Chapter 18 Solution pdf form BAT4M

Weygandt, Kieso, Kimmel, Trenholm, Kinnear Accounting Principles, Third Canadian Edition

CHAPTER 18

Financial Statement Analysis

ASSIGNMENT CLASSIFICATION TABLE

Study Objectives

1. Explain and apply horizontal analysis.

2. Explain and apply vertical analysis.

3. Identify and use ratios to analyze a company’s liquidity, profitability, and solvency.

4. Recognize and illustrate the limitations of financial statement analysis.

Questions

1, 2, 3, 4,

5

4, 5, 6, 7 3, 4, 5

8, 9, 10,

11, 12, 13,

14, 15, 16

17, 18, 19,

20, 21, 22

Brief

Exercises Exercises

1, 2 3 1, 3, 4

6, 7, 8, 9,

10, 11

12, 13,

14

2, 3, 4

5, 6, 7, 8,

9, 10, 11

12, 13

Problems

Set A

1

2

2, 3, 4, 5,

6, 7, 8, 9

9, 10

Problems

Set B

1

2

2, 3, 4, 5,

6, 7, 8, 9

9, 10

Solutions Manual 18-1 Chapter 18

Copyright © 2009 John Wiley & Sons Canada, Ltd. Unauthorized copying, distribution, or transmission of this page is strictly prohibited.


ASSIGNMENT CHARACTERISTICS TABLE

Problem

Number Description

Difficulty

Level

1A

2A

10A

1B

2B

3B

4B

5B

6B

7B

8B

9B

3A

4A

5A

6A

7A

8A

9A

10B

Prepare horizontal analysis and comment.

Prepare vertical analysis, calculate profitability ratios, and comment.

Calculate ratios.

Calculate and evaluate ratios for two years.

Calculate and evaluate ratios for two companies.

Analyze ratios.

Analyze ratios.

Determine impact of transactions on ratios.

Calculate and evaluate profitability ratios with discontinued operations.

Prepare income statement and statement of retained earnings, with irregular items.

Prepare horizontal analysis and comment.

Prepare vertical analysis, calculate profitability ratios, and comment.

Calculate ratios.

Calculate and evaluate ratios for two years.

Calculate and evaluate ratios for two companies.

Analyze ratios.

Analyze ratios.

Determine impact of transactions on ratios.

Calculate and evaluate profitability ratios with discontinued operations.

Prepare income statement and statement of retained earnings, with irregular items.

Simple

Moderate

Moderate

Moderate

Moderate

Moderate

Moderate

Complex

Moderate

Moderate

Simple

Moderate

Moderate

Moderate

Moderate

Moderate

Moderate

Complex

Moderate

Moderate

25-35

60-70

50-60

35-40

70-80

45-55

25-35

15-20

20-25

55-65

25-35

Time

Allotted (min.)

60-70

50-60

35-40

70-80

45-55

25-35

15-20

20-25

55-65




BLOOM’S TAXONOMY TABLE

Correlation Chart between Bloom’s Taxonomy, Study Objectives and End-of-

Chapter Material

Study Objectives Knowledge Comprehension Application

1. Explain and apply horizontal

Q18-2 Q18-1

Q18-3

Q18-4

BE18-1

BE18-2

BE18-3 analysis. Q18-5 E18-1

E18-3

E18-4

P18-1A

P18-1B

2. Explain and apply vertical analysis.

Q18-6 Q18-4

Q18-5

Q18-7

3. Identify and use ratios to analyze a company’s liquidity, profitability, and solvency.

Q18-8 Q18-9

Q18-12

Q18-14

BE18-6

E18-5

BE18-3

BE18-4

BE18-5

E18-2

E18-3

E18-4

BE18-7

BE18-10

BE18-11

E18-10

P18-3A

P18-9A

P18-3B

P18-9B

Analysis

P18-2A

P18-2B

Q18-10

Q18-11

Q18-13

Q18-15

Q18-16

BE18-8

BE18-9

E18-6

E18-7

E18-8

E18-9

E18-11

P18-2A

P18-4A

P18-5A

P18-6A

P18-7A

P18-8A

P18-2B

P18-4B

P18-5B

P18-6B

P18-7B

P18-8B

Synthesis Evaluation

4. Recognize and illustrate the limitations of financial statement analysis.

Broadening Your

Perspective

Q18-17

Q18-18

Q18-20

Q18-21

Q18-22

BE18-12

Q18-19

BE18-13

BE18-14

E18-12

E18-13

P18-9A

P18-10A

P18-9B

P18-10B

BYP18-1

Continuing

Cookie

Chronicle

BYP18-2

BYP18-3

BYP18-4

BYP18-5




ANSWERS TO QUESTIONS

1. (a) Comparison of financial information can be made on an intracompany basis, an intercompany basis, and an industry average basis.

(1) An intracompany basis compares the same item with prior periods, or with other financial items in the same period, for one company. A store may compare this year’s sales to last year’s sales, for example.

(2) An intercompany basis compares the same item with one or more other company’s financial statements. The intercompany basis of comparison provides insight into a company's competitive position in relation to other companies.

(3) The industry average basis compares an item with the average of that item for the industry. For example, a department store may compare its sales per square foot of floor space with the average sales per square foot of floor space for department stores.

(b) The intracompany basis of comparison is useful in detecting changes in financial relationships and significant trends within a company. The intercompany basis of comparison provides insight into a company's competitive position in relation to other companies. The industry average basis provides information as to a company's relative position within the industry.

The use of all three comparisons, when combined with economic and non-financial measures provides the investor with an in-depth analysis of the investment potential of the company.

2. Percentage of base period amount: The amount for the period in question is divided by the base-year amount, and the result is multiplied by 100 to express the answer as a percentage.

Percentage change for a period: The amount from the previous period is subtracted from the current period amount. The result is divided by the amount from the previous period and then multiplied by 100 to express the answer as a percentage.

3. (a) An answer cannot be calculated when there is no value in a base year, because division by 0 is mathematically impossible.

(b) An answer cannot be calculated when there is a negative value in a base year and a positive value in the next year.




QUESTIONS (Continued)

4. Horizontal analysis (also called trend analysis) measures the dollar and percentage increase or decrease of an item over a period of time. In this approach, the amount of the item on one statement is compared with the amount of that same item on one or more earlier statements.

Vertical analysis expresses each item within a financial statement in terms of a percent of a relevant total or other common basis within the same statement, for the same time period.

5. A comparison of the first quarter in 2006 after Tim Hortons became a public company to the first quarter in 2005 when Tim Hortons was part of

Wendy’s International would be of limited value. A vertical analysis of the income statement and balance sheet might be useful to determine the company’s performance since it separated from Wendy’s. However, any horizontal analysis would not be comparable with the prior period(s).

6. (a)

On a balance sheet, total assets and total liabilities and shareholders’ equity are assigned a value of 100%.

(b) On an income statement, net sales is assigned a value of 100%.

7. Yes, it can. By converting the accounting numbers to percentages, companies of vastly different sizes with different currencies can be compared.

8. (a) Liquidity ratios measure the short-term ability of a company to pay its maturing obligations and to meet it unexpected needs for cash.

(b) Profitability ratios measure the income or operating success of a company for a specific period of time.

(c) Solvency ratios measure the ability of the company to survive over a long period of time.

9. (a) Asset turnover

(b) Inventory turnover or days sales in inventory

(c) Return on shareholders' equity

(d) Interest coverage

(e) Current ratio





10. A high current ratio does not always mean that a company is liquid. A high current ratio might be hiding liquidity problems with regards to inventory or accounts receivable. For example, a high level of inventory will cause the current ratio to increase. Increases in inventory can be due to the fact that inventory is not selling and may be obsolete. Increases in the current ratio w ill also occur if the company’s accounts receivable increase. An increase in accounts receivable could indicate the company is having trouble collecting its overdue accounts, which again would mean liquidity problems for the business.

11. Aubut Corporation is collecting its receivables much more slowly than the industry average. Aubut collects its receivables, on average, every 81 days (365 ÷ 4.5), compared to the industry average of 56 days (365 ÷

6.5). This could indicate that Aubut is not using the same credit checks or collection policies as the rest of the industry.

However, a slower receivables turnover than the industry does not always indicate a problem. The receivables turnover ratio can be misleading in that some companies encourage credit and revolving charge sales and slow collections, in order to earn a healthy return on the outstanding receivables in the form of high rates of interest.

12.

Wong’s solvency is better than that of the industry. It is carrying a slightly lower percentage of debt than the industry (37% versus 39%) and has a higher interest coverage ratio (3 versus 2.5).

13. The company’s free cash low may have fallen because it used the cash for capital expenditures. A company that has a lower free cash flow has less cash available for expansion and other expenditures and therefore, is often considered to be less solvent.

14. Yes, Saputo has made effective use of leverage. Saputo earned a higher return using borrowed money (12%) than it paid on the borrowed money.

This enabled Saputo to use money supplied by creditors to increase the return to the shareholders (19%).





15. An investor interested in growth would want to invest in a company with a high price-earnings ratio and a low dividend payout. The high priceearnings ratio indicates that investors expect this company’s earnings to grow and are willing to pay for this anticipated future growth. A low payout ratio generally indicates that the company has growth opportunities and is choosing to reinvest earnings to finance this future growth rather than paying earnings out as dividends.

An investor interested in shares with income potential would likely choose a company that pays out its earnings as dividends and therefore has a higher dividend payout ratio.

16. No, the president should not be overly concerned about the decrease in the ratios. They declined because of the price decrease. Since net income has risen, the increase in sales quantity is more than making up for the unit price decrease. The company is making fewer dollars profit for each item sold, but is selling sufficiently more items to increase its net income.

However, this practice may not be sustainable in the long-term, particularly if higher sales in the current period will end up reducing sales in a future period. In addition, operating expenses may increase because of the additional sales so the president should continue to closely watch both cost of goods sold and operating expenses in relation to sales.

17. 1. Use of estimates which may be inaccurate. To the extent that these estimates may be inaccurate or biased, the financial ratios and percentages are inaccurate or biased as well.

2. Use of cost which is not adjusted for price-level changes. Failing to adjust for the effect of general price level changes may lead to inaccurate conclusions about information such as the company’s rate of growth.

3. Use of alternative accounting methods. Differences in accounting principles make intercompany comparisons difficult and often misleading.

4. Quality of earnings. Management may try to manipulate income by choosing estimates and accounting policies to manage income.

(Note: Question 17 continues on the next page)





17. (Continued)

5. Earning power and irregular items. Financial statements often include non-recurring items that are not typical of normal business operations.

If such items are not presented separately on the income statement, investors may make false assumptions concerning a company’s ongoing earning potential.

6. Diversification of firms. Today, many firms are so diversified that intercompany comparisons or the use of industry statistics becomes impossible, as these companies cannot be classified into one industry.

18. If management wanted to increase income, it could decrease the amortization expense by increasing the estimated useful life of the asset.

Management of income through, for example, the changing of accounting estimates may lead to reported income that is confusing and misleading to users. For example, if a company changes its estimate of an asset’s useful life, amortization expense will change. The clarity and thoroughness of the income may be reduced which would lead to a lower quality of earnings.

Note to the instructor: Other accounting estimates might include residual value, bad debts, and warranties, amongst others.

19. (a) The use of FIFO in periods of rising prices causes cost of goods sold to be lower and income to be higher.

(b) Reducing the machinery’s life from five years to three years causes a higher amortization expense per year, which reduces net income.

(c) Declining-balance amortization is higher than straight-line amortization in the early years of an asset’s life, but becomes lower in the later years. Therefore, if straight-line amortization is used, net income will be higher initially but will be lower in later years.

20.

Lai’s profit margin has improved. When comparing the company’s profit margin before considering atypical items, we see that the profit margin has improved from 5% to 8%. Discontinued operations are a nonrecurring item and should be excluded for analysis purposes.





21. The concept of earning power is defined as net income adjusted for irregular or non-typical items. It is the amount of income that a company can expect to earn from its normal operations. In order to distinguish a company’s net income from its earning power, irregular items, such as discontinued operations and extraordinary items, are reported separately on the income statement. Investors trying to get a picture of the company’s future growth potential should not include these items in their analysis of future earnings potential because they are not expected to occur on an ongoing basis.

22. Discontinued operations refer to the disposal of an identifiable reporting or operating segment of the business. It is important to report discontinued operations separately because they represent atypical items. Investors trying to get a picture of the company’s future growth potential should not include this item in their analysis of future earnings potential because it is not expected to occur on an ongoing basis.




SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 18-1

Cash

Accounts receivable

Inventory

Prepaid expenses

Property, plant, and equipment

Intangible assets

Total assets a b

2008 2007

$ 24 $ 45

268

499

257

481

22 0

3,216 3,246

532 532

$4,561 $4,561

Increase (Decrease) c d

Amount Percentage

(a - b)

($21)

(c ÷ b)

(46.7)%

11

18

22

(30)

4.3%

3.7% n/a

(0.9)%

0

0

0.0%

0.0%


Comparing the percentages presented results in the following conclusions: The net income for Tilden Ltd. decreased in 2008 because of the combination of a decrease in sales and an increase in both cost of goods sold and operating expenses.

However, the reverse was true in 2007 as sales increased, while both cost of goods sold and expenses decreased. This resulted in an increase in net income.





Horizontal Analysis

Cash

Accounts

Increase (Decrease)

Dec. 31, 2008 Dec. 31, 2007 Amount Percentage

$150,000 $175,000 $(25,000) (14.3)%

1

receivable

Inventory

600,000

780,000

400,000

600,000

200,000

180,000

50.0%

2

30.0%

3

Noncurrent

assets 3,130,000 2,800,000 330,000 11.8%

4

1

$(25,000)

$175,000



(14.3)%

2

$200,000

$400,000



50%

3

$180,000

$600,000



30%

4

$330,000

$2,800,000

= 11.8%

Vertical Analysis

Cash

Dec. 31, 2008 Dec. 31, 2007

Amount Percentage Amount Percentage

$ 150,000 3.2% $ 175,000 4.4%

Accounts

receivable

Inventory

Noncurrent

assets

600,000

780,000

3,130,000

Total assets $4,660,000

12.9%

16.7%

67.2%

100.0%

400,000

600,000

2,800,000

$3,975,000

10.1%

15.1%

70.4%

100.0%

2008 Calculations: 2007 Calculations

$150,000 ÷ $4,660,000 = 3.2% $175,000 ÷ $3,975,000 = 4.4%

$600,000 ÷ $4,660,000 = 12.9% $400,000 ÷ $3,975,000 = 10.1%

$780,000 ÷ $4,660,000 = 16.7% $600,000 ÷ $3,975,000 = 15.1%

$3,130,000 ÷ $4,660,000 = 67.2% $2,800,000 ÷ $3,975,000 = 70.4%





Net sales

Cost of goods sold

Gross profit

2008 2007

Amount Percentage Amount Percentage

$1,914

1,612

302

100.0%

15.8%

$2,073

84.2% 1,674

399

100.0%

80.8%

19.2%

Operating expenses 218

Income before income tax

Income tax expense

Net income

84

30

$ 54

11.4% 210

4.4% 189

1.6% 68

2.8% $ 121

10.1%

9.1%

3.3%

5.8%


Sales


Operating expenses


Net income

2008

100%

59%

25%

3%

13%

2007

100%

62%

27%

2%

9%

2006

100%

64%

28%

2%

6%

Net income as a percentage of sales for Waubons increased over the three-year period, because cost of goods sold and operating expenses both decreased as a percentage of sales every year.





(a) Deterioration: A decrease in the receivables turnover would be viewed as deterioration. It is taking longer to collect the accounts.

(b) Deterioration: The increase in the days sales in inventory turnover would be viewed as deterioration. It is taking the company longer to sell the inventory and consequently there is a greater chance of inventory obsolescence, and higher carrying costs.

(c) Improvement: The decrease in debt to total assets would be viewed as an improvement because it means that the company has reduced its obligations to creditors and has raised its equity "buffer." However, the lower leverage will not be to the advantage of the shareholders if operations are sufficiently profitable.

(d) Deterioration: A decrease in interest coverage would be viewed as deterioration because it means that the company's ability to meet interest payments as they come due has weakened.

(e) Improvement: An increase in the gross profit margin would be viewed as an improvement because it means that a greater percentage of net sales is going towards income.

(f) Deterioration: A decrease in asset turnover would be viewed as deterioration because it means the company has become less efficient at using its assets to generate sales.

(g) Improvement: An increase in the return on equity would be viewed as an improvement because it means more net income was generated per dollar of equity investment.




BRIEF EXERCISE 18-6 (Continued)

(h) Improvement: An increase in the payout ratio would normally be viewed as an improvement. However, some shareholders may view this as a deterioration if they prefer that the company retain its earnings to fuel growth.


Holysh’s liquidity is deteriorating even though its current ratio is higher. The receivables are being collected more slowly, and it is taking longer to sell the inventory. These less-liquid assets are a higher proportion of the current assets than last year.


2005

(a) Receivables turnover

Net credit sales

Average net receivable s

$6,462,581

=

($247,014 + $292,462) ?

2004

$6,364,983

=

($292,462 + $242,306) ?

= 24.0 times

(b) Collection period

= 23.8 times

365 days

Receivable s turnover

=

365 days

24.0

=

365 days

23.8

= 15.2 days

= 15.3 days

Management should be pleased with the effectiveness of its credit and collection policies. The collection period of 15.2 days is well within the 30 days allowed in the credit terms.





(a) Inventory turnover




Average inventory

2008

$4,540,000





$960,000



2

$1,020,000 



= 4.6 times

2007

$4,550,000





$840,000 + $960,000

2





= 5.1 times

(b) Days sales in inventory

365



79.3

days

4.6

365



71.6

days

5.1

Management should be concerned with the fact that inventory is moving more slowly in 2008 than it did in 2007.

The decrease in the turnover ratio could be because of poor pricing decisions or because the company has obsolete inventory, for example.


($ in thousands)

(a) Debt to total assets

$1,872,374

$4,375,383

= 42.8%

(b) Interest coverage

$364,494 + $48,649 + $186,102

= 12.3 times

$48,649

(c) Free cash flow $450,575 - $274,182 = $176,393





(US$ in millions)

(a) Asset turnover =

Net sales

Average total assets

=

$16,078.1





$7,071.1 + $7,676.1

2





= 2.2 times

(b) Profit margin =

Net income

Net sales

=

$834.4

$16,078.1

= 5.2%


(a) 4

(b) 1

(c) 6

(d) 2

(e) 1

(f) 3

(g) 5

(h) 2

(i) 6

(j) 5





(a) Income tax on continuing operations

= $500,000 X 25% =

(b) Tax savings on loss from operations of discontinued operations

= ($154,000) X 25% = ($38,500)

Tax on gain on sale of discontinued operations

= $60,000 X 25% = 15,000

(c)

$125,000

($23,500)

LIMA CORPORATION

Income Statement (Partial)

For the Current Year

Income before income tax ......................................... $500,000

Income tax expense ................................................... 125,000

Income from continuing operations ......................... 375,000

Discontinued operations

Loss from operations of discontinued

operations, net of $38,500

income tax savings.............................. ($115,500)

Gain on disposal of discontinued

operations, net of $15,000 income tax 45,000 (70,500)

Net income .................................................................. $304,500





OSBORN CORPORATION


Year Ended December 31, 2008

Income before income tax ........................................... $950,000

Income tax expense ($950,000 X 25%) .......................

Income from continuing operations ...........................

237,500

712,500


Loss from operations of Mexico facility,

net of $75,000 ($300,000 X 25%)

income tax savings ................................. $225,000

Loss on disposal of Mexico facility, net of

$40,000 ($160,000 X 25%) income

tax savings ............................................... 120,000 (345,000)

Net income ......................................................................... $367,500




SOLUTIONS TO EXERCISES

EXERCISE 18-1

DRESSAIRE INC.

Current assets

2008

$120,000

2007 2006

$ 80,000 $100,000

Noncurrent assets 400,000 350,000 300,000

Current liabilities 90,000

Noncurrent liabilities 145,000

70,000

95,000

100,000

100,000

Shareholders' equity 285,000 265,000 200,000

(a)

Current assets

Noncurrent assets

Current liabilities

2008

120%

133%

90%

Noncurrent liabilities 145%

Shareholders' equity 143%

(b)

Current assets



Noncurrent liabilities

Shareholders' equity

2007

2008

50%

14%

29%

53%

8%

80%

117%

70%

95%

133%

2006

100%

100%

100%

100%

100%

2007

(20%)

17%

(30%)

(5%)

33%




EXERCISE 18-2

FLEETWOOD CORPORATION

Income Statement

Year Ended December 31

Sales

2008

Amount Percent

$800,000 100.0%

Cost of goods sold 500,000 62.5%

Gross profit 300,000 37.5%

2007

Amount

$600,000

390,000

210,000

Percent

100.0%

65.0%

35.0%

156,000 26.0% Operating expenses 200,000 25.0%

Income before

income tax 100,000 12.5%

Income tax expense 25,000 3.1%

$ 75,000 9.4% Net income

54,000

13,500

$ 40,500

9.0%

2.2%

6.8%




EXERCISE 18-3

(a)

OLYMPIC CORPORATION



Net sales

2008

$600,000

2007

$550,000

Increase or (Decrease)

Amount Percentage

$50,000

Cost of goods sold 460,000 400,000 60,000

9.1%

15.0%

Gross profit 140,000 150,000 (10,000)

Operating expenses 55,000 50,000 5,000

Income before

(6.7%)

10.0%

income tax

Income tax

Net income

85,000 100,000 (15,000) (15.0%)

34,000 40,000 (6,000) (15.0%)

$ 51,000 $ 60,000 $ (9,000) (15.0%)

(b)

OLYMPIC CORPORATION



Net sales

Cost of goods

sold

Gross profit

Operating

expenses

Income before

income tax

Income tax

Net income

2008 2007

Amount Percent Amount Percent

$600,000 100.0% $550,000 100.0%

460,000 76.7%

140,000 23.3%

55,000 9.1%

85,000 14.2%

34,000 5.7%

$ 51,000 8.5%

400,000

150,000

50,000

100,000

40,000

$ 60,000

72.7%

27.3%

9.1%

18.2%

7.3%

10.9%




EXERCISE 18-4

(a)

Assets

MOUNTAIN EQUIPMENT CO-OPERATIVE

Balance Sheet

December 31

(in thousands)

2005 2004

Increase (Decrease)

Amount Percent

Current assets $ 69,237 $58,150 $11,087 19.1%

Property, plant,

and equipment 37,587 39,225

Deferred store

opening costs 0 296

Total assets $106,824 $97,671

Liabilities and

Members' Equity

(1,638)

(296)

$ 9,153

(4.2%)

(100.0%)

9.4%

Current liabilities $ 21,271 $18,873

Long-term liabilities 641 4,113

Total liabilities 21,912 22,986

Members' Equity 84,912 74,685

Total liabilities

and members'

equity $106,824 $97,671

$2,398

(3,472)

(1,074)

10,227

$ 9,153

12.7%

(84.4%)

(4.7%)

13.7%

9.4%




EXERCISE 18-4 (Continued)

(b)

MOUNTAIN EQUIPMENT CO-OPERATIVE

Balance Sheet

December 31

(in thousands)

Current assets

2005 2004

Amount Percent

$ 69,237 64.8%

Amount

$58,150

Percent

59.5%

Property, plant,

and equipment 37,587 35.2% 39,225

Deferred site

operating costs 0 0.0% 296

40.2%

0.3%

100.0% Total assets $106,824 100.0% $97,671

Liabilities and

Members' Equity

Current liabilities $ 21,271 19.9% $18,873

Long-term liabilities 641 0.6% 4,113

19.3%

4.2%

Total liabilities 21,912 20.5%

Members' Equity 84,912 79.5%

22,986

74,685


and members'

equity $106,824 100.0% $97,671

23.5%

76.5%

100.0%

(c) During 2005, the percentage of current assets increased and the percentage of property, plant and equipment decreased compared to 2004. Also, debt to total assets decreased indicating that, compared to 2004, Mountain

Equipment Co-op is financing its assets more with equity than debt.




EXERCISE 18-5

Ratio

Asset turnover

Collection period

Current ratio

Days sales in inventory

Debt to total assets

Earnings per share

Free cash flow

Gross profit margin

Interest coverage

Inventory turnover

Payout ratio

Price-earnings ratio

Profit margin

Receivables turnover

Return on assets

Return on equity

Classification

P

L

L

L

S

P

S

P

S

L

P

P

P

L

P

P




EXERCISE 18-6

($ in millions)

(a) Working capital

= $1,395 - $710 = $685

Current ratio

= 1.96:1 ($1,395



$710)


= 6.2 times ($3,894



[($676 + $586) ÷ 2])


= 58.9 days (365 ÷ 6.2 times)


= 4.3 times ($2,600



[($628 + $586) ÷ 2])

Days sale in inventory

= 84.9 days (365 ÷ 4.3 times)





(b)

Ratio

Working capital

Current ratio

Nordstar

$685

1.96:1

Canadian

Tire

$160

1.6:1

Industry

Average

N/A

2.1:1

Receivables turnover 6.2x

Collection period 58.9 days

15.2x

24 days

66.1x

6 days

Inventory turnover 4.3x 9.6x 6.8x

Days sales in inventory 84.9 days 38 days 54 days

Nordstar is less liquid than Canadian Tire and the industry.

One must be cautious in interpreting Nordstar’s current ratio. It is artificially high because the company is having problems in its receivables collection and inventory turnover. The collection period is significantly is higher than Canadian Tire, and more importantly, the industry in general. The inventory turnover is also well below the industry average. Nordstar needs to focus its efforts on increasing its turnover of receivables and inventory.




EXERCISE 18-7

(a) The company’s collection of its accounts receivables has deteriorated over the past three years. It is taking the company longer to collect its outstanding receivables as evidenced by the decrease in the accounts receivable turnover.

(b) The company is selling its inventory slower as the inventory turnover is declining.

(c) Overall, the company’s liquidity has deteriorated. The increase in the current ratio is caused by the increase in inventory and receivables due to the slowdown in the movement of these assets. Even though the company’s current ratio is higher, if the underlying assets cannot be converted to cash to repay current liabilities, then liquidity has deteriorated.

EXERCISE 18-8

(a) The debt to total assets has weakened over the past three years.

(b) The interest coverage has improved over the past three years.

(c) The company’s solvency initially appears to be worsening as evidenced by its increased reliance on debt. However, its interest coverage ratio is improving, so the company appears to be able to handle this increasing level of debt. I would conclude that the solvency is not really worse.




EXERCISE 18-9

(a) Petro-Canada is more profitable. Its earnings per share and profit margin are both higher than Imperial Oil’s.

(b) Investors favour Imperial Oil. It has a higher price-earnings ratio.

(c) Investors would purchase shares in Imperial Oil and Petro-

Canada primarily for growth reasons. The payout ratio is not overly large, so shareholders would expect to purchase shares for future profitable resale while still earning a reasonable dividend, but not primarily for the dividend income.




EXERCISE 18-10


(a) Asset turnover (P)

$849,616





$391,103 + $393,085

2





$275,447

= 70.4%

$391,103

= 2.2 times

(b) Debt to total assets (S)

(c) Earnings per share (P)

(d) Free cash flow (S)

(e) Interest coverage (S)

$25,337

24,134

= $1.05

$67,106 - $17,407 = $49,699

(f) Price-earnings ratio (P)

(g) Profit margin (P)

(h) Return on assets (P)

$25,337 + $3,917 + $360

= 7.6 times

$3,917

$14.10

= 13.43 times

$1.05

$25,337

$849,616

= 2.98%

$25,337





$391,103 + $393,085

2





= 6.5%

(i) Return on equity (P)

$25,337





$115,656 + $88,868

2





= 24.8%





Note: (L) stands for liquidity ratio, (P) for profitability ratio, and

(S) for solvency ratio.




EXERCISE 18-11

(a) Suncor is more liquid. It has a higher current ratio, and although that may be partially due to its level of receivables, Suncor’s receivable turnover is well above the industry average. Husky has only $0.60 of current assets for every $1 of current liabilities.

(b) Husky is more solvent. It has a lower proportion of debt and covers its interest cost more times.

(c) Husky is more profitable. It has a higher profit margin and a higher return on assets than Suncor.

(d) Investors favour Suncor. Its shares are trading at 26.9 times its EPS. This is not consistent with the findings in (b) and (c). Share price is often based, to a large extent, upon expectations about future earnings. It seems as though investors see a brighter future for Suncor.




EXERCISE 18-12

(a)

DAVIS LTD.



Income from continuing operations ................................. $270,000


Gain from operations of division, net of

$33,000 income taxes ................................... $77,000

Loss from disposal of division, net of

$21,000 income tax savings ......................... (49,000) 28,000

Net income ........................................................................ $298,000

(b) The net-of-tax effect of the cumulative change in accounting principle (item 2) would be presented in the

Statement of Retained Earnings as an adjustment to opening retained earnings.




EXERCISE 18-13

PETRIE LTD.


Year Ended May 31, 2008

Sales ...................................................................

Cost of goods sold ...........................................

Gross profit .......................................................

Operating expenses .........................................

Operating income .............................................

Other revenue

Investment revenue ..................................... $20,000

Other expenses

$1,000,000

400,000

600,000

300,000

300,000

Loss on sale of available-for-sale securities .................................................. (10,000)

Interest expense ........................................... (50,000) (40,000)

Income before income tax ............................... 260,000

Income tax expense ($260,000 X 25%) ...........

Income from continuing operations ...............

65,000

195,000


Loss on operations of division, net of

$10,000 income tax savings ...................... $(30,000)

Gain on disposal of division, net of

$25,000 income tax savings ...................... 75,000 45,000

Net income ........................................................ $ 240,000




SOLUTIONS TO PROBLEMS

PROBLEM 18-1A

(a)

2005 2004 2003 2002 2001

Operating revenues 290.3% 220.1% 179.7% 142.1% 100.0%

Operating expenses 307.8% 246.2% 177.2% 141.8% 100.0%

Interest expense 2187.1% 1727.8% 929.8% 176.1% 100.0%

Income tax expense 132.7%

Net income (loss) 65.4%

5.7% 174.8% 147.4% 100.0%

(46.8%) 164.9% 141.1% 100.0%

Current assets 372.8% 227.5% 322.9% 166.8% 100.0%

Total assets



Share capital

562.5% 477.2% 375.4% 199.3% 100.0%

396.3% 320.2% 250.4% 184.1% 100.0%

898.5% 749.7% 521.8% 249.5% 100.0%

376.5% 319.1% 290.9% 163.7% 100.0%

Retained earnings 218.0% 192.0% 221.5% 156.0% 100.0%

Calculations: Current value ÷ base year value X 100

(b) Noncurrent assets and noncurrent liabilities are primarily responsible for changes in WestJet’s financial position.

They have grown much faster than current assets and current liabilities. Operating expenses have been growing faster than operating revenues. That, combined with a massive increase in interest expense, has caused net income to decline during the five-year period.

(c) WestJet has been increasingly relying on long-term debt to finance its operations. Total liabilities are up 898.5% while current liabilities are only up 396.3%. Total sha reholders’ equity is up about 310% [($486,706 + $201,447) ÷ ($129,268 +

$92,412) X 100].




PROBLEM 18-2A

(a)



Manitou Ltd.

Dollars

Net sales $350,000

Cost of goods sold 200,000

Percent

Muskoka Ltd.

Dollars

100.0% $1,400,000

57.1% 720,000

Percent

100.0%

51.4%

Gross profit

Income from

operations

Interest expense

Income before

150,000

Operating expenses 50,000

100,000

3,000

42.9% 680,000

14.3% 272,000

28.6% 408,000

0.9% 10,000

48.6%

19.4%

29.2%

0.7%

income taxes

Income tax expense 23,000

Net income

97,000

$ 74,000

27.7% 398,000

6.6% 100,000

21.1% $ 298,000

28.5%

7.2%

21.3%




PROBLEM 18-2A (Continued)

(b)

Gross Profit Margin: Gross profit margin ÷ Net sales

Manitou

= $150,000 ÷ $350,000

= 42.9%

Muskoka

= $680,000 ÷ $1,400,000

= 48.6%

Profit Margin: Net income ÷ Net sales

Manitou

= $74,000 ÷ $350,000

= 21.1%

Muskoka

= $298,000 ÷ $1,400,000

= 21.3%

Return on Assets: Net income ÷ Average total assets

Manitou:

$74,000 ÷ $457,500

Muskoka

$298,000 ÷ $1,625,000

= 18.3% = 16.2%

Asset Turnover: Net sales ÷ Average total assets

Manitou:

$350,000 ÷ $457,500

Muskoka

$1,400,000 ÷ $1,625,000

= 0.77 times = 0.86 times

Return on Equity: Net income ÷ Average shareholders’ equity

Manitou:

$74,000 ÷ $392,500

= 18.9%

Muskoka

$298,000 ÷ $1,112,500

= 26.8%

(c) Muskoka appears to be more profitable. All of its ratios are better than Manitou’s, although the profit margins are almost the same. Muskoka’s return on equity is significantly higher than Manitou’s.




PROBLEM 18-3A

Working capital $250,500 – $190,150 = $60,350

Current ratio

$250,500

= 1.3:1

$190,150


$540,000





$86, 400 + $64,000

2





= 7.2 times

Days sales in inventory 365 days ÷ 7.2 = 50.7 days


$780,000





$116,200 + $5,500 + $93,800 + $4,500

2





= 7.1 times

Collection period 365 days ÷ 7.1 = 51.4 days


$240,000

$780,000

= 30.8%

Profit margin

$59,650

$780,000

= 7.6%

Asset turnover

$780,000





$715,800 + $672,000

2





= 1.1 times






$59,650

($715,800 + $672,000) ?

= 8.6%


$59,650





$445,650 + $396,000

2





= 14.2%


$59,650

15,000

= $3.98

Payout ratio

$1,800

$59,650

= 3.0%


$270,150

$715,800

= 37.7%


$59,650 +$9,920 + $26,550

= 9.7 times

$9,920

Free cash flow $89,000 - $53,500 = $35,500




PROBLEM 18-4A

(a) 2008

Working capital

$515,000 - $337,750 =

$177,250

Current ratio

$515,000

$337,750

= 1.5:1


$650,000





$340,000 + $300,000

2





= 2.0 times


365 ÷ 2.0 = 182.5 days


$1,000,000





$105,000 + $91,000

2





= 10.2 times


365 ÷ 10.2 = 35.8 days


$537,750

$1,340,000

= 40.1%

2007

$460,000 - $315,000 =

$145,000

$460,000

$315,000

= 1.5:1

$635,000





$300,000 + $350,000

2





= 2.0 times

365 ÷ 2.0 = 182.5 days

$940,000





$91,000 + $83,000

2





= 10.8 times

365 ÷ 10.8 = 33.8 days

$515,000

$1,235,000

= 41.7%





(a) (Continued)


$145,000

= 4.9 times

$30,000

$120,000

= 4.0 times

$30,000

Free cash flow

$92,000 - $80,000 = $12,000 $65,000 - $50,000 = $15,000

Profit margin

$86,250

$1,000,000

= 8.6%

$67,500

$940,000

= 7.2%


$350,000

$1,000,000

= 35.0%

$305,000

$940,000

= 32.4%

Asset turnover

$1,000,000





$1,340,000 + $1,235,000

2





$940,000





$1,235,000 + $1,175,000

2





= 0.8 times


$86,250





$1,340,000 + $1,235,000

2





= 6.7%

= 0.8 times

$67,500





$1,235,000 + $1,175,000

2





= 5.6%





(a) (Continued)


$86,250





$802,250 + $720,000

2





= 11.3%


$86,250

100,000

= $0.86

$67,500





$720,000 + $656,600

2





= 9.8%

$67,500

= $0.68

100,000

Payout

$4,000

$86,250

= 4.6%

$4,000

$67,500

= 5.9%

(b) Star Track’s liquidity has deteriorated. Two-thirds of its current assets are inventory, which is only turning over twice a year. Solvency is largely unchanged although the interest coverage is better in 2008. Almost of all of the profitability ratios are improved in 2008.




PROBLEM 18-5A


Liquidity

Current ratio

The Brick

$284,373

$278,213

= 1.0:1

Receivables $1,214,405 turnover

$45,862


$34,697 + $1,087

$5,233

= 6.8 times

Leon ’s

$189,690

$99,579

= 1.9:1

$547,744

$19,234 n/a

Industry

1.2:1

8.3 times


= 26.5 times

$739,505

$181,266

= 28.5 times

$323,629

$71,962

4.9 times

= 4.1 times = 4.5 times

Overall, Leon’s liquidity is better than the Brick’s and better than the industry average.

Solvency

The Brick Leon ’s Industry


$445,511

$923,900

$121,264

$381,702

40.1%

= 48.2% = 31.8%

2.0 times





Based solely on the debt to total assets ratio since the interest coverage ratio is not available for Leon’s, Leon’s is more solvent than The Brick. The Brick has a higher portion of debt than the industry average.

Profitability

The Brick

Profit margin

Asset turnover

Return on

$32,004

$1,214,405

= 2.6%

$1,214,405

$892,200

= 1.4 times

$32,004

Leon

$48,964

$547,744

= 8.9%

$547,744

$376,316

’s

= 1.5 times

Industry

1.6%

0.6 times

0.8% assets

$892,200

$48,964

$376,613

Return on

= 3.6% = 13.0%

2.3% equity

$32,004

$494,890

$48,964

$255,152

= 6.5% = 19.2%

Leon’s is more profitable than The Brick, and The Brick is more profitable than the industry average.




PROBLEM 18-6A

(a) Accounts receivable management can be assessed by reviewing each com pany’s receivables turnover ratio and average collection period. Refresh’s average collection period of 32 days (365 ÷ 11.4) days is reasonable when com pared to its credit terms of 30 days. Flavour’s average collection period of 37 days (365 ÷ 9.8) days is worse than that of Refresh, but still better than the average firm in the industry (365 ÷ 9.3 = 39 days).

(b) Each company’s ability to manage its inventory can be measured by the inventory turnover ratio. Currently Refresh is turning over its inventory 5.8 times per year, which can also be expressed as days in inventory of approximately 63 days (365 ÷ 5.8 times). When compared to the turnover for

Flavour and the industry average, it appears that Refresh is turning over its inventory at a slower rate than the competition.

(c) Refresh appears to be the more solvent of the two companies. Refresh has a lower debt to total assets ratio, indicating that Refresh has a lower percentage of its assets financed by debt. As well, Refresh has a higher times interest earned ratio indicating that Refresh has a better ability to service its debt as interest payments become due.

(d) Refresh’s higher gross profit margin may be attributable to a number of factors:



The company may be selling its products at a higher price.



The company may be paying less for its inventory than the competition. This may occur if, for example, Refresh is able to purchase inventory in large volumes and receives purchase discounts.





(e) The asset turnover is the same for both companies.

Therefore, Refresh’s higher return on assets seems to be attributable to Refresh’s higher profit margin.

(f) Market price per share

Refresh

= Price earnings ratio x Earnings per share

= 50.3 x $0.98

= $49.29

Flavour

= Price earnings ratio x Earnings per share

=24.3 x $1.37

= $33.29

(g) The priceearnings ratio reflects investors’ assessment of the future prospects of a company. As indicated by its higher price-earnings ratio, investors appear to believe that

Refresh has the better possibility for growing its earnings and dividends.




PROBLEM 18-7A

(a) It is difficult to say which company is more liquid. Snap-on has a higher current ratio and turns its inventory over more quickly than Black and Decker, but collects its receivables more slowly.

(b) Snap-on is more solvent. Snap-on has significantly less debt than Black and Decker and is more in line with the industry average. However, both companies are able to cover their interest better than the industry average.

(c) Both companies appear to be profitable. Snap-on has a higher gross margin than Black and Decker but Black and

Decker has a higher profit margin, earns a higher return on assets, and offers a much better return on equity. All of this would indicate that Black and Decker is the more profitable company.

(d) Investors seem to favour Snap-on as it has the higher price-earnings ratio. This is consistent with (b) as investors would likely favour a company with a better solvency position. However, this is not consistent with (c), as you would expect investors to favour the more and profitable company. Investors must be anticipating better future profitability from Snap-on.




PROBLEM 18-8A

(a)

Receivables

Turnover

(10X)

Profit

Margin

(10%)

Earnings per Share

($2)

Debt to

Total

Assets

(40%)

Free

Cash

Flow

($25,000) Transaction

1. Issues common shares

2. Collects an account receivable

3. Issues a mortgage note payable

4. Sells equipment at a loss

5. Share price increases from $10 per share to

$12 per share

NE

I

NE

NE

NE

NE

NE

D

D

NE

D

NE

NE

D

NE

D

NE

I

I

NE

NE

I

NE

I

NE

(b) A change in the profit margin ratio or the earnings per share would have no impact on the above changes.




PROBLEM 18-9A

(a) Before Discontinued Operations

2005

Profit margin $700

$3,932

2004

$710

$2,944

Asset turnover



= 17.8%

$3,932

$13, 486

= 0.3 times

$700

$13, 486

= 5.2%

$700

$3, 438

= 24.1%

$2,944

$10,050

= 0.3 times

$710

$10,050

= 7.1%

$710

$2, 471

= 20.4% = 28.7%

After Discontinued Operations

2005

Profit margin $1,152

$3,932

2004

$793

$2,944

Asset turnover



= 29.3%

$3,932

$13, 486

= 0.3 times

$1,152

$13, 486

= 8.5%

$1,152

$3, 438

= 33.5%

= 26.9%

$2,944

$10,050

= 0.3 times

$793

$10,050

= 7.9%

$793

$2, 471

= 32.1%

2003

$507

$2,632

= 19.3%

$2,632

$7,191

= 0.4 times

$507

$7,191

= 7.1%

$507

$1,832

= 27.7%

2003

$578

$2,632

= 22.0%

$2,632

$7,191

= 0.4 times

$578

$7,191

= 8.0%

$578

$1,832

= 31.6%





(b) Overall, profitability is declining when calculated before discontinued operations and increasing when calculated after discontinued operations. Return on equity is the most graphic example.

(c) Investors are interested in the future. Analysis based on continuing operations is therefore more relevant to them.




PROBLEM 18-10A

(a)

ZURICH CORPORATION



Net sales ............................................................................ $1,700,000

Cost of goods sold ........................................................... 0 1,100,000

Gross profit ....................................................................... 600,000

Operating expenses ......................................................... 260,000

Income from operations ................................................... 340,000

Other revenues ................................................. $20,000

Other expenses ................................................. 0 8,000 0 ( 12,000

Income before income tax ............................................... 352,000

Income tax expense ($352,000 X 25%) ........................... 88,000

Income from continuing operations ............................... 264,000


Gain from operations of discontinued division,

net of $5,000 income tax expense .............. $15,000

Loss on sale of discontinued division,

net of $17,500 income tax saving ............... (52,500) (37,500)

Net income ........................................................................ $ 226,500

Earnings per share:

Continuing operations ................................. $2.64

Discontinued operations ............................. (0.38)

Net income .................................................... $2.26





(b)

ZURICH CORPORATION

Statement of Retained Earnings


Balance, January 1 as originally reported ..........

Add: Cumulative effect of change in amortization

method, net of $15,000 income tax ....................

Balance, January 1 as adjusted ...........................

Add: Net income ....................................................

Less: Cash dividends ............................................

Retained earnings, December 31 .........................

$ 940,000

45,000

985,000

226,500

1,211,500

25,000

$1,186,500




PROBLEM 18-1B

(a)

Revenues

Cost of sales

BIG ROCK BREWERY INCOME TRUST

Income Statement Horizontal Analysis

Year ended December 31

2005 2004 2003

(12 months) (12 months) (9 months)

142.3%

148.1%

136.1%

133.0%

100.0%

100.0%

Gross profit

Operating expenses

Income before income taxes


Net income

139.0%

137.7%

142.2%

126.4%

145.3%

BIG ROCK BREWERY INCOME TRUST

Balance Sheet Horizontal Analysis

December 31

2005

137.8%

136.4%

141.3%

104.2%

148.5%

2004

Assets

Current assets


Total assets

127.6% 99.4% 100.0%

94.2% 100.6%

100.0%

100.0%

100.0%

100.0%

100.0%

2003

100.0%

102.4% 100.3% 100.0%

Liabilities & Unitholders’ Equity


Noncurrent liabilities


Unitholders' equity

Total liabilities & equity

78.6% 81.0% 100.0%

87.9% 80.7% 100.0%

84.6% 80.8% 100.0%

111.8% 110.6% 100.0%

102.4% 100.3% 100.0%




PROBLEM 18-1B (Continued)

(b) One would expect to see about a 33% increase for all income statement items between 2003 and 2004 due to the different time frames. That seems to be the case for everything except income tax, which was largely unchanged. Cost of sales rose faster than sales in 2005, which led to a lower net income.

On the balance sheet, current assets have increased significantly while current liabilities have decreased. This should mean the company’s liquidity is improved.

(c) The different time frames should not impact the balance sheet analysis. The income statement analysis must consider the time frame in order to be meaningful. One can compare 2004 and 2005 without any problems, but the comparison with 2003 data is not very meaningful.




PROBLEM 18-2B

(a)

CHEN AND CHUAN COMPANIES

Income Statements


Net sales

Cost of goods

Chen Inc.

Dollars

$1,849,035

sold

Gross profit

Operating

expenses

1,080,490

768,545

502,275

Income from

operations 266,270

Interest expense 6,800

Percent

Chuan Ltd.

Dollars

100.0% $539,038

58.4%

41.6%

27.2%

14.4%

0.4%

338,006

201,032

79,000

122,032

1,252

Percent

100.0%

62.7%

37.3%

14.7%

22.6%

0.2%

Income before

income tax

Income tax

expense

259,470 14.0% 120,780

Net income

103,800

$ 155,670

5.6%

8.4%

48,300

$ 72,480

(b) Gross Profit Margin: Gross profit margin ÷ Net sales

Chen

= $768,545 ÷ $1,849,035

Chuan

= $201,032 ÷ $539,038

22.4%

9.0%

13.4%

= 41.6% = 37.3%

Profit Margin: Net income ÷ Net sales

Chen

= $155,670 ÷ $1,849,035

= 8.4%

Chuan ’

= $72,480 ÷ $539,038

= 13.4%





(b) (Continued)

Asset Turnover: Net sales ÷ Average total assets

Chen

= $1,849,035 ÷ $894,750

Chuan’s

= $539,038 ÷ $251,313

= 2.1 times = 2.1 times

Return on Assets: Net income ÷ Average total assets

Chen

= $155,670 ÷ $894,750

= 17.4%

Chuan

= $72,480 ÷ $251,313

= 28.9%

Return on Equity:

Net income ÷ Average shareholders’ equity

Chen

= $155,670 ÷ $724,430

= 21.5%

Chuan

= $72,480 ÷ $186,238

= 38.9%

(c) Chuan seems to be a much more profitable company.

Although Chen has a higher gross profit margin, Chuan has a better profit margin, which means it can generate more net income per dollar of sales. Chuan ’s assets are returning more even though the asset turnover is the same as Chen’s. Finally Chuan’s shareholders are enjoying a much better return on their investment.




PROBLEM 18-3B

Working capital $310,900 - $208,500 = $102,400

Current ratio

$310,900

$208,500

= 1.5:1


$1,005,500





$143,000



$115,500

2





= 7.8 times

Days sales in inventory 365 days ÷ 7.8 = 46.8 days


$1,918,500





$107,800 + $5,400 + $102,800 + $5,100

2





= 17.4 times

Collection period 365 days ÷ 17.4 = 21.0 days


$913,000

$1,918,500

= 47.6%

Profit margin

$265,300

$1,918,500

= 13.8%

Asset turnover

$1,918,500





$990,200



2

$852,800 



= 2.1 times






$265,300

($990,200



$852,800)



2

= 28.8%


$265,300





$695,700 + $465, 400

2





= 45.7%


$265,300

60,000 -





4,000

2





= $4.57


$294,500

$990,200

= 29.7%


$265,300



$28,000

$28,000

= 14.54 times



$113,700

Free cash flow = $313,900 - $161,000

= $152,900




PROBLEM 18-4B

Liquidity

Working capital

2008 2007

Current ratio

= $179,000

$364,000

$185,000

= 2.0:1

= $161,000

$343,000

$182,000

= 1.9:1

Receivables

Turnover*

$900,000 x 75%

$96,500

= 7.0 times

* Average gross receivables for 2008

$840,000 x 75%

$92,500

= 6.8 times

= ($94,000 + $5,000 + $90,000 + $4,000) ÷ 2

Average gross receivables for 2007

= ($90,000 + $4,000 + $88,000 + $3,000) ÷ 2


365 days ÷ 7.0

= 52.1 days

365 days ÷ 6.8

= 53.7 days


$620,000

$127,500

$575,000

$120,000


= 4.9 times

365 days ÷ 4.9

= 74 days

= 4.8 times

365 days ÷ 4.8

= 76 days





Profitability

2008

$280,000 = 31.1%

Gross profit

Profit margin

$900,000

$56,000

$900,000

= 6.2%

Payout ratio

2007

$265,000 = 31.5%

$840,000

$55,000

$840,000

= 6.5%

Asset turnover

$900,000





$754,000 + $648,000

2





$840,000





$648,000



$630,000

2





= 1.3 times


$56,000





$754,000 +$648,000

2





= 1.3 times





$55,000

$648,000



$630,000

2






= 8.0%

$56,000





$369,000 + $316,000

2





= 8.6%

$55,000





$316,000 + $269,000

2





EPS

= 16.4%

$56,000

20,000

= $2.80

= 18.8%

$55,000

= $2.75

20,000

$8,000

$56,000

= 14.3%

$8,000

$55,000

= 14.5%





Solvency

2008


$385,000

$754,000

= 51.1%


$116,000

$30,000

Free cash flow

2007

$332,000

$648,000

= 51.2%

$105,000

$20,000

= 3.9 times

$68,000 - $120,000

= ($52,000)

= 5.3 times

$60,000 - $50,000

= $10,000

(b) An overall increase in short-term liquidity has occurred. All measures have improved.

Profitability, with the exception of EPS, has decreased slightly.

Free cash flow and the interest coverage ratios have deteriorated. The debt to total assets ratio is largely unchanged.




PROBLEM 18-5B

(a) ($ in millions)

Liquidity

Current ratio

$1,157

$703

Domtar

= 1.6:1

Cascades

$1,125

= 1.9:1

$595

Receivables $4,996 turnover

$260

= 19.2 times



365 ÷ 19.2

= 19.0 days

$4,333

$719

= 6.0 times

$3, 460

$536

= 6.5 times

365 ÷ 6.5

= 56.2 days

$2,890

$548

= 5.3 times


Solvency

365 ÷ 6.0

= 60.8 days

Domtar

Debt to total $3,583 assets

$5,192

= 69.0%

365 ÷ 5.3

= 68.9 days

Industry

1.5:1

7.9 times

46 days

5.7 times

64 days

Cascades Industry

$2,149

$3,046

88.0%

= 70.6%





Profitability

Domtar

Gross profit

$633 margin

$4,966

= 12.7%

Profit margin

$(388)

$4,966

Asset turnover

= (7.8)%

$4,996

$5, 436

= 0.9 times


$(388)

$5, 436

= (7.1)%


$(388)

$1,828

= (21.2)%

Cascades Industry

$570

24.7%

$3, 460

= 16.5%

$(97)

$3, 460

(1.3)%

= (2.8)%

0.9 times

$3, 460

$3,095

= 1.1 times

(1.0)%

$(97)

$3,095

= (3.1)%

$(97)

$978

= (9.9)%

(19.6)%





(b) Overall, Domtar’s liquidity is better than the Cascades’ and better than the industry average. Especially noteworthy is its receivables turnover, which is much better than average.

Cascades ’ liquidity is about average for the industry.

Both companies are more solvent than the industry average.

Both companies are less profitable than the industry average, but Domtar is worse than Cascades.

(c) Yes, a negative percentage return is meaningful.




PROBLEM 18-6B

(a) Paperclip’s accounts receivable management can be assessed by reviewing the company’s receivables turnover, which indicates how often the company is “turning” over its receivables; that is, how long the company is taking to collect its accounts receivable. Paperclip’s receivables turnover of 11.8 times can also be expressed as an average collection period of 30.9 days (365 ÷ 11.8). This receivables turnover is excellent when compared to its credit terms of

30 days. As well, Paperclip’s receivables turnover is better than Stapler and the in dustry average indicating Paperclip’s management is doing a better job at controlling the collection of the company’s receivables.

(b) Paperclip’s ability to manage its inventory can be measured by the inventory turnover ratio. Currently Paperclip is turning over its inventory 7 times per year which can also be expressed as approximately every 52 days (365 ÷ 7 times). When compared to the turnover for Stapler and the industry average it appears that Paperclip is turning over its inventory faster than the competition.

(c) Stapler appears to be the more solvent of the two companies. Stapler has a lower debt to total assets ratio indicating that Stapler has a lower percentage of its assets financed by debt. As well, Stapler has a higher times interest earned ratio indicating that Stapler has a better ability to service its debt as interest payments become due.

When looking at the debt to total assets, Paperclip appears to be on a par with the average company in the industry.

How ever, when assessing Paperclip’s ability to service its debt (as indicated by the times interest earned ratio) it can be seen that Paperclip is not as solvent as the average firm in the industry.





(d) Paperclip’s lower gross margin may be attributable to a number of factors:



The company may be selling its products at a lower price hoping to increase it sales volume and hence profit.



The company may be paying more for its inventory than the competition. This may occur if, for example,

Paperclip is not able to purchase inventory in the same quantity for the same price as its competition.

(e) Paperclip may have a lower payout ratio than Stapler and the industry aver age due to the fact that Paperclip’s management may have decided to retain profits in the business to finance future growth.

(f) Paperclip market price per share

= Price earnings ratio X Earnings per share

= 29 X $3.50 = $101.50

Stapler market price per share

= Price earnings ratio X Earnings per share

= 45 X $0.40 = $18.00

(g) The priceearnings ratio reflects investors’ assessment of the future prospects of a company. As indicated by its higher price-earnings ratio, investors appear to believe that

Stapler has the better possibility for growing its earnings and dividends.




PROBLEM 18-7B

(a) It appears that Agrium is more liquid. Although its receivables and inventory turn over a bit slower than

Potash’s, its current ratio is far better.

(b) Potash is more solvent, but both companies are covering their interest adequately.

(c) Overall, Potash is more profitable. It has a higher profit margin and its EPS is more than double that of Agrium.

Gross profit margin, return on assets and return on equity are similar for the two companies.

(d) Based on its higher price-earnings ratio, investors favour

Potash over Agrium. This is consistent with its superior solvency and profitability.




PROBLEM 18-8B

(a)

Current

Ratio

(1.5:1)

Inventory

Turnover

(10X)

Debt to

Total

Assets

(40%) Transaction

1. Paid an account payable.

2. Collects an account receivable.

3. Buys a held-tomaturity investment.

4. Sells merchandise for cash at a profit.

5. Buys equipment with cash.

I

NE

D

I

D

NE

NE

NE

I

NE

D

NE

NE

D

NE

(b) 1. The current ratio would now decrease.

2. There would still be no effect.

3. The current ratio would still decrease.

4. The current ratio would still improve.

5. The current ratio would still decrease.

Asset

Turnover

(2X)

Profit

Margin

(10%)

I NE

NE

NE

I

NE

NE

NE

I

NE




PROBLEM 18-9B

(a)

Before Discontinued Operations

2005


$20,320

Asset turnover


= 0.8%

$20,320

$29,990

= 0.7 times

$155

$29,990


= 0.5%

$155

$10,025

= 1.5%

After Discontinued Operations

2005


$20,320

Asset turnover



= 0.6%

$20,320

$29,990

= 0.7 times

$129

$29,990

= 0.4%

$129

$10,025

= 1.3%

2004

$243

$24,948

= 1.0%

$24,948

$32,644

= 0.8 times

$243

$32,644

= 0.7%

$243

$10,342

= 2.3%

2004

$258

$24,948

= 1.0%

$24,948

$32,644

= 0.8 times

$258

$32,644

= 0.8%

$258

$10,342

= 2.5%

2003

$262

$13,850

= 1.9%

$13,850

$24,854

= 0.6 times

$262

$24,854

= 1.1%

$262

$9,124

= 2.9%

2003

$103

$13,850

= 0.7%

$13,850

$24,854

= 0.6 times

$103

$24,854

= 0.4%

$103

$9,124

= 1.1%





(b) Overall, profitability is declining when calculated before discontinued operations. Profitability increases, then declines when calculated after discontinued operations.

Return on equity is the most graphic example. Data for

2003 varies the most before and after discontinued operations.

(c) Investors are interested in the future. Analysis based on continuing operations is therefore more relevant to them.




PROBLEM 18-10B

HYPERCHIP CORPORATION


Year Ended November 30, 2008

Net sales ............................................................................ $1,500,000

Cost of goods sold ........................................................... 0 , 800,000

Gross profit ....................................................................... 700,000

Operating expenses ......................................................... 240,000

Income from operations ................................................... 460,000

Other revenues ................................................. $40,000

Other expenses ................................................. 0 30,000 , 0 10,000

Income before income tax ............................................... 470,000

Income tax expense ($470,000 X 30%) ........................... 0 , 141,000

Income from continuing operations ............................... 329,000


Loss from operations of ceramics division,

net of $45,000 income tax saving ............... $105,000

Loss on sale of ceramics division,

net of $21,000 income tax saving ............... 0 49,000 154,000

Net income ........................................................................ $ 175,000

Earnings per share:

Continuing operations ................................. $1.40

Discontinued operations ............................. (0.66)

Net income .................................................... $0.74





(b)

HYPERCHIP CORPORATION

Statement of Retained Earnings

Year Ended November 30, 2008

Balance, December 1 as originally reported ........... $1,225,000

Less: Cumulative effect of change in amortization

method, net of $9,000 income tax saving ............. 21,000

Balance, December 1 as adjusted ........................... 1,204,000

Add: Net income ........................................................ 175,000

1,379,000

Less: Cash dividends ................................................ 30,000

Retained earnings, November 30 ............................. $1,349,000




CONTINUING COOKIE CHRONICLE

(a) 1. Current ratio

$56,741

$30, 411

= 1.9:1

2. Receivables turnover

$462,500

= 142.3 times

$3,250

3. Inventory turnover

$231,250

= 12.9 times

$17,897

4. Debt to total assets

$34,911

$143,591

= 24.3%

5. Interest coverage

$92,913

= 225 times

$413

6. Gross profit margin

$231,250

$462,500

= 50.0%

7. Profit margin

$74,000

$462,500

= 16.0%




CONTINUING COOKIE CHRONICLE (Continued)

(a) (Continued)

8. Asset turnover

$462,500

$143,591

= 3.2 times

9. Return on assets

$74,000

$143,591

= 51.5%

10. Return on equity

$74,000

$108,680

= 68.1%

(b) The company had a very good year. It was very profitable and has a healthy balance sheet. The company is carrying very little debt and can cover the interest charges easily.

There are no liquidity or solvency problems

(c) The bank should have no qualms about lending money to the company. The new debt ratio would still be reasonably low [($34,911 + $20,000) ÷ ($143,591 + $20,000) = 33.6%].

Even if there were no increases in revenue, operating income would still be more than adequate to cover the additional interest expense. The company is very profitable and is an acceptable credit risk for the bank.

(d) Instead of bank financing, Cookies & Coffee Creations could lease the equipment. Cookie & Coffee Creations could also consider equity financing.




BYP 18-1 FINANCIAL REPORTING PROBLEM

(a)

THE FORZANI GROUP LTD.

Consolidated Balance Sheets

(in thousands)

ASSETS

Current

Cash


Inventory


Capital assets

Goodwill and other intangibles

Other assets

2006

2,647 87.6%

368,842 100.7%

193,594 107.7%

75,805 143.6%

10,080 107.1%

2005

$ 19,266 74.0% $ 26,018 100.0%

68,927 117.7% 58,576 100.0%

278,002 99.8% 278,631 100.0%

3,022 100.0%

366,247 100.0%

179,702 100.0%

52,790 100.0%

9,415 100.0%

Future income tax asset

LIABILITIES

Current

4,885 - - -

$653,206 107.4% $608,154 100.0%

accrued liabilities

Current portion of longterm debt

Accounts payable and

$244,293 102.5% $238,239 100.0%

5,135 325.0% 1,580 100.0%

249,428 104.0% 239,819 100.0%

Long-term debt

Deferred lease inducements

58,805 146.0% 40,278 100.0%

Deferred rent liability

62,883 100.4% 62,613 100.0%

3,810 172.2% 2,213 100.0%

Future income tax liability - 0.0% 384 100.0%

374,926 108.6% 345,307 100.0%




BYP 18-1 (Continued)

(a) Continued

Share capital



(in thousands)

SHAREHOLDERS ’ EQUITY

138,131 100.2% 137,811 100.0%

Contributed surplus

Retained earnings

4,271 146.5% 2,915 100.0%

135,878 111.3% 122,121 100.0%

278,280 105.9% 262,847 100.0%

$653,206 107.4% $608,154 100.0%





(a) (Continued)


Consolidated Statements of Operations

Years Ended January 29 and January 30

(in thousands)

Revenue

Retail

Wholesale

Cost of sales

Gross margin

Operating and admin. expenses

2006 2005

$ 856,149

273,255

119.1

% $718,820

102.6

% 266,234

100.0

%

100.0

%

1,129,404 114.7% 985,054 100.0%

746,313 114.6% 651,158 100.0%

383,091 114.7% 333,896 100.0%

Store operating

General and

administrative

Operating earnings

Amortization

Interest

Loss on write-down of

investments

Earnings before income

taxes

Provision for income

taxes

Current

225,218

88,720

118.0

% 190,891

133.3

% 66,536

100.0

%

100.0

%

313,938 122.0% 257,427 100.0%

69,153 90.4% 76,469 100.0%

41,343 115.2% 35,885 100.0%

6,145 138.2% 4,447 100.0%

- 0.0% 2,208 100.0%

47,488 111.6% 42,540 100.0%

21,665 63.9%

8,784 86.1%

33,929 100.0%

10,207 100.0




%

Future -876 - 2,177

100.0

%

7,908 63.9% 12,384 100.0%

Net earnings


(b)

$ 13,757 63.9%



(in thousands)

$ 21,545 100.0%

ASSETS

Current

Cash


Inventory

2006 2005

$ 19,266 2.9% $ 26,018 4.3%

68,927 10.6% 58,576 9.6%

278,002 42.6% 278,631 45.8%

2,647 0.4% 3,022 0.5%

368,842 56.5% 366,247 60.2%

193,594 29.7% 179,702 29.5%


Capital assets

Goodwill and other intangibles

Other assets

Future income tax asset

75,805 11.6% 52,790 8.7%

10,080 1.5% 9,415 1.6%

4,885 0.7% - 0.0%

LIABILITIES

$653,206 100.0% $608,154 100.0%

Current

Accounts payable and $244,293 37.4% $238,239 39.2%

accrued liabilities

Current portion of

long-term debt 5,135 0.8% 1,580 0.2%

249,428 38.2% 239,819 39.4%

Long-term debt 58,805 9.0% 40,278 6.6%




Deferred lease

inducements

Deferred rent liability

62,883 9.6% 62,613 10.3%

3,810 0.6% 2,213 0.4%

Future income tax liability - 0.0% 384 0.1%

374,926 57.4% 345,307 56.8%





(b)



Share capital

(in thousands)

SHAREHOLDERS ’ EQUITY

138,131 21.1% 137,811 22.6%

Contributed surplus

Retained earnings

4,271 0.7% 2,915 0.5%

135,878 20.8% 122,121 20.1%

278,280 42.6% 262,847 43.2%

$653,206 100.0% $608,154 100.0%





(b) (Continued)


Consolidated Statements of Operations

Years Ended January 29 and January 30

(in thousands)

Revenue

Retail

2006 2005

$ 856,149 75.8% $ 718,820 73.0%

273,255 24.2% 266,234 27.0% Wholesale

Cost of sales

1,129,404 100.0% 985,054 100.0%

746,313 66.1% 651,158 66.1%

Gross margin 383,091 33.9% 333,896 33.9%

Operating and admin. expenses

Store operating

General and

administrative

225,218 19.9% 190,891 19.4%

88,720 7.9% 66,536 6.7%

Operating earnings

Amortization

Interest

Loss on write-down of

investments

313,938 27.8% 257,427 26.1%

69,153

41,343

6,145

6.1%

3.7%

0.5%

76,469

35,885

4,447

7.8%

3.6%

0.5%

- 0.0% 2,208 0.2%

Earnings before income

taxes

Provision for income taxes

Current

47,488 4.2% 42,540 4.3%

21,665 1.9% 33,929 3.5%

8,784 0.8% 10,207 1.1%

Future

Net earnings

-876 -0.1% 2,177 0.2%

7,908 0.7% 12,384 1.3%

$ 13,757 1.2% $ 21,545 2.2%








(c) Horizontal analysis

On the balance sheet, the proportion of cash decreased, and the proportion of accounts receivables increased.

Goodwill and other intangibles are up 44% over the previous year. The current portion of long-term debt is up over three times the previous year.

On the income statement, retail revenue is up 19% while wholesale revenue is up only 3%. General and administrative expenses rose faster than revenue (33% versus 19%). Interest costs increased 38%. These factors combined to bring net income down by about 36%.

Vertical analysis

No significant changes were apparent.




BYP 18-2 INTERPRETING FINANCIAL STATEMENTS

(a) In terms of liquidity, both companies have cause for concern. Both have low current ratios relative to the industry although CP ’s current ratio is slightly better than

CN’s. The receivable turnover for both companies is much slower than the industry average.

(b) CN is more solvent than CP, but neither company is covering their interest costs as well as the industry average, in spite of having close to the average portion of debt. CN’s free cash flow is vastly superior to CP’s.

(c) CN appears to be more profitable. Almost all of its ratios are better than average and better than those of CP. CN’s profit margin is far superior.




BYP 18-3 COLLABORATIVE LEARNING ACTIVITY

All of the material supplementing the collaborative learning activity, including a suggested solution, can be found in the

Collaborative Learning section of the Instructor Resource site accompanying this textbook.




BYP 18-4 COMMUNICATION ACTIVITY

Memorandum

To: Self

Re: Limitations of financial statements.

In evaluating the financial performance of an entity it is important to understand the limitations of financial statements.

To address this issue, I should inquire of the audit committee some of the following questions:

1. To what extent is inflation an issue for the company.

2. What estimates have been used in preparing the financial statements? How reliable are these estimates?

3. What accounting policies are being used? Have any of these policies changed during the year? How do the policies of this company compare to those used by similar companies?

4. How diversified is this company? Are there competitors that are similar enough for comparisons to be made?

5. How would you describe the quality of earnings reported by the company? Has management been pressured to increase earnings? Are there any bonus plans or stock option plans, which would lead management to manipulate earnings?




BYP 18-5 ETHICS CASE

(a) The stakeholders in this case are:



Sabra Surkis, president of Surkis Industries



Carol Dunn, public relations director



You, as controller of Surkis Industries



Shareholders and creditors of Surkis Industries



Potential creditors and investors in Surkis Industries



Any other readers of the press release

(b) The president's press release is deceptive and incomplete, and to that extent his action is unethical.

(c) As controller you should at least inform Carol, the public relations director, about the biased content of the release.

She should be aware that the information she is about to release, while factually accurate, is deceptive and incomplete. Both the controller and the public relations director (if she agrees) have the responsibility to inform the president of the bias of the about-to-be-released information.




Legal Notice

Copyright

Copyright © 2009 by John Wiley & Sons Canada, Ltd. or related companies. All rights reserved.

The data contained in these files are protected by copyright. This manual is furnished under licence and may be used only in accordance with the terms of such licence.

The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd.



Chapter 18 Solution pdf form BAT4M

CHAPTER 18

Financial Statement Analysis

ASSIGNMENT CLASSIFICATION TABLE

ASSIGNMENT CHARACTERISTICS TABLE

BLOOM’S TAXONOMY TABLE

ANSWERS TO QUESTIONS

SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 18-1

BRIEF EXERCISE 18-2

BRIEF EXERCISE 18-3

BRIEF EXERCISE 18-4

BRIEF EXERCISE 18-5

BRIEF EXERCISE 18-6

BRIEF EXERCISE 18-6 (Continued)

BRIEF EXERCISE 18-7

BRIEF EXERCISE 18-8

BRIEF EXERCISE 18-9

BRIEF EXERCISE 18-10

BRIEF EXERCISE 18-11

BRIEF EXERCISE 18-12

BRIEF EXERCISE 18-13

BRIEF EXERCISE 18-14

SOLUTIONS TO EXERCISES

EXERCISE 18-1

EXERCISE 18-2

EXERCISE 18-3

EXERCISE 18-4

EXERCISE 18-5

EXERCISE 18-6

EXERCISE 18-7

EXERCISE 18-8

EXERCISE 18-9

EXERCISE 18-10

EXERCISE 18-10 (Continued)

EXERCISE 18-11

EXERCISE 18-12

EXERCISE 18-13

SOLUTIONS TO PROBLEMS

PROBLEM 18-1A

PROBLEM 18-2A

PROBLEM 18-3A

PROBLEM 18-4A

PROBLEM 18-5A

PROBLEM 18-6A

PROBLEM 18-7A

PROBLEM 18-8A

PROBLEM 18-9A

PROBLEM 18-10A

PROBLEM 18-1B

PROBLEM 18-2B

PROBLEM 18-3B

PROBLEM 18-4B

PROBLEM 18-5B

PROBLEM 18-6B

PROBLEM 18-7B

PROBLEM 18-8B

PROBLEM 18-9B

PROBLEM 18-10B

CONTINUING COOKIE CHRONICLE

BYP 18-1 FINANCIAL REPORTING PROBLEM

BYP 18-2 INTERPRETING FINANCIAL STATEMENTS

BYP 18-3 COLLABORATIVE LEARNING ACTIVITY

BYP 18-4 COMMUNICATION ACTIVITY

BYP 18-5 ETHICS CASE

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