CHAPTER 4

MANAGEMENT ACCOUNTING - Solutions Manual

Chapter 5 Financial Statement Analysis IIFinancial Statement Analysis II Chapter 5

CHAPTER 5FINANCIAL STATEMENTS ANALYSIS - II

I.Questions1. 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.

2. 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.

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. 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.

6. 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.

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 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.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. True3. True5. True7. True9. False

2. True4. False 6. True8. True10. False

III.Problems

Problem 1 (Common Size Income Statements)

Common size income statements for 2005 and 2006:

20062005

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

P 47,600

Marketable securities175,040

Accounts receivable230,540

Inventory179,600

Unexpired insurance 4,500

Total current assetsP637,280Current liabilities:

Notes payableP 70,000

Accounts payable125,430

Salaries payable7,570

Income taxes payable14,600

Unearned revenue 10,000

Total current liabilitiesP227,600Requirement (b)

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

20062005

Sales

100.0%100.0%

Less cost of goods sold

63.260.0

Gross margin

36.840.0

Selling expenses

18.017.5

Administrative expenses

13.614.6

Total expenses

31.632.1

Net operating income

5.27.9

Interest expense

1.41.0

Net income before taxes

3.8%6.9%

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)

Ms. Freeze,Inc.Industry Average

Sales (net)100%100%

Cost of goods sold 49 57

Gross profit on sales51%43%

Operating expenses:

Selling21%16%

General and administrative 17 20

Total operating expenses 38% 36%

Operating income13%7%

Income taxes 6 3

Net income 7% 4%

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.

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 1The income statement in common-size form would be:

2006 2005

Sales

100.0%100.0%

Less cost of goods sold

65.0 60.0

Gross margin

35.040.0

Less operating expenses

26.3 30.4

Net operating income

8.79.6

Less interest expense

1.2 1.6

Net income before taxes

7.58.0

Less income taxes (30%)

2.3 2.4

Net income

5.3% 5.6%

The balance sheet in common-size form would be:

20062005

Current assets:

Cash

2.0%5.1%

Accounts receivable, net

15.010.1

Inventory

30.115.2

Prepaid expenses

1.0 1.3

Total current assets

48.131.6

Plant and equipment

51.9 68.4

Total assets

100.0%100.0%

Liabilities:

Current liabilities

25.1%12.7%

Bonds payable, 12%

20.1 25.3

Total liabilities

45.1 38.0

Equity:

Preference shares, 8%, P10 par

15.019.0

Ordinary shares, P5 par

10.012.7

Retained earnings

29.8 30.4

Total equity

54.9 62.0

Total liabilities and equity

100.0%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:

CashP 74.8

Receivables152.7

Merchandise inventories1,191.8

Prepaid expenses 95.5

Total current assetsP1,514.8

Quick assets:

CashP 74.8

Receivables 152.7

Total quick assetsP 227.5

Requirement (b)(1)Current ratio:

Current assets (Req. a)P1,514.8

Current liabilitiesP1,939.0

Current ratio (P1,514.8 ( P1,939.0)0.8 to 1

(2)Quick ratio:

Quick assets (Req. a)P 227.5

Current liabilitiesP1,939.0

Quick ratio (P227.5 ( P1,939.0)0.1 to 1

(3)Working capital:

Current assets (Req. a)P1,514.8

Less: Current liabilitiesP1,939.0

Working capitalP(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.

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:

CashP 47,524

Marketable securities (short-term)55,926

Accounts receivable 23,553

Total quick assets P127,003

(2)Current assets:

CashP 47,524

Marketable securities (short-term)55,926

Accounts receivable23,553

Inventories32,210

Prepaid expenses 5,736

Total current assetsP164,949

(3)Current liabilities:

Notes payable to banks (due within one year)P 20,000

Accounts payable5,912

Dividends payable1,424

Accrued liabilities (short-term)21,532

Income taxes payable 6,438

Total current liabilitiesP 55,306

Requirement (b)(1)Quick ratio:

Quick assets (Req. a)P127,003

Current liabilities (Req. a)P 55,306

Quick ratio (P127,003 ( P55,306)2.3 to 1

(2)Current ratio:

Current assets (Req. a)P164,949

Current liabilities (Req. a)P 55,306

Current ratio (P164,949 ( P55,306)3.0 to 1

(3)Working capital:

Current assets (Req. a)P164,949

Less: Current liabilities (Req. a) 55,306

Working capitalP109,643

(4)Debt ratio:

Total liabilities (given)P 81,630

Total assets (given)P353,816

Debt ratio (P81,630 ( P353,816)23.1%

Requirement (c)(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 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)

P1,300,000

Current liabilities (P1,300,000 2.5)

520,000

Working capital

P780,000

Requirement 2

Requirement 3

a.Working capital would not be affected:

Current assets (P1,300,000 P100,000)

P1,200,000

Current liabilities (P520,000 P100,000)

420,000

Working capital

P 780,000

b.The current ratio would rise:

Problem 9 (Selected Financial Ratios)1.Gross margin percentage:

2.Current ratio:

3.Acid-test ratio:

4.Accounts receivable turnover:

5.Inventory turnover:

6.Debt-to-equity ratio:

7.Times interest earned:

8.Book value per share:

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

Problem 10 (Selected Financial Ratios for Ordinary Shareholders)1.Earnings per share:

2.Dividend payout ratio:

3.Dividend yield ratio:

4.Price-earnings ratio:

Problem 11 (Selected Financial Ratios for Ordinary Shareholders)1.Return on total assets:

2.Return on ordinary shareholders equity:

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 only7%.

10% interest rate (1 0.30) = 7% after-tax cost.

Problem 12 (Selected Financial Measures for Short-Term Creditors)

Requirement (1)

Current assets (P80,000 + P460,000 + P750,000 + P10,000)

P1,300,000

Current liabilities (P1,300,000 2.5)

520,000

Working capital

P780,000

Requirement (2)

Requirement (3)

a.Working capital would not be affected by a P100,000 payment on accounts payable:

Current assets (P1,300,000 P100,000)

P1,200,000

Current liabilities (P520,000 P100,000)

420,000

Working capital

P780,000

b.The current ratio would increase if the company makes a P100,000 payment on accounts payable:

Problem 13 (Effects of Transactions on Various Financial Ratios)1.DecreaseSale of inventory at a profit will be reflected in an increase in retained earnings, which is part of shareholders equity. An increase in shareholders equity will result in a decrease in the ratio of assets provided by creditors as compared to assets provided by owners.

2.No effectPurchasing land for cash has no effect on earnings or on the number of ordinary shares outstanding. One asset is exchanged for another.

3.IncreaseA sale of inventory on account will increase the quick assets (cash, accounts receivable, marketable securities) but have no effect on the current liabilities. For this reason, the acid-test ratio will increase.

4.No effectPayments on account reduce cash and accounts payable by equal amounts; thus, the net amount of working capital is not affected.

5.DecreaseWhen a customer pays a bill, the accounts receivable balance is reduced. This increases the accounts receivable turnover, which in turn decreases the average collection period.

6.DecreaseDeclaring a cash dividend will increase current liabilities, but have no effect on current assets. Therefore, the current ratio will decrease.

7.IncreasePayment of a previously declared cash dividend will reduce both current assets and current liabilities by the same amount. An equal reduction in both current assets and current liabilities will always result in an increase in the current ratio, so long as the current assets exceed the current liabilities.

8.No effectBook value per share is not affected by the current market price of the companys stock.

9.DecreaseThe dividend yield ratio is obtained by dividing the dividend per share by the market price per share. If the dividend per share remains unchanged and the market price goes up, then the yield will decrease.

10.IncreaseSelling property for a profit would increase net income and therefore the return on total assets would increase.

11.IncreaseA write-off of inventory will reduce the inventory balance, thereby increasing the turnover in relation to a given level of cost of goods sold.

12.IncreaseSince the companys assets earn at a rate that is higher than the rate paid on the bonds, leverage is positive, increasing the return to the ordinary shareholders.

13.No effectChanges in the market price of a stock have no direct effect on the dividends paid or on the earnings per share and therefore have no effect on this ratio.

14.DecreaseA decrease in net income would mean less income available to cover interest payments. Therefore, the times-interest-earned ratio would decrease.

15.No effectWrite-off of an uncollectible account against the Allowance for Bad Debts will have no effect on total current assets. For this reason, the current ratio will remain unchanged.

16.DecreaseA purchase of inventory on account will increase current liabilities, but will not increase the quick assets (cash, accounts receivable, marketable securities). Therefore, the ratio of quick assets to current liabilities will decrease.

17.IncreaseThe price-earnings ratio is obtained by dividing the market price per share by the earnings per share. If the earnings per share remains unchanged, and the market price goes up, then the price-earnings ratio will increase.

18.DecreasePayments to creditors will reduce the total liabilities of a company, thereby decreasing the ratio of total debt to total equity.

Problem 14 (Interpretation of Financial Ratios)

a.The market price is going down. The dividends paid per share over the three-year period are unchanged, but the dividend yield is going up. Therefore, the market price per share of stock must be decreasing.

b.The earnings per share is increasing. Again, the dividends paid per share have remained constant. However, the dividend payout ratio is decreasing. In order for the dividend payout ratio to be decreasing, the earnings per share must be increasing.

c.The price-earnings ratio is going down. If the market price of the stock is going down [see part (a) above], and the earnings per share are going up [see part (b) above], then the price-earnings ratio must be decreasing.

d.In Year 1, leverage was negative because in that year the return on total assets exceeded the return on ordinary equity. In Year 2 and in Year 3, leverage was positive because in those years the return on ordinary equity exceeded the return on total assets employed.

e.It is becoming more difficult for the company to pay its bills as they come due. Although the current ratio has improved over the three years, the acid-test ratio is down. Also note that the accounts receivable and inventory are both turning more slowly, indicating that an increasing portion of the current assets is being made up of those items, from which bills cannot be paid.

f.Customers are paying their bills more slowly in Year 3 than in Year 1. This is evidenced by the decline in accounts receivable turnover.

g.Accounts receivable is increasing. This is evidenced both by a slowdown in turnover and in an increase in total sales.

h.The level of inventory undoubtedly is increasing. Notice that the inventory turnover is decreasing. Even if sales (and cost of goods sold) just remained constant, this would be evidence of a larger average inventory on hand. However, sales are not constant but rather are increasing. With sales increasing (and undoubtedly cost of goods sold also increasing), the average level of inventory must be increasing as well in order to service the larger volume of sales.

IV.CasesCase 1 (Common-Size Statements and Financial Ratios for Creditors)Requirement 1

This YearLast Year

a.Current assets

P2,060,000P1,470,000

Current liabilities

1,100,000 600,000

Working capital

P 960,000P 870,000

b.Current assets (a)

P2,060,000P1,470,000

Current liabilities (b)

P1,100,000P600,000

Current ratio (a) (b)

1.87 to 12.45 to 1

c.Quick assets (a)

P740,000P650,000

Current liabilities (b)

P1,100,000P600,000

Acid-test ratio (a) (b)

0.67 to 11.08 to 1

d.Sales on account (a)

P7,000,000P6,000,000

Average receivables (b)

P525,000P375,000

Turnover of receivables (a) (b)

13.3 times16.0 times

Average age of receivables:365 turnover

27.4 days22.8 days

e.Cost of goods sold (a)

P5,400,000P4,800,000

Average inventory (b)

P1,050,000P760,000

Inventory turnover (a) (b)

5.1 times6.3 times

Turnover in days: 365 turnover

71.6 days57.9 days

f.Total liabilities (a)

P1,850,000P1,350,000

Equity (b)

P2,150,000P1,950,000

Debt-to-equity ratio (a) (b)

0.86 to 10.69 to 1

g.Net income before interest and taxes (a)

P630,000P490,000

Interest expense (b)

P90,000P90,000

Times interest earned (a) (b)

7.0 times5.4 times

Requirement 2a.METRO BUILDING SUPPLY

Common-Size Balance Sheets

This YearLast Year

Current assets:

Cash

2.3%6.1%

Marketable securities

0.01.5

Accounts receivable, net

16.312.1

Inventory

32.524.2

Prepaid expenses

0.50.6

Total current assets

51.544.5

Plant and equipment, net

48.555.5

Total assets

100.0%100.0%

Liabilities:

Current liabilities

27.5%18.2%

Bonds payable, 12%

18.822.7

Total liabilities

46.340.9

Equity:

Preference shares, P50 par, 8%

5.06.1

Ordinary shares, P10 par

12.515.2

Retained earnings

36.337.9

Total equity

53.859.1

Total liabilities and equity

100.0%100.0%

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

Common-Size Income Statements

This YearLast Year

Sales

100.0%100.0%

Less cost of goods sold

77.180.0

Gross margin

22.920.0

Less operating expenses

13.911.8

Net operating income

9.08.2

Less interest expense

1.31.5

Net income before taxes

7.76.7

Less income taxes

3.12.7

Net income

4.6%4.0%

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 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.This YearLast Year

Net income

P324,000P240,000

Less preference dividends

16,000 16,000

Net income remaining for ordinary (a)

P308,000P224,000

Average number of ordinary shares (b)

50,00050,000

Earnings per share (a) (b)

P6.16P4.48

b.Ordinary dividend per share (a)*

P2.16P1.20

Market price per share (b)

P45.00P36.00

Dividend yield ratio (a) (b)

4.8%3.33%

*P108,000 50,000 shares = P2.16; P60,000 50,000 shares = P1.20

c.Ordinary dividend per share (a)

P2.16P1.20

Earnings per share (b)

P6.16P4.48

Dividend payout ratio (a) (b)

35.1%26.8%

d.Market price per share (a)

P45.00P36.00

Earnings per share (b)

P6.16P4.48

Price-earnings ratio (a) (b)

7.38.0

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 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.This YearLast Year

Equity

P2,150,000P1,950,000

Less preference shares

200,000 200,000

Ordinary equity (a)

P1,950,000P1,750,000

Number of ordinary shares (b)

50,00050,000

Book value per share (a) (b)

P39.00P35.00

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.This YearLast Year

Net income

P324,000P240,000

Add after-tax cost of interest paid:

[P90,000 (1 0.40)]

54,000 54,000

Total (a)

P 378,000P294,000

Average total assets (b)

P3,650,000P3,000,000

Return on total assets (a) (b)

10.4%9.8%

b.This YearLast Year

Net income

P324,000P240,000

Less preference dividends

16,000 16,000

Net income remaining for ordinary

shareholders (a)

P308,000P224,000

Average total equity*

P2,050,000P1,868,000

Less average preference shares

200,000 200,000

Average ordinary equity (b)

P1,850,000P1,668,000

*1/2(P2,150,000 + P1,950,000); 1/2(P1,950,000 + P1,786,000).

Return on ordinary equity (a) (b)

16.6%13.4%

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

This YearLast Year

a.Net income

P280,000P168,000

Add after-tax cost of interest:

P120,000 (1 0.30)

84,000

P100,000 (1 0.30)

70,000

Total (a)

P364,000P238,000

Average total assets (b)

P5,330,000P4,640,000

Return on total assets (a) (b)

6.8%5.1%

b.Net income

P280,000P168,000

Less preference dividends

48,000 48,000

Net income remaining for ordinary (a)

P232,000P120,000

Average total equity

P3,120,000P3,028,000

Less average preference shares

600,000 600,000

Average ordinary equity (b)

P2,520,000P2,428,000

Return on ordinary equity (a) (b)

9.2%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 2This YearLast Year

a.Net income remaining for ordinary (a)

P232,000P 120,000

Average number of ordinary shares (b)

50,00050,000

Earnings per share (a) (b)

P4.64P2.40

b.Ordinary dividend per share (a)

P1.44P0.72

Market price per share (b)

P36.00P20.00

Dividend yield ratio (a) (b)

4.0%3.6%

c.Ordinary dividend per share (a)

P1.44P0.72

Earnings per share (b)

P4.64P2.40

Dividend payout ratio (a) (b)

31.0%30.0%

d.Market price per share (a)

P36.00P20.00

Earnings per share (b)

P4.64P2.40

Price-earnings ratio (a) (b)

7.88.3

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

P3,200,000P3,040,000

Less preference shares

600,000 600,000

Ordinary equity (a)

P2,600,000P2,440,000

Number of ordinary shares (b)

50,00050,000

Book value per share (a) (b)

P52.00P48.80

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)

P1,050,000P860,000

Sales (b)

P5,250,000P4,160,000

Gross margin percentage (a) (b)

20.0%20.7%

Requirement 3This YearLast Year

a.Current assets

P2,600,000P1,980,000

Current liabilities

1,300,000 920,000

Working capital

P1,300,000P1,060,000

b.Current assets (a)

P2,600,000P1,980,000

Current liabilities (b)

P1,300,000P920,000

Current ratio (a) (b)

2.0 to 12.15 to 1

c.Quick assets (a)

P1,220,000P1,120,000

Current liabilities (b)

P1,300,000P920,000

Acid-test ratio (a) (b)

0.94 to 11.22 to 1

d.Sales on account (a)

P5,250,000P4,160,000

Average receivables (b)

P750,000P560,000

Accounts receivable turnover (a) (b)

7.0 times7.4 times

Average age of receivables,

365 turnover

52 days49 days

e.Cost of goods sold (a)

P4,200,000P3,300,000

Average inventory (b)

P1,050,000P720,000

Inventory turnover (a) (b)

4.0 times4.6 times

Number of days to turn inventory,

365 days turnover (rounded)

91 days79 days

f.Total liabilities (a)

P2,500,000P1,920,000

Equity (b)

P3,200,000P3,040,000

Debt-to-equity ratio (a) (b)

0.78 to 10.63 to 1

g.Net income before interest and taxes (a)

P520,000P340,000

Interest expense (b)

P120,000P100,000

Times interest earned (a) (b)

4.3 times3.4 times

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

P140,800

Less: Cost of Sales (4)

84,480Gross Profit

P 56,320

Less: Expenses

46,320Net Income (1)

P 10,000Bulacan Company

Balance Sheet

December 31, 2005A s s e t s

Current Assets:

Cash

P 27,720

Accounts Receivable (5)

28,160

Merchandise Inventory (3)

21,120Total Current Assets (2)

P 77,000

Fixed Assets (8)

55,000Total Assets

P132,000

Liabilities and Equity

Current Liabilities:

Accounts Payable (2)

P 44,000

Equity:

Share Capital (issued 20,000 shares) (6)

P40,000

Retained Earnings

48,000

88,000Total Liabilities and Equity

P132,000Supporting Computations:

(1)Earnings Per Share

=

P0.50=

X (Net Income)

=

P10,000

(2)Current Assets

Pxx

1.75

Current Liabilities xx

1

Working CapitalP33,000

0.75

Current Liabilities

=

P33,000 ( 0.75

=

P44,000

(3)Current Ratio

=

1.27

=

X (Current Assets)

=

P77,000

Quick Ratio

=

1.27

=

X (Current Assets)

=

P55,880

Current AssetsP77,000

Quick Assets 55,800

InventoryP21,120

(4)Inventory turnover

=

4=

X (Cost of Sales)

=

P84,480

(5)Average age of outstanding

=

Accounts Receivable

=

73 days (Average age of

receivables)

=

5

=

5

X (Receivables)

=

P28,160

Another Method:

=73 days

=P28,160 Accounts receivable

(6)Earnings for the year as a percentage of Share Capital

=25%

Share Capital

=P40,000

(7)Current

Fixed

Current Liabilities +

Assets

Assets

= Equity

P77,000 + 0.625X

=P44,000 + X

0.375X

=P33,000

X

=P88,000 Equity

(8)Fixed Assets to Equity

=

0.625

=

0.625

X (Fixed Assets)

=

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. These ratios are computed below:

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.

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 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.

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.

Case 6 (Financial Ratios for Ordinary Shareholders)

[pesos in thousands]

Requirement (1)

Calculation of the gross margin percentage:

Requirement (2)

Calculation of the earnings per share:

Requirement (3)

Calculation of the price-earnings ratio:

Requirement (4)

Calculation of the dividend payout ratio:

Requirement (5)

Calculation of the dividend yield ratio:

Requirement (6)

Calculation of the return on total assets:

Requirement (7)

Calculation of the return on ordinary shareholders equity:

Beginning balance, shareholders equity (a)

P39,610

Ending balance, shareholders equity (b)

41,080

Average shareholders equity [(a) + (b)]/2

40,345

Average preference shares1,000

Average ordinary shareholders equity

P39,345

Requirement (8)

Calculation of the book value per share:

Case 7 (Financial Ratios for Short-Term Creditors)

Requirement (1)

Calculation of working capital:

Requirement (2)

Calculation of the current ratio:

Requirement (3)

Calculation of the acid-test ratio:Requirement (4)

Calculation of accounts receivable turnover:

Requirement (5)

Calculation of the average collection period:

Requirement (6)

Calculation of inventory turnover:

Requirement (7)

Calculation of the average sale period:

Case 8 (Financial Ratios for Long-Term Creditors)

Requirement (1)

Calculation of the times interest earned ratio:

Requirement (2)

Calculation of the debt-to-equity ratio:

V.Multiple Choice Questions1. A11. C21. B31. C41.C

2. C12. A22. D32. D

3. D13. C23. A33. C

4. B14. B24. C34. A

5. A15. D25. A35. A

6. D16. B26. C36. C

7. C17. A27. D37. A

8. D18. C28. A38. A

9. A19. A29. D39. C

10. B20. C30. A40. C

= 1.17

P22,680

P19,400

=

= P3,280

P22,680 P19,400

=

Current assets Current liabilities

=

Working capital

= P66.80 per share

P41,080 P1,000

600 shares

=

Total shareholders equity Preference shares

Number of ordinary shares outstanding

=

Book value

per share

= 4.9%

P1,980 P60

P39,345

=

Net income Preference dividends

Average ordinary shareholders equity

=

Return on ordinary shareholders equity

= 3.7%

P1,980 + [P800 x (1 0.40)]

(P65,810 + P68,480) / 2

=

Net income + [Interest expense x (1 Tax rate)]

Average total assets

=

Return on total assets

= 2.9%

P0.75

P26.00

=

Dividends per share

Market price per share

=

Dividend yield ratio

= 23.4%

P0.75

P3.20

=

Dividends per share

Earnings per share

=

Dividend payout ratio

= P3.20 per share

P1,980 P60

600 shares

=

Net income Preference dividends

Average number of ordinary shares outstanding

=

Earnings per share

= 34.8%

P23,000

P66,000

=

Gross margin

Sales

=

Gross margin percentage

= 8.1

P26

P3.20

=

Market price per share

Earnings per share

=

Price-earnings ratio

= 2.9 (rounded)

P1,200,000

P420,000

=

Current assets

Current liabilities

=

= 1.04 (rounded)

Current ratio

= 1.8 (rounded)

P290,000

P164,000

Current rate =

Current assets

Current liabilities

Current ratio =

Acid-test ratio =

Cash + Marketable securities + Accounts receivable

Current liabilities

Acid-test ratio =

P80,000 + P0 + P460,000

P520,000

= 1.04 to 1 (rounded)

= 2.9 to 1 (rounded)

P1,200,000

P420,000

Current rate =

Current assets

Current liabilities

Current ratio =

Gross margin

Sales

= 40%

P840,000

P2,100,000

=

=

= 2.45 to 1

P490,000

P200,000

Current assets

Current liabilities

=

= 0.91 to 1 (rounded)

P181,000

P200,000

Quick assets

Current liabilities

=

= 14 times

P2,100,000

P150,000

Sales

Average accounts receivables

= 26.1 days (rounded)

365 days

14 times

= 81.1 days to turn (rounded)

365 days

4.5 times

=

= 4.5 times

P1,260,000

P280,000

Cost of goods sold

Average inventory

=

= 0.63 to 1 (rounded)

P500,000

P800,000

Total liabilities

Total equity

=

= 6.0 times

P180,000

P30,000

Earnings before interest

and income taxes

Interest expense

=

= P40 per share

P800,000

20,000 shares*

Equity

Ordinary shares outstanding

=

= P5.25 per share

P105,000

20,000 shares

Net income to ordinary shares

Average ordinary shares outstanding

=

= 60%

P3.15

P5.25

Dividends paid per share

Earnings per share

=

= 5%

P3.15

P63.00

Dividends paid per share

Market price per share

=

= 12.0

P63.00

P5.25

Market price per share

Earnings per share

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)

=

=

= 10.5%

P126,000

P1,200,000

=

= 13.8% (rounded)

P105,000

P762,500

P105,000

(P725,000 + P800,000)

=

Net income preference dividends

Average ordinary shareholders equity

=

Return on ordinary shareholders equity

Net Income

Ordinary Shares Outstanding

X

20,000

Current Assets

Current Liabilities

X

44,000

Quick Assets

Current Liabilities

X

44,000

Cost of Sales

Ave. Inventory

X

P21,120

Quick Assets

Current Liabilities

365

5

Net Sales

Average Receivables

P140,800

X

P140,800

365

P10,000

Share Capital

+

Fixed Assets

Equity

X

P140,800

= 0.70 (rounded)

P70,000 + P0 + P50,000

P164,000

Acid-test ratio =

Cash + Marketable securities + Accounts receivable

Current liabilities

Acid-test ratio =

P80,000 + P0 + P460,000 + P0

P520,000

=

Cash + Marketable securities

+ Accounts receivable + Short-term notes

Current liabilities

=

Acid-test ratio

=

= 5.0

P20,000

P80,000 x 0.10 x (6/12)

Net operating income

Interest on the loan

= 2.0 (rounded)

P290,000 + P45,000

P164,000

Current rate =

Current assets

Current liabilities

Current ratio =

= 0.70 (rounded)

P70,000 + P0 + P50,000

P164,000

Acid-test ratio =

Cash + Marketable securities + Current receivables

Current liabilities

Acid-test ratio =

= 1.00 (rounded)

P70,000 + P0 + P50,000 + P45,000

P164,000

Acid-test ratio =

Cash + Marketable securities + Current receivables

Current liabilities

Acid-test ratio =

= 2.0 (rounded)

P290,000 + P45,000

P164,000

Current rate =

Current assets

Current liabilities

Current ratio =

Current assets

Current liabilities

=

Current ratio

= 0.52

P1,080 + P0 + P9,000 + P0

P19,400

Acid-test ratio =

Cash + Marketable securities

+ Accounts receivable + Short-term notes

Current liabilities

Acid-test ratio =

= 8.5

P66,000

(P6,500 + P9,000) / 2

Acid-test ratio =

Sales on account

Average accounts receivable balance

=

Accounts receivable

turnover

=

Average collection

period

365 days

8.5

Acid-test ratio =

365 days

Accounts receivable turnover

= 42.9 days

=

Inventory

turnover

P43,000

(P10,600 + P12,000) / 2

Acid-test ratio =

Cost of goods sold

Average inventory balance

= 3.8

= 96.1 days

=

Average sale

period

365 days

3.8

Acid-test ratio =

365 days

Inventory turnover

= 5.1

=

Times interest earned ratio

P4,100

P800

Acid-test ratio =

Earnings before interest expense

and income taxes

Inventory expense

= 0.67

=

Debt-to-equity

ratio

P27,400

P41,080

Acid-test ratio =

Total liabilities

Shareholders equity

5-15-385-39