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Chapter 4

Review of Accounting

Overview:

This chapter provides a review of accounting principles and practices. The

components of the balance sheet, income statement, and cash flow statements are

reviewed. You also learn to calculate depreciation and taxes. An understanding

of these financial statements enables the financial manager to analyze the cash

needs of his/her firm, enabling him/her to help the firm achieve financial success.

What You Should Know From This Chapter:

1. Explain how financial managers use the three basic accounting financial

statements: the income statement, the balance sheet, and the statement of

cash flows:

Income Statement: The items on the income statement that you should understand

include revenue items such as sales; and expenses which are listed as follows:

a. Cost of goods sold (labor, materials, overhead expenses)

b. Selling and administrative expenses (marketing salaries, office support,

insurance, etc.)

c. Depreciation (allocation of cost of plant and equipment)

d. Interest (payments associated with any interest-bearing liabilities of the

company)

You should also understand the difference between operating income (EBIT),

earnings before taxes (EBT), and net income. The importance of earnings per

share is also discussed.

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Balance Sheet: The items on the balance sheet that you should understand include the

categories of assets, liabilities, and equity and are described as follows:

Assets:

Current Assets are short-term liquid assets and include such items as:

Cash, marketable securities, inventory, accounts receivable, and prepaid

expenses.

Fixed Assets include assets that are expected to provide a benefit to the

firm for more than one year.

Liabilities:

How the assets are financed.

Current Liabilities are short-term debt obligations and include such items

as notes payable, accounts payable, and wages payable.

Long-term Liabilities include bonds payable and other debt not due in less

than one year.

Equity: How the assets are financed other than by debt.

Common Stock is the stated value on the stock certificate times the number

of shares issued.

Capital in excess of par is the total of the original market price per share

for each stock sold minus the par value of the stock.

Retained Earnings represents the sum of all the net income of a business

that has not been paid out in dividends.

Statement of Cash Flows: This statement shows how cash flows into and out of a

company over a given period of time.

2. Discuss how depreciation affects cash flow, and compute depreciation

expense:

Depreciation expense for a given period is determined by calculating the total

amount to be depreciated and then calculating the percentage of that total to be

allocated to a given time period.

Methods used include straight-line where you divide the cost of the asset by the

number of years of life for the asset according to classification rules, and charge

off the result as depreciation expense each year.

The Modified Accelerated Cost Recovery System (MACRS) specifies that some

percent of the cost of assets will be charged each year as depreciation expense

during the asset’s life. Larger percentages are allocated to early years under this

system. The table of deduction percentages allowed is given in Table 4-1 on page

73 of the text.

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3. Explain how to explain how taxes affect a firm’s value, and calculate

marginal and average tax rates:

The marginal tax rate generally increases as the level of taxable income

increases. This pattern reflects the progressive tax rate structure imposed by the

federal government. The marginal tax rate is the rate applied to the next dollar of

taxable income.

The average tax rate is calculated by dividing tax dollars paid by earnings before

taxes:

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Terminology and Concept Review

4-1. The ________________________shows the firm’s assets, liabilities, and equity at

a given point in time.

4-2. _______________________ are assets that are expected to provide a benefit to

the firm for more than one year.

4-3. The _____________________________ contains audited financial statements

submitted annually to the SEC for distribution to the public.

4-4. The tax rate that applies to the next dollar of taxable income earned, the

_____________________________, changes as the level of taxable income

changes.

4-5. _____________________________ specifies the percent of the cost of assets that

will be charged each year as depreciation expense during the asset’s life as

dictated by the Tax Reform Act of 1986.

4-6. In addition to the income statement, many firms prepare a short

____________________________ that records dividend and retained earnings

information.

4-7. Which of the following would be considered either current assets or liabilities?

Cash, Fixed Assets, Retained Earnings, Accounts Payable, Inventory

4-8. What statement measures a firm’s profitability over a period of time?

___________________________________________________________

4-9. What is the formula for EPS? ____________________________________

4-10. Current assets minus current liabilities = ___________________________.

4-11. Give the formula for calculating the effective tax rate. ________________

4-12. Finish the following statement: The matching principle says that

____________________________________________________________.

4-13. True or False: Net profit is equivalent to net cash flow at the end of an

accounting period. ___

4-14. The stated value printed on the stock certificate is called the ____________.

4-15. Finish the following statement: Depreciation basis is equal to

____________________________________________________________.

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Problems and Short-Answer Questions

4-16. What is the difference between capital in excess of par and common stock?

4-17. Explain the difference between a prepaid expense and an accrued expense; why is

one considered an asset and one a liability?

4-18. Retained earnings includes net income before any dividends are deducted.

Comment on this statement.

4-19. You have a net income of $76,000; taxes are paid at a rate of 40%; common stock

dividends paid are $40,000; and shares of stock outstanding are 50,000. Calculate

the EPS.

4-20. Cash at the end of 2011 was $100,000 and cash at the end of 2012 was $105,000.

Your cash flow statement shows a net cash position of zero. Is this possible?

Explain.

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4-21. The following information corresponds to Flynn Corporation’s 2012 operations.

COGS $400,000

S&A Expenses 50,000

Depreciation 400,000

Sales 1,000,000

Interest Expense 10,000

Tax Rate 35%

Calculate the following income statement items:

a. Gross Profit

b. EBIT

c. EBT

d. Taxes

e. Net Income

4-22. The following information corresponds to AREO Corporation’s 2012 operations.

Sales $13,000,000

Net Income 400,000

Interest Expense 100,000

Preferred Dividends 200,000

Common Stock Dividends 300,000

Beginning Retained Earnings 900,000

Calculate Ending Retained Earnings:

4-23. Explain why the change in retained earnings is not included on the cash-flow

statement.

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Use the following information for Questions 4-24 to 4-29:

Balance Sheet Dec-12 Dec-11 Dec-12 Dec-11

Assets Liabilities

Cash 4750 3614 Notes Payable 0 0

Marketable Securities 398 626 Accounts Payable 563 324

Net Receivables 581 475 Taxes Payable 410 305

Inventories 88 102 Accrued Expenses 374 284

Prepaids 201 121 Long-Term Debt 530 0

Gross Plant & Equip 1907 1445 Stockholders'

Equity

Accumulated Dep. 715 515 Common Stock 2005 2005

Net Plant & Equip. 1192 930 Retained Earnings 3328 2950

4-24. Compute the following totals for Dec of 2011 and 2012.

a. Current Assets

b. Total Assets

c. Current Liabilities

d. Total Liabilities

e. Total Stockholders’ Equity

4-25. Show whether or not the basic accounting equation is satisfied in problem 4-24.

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4-26. Calculate the cash flows from the changes in the following from the end of 2011

to the end of 2012. Indicate inflow or outflow.

a. Accumulated Depreciation

b. Net Receivables

c. Inventories

d. Prepaids

e. Plant and Equipment

f. Accounts Payable

g. Accrued Expenses

h. Long-Term Debt

i. Common Stock

j. Taxes Payable

k. Marketable Securities

4-27. Prepare a statement of cash flows in proper form using the inflows and outflows

from question 4-24. Assume net income from the 2012 income statement was

$1,396.80

4-28. Show whether or not your net cash flow matches the change in cash between the

end of 2011 and end of 2012 balance sheets.

4-29. Show whether or not the retained earnings equation balances.

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4-30. A firm expects to have earnings before depreciation and taxes of $200,000 in each

of the next three years. There are no interest payments and taxes are at a rate of

35%. It is considering the purchase of an asset costing $200,000 requiring

$20,000 in installation costs and having a MACRS recovery period of three years.

a. Calculate the annual depreciation for each year using the MACRS depreciation

percentages. (Schedule on page 73)

b. If common stock dividends paid are $20,000 and shares of common stock

outstanding are 25,000, what is the EPS in year two?

4-31. Calculate earnings per share for the following:

Net income 575,000

Interest expense 40,000

Common dividends paid 125,000

Common shares outstanding 450,000

4-32. Silverun, Inc., has before tax income of $500,000.

a. Using the corporate progressive tax rate schedule, calculate its tax obligation.

(Schedule in Table 4-2 on page 74)

b. What is its marginal tax rate?

c. What is Silverun’s average (effective) tax rate?

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4-33. Hibbert Inc. had retained earnings at the end of 2011 of $3,500,000. 2012 net

income was $500,000 and retained earnings for the end of 2012 was $3,700,000.

What was the amount paid in dividends to common stockholders in 2012?

4-34. Wilmot Manufacturing bought new equipment in 2012 for $500,000 (total cost).

The equipment falls into the MACRS seven-year class. What would be the

depreciation taken on this equipment in year 3 using MACRS rules?

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Answers

4-1. Balance sheet (Page 72)

4-2. Fixed assets (Page 72)

4-3. 10 K report (Page 68)

4-4. Marginal tax rate (Page 79)

4-5. MACRS (Page 78)

4-6. Statement of retained earnings (Page 71)

4-7. Cash, accounts payable, inventory (Page 72)

4-8. Income Statement (Page 68)

4-9. Net Income

Number of shares of common stock outstanding (Page 71)

4-10. Net Working Capital (Page 72)

4-11. Effective taxes paid

EBT (Page 80)

4-12. Expenses should be matched to the revenues they help to generate. (Page 78)

4-13. False (Page 77)

4-14. Par value (Page 74)

4-15. The cost of the asset plus any setup or delivery costs that may be incurred.

(Page 78)

4-16. The common stock reflects the par value printed on the stock certificate times the

number of shares issued which is usually very low. Capital in excess of par is the

total of the original market price per share value for each stock sold minus the par

value. (Page 74)

4-17. A prepaid expense represents future expenses expected but that have been paid in

advance. The benefit is owed to the company and is considered an asset.

Accrued expenses are business expenses that have not been paid yet and are owed

by the company and are considered liabilities. (Page 72)

4-18. Retained earnings represent the accumulation of earnings after dividends have

been paid out that have been retained for reinvestment in the firm. Dividends

paid out by definition are not retained. (Page 74).

4-19. EPS: $76,000/50,000 shares = $1.52 (Page 71)

4-20. No, this is not possible. The statement of cash flows shows the changes in the

cash position; thus the change in the actual cash account should be equal to the

change in cash position as reflected on the cash-flow statement. (Page 74)

4-21. a. GP = $600,000

b. EBIT = $150,000

c. EBT = $140,000

d. Taxes = $ 49,000

e. Net Profit = $ 91,000 (Page 69)

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4-22. Beginning retained earnings plus net income minus dividends = ending retained

earnings: 900,000 + 400,000 - 200,000 - 300,000 = $800,000 (Page 71)

4-23. If the change in retained earnings is included on the cash-flow statement, there

would be a problem with double counting as income has already been added at the

beginning of the statement. Retained earnings reflects net income (less dividends

paid). (Page 71)

4-24. 2012 2011

a. CA = $6,018 $4,938

b. TA = $7,210 $5,868

c. CL = $1,347 $ 913

d. TL = $1,877 $ 913

e. TE = $5,333 $4,955 (Page 72)

4-25. $7,210 = $1,877 + $5,333

$5,868 = $913 + $4,955 (Page 73)

4-26. a. Depreciation 200 inflow

b. Net Receivables 106 outflow

c. Inventory 14 inflow

d. Prepaids 80 outflow

e. Plant/Equipment 462 outflow

f. Accounts Payable 239 inflow

g. Accrued Expenses 90 inflow

h. Long-Term Debt 530 inflow

i. Common Stock 0

j. Taxes Payable 105 inflow

k. Marketable Sec. 228 inflow (Page 74)

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4-27.

Operations Net Income $1,396.80

Plus:

Depreciation 200.00

Marketable Sec. 228.00

Inventory 14.00

Accounts Payable 239.00

Taxes Payable 105.00

Accrued Expenses 90.00

Minus:

Net Receivables 106.00

Prepaids 80.00

Total Operating Cash Flow +$2,086.80

Investments Minus:

Increase in Plant/Equipment $ 462.00

Total Cash Flow from Invest. -$ 462.00

Financing Plus:

Increase in Long-Term Debt $ 530.00

Minus:

Dividends 1,018.80

Total Financing Cash Flow -$ 488.80

Net Cash Flow +$1,136.00

(Page 77)

4-28. Beginning cash: $3,614

Ending cash: 4,750

Change $1,136 (page 77)

4-29. Beginning Retained Earnings: $2,950 + Net Income: $1,396.80 - Dividends:

$1,018.80 = Ending Retained Earnings: $3,328. (Page 74)

4-30. a.

Year Depreciation

1 $ 73,260

2 97,900

3 32,560

4 16,280

b. EPS: Revenues $200,000

Depreciation 97,900

EBT 102,100

Taxes 35,735

Net Income 66,365

66,365/25,000 = $2.65 (Page 70)

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4-31.

= $1.28 (Page 70)

4-32. a. $50,000 @ 15% $7,500

25,000 @ 25% 6,250

25,000 @ 34% 8,500

235,000 @ 39% 91,650

165,000 @ 34% 56,100

$170,000

b. 34%

c. 170,000/500,000 = 34% (Page 80)

4-33. $3,500,000 + 500,000 – 3,700,000 = $300,000 (Page 74)

4-34. $400,000 x 17.5% = $87,500 (Page 78).

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Chapter 5

Analysis of Financial Statements

Overview:

In order to understand how a firm is doing from a financial perspective, it is

useful to do a financial analysis. This is accomplished through the construction of

a series of financial ratios. These ratios help the manager to analyze the firm in

terms of its profitability, liquidity levels, debt load, and asset utilization. By

comparing these ratios over a series of years, the analyst can get a picture of the

firm’s overall financial strength. The analyst can also compare these ratios with

those of other firms in the industry to see how well the firm is doing compared to

its peers.

After reading this chapter and working through the problems, you should feel

comfortable in doing your own analysis of a firm and should be able to tell a story

about the firm’s ability to remain a going concern.


1. Explain how financial ratio analysis helps financial managers assess the

health of a company:

Financial ratios are numbers that express the value of one financial variable

relative to another. They are comparative measures because they show relative

value and allow the financial analysts to compare information that could not be

compared in its raw form. Ratios may be used to compare:

One ratio to a related ratio

The firm’s performance to management’s goals

The firm’s past and present performance

The firm’s performance to that of similar firms.

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2. Compute profitability, liquidity, debt, asset utilization, and market value

ratios:

Profitability ratios measure how much company revenue is eaten up by expenses,

how much a company earns relative to sales generated, and the amount earned

relative to the value of the firm’s assets and equity.

Liquidity Ratios measure the ability of a firm to meet its short-term obligations.

Current Ratio = Current Assets

Current Liabilities

Quick Ratio = Current Assets Less Inventory

Current Liabilities

Debt Ratios assess the relative size of a firm’s debt load and the firm’s ability to

pay off the debt.

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Asset Activity Ratios measure how efficiently a firm uses its assets.

Market Value Ratios measure the market’s perception of the future earning power

of a company as reflected in the stock share price.

Economic Value Added (EVA) measures the amount of profit remaining after

accounting for the return expected by the firm’s investors and is said to be an

“estimate of the true economic profit.”

EVA = EBIT(1-TR) – (IC x Ka)

Where EBIT = earnings before interest and taxes

TR = the effective or average income tax rate

IC = invested capital

Ka = investors’ required rate of return on their investment.

Market Value Added (MVA) is the market value of the firm, debt plus equity,

minus the total amount of capital invested in the firm and is similar to the market

to book (M/B) ratio. MVA, however focuses on total market value and total

invested capital, whereas M/B focuses on the per share stock price and invested

equity capital.

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The Du Pont System of ratio analysis examines the relationships between ratios.

Du Pont Equation:

Return on Assets = Net Profit Margin x Total Asset Turnover

Modified Du Pont Equation:

ROE = Net Profit Margin x Total Asset Turnover x Equity Multiplier

3. Compare financial information over time and among companies:

Trend analysis uses computed ratio values for several time periods and compares

them.

Industry analysis (Cross-Sectional analysis) judges whether a firm’s ratio is too

high or too low in comparison with other firms in the industry.

4. Locate ratio value data for specific companies and industries:

Analysts can gather information about publicly traded corporations at most

libraries, on CD-ROM databases, and on the Internet.

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5-1. The ___________________compares all the current assets of the firm to all the

company’s current liabilities.

5-2. The difference between the firm’s future earnings and liquidation value is the

_____________________ of the firm.

5-3. In the modified Du Pont equation, ROE is the product of net profit margin, total

asset turnover, and the ________________________.

5-4. One way to judge whether a firm’s ratio is too high or too low is to compare it to

the ratios of other firms in the industry. This is sometimes called ____________.

5-5. The ___________________________tells us how efficiently the firm converts

inventory to sales.

5-6. The ___________________________is the percentage of debt relative to the

amount of equity of the firm.

5-7. The ____________________________measures how much profit out of each

sales dollar is left after all expenses are subtracted.

5-8. The ____________________________measures the average return on the firm’s

capital contributions from its owners.

5-9. The ___________________________measures how many days, on average, the

company’s credit customers take to pay their accounts.

5-10. The ___________________________is the market price per share of a

company’s common stock divided by the accounting book-value-per-share ratio.

5-11. The ___________________________measures how efficiently a firm utilizes its

assets.

5-12. Explain trend analysis. _______________________________________________

_________________________________________________________________

5-13. What is meant by the leverage effect? ___________________________________

_________________________________________________________________

5-14. Explain the difference between the current and the quick ratio. _______________

_________________________________________________________________

5-15. What is a mixed ratio? _______________________________________________

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5-16. Why is the EVA an important new tool in financial analysis?

__________________________________________________________________

________________

5-17. Why are M/B and MVA highly correlated? ______________________________

_________________________________________________________________

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5-18. Use the following information to construct and solve the Du Pont and Modified

Du Pont equations for Ace International: (Hint: Solve for equity)

Sales $18,530,000

Net Income 377,900

Total Assets 11,097,510

Debt/Total Assets 64.20%

5-19. Given $2,044,000 in total assets, $1,351,000 in total stockholders’ equity, and

debt-to-total-asset ratio of 33.90%, calculate the debt to equity ratio.

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Use the following information to answer questions 5-20 to 5-24:

Computer Whiz, Inc. Dec 31, 2012

Income Statement Balance Sheet

Sales 5,937,000 Assets

Cost of Goods Sold 608,000 Cash 4,750,000 Gross Profit 5,329,000 Net Receivables 581,000 Selling & Ad. Expenses 3,022,000 Inventories 88,000

Depreciation 269,000 Prepaid

Operating Income (EBIT)

2,038,000 Other Current 201,000

Interest Expense 221,000 Total Current Assets 5,620,000 Other Expense 177,000

EBT 1,640,000 Gross Plant & Equip.. 1,907,000 Taxes 714,000 Accumulated Dep. 715,000 Net Income 926,000 Net Plant & Equip.. 1,192,000

Other Assets 398,000


Liabilities

Accounts Payable 563,000 Taxes Payable 410,000 Accrued Expenses 130,000 Other Current Liabilities 244,000 Total Current Liabilities 1,347,000 Long-Term Debt 530,000 Total Liabilities 1,877,000

Equity

Preferred Stock 0 Common Stock 2,005,000 Capital in Excess of Par 0 Retained Earnings 3,328,000 Total Common Equity 5,333,000 Total Equity 5,333,000 Total Liabilities & Equity 7,210,000

Year 2012

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5-20. Calculate the following profitability ratios for 2012.

a. Gross Profit Margin

b. Operating Profit Margin

c. Net Profit Margin

d. Return on Assets

e. Return on Equity

5-21. Calculate the following liquidity ratios for the end of 2012.

a. Current Ratio

b. Quick ratio

5-22. Calculate the following debt ratios for the end of 2012.

a. Debt to Total Assets

b. Times Interest Earned

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5-23. Calculate the following asset activity ratios for the end of 2012.

a. Average Collection Period

b. Inventory Turnover

c. Total Asset Turnover

5-24. Construct and solve Computer Whiz, Inc.’s, Modified Du Pont equation for 2012.

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5-25. Calculate the following profitability ratios for 2012.

a. Gross Profit Margin

b. Operating Profit Margin


ABC Fitness Company

Dec 31, 2012


Sales 1,968,016 Assets Cost of Goods Sold 1,466,733 Cash 89,469 Gross Profit 501,283 Net Receivables 55,514

Selling/G&A 361,402

Inventories 322,433

Depreciation 35,700 Prepaid eeEExpen

8,775 Operating Income (EBIT) 104,181

Total Current Assets 476,191

Interest Expense 6,234 Other Expense 14,124 Gross Plant & Equip.. 955,661 EBT 83,823 Accumulated Dep. 338,513 Taxes 24,701 Net Plant & Equip.. 617,148 Net Income 59,122 Other Assets 24,621


Liabilities Notes Payable 1,127 Accounts Payable 144,638 Taxes Payable 16,797 Accrued Expenses 98,233 Total Current Liabilities 260,795

Long-Term Debt 415,138 Deferred Taxes 20,396 Total Liabilities 696,329

Equity Common Stock 200,320 Capital in Excess of Par 42,843 Retained Earnings 178,468 Total Equity 421,631 Total Liab. & Equity 1,117,960

Year 2012

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d. Return on Assets

e. Return on Equity

5-26. Calculate the following liquidity ratios for the end of 2012.

a. Current Ratio

b. Quick Ratio

5-27. Calculate the following debt ratios for the end of 2012.

a. Debt to Total Assets

b. Times Interest Earned

5-28. Calculate the following asset activity ratios for the end of 2012.

a. Average Collection Period

b. Inventory Turnover

c. Total Asset Turnover

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5-29. Construct and solve ABC Fitness Company’s Modified Du Pont equation for

2012.

5-30. From the values of the different ratios given, calculate the missing balance sheet

and income statement items of XYZ Inc. (round up the figures to nearest tens).

Average Collection Period 8.29 days

Inventory Turnover 4.63x

Debt to Asset Ratios 64.20%

Current Ratio 1.67

Return on Equity 9.51%

Return on Assets 3.41%

Operating Profit Margin 4.27%

Gross Profit Margin 26.34%

58


5-31. What must net income be in 2012 if XYZ Inc. wants to maintain a net profit

margin of 12% on net sales of $100,000?

5-32. Explain what a debt to equity ratio of 10 means.

5-33. A high inventory turnover ratio is always good. Comment on this statement.

XYZ Inc. Dec 31, 2012


Assets Sales 1,852,929 Cash Cost of Goods Sold Net Receivables Gross Profit Inventories Selling & Ad. Expenses Prepaids

13,001 Depreciation ExExpense

53,474 Total Current Assets 468,289 Operating Income (EBIT)

Interest Expense Gross Plant & Equip.. 920,841 Other Expense 13,742 Accumulated Dep. 302,777 EBT

Net Plant & Equip.. 618,064

Taxes 24,628 Other Assets 21,857 Net Income Total Assets

Liabilities Notes Payable Accounts Payable 149,293 Taxes Payable 30,000 Accrued Expenses 86,470 Total Current Liabilities 281,476

Long-Term Debt Deferred Taxes 17,423 Total Liabilities 710,839

Equity Common Stock 200,320 Capital in Excess of Par 42,843 Retained Earnings Total Equity Total Liab. & Equity 1,108,210

Year: 2012

59

5-34. Explain the purpose of the Du Pont model.

5-35. Explain what a P/E ratio of 18 means.

5-36. Given the following information, calculate the current ratio and the ROE.

Total Equity $10,000

Total Liabilities 15,000

Total Sales 20,000

Current Assets 10,000

Long-Term Liabilities 5,000

Net Profit Margin 8%

60

5-37. Assume the Riddley Venture Corporation has:

Total Common Stock Equity at Year-End 2012 $10,000,000

Number of Common Shares Outstanding 750,000

Market Price per share $200

Calculate the following:

a. Book value per share

b. Market to book value ratio

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5-38.

a. For ABC Fitness Company, calculate the economic value added (EVA) if

the weighted average rate of return expected by the suppliers of the firm’s

capital is 11%, and the market price of the firm’s stock is $12, and there are

100,000 shares outstanding.

ABC Fitness Company Dec 31, 2012


Sales 1,968,016 Assets Cost of Goods Sold 1,466,733 Cash 89,469 Gross Profit 501,283 Net Receivables 55,514 Selling & Ad. Expenses

361,402 Inventories 322,433

Depreciation 35,700 Prepaids 8,775 Operating Income (EBIT) 104,181

Total Current Assets 476,191

Interest Expense 6,234 Other Expense 14,124 Gross Plant & Equip.. 955,661 EBT 83,823 Accumulated Dep. 338,513 Taxes 29,338 Net Plant & Equip.. 617,148 Net Income 54,485 Other Assets 24,621


Liabilities Notes Payable 1,127 Accounts Payable 144,638 Taxes Payable 16,797 Accrued Expenses 98,233 Total Current Liabilities 260,795

Long-Term Debt 415,138 Deferred Taxes 20,396 Total Liabilities 696,329

Equity Common Stock 200,320 Capital in Excess of Par 42,843 Retained Earnings 178,468 Total Equity 421,631 Total Liab. & Equity 1,117,960

Year 2012

62

b. Calculate the market value added (MVA) for ABC Fitness.

c. Comment on your two answers.

63

Answers

5-1. Current ratio (Page 100)

5-2. Going concern value (Page 105)

5-3. Equity multiplier (Page 108)

5-4. Cross-sectional analysis (Page 110)

5-5. Inventory turnover ratio (Page 103)

5-6. Debt to equity ratio (Page 101)

5-7. Net profit margin (Page 98)

5-8. Return on equity (Page 99)

5-9. Average collection period (Page 102)

5-10. Market to book value ratio (Page 104)

5-11. Total asset turnover Ratio (Page 103)

5-12. Trend analysis uses ratios to compare a firm’s past and present performance.

(Page 111)

5-13. The leverage effect is a result of debt on the balance sheet. By using borrowed

funds, the firm can increase its ROE. (Page 101)

5-14. The quick ratio is similar to the current ratio but is a more rigorous measure of

liquidity because it excludes inventory from current assets. (Page 100)

5-15. A mixed ratio is a ratio that uses both income statement and balance sheet

variables as inputs. (Page 99)

5-16. It enables the investors to see whether the income earned was sufficient to cover

their expected return. It is an estimate of the amount that earnings exceed or fall

short of the required minimum rate of return investors could get investing in other

securities of comparable risk. (Page 106)

5-17. Both focus on the value of the stock: MVA focuses on total market value while

M/B focuses on per share stock price and both focus on total invested capital.

(Page 105)

5-18. Debt/Total Assets = 64.20%; Equity/Total Assets = 35.80%; Total Assets/Equity

= 2.79. Du Pont Model = .0204 x 1.67 = 3.41%

Modified Model = .0204 x 1.67 x 2.79 = 9.52%.

(Page 108)

5-19. x/2044000 = .3390; x(debt) = 692,916; Debt/Equity = 692,916/1351000 = 51%.

(Page 101)

5-20. a. $5,329/5,937 = 89.76%

b. $2,038/5,937 = 34.33%

c. $926/5,937 = 15.60%

d. $926/7,210 = 12.84%

e. $926/5,333 = 17.36%

(Pages 96-99)

64

5-21. a. $5,620/1,347 = 4.17

b. $5,532/1,347 = 4.11

(Page 100)

5-22. a. $1,877/7,210 = 26.03%

b. $2,038/221 = 9.22

(Page 101)

5-23. a. $581/($5,937/365) = 35.72 days

b. $5,937/88 = 67.47

c. $5,937/7,210 = 0.823

(Page 102)

5-24. ROE = profit margin x total asset turnover x equity multiplier:

17.36% = 15.6% x .823 x 1.352

(Page 108)

5-25. a. $501.283/1,968.016 = 25.47%

b. $104.181/1,968.016 = 5.29%

c. $59.122/1,968.016 = 3.00%

d. $59.122/1,117.96 = 5.29%

e. $59.122/421.631 = 14.02%

(Page 96-100)

5-26. a. $476.191/260.795 = 1.83

b. $153.758/260.795 = .59

(Page 100)

5-27. a. $696.329/1,117.96 = 62.29%

b. $104.181/34.482 = 3.02

(Page 101)

5-28. a. $55.514/(1,968.016/365) = 10.3 days

b. $1,968.016/322.433 = 6.10

c. $1,968.016/1,117.96 = 1.76

(Page 102)

5-29. ROE = net profit margin x total asset turnover x equity multiplier:

14.02% = 3% x 1.76 x 2.652 (Page 108)

65

5-30.

5-31. .12 x 100,000 = $12,000 (Page 98)

5-32. This means that the firm has 10 times as much debt as equity. (Page 101)

5-33. While the firm may want to see inventory turning over which means good sales;

perhaps the firm is not maintaining enough inventory on hand which could mean

a loss of potential sales. (Page 103)

5-34. The Du Pont model enables the firm to look at the components of both ROA and

ROE to see what impact individual ratios have upon these returns. For example,

is profitability too low, or are turnover ratios too low. The firm can look at the

factors comprising their various returns to better analyze their effectiveness.

(Page 104)

5-35. A P/E ratio of 18 measures how much investors are willing to pay for claim to one

dollar of the earnings per share of the firm. It would take 18 years of the

company’s current earnings rate for the investor to earn net profits of $18 per

share. (Page 104)

Balance Sheet Income Statement

Assets

Cash 13,008 Sales 1,852,929

Net Receivables 42,080 Cost of Goods Sold 1,364,868

Inventories 400,200 Gross Profit 488,061

Prepaids 13,001 Selling & Ad. Expenses 355,467

Total Current Assets 468,289 Depreciation 53,474

Operating Profit 79,120

Gross Plant & Equip. 920,841 Interest Expense 2,960

Accumulated Dep. 302,777 Other Expense 13,742

Net Plant & Equip.. 618,064 PreTax Income 62,418

Other Assets 21,857 Taxes (39.46%) 24,628

Total Assets 1,108,210 Net Profit 37,790

Liabilities

Notes Payable 15,710

Accounts Payable 149,293

Taxes Payable 30,000

Accrued Expenses 86,473

Total Current Liabilities 281,476

Long-Term Debt 411,940

Deferred Taxes 17,423

Total Liabilities 710,839

Equity

Common Stock 200,320

Capital in Excess of Par 42,843

Retained Earnings 154,208

Total Equity 397,371

Total Liabilities & Equity 1,108,210

66

5-36. Current ratio = 10,000/10,000 = 1. (Page 100)

ROE = 1,600/10,000 = 16%. (Page 99)

5-37. a. $10,000,000/750,000 = $13.33 per share

b. $200/$13.33 = $15.00 per share (Page 104)

5-38. a. EVA = 104,181(1-0.35) – ((120,000 + 416,268 x 0.11)) = ($110,071)

b. MVA = ($1,200,000 + 416,268) – (421,631 + 416,268) = $778,366

c. Although the EVA is negative, the MVA is positive which could mean that for

this year, there might have been some unusual happening in the firm which

caused a lower than average EBIT, in turn causing a low EVA. It would be

important to review trends before becoming too alarmed at this point. (Pages

105-107)

67

Chapter 6

Forecasting for Financial Planning

Overview:

Once you have completed the financial analysis of your firm, you are ready to

forecast the financial needs for the future. An estimate of sales is prepared, and

the financial manager must determine the future financial needs of the firm based

on the change in forecasted sales. Increased levels of sales will necessitate

growth in other assets and liabilities and could affect the future financial standing

of the firm. It is up to the financial manager to determine those needs so that the

firm is not faced with an unexpected demand for new funds; a demand which

could over-burden the firm with debt or liquidity problems if not properly

addressed.


1. Explain why forecasting is vital to business success:

Forecasting in business is especially important because failing to anticipate future

trends can be devastating. Financial decisions are based on forecasts of situations

a business expects to confront in the future. There are three general approaches

discussed in this chapter: experience, probability, and correlation.

Experience means that we think things will happen a certain way in the future

because they happened that way in the past. Probability means things will happen

a certain way in the future because the laws of probability indicate that it will be

so. Correlation means we think things will happen a certain way in the future

because there is a high correlation between the behavior of one item and the

behavior of another item that we know more about.

2. Describe the financial statement forecasting process:

The forecasting process depends on the demand for a firm’s products and the

strength of the competition. Sales, marketing, and production personnel all

usually provide estimates for top management to use in their strategic decisions

affecting the firm as a whole. Sales forecasting is a group effort.

68

3. Prepare pro forma (projected) financial statements:

The cash budget and capital budget are used in the preparation of pro forma

financial statements. The cash budget shows the projected flow of cash in and out

of the firm for specified time periods, while the capital budget shows planned

expenditures for major asset acquisitions.

The pro forma income statement projects values for sales, costs and expenses

associated with sales, general and administrative expenses, depreciation, interest,

taxes, dividends paid, and addition to retained earnings.

Items which tend to move spontaneously with changes in the sales level include

COGS and selling and marketing expenses. General and administrative expenses

are more fixed in nature and tend to change as levels of fixed expenditures

change. Depreciation changes according to the depreciation schedule—not

directly with changes in sales. Interest expense will change only as debt levels

change. Dividends paid can be as a percent of sales and thus move with sales, but

this is also a discretionary item decided upon by management. Retained earnings

is calculated by adding net income after dividends paid to beginning retained

earnings.

The pro forma balance sheet is created by examining each individual line-item

account. Most current assets and current liabilities (with the exception of notes

payable) move spontaneously with sales. Usually it is assumed that notes payable

will be paid off at year end and new financing needs will be plugged into this

account to balance the statement. Plant and equipment changes will be based on

the capital budget expenditures. Long-term debt and new stock issues will

depend on the calculated financial needs when the pro forma statements are

completed.

Additional funds needed is one of the most important reasons for producing pro

forma financial statements. Additional funds needed occurs when forecast assets

exceed forecast liabilities and equity. It is called excess financing when forecast

liabilities and equity exceed forecast assets. With this knowledge, financial

managers can make the necessary financing arrangements in the financial markets

before a crisis occurs.

Once additional funds needed have been calculated, forecasters should revise the

pro forma income statement to reflect the new interest charges. However, if they

make the revision, it will reduce the next year’s net income, which in turn will

reduce the new year’s retained earnings on the balance sheet forecast. Everything

is thrown out of balance. This is known as the balancing problem. You need to

recast the financial statements several times over until the additional amount of

interest expense becomes negligible.

69

4. Explain the importance of analyzing forecasts:

The forecasts enable the financial manager to see where current trends are leading

the firm in the future, what effect management’s current plans and budgets will

have on the firm, and what actions to take to avoid problems revealed in the pro

forma statements. These points are discussed in detail in this chapter.

70


6-1. The ___________________________shows the projected flow of cash in and out

of the firm for specified time periods.

6-2. The difference between forecasted assets and forecasted liabilities and equity

before external financing is called ___________________________________.

6-3. Forecasted financial statements are commonly referred to as_______________

_________________________.

6-4. The _______________________shows planned expenditures for major asset

acquisitions.

6-5. True or False: General and Administrative Expenses usually move spontaneously

with sales. _______

6-6. When forecasted liabilities and equity exceed forecasted assets, it is called

_______________.

6-7. The balancing problem refers to what variable? _________________________

6-8. List eight items from the balance sheet and income statement, which would

probably move spontaneously with sales.

_________________________ ___________________________

_________________________ ___________________________

_________________________ ___________________________

_________________________ ___________________________

6-9. What are the most important reasons for doing pro forma statements?

________________________

6-10. Write the equation for ending retained earnings.

_______________________________________________________________

6-11. What is the forecasted value for notes payable when a first pass pro forma balance

sheet is prepared? ________________________________________________

6-12. True or False: Cash rarely moves with changes in sales forecasts. __________

71


Use the following information to answer questions 6-13 through 6-16:


December 31, 2012 December 31, 2012

(in thousands) (in thousands)

Sales $40,000 Assets:

COGS 18,200 Total Current Assets $100,000

21,800 Net Plant & Equipment 70,000

Total Assets $170,000 Selling Expenses 4,000

Depreciation 3,000 Liabilities & Equity:

Fixed Expenses 4,000 Accounts Payable $40,000


EBIT 10,800 Accrued Expenses 10,000

Taxes (40%) 4,320

Bonds Payable 40,000

Net Income 6,480 Common Stock 40,000

Paid-in-Surplus 20,000

Common Stock Div. 1,200 Retained Earnings 10,000

$ 5,280

Total Liabilities & Equity $170,000

Sales for 2013 are projected to be $60,000; the firm currently uses straight line

depreciation. No new equipment purchases are planned for 2013. There will be a 10%

earnings distribution for 2013. Notes Payable will be paid off at the end of 2012.

6-13. Forecast net income for 2013.

6-14. Forecast retained earnings for 2013.

6-15. Forecast total assets for 2013.

72

6-16. Forecast additional funds needed in 2013.

Use the following information to answer question 6-17:

2012

Cash $20,000

Accounts Receivable 30,000

Inventory 70,000

Fixed Assets, gross 110,000

Accumulated Depreciation 30,000

Fixed Assets, net 80,000

6-17. The firm currently uses straight line depreciation. Depreciation in 2012 was

$4,000. Sales are expected to grow by 50% in 2013. All net income is paid out in

dividends and no new stock issues are planned. Calculate total assets for 2013.

6-18. Explain what is meant by the balancing problem in forecasting.

6-19. Explain which of the following items would move spontaneously with sales and

which would not.

a. Retained Earnings

b. Notes Payable

c. Accounts Receivable

d. Long-Term Debt

e. Accounts Payable

73

Use the following information to answer questions 6-20 through 6-23:

Balance Sheet

December 31, 2012

(in thousands)

Assets: Liabilities:

Cash 10,000 Accounts Payable $30,000

Accounts Receivable 40,000 Notes Payable 20,000

Inventory 30,000 Accrued Expenses 10,000

Total Current 80,000 Total Current 60,000

Fixed Assets, net 40,000 Long-Term Debt 20,000

Common Stock 32,000

Total assets $120,000 Retained Earnings 8,000

Total Liability

and Equity $120,000

Net income for 2012 was $20,000. Sales for 2013 are projected to increase by 20%. No

new equipment purchases are planned for 2013; the dividend payout ratio will be 100%

in 2013. Notes Payable are paid off at the end of 2012. Net income for 2013 is projected

to be $24,000.

6-20. Project net profits for 2013.

6-21. Projected Additional Funds Needed in 2013 will be:

6-22. Project retained earnings for 2013.

6-23. Project total assets for 2013.

74

6-24. Explain the importance of knowing additional funds needed.


2012

Total Assets $37,500

Accounts Payable $ 1,500

Notes Payable 2,500


Common Stock 12,500


Total Liabilities/Equity $37,500

Total sales in 2012were $50,000, resulting in a net income of $5,000. Sales are expected

to grow by 10% in 2013; the dividend payout ratio is 15% of net income. Net income for

2013 is projected to be $5,500.

6-25. Project common equity for 2013.


2012

Total Assets $150,000

Accounts Payable $ 6,000



Common Stock 50,000


Total Liabilities/Equity $ 150,000

Total sales in 2012 were $200,000 resulting in a net income of $20,000. Sales are

expected to grow by 50% in 2013, the dividend payout ratio is 0% of net income. Net

income is projected to be $30,000 in 2013.

75

6-26. Project common equity for 2013.

6-27. Why is it important to consider the current ratio and debt ratio if additional funds

are needed?

76

Use the following information to answer questions 6-28 and 6-29.

2011 2012

Sales 400 800

Variable Costs 200 400

Fixed Costs 160 200

Net Income 40 200

Dividends 30 100

Current Assets 240 480

Fixed Assets 400 500

Total Assets 640 980

Current Liabilities 80 320

Long-Term Debt 80 80

Common Stock 80 80

Retained Earnings 400 500

Total Liabilities & Equity 640 980

6-28. Compute the following ratios for 2011 and 2012:

2011 2012

a. Current Ratio

b. Debt to Assets Ratio


d. Return on Assets

e. Return on Equity

6-29. Comment on any trends revealed by your ratio analysis.

77

6-30. EBIT has been 20% of sales for the past three years and is expected to continue at

this level. If sales in 2013 are projected at $1,000,000, what would EBIT be?

6-31. Sales are expected to double in 2013 to $200,000. General and Administrative

expenses were $25,000 in 2012. Calculate General and Administrative expenses

for 2013.

78

Answers

6-1. Cash budget (Page 138)

6-2. Additional funds needed (Page 145)

6-3. Pro forma financial statements (Page 138)

6-4. Capital budget (Page 138)


6-6. Excess financing (Page 145)

6-7. Interest expense (Page 146)

6-8. COGS, selling expense, cash, marketable securities, inventory, accounts

receivable, accounts payable, accrued expenses. (Comprehensive)

6-9. The importance of knowing additional funds needed (Page 145)

6-10. Beginning Retained Earnings + Net Income - Dividends Paid. (Page 144)

6-11. Zero (Page 144)


6-13 to 6-16: Income Statement Balance Sheet

December 31, 2013 December 31, 2013

(in thousands) (in thousands)

Sales $60,000 Assets:

COGS 27,300 Total Current Assets $150,000

32,700 Net Plant & Equipment 67,000

Total Assets $217,000 Selling Expenses 6,000

Depreciation 3,000 Liabilities & Equity:

Fixed Expenses 4,000 Accounts Payable $ 60,000

Notes Payable -0-

EBIT 19,700 Accrued Expenses 15,000

Taxes (40%) 7,880

Bonds Payable 40,000

Net Income 11,820 Common Stock 40,000

Paid-in-Surplus 20,000

Common Stock Div. 1,182 Retained Earnings 20,638

To Retained Earnings 10,638

Total Liabilities & Equity $195,638

6-13. Net Income = $11,820

6-14. Retained Earnings = $20,638

6-15. Total Assets = $217,000

6-16. Additional Funds Needed = $217,000 – $195,638 = $21,362

(Comprehensive)

79

6-17. 2012 2013

Cash $20,000 $30,000

Accounts Receivable 30,000 45,000

Inventory 70,000 105,000

Fixed Assets, gross 110,000 110,000

Accumulated Depreciation 30,000 34,000

Fixed Assets, net 80,000 76,000

$256,000 Total Assets (Page 147)

6-18. If a company borrows the additional funds needed, then the firm will incur new

interest charges that were not included in the original pro forma income

statement. To be accurate, forecasters should revise the pro forma income

statement to include the new interest. However, this will reduce net income and

retained earnings, which will throw the balance sheet out of balance again. (Page

146)

6-19. As sales increase, there will be more accounts receivable as customers buy more

goods, and accounts payable will increase as the firm purchases more goods to

accommodate new sales; thus, both move spontaneously with sales.

Notes payable typically is paid off at year end and can be a plug for additional

funds needed. Long-term debt by definition is not a short-term item and will be

changed only if the change in sales causes some new long-term new needs on the

balance sheet. Retained earnings increases by net income but depends on the

dividend payout ratio and thus does not move spontaneously with sales. (Pages

142–145)

6-20 through 6-23:

Balance Sheet

December 31, 2013

(in thousands)

Assets: Liabilities:

Cash 12,000 Accounts Payable $36,000

Accounts Receivable 48,000 Notes Payable -0-

Inventory 36,000 Accrued Expenses 12,000

Total Current 96,000 Total Current 48,000

Other Assets 40,000 Long-Term Debt 20,000

Common Stock 32,000

Total assets $136,000 Retained Earnings 8,000

Total Liability

and Equity $108,000

80

6-20. Net Profits = $24,000

6-21. Additional Funds Needed = $28,000

6-22. Retained Earnings = $8,000

6-23. Total Assets = $136,000

(Comprehensive)

6-24. The determination of additional funds needed is one of the most important reasons

for producing pro forma financial statements. With this knowledge, the financial

manager can make the necessary financing arrangements in the financial markets

before a crisis occurs. (Page 145)

6-25. Beginning Retained Earnings: $11,000 + Net Income: $5,500 – Dividends paid:

$825 = Ending Retained Earnings: $15,675 + Common Stock: $12,500 = Total

Common Equity: $28,175. (Page 144)

6-26. Beginning Retained Earnings: $44,000 + Net Income: $30,000 – Dividends paid:

$0 = Ending Retained Earnings: $74,000+ Common Stock: $50,000 = Total

Common Equity: $124,000. (Page 144)

6-27. You need to consider the liquidity level of the firm as well as the overall debt

position. Debt financing increase the risk level of the firm if the financial

manager is not careful. Liquidity decreases as the firm may be unable to meet its

debt payments. (Page 146)

6-28.

2012 2013

a. Current Ratio 3 1.5

b. Debt to Assets Ratio 25% 41%

c. Net Profit Margin 10% 25%

d. Return on Assets 6.25% 20.4%

e. Return on Equity 8.33% 34.48% (Comprehensive)

6-29. Profitability is obviously up by a great deal. The financial manager, however,

should consider the price of this increase. The large increase in the debt level

could make bankers and investors nervous. The decrease in liquidity levels

should also be addressed. Of course, more years of statements as well as industry

analysis is needed to do a good job of financial analysis. (Comprehensive)

6-30. $200,000 (Pages 142-143)

6-31. Without any additional information, we would assume that G & A Expenses

would remain unchanged as they do not typically move spontaneously with sales.

(Page 141)

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