MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual

CHAPTER 5 FINANCIAL STATEMENTS ANALYSIS - II

I. Questions
1.

By looking at trends, an analyst hopes to get some idea of whether a situation is improving, remaining the same, or deteriorating. Such analyses can provide insight into what is likely to happen in the future. Rather than looking at trends, an analyst may compare one company to another or to industry averages using common-size financial statements. Ratios highlight relationships, movements, and trends that are very difficult to perceive looking at the raw underlying data standing alone. Also, ratios make financial data easier to grasp by putting the data into perspective. As to the limitation in the use of ratios, refer to page 129.

2.

3. Price-earnings ratios are determined by how investors see a firms future prospects. Current reported earnings are generally considered to be useful only so far as they can assist investors in judging what will happen in the future. For this reason, two firms might have the same current earnings, but one might have a much higher price-earnings ratio if investors view it to have superior future prospects. In some cases, firms with very small current earnings enjoy very high price-earnings ratios. This is simply because investors view these firms as having very favorable prospects for earnings in future years. By definition, a stock with current earnings of P4 and a price-earnings ratio of 20 would be selling for P80 per share.
4.

A managers financing responsibilities relate to the acquisition of assets for use in his or her company. The acquisition of assets can be financed in a number of ways, including through issue of ordinary shares, through issue of preference shares, through issue of long-term debt, through leasing, etc. A managers operating responsibilities relate to how these assets are used once they have been acquired. The return on total assets ratio is designed to measure how well a manager is discharging his or her operating responsibilities. It does this by looking at a companys income before any consideration is given as to how the income will be distributed among capital resources, i.e., before interest deductions.

5-1

Chapter 5 Financial Statement Analysis II 5.

Financial leverage, as the term is used in business practice, means obtaining funds from investment sources that require a fixed annual rate of return, in the hope of enhancing the well-being of the ordinary shareholders. If the assets in which these funds are invested earn at a rate greater that the return required by the suppliers of the funds, then leverage is positive in the sense that the excess accrues to the benefit of the ordinary shareholders. If the return on assets is less than the return required by the suppliers of the funds, then leverage is negative in the sense that part of the earnings from the assets provided by the ordinary shareholders will have to go to make up the deficiency. How a shareholder would feel would depend in large part on the stability of the firm and its industry. If the firm is in an industry that experiences wide fluctuations in earnings, then shareholders might be very pleased that no interest-paying debt exists in the firms capital structure. In hard times, interest payments might be very difficult to meet, or earnings might be so poor that negative leverage would result.

6.

7. No, the stock is not necessarily overpriced. Book value represents the cumulative effects on the balance sheet of past activities evaluated using historical prices. The market value of the stock reflects investors beliefs about the companys future earning prospects. For most companies market value exceeds book value because investors anticipate future growth in earnings. 8. A company in a rapidly growing technological industry probably would have many opportunities to invest its earnings at a high rate of return; thus, one would expect it to have a low dividend payout ratio.
9.

It is more difficult to obtain positive financial leverage from preference shares than from long-term debt due to the fact that interest on long-term debt is tax deductible, whereas dividends paid on preference shares are not tax deductible.

10. The current ratio would probably be highest during January, when both current assets and current liabilities are at a minimum. During peak operating periods, current liabilities generally include short-term borrowings that are used to temporarily finance inventories and receivables. As the peak periods end, these short-term borrowings are paid off, thereby enhancing the current ratio.
11. A 2-to-1 current ratio might not be adequate for several reasons. First,

the composition of the current assets may be heavily weighted toward

5-2

Financial Statement Analysis II Chapter 5

slow-turning inventory, or the inventory may consist of large amounts of obsolete goods. Second, the receivables may be large and of doubtful collectibility, or the receivables may be turning very slowly due to poor collection procedures. 12. Expenses (including the cost of goods sold) have been increasing at an even faster rate than net sales. Thus Sunday is apparently having difficulty in effectively controlling its expenses. 13. If the companys earnings are very low, they may become almost insignificant in relation to stock price. While this means that the p/e ratio becomes very high, it does not necessarily mean that investors are optimistic. In fact, they may be valuing the company at its liquidation value rather than a value based upon expected future earnings. 14. From the viewpoint of the companys shareholders, this situation represents a favorable use of leverage. It is probable that little interest, if any, is paid for the use of funds supplied by current creditors, and only 11% interest is being paid to long-term bondholders. Together these two sources supply 40% of the total assets. Since the firm earns an average return of 16% on all assets, the amount by which the return on 40% of the assets exceeds the fixed-interest requirements on liabilities will accrue to the residual equity holders the ordinary shareholders raising the return on equity. 15. The length of operating cycle of the two companies cannot be determined from the fact the one companys current ratio is higher. The operating cycle depends on the relationships between receivables and sales, and between inventories and cost of goods sold. The company with the higher current ratio might have either small amounts of receivables and inventories, or large sales and cost of sales, either of which would tend to produce a relatively short operating cycle. 16. The investor is calculating the rate of return by dividing the dividend by the purchase price of the investment (P5 P50 = 10%). A more meaningful figure for rate of return on investment is determined by relating dividends to current market price, since the investor at the present time is faced with the alternative of selling the stock for P100 and investing the proceeds elsewhere or keeping the investment. A decision to retain the stock constitutes, in effect, a decision to continue to invest P100 in it, at a return of 5%. It is true that in a historical sense the investor is earning 10% on the original investment, but this is interesting history rather than useful decision-making information.
5-3

Chapter 5 Financial Statement Analysis II

17. A corporate net income of P1 million would be unreasonably low for a large corporation, with, say, P100 million in sales, P50 million in assets, and P40 million in equity. A return of only P1 million for a company of this size would suggest that the owners could do much better by investing in insured bank savings accounts or in government bonds which would be virtually risk-free and would pay a higher return. On the other hand, a profit of P1 million would be unreasonably high for a corporation which had sales of only P5 million, assets of, say, P3 million, and equity of perhaps one-half million pesos. In other words, the net income of a corporation must be judged in relation to the scale of operations and the amount invested. II. True or False 1. True 2. True III. Problems Problem 1 (Common Size Income Statements) Common size income statements for 2005 and 2006: 2006 2005 Sales................................................. 100% 100% Cost of goods sold............................. 66 67 Gross profit....................................... 34% 33% Operating expenses........................... 28 29 Net income........................................ 6% 4% The changes from 2005 to 2006 are all favorable. Sales increased and the gross profit per peso of sales also increased. These two factors led to a substantial increase in gross profit. Although operating expenses increased in peso amount, the operating expenses per peso of sales decreased from 29 cents to 28 cents. The combination of these three favorable factors caused net income to rise from 4 cents to 6 cents out of each peso of sales. Problem 2 (Measures of Liquidity) Requirement (a) Current assets: Cash
5-4

3. True 4. False

5. True 6. True

7. True 8. True

9. False 10. False

P 47,600

Financial Statement Analysis II Chapter 5

Marketable securities Accounts receivable Inventory Unexpired insurance Total current assets Current liabilities: Notes payable Accounts payable Salaries payable Income taxes payable Unearned revenue Total current liabilities Requirement (b)

175,040 230,540 179,600 4,500 P637,280 P 70,000 125,430 7,570 14,600 10,000 P227,600

The current ratio is 2.8 to 1. It is computed by dividing the current assets of P637,280 by the current liabilities of P227,600. The amount of working capital is P409,680, computed by subtracting the current liabilities of P227,600 from the current assets of P637,280. The company appears to be in a strong position as to short-run debt-paying ability. It has almost three pesos of current assets for each peso of current liabilities. Even if some losses should be sustained in the sale of the merchandise on hand or in the collection of the accounts receivable, it appears probable that the company would still be able to pay its debts as they fall due in the near future. Of course, additional information, such as the credit terms on the accounts receivable, would be helpful in a careful evaluation of the companys current position. Problem 3 (Common-Size Income Statement) Requirement 1 Sales.................................................................... Less cost of goods sold......................................... Gross margin........................................................ Selling expenses................................................... Administrative expenses....................................... Total expenses...................................................... Net operating income........................................... Interest expense.................................................... Net income before taxes.......................................
5-5

2006 100.0 % 63.2 36.8 18.0 13.6 31.6 5.2 1.4 3.8 %

2005 100.0 % 60.0 40.0 17.5 14.6 32.1 7.9 1.0 6.9 %

Chapter 5 Financial Statement Analysis II

Requirement 2 The companys major problem seems to be the increase in cost of goods sold, which increased from 60.0% of sales in 2005 to 63.2% of sales in 2006. This suggests that the company is not passing the increases in costs of its products on to its customers. As a result, cost of goods sold as a percentage of sales has increased and gross margin has decreased. Selling expenses and interest expense have both increased slightly during the year, which suggests that costs generally are going up in the company. The only exception is the administrative expenses, which have decreased from 14.6% of sales in 2005 to 13.6% of sales in 2006. This probably is a result of the companys efforts to reduce administrative expenses during the year. Problem 4 (Comparing Operating Results with Average Performance in the Industry) Requirement (a) Sales (net) Cost of goods sold Gross profit on sales Operating expenses: Selling General and administrative Total operating expenses Operating income Income taxes Net income........................................ Requirement (b) Ms. Freezes operating results are significantly better than the average performance within the industry. As a percentage of sales revenue, Ms. Freezes operating income and net income after nearly twice the average for the industry. As a percentage of total assets, Ms. Freezes profits amount to an impressive 23% as compared to 14% for the industry. The key to Ms. Freezes success seems to be its ability to earn a relatively high rate of gross profit. Ms. Freezes exceptional gross profit rate (51%) probably results from a combination of factors, such as an ability to command a premium price for the companys products and production efficiencies which lead to lower manufacturing costs.
5-6

Ms. Freeze, Inc. 100% 49 51% 21% 17 38% 13% 6 7%

Industry Average 100% 57 43% 16% 20 36% 7% 3 4%

Financial Statement Analysis II Chapter 5

As a percentage of sales, Ms. Freezes selling expenses are five points higher than the industry average (21% compared to 16%). However, these higher expenses may explain Ms. Freezes ability to command a premium price for its products. Since the companys gross profit rate exceeds the industry average by 8 percentage points, the higher-than-average selling costs may be part of a successful marketing strategy. The companys general and administrative expenses are significantly lower than the industry average, which indicates that Ms. Freezes management is able to control expenses effectively. Problem 5 (Common-Size Statements) Requirement 1
The income statement in common-size form would be:

Sales......................................................... Less cost of goods sold............................. Gross margin............................................ Less operating expenses............................ Net operating income................................ Less interest expense................................ Net income before taxes............................ Less income taxes (30%).......................... Net income...............................................

2006 100.0% 65.0 35.0 26.3 8.7 1.2 7.5 2.3 5.3%

2005 100.0% 60.0 40.0 30.4 9.6 1.6 8.0 2.4 5.6%

The balance sheet in common-size form would be: 2006 Current assets: Cash .......................................................... Accounts receivable, net .......................................................... Inventory .......................................................... Prepaid expenses .......................................................... Total current assets Plant and equipment................................. Total assets...............................................
5-7

2005 5.1% 10.1 15.2 1.3 31.6 68.4 100.0%

2.0% 15.0 30.1 1.0 48.1 51.9 100.0%

Chapter 5 Financial Statement Analysis II

Liabilities: Current liabilities............................... Bonds payable, 12%........................... Total liabilities............................. Equity: Preference shares, 8%, P10 par Ordinary shares, P5 par Retained earnings Total equity Total liabilities and equity........................

25.1% 20.1 45.1 15.0 10.0 29.8 54.9 100.0%

12.7% 25.3 38.0 19.0 12.7 30.4 62.0 100.0%

Note: Columns do not total down in all cases due to rounding differences. Requirement 2 The companys cost of goods sold has increased from 60 percent of sales in 2005 to 65 percent of sales in 2006. This appears to be the major reason the companys profits showed so little increase between the two years. Some benefits were realized from the companys cost-cutting efforts, as evidenced by the fact that operating expenses were only 26.3 percent of sales in 2006 as compared to 30.4 percent in 2005. Unfortunately, this reduction in operating expenses was not enough to offset the increase in cost of goods sold. As a result, the companys net income declined from 5.6 percent of sales in 2005 to 5.3 percent of sales in 2006. Problem 6 (Solvency of Alabang Supermarket) Requirement (a) (Pesos in Millions) Current assets: Cash Receivables Merchandise inventories Prepaid expenses Total current assets Quick assets: Cash
5-8

74.8 152.7 1,191.8 95.5 P1,514.8 74.8

Financial Statement Analysis II Chapter 5

Receivables Total quick assets Requirement (b) (1) Current ratio: Current assets (Req. a) Current liabilities Current ratio (P1,514.8 P1,939.0) (2) Quick ratio: Quick assets (Req. a) Current liabilities Quick ratio (P227.5 P1,939.0) (3) Working capital: Current assets (Req. a) Less: Current liabilities Working capital

152.7 P 227.5

P1,514.8 P1,939.0 0.8 to 1 P 227.5 P1,939.0 0.1 to 1 P1,514.8 P1,939.0 P(424.2)

Requirement (c) No. It is difficult to draw conclusions from the above ratios. Alabang Supermarkets current ratio and quick ratio are well below safe levels, according to traditional rules of thumb. On the other hand, some large companies with steady ash flows are able to operate successfully with current ratios lower than Alabang Supermarkets. Requirement (d) Due to characteristics of the industry, supermarkets tend to have smaller amounts of current assets and quick assets than other types of merchandising companies. An inventory of food has a short shelf life. Therefore, the inventory of a supermarket usually represents only a few weeks sales. Other merchandising companies may stock inventories representing several months sales. Also, supermarkets sell primarily for cash. Thus, they have relatively few receivables. Although supermarkets may generate large amounts of cash, it is not profitable for them to hold assets in this form. Therefore, they are likely to reinvest their cash flows in business operations as quickly as possible.
5-9

Chapter 5 Financial Statement Analysis II

Requirement (e) In evaluating Alabang Supermarkets liquidity, it would be useful to review the companys financial position in prior years, statements of cash flows, and the financial ratios of other supermarket chains. One might also ascertain the companys credit rating from an agency such as Dun & Bradstreet. Note to Instructor: Prior to the year in which the data for this problem was collected, Alabang Supermarket had reported a negative retained earnings balance in its balance sheet for several consecutive periods. The fact that Alabang Supermarket has only recently removed the deficit from its financial statements is also worrisome.

Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk) Requirement (a) (1) Quick assets: Cash Marketable securities (short-term) Accounts receivable Total quick assets (2) Current assets: Cash Marketable securities (short-term) Accounts receivable Inventories Prepaid expenses Total current assets (3) Current liabilities: Notes payable to banks (due within one year) Accounts payable Dividends payable Accrued liabilities (short-term)
5-10

P 47,524 55,926 23,553 P127,003 P 47,524 55,926 23,553 32,210 5,736 P164,949 P 20,000 5,912 1,424 21,532

Financial Statement Analysis II Chapter 5

Income taxes payable Total current liabilities Requirement (b) (1) Quick ratio: Quick assets (Req. a) Current liabilities (Req. a) Quick ratio (P127,003 P55,306) (2) Current ratio: Current assets (Req. a) Current liabilities (Req. a) Current ratio (P164,949 P55,306)

6,438 P 55,306

P127,003 P 55,306 2.3 to 1 P164,949 P 55,306 3.0 to 1

(3) Working capital: Current assets (Req. a) Less: Current liabilities (Req. a) Working capital (4) Debt ratio: Total liabilities (given) Total assets (given) Debt ratio (P81,630 P353,816) Requirement (c)

P164,949 55,306 P109,643 P 81,630 P353,816 23.1%

(1) From the viewpoint of short-term creditors, Bonbon Sweets appear highly liquid. Its quick and current ratios are well above normal rules of thumb, and the companys cash and marketable securities alone are almost twice its current liabilities. (2) Long-term creditors also have little to worry about. Not only is the company highly liquid, but creditors claims amount to only 23.1% of total assets. If Bonbon Sweets were to go out of business and liquidate its assets, it would have to raise only 23 cents from every peso of assets for creditors to emerge intact. (3) From the viewpoint of shareholders, Bonbon Sweets appears overly liquid. Current assets generally do not generate high rates of return. Thus, the companys relatively large holdings of current assets dilutes its
5-11

Chapter 5 Financial Statement Analysis II

return on total assets. This should be of concern to shareholders. If Bonbon Sweets is unable to invest its highly liquid assets more productively in its business, shareholders probably would like to see the money distributed as dividends. Problem 8 (Selected Financial Measures for Short-term Creditors) Requirement 1 Current assets (P80,000 + P460,000 + P750,000 + P10,000)........................................................................... Current liabilities (P1,300,000 2.5)................................... Working capital.................................................................... Requirement 2 Acid-test ratio = Acid-test ratio = Requirement 3 a. Working capital would not be affected: Current assets (P1,300,000 P100,000)........................... Current liabilities (P520,000 P100,000)......................... Working capital................................................................. b. The current ratio would rise: Current ratio Current rate = = Current assets Current liabilities P1,200,000 P420,000 = 2.9 to 1 (rounded) P1,200,000 420,000 P 780,000 P1,300,000 520,000 P 780,000

Cash + Marketable securities + Accounts receivable Current liabilities P80,000 + P0 + P460,000 P520,000 = 1.04 to 1 (rounded)

Problem 9 (Selected Financial Ratios) 1. Gross margin percentage: Gross margin Sales = P840,000 P2,100,000 = 40%

5-12

Financial Statement Analysis II Chapter 5

2. Current ratio: Current assets Current liabilities 3. Acid-test ratio: Quick assets Current liabilities

P490,000 P200,000

= 2.45 to 1

P181,000 P200,000

= 0.91 to 1 (rounded)

4. Accounts receivable turnover: Sales Average accounts receivables 365 days 14 times 5. Inventory turnover: Cost of goods sold Average inventory 365 days 4.5 times 6. Debt-to-equity ratio: Total liabilities Total equity 7. Times interest earned: Earnings before interest and income taxes Interest expense 8. Book value per share: Equity Ordinary shares outstanding = P800,000 20,000 shares* = P40 per share = P180,000 P30,000 = P500,000 P800,000 = 0.63 to 1 (rounded) = P1,260,000 P280,000 = 4.5 times = P2,100,000 P150,000 = 14 times

= 26.1 days (rounded)

= 81.1 days to turn (rounded)

= 6.0 times

* P100,000 total par value P5 par value per share = 20,000 shares 5-13

Chapter 5 Financial Statement Analysis II

Problem 10 (Selected Financial Ratios for Ordinary Shareholders) 1. Earnings per share: Net income to ordinary shares Average ordinary shares outstanding 2. Dividend payout ratio: Dividends paid per share Earnings per share 3. Dividend yield ratio: Dividends paid per share Market price per share 4. Price-earnings ratio: Market price per share Earnings per share = P105,000 20,000 shares = P5.25 per share

P3.15 P5.25

= 60%

P3.15 P63.00

= 5%

P63.00 P5.25

= 12.0

Problem 11 (Selected Financial Ratios for Ordinary Shareholders) 1. Return on total assets: Return on total = assets = = Net income + [Interest expense x (1 Tax rate)] Average total assets P105,000 + [P30,000 x (1 0.30)] (P1,100,000 + P1,300,000) P126,000 P1,200,000 = 10.5%

2. Return on ordinary shareholders equity: = Net income preference dividends Average ordinary shareholders equity P105,000 (P725,000 + P800,000)
5-14

Return on ordinary shareholders equity = =

Financial Statement Analysis II Chapter 5

P105,000 P762,500

= 13.8% (rounded)

3. Financial leverage was positive, since the rate of return to the ordinary shareholders (13.8%) was greater than the rate of return on total assets (10.5%). This positive leverage is traceable in part to the companys current liabilities, which may carry no interest cost, and to the bonds payable, which have an after-tax interest cost of only 7%. 10% interest rate (1 0.30) = 7% after-tax cost. IV. Cases Case 1 (Common-Size Statements and Financial Ratios for Creditors) Requirement 1 This Year P2,060,000 1,100,000 P 960,000 P2,060,000 P1,100,000 1.87 to 1 P740,000 P1,100,000 0.67 to 1 P7,000,000 P525,000 13.3 times 27.4 days P5,400,000 P1,050,000 Last Year P1,470,000 600,000 P 870,000 P1,470,000 P600,000 2.45 to 1 P650,000 P600,000 1.08 to 1 P6,000,000 P375,000 16.0 times 22.8 days P4,800,000 P760,000

a. Current assets.......................................... Current liabilities..................................... Working capital........................................ b. Current assets (a)..................................... Current liabilities (b)................................ Current ratio (a) (b).............................. c. Quick assets (a)....................................... Current liabilities (b)................................ Acid-test ratio (a) (b)............................ d. Sales on account (a)................................. Average receivables (b)............................ Turnover of receivables (a) (b)............. Average age of receivables: 365 turnover......................................... e. Cost of goods sold (a).............................. Average inventory (b)...............................
5-15

Chapter 5 Financial Statement Analysis II

Inventory turnover (a) (b)..................... f. Turnover in days: 365 turnover............. Total liabilities (a).................................... Equity (b)................................................. Debt-to-equity ratio (a) (b)...................

5.1 times 71.6 days P1,850,000 P2,150,000 0.86 to 1 P630,000 P90,000 7.0 times

6.3 times 57.9 days P1,350,000 P1,950,000 0.69 to 1 P490,000 P90,000 5.4 times

g. Net income before interest and taxes (a). . Interest expense (b).................................. Times interest earned (a) (b)................. Requirement 2 a.

METRO BUILDING SUPPLY Common-Size Balance Sheets This Year Current assets: Cash.................................................... Marketable securities.......................... Accounts receivable, net...................... Inventory............................................. Prepaid expenses................................. Total current assets................................. Plant and equipment, net......................... Total assets............................................. Liabilities: Current liabilities................................. Bonds payable, 12%............................ Total liabilities........................................ Equity: Preference shares, P50 par, 8%........... Ordinary shares, P10 par..................... Retained earnings................................ Total equity............................................. Total liabilities and equity....................... 2.3 % 0.0 16.3 32.5 0.5 51.5 48.5 100.0 % Last Year 6.1 % 1.5 12.1 24.2 0.6 44.5 55.5 100.0 %

27.5 % 18.8 46.3 5.0 12.5 36.3 53.8 100.0 %

18.2 % 22.7 40.9 6.1 15.2 37.9 59.1 100.0 %

Note: Columns do not total down in all cases due to rounding. b. METRO BUILDING SUPPLY
5-16

Financial Statement Analysis II Chapter 5

Common-Size Income Statements Sales........................................................ Less cost of goods sold............................ Gross margin........................................... Less operating expenses........................... Net operating income............................... Less interest expense................................ Net income before taxes........................... Less income taxes.................................... Net income............................................... Requirement 3 The following points can be made from the analytical work in parts (1) and (2) above: The company has improved its profit margin from last year. This is attributable to an increase in gross margin, which is offset somewhat by an increase in operating expenses. In both years the companys net income as a percentage of sales equals or exceeds the industry average of 4%. Although the companys working capital has increased, its current position actually has deteriorated significantly since last year. Both the current ratio and the acid-test ratio are well below the industry average, and both are trending downward. (This shows the importance of not just looking at the working capital in assessing the financial strength of a company.) Given the present trend, it soon will be impossible for the company to pay its bills as they come due. The drain on the cash account seems to be a result mostly of a large buildup in accounts receivable and inventory. This is evident both from the common-size balance sheet and from the financial ratios. Notice that the average age of the receivables has increased by 5 days since last year, and that it is now 9 days over the industry average. Many of the companys customers are not taking their discounts, since the average collection period is 27 days and collection terms are 2/10, n/30. This suggests financial weakness on the part of these customers, or sales to customers who are poor credit risks. Perhaps the company has been too aggressive in expanding its sales. The inventory turned only 5 times this year as compared to over 6 times last year. It takes three weeks longer for the company to turn its inventory than
5-17

This Year 100.0 % 77.1 22.9 13.9 9.0 1.3 7.7 3.1 4.6 %

Last Year 100.0 % 80.0 20.0 11.8 8.2 1.5 6.7 2.7 4.0 %

Chapter 5 Financial Statement Analysis II

the average for the industry (71 days as compared to 50 days for the industry). This suggests that inventory stocks are higher than they need to be. In the authors opinion, the loan should be approved on the condition that the company take immediate steps to get its accounts receivable and inventory back under control. This would mean more rigorous checks of creditworthiness before sales are made and perhaps paring out of slow paying customers. It would also mean a sharp reduction of inventory levels to a more manageable size. If these steps are taken, it appears that sufficient funds could be generated to repay the loan in a reasonable period of time. Case 2 (Financial Ratios for Ordinary Shareholders) Requirement 1 a. Net income............................................. Less preference dividends....................... Net income remaining for ordinary (a).... Average number of ordinary shares (b)... Earnings per share (a) (b).................... b. Ordinary dividend per share (a)*............ Market price per share (b)...................... Dividend yield ratio (a) (b).................. *P108,000 50,000 shares = P2.16; P60,000 50,000 shares = P1.20 c. Ordinary dividend per share (a)................ Earnings per share (b)............................... Dividend payout ratio (a) (b)................. d. Market price per share (a)......................... Earnings per share (b)............................... Price-earnings ratio (a) (b)..................... P2.16 P6.16 35.1% P45.00 P6.16 7.3 P1.20 P4.48 26.8% P36.00 P4.48 8.0 This Year P324,000 16,000 P308,000 50,000 P6.16 P2.16 P45.00 4.8% Last Year P240,000 16,000 P224,000 50,000 P4.48 P1.20 P36.00 3.33%

Investors regard Metro Building Supply less favorably than other firms in the industry. This is evidenced by the fact that they are willing to pay only 7.3 times current earnings for a share of the companys stock, as compared to 9 times current earnings for the average of all stocks in the industry. If investors were willing to pay 9 times current earnings for
5-18

Financial Statement Analysis II Chapter 5

Metro Building Supplys stock, then it would be selling for about P55 per share (9 P6.16), rather than for only P45 per share. e. Equity....................................................... Less preference shares.............................. Ordinary equity (a)................................... Number of ordinary shares (b).................. Book value per share (a) (b).................. This Year P2,150,000 200,000 P1,950,000 50,000 P39.00 Last Year P1,950,000 200,000 P1,750,000 50,000 P35.00

A market price in excess of book value does not mean that the price of a stock is too high. Market value is an indication of investors perceptions of future earnings and/or dividends, whereas book value is a result of already completed transactions and is geared to the past. Requirement 2 a. Net income................................................ Add after-tax cost of interest paid: [P90,000 (1 0.40)].......................... Total (a).................................................... Average total assets (b)............................. Return on total assets (a) (b).................. This Year P 324,000 54,000 P 378,000 P3,650,000 10.4% Last Year P 240,000 54,000 P 294,000 P3,000,000 9.8%

b. Net income................................................ Less preference dividends......................... Net income remaining for ordinary shareholders (a)..................................... Average total equity*................................ Less average preference shares................. Average ordinary equity (b)......................

This Year P 324,000 16,000 P 308,000 P2,050,000 200,000 P1,850,000

Last Year P 240,000 16,000 P 224,000 P1,868,000 200,000 P1,668,000

*1/2(P2,150,000 + P1,950,000); 1/2(P1,950,000 + P1,786,000). Return on ordinary equity (a) (b)........

5-19

16.6%

13.4%

Chapter 5 Financial Statement Analysis II

c. Financial leverage is positive in both years, since the return on ordinary equity is greater than the return on total assets. This positive financial leverage is due to three factors: the preference shares, which has a dividend of only 8%; the bonds, which have an after-tax interest cost of only 7.2% [12% interest rate (1 0.40) = 7.2%]; and the accounts payable, which may bear no interest cost. Requirement 3 We would recommend keeping the stock. The stocks downside risk seems small, since it is selling for only 7.3 times current earnings as compared to 9 times earnings for the average firm in the industry. In addition, its earnings are strong and trending upward, and its return on ordinary equity (16.6%) is extremely good. Its return on total assets (10.4%) compares favorably with that of the industry. The risk, of course, is whether the company can get its cash problem under control. Conceivably, the cash problem could worsen, leading to an eventual reduction in profits through inability to operate, a reduction in dividends, and a precipitous drop in the market price of the companys stock. This does not seem likely, however, since the company can easily control its cash problem through more careful management of accounts receivable and inventory. If this problem is brought under control, the price of the stock could rise sharply over the next few years, making it an excellent investment. Case 3 (Comprehensive Ratio Analysis) Requirement 1 a. Net income................................................ Add after-tax cost of interest: P120,000 (1 0.30)........................... P100,000 (1 0.30)........................... Total (a).................................................... Average total assets (b)............................. Return on total assets (a) (b).................. b. Net income................................................ Less preference dividends.........................
5-20

This Year P 280,000 84,000 P 364,000 P5,330,000 6.8% P 280,000 48,000

Last Year P 168,000 70,000 P 238,000 P4,640,000 5.1% P 168,000 48,000

Financial Statement Analysis II Chapter 5

Net income remaining for ordinary (a)...... Average total equity.................................. Less average preference shares................. Average ordinary equity (b)...................... Return on ordinary equity (a) (b)...........

P 232,000 P3,120,000 600,000 P2,520,000 9.2%

P 120,000 P3,028,000 600,000 P2,428,000 4.9%

c. Leverage is positive for this year, since the return on ordinary equity (9.2%) is greater than the return on total assets (6.8%). For last year, leverage is negative since the return on the ordinary equity (4.9%) is less than the return on total assets (5.1%). Requirement 2 a. Net income remaining for ordinary (a)..... Average number of ordinary shares (b).... Earnings per share (a) (b)..................... b. Ordinary dividend per share (a)................ Market price per share (b)....................... Dividend yield ratio (a) (b)................... c. Ordinary dividend per share (a)................ Earnings per share (b).............................. Dividend payout ratio (a) (b)................ d. Market price per share (a)......................... Earnings per share (b)............................... Price-earnings ratio (a) (b)..................... P 232,000 50,000 P4.64 P1.44 P36.00 4.0% This Year P1.44 P4.64 31.0% P36.00 P4.64 7.8 P 120,000 50,000 P2.40 P0.72 P20.00 3.6% Last Year P0.72 P2.40 30.0% P20.00 P2.40 8.3

Notice from the data given in the problem that the average P/E ratio for companies in Helixs industry is 10. Since Helix Company presently has a P/E ratio of only 7.8, investors appear to regard it less well than they do other companies in the industry. That is, investors are willing to pay only 7.8 times current earnings for a share of Helix Companys stock, as compared to 10 times current earnings for a share of stock for the average company in the industry. e. Equity...................................................... Less preference shares.............................
5-21

P3,200,000 600,000

P3,040,000 600,000

Chapter 5 Financial Statement Analysis II

Ordinary equity (a).................................. Number of ordinary shares (b)................. Book value per share (a) (b).................

P2,600,000 50,000 P52.00

P2,440,000 50,000 P48.80

Note that the book value of Helix Companys stock is greater than the market value for both years. This does not necessarily indicate that the stock is selling at a bargain price. Market value is an indication of investors perceptions of future earnings and/or dividends, whereas book value is a result of already completed transactions and is geared to the past. f. Gross margin (a)...................................... Sales (b).................................................. Gross margin percentage (a) (b)........... P1,050,000 P5,250,000 20.0% P860,000 P4,160,000 20.7%

Requirement 3 a. Current assets.......................................... Current liabilities..................................... Working capital....................................... b. Current assets (a)..................................... Current liabilities (b)............................... Current ratio (a) (b).............................. c. Quick assets (a)....................................... Current liabilities (b)............................... Acid-test ratio (a) (b)............................ d. Sales on account (a)................................. Average receivables (b)............................ Accounts receivable turnover (a) (b)..... Average age of receivables, 365 turnover..................................... e. Cost of goods sold (a).............................. Average inventory (b).............................. Inventory turnover (a) (b).....................
5-22

This Year P2,600,000 1,300,000 P1,300,000 P2,600,000 P1,300,000 2.0 to 1 P1,220,000 P1,300,000 0.94 to 1 P5,250,000 P750,000 7.0 times 52 days P4,200,000 P1,050,000 4.0 times

Last Year P1,980,000 920,000 P1,060,000 P1,980,000 P920,000 2.15 to 1 P1,120,000 P920,000 1.22 to 1 P4,160,000 P560,000 7.4 times 49 days P3,300,000 P720,000 4.6 times

Financial Statement Analysis II Chapter 5

Number of days to turn inventory, 365 days turnover (rounded)............. f. Total liabilities (a)................................... Equity (b)................................................ Debt-to-equity ratio (a) (b)...................

91 days P2,500,000 P3,200,000 0.78 to 1 P520,000 P120,000 4.3 times

79 days P1,920,000 P3,040,000 0.63 to 1 P340,000 P100,000 3.4 times

g. Net income before interest and taxes (a). . Interest expense (b).................................. Times interest earned (a) (b)................. Requirement 4

As stated by Meri Ramos, both net income and sales are up from last year. The return on total assets has improved from 5.1% last year to 6.8% this year, and the return on ordinary equity is up to 9.2% from 4.9% the year before. But this appears to be the only bright spot in the companys operating picture. Virtually all other ratios are below the industry average, and, more important, they are trending downward. The deterioration in the gross margin percentage, while not large, is worrisome. Sales and inventories have increased substantially, which should ordinarily result in an improvement in the gross margin percentage as fixed costs are spread over more units. However, the gross margin percentage has declined. Notice particularly that the average age of receivables has lengthened to 52 daysabout three weeks over the industry averageand that the inventory turnover is 50% longer than the industry average. One wonders if the increase in sales was obtained at least in part by extending credit to high-risk customers. Also notice that the debt-to-equity ratio is rising rapidly. If the P1,000,000 loan is granted, the ratio will rise further to 1.09 to 1. In the authors opinion, what the company needs is more equitynot more debt. Therefore, the loan should not be approved. The company should be encouraged to make another issue of ordinary stock in order to provide a broader equity base on which to operate. Case 4 (Statement Reconstruction Using Ratios) Bulacan Company Income Statement For the Year Ended December 31, 2005 Sales
5-23

P140,800

Chapter 5 Financial Statement Analysis II

Less: Cost of Sales (4) Gross Profit Less: Expenses Net Income (1)

84,480 P 56,320 46,320 P 10,000

Bulacan Company Balance Sheet December 31, 2005 Assets Current Assets: Cash Accounts Receivable (5) Merchandise Inventory (3) Total Current Assets (2) Fixed Assets (8) Total Assets Liabilities and Equity Current Liabilities: Accounts Payable (2) Equity: Share Capital (issued 20,000 shares) (6) Retained Earnings Total Liabilities and Equity Supporting Computations: (1) Earnings Per Share P0.50 = = Net Income Ordinary Shares Outstanding X 20,000 P 44,000 P40,000 48,000 P 27,720 28,160 21,120 P 77,000 55,000 P132,000

88,000 P132,000

5-24

Financial Statement Analysis II Chapter 5

X (Net Income) (2) Current Assets Pxx Current Liabilities xx Working Capital P33,000 Current Liabilities (3) Current Ratio 1.27 X (Current Assets) Quick Ratio 1.27 X (Current Assets) Current Assets Quick Assets Inventory (4) Inventory turnover 4 X (Cost of Sales) (5) Average age of outstanding Accounts Receivable 365 5 Net Sales Average Receivables P77,000 55,800 P21,120

P10,000 1.75 1 0.75

= = = = = = = =

P33,000 0.75 P44,000 Assets Current Current Liabilities X 44,000 P77,000 Quick Assets Current Liabilities X 44,000 P55,880

= = = = =

Cost of Sales Ave. Inventory X P21,120 P84,480 Quick Assets Current Liabilities 73 days (Average age of receivables)

5-25

Chapter 5 Financial Statement Analysis II

= P140,800 X X (Receivables) Another Method: P140,800 365 = =

5 5 P28,160

73 days

P28,160 Accounts receivable

(6) Earnings for the year as a percentage of Share Capital P10,000 = 25% Share Capital Share Capital (7) Current Assets
+

= = = = =

P40,000 Current Liabilities + Equity P44,000 + X P33,000 P88,000 Equity

Fixed Assets

P77,000 + 0.625X 0.375X X (8) Fixed Assets to Equity Fixed Assets Equity X P140,800 X (Fixed Assets)

= = =

0.625 0.625 P55,000

Case 5 (Ethics and the Manager) Requirement 1 The loan officer stipulated that the current ratio prior to obtaining the loan must be higher than 2.0, the acid-test ratio must be higher than 1.0, and the interest on the loan must be no more than four times net operating income.
5-26

Financial Statement Analysis II Chapter 5

These ratios are computed below: Current ratio Current rate Acid-test ratio = Acid-test ratio = = = Current assets Current liabilities

P290,000 = 1.8 (rounded) P164,000 Cash + Marketable securities + Accounts receivable Current liabilities

P70,000 + P0 + P50,000 = 0.70 (rounded) P164,000 Net operating income P20,000 = P80,000 x 0.10 x (6/12) = 5.0 Interest on the loan

The company would fail to qualify for the loan because both its current ratio and its acid-test ratio are too low. Requirement 2 By reclassifying the P45 thousand net book value of the old machine as inventory, the current ratio would improve, but there would be no effect on the acid-test ratio. This happens because inventory is considered to be a current asset but is not included in the numerator when computing the acid-test ratio. Current ratio Current rate Acid-test ratio = Acid-test ratio = = = Current assets Current liabilities P290,000 + P45,000 = 2.0 (rounded) P164,000

Cash + Marketable securities + Current receivables Current liabilities

P70,000 + P0 + P50,000 = 0.70 (rounded) P164,000 Even if this tactic had succeeded in qualifying the company for the loan, we strongly advise against it. Inventories are assets the company has acquired for the sole purpose of selling them to outsiders in the normal course of business. Used production equipment is not considered to be inventoryeven if there is a clear intention to sell it in the near future. Since the loan officer would not expect used equipment to be included in inventories, doing so would be intentionally misleading. Nevertheless, the old equipment is an asset that could be turned into cash. If
5-27

Chapter 5 Financial Statement Analysis II

this were done, the company would immediately qualify for the loan since the P45 thousand in cash would be included in the numerator in both the current ratio and in the acid-test ratio. Current ratio Current rate Acid-test ratio = Acid-test ratio = = = Current assets Current liabilities P290,000 + P45,000 = 2.0 (rounded) P164,000

Cash + Marketable securities + Current receivables Current liabilities

P70,000 + P0 + P50,000 + P45,000 = 1.00 (rounded) P164,000 However, other options may be available. After all, the old machine is being used to relieve bottlenecks in the plastic injection molding process and it would be desirable to keep this standby capacity. We would advise Rome to fully and honestly explain the situation to the loan officer. The loan officer might insist that the machine be sold before any loan is approved, but he might instead grant a waiver of the current ratio and acid-test ratio requirements on the basis that they could be satisfied by selling the old machine. Or he may approve the loan on the condition that the equipment is pledged as collateral. In that case, Rome would only have to sell the machine if he would otherwise be unable to pay back the loan. V. Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8. 9. 10. A C D B A D C D A B 11. 12. 13. 14. 15. 16. 17. 18. 19. 20. C A C B D B A C A C 21. 22. 23. 24. 25. 26. 27. 28. 29. 30. B D A C A C D A D A 31. 32. 33. 34. 35. 36. 37. 38. 39. 40. C D C A A C A A C C 41. C

5-28