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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 - 13 - 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 - 14 - 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 - 15 - 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 = - 16 - 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 ÷ 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 - 17 - 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 an additional $10,470 from 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 - 18 - 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 - 19 - 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 Adm. 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% - 20 - 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 Adm. 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. - 21 -