the Year Ended December 31, 2015
Sales
Cost of goods sold
Gross profit
Expenses
Net income
$312,500
187,500
$125,000
100,000
$ 25,000
Tumwater Canyon Campsites
Statement of Current Assets and Liabilities
December 31, 2015
Current assets
Cash
Accounts receivable
Inventory
Total current assets
$ 21,875
78,125
75,000
$175,000
Current liabilities
Accounts payable
$200,000
Total current liabilities
________
$200,000
P5–9
a.
Mountain-Pacific Railroad
Common-Size Balance Sheet
December 31, 2015 and 2014
2015
Assets
Current assets:
Cash
Short-term marketable securities
Accounts receivable
Inventory
Prepaid expenses
Total current assets
Long-term investments
Property, plant, and equipment
Accumulated depreciation
Total assets
Liabilities and Stockholders' Equity
Current liabilities:
Accounts payable
Wages payable
Dividends payable
Income taxes payable
Current portion of long-term debt
Total current liabilities
Mortgage payable
Common stock ($10 par value)
Additional paid-in capital
Retained earnings
Total liabilities and
stockholders' equity
2014
Dollar
%
Dollar
10,000
125,000
500,000
200,000
50,000
$ 885,000
225,000
430,000
(65,000)
$ 1,475,000
0.68%
8.47%
33.90%
13.56%
3.39%
60.00%
15.25%
29.15%
(4.40%)
100.00%
$ 312,000
120,000
150,000
210,000
75,000
$ 867,000
225,000
540,000
(100,000)
$ 1,532,000
20.36%
7.83%
9.79%
13.71%
4.90%
56.59%
14.69%
35.25%
(6.53%)
100.00%
$
50,000
2,000
5,000
35,000
175,000
$ 267,000
450,000
110,000
95,000
610,000
3.26%
0.13%
0.33%
2.29%
11.42%
17.43%
29.37%
7.18%
6.20%
39.82%
$ 1,532,000
100.00%
$
$
10,000
5,000
125,000
50,000
100,000
290,000
350,000
200,000
135,000
500,000
0.68%
0.34%
8.47%
3.39%
6.78%
19.66%
23.73%
13.56%
9.15%
33.90%
$ 1,475,000
100.00%
$
%
P5–9
Continued
Mountain-Pacific Railroad
Common-Size Income Statement
For the Years Ended December 31, 2015 and 2014
2015
Dollar
Revenue:
Net cash sales
Net credit sales
Total revenue
Cost of goods sold:
Beginning inventory
Net purchases
Cost of goods available for sale
Less ending inventory
Cost of goods sold
Gross profit
Selling & administrative expenses:
Depreciation expense
General selling expenses
General administrative expenses
Total selling & administrative
exp.
Income from operations
Interest expense
Income from continuing operations
(before taxes)
Income taxes
Income before unusual items
Unusual loss (net of tax
benefit of $60,000)
Net income
$ 1,955,000
4,150,000
$ 6,105,000
$
210,000
4,005,000
$ 4,215,000
200,000
$ 4,015,000
$ 2,090,000
2014
%
32.02%
67.98%
100.00%
Dollar
$ 2,775,000
1,410,000
$ 4,185,000
%
66.31%
33.69%
100.00%
3.44%
65.60%
69.04%
3.28%
65.76%
34.24%
$
300,000
2,475,000
$ 2,775,000
210,000
$ 2,565,000
$ 1,620,000
7.17%
59.14%
66.31%
5.02%
61.29%
38.71%
75,000
575,000
480,000
1.23%
9.42%
7.86%
$
90,000
600,000
420,000
2.15%
14.34%
10.04%
$ 1,130,000
$ 960,000
50,000
18.51%
15.73%
0.82%
$ 1,110,000
$ 510,000
65,000
26.53%
12.18%
1.55%
$
14.91%
5.08%
9.83%
$
$
910,000
310,000
600,000
$
445,000
151,000
294,000
10.63%
3.61%
7.02%
$
115,000
485,000
1.88%
7.95%
$
0
294,000
0.00%
7.02%
$
By looking at the common-size balance sheets and income statements, we can observe the
following:
1. The proportion of current assets to total assets has increased slightly from 57% to 60%. The
composition of current assets has changed dramatically. Cash balance has declined by
about 19% and accounts receivables have gone up by about 24%.
2. Since current liabilities are up by 2% and long-term debt is reduced by only 6%, it is not
clear, without the statement of cash flows, where the cash went.
3. Such a dramatic increase of 24% in the accounts receivable can be a cause for concern. Is
the company relaxing its credit policies or is it having a poor collection year? Depending
upon the cause, one may anticipate that net cash flow problems could occur in 2016.
P5–9
Concluded
4. Since retained earnings are down by approximately 6%, and the net income is slightly up,
one can only conclude, in the absence of other information, that a hefty dividend was
probably paid. This could also explain the dramatic decrease in the cash balance.
5. It seems that the relative composition of cash versus credit sale is switching from 2014 to
2015. This corroborates the dramatic increase in accounts receivable.
6. It is also clear that the company’s increased cost of goods sold has cut into its gross profit,
which is down by almost the same amount (4%) as the increment in the cost of goods sold.
7. The company has been quite successful in running tight operations, as is evidenced by a
reduction in the total selling and administrative expenses. Reductions such as this would add
value to its stock in the long run.
b. The proportion of credit sales and cash sales to total sales changed dramatically from 2014 to
2015. The company made approximately twice as many credit sales during 2015 as it made
during 2014. This shift flowed through to the balance sheet. Fewer cash sales caused (1) the
Cash balance to decrease and (2) the Accounts Receivable balance to increase during 2015.
c. Common-size financial statements allow people to make comparisons across time and across
companies by providing a benchmark against which to make the comparisons. Standard
financial statements allow only absolute comparisons. By providing a benchmark, common-size
financial statements allow relative comparisons. Such comparisons allow financial statement
users to focus on the relative importance of an account rather than on whether an account
simply increased or decreased in absolute terms. Further, common-size financial statements can
provide financial statement users with insights as to why an account balance changed or why a
certain trend has developed. For example, in the case of Mountain-Pacific Railroad, the shift in
the relative importance of cash and accounts receivable can be explained by examining the shift
in the relative importance of cash and credit sales.
P5–10
a. Return on Equity = Net Income ÷ Average Stockholders' Equity
2014: $294,000 ÷ $815,000 = .361
2015: $485,000 ÷ [($815,000 + $835,000) ÷ 2] = .588
Current Ratio = Current Assets ÷ Current Liabilities
2014: $867,000 ÷ $267,000 = 3.247
2015: $885,000 ÷ $290,000 = 3.052
Quick Ratio = (Cash + Marketable Securities + Accounts Receivable) ÷ Current Liabilities
2014: ($312,000 + $120,000 + $150,000) ÷ $267,000 = 2.180
2015: ($10,000 + $125,000 + $500,000) ÷ $290,000 = 2.190
P5–10
Continued
Return on Assets = (Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Average Total Assets
2014: ($294,000 + [$65,000 (1 - .34)]) ÷ $1,532,000 = .220
2015: ($485,000 + [$50,000 (1 - .34)]) ÷ [($1,532,000 + $1,475,000) ÷ 2] = .345
Receivables Turnover = Net Credit Sales ÷ Average Accounts Receivable
2014: $1,410,000 ÷ $150,000 = 9.400
2015: $4,150,000 ÷ [($150,000 + $500,000) ÷ 2] = 12.769
Earnings per Share = Net Income ÷ Average Number of Common Shares Outstanding
2014: $294,000 ÷ 11,000 = $26.73
2015: $485,000 ÷ [(11,000 + 20,000) ÷ 2] = $31.29
Price/Earnings Ratio = Market Price per Share ÷ Earnings per Share
2014: $45.00 ÷ $26.73 = 1.684
2015: $70.00 ÷ $31.29 = 2.237
Debt/Equity Ratio = Total Liabilities ÷ Total Stockholders' Equity
2014: ($267,000 + $450,000) ÷ $815,000 = .880
2015: ($290,000 + $350,000) ÷ $835,000 = .766
Return on Sales = (Net Income + [Interest Expense (1 – Tax Rate)]) ÷ Net Sales
2014: ($294,000 + [$65,000 (1 - .34)]) ÷ $4,185,000 = .081
2015: ($485,000 + [$50,000 (1 - .34)]) ÷ $6,105,000 = .085
Financial Leverage = Return on Equity – Return on Assets
2014: .361 – .220 = .141
2015: .588 – .345 = .243
Dividend Yield = Dividend per Share ÷ Market Price per Share
2014: ($10,000 ÷ 11,000 shares) ÷ $45 = .020
2015: {$595,000 ÷ [(11,000 + 20,000) ÷ 2]} ÷ $70 = .548
Return on Investment =
(Market Price1 – Market Price0 + Dividends per Share) ÷
Market Price0
2014: ($45 – $50 + $0.91) ÷ $50 = –.082
2015: ($70 – $45 + $38.39) ÷ $45 = 1.409
P5–10
Continued
Interest Coverage Ratio = (Net Income Before Taxes and Interest Expense) ÷ Interest Expense
2014: ($445,000 + $65,000) ÷ $65,000 = 7.846
2015: ($910,000 + $50,000) ÷ $50,000 = 19.200
Inventory Turnover = Cost of Goods Sold ÷ Average Inventory
2015: $4,015,000 ÷ [($210,000 + $200,000) ÷ 2] = 19.585
It appears that during 2015 the company became more efficient at using capital provided by all
investors and by equity owners. Both return on assets and return on equity increased by over
50% during 2015. Further, as evidenced by the increase in financial leverage, the company was
also more efficient at using debt to benefit the equity owners.
The dramatic increase in inventory turnover is probably the primary reason the company became
more efficient at using capital. The higher number of inventory turns allowed the company to
generate more profits, thereby increasing return on equity, return on assets, financial leverage,
and earnings per share. The company also became slightly more efficient at managing its costs,
as evidenced by the increase in return on sales.
The company has more than sufficient current assets to meet its current liabilities, as evidenced
by its current ratio. The company's receivable turnover increased dramatically during 2015,
which indicates that it is doing a better job of collecting from its customers. Closer inspection of
the receivable turnover, however, reveals that Mountain-Pacific may actually be doing a worse
job of collecting from its credit customers. If the 2015 receivable turnover is calculated using just
the December 31, 2015 receivables balance instead of using the average receivables balance,
the receivable turnover falls to 8.3, which is less than the turnover rate in 2014. Further, the
increase in the inventory turnover may indicate future solvency problems. As the inventory
turnover increases, the company will have to acquire inventory more often. Therefore, increasing
the number of inventory turnovers places added pressure on the company to have sufficient
cash to meet its debts as they come due. If the company is unable to generate cash from its
receivables on a timely basis, and if it continues to suffer a decline in cash sales, it could very
well experience severe solvency problems.
P5–10
Concluded
b. Based on the average of the company's 2014 and 2015 ratios, Mountain-Pacific's return on
equity, current ratio, and return on assets are almost identical to the industry averages. While the
absolute levels of these ratios are similar, the trend of Mountain-Pacific's ratios provides
additional information on the company's performance. Based on return on equity, the company
has become more efficient during 2012 at managing the equity owners' capital, and based on
return on assets, the company has also become more efficient at managing the capital provided
by both debt and equity investors. These trends imply that Mountain-Pacific has also become
more effective at using debt to benefit the equity owners. Further, the company is now more
efficient than the average company in the industry. Several other ratios, such as receivables
turnover, return on investment, and times interest earned, indicate that Mountain-Pacific is also
performing better than the industry average.
When Mountain-Pacific’s quick ratio is compared to the industry average, the company's
solvency position appears to be better. Without having additional information about MountainPacific's solvency position, it is difficult to conclude how the company is performing relative to the
rest of the industry.
P5–12
a. Watson Metal Products' 2016 income statements under the different financing alternatives would
be as follows.
Income from operations*
Interest expense
Net income before taxes
Income taxes
Net income
* $16,500,000
Alternative 1
Alternative 2
Alternative 3
$ 16,500,000
4,000,000
$ 12,500,000
5,000,000
$ 7,500,000
$ 16,500,000
4,750,000
$ 11,750,000
4,700,000
$ 7,050,000
$ 16,500,000
4,375,000
$ 12,125,000
4,850,000
$ 7,275,000
= $15,000,000 2016 income from operations from non-French
operations per the 2015 income statement + $1,500,000 2016
income from operations from French operations.
The formulas for the requested ratios are:
Earnings per Share
Return on Equity
Return on Assets
Financial Leverage
Debt/Equity Ratio
=
=
=
=
=
Net Income ÷ Average Number of Common Shares Outstanding
Net Income ÷ Average Stockholders' Equity
(Net Income + [Interest Expense (1– Tax Rate)]÷ Average Total Assets
Return on Equity – Return on Assets
Total Liabilities ÷ Total Stockholders' Equity
Note: Although several of the ratios use averages, ending balances were used as specified in
the problem.
Alternative 1
EPS: $7,500,000 ÷ (2,000,000 shares* + 200,000 shares) = $3.41
* 2,000,000 shares = $6,600,000 2015 net income ÷ $3.30 2015 earnings per share
ROE: $7,500,000 ÷ ($45,000,000 + $5,000,000a + $7,500,000b) = .1304
a $5,000,000 = 200,000 shares  $25 per share
b $7,500,000 = 2016 net income
ROA: ($7,500,000 + [$4,000,000 (1 – .4)]) ÷ ($35,000,000 + $45,000,000 + $5,000,000 +
$7,500,000) = .1070
Leverage: .1304 – .1070 = .0234
Debt/Equity:
$35,000,000 ÷ ($45,000,000 + $5,000,000 + $7,500,000) = .609
Alternative 2
EPS: $7,050,000 ÷ 2,000,000 shares = $3.53
ROE: $7,050,000 ÷ ($45,000,000 + $7,050,000) = .1354
ROA: ($7,050,000 + [$4,750,000 (1 - .40]) ÷ ($35,000,000 + $45,000,000 + $5,000,000 +
$7,050,000) = .1076
Leverage: .1354 – .1076 = .0278
Debt/Equity:
($35,000,000 + $5,000,000) ÷ ($45,000,000 + $7,050,000) = .768
Alternative 3
EPS: $7,275,000 ÷ (2,000,000 shares + 100,000 shares) = $3.46
ROE: $7,275,000 ÷ ($45,000,000 + $2,500,000* + $7,275,000) = .1328
* $2,500,000 = 100,000 shares  $25 per share
ROA: ($7,275,000 + [$4,375,000 (1 - .4)]) ÷ ($35,000,000 + $45,000,000 + $5,000,000 +
$7,275,000) = .1073
Leverage: .1328 – .1073 = .0255
Debt/Equity: ($35,000,000 + $2,500,000) ÷ ($45,000,000 + $2,500,000 + $7,275,000) = .685
b. Alternative 2 prevents a dilution of the stockholders' position. Since this alternative did not
require any additional shares of stock to be issued, it provides the largest earnings per share.
Alternative 2 allows the company to more effectively manage its stockholders' investment, as
evidenced by return on equity, and all investments, as evidenced by return on assets. The only
potentially serious drawback of this alternative is that it makes the company more risky, as
evidenced by it having the largest debt/equity ratio. Further, Alternative 2 allows the company to
use debt to benefit stockholders more effectively than is allowed with either of the other two
alternatives. Under Alternative 3, stockholders earn a slightly smaller return on their equity, but
incur fewer risks, since the company has issued less debt. Alternative 1 provides a marginally
lower return to stockholders, but imposes even less risk on them. Stockholders must trade off the
risk from issuing debt against the benefits of issuing debt. If the company is close to violating
debt covenants or projects weak future cash flows, then Alternatives 1 or 3 would probably be
preferable. Otherwise, Alternatives 2 or 3 would probably be preferable.
P5–12
c.
Concluded
Alternative 1
$3.30 = ($6,600,000 + Net income from expansion project) ÷ (2,000,000 shares +
200,000 shares)
Net income from expansion project = $660,000
Alternative 2
$3.30 = ($6,600,000 + Net income from expansion project) ÷ 2,000,000 shares
Net income from expansion project = $0
Alternative 3
$3.30 = ($6,600,000 + Net income from expansion project) ÷ (2,000,000 shares +
100,000 shares)
Net income from expansion project = $330,000
P5–13
Note: Although some ratios use average balances, year-end balances were used in the ratios as
directed in the problem.
a.
Return on Equity =
.75 =
Total Stockholders' Equity =
b.
Debt/Equity Ratio =
.4 =
Total Liabilities =
c. Total Assets
d.
e.
f.
=
=
=
Return on Assets
.65
Interest Expense
Total Liabilities ÷ Total Stockholders' Equity
Total Liabilities ÷ $600,000
$240,000
Total Liabilities + Total Stockholders' Equity
$240,000 + $600,000
$840,000
=
=
=
(Net Income + Interest Expense) ÷ Total Assets
($450,000 + Interest Expense) ÷ $840,000
$96,000
Net Income After Taxes =
$450,000 =
Net Income Before Taxes =
Return on Sales =
.2 =
Net Sales =
g. Credit Sales
Net Income ÷ Total Stockholders' Equity
$450,000 ÷ Total Stockholders' Equity
$600,000
Income Before Taxes  (1 – Tax Rate)
Net Income Before Taxes  (1 – 34%)
$681,818
Net Income ÷ Net Sales
$450,000 ÷ Net Sales
$2,250,000
= Net Sales  80%
= $2,250,000  80%
= $1,800,000
P5–13
Concluded
h. Receivables Turnover =
25 =
Accounts Receivable =
Net Credit Sales ÷ Accounts Receivable
$1,800,000 ÷ Accounts Receivable
$72,000
i.
Cost of Goods Sold
Net Sales  55%
$2,250,000  55%
$1,237,500
j.
Average Days' Supply of Inventory =
12.167 =
Inventory Turnover =
k.
l.
m.
Inventory Turnover
30
Inventory
Current Liabilities
=
=
=
Cost of Goods Sold ÷ Inventory
$1,237,500 ÷ Inventory
$41,250
Current Assets ÷ Current Liabilities
Current Assets ÷ $84,000
$252,000
Quick Ratio
=
2.0
Marketable Securities
=
=
o. Noncurrent Assets
365 ÷ Inventory Turnover
365 ÷ Inventory Turnover
30
= Total Liabilities  35%
= $240,000  35%
= $84,000
Current Ratio =
3.00 =
Current Assets =
n.
p.
=
=
=
=
=
=
(Cash + Accounts Receivable + Mkt. Securities) ÷ Current
Liabilities
($68,000 + $72,000 + Marketable Securities) ÷ $84,000
$28,000
Total Assets – Current Assets
$840,000 – $252,000
$588,000
Earnings per Share
$16.00
Common Shares Outstanding
=
=
=
Net Income ÷ Number of Common Shares Outstanding
$450,000 ÷ Number of Common Shares Outstanding
28,125 shares
ID5–1
(1) Bank of America
(2) Bed, Bath & Beyond
(3) HP
(4) Kelly Services
Bank of America is Company #1. As a commercial bank, B of A generates service revenue (see
Income Statement) and carries receivables (loans) that are funded by deposits (current liabilities on
the balance sheet). Banks also are highly leveraged; Company #1 has the lowest equity of the four
companies shown.
Bed, Bath & Beyond is Company #2. As a retailer, BB & B generates sales revenue from providing
inventory to its customers. Company #2 is the only company of the four shown with 100% sales
revenue. Further, the company has a significant investment in inventories, as do all retailers.
Hewlett Packard is Company #3. As a technology and consulting company, HP will generate both
sales revenue (from the sale of products such as printers) and service revenue (from its consulting
business). Of the four companies, only #3 has a mix of sales and service revenue. The company
also has investment in inventories, receivables and long-term assets, common for a manufacturing
concern.
Kelly Services is Company #4. As a temp agency, Kelly will generate service revenue from placing
workers and will also carry accounts receivable from its large clients. The company does not carry
inventory and does not need a significant investment in long-term assets to operate.
ID5–2
(1) General Electric
(2) EchoStar
(3) Walgreen’s
(4) Campbell’s Soup
General Electric is Company #1. GE operates as both a manufacturer and a diversified financial
services firm, generating both sales and service revenue. The financial services business, similar to
Bank of America in ID5-1, will carry a significant amount of receivables.
EchoStar is Company #2. The company sells customers satellite dishes and the television services
that are received by the dishes. Further, satellite television services are a relatively new business;
start-up operations often show losses for a number of years and Company #2 is showing a loss on
the income statement.
Walgreen’s is Company #3. As a retailer, the company will generate sales revenue and carry heavy
investment in inventories. (The inventory line is greater in #3 than it is in #4.)
Campbell’s is Company #4. The description indicates that Campbell’s has been growing by
acquisition, which usually generates goodwill, an intangible asset carried under “Other Assets”.
Further, manufacturers typically carry balances in receivables, inventory and long-term assets such
as property, plant and equipment.