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Chapter 9 Financial Statement Analysis

Solutions to Optional Homework:


Exercise 93
a.
KEYSTONE PUBLISHING COMPANY
Common-Size Income Statement
For the Year Ended December 31, 2003
Keystone
Publishing
Company
Amount
Percent
Sales..................................................................
Sales returns and allowances.........................
Net sales............................................................
Cost of goods sold...........................................
Gross profit.......................................................
Selling expenses..............................................
Administrative expenses.................................
Total operating expenses................................
Operating income.............................................
Other income....................................................
Other expense...................................................
Income before income tax...............................
Income tax expense.........................................
Net income........................................................

$ 2,450,000
24,500
$ 2,425,500
850,000
$ 1,575,500
$ 970,000
280,000
$ 1,250,000
$ 325,500
30,000
$ 355,500
40,000
$ 315,500
97,000
$ 218,500

101.0%
1.0
100.0%
35.0
65.0%
40.0%
11.5
51.5%
13.5%*
1.2
14.7%
1.6
13.1%*
4.0
9.1%*

Publishing
Industry
Average
101.0%
1.0
100.0%
40.0
60.0%
39.0%
10.5
49.5%
10.5%
1.2
11.7%
1.7
10.0%
4.0
6.0%

*Rounded to next highest tenth of a percent.


b.

The cost of goods sold is 5 percentage points lower than the industry
average, but the selling expenses and administrative expenses are 2
percentage points higher than the industry average. The combined impact is
for net
income as a percentage of sales to be 3 percentage points better
than the industry average. Apparently, the company is managing the cost of
publishing books better than the industry but has slightly higher selling and
administrative expenses relative to the industry. The cause of the higher
selling and administrative expenses as a percentage of sales, relative to the
industry, can be investigated further.

Exercise 94
ATLAS FITNESS EQUIPMENT COMPANY
Comparative Balance Sheet
December 31, 2004 and 2003
2004
Amount
Percent

2003
Amount
Percent

Current assets...............................
Property, plant, and equipment....
Intangible assets...........................
Total assets....................................

$180,000
340,000
30,000
$550,000

32.73%
61.82
5.45
100.00%

$150,000
330,000
35,000
$515,000

29.13%
64.08
6.79*
100.00%

Current liabilities...........................
Long-term liabilities......................
Common stock...............................
Retained earnings.........................
Total liabilities and
stockholders equity................

$120,000
175,000
50,000
205,000

21.82%
31.82
9.09
37.27

$125,000
150,000
40,000
200,000

24.27%
29.13
7.77
38.83

$550,000

100.00%

$515,000

100.00%

*Rounded to next lowest hundredth of a percent.


Exercise 95
a.

NEON FLASHLIGHT COMPANY


Comparative Income Statement
For the Years Ended December 31, 2004 and 2003

Sales.............................................
Cost of goods sold.....................
Gross profit.................................
Selling expenses.........................
Administrative expenses...........
Total operating expenses..........
Income before income tax.........
Income tax expense...................
Net income..................................
b.

2004
Amount

2003
Amount

Increase (Decrease)
Amount
Percent

$ 400,000
170,000
$ 230,000
$ 70,000
50,000
$ 120,000
$ 110,000
28,000
$ 82,000

$460,000
200,000
$260,000
$ 60,000
40,000
$100,000
$160,000
40,000
$120,000

$(60,000)
(30,000)
$(30,000)
$ 10,000
10,000
$ 20,000
$(50,000)
(12,000)
$(38,000)

(13.04)%
(15.00)%
(11.54)%
16.67%
25.00%
20.00%
(31.25)%
(30.00)%
(31.67)%

The net income for Neon Flashlight Company decreased by approximately


32% from 2003 to 2004. This decrease was the combined result of a decrease
in sales of 13.04% and higher expenses. The cost of goods sold decreased at
a faster rate than the decrease in sales, thus causing gross profit to
decrease less than the decrease in sales. In addition, selling and
administrative expenses increased between 2003 and 2004.

Exercise 97

a. (1)

(2)

b.

Current ratio =

Current assets
Current liabilities

Current year:

$4,362
$7,914

= 0.55

Acid-test ratio =

Quick assets
Current liabilities

Current year:

$2,847
$7,914

= 0.36

Preceding year:

$6,251
$4,257

= 1.47

Preceding year:

$5,033
$4,257

= 1.18

The liquidity of PepsiCo has declined significantly over this time period.
Both the current and acid-test ratios have declined by more than half from
the preceding year. A review of the current assets and liabilities reveals that
cash and marketable securities have dropped significantly while short-term
borrowings were made during the current year. The combined effect reduced
PepsiCos liquidity position. During this time period, PepsiCo was acquiring
bottlers. This investment required cash and short-term borrowings, which
placed a temporary squeeze on liquidity.

Exercise 99
a. (1)

Net sales

Accounts receivable turnover: Average accounts receivable


Current year:

(2)

$1,450,000
= 7.0
$207,143

Preceding year:

Number of days' sales in receivables:


Current year:
Preceding year:

$1,300,000
= 6.0
$216,667

Accounts receivable , end of year


Average daily sales

$222,466
= 56.0 days
$3,973 *

$235,068
= 66.0 days
$3,562

*$3,973 = $1,450,000/365 days

b.

$3,562 = $1,300,000/365 days

The collection of accounts receivable has improved. This can be seen in


both the increase in accounts receivable turnover and the reduction in the
collection period. The credit terms require payment in 60 days. In the
previous period, the collection period exceeded these terms. However, the
company apparently became more aggressive in collecting accounts
receivable or more restrictive in granting credit to customers. Thus, in the
current period the collection period is within the credit terms of the
company.

Exercise 912
a. (1)

Cost of goods sold

Inventory turnover: Average inventory


Dell:

$25,661
= 75.7
($400 $278) / 2

Gateway:

(2)

$5,241
= 24.1
($315 $120) / 2

Inventory, end of year

Number of days' sales in inventory: Average daily cost of goods sold


Dell:

$278
= 4.0 days
$70.3 *
$120

Gateway: $14.4 = 8.3 days


*$70.3 = $25,661/365 days

$14.4 = $5,241/365 days


b.

Dell has a much higher inventory turnover ratio than does Gateway (75.7 vs.
24.1), or a 3:1 ratio. Likewise, Dell has nearly half the number of days sales
in inventory (4.0 days vs. 8.3), or a 2:1 superiority ratio. However, we can
conclude that Gateways is making significant advances on Dell since the
superiority ratio for the number of days sales of inventory using the ending
inventory balance is less than for the inventory turnover (using average
inventory balances).
These significant differences are a result of Dells make-to-order operating
strategy. Dell has successfully developed a manufacturing process that is
able to fill a customer order quickly. As a result, Dell does not need to
prebuild computers for inventory. Gateway, in contrast, prebuilds computers
to be sold in its retail channel and for some of its telephone and internet
sales. In this industry, there is great obsolescence risk in holding computers
in inventory. New technology can make an inventory of computers difficult to
sell; therefore, inventory is costly and risky. Dells operating strategy is
considered revolutionary and is now being adopted by many both in and out
of the computer industry. Indeed, at the time of this writing, Gateway and
Hewlett-Packard are changing their practices to mirror those of Dell. As a
side note, Apple Computer employs similar manufacturing techniques as
does Dell and, thus, also enjoys excellent inventory efficiency.

Exercise 913
a.

Total liabilities

Ratio of liabilities to stockholders equity: Total stockholders' equity


$2,250,000

Dec. 31, 2004: $3,600,000 = 0.63


b.

Number of times bond


interest charges were earned:

Dec. 31, 2004:


Dec. 31, 2003:

$2,604,000

Dec. 31, 2003: $3,100,000 = 0.84

Income before tax + Interest expense


Interest expense

$252,000 + $168,000 *
= 2.50
$168,000
$216,000 $192,000
$192,000

= 2.13

*$2,100,000 0.08 = $168,000

c.

$2,400,000 0.08 = $192,000

Both the ratio of liabilities to stockholders equity and the number of times
bond interest charges were earned have improved significantly from 2003 to
2004. These results are the combined result of a higher income before taxes,
lower serial bonds payable, and lower current liabilities in the year 2004
compared to 2003.

Exercise 914
a.

Rate earned on total assets:


2004:

$520,000 + $40,000
$3,000,000 *

Net income plus interest


Average total assets

= 18.7%

2003:

$600,000 $40,000
= 25.6%
$2,500,000

*($2,800,000 + $3,200,000)/2

($2,200,000 + $2,800,000)/2
Net income

Rate earned on stockholders equity: Average stockholders' equity


2004:

$600,000

$520,000
= 20.8%
$2,500,000 *

2003: $2,000,000 = 30.0%

*($2,270,000 + $2,730,000)/2
Rate earned on
common stockholders' equity:

2004:

Net income less preferred dividends


Average common stockholders' equity

$520,000 $60,000
= 23.0%
$2,000,000 *

*($2,230,000 + $1,770,000)/2
b.

($1,730,000 + $2,270,000)/2

2003:

$600,000 $60,000
= 36.0%
$1,500,000

($1,770,000 + $1,230,000)/2

The profitability ratios indicate that Central States profitability has


deteriorated. Most of this change is from net income falling from $600,000 in
2003 to $520,000 in 2004. The cost of debt is 10%. Since the rate of return on
assets exceeds this amount in either year, there is positive leverage from the
use of debt. However, this leverage is greater in 2003 because the rate of
return on assets exceeds the cost of debt by a higher amount in 2003.

Exercise 915
a.

Net income

Rate earned on total assets: Average total assets


2002:

b.

$29,105
= 3.36%
($882,986 $848,115 ) / 2

2001:

$52,363
= 6.49%
($848,115 $765,117 ) / 2
Net income

Rate earned on stockholders equity: Average stockholders' equity


2002:

$29,105
= 4.91%
($612,129 $574,029) / 2

2001:

$52,363
= 9.61%
($574,029 $515,622) / 2

c.

Both the rate earned on total assets and the rate earned on stockholders
equity have deteriorated over the two-year period. The rate earned on total
assets declined from 6.49% to 3.36%, which is nearly half the return of the
prior year. The rate earned on stockholders equity declined from 9.61% to
4.91%. The rate earned on stockholders equity exceeds the rate earned on
total assets due to the use of positive leverage.

d.

Fiscal year 2002 was a difficult time for the apparel industry. The rate earned
on total assets for Ann Taylor barely exceeded the industry average (3.36%
vs. 3.2%). The rate earned on stockholders equity was less than the industry
average by more than a whole percentage point (6.49% vs. 7.6%). This
suggests that the industry uses more leverage than does Ann Taylor, on
average.

Exercise 916
a.

Fixed assets

Ratio of fixed assets to long-term liabilities: Long-term liabilities


$2,500,000
= 2.08
$1,200,000

b.

Total liabilities

Ratio of liabilities to stockholders equity: Total stockholders' equity


$1,300,000
= 0.37
$3,500,000

Exercise 916
c.

(Concluded)
Net sales

Ratio of net sales to assets: Average total assets (excluding investments)


$5,000,000
$4,400,000 *

= 1.14

*[($4,400,000 + $4,800,000)/2] $200,000. The end-of-period total assets equal


the sum of total liabilities ($1,300,000) and stockholders equity ($3,500,000).
d.

Rate earned on total assets:

Net income plus interest


Average total assets

$500,000 + $90,000
= 12.83%
$4,600,000 *

*($4,400,000 + $4,800,000)/2
e.

Net income

Rate earned on stockholders equity: Average stockholders' equity


$500,000
= 15.15%
$3,300,000 *

*[($600,000 + $1,600,000 + $900,000) + $3,500,000]/2


f.

Net income less preferred dividends


Rate earned on
common stockholders' equity: Average common stockholders' equity
$500,000 $48,000
= 16.74%
$2,700,000 *

* [($1,600,000 + $900,000) + ($1,600,000 + $1,300,000)]/2

Exercise 917
a.

Income before tax + Interest expense


Number of times bond
interest charges were earned:
Interest expense
$800,000 + $360,000
= 3.22 times
$360,000

b.

Number of times preferred dividends were earned:

Net income
Preferred dividends

$600,000
= 12 times
$50,000

c.

Earnings per share on common stock:

Net income Preferred dividends


Common shares outstanding

$600,000 $50,000
= $2.20
250,000 shares

d.

Price-earnings ratio:

Market price per share


Earnings per share

$44
= 20
$2.20

e.

Common dividends

Dividends per share of common stock: Common shares outstanding


$220,000
= $0.88
250,000 shares

f.

Dividend yield:
$0.88
= 2%
$44.00

Common dividend per share


Share price

Exercise 918
a.

Earnings per share:

Net income Preferred dividends


Common shares outstanding

$588,000 $108,000
= $1.20
400,000 shares

b.

Price-earnings ratio:

Market price per share


Earnings per share

$36.00
= 30
$1.20

c.

Common dividends

Dividends per share: Common shares outstanding


$500,000
= $1.25
400,000 shares

d.

Dividend yield:

Common dividend per share


Share price

$1.25
= 3.47% (rounded)
$36.00

Exercise 919
a.

Earnings per share on income before extraordinary items:


Net income......................................................................
Less gain on condemnation.........................................
Plus loss from flood damage........................................
Income before extraordinary items..............................

$2,800,000
(400,000)
600,000
$3,000,000

Earnings before extraordinary items per share on common stock:


Income before extraordinary items Preferred dividends
Common shares outstanding
$3,000,000 $640,000
= $9.44 per share
250,000 shares

b.

Earnings per share on common stock:

Net income Preferred dividends


Common shares outstanding

$2,800,000 $640,000
= $8.64 per share
250,000 shares

PROBLEMS
Problem 91
1.
BETTER BISCUIT COMPANY
Comparative Income Statement
For the Years Ended December 31, 2004 and 2003

Sales.................................................
Sales returns and allowances.......
Net sales..........................................
Cost of goods sold.........................
Gross profit.....................................
Selling expenses.............................
Administrative expenses...............
Total operating expenses...............
Income from operations.................
Other income...................................
Income before income tax.............
Income tax expense........................
Net income.......................................

2.

2004

2003

$715,000
5,000
$710,000
281,250
$428,750
$136,400
42,350
$178,750
$250,000
3,500
$253,500
85,000
$168,500

$550,000
5,000
$545,000
225,000
$320,000
$110,000
35,000
$145,000
$175,000
3,000
$178,000
60,000
$118,000

Increase (Decrease)
Amount Percent
$165,000
0
$165,000
56,250
$108,750
$ 26,400
7,350
$ 33,750
$ 75,000
500
$ 75,500
25,000
$ 50,500

30.00%
0.00%
30.28%
25.00%
33.98%
24.00%
21.00%
23.28%
42.86%
16.67%
42.42%
41.67%
42.80%

The profitability has significantly improved. Sales have increased by 30%


over the 2003 base year. In addition, cost of goods sold, selling expenses,
and administrative expenses grew at a slower rate. Increasing sales
combined with costs that increase at a slower rate result in strong earnings
growth. In this case, net income grew in excess of 42% over the base year.

Problem 92
1.
STAINLESS FLOW SYSTEMS INC.
Comparative Income Statement
For the Years Ended December 31, 2004 and 2003

Sales.....................................................
Sales returns and allowances...........
Net sales..............................................
Cost of goods sold.............................
Gross profit.........................................
Selling expenses.................................
Administrative expenses...................
Total operating expenses...................
Income from operations.....................
Other income.......................................
Income before income tax.................
Income tax expense............................
Net income...........................................

2004
Amount Percent

2003
Amount Percent

$810,000 100.62%
5,000
0.62
$805,000 100.00%
438,700
54.50
$366,300
45.50%
$165,800
20.60%
96,600
12.00
$262,400
32.60%
$103,900
12.90%*
2,000
0.25
$105,900
13.15%*
37,000
4.60
$ 68,900
8.55%*

$775,000 100.65%
5,000
0.65
$770,000 100.00%
416,000
54.03
$354,000
45.97%
$115,800
15.04%
93,400
12.13
$209,200
27.17%
$144,800
18.80%*
1,800
0.23
$146,600
19.03%*
51,000
6.62
$ 95,600
12.41%*

*Rounded to next lowest hundredth of a percent.


2.

The net income as a percentage of sales has declined. All costs and
expenses, other than selling expenses, have maintained their approximate
cost as a percentage of sales relationship between 2003 and 2004. Selling
expenses as a percentage of sales, however, have increased from 15.04% to
20.60% of sales. Apparently, the new advertising campaign has not been
successful. The increased expense has not produced sufficient sales to
maintain relative profitability. Thus, selling expenses as a percentage of
sales have deteriorated.

Problem 93
1.

a.

Working capital = Current assets Current liabilities


$740,000 $300,000 = $440,000

b.

Current ratio = Current liabilitie s

Current assets

$740,000
= 2.47
$300,000

c.

Acid-test ratio =

Quick assets
Current liabilities

$150,000 $64,000 $221,000


= 1.45
$300,000

2.
Transaction

Working
Capital

a.
b.
c.
d.
e.
f.
g.
h.
i.
j.

$440,000
440,000
440,000
440,000
415,000
440,000
560,000
440,000
540,000
440,000

Supporting Calculations
Current Acid-Test Current
Quick
Current
Ratio
Ratio
Assets
Assets
Liabilities
2.47
2.83
2.29
2.57
2.28
2.47
2.87
2.47
2.80
2.47

1.45
1.56
1.28
1.48
1.34
1.45
1.85
1.45
1.78
1.42

$740,000
680,000
780,000
720,000
740,000
740,000
860,000
740,000
840,000
740,000

$435,000
375,000
435,000
415,000
435,000
435,000
555,000
435,000
535,000
426,000

$300,000
240,000
340,000
280,000
325,000
300,000
300,000
300,000
300,000
300,000

Problem 94
1.

Working capital: $1,999,000 $600,000 = $1,399,000


Calculated
Ratio

Numerator

2. Current ratio...................
$1,999,000
3. Acid-test ratio................
$1,473,000
4. Accounts receivable
turnover..........................
$6,100,000
5. Number of days' sales
in receivables.................
$350,000
6. Inventory turnover.........
$2,800,000
7. Number of days' sales
in inventory....................
$500,000
8. Fixed assets to longterm liabilities................
$3,100,000
9. Liabilities to stockholders' equity...............
$2,400,000
10. Number of times
interest charges
earned............................. $733,000 + $157,000
11. Number of times
preferred dividends
earned.............................
$503,000
12. Ratio of net sales to
assets.............................
$6,100,000
13. Rate earned on total
assets............................. $503,000 + $157,000
14. Rate earned on stockholders' equity...............
$503,000
15. Rate earned on
common stockholders' equity............... ($503,000 $48,000)
16. Earnings per share
on common stock.......... ($503,000 $48,000)
17. Price-earnings ratio.......
$80.00
18. Dividends per share
of common stock...........
$120,000
19. Dividend yield................
$0.80

Denominator

Value

$600,000
$600,000

3.3
2.5

($350,000 + $365,000)/2

17.1

($6,100,000/365)
($500,000 + $480,000)/2

20.9
5.7

($2,800,000/365)

65.2

$1,800,000

1.7

$3,399,000

0.7

$157,000

5.7

$48,000

10.5

($5,099,000 + $3,864,000)/2

1.4

($5,799,000 + $4,364,000)/2

13.0%

($3,399,000 + $2,964,000)/2

15.8%

($2,799,000 + $2,464,000)/2

17.3%

150,000
$3.03

$3.03
26.4

150,000
$80.00

$0.80
1.0%

Problem 95
a.

0.30

0.25
Rate Earned on Total Assets

1.

0.20

0.15

0.10

0.05

0.00
2000

2001

2002

2003

2004

Years
Industry

$244,000

2004: $2,300,000 = 0.11


$288,000

2003: $2,150,000 = 0.13


$288,000

2002: $2,000,000 = 0.14

Jupiter Com pany

$326,000

2001: $1,750,000 = 0.19


$370,000

2000: $1,500,000

= 0.25

Problem 95
b.

0.60
Rate Earned on Stockholders' Equity

1.

(Continued)

0.50

0.40

0.30

0.20

0.10

0.00
2000

2001

2002

2003

2004

Years
Industry

$100,000

2004: $1,100,000 = 0.09


$150,000

2003: $1,000,000 = 0.15


$150,000

2002: $850,000

= 0.18

Jupiter Com pany

$200,000

2001: $700,000 = 0.29


$250,000

2000: $500,000 = 0.50

Problem 95
c.

4
Num ber of Tim es Interest Charges Earned

1.

(Continued)

3.5
3
2.5
2
1.5
1
0.5
0
2000

2001

2002

2003

2004

Years
Industry

$274,000

2004: $144,000 = 1.90


$333,000

2003: $138,000 = 2.41


$333,000

2002: $138,000 = 2.41

Jupiter Com pany

$386,000

2001: $126,000 = 3.06


$445,000

2000: $120,000 = 3.71

Problem 95

(Continued)

1. d.

Ratio of Liabilities to Stockholders' Equity

2.50

2.00

1.50

1.00

0.50
2000

2001

2002

2003

2004

Years
Industry

$1,200,000

2004: $1,100,000 = 1.09


$1,150,000

2003: $1,000,000 = 1.15


$1,150,000

2002: $850,000 = 1.35

Jupiter Com pany

$1,050,000

2001: $700,000 = 1.50


$1,000,000

2000: $500,000 = 2.00

Problem 95
2.

(Concluded)

Both the rate earned on total assets and the rate earned on stockholders'
equity have been moving in a negative direction in the last five years. Both
measures have moved below the industry average within the last year. The
rate earned on stockholders' equity has been moving down at a faster rate
because of the increasing use of leverage over the time period. The use of
leverage (debt) can be seen from the ratio of liabilities to stockholders'
equity. This ratio has fallen below the industry average, indicating that the
company has more debt relative to stockholders' equity. Since the rate
earned on assets has been below the interest cost of the debt in the last
year, the rate earned on stockholders' equity has been below the rate earned
on assets (the use of leverage has had a negative impact). The number of
times interest charges have been earned has been falling below the industry
average for several years. This is the combined result of an increasing use of
leverage and low profitability. The number of times interest is earned has
fallen to a dangerously low level in 2004. The low profitability and times
interest charges are earned in 2004, as well as the five-year trend, should be
a major concern to the company's management, stockholders, and creditors.