# Financial Statement Analysis ```CHAPTER 4
FINANCIAL STATEMENT ANALYSIS
SOLUTIONS TO SELF-TEST EXERCISES
Exercise 1 – Vertical Analysis of Financial Statements
A. Vertical analysis of the balance sheets
% of total assets and % of total liabilities and equity
2006
2007
2008
Total current assets
Total capital assets
Total assets
44.30
55.70
100.00
50.75
49.25
100.00
36.89
63.11
100.00
Total current liabilities
Total long-term debts
Total liabilities
Total owners’ equity
Total liabilities and equity
22.94
25.32
47.26
52.74
100.00
22.39
18.66
41.04
58.96
100.00
20.72
31.40
52.12
47.88
100.00
2006
2007
2008
100.00
100.00
100.00
49.43
13.71
50.24
14.39
49.25
18.63
7.14
7.86
9.63
B. Vertical analysis of the income statements
% of sales revenue
Sales revenue
Gross profit
Operating income
Net income
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Chapter 4 – Financial Statement Analysis
Exercise 2 – Horizontal Analysis of the Financial Statements
A. Horizontal analysis of the balance sheets
% increase
2007
2008
Total current assets
Total net capital assets
Total assets
29.52
0.000
13.08
72.79
204.55
137.69
Total current liabilities
Total long-term debts
Total liabilities
Total owners’ equity
Total liabilities and equity
15.38
-16.67
- 1.79
26.40
13.08
120.00
300.00
201.82
93.04
137.69
B. Horizontal analysis of the income statements
% increase
2007
2008
Gross profit
Operating income
Net income
21.97
25.00
32.00
86.73
148.33
133.33
Exercise 3 – Liquidity Ratios
Current ratio
Current assets
--------------------Current liabilities
=
\$ 136,000
-----------\$ 60,000
=
2.27 times
\$ 71,000
----------\$ 60,000
=
1.18 times
Quick ratio
Quick assets
--------------------- =
Current liabilities
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Chapter 4 – Financial Statement Analysis
Exercise 4 – Debt/Coverage Ratios
Debt-to-total-assets ratio
Total Debt
---------------Total Assets
=
\$ 110,000
------------\$ 268,000
=
41.04%
\$ 110,000
-------------\$ 158,000
=
0.70 times
Debt-to-equity ratio
Total debt
----------------Total equity
=
Times-interest-earned ratio
Income before taxes + Interest charges
---------------------------------------------Interest charges
=
\$ 60,000
-----------\$ 14,000
= 4.29 times
EBT + Interest charges + Lease
-------------------------------------- =
Interest charges + Lease
\$ 67,000
-----------\$ 21,000
=
Fixed-charges coverage ratio
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3.19 times
Chapter 4 – Financial Statement Analysis
Exercise 5 – Asset-Management Ratios
Average collection period
Accounts receivables
------------------------Average daily sales
=
\$ 45,000
-----------\$ 1,151
=
39.1 days
\$ 209,000
------------\$ 65,000
=
3.2 times
\$ 420,000
-----------\$ 132,000
=
3.18 times
\$ 420,000
-------------\$ 268,000
=
1.57 times
Inventory turnover ratio
Cost of sales
---------------Inventory
=
Capital assets turnover ratio
Sales revenue
--------------------Net capital assets
=
Total assets turnover ratio
Sales revenue
---------------Total assets
=
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Chapter 4 – Financial Statement Analysis
Exercise 6 – Using Financial Ratios as a Management Tool to Improve Cash Flow
If CompuTech is able to improve its average collection period and inventory turnover, the
Millers could improve its cash position by \$29,026.
A. CompuTech could generate \$ 10,470 in cash by improving the average collection to 30
days.
Existing average daily sales is \$1,151 and average collection period is
39.1days (see self- test exercise no. 5)
Target performance of 30 days
Existing accounts receivable
Target \$ 1,151 x 30 days
=
\$45,000
\$34,530
Reduction of
\$10,470
B. The company could generate \$ 18,556 in cash by improving the inventory turnover
rate to 4.5 times.
Existing inventory is \$65,000, inventory turnover is 3.2 times and total cost of
sales is \$209,000 (see self-exercise no. 5)
Target performance to 4.5 times
Existing inventory
Target (\$209,000 &divide; 4.5)
\$65,000
\$46,444
Reduction of
\$18,556
Cash generated
In total, CompuTech would generate \$29,026 in additional cash.
Accounts receivable
Inventory
Existing
Target
\$ 45,000
34,530
\$ 65,000
46,444
Incremental cash
\$ 10,470
\$ 18,556
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Total
\$ 29,026
Chapter 4 – Financial Statement Analysis
Exercise 7 – Cash Flow Forecast
CompuTech could generate a total of \$ 102,026 in additional cash by the end of the year
2007.
Sources
From operations
Income after taxes
Amortization
\$33,000
40,000
Cash flow from operations
+ \$ 73,000
The company could obtain
accounts receivable.
See the calculation in
Self-test exercise no. 5
Existing accounts receivable
New target
\$ 45,000
34,510
+ \$ 10,470
From inventory, the company
could obtain an additional \$ 18,556
See the calculation in
Self-test exercise no. 6
New target
\$65,000
34,510
Total internally generated funds
+ \$ 18,556
+ \$ 102,026
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Chapter 4 – Financial Statement Analysis
Exercise 8 – Profitability Ratios
Profit margin on sales revenue ratio
Operating income
--------------------Sales revenue
=
\$ 60,000
------------\$ 420,000
=
14.29%
=
\$ 33,000
-------------\$ 420,000
=
7.86%
=
\$ 33,000
-----------\$ 268,000
=
12.31%
=
\$ 33,000
-------------\$ 158,000
=
20.89%
Return on sales revenue ratio
Net income
----------------Sales revenue
Return on total assets ratio
Net income
---------------Total assets
Return on equity ratio
Net income
-----------------Owners' Equity
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Chapter 4 – Financial Statement Analysis
Exercise 9 – Calculating the ROA Using the Du Pont Financial System
A. The 2007 return on total assets is 22.39%. Here is the calculation.
Cash
Accounts receivable
Prepaid expenses
Inventory
Total current assets
Capital assets
Sales revenue
Total assets
Total assets turnover
\$21,000
\$45,000
\$ 5,000
\$65,000
Cost of sales
Amortization
Selling expenses
Sales revenue
Total cost of operation
Operating profit
Sales revenue
Profit on sales revenue
\$209,000
\$ 40,000
\$ 66,000
\$ 45,000
\$136,000
\$132,000
\$420,000
\$268,000
1.57
\$420,000
\$360,000
\$ 60,000
\$420,000
14.29
Return on total assets
22.39%
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Chapter 4 – Financial Statement Analysis
B. The 2008 return on total assets is 23.39%.
Cash
Accounts receivable
Prepaid expenses
Inventory
Total current assets
Capital assets
Sales revenue
Total assets
Total assets turnover
\$ 25,000
\$ 90,000
\$ 10,000
\$110,000
Cost of sales
Amortization
Selling expenses
Sales revenue
Total cost of operation
Operating profit
Sales revenue revenue
Profit on sales
\$406,000
\$ 80,000
\$ 95,000
\$ 70,000
\$235,000
\$402,000
\$800,000
\$637,000
1.26
\$800,000
\$651,000
\$149,000
\$800,000
18.63
Return on total assets
23.39%
As shown, there is a slight improvement in the return on total assets performance. Despite
the fact that there was a sharp drop in the total assets turnover between the two years
(1.57 versus 1.26) which shows that the productivity of assets deteriorated, there was an
abrupt increase in the profit on sales revenue performance (14.29 versus 18.63). This is
due to the fact that while sales revenue increased by 90.5% between the two years,
operating profit showed a whopping 148.3 increase.
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