SM Chapter 13

13-1
CHAPTER 13
Financial Statement Analysis
OVERVIEW OF EXERCISES, PROBLEMS, AND CASES
Learning Objective
Exercises
Estimated
Time in
Minutes
Level
1. Explain the various limitations and considerations in financial

statement analysis.
2. Use comparative financial statements to analyze a company
over time (horizontal analysis).
12*
13*
45
30
Mod
Mod
3. Use common-size financial statements to compare various

financial statement items (vertical analysis).
12*
13*
45
30
Mod
Mod
4. Compute and use various ratios to assess liquidity.
1
2
3
4
5
15
15
30
20
30
Mod
Mod
Mod
Mod
Mod
5. Compute and use various ratios to assess solvency.
6
7
20
20
Mod
Mod
8
9
10
11
20
20
15
10
Mod
Mod
Mod
Mod
6. Compute and use various ratios to assess profitability.
7. Explain how to report on and analyze other income statement

items (Appendix)
*Exercise, problem, or case covers two or more learning objectives
Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
13-2
FINANCIAL ACCOUNTING SOLUTIONS MANUAL
Learning Objective
Problems
and
Alternates
Estimated
Time in
Minutes
Level

statement analysis.
2. Use comparative financial statements to analyze a company over
time (horizontal analysis).
3. Use common-size financial statements to compare various financial
statement items (vertical analysis).
1
2
5*
7*
40
40
30
40
Mod
Mod
Mod
Mod
1#
2#
5*
6*
7*
30
30
30
40
40
Mod
Mod
Mod
Diff
Mod
3
4
5*
6*
7*
20
60
30
40
40
Mod
Diff
Mod
Diff
Mod

items (Appendix).
#Alternate problem only
CHAPTER 13 FINANCIAL STATEMENT ANALYSIS
13-3
Estimated
Time in
Minutes
Level
2. Use comparative financial statements to analyze a company over 1

time (horizontal analysis).
45
Mod
3. Use common-size financial statements to compare various

financial statement items (vertical analysis).
2
3
6
45
45
45
Mod
Mod
Mod
4*
5*
7*
8
45
45
45
30
Mod
Mod
Diff
Med
4*
5*
7*
45
45
45
Mod
Mod
Diff
4*
5*
45
45
Mod
Mod
Learning Objective
Cases

statement analysis.

items (Appendix)
13-4
QUESTIONS
1.
The inventory valuation method used by a company will have a significant

effect on many ratios. Depending on the relative movement of prices, the
choice between LIFO and FIFO will result in significantly different amounts
reported for inventory. For example, in a period of rising prices, the use of
LIFO will reduce inventory (relative to what it would have been under
FIFO) and thus reduce the current ratio and the acid-test ratio. The
inventory turnover ratio will differ as well, because LIFO will result in more
cost of goods sold expense. Thus, all other things being equal, in a period
of rising prices, a LIFO company will report a higher turnover of inventory
than a FIFO company. The LIFO companys cash flow will be better
because it will pay less in taxes. Thus, the various ratios that involve cash
from operations will be affected. Finally, the profitability ratios will be
affected by the choice of an inventory method. For example, the LIFO
company will report lower profits and thus have a lower profit margin.
2.
One of the difficulties in comparing a companys ratios with industry

standards is that the standards are an average for all companies
surveyed. First, your company may be much larger or smaller than the
average company in the survey. Second, many large companies today are
conglomerates, and their operations cross over the traditional boundaries
of any one industry. This makes comparison with industry standards
difficult. Finally, your company may use different accounting methods than
most others in the survey. If your company uses straight-line depreciation
but a majority of the sample companies use accelerated depreciation,
comparisons can be difficult.
3.
Published financial statements, as well as those often used by

management, are based on historical costs and have not been adjusted for
inflation. Trend analysis is one type of analysis that must be performed
with particular caution if inflation is significant. An increase in sales, for
example, may be due to an increase in prices, rather than to an increase
in the number of units sold. Inflation affects the various financial
statements differently. Some period expenses, such as advertising, are
usually not seriously misstated in historical cost terms.
However,
depreciation based on costs paid for assets that are fifty years old will be
much different from depreciation adjusted for the effects of inflation.
4.
The analysis of financial statements over a series of years is called

horizontal analysis. For example, by looking for trends in certain costs
over a series of years (thus the name trend analysis), the analyst is able to
more accurately predict future costs. Common-size financial statements
are statements in which all amounts are stated as a percentage of one
selected item on the statement, such as net sales. Thus, vertical analysis
of a single years income statement will help the analyst discern the
relative amounts incurred for various costs.
13-5
5.
Rising costs to either manufacture or purchase inventory could be

responsible for a decline in gross profit in the face of an increase in sales.
Assume that 1,000 units of a product are sold with a unit cost of $80 and a
selling price of $100. Sales total $100,000, and gross profit is $20,000.
Assume that in the following year, the company raises the selling price to
$115 because of rising costs. If the cost to make a unit goes up to $96
and the company sells another 1,000 units, sales will increase by 15% to
$115,000, but gross profit will decrease to 1,000 X ($115 $96), or
$19,000a decrease in gross profit of 5%.
6.
The composition of current assets indicates the relative size of cash,

accounts receivable, inventory, and other short-term assets. A relatively
large balance in inventory may indicate that a company is not turning over
its products quickly enough. Similarly, a large accounts receivable
balance could signal a problem in the collection department. Finally, a
large cash balance may be a sign that the company is not taking
advantage of short-term investment opportunities.
7.
Ratios can be categorized according to their use in performing three types

of analysis: (1) liquidity analysis, (2) solvency analysis, and (3) profitability
analysis.
8.
The first stage in the operating cycle for a manufacturer is the purchase of
raw material and its transformation into a final product. The second step is
the sale of the product, and the third is the collection of any receivable
from credit granted to the customer. The operating cycle differs for a
retailer in that a finished product is purchased from a wholesaler and there
is not the time involved in production.
9.
Current assets are reported on a balance sheet in the order of their

nearness to cash, or liquidity. Cash is obviously presented first, followed
by short-term investments. Accounts receivable, one step removed from
cash, are shown next, and then inventory. Because prepaid assets, such
as supplies or insurance paid for in advance, will not be converted into
cash, they are normally reported last in the current asset section of the
balance sheet.
10.
A relatively low acid-test or quick ratio compared with the current ratio
probably indicates a large inventory balance. Large amounts of inventory
may be normal for a company, but on the other hand they could signal
problems in moving obsolete items. The inventory turnover ratio for the
most recent period should be compared with those of prior periods to
determine whether there has been a decrease in the number of turns per
year. A less likely explanation for a low quick ratio compared with the
current ratio would be large balances in various prepayments, such as
supplies and insurance.
13-6
11.
All turnover ratios are a measure of the activity for a period compared with
the investment necessary to carry on that activity. For example, the
inventory turnover ratio measures the relationship between inventory sold,
on a cost basis, and the average amount of inventory on hand during that
time period. The base is the average inventory because it is divided into
an activity measure for the entire periodthat is, cost of goods sold.
12.
An accounts receivable turnover of nine times translates to an average

number of days in receivables of 40 (360/9). If the credit department
extends terms of 2/10, net 30, investigation of the companys actual credit
policies is warranted. For example, the department may routinely give
customers up to 40 or 50 days to pay. If this policy does not create any
cash flow problems, why have terms of 2/10, net 30? Alternatively, the
average time to collect may be an indication that the credit department is
extending credit to customers who are not good credit risks.
13.
One possible explanation for a decrease in inventory turnover is slowmoving items. Caution must be used, however, because a low inventory
turnover may simply be a seasonal phenomenon. For example, the ratio
for the third quarter of the year should be compared with that of the third
quarter of the prior year. Problems in the sales department may also
partially explain a low turnover of inventory. Or, the company may be
pricing itself out of the market and need to consider lowering its prices to
meet the competition.
14.
A manufacturers operating cycle runs from the purchase of raw materials,

to the transformation of the materials into a final product, to sale, to the
collection of any receivable. This differs from the operating cycle of a
service business because the latter does not technically sell a product.
Service businesses must look for alternative measures of efficiency. For
example, an airline would be interested in the average amount of time
elapsed between the sale of a ticket and collection from the passenger. A
public accounting firm might want to know the average length of time that
passes after an audit is finished before the client pays the bill.
15.
Liquidity analysis is concerned with the ability of the company to pay its
debts as they are due and thus focuses on the current assets and
liabilities. Solvency is the ability to stay in business over the long run.
The debt-to-equity ratio and the debt service coverage ratio are two
measures of the firms solvency.
16.
The debt service coverage ratio is superior to the times interest earned
ratio as a measure of solvency for two reasons. First, the ratio considers
the need to pay both interest and principal, whereas the times interest
earned ratio deals only with interest. Second, the necessary payments to
service debt are compared with the cash available to pay the debt, while
the times interest earned ratio uses an accrual income number in its
numerator.
13-7
17.
Both are right. Many different ratios are used to assess the relative mix of
a companys capital structure. The debt-to-equity ratio measures the
amount of outstanding debt relative to the amount of stockholders equity.
An alternative measure is to divide the same debt by the total assets of the
company. A different ratio will obviously result, but as long as the same
measure is used consistently, either ratio is an indicator of solvency.
18.
The debt service coverage ratio measures the amount of cash generated
from operating activities that is available to repay the interest and any
maturing debt. A loan officer is primarily concerned with the companys
ability to meet interest and principal payments on time and, therefore,
would be very interested in this ratio.
19.
Dividends are not a legal obligation, but they often become an expectation
on the part of stockholders. Therefore, when computing the cash available
to make capital acquisitions, it is helpful to take into account the normal
dividend requirements.
20.
The numerator in any rate of return ratio must match the investment or
base in the denominator. If total assets is the base, the numerator must be
a measure of the income available to all providers of capital. Interest
expense, net of tax, is added back to net income because the creditors are
one of the sources of capital, and we want to consider the income
available before any of the sources of funds are given a distribution.
Interest must be on a net or after-tax basis to be consistent with net
income, which is on an after-tax basis.
21.
A return on stockholders equity that is lower than the return on assets

means that the company is not successfully using borrowed funds. Return
on assets measures the return to all providers of capital, whereas return
on equity is concerned only with common stockholders. The company has
not been able to earn an overall return that is as high as what is being
paid to creditors and preferred stockholders. Leverage deals with the use
of someone elses money to earn a favorable return. Presently, this
company is not successfully employing financial leverage.
22.
The price/earnings ratio is sometimes used as an indicator of the quality of

a companys earnings because it combines a measure of the companys
performance, based on its earnings, and the companys worth as
measured by the market price of its stock. The ratio of price to earnings is
an indication of the markets assessment of the companys performance.
For example, the use of different accounting methods can cause the
market to value the price of one companys stock higher than another
companys stock, even though they report similar earnings. This could be
the case if one defers taxes by using LIFO whereas the other uses FIFO.
This differing treatment of the two stocks is a statement by the market
about the quality of the two companys earnings.
13-8
23.
Most of the liquidity ratios are primarily suited to use by management. For
example, the investor would not normally place major emphasis on the
turnover of either inventory or receivables. On the other hand, turnover
ratios must be constantly monitored by management. The stockholder will
be very interested in both the dividend payout ratio and the dividend yield.
A banker would rely partially on a companys debt service coverage in the
past as an indication of its ability to repay a potential loan in the future.
24.
The inventory turnover ratio is meaningless to a service business such as

a law firm or a public accounting firm. These firms do not sell a tangible
product; instead, they sell their professional expertise and thus must rely
on alternative measures of their efficiency in marketing their services. An
accounting firm, for example, might keep detailed records on the number
of clients served, the average annual billings to each client, and the ratio
of these billings to the average costs incurred on each audit.
25. Separate reporting of discontinued operations, extraordinary items and the

cumulative effect of a change in accounting principle assists the reader of
the statements in making predictions about the future profitability of the
business. For example, users of the income statement may want to ignore
these items when assessing the future prospects for the company because
these items by their nature are not likely to reoccur in the future.
EXERCISES
LO 4
EXERCISE 13-1 ACCOUNTS RECEIVABLE ANALYSIS
1. Accounts receivable turnover:

Net credit sales/Average accounts receivable:
2004: $600,000/[($150,000 + $100,000)/2] = $600,000/$125,000 = 4.8 times
2003: $540,000/[($100,000 + $80,000)/2] = $540,000/$90,000 = 6 times
2. Number of days sales in receivables:
2004: 360/4.8 = 75 days
2003: 360/6 = 60 days
3. The average age of a receivable in 2003 was the same number of days as
the maximum credit period of 60 days. The average age in 2004 of 75 days,
however, is significantly in excess of the credit period. The company needs
to investigate this increase and decide whether efforts are needed to speed
up the collection process.
The company may decide that allowing
customers more liberal payment terms has had a positive effect on sales, as
evidenced by the increase in sales, and not want to press its customers for
earlier payment. Conversely, the company may find that allowing an extra
15 days for payment causes cash flow problems.
LO 4
13-9
EXERCISE 13-2 INVENTORY ANALYSIS
1. Inventory turnover:
Cost of goods sold/Average inventory:
2004: $7,100,000/[($200,000 + $150,000)/2] = $7,100,000/$175,000
= 40.57 times
2003: $8,100,000/[($150,000 + $120,000)/2] = $8,100,000/$135,000
= 60 times
2. Number of days sales in inventory:
2004: 360/40.57 = 8.9 days
2003: 360/60 = 6 days
3. Inventory turnover has declined dramatically from the prior year. Many
different explanations are possible for this decline, such as problems in the
sales effort, over-pricing of the products relative to the competition, or
inferior produce. Management needs to investigate the problem and decide
who should be held responsible for the slow movement. The company may
find that no one department or individual is totally responsible and that many
different parts of the business need to work together to improve the turnover
of inventory.
LO 4
EXERCISE 13-3 ACCOUNTS RECEIVABLE AND INVENTORY

ANALYSES FOR COCA-COLA AND PEPSI
1. Calculations (all dollar amounts in millions):

a. Accounts Receivable Turnover Ratio:
Coca-Cola Company
$19,564/[($2,097 + $1,882)/2] = $19,564/$1,989.5 = 9.83 times
PepsiCo, Inc.
$25,112/[($2,531 + $2,142)/2] = $25,112/$2,336.5 = 10.75 times
b. Days Sales in Receivables:
Coca-Cola Company
360/9.83 = 36.6 days
PepsiCo, Inc.
360/10.75 = 33.5 days
c. Inventory Turnover Ratio:
Coca-Cola Company
$7,105/[($1,294 + $1,055)/2] = $7,105/$1,174.5 = 6.0 times
PepsiCo, Inc.
$11,497/[($1,342 + $1,310/2] = $11,497/$1,326 = 8.7 times
13-10
d. Days Sales in Inventory:

Coca-Cola Company
360/6.0 = 60 days
PepsiCo, Inc.
360/8.7 = 41.4 days
e. Cash to Cash Operating Cycle:
Coca-Cola Company
36.6 + 60 = 96.6 days
PepsiCo, Inc.
33.5 + 41.4 = 74.9 days
2. PepsiCo, Inc. has a higher accounts receivable turnover ratio and,
accordingly, a lower number of days sales in receivables than Coca-Cola.
PepsiCo, Inc. also a higher inventory turnover ratio and, accordingly, a lower
number of days sales in inventory. PepsiCo, Inc. also has a lower cash to
cash operating cycle.
LO 4
EXERCISE 13-4 LIQUIDITY ANALYSES FOR COCA-COLA AND

PEPSICO
1. Calculations (all dollar amounts in millions):

Coca Cola Company
PepsiCo, Inc.
a.
Current ratio
$7,352/$7,341 = 1.00 to 1
$6,413/$6,052 = 1.06 to 1
b.
Quick assets
$2,126 + $219 + $2,097

= $4,442
$1,638 + 207 + $2,531

$4,376
Acid-test or
Quick ratio
$4,442/$7,341 = .61 to 1
$4,376/$6,052 = .72 to 1
2. PepsiCos current and acid-test (or quick) ratios are higher than Coca
Colas. Based on these measures, PepsiCo appears to be more liquid than
Coca Cola.
3. Other ratios that can be used to more fully assess the liquidity of these two
companies are these: cash flow from operations to current liabilities ratio,
accounts receivable turnover ratio, number of days sales in receivables,
inventory turnover ratio, number of days sales in inventory, and cash to
cash operating cycle.
LO 4
13-11
EXERCISE 13-5 LIQUIDITY ANALYSES FOR

MCDONALDS AND WENDYS
1. Calculations:
McDonalds
(In millions)
$1,715.4 $2,422.3
= $(706.9)
$1,715.4/$2,422.3
= .71
Wendys
(In thousands)
$330,819 $360,075
= $(29,256)
$330,819/$360,075
=.92
a.
Working capital
b.
Current ratio
c.
Quick assets
$330.4+$855.3
= $1,185.7
$171,944+$86,416+11,204
= $ 269,564
Acid-test or
Quick ratio
$1,185.7/$2,422.3
= .49
$269,564/$360,075
= .75
2. Both McDonalds and Wendys have negative working capital. Wendys

current and acid-test (or quick) ratios are both higher than McDonalds.
Based on these measures, Wendys appears to be somewhat more liquid
than McDonalds.
3. Calculations of cash flow from operations to current liabilities ratios:
McDonalds (in millions)
$2,890.1/[($2,422.3 + $2,248.3)/2] = $2,890.1/$2,335.3 = 123.8%
Wendys (in thousands)
$444,256/[($360,075 + $296,687)/2] = $444,256/$328,381 = 135.3%
This ratio overcomes the two limitations of the current and the quick ratios,
because it focuses on cash and cash flows. McDonalds cash flow from
operations to current liabilities ratio is slightly lower than Wendys.
Together with the current and quick ratios, Wendys appears to be more
liquid overall than is McDonalds.
4. McDonalds has negative working capital but a strong cash flow from
operations to current liabilities ratio. As such, McDonalds might be able to
cover its short-term cash requirements through short-term borrowings.
13-12
LO 5
EXERCISE 13-6 SOLVENCY ANALYSES FOR

TOMMY HILFIGER
1.
2003
$984,776/$1,043,375
= .94 to 1
2002
$1,096,989/1,497,462
= .73 to 1
Times interest
earned
[($513,605)+ $46,976 +
$14,144]/$46,976 =
($452,485)/$46,976
= (9.6) to 1
($134,545+ $41,177 +
$20,069)/$41,177 =
$195,791/$41,177
= 4.8 to 1
Debt service
coverage
ratio*
($230,105 + $46,976 +
$14,144)/($46,976 +
$74,234) = $291,225/
$121,210 = 2.4 times
($353,100 + $41,177 +
$20,069)/($41,177+
$155,538)= $414,346/
$196,715 = 2.1 times
a.
Debt-to-equity
ratio
b.
c.
*The amounts for interest and taxes represent interest expense and income
tax expense rather than the amounts paid.
d.
Cash flow from

($230,105 $0)/$71,903
operations to
($353,1000)/$96,923
to capital
= 320.0%
= 364.3%
capital expenditures ratio
2. The companys debt to equity ratio increased during 2003, due in large part
to the significantly lower stockholders equity, the result of the net loss
recorded for the year. The net loss results in a times interest earned ratio
that is a negative number for 2003. Interestingly, the company continued to
generate positive cash flow from operating activities, and even though the
ratio of this number to capital expenditures decreased slightly, the debt
service coverage ratio actually increased in 2003.
LO 5
1. a.
b.
EXERCISE 13-7 SOLVENCY ANALYSIS
Debt-to-equity ratio: Total liabilities/Total stockholders equity

At 12/31/04:
($350,000 + $600,000)/$1,650,000
= $950,000/$1,650,000 = .58 to 1
At 12/31/03:
($405,000 + $800,000)/$1,500,000
= $1,205,000/$1,500,000 = .80 to 1
Times interest earned for 2004 (Net income + Interest expense +

Income tax expense)/Interest expense:
($150,000 + $89,000 + $111,000)/$89,000 = $350,000/$89,000 =
3.93 to 1
13-13
c. Debt service coverage for 2004 (Cash flows from operations before
interest and tax payments)/Interest and principal payments:
($185,000 + $89,000+ $96,000*)/($89,000 + $275,000**) =
$370,000/$364,000 = 1.02 times
*Taxes payable, 12/31/03
$ 45,000
Add: Tax expense
111,000
Less: Taxes payable 12/31/04
65,000
Taxes paid during 2004
$ 96,000
**Principal payments:
a. Short-term notes payable
b. Serial bonds
Total
$ 75,000
200,000
$ 275,000
2. The companys debt-to-equity ratio has decreased because of the

repayment of the short-term notes and the installment payment on the serial
bonds. The ratio at the end of 2004 of almost .6 to 1 indicates a relatively
conservative balance of debt to stockholders equity. The times interest
earned ratio indicates that Impacts profits before interest and taxes were
almost four times the amount of interest expense.
Two problems arise, however, in using the times interest earned ratio as
the sole measure of solvency. First, it considers the payment of only
interest, not principal. Second, principal and interest payments must be
made with cash, not profits. The debt service coverage ratio is a much
better indication of the companys ability to meet its obligations. A ratio of
1.02 times indicates that Impact generated just enough cash from operations
to meet its principal and interest payments in 2004.
LO 6
EXERCISE 13-8 RETURN RATIOS AND LEVERAGE
1. Ratios:
a.
Return on sales = (Net income + Interest expense, net of tax)/Net sales

[($60,000 + ($50,000 X 60%)]/$650,000
= $90,000/$650,000 = 13.85%
b.
Asset turnover = Net sales/Average total assets

$650,000/[($1,600,000 + $2,000,000*)/2]
= $650,000/$1,800,000 = .36 times
*Total assets at end of year are the same as total liabilities and
stockholders equity (given).
c.
Return on assets = (Net income + Interest expense, net of tax)/Average

total assets
$90,000 (from Part a.)/$1,800,000 (from Part b.) = 5%
13-14
d.
Return on common stockholders equity = (Net income Preferred

dividends)/Average common stockholders equity
($60,000 $25,000*)/[($950,000 + $915,000**)/2]
= $35,000/$932,500 = 3.75%
*Preferred dividends: $250,000 par value X 10%
**Stockholders equity at beginning of year:
Common stock
Retained earnings $350,000 at end of
year less $60,000 net income plus
$25,000 dividends
Stockholders equity at beginning of year
$ 600,000
315,000
$ 915,000
2. Evergreen has not been successful in using outside funds because the
return on stockholders equity of 3.75% is less than the return to all
providers of capital, as measured by the return on assets of 5%.
Evidence that Evergreen has not successfully employed leverage is
found by looking closer at the cost of outside funds. The average cost of
borrowed funds is $50,000 in interest expense divided by $650,000 in shortterm loans payable and long-term bonds. This cost of 7.7% times 1 minus
the tax rate, or 60%, translates to an after-tax borrowing rate of 4.62%. The
return paid to the preferred stockholders is 10%. Both of these rates exceed
the return to the common stockholder of 3.75% and indicate that Evergreen
is not successfully employing leverage.
LO 6
EXERCISE 13-9 RELATIONSHIPS AMONG

RETURN ON ASSETS, RETURN ON SALES, AND
ASSET TURNOVER
Case 1.
Return on assets = Net income (assuming no interest

expense)/Average total assets = $10,000/$60,000 = 16.67%.
Case 2.
Return on sales = Net income/Net sales

2% = $25,000/X
Net sales = $1,250,000
Case 3.
Return on assets = Return on sales

X = 6% X 1.5
Return on assets = 9%
Case 4.
Asset turnover = Net sales/Average total assets.

1.25 = $50,000/X
Average total assets = $40,000
Return on assets = Net
expense)/Average total assets
10% = X/$40,000
Net income = $4,000
Asset turnover
income
(assuming
no
interest
Case 5.
LO 6
Return on assets = Net income

expense)/Average total assets
15% = $20,000/X
Average total assets = $133,333
(assuming
no
13-15
interest
EXERCISE 13-10 EPS, P/E RATIO, AND

DIVIDEND RATIOS
1. Ratios:
a. Earnings per common share = (Net income
dividends)/Number of common shares outstanding:
[$1,300,000 8%($5,000,000)]/400,000 shares
= ($1,300,000 $400,000)/400,000
= $900,000/400,000 = $2.25 per share
less
preferred
b.
Price earnings ratio = Current market price/EPS

= $24.75/$2.25 = 11 to 1
c.
Dividend payout ratio = Common dividends per share/EPS

= ($.40 X 4 quarters)/$2.25
= $1.60/$2.25 = 71.11%
d.
Dividend yield ratio = Common dividends per share/Market price

= $1.60 (from Part c.)/$24.75 = 6.46%
2. An investment advisor needs to be aware of industry trends, the general

economic environment, the historical performance of the company, the
investors attitudes about risk, and any other relevant data needed to make
an informed decision.
LO 6
EXERCISE 13-11 EARNINGS PER SHARE AND

EXTRAORDINARY ITEMS (APPENDIX)
1. Earnings per share before extraordinary items = (Net income before

extraordinary loss less preferred dividends)/Number of common shares
outstanding:
[$5,850,000 (9%)($2,000,000)]/1,500,000 shares
= ($5,850,000 $180,000)/1,500,000 shares
= $5,670,000/1,500,000 shares = $3.78 per share
2. Earnings per share (after the extraordinary loss) = (Net income preferred
dividends)/Number of common shares outstanding:
($2,130,000 $180,000)/1,500,000 shares
= $1,950,000/1,500,000 = $1.30 per share
3. Management is accountable for the overall operation of the company and
thus, to some extent, must be evaluated on the basis of the bottom line as
measured by the earnings per share after the extraordinary loss from the
flood. In attempting to forecast future profits, however, both management
and a potential stockholder would be much more concerned with EPS
13-16
exclusive of any extraordinary items, because these gains and losses are
unusual in nature and infrequently occurring.
MULTI-CONCEPT EXERCISES
LO 2,3
1.
EXERCISE 13-12 COMMON-SIZE BALANCE

SHEETS AND HORIZONTAL ANALYSIS
FARINET COMPANY
COMMON-SIZE COMPARATIVE BALANCE SHEETS
DECEMBER 31, 2004 AND 2003
Cash
Accounts receivable
Inventory
Prepaid rent
Total current assets
Land$
Plant and equipment
Accumulated
depreciation
Total long-term
assets
Total assets
Accounts payable
Income taxes payable
Short-term notes
payable
Total current
liabilities
Bonds payable
Common stock
Retained earnings
Total stockholders
equity
Total liabilities and
stockholders equity
12/31/04
Dollars
Percent
$ 16,000
1.7%*
40,000
4.3
30,000
3.3
18,000
2.0
$ 104,000
11.3%
150,000
16.2%
800,000
86.6
(130,000)
(14.1)
12/31/03
Dollars
Percent
$ 20,000
2.5%*
30,000
3.8
50,000
6.2
12,000
1.5
$ 112,000
14.0%
150,000
18.7%
600,000
74.8
(60,000)
$ 820,000
$ 924,000
88.7
100.0%
$ 690,000
$ 802,000
86.0
100.0%
$ 24,000
6,000
2.6%
.6
$ 20,000
10,000
2.5%
1.3
70,000
7.6
50,000
6.2
$ 100,000
$ 150,000
$ 400,000
274,000
10.8%
16.2%
43.3%
29.7
$ 80,000
$ 200,000
$ 300,000
222,000
10.0%
24.9%
37.4%
27.7
$ 674,000
73.0%*
$ 522,000
65.1%
$ 924,000
100.0%
$ 802,000
100.0%
*Rounded to total.
2.
(7.5)
Observations from Farinets common-size balance sheets:
13-17
a. Current assets as a percentage of total assets has decreased. At the

same time, current liabilities has accounted for about the same
percentage of total equities in the two years.
b. The relative mix of current assets has changed from one year to the next.
Cash now accounts for a smaller share of total assets, as does inventory,
whereas accounts receivable accounts for a slightly higher percentage of
total assets.
c. Major investments in plant and equipment have been made in 2004. At
the end of 2003, plant and equipment accounted for three-fourths of the
total assets, and now it accounts for over 86% of the total.
d. Bonds payable now make up a smaller share of the capital structure with
the retirement of $50,000 during 2004.
e. Short-term borrowings increased and now represent a larger share of the
current liabilities (from $50,000/$80,000, or 62.5%, to $70,000/$100,000,
or 70%).
13-18
3.
FARINET COMPANY
COMPARATIVE BALANCE SHEETS
DECEMBER 31, 2004 AND 2003
Cash
Accounts receivable
Inventory
Prepaid rent
Land
Plant and equipment
Accumulated
depreciation
Total long-term
assets
Total assets
Accounts payable
Income tax payable
Short-term notes
payable
Total current
liabilities
Bonds payable
Common stock
Retained earnings
Total stockholders
equity
Total liabilities and
stockholders equity
December 31
2004
2003
$ 16,000
$ 20,000
40,000
30,000
30,000
50,000
18,000
12,000
$ 104,000
$ 112,000
$ 150,000
$ 150,000
800,000
600,000
(130,000)
Increase (Decrease)
Dollars
Percent
$ (4,000)
(20)%
10,000
33
(20,000)
(40)
6,000
50
$ (8,000)
(7)%
$
0
0%
200,000
33
(60,000)
(70,000)
(117)
$ 820,000
$ 924,000
$ 690,000
$ 802,000
$ 130,000
$ 122,000
19%
15%
$ 24,000
6,000
$ 20,000
10,000
70,000
50,000
$ 100,000
$ 150,000
$ 400,000
274,000
$ 80,000
$ 200,000
$ 300,000
222,000
$ 20,000
$ (50,000)
$ 100,000
52,000
25%
(25)%
33%
23
$ 674,000
$ 522,000
$ 152,000
29%
$ 924,000
$ 802,000
$ 122,000
15%
4,000
(4,000)
20%
(40)
20,000
40
4.
a.
Largest changes
Accumulated depreciation
b.
c.
d.
Prepaid rent
Inventory
Income tax payable
e.
Short-term notes payable
LO 2,3
1.
13-19
Refer to
Fixed asset records, showing
additions to plant and
equipment and depreciation
calculations
Rental agreements
Purchase orders, sales records
Income tax return and
supporting records
Loan agreements
EXERCISE 13-13 COMMON-SIZE INCOME

STATEMENTS AND HORIZONTAL ANALYSIS
MARINERS CORP.
COMMON-SIZE COMPARATIVE INCOME STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003
(IN THOUSANDS OF DOLLARS)
Sales revenue
Cost of goods sold
Gross profit
Selling and administrative expense
Operating income
Interest expense
Income before tax
Income tax expense
Net income
2004
Dollars
Percent
$ 60,000
100.0%
42,000
70.0
$ 18,000
30.0%
2003
Dollars
Percent
$ 50,000
100.0%
30,000
60.0
20,000
40.0%
9,000
$ 9,000
2,000
$ 7,000
2,000
$ 5,000
5,000
$ 15,000
2,000
$ 13,000
4,000
$ 9,000
15.0
15.0%
3.3
11.7%
3.3
8.4%*
10.0
30.0%
4.0
26.0%
8.0
18.0%
*Rounded to total.
2. Observations from Mariners common-size statements:
a. Although sales increased in absolute dollars, the gross profit percentage
has decreased significantly because of a higher ratio of cost of goods
sold to sales: from 60% to 70%.
b. Selling and administrative expenses have increased both in absolute
dollars and as a percentage of sales. An increase from 10% to 15% of
sales is a drastic increase in the importance of this cost relative to sales.
c. Interest expense remained the same in absolute dollars, but because
sales increased, it decreased slightly from 4% to 3.3% of sales.
d. The bottom line net income decreased both in absolute dollars and as a
percentage of sales. The solid increase in sales is more than offset by
the large increases in both product costs and selling and administrative
expenses.
13-20
3.
MARINERS CORP.
COMPARATIVE STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 2004 AND 2003
Sales revenue
Cost of goods sold
Gross profit
Selling and administrative expense
Operating income
Interest expense
Income before tax
Income tax expense
Net income
4.
Largest changes
Selling and administrative
expenses
Income tax expense
December 31
2004
2003
$ 60,000
$ 50,000
42,000
30,000
$ 18,000
$ 20,000
Increase (Decrease)
Dollars
Percent
$ 10,000
20%
12,000
40
$ (2,000)
(10)%
9,000
$ 9,000
2,000
$ 7,000
2,000
$ 5,000
$ 4,000
$ (6,000)
0
$ (6,000)
(2,000)
$ (4,000)
5,000
$ 15,000
2,000
$ 13,000
4,000
$ 9,000
80
(40)%
0
(46)%
(50)
(44)%
Refer to
Individual records, for the
various expenses
Income tax return and supporting
records
PROBLEMS
LO 4
PROBLEM 13-1 EFFECT OF TRANSACTIONS ON

WORKING CAPITAL, CURRENT RATIO, AND QUICK
RATIO
1. Calculation of working capital, current ratio, and quick ratio (dollar amounts
in thousands):
Working capital
($70 + $60 + $80 + $100 + $10) ($75 + $25 + $40 + $60)
= $320 $200 = $120
Current ratio
$320/$200 = 1.60 to 1
Quick ratio
($70 + $60 + $80)/$200 = $210/$200 = 1.05 to 1
2.
Effect of transactions on working capital, current ratio, and quick ratio:
Transaction
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
Working
Capital
(in Thousands)
Effect
of
Transaction
Current
Ratio
$120
none
1.545
decrease
.955
decrease
$120
none
1.60
none
.975
decrease
$120
none
1.706
increase
1.059
increase
$120
none
1.60
none
1.05
none
$120
none
1.60
none
.95
decrease
$180
increase
1.90
increase
1.35
increase
$120
none
1.686
increase
1.057
increase
$120
none
1.50
decrease
1.042
decrease
$ 75
decrease
1.375
decrease
.825
decrease
$120
$ 90
none
decrease
1.60
1.45
none
decrease
$105
decrease
1.488
decrease
Purchased inventory
on account, $20,000
Purchased inventory
for cash, $15,000
Paid suppliers on
account, $30,000
Received cash on
account, $40,000
Paid insurance for
next year, $20,000
Made sales on account,
$60,000
Repaid short-term loans
at bank, $25,000
Borrowed $40,000 at
bank for 90 days
Declared and paid
$45,000 cash dividend
Purchased $20,000 of
trading securities
Paid $30,000 in salaries
Accrued additional
$15,000 in taxes
LO 4
Effect
of
Transaction
13-21
Quick
Ratio
1.05
.90
.977
Effect
of
Transaction
none
decrease
decrease
PROBLEM 13-2 EFFECT OF TRANSACTIONS ON

WORKING CAPITAL, CURRENT RATIO, AND QUICK
RATIO
1. Calculation of working capital, current ratio and quick ratio (dollar amounts
in thousands):
Working capital
($70 + $60 + $80 + $100 + $10) ($75 + $25 + $40 + $210)
= $320 $350 = $(30)
Current ratio
$320/$350 = .91 to 1
Quick ratio
($70 + $60 + $80)/$350 = $210/$350 = .60 to 1
2.
Effect of transactions on working capital, current ratio, and quick ratio:
13-22
Transaction
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
Purchased inventory
on account, $20,000
Purchased inventory
for cash, $15,000
Paid suppliers on
account, $30,000
Received cash on
account, $40,000
Paid insurance for
next year, $20,000
$60,000
at bank, $25,000
Borrowed $40,000 at
bank for 90 days
Declared and paid
trading securities
Accrued additional
$15,000 in taxes
LO 6
Working
Capital
(in Thousands)
Effect
of
Transaction
Current
Ratio
$(30)
none
.919
$(30)
none
$(30)
Effect
of
Transaction
Quick
Ratio
Effect
of
Transaction
increase
.568
decrease
.91
none
.557
decrease
none
.906
decrease
.563
decrease
$(30)
none
.91
none
.60
none
$(30)
none
.91
none
.543
decrease
$ 30
increase
1.086
increase
.771
increase
$(30)
none
.908
decrease
.564
decrease
$(30)
none
.923
increase
.641
increase
$(75)
decrease
.786
decrease
.471
decrease
$(30)
$(60)
none
decrease
.91
.829
none
decrease
.60
.514
none
decrease
$(45)
decrease
.887
decrease
.575
decrease
PROBLEM 13-3 GOALS FOR SALES AND RETURN ON

ASSETS
1. a. Return on sales = net income after adding back interest expense,

net of tax/net sales
= $5,000,000/$60,000,000 = 8.33%
b. Asset turnover = net sales/average total assets
= $60,000,000/$40,000,000 = 1.5 times
c. Return on assets = return on sales
= 8.33% X 1.5 = 12.5%
asset turnover
2. Asset turnover = ($60,000,000 X 120%)/($40,000,000

= $72,000,000/$45,000,000 = 1.6 times
112.5%)
3. If average total assets are $45,000,000 and the goal is a 15% return on
assets, net income will need to be 15% of $45,000,000, or $6,750,000.
4. Income will have to increase by 35%, ($6,750,000 $5,000,000)/
$5,000,000, to achieve the goal of a 15% return on assets. The president
has set a goal for an increase in sales of only 20%. To increase income by
a larger percentage than the increase in sales will require cost-cutting in the
various departments of the business. The company may want to look for
13-23
cheaper sources of supply for its materials, as long as the quality of the
product is maintained. Efforts will need to be made to cut selling, general,
and administrative expenses as well.
PROBLEM 13-4 GOALS FOR SALES AND
INCOME GROWTH
LO 6
1. Selected financial data (in millions of dollars):

1. Sales*
2. Net income(sales X 3%)*
3. Dividends declared and paid
(greater of $3,000,000
or 50% of net income)
4. Owners equity, December 31
balance (prior years balance +
net income less dividends)
5. Debt, Dec. 31 balance**
Selected ratios:
6. Return on owners equity
(Item 2/Item 4)
2007
266.2
7.986
2006
242.0
7.26
2005
220.0
6.6
3.993
3.63
3.3
80.923
52.177
76.93
44.07
73.3
36.7
9.9%
9.4%
9.0%
Note: The return on owners equity ratios in the problem for 2002-2004 are
based on year-end owners equity rather than the average for each year.
Therefore, to be consistent, year-end balances are used for 2005-2007.
7.
Debt to total assets

[Item 5/(Item 4 + Item 5)]
39.2%
36.4%
33.4%
*Sales and net income increase at the rate of 10% per year.
**Calculation of total debt balance:
Total assets (sales/asset
turnover rate of 2)
$ 133.100
Less: Owners equity
(Item 4)
80.923
Debt
$ 52.177
$ 121.00
$ 110.0
76.93
$ 44.07
73.3
$ 36.7
2. No, the CEO will not be able to meet all her requirements if a 10% per year
growth in income and sales is achieved. If under the stated assumptions
that the net income to sales ratio be maintained at 3% with annual sales
growth of 10%, and the asset turnover ratio be maintained at 2, the goal of
holding debt to 35% of total assets will be met only in 2005. The debt will
increase to 36.4% of total assets in 2006 and to 39.2% of total assets in
2007 under the proposed plan. The calculations assume that all other
factors remain constant. Because some of the factors that affect stock
prices are outside the companys control, it cannot be determined whether
the main requirement of improving the stock price can be met if the expected
performance is accomplished.
13-24
3. Alternative actions to be considered to improve the return on equity and

support the increased dividend payments:
a. Improve the return on assets by
reducing the asset base through better asset management.
improving asset quality to generate higher returns per dollar
invested, including the acquisition of a subsidiary or a more
profitable line of business.
b. Improve profits by
concentrating production and sales on high profit-producing lines.
cost control efforts to maintain and reduce both variable and fixed
costs.
4. The CEO is probably concerned with the potential impact that greater debt
would have on the companys cost of capital. Increasing debt relative to
owners equity creates added risk, which translates to higher returns
required by investors in the companys stocks and bonds. If investors
perceive that the companys financial risks have increased, the market
prices for its long-term debt issues will fall (interest rates will rise), and
greater dividend payments will be necessary to maintain the market price of
the stock.
MULTI-CONCEPT PROBLEMS
LO 4,5,6
PROBLEM 13-5 BASIC FINANCIAL RATIOS
1. Financial ratios for 2004 for CCB Enterprises (thousands omitted):

a. Times interest earned = (Net income + Income tax expense + Interest
expense)/Interest expense
= ($72,000 + $48,000 + $20,000)/$20,000
= $140,000/$20,000 = 7 to 1
b. Return on total assets = (Net income + Interest expense, net of
tax)/Average total assets
= {$72,000 + [$20,000 X (1 40%*)]}/[($540,000 + $510,000)/2]
= $84,000/$525,000 = 16%
*Tax rate = Income taxes/Income before tax = $48,000/$120,000 = 40%.
c. Return on common stockholders equity = (Net income Preferred
= $72,000/[($260,000 + $217,000)/2]
= $72,000/$238,500 = 30.19%
d. Debt/equity ratio = Total liabilities/Total stockholders equity
= $280,000/$260,000 = 1.08 to 1
13-25
e. Current ratio = Current assets/Current liabilities

= $144,000/$120,000 = 1.2 to 1
f. Quick (acid-test) ratio = (Cash + Marketable securities + Short-term
receivables)/Current liabilities
= ($26,000 + $48,000)/$120,000
= $74,000/$120,000 = .62 to 1
g. Accounts receivable turnover ratio = Net credit sales/Average accounts
receivable
= $800,000/[($48,000 + $50,000)/2]
= $800,000/$49,000 = 16.3 times
h. Number of days sales in receivables = Number of days in
period/Accounts receivable turnover
= 360 days/16.3 times = 22 days
i. Inventory turnover ratio = Cost of goods sold/Average inventory
= $540,000/[($65,000 + $62,000)/2]
= $540,000/$63,500 = 8.5 times
j. Number of days sales in inventory = Number of days in period/Inventory
turnover
k. Number of days in cash operating cycle = Days sales in inventory + Days
sales in receivables
= 42 days + 22 days = 64 days
2. Comments on the overall financial health of CCB Enterprises:
The current ratio indicates a fairly strong liquidity position, although the
significantly smaller quick ratio may signal a problem with excess inventory.
Whether or not the quick ratio is indicative of a liquidity problem could be
determined more accurately by comparing this ratio with prior years, as well
as with an industry average.
Inventory turnover of 8.5 times may not be a problem area (see
discussion of quick ratio above), but it should be compared with those of
prior years and with an industry averageturning over inventory every 42
days may be normal for the industry.
The length of time that receivables are outstanding, 22 days, appears to
be relatively short. It may indicate that the credit department is doing a
good job in screening customers for credit. On the other hand, if the credit
terms are too stringent, the company may be losing good customers.
Comparison of this statistic with those of other companies in the same line
of business would help to determine whether there is a problem in the credit
department.
The company appears to be successfully using outside capital, as is
evidenced by a return on assets of 16%, but a return on stockholders equity
of almost double this30.2%. Further evidence of the companys use of
leverage could be found by examining the exact cost of each individual
13-26
source of capital. For example, what are the terms of the instruments that
make up long-term debt, and what is the effective interest cost of each?
The times interest earned ratio indicates that earnings are seven times
the amount of interest expensewhat appears to be excellent coverage.
However, how much cash is generated from operations? Is this cash
sufficient to cover not only interest payments but also maturing principal
amounts? Calculation of the debt service coverage ratio, with information
found on a cash flows statement, would provide further evidence of the
companys solvency.
Finally, to fully evaluate the companys financial health, it would be
necessary to know more about its plans for the long run. Does it plan to
expand plant and equipment? Are there any plans to take on additional
products or acquire another company? Are any additional debt issues being
contemplated?
LO 5,6
PROBLEM 13-6 PROJECTED RESULTS

MEET CORPORATE OBJECTIVES
TO
1. Projected results for the four objectives for Tablon, Inc. (in thousands of
dollars):
Sales growth of 20% will be achieved:
Sales increase for the year
Sales for 2004
$30,000 - $25,000 = 20%

$25,000
Return on stockholders equity of 15% will not be met:

Net income preferred dividends
Average stockholders equity
$1,200 - $0*_
($9,300 + $8,700)/2
= $1,200/$9,000
= 13.3%
*No preferred stock
Long-term debt-to-equity ratio of not more than 1 will not be achieved:
Long-term debt at 5/31/05
=
Stockholders equity at 5/31/05
$10,000____
$5,000 + $4,300)
= $10,000/$9,300
= 1.08 to 1
A cash dividend of 50% of net income, with a minimum payment of at
least $400,000 will be met:
50% X 2005 net income = .50 X $1,200 = $600
13-27
($600 is the forecasted dividend payment)

2. Contributing factors to Tablons failure to meet all its objectives include the
following:
Each of the three expenses, cost of goods sold, selling expenses, and
administrative expenses and interest, as a percentage of sales, are
expected to increase in 2005 from 2004:
2004
2005
Cost of goods sold
52%
53.33%
Selling expenses
20%
23.33%
Administrative expenses and interest
16%
16.67%
Accounts receivable will increase by $3,000,000 during the yeara 73%
increase, compared with an increase in sales of only 20%. This could
cause a cash flow problem and possibly an increase in bad debts.
Production will exceed sales needs, as is evidenced by the 23% expected
increase in the amount of inventory. This will result in additional carrying
costs for the year.
Long-term borrowing increased by 50% in the first six months of 2004,
and for the full year it is expected to be up by 66.67% from the beginning
of the year.
3. Possible actions that the controller could recommend to the president in
response to the problems cited above include the following:
Review the accounts receivable collection process to determine ways to
speed up collection and to determine whether credit is being extended to
high-risk customers.
Slow down the production during the remainder of the year.
Examine the reasons for an increase in the ratio of cost of goods sold to
sales.
Review the selling and administrative expenses to determine whether
certain areas can be cut back and still provide necessary services.
Review the continuing increases in long-term debt and decide whether
they are necessary. Consider the issuance of preferred stock as an
alternative form of financing.
LO 4,5,6
1.
PROBLEM 13-7 COMPARISON WITH INDUSTRY AVERAGES
Industry
13-28
Ratio
Current ratio
Acid-test (quick) ratio
Accounts receivable turnover
Inventory turnover
Debt-to-equity ratio
Times interest earned
Return on sales
Asset turnover
Return on assets
Return on common
stockholders equity
Average
1.23
.75
33 times
29 times
.53
8.65 times
6.57%
1.95 times
12.81%
Heartland, Inc.
.92
.53
39 times
31 times
.69
4.43 times
4.54%
1.98 times
8.97%
17.67%
11.78%
Calculations for Heartlands ratios (thousands omitted):

Current ratio = Current assets/Current liabilities
$31,100/$33,945 = .92 to 1
Acid-test ratio = (Cash + Marketable securities + Accounts
receivable)/Current liabilities
($1,135 + $1,250 + $15,650)/$33,945 = $18,035/$33,945 = .53 to 1
Accounts receivable turnover ratio = Sales/Average accounts receivable
$542,750/[($15,650 + $12,380/2] = $542,750/$14,015 = 39 times
Inventory turnover ratio = Cost of goods sold/Average inventory
$435,650/[($12,680 + $15,870)/2] = $435,650/$14,275 = 31 times
Debt-to-equity ratio = Total liabilities/Total stockholders equity
($33,945 + $80,000)/$165,580 = $113,945/$165,580 = .69 to 1
Times interest earned = (Net income + Interest expense + Income tax
$19,095 + $9,275 + $12,730)/$9,275 = $41,100/$9,275 = 4.43 times
[$19,095 + $9,275(1 .40*)]/$542,750 = ($19,095 + $5,565)/$542,750 =
$24,660/$542,750 = 4.54%
*Tax rate is $12,730/$31,825 = 40%.
$542,750/[($279,525 + $270,095)/2] = $542,750/$274,810 = 1.98 times
Return on assets = (Net income + Interest expense, net of tax)/Average total
assets
$24,660 (above)/$274,810 (above) = 8.97%
$19,095/[($165,580 + $158,485)/2] = $19,095/$162,032.5 = 11.78%
2. Heartland is not as liquid as the average company in the industry, as is
evidenced by its lower current and quick ratios. The inventory turnover ratio
13-29
is very close to the industry average, whereas the accounts receivable

turnover is significantly better. Note, however, that the industry has a very
high turnoverin fact, the average number of days in receivables for the
industry is 360/33, or 11 days. Heartlands accounts payable has increased
significantly during a year in which inventory has actually decreased.
The company is not as solvent as the rest of the industry, either, as is
indicated by its higher debt-to-equity ratio and lower times interest earned
ratio. The heavy reliance on outside funds is also reflected in the
profitability of the company. Even though Heartlands return on equity is
higher than its return on assets, both ratios are significantly lower than the
comparable industry averages. Its asset turnover is slightly higher than the
industry norm.
3. If the banks primary consideration in making the loan decision is the
companys relative performance compared with that of the competition, it
probably will not approve the loan. Heartland is already more highly
leveraged than the average company in the industry, and it is not nearly as
profitable. However, the loan decision will depend on other factors in
addition to the companys relative standing in its industry. For example, the
bank will look at how Heartlands ratios this year compare with those of prior
years. Maybe the company is smaller than others in the industry and has
always performed at its current level. If the bank approves the loan, it will
probably require a higher interest rate to compensate for any perceived
additional risk.
ALTE R N ATE P R O B L E M S
13-30
LO 5
PROBLEM 13-1A EFFECT OF TRANSACTIONS ON

DEBT-TO-EQUITY RATIO
1. Calculation of debt-to-equity ratio (ooos omitted):

($150 + $375)/$400 = $525/$400 = 1.31 to 1
2. Effect of transactions on debt-to-equity ratio:

Transaction
Purchased inventory on
account, $20,000
b. Purchased inventory for
cash, $15,000
c. Paid suppliers on
account, $30,000
d. Received cash on
account, $40,000
e. Paid insurance for next
year, $20,000
f. Made sales on account,
$60,000
g. Repaid short-term loans
at bank, $25,000
Debt-to-Equity
Ratio
Effect of
Transaction
1.363
increase
1.31
none
1.238
decrease
1.31
none
1.31
none
1.141
decrease
1.25
decrease
1.413
increase
1.479
increase
1.31
1.419
none
increase
1.403
increase
a.
h. Borrowed $40,000 at
bank for 90 days
i. Declared and paid
j. Purchased $20,000 of
trading securities
k. Paid $30,000 in salaries
l. Accrued additional
$15,000 in taxes
LO 5
PROBLEM 13-2A EFFECT OF TRANSACTIONS ON

DEBT-TO-EQUITY RATIO
13-31
1. Calculation of debt-to-equity ratio (ooos omitted):

($25 + $125)/$400 = $150/$400 = .38 to 1
2. Effect of transactions on debt-to-equity ratio:
a.
b.
c.
d.
e.
f.
g.
h.
i.
j.
k.
l.
LO 6
Transaction
Purchased inventory on
account, $20,000
Purchased inventory for
cash, $15,000
Paid suppliers on
account, $30,000
Received cash on
account, $40,000
Paid insurance for next
year, $20,000
$60,000
at bank, $25,000
Borrowed $40,000 at
bank for 90 days
Declared and paid
trading securities
Accrued additional
$15,000 in taxes
Debt-to-Equity
Ratio
Effect of
Transaction
.425
increase
.38
none
.30
decrease
.38
none
.38
none
.326
decrease
.313
decrease
.475
increase
.423
increase
.38
.405
none
increase
.429
increase
PROBLEM 13-3A GOALS FOR SALES AND

RETURN ON ASSETS
1. a. Return on sales = net income after adding back interest expense,

net of tax/net sales
= $60,000/$750,000 = 8%
b. Asset turnover = net sales/average total assets
= $750,000/$400,000 = 1.88 times
c. Return on assets = return on sales
= 8% X 1.88 = 15.04%
asset turnover
2. Asset turnover = ($750,000 X 115%)/($400,000

= $862,500/$440,000 = 1.96 times
110%)
3. If average total assets are $440,000 and the goal is a 20% return on assets,
net income will need to be 20% of $440,000, or $88,000.
13-32
4. Income will have to increase by 47%, ($88,000 $60,000)/$60,000, to

achieve the goal of a 20% return on assets. The president has set a goal for
an increase in sales of only 15%. To increase income by a larger
percentage than the increase in sales will require cost-cutting in the various
departments of the business. The company may want to look for cheaper
sources of supply for its materials as long as the quality of the product is
maintained. Efforts will need to be made to cut selling, general, and
administrative expenses as well.
LO 6
PROBLEM 13-4A GOALS FOR SALES AND

INCOME GROWTH
1. Selected financial data (in millions of dollars):

1. Sales*
2. Net income(sales X 3%)*
3. Dividends declared and paid
(greater of $2,000,000
or 60% of net income)
4. Owners equity, December 31
balance (prior years
balance + net income less
dividends)
5. Debt, Dec. 31 balance**
Selected ratios:
6. Return on owners equity
(Item 2/Item 4)
2007
133.1000
3.9930
2006 2005
121.000 110.0
3.630
3.3
2.3958
2.178
2.0
44.3492
22.2008
42.752
17.748
41.3
13.7
9.0%
8.5%
8.0%
Note: The return on owners equity ratios in the problem for 2002-2004 are
based on year-end owners equity rather than the average for each year.
Therefore, to be consistent, year-end balances are used for 2005-2007.
7. Debt to total assets
[Item 5/(Item 4 + Item 5)]
33.36%
29.3%
24.9%
*Sales and net income increase at the rate of 10% per year.
**Calculation of total debt balance:
Total assets (sales/asset
turnover rate of 2)
$ 66.5500
Less: Owners equity
(Item 4)
44.3492
Debt
$22.2008
2.
$ 60.500
$ 55.0
42.752
$17.748
41.3
$13.7
No, the CEO will not be able to meet all his requirements if a 10% per year
growth in income and sales is achieved. If under the stated assumptions
that the net income to sales ratio be maintained at 3% with annual sales
growth of 10%, and the asset turnover ratio be maintained at 2, the goal of
13-33
holding debt to 25% of total assets will only be met in 2005. The debt will
increase to 29.3% of total assets in 2006 and to 33.36% of total assets in
2007 under the proposed plan. The calculations assume that all other
factors remain constant. Because some of the factors that affect stock
prices are outside the companys control, it cannot be determined whether
the main requirement of improving the stock price can be met if the expected
performance is accomplished.
3. Alternative actions to be considered to improve the return on equity and
support the increased dividend payments:
a. Improve the return on assets by
reducing the asset base through better asset management.
improving asset quality to generate higher returns per
dollar invested, including the acquisition of a subsidiary
or a more profitable line of business.
b. Improve profits by
concentrating production and sales on high profit-producing lines.
cost control efforts to maintain and reduce both variable and fixed
costs.
ALTERNATE MULTI-CONCEPT PROBLEMS
LO 4,5,6
PROBLEM 13-5A BASIC FINANCIAL RATIOS
1. Financial ratios for 2004 for SST Enterprises (thousands omitted):

a. Times interest earned = (Net income + Income tax expense + Interest
= ($60,000 + $27,000 + $15,000)/$15,000
= $102,000/$15,000 = 6.8 times
b. Return on total assets = (Net income + Interest expense, net of
tax)/Average total assets
= {$60,000 + [$15,000 X (1 31%*)]}/[($300,000 + $295,000)/2]
= $70,350/$297,500 = 23.65%
*Tax rate = Income taxes/Income before tax = $27,000/$87,000 = 31%.
c. Return on common stockholders equity = (Net income Preferred

= $60,000/[($180,000 + $165,000)/2]
= $60,000/$172,500 = 34.78%
d. Debt/equity ratio = Total liabilities/Total stockholders equity
= $120,000/$180,000 = .67 to 1
13-34
e. Current ratio = Current assets/Current liabilities

= $100,000/$105,000 = .95 to 1
f. Quick (acid-test) ratio = (Cash + Marketable securities + Short-term
= ($27,000 + $36,000)/$105,000
= $63,000/$105,000 = .6 to 1
g. Accounts receivable turnover ratio = Net credit sales/Average accounts
receivable
= $600,000/[($36,000 + $37,000)/2]
= $600,000/$36,500 = 16.4 times
h. Number of days sales in receivables = Number of days in
period/Accounts receivable turnover
i. Inventory turnover ratio = Cost of goods sold/Average inventory
= $405,000/[($35,000 + $42,000)/2]
= $405,000/$38,500 = 10.52 times
j. Number of days sales in inventory = Number of days in period/Inventory
turnover
k. Number of days in cash operating cycle = Days sales in inventory + Days
sales in receivables
= 34 days + 22 days = 56 days
2. Comments on the overall financial health of SST Enterprises:
The current ratio is slightly less than 1 to 1, and the significantly smaller
quick ratio may signal a problem with excess inventory. Whether or not the
quick ratio is indicative of a liquidity problem could be determined more
accurately by comparing this ratio with those of prior years, as well as with
an industry average.
Inventory turnover of 10.52 times may not be a problem area (see
discussion of quick ratio above), but it should be compared with those of
prior years and with an industry averageturning over inventory every 34
days may be normal for the industry.
The length of time that receivables are outstanding, 22 days, appears to
be relatively short. It may be an indication that the credit department is
doing a good job in screening customers for credit. On the other hand, if the
credit terms are too stringent, the company may be losing good customers.
Comparison of this statistic with other companies in the same line of
business would help to determine whether there is a problem in the credit
department.
The company appears to be successfully using outside capital, as is
evidenced by a return on assets of 23.65% but a much higher return on
stockholders equity of 34.78%. Further evidence of the companys use of
leverage could be found by examining the exact cost of each individual
13-35
source of capital. For example, what are the terms of the instruments that
make up long-term debt and what is the effective interest cost of each?
The times interest earned ratio indicates that earnings are nearly seven
times the amount of interest expensethat would appear to be excellent
coverage. However, how much cash is generated from operations? Is this
cash sufficient to cover not only interest payments but also maturing
principal amounts? Calculation of the debt service coverage ratio, with
information found on a cash flows statement, would provide further evidence
of the companys solvency.
Finally, to fully evaluate the companys financial health, it would be
necessary to know more about its plans for the long run. Does it plan to
expand plant and equipment? Are there any plans to take on additional
products or acquire another company? Are any additional debt issues being
contemplated?
LO 5,6
PROBLEM 13-6A PROJECTED RESULTS TO MEET CORPORATE OBJECTIVES
1. Projected results for the four objectives for Grout, Inc. (in thousands of
dollars):
Sales growth of 10% will be exceeded:
Sales increase for the year
Sales for 2004
$12,000 - $10,000 = 20%

$10,000
Return on stockholders equity of 20% will not be met:

Net income preferred dividends =
$400 - $0*
Average stockholders equity
($5,000 + $5,000)/2
= $400/$5,000
= 8%
*No preferred stock.
Long-term debt-to-equity ratio of not more than 1 will not be achieved:
Long-term debt at 9/30/05
Stockholders equity at 9/30/05
$5,500____
($4,000 + $1,000)
= $5,500/$5,000
= 1.1 to 1
A cash dividend of 50% of net income will be met (dividends of 100% of
net income are projected), but a minimum dividend payment of $500,000
will not be met (the projected dividends are only $400,000).
13-36
2. Contributing factors to Grouts failure to meet all its objectives include the
following:
Cost of goods sold, as a percentage of sales, is expected to increase in
2005 from 2004, and the other two operating expenses are expected to
remain the same:
2004
2005
Cost of goods sold
60%
66.67%
Selling expenses
15%
15.00%
Administrative expenses and interest
10%
10.00%
Accounts receivable will increase by $500,000 during the yeara 24%
increase compared with an increase in sales of 20%. The potential for an
increase in bad debts will need to be monitored.
Production will exceed sales needs, as is evidenced by the 20% expected
increase in the amount of inventory. This will result in additional carrying
costs for the year.
Long-term borrowing increased by 37.5% in the first six months of 2005,
and it is expected to stay at this level at the end of the year.
3. Possible actions that the controller could recommend to the president in
response to the problems cited above include the following:
Review the accounts receivable collection process to determine ways to
speed up collection and to determine whether credit is being extended to
high-risk customers.
Slow down the production during the remainder of the year.
Examine the reasons for an increase in the ratio of cost of goods sold to
sales.
Review the continuing increases in long-term debt and decide whether
they are necessary. Consider the issuance of preferred stock as an
alternative form of financing.
LO 4,5,6
13-37
PROBLEM 13-7A A COMPARISON WITH

INDUSTRY AVERAGES
1.
Ratio
Current ratio
Acid-test (quick) ratio
Inventory turnover
Debt-to-equity ratio
Times interest earned
Return on sales
Asset turnover
Return on common
stockholders equity
Industry
Average
1.20
.50
35 times
.50
25 times
3%
3.5 times
Midwest, Inc.
1.26
.34
37.27 times
.69
4.13 times
4.68%
3.82 times
20%
23.19%
Calculations for Midwests ratios (thousands omitted):

$12,440/$9,900 = 1.26 to 1
Acid-test ratio = (Cash + Marketable securities +
receivable)/Current liabilities
($1,790 + $1,200 + $400)/$9,900 = $3,390/$9,900 = .34 to 1
Accounts
Inventory turnover ratio = Cost of goods sold/Average inventory

$300,000/[($7,400 + $8,700)/2] = $300,000/$8,050 = 37.27 times
Debt-to-equity ratio = Total liabilities/Total stockholders equity
($9,900 + $36,000)/$66,100 = $45,900/$66,100 = .69 to 1
Times interest earned = (Net income + Interest expense + Income tax
($14,900 + $8,600 + $12,000)/$8,600 = $35,500/$8,600 = 4.13 times
[$14,900 + $8,600(1 .446*)]/$420,500 = ($14,900 + $4,764)/$420,000 =
$19,664/$420,500 = 4.68%
*Tax rate is $12,000/$26,900 = 44.6%.
$420,500/[($108,000 + $112,000)/2] = $420,500/$110,000 = 3.82 times
$14,900/[($62,400 + $66,100)/2]
= $14,900/$64,250 = 23.19%
2. Midwest is not quite as liquid as the average company in the industry, as is
evidenced by its lower quick ratio. The inventory turnover ratio is very
similar to the industry average. Midwests accounts payable has decreased
during the year, although this is offset by increases in each of the other
three current liabilities.
13-38
The company is not as solvent as the rest of the industry either, as is

indicated by its higher debt-to-equity ratio and lower times interest earned
ratio. The heavy reliance on outside funds, however, has not been a
detriment to the companys profitability. Midwests return on equity is higher
than the industry average.
3. Midwest is already more highly leveraged than the average company in the
industry, but as was indicated earlier, has used borrowed money effectively.
However, the loan decision will depend on other factors in addition to the
companys relative standing in its industry. For example, the bank will look
at how Midwests ratios this year compare with those of prior years. Maybe
the company is smaller than others in the industry and has always
performed at its current level. If the bank approves the loan, it will probably
require a higher interest rate to compensate for any perceived additional
risk.
DECISION CASES
READING AND INTERPRETING FINANCIAL STATEMENTS
LO 2
DECISION CASE 13-1 HORIZONTAL ANALYSIS FOR WINNEBAGO INDUSTRIES
1. and 2.
Income Statement Accounts

Net revenues*
Cost of manufactured products
Gross profit
Selling expenses
General, and administrative
expenses
Financial income
Income before income taxes
Provision for taxes
Income before cumulative
effect of change in accounting
principle
Cumulative effect of change
in accounting principle
Net income
(In millions of dollars)

Increase (Decrease) from:
2001 to 2002
2000 to 2001
Dollars
$152.5
120.3
32.2
1.3
%
22.6%
20.4
36.9
7.2
Dollars
$(71.7)
(52.6)
(19.1)
(.4)
%
(9.6)%
(8.2)
(18.0)
(2.3)
5.1
(.9)
24.8
13.9
37.7
(23.8)
41.9
89.9
(3.5)
.4
(14.8)
(10.1)
(20.5)
12.5
(20.0)
(40.0)
10.9
25.0
(4.6)
(9.6)
1.1
$12.0
(100.0)
28.0
(1.1)
$(5.7)
0
(11.8)
* Includes both revenue from manufactured products and dealer financing

revenue. Thus, the gross profit ratios include both of these forms of revenue
also.
13-39
3. Net revenues increased by 22.6% in 2002, after a decrease in 2001 of

9.6%. Also, gross profit increased even more significantly, by 36.9%.
These increases are reflected in the increase of 28% in net income.
LO 3
DECISION CASE 13-2 VERTICAL ANALYSIS FOR

WINNEBAGO INDUSTRIES
1. Common-size comparative income statements:

COMMON-SIZE CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED AUGUST 31, 2002 AND AUGUST 25, 2001
(IN MILLIONS OF DOLLARS)
2002
Dollars
Net revenues*
$828.4
Cost of manufactured products
708.9
Gross profit
119.5
Selling expenses
19.6
General, and administrative expenses
18.7
Financial income
2.9
84.1
Provision for taxes
29.4
Income before cumulative effect
of change in accounting principle
54.7
Cumulative effect of change in
acounting principle
0
Net income
$ 54.7
2001
%
100.0%
85.6
14.4
2.4
Dollars
$ 675.9
588.6
87.3
18.3
%
100.0%
87.1
12.9
2.7
2.3
.4
10.2
3.5
13.6
3.8
59.2
15.5
2.0
.6
8.8
2.3
6.6
43.8
6.5
0
6.6%
1.1
$ 42.7
.2
6.3%
* Includes both revenue from manufactured products and dealer financing

revenue. Thus, the gross profit ratios include both of these forms of revenue
also.
2. Cost of manufactured products as a percentage of sales decreased by 1.5%
from 2001 to 2002; as a result, the gross margin ratio is correspondingly
1.5% higher in 2002. Selling expenses decreased as a percentage of sales
by .3% and was offset by the same percentage increase in general and
administrative expenses. These factors contributed to a slight increase in
net income as a percentage of sales, from 2001to 2002.
13-40
3. Common-size comparative balance sheets

COMMON-SIZE CONSOLIDATED BALANCE SHEETS
AT AUGUST 31, 2002 AND AUGUST 25, 2001
2002
Cash and cash equivalents
Receivables, less allowance
for doubtful accounts
Dealer financing receivables,
less allowance for doubtful
accounts
Inventories
Prepaid expenses
Deferred income taxes
Property and equipment,
net
Investment in life insurance
Other assets
Total assets
Dollars
$ 42.2
2001
%
12.5%
Dollars
$ 102.3
%
29.1%
28.6
8.5
21.6
6.1
37.9
113.7
4.3
6.9
233.6
11.2
33.7
1.3
2.0
69.3
40.3
79.8
3.6
6.7
254.3
11.5
22.7
1.0
1.9
72.3
48.9
23.6
22.4
8.5
$ 337.1
Accounts payable, trade

$ 44.2
2.6
Accrued expenses:
Accrued compensation
18.7
Product warranties
8.2
Insurance
6.0
Promotional
4.5
Other
4.5
Total current liabilities
88.6
Postretirement health care and
Deferred compensation benefits
68.7
Common stock, par value
12.9
Additional paid-in capital
25.7
Reinvested earnings
284.9
Treasury stock, at cost
(143.7)
Total stockholders equity
179.8
Total equities
$ 337.1
14.5
7.0
6.6
2.5
100.0%
46.5
22.2
21.5
7.4
$ 351.9
13.2
6.3
6.1
2.1
100.0%
13.1%
.8
$ 40.7
4.9
11.6%
1.4
5.5
2.4
1.8
1.3
1.3
26.3
20.4
3.8
7.6
84.5
(42.6)
53.3
100.0%
13.7
8.1
4.6
3.2
4.8
80.0
64.5
12.9
22.3
234.1
(61.9)
207.5
$ 351.9
3.9
2.3
1.3
.9
1.4
22.7
18.3
3.7
6.3
66.5
(17.6)
59.0
100.0%
13-41
4. Within the current asset category, cash decreased significantly in relative

importance from the prior year, 29.1% in 2001 versus 12.5% in 2002.
Overall, there was a minor decrease in current assets as a percentage of
total assets. Property, plant, and equipment increased slightly, from 13.2%
of total assets to 14.5% of total assets.
Total current liabilities increased as a percentage of total equities from
22.7% in 2001 to 26.3% in 2002. The only other liability, postretirement
health care and deferred compensation benefits increased in relative
importance, from 18.3% in 2001 to 20.4% in 2002. The most significant
change on the balance sheet was the large increase in treasury stock.
Because the company purchased a significant amount of its own stock
during 2002, this account increased dramatically, from less than 18% of total
equities to over 42%.
LO 3
DECISION CASE 13-3 COMPARING TWO COMPANIES IN THE

SAME INDUSTRY: WINNEBAGO INDUSTRIES AND MONACO
COACH CORPORATION
1. Common-size comparative income statements:

MONACO COACH CORPORATION
COMMON-SIZE CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 28, 2002 AND DECEMBER 29, 2001
Net sales
Cost of sales
Gross profit
Selling, general, and administrative expenses
Amortization of goodwill
Operating income
Other income, net
Interest expense
Provision for income taxes
Net income
2002
Dollars
%
$1,222.7
100.0%
1,059.6
86.7
163.1
13.3
87.2
0
75.9
.1
2.8
73.3
28.8
$44.5
7.1
0
6.2
.2
6.0
2.4
3.6%
2001
Dollars
$ 937.1
823.1
114.0
%
100.0%
87.8
12.2
70.7
.6
42.7
.3
2.4
40.6
15.7
$ 24.9
7.5
.1
4.6
.0
2.6
4.3
1.7
2.6%
2. During 2002, Winnebago Industries reported a slightly higher gross profit

ratio than Monaco Coach Corporation. Also, Winnebago Industries ratio of
net income to net sales, or profit margin as it is called, was higher in 2002
than was the same ratio for Monaco Coach Corporation.
13-42
3. Common-size comparative balance sheets

MONACO COACH CORPORATION
COMMON-SIZE CONSOLIDATED BALANCE SHEETS
AT DECEMBER 28, 2002 AND DECEMBER 29, 2001
2002
Trade receivables, net
Inventories
Resort lot inventory
Prepaid expenses
Notes receivable
Property, plant and equipment
net
Debt issuance costs, net
Goodwill, net
Total assets
2001
Dollars
$ 116.6
175.6
26.9
3.6
33.4
356.1
0
%
21.3%
32.1
4.9
6.6
6.1
65.1
0
Dollars
82.9
127.1
0
2.1
27.3
239.4
8.2
%
19.4%
29.8
0
.5
6.4
56.1
1.9
135.4
.7
55.3
$ 547.4
24.7
.1
10.1
100.0%
122.8
.9
55.9
$ 427.1
28.8
.2
13.0
100.0%
Book overdraft
Line of credit
Current portion of long-term
Note payable
Accounts payable
Product liability reserve
Product warranty reserve
Accrued expenses and other
liabilities
Total current liabilities
Long-term note payable
3.5
51.4

Common stock,par value
Additional paid-in capital
Retained earnings
Total stockholders equity
Total equities
14.6
.3
51.5
208.8
260.6
$ 547.4
.6%
9.4
5.9
26.0
1.4%
6.1
21.7
78.1
21.3
31.7
4.5
4.0
14.3
3.9
5.8
.8
10.0
66.9
19.9
22.8
0
2.3
15.7
4.7
5.3
0
29.6
241.9
30.3
5.4
44.2
5.5
19.2
175.7
30.0
4.5
41.1
7.0
2.7
.1
9.4
38.1
47.6
100.0%
8.3
.3
48.5
164.3
213.1
$427.1
1.9
.1
11.4
38.5
50.0
100.0%
4. Winnebago Industries has a slightly higher percentage of its total assets in

the current assets category at the end of 2002 than does Monaco Coach
Corporation. Conversely, Winnebago Industries current liabilities are a
lower percentage of total liabilities and stockholders equity than for Monaco
Coach Corporation. The ratio of stockholders equity to total liabilities and
stockholders equity is about 53% for Winnebago Industries while this same
ratio for Monaco Coach Corporation is about 48%.
LO 4,5,6
13-43
DECISION CASE 13-4 RATIO ANALYSIS FOR WINNEBAGO

INDUSTRIES
1. Ratios and other amounts for Winnebago Industries (all dollar amounts in
thousands):
a.
Working capital = Current assets Current liabilities

2002: $233,596 $88,601 = $144,995
2001: $254,256 $80,008 = $174,248
b.

2002: $233,596/$88,601 = 2.6 to 1
2001: $254,256/$80,008 = 3.2 to 1
c. Acid-test ratio = (Cash +

Receivables + Dealer financing
receivables) /Current liabilities
2002: ($42,225 + $28,616 + $37,880)/$88,601 = $108,721/$88,601
= 1.2 to 1
2001: ($102,280 + $21,571 + $40,263)/$80,008 = $164,114/$80,008
2.1to 1
d. Cash flow from operations to current liabilities = Net cash provided by
operating activities/Average current liabilities
2002: $36,790/$88,601 = 41.5 %
2001: $81,912/$80,008 = 102.4%
e. Number of days sales in receivables = Number of days in the
period/Accounts receivable turnover (Net credit sales/Average
Receivables and Dealer financing receivables)
2002: Turnover = $828,403/($28,616 + $37,880) = 12.5
Number days = 360 days/12.5 = 28.8 days
2001:
f.
Turnover = $675,927/($21,571 + $40,263) = 10.9

Number of days sales in inventory = Number of days in the

period/Inventory turnover (Cost of manufactured products/Average
inventory)
2002: Turnover = $708,865/$113,654 = 6.2
2001:
Turnover = $588,561/$79,815 = 7.4

g. Debt-to-equity ratio = Total liabilities/Total stockholders equity

2002: ($88,601 + $68,661)/$179,815 = $157,262/$179,815
= .87 to 1
2001: ($80,008 + $64,450)/$207,464 = $144,458/$207,464
= .70 to 1
13-44
h. Cash flow from operations to capital expenditures = (Cash flow from

operations Total dividends paid)/Cash paid for acquisitions
2002: ($36,790 - $3,954)/$10,997 = 298.6%
2001: ($81,912 - $4,121)/$9,089 = 855.9%
i.
Asset turnover = Net sales/Total assets

2002: $828,403/$337,077 = 2.5 times
2001: $675,927/$351,922 = 1.9 times
j.
Return on sales = (Net income + Interest expense* net of tax)/Net sales

2002: [$54,671 + $298(1 .40)]/$828,403 = $54,849.8/$828,403 =
6.6%
2001: [$42,704 + $89(1 .40)]/$675,927 = $42,757.4/$675,927 =
6.3%
Interest expense appears as part of financial income on the income
statement and its amount is reported in Note 8 to the financial
statements.
k.
Return on assets = (Net income + Interest expense, net of tax)/Total

assets
2002: $54,849.8 (from j.)/$337,077 = 16.3 %
2001: $42,757.4 (from j.)/$351,922 = 12.1 %
l.
Return on common stockholders equity = (Net income preferred

dividends)/Common stockholders equity
2002 ($54,671 - $0/$179,815 = 30.4%
2001: ($42,704 - $0) /$207,464 = 20.6 %
2. Winnebago Industries appears to be relatively liquid over the two-year

period, although all of the measures of liquidity declined in 2002, such as
working capital, the current ratio, the acid-test ratio and cash flow from
operations to current liabilities and the two turnover ratios.
The companys debt-to-equity ratio increased slightly in 2002. The ratio
of cash flows from operations to capital expenditures decreased dramatically
in 2002, from 855.9% during 2001 to 298.6% in 2002, primarily as a result of
a decrease in cash flow from operations.
Asset turnover increased from 1.9 times in 2001 to 2.5 times in 2002.
Winnebago Industries return on sales remained relatively unchanged, its
return on assets increased from 12.1% in 2001 to 16.3% in 2002, and its
return on common stockholders equity decreased from 20.6% in 2001 to
30.4% in 2002.
13-45
MAKING FINANCIAL DECISIONS

LO 4,5,6
DECISION CASE 13-5 ACQUISITION DECISION
1. Several measures give an indication as to the companys liquidity:

Working capital has nearly doubled over the two-year period, from
$88,930,000 in 2003 to $161,820,000 in 2004.
Both the current ratio and the quick ratio have also increased:
2004: $324,120/$162,300 = 2.00 to 1
2003: $215,180/$126,250 = 1.70 to 1
Quick ratio = (Cash + Marketable securities + Short-term
2004: ($48,500 + $3,750 + $128,420)/$162,300 = 1.11 to 1
2003: ($24,980 +0 + $84,120)/$126,250 = .86 to 1
The accounts receivable turnover for 2004 = Net credit sales/Average
accounts receivable: $875,250/[($128,420 + $84,120)/2] = 8.24 times, or
an average collection period of 360/8.24 = 44 days
Whether this is a reasonable number of days outstanding could be
partially determined by an examination of the companys credit terms.
The inventory turnover for 2004 = Cost of goods sold/Average inventory:
$542,750/[($135,850 + $96,780)/2] = 4.67 times, or an average number of
days sales in inventory of 360/4.67 = 77 days
The cash operating cycle for 2004 is 44 + 77 = 121 days
Conclusion: The company appears on the surface to be fairly liquid, but
each of the above measures of liquidity should be compared with industry
averages. One area of concern is the large increase in both receivables
and inventories from the prior year. The company could be experiencing
collection problems. The inventory should be examined more closely for
possible obsolescence and slow-moving items.
2. The companys solvency can be examined by looking at the following
factors:
The debt-to-equity ratio has increased slightly from the prior year: Total
liabilities/Total stockholders equity
2004: ($162,300 + $275,000)/$532,710 = .82 to 1
2003: ($126,250 + $275,000)/$519,820 = .77 to 1
The times interest earned ratio = Operating income*/Interest expense:
$68,140/$45,000 or 1.51 times
*The ratio is normally calculated as net income + income tax expense +
interest expense, divided by interest expense. Because the company has
13-46
an extraordinary gain to take into account, the easiest approach is to use

the income number before taking all of these items into account, i.e.,
operating income.
Conclusion: The company is carrying a heavy debt burden even though
the bonds are not due until 2011. It will continue to have large interest
payments for the next seven years. Further information on the operating
cash flows is necessary to see whether funds will be available to service the
debt currently outstanding. Interest payments not only will be a significant
cash drain but also will affect the companys profitability.
3. Profitability can be assessed by looking at a number of ratios for 2004. The
extraordinary gain should be ignored in assessing profitability for our
purposes, because we are interested in the future performance of the
company and this gain is not expected to recur in the future.
Return on assets = (Net income + Interest expense, net of tax)/Average
total assets: [$13,890 + ($45,000)(1.40*)] divided by ($970,010 +
$921,070)/2 = $40,890/$945,540 = 4.3%
*The tax rate can be approximated by dividing income tax expense of $9,250
by net income before taxes and extraordinary items of $23,140.
Return on sales = (Net income + Interest expense, net of tax)/Net sales:
$40,890/$875,250 = 4.7%
Asset turnover = Net sales/Average total assets: $875,250/$945,540 = .
93 times
dividends)/Average common stockholders equity: $13,890/[($532,710 +
$519,820)/2] = $13,890/$526,265 = 2.6%
The average cost of borrowed funds can be approximated: $45,000 in
interest expense divided by an average of short-term notes and bonds
combined of [($80,000 + $275,000) + ($60,000 + $275,000)]/2 =
$45,000/$345,000 = 13%. The after-tax cost of these borrowed funds is
13% X (1 .40) = 7.8%.
4. It would be difficult to recommend to the vice-president of acquisitions that
Heavy Duty be acquired. It has not demonstrated the ability to be a
profitable member of the Diversified family over the long run. Disregarding
the extraordinary gain, the profit margin before interest and taxes was only
7.8%. Heavy Duty relies on a considerable amount of outside debt for
funding, but it is proving to be too costly at an after-tax cost of 7.8%. This is
further evidenced by an overall return on assets, 4.3%, which is higher than
the return to the stockholder of only 2.6%. While Heavy Duty is at least
profitable, it is unlikely that the president and board of directors of
Diversified will be satisfied with a company that yields such a low return. In
addition, it may prove very difficult for Heavy Duty to generate the necessary
funds to repay the bonds in 2011.
LO 3
1.
13-47
DECISION CASE 13-6 PRICING DECISION
BPO
COMMON-SIZE COMPARATIVE INCOME STATEMENTS
FOR YEARS 1-3
(IN THOUSANDS OF DOLLARS)
Year 3
Sales
Cost of goods sold
Gross profit
Operating expenses
Net income
$
$125
62
63
53
$ 10
Year 2
%
$
100.0% $110
49.6
49
50.4%
61
42.4
49
8.0% $ 12
%
100.0%
44.5
55.5%
44.5
11.0%
Year 1
$
$100
40
60
45
$ 15
%
100.0%
40.0
60.0%
45.0
15.0%
2. Net income has decreased while sales have increased because BPO has
not held the line on its product costs. The gross profit ratio has declined
significantly, because of the increase in cost of goods sold relative to sales,
from 40% to nearly 50%.
3.
BPO
INCOME STATEMENT
YEAR 4
Sales: $125,000 X 1.10
Cost of goods sold: $62,000 X 1.08
Gross profit
Operating expenses $53,000 X 1.08
Net income
$ 137,500
66,960
$ 70,540
57,240
$ 13,300
4. With a 10% increase in volume, BPO will not need to increase its prices.
On the basis of the projections, it will report an increase in net income of
33%.
ACCOUNTING AND ETHICS: WHAT WOULD YOU DO?
LO 4,5
DECISION CASE 13-7 PROVISIONS IN A LOAN AGREEMENT
1. No, Midwest is not in violation of its existing loan agreement. The current
ratio is $16/$10, or 1.6 to 1, which is above the minimum requirement of 1.5.
The debt-to-equity ratio is $25/$55 or .45 to 1, which is below the maximum
of .5.
2. Jackson has handled each of the two items incorrectly, and the controller
has the responsibility to make corrections before the statements are
released. The treatment of both items is in violation of accounting
standards. First, the $5 million note should be included in current liabilities,
since it is due in six months. The mere intent of the company to roll over or
13-48
refinance the note does not by itself justify the exclusion of it from current
liabilities. [Note: The instructor may want to use this opportunity to point
out that an accounting standard (SFAS No. 6) requires a company to
demonstrate the ability to refinance an obligation before classifying it as
long-term.] Second, the controller should not have recorded the deposit
from the state as revenue. Instead, it is a liability until the work is
completed.
3. Revised balance sheet:
Current assets
Long-term assets
$ 16
64
Total
$ 80
Current liabilities
Long-term debt
Stockholders equity
Total
$ 17
10
53
$ 80
Current liabilities should be $10, as reported, plus $5 for the note due in six
months and $2 for the deposit from the state. Long-term debt is reduced by
$5 for the note that is reclassified as short-term. Stockholders equity is
reduced by $2 because the deposit should be included in current liabilities
rather than revenue as recorded by Jackson.
Revised ratios:
Current ratio: $16/$17 = .94 to 1
Debt-to-equity ratio: $27/$53 = .51 to 1
These revisions will put Midwest in violation of its loan agreement with
Southern National Bank. The current ratio is significantly below the
minimum level of 1.5, while the debt-to-equity ratio is slightly above the
maximum of .5.
LO 4
DECISION CASE 13-8 INVENTORY TURNOVER
1. The president calculated the inventory turnover ratio of 90 times by dividing

sales revenue of $3,690,000 by the average inventory balance of $41,000
(the average of $40,000 at the end of 2004 and $42,000 at the end of 2003).
2. The president has erroneously used sales rather than cost of goods sold to
calculate inventory turnover. Because inventory is stated at cost, cost of
goods sold must be used in the numerator, not sales. The correct
calculation is
($3,690,000 X 1 .40*)/$41,000 = $2,214,000/$41,000 = 54 times
*The gross profit ratio is 40%. Therefore, cost of goods sold is 1 40%, or
60% of sales.
3. It is understandable why the president would prefer to report an inventory
turnover of 90 times, rather than 54 times. In the fruits and vegetables
business, the company needs to be able to show that it turns the inventory
frequently to maintain freshness. As controller, you have a responsibility to
the public not to intentionally misrepresent the company. You must tell the
president that his calculations are incorrect and explain to him how the ratio
13-49
should be computed.
FROM CONCEPT TO PRACTICE 13.1
Winnebago Industries annual report provides a ten-year summary of selected
financial data following the auditors report. One of the most significant trends is
the steady growth in net income, to a high of $54.7 million in 2002.
Monaco Coach provides a five-year summary of selected financial data after its
auditors report of its annual report. One of the most significant trends for
Monaco Coach has been its steady increase in net sales over this period, with a
record-high level of over $1.2 billion in 2002.
Wrigleys gross profit ratio for each year is as follows:
2002 2001 2000 1999 1998 1997 1996 1995
1994
1993
58.1% 58.5% 57.5% 55.8% 55.0% 53.6% 53.2% 53.2% 53.8%
1992
54.2%
52.9 %
Over this time period, the ratio has seen a relatively steady increase, from a low
of 52.9% in 1992 to a high of 58.5% in 2001.
Winnebago Industries dividend payout ratio for each year is:
2002: $.20/$2.74 = 7.3%
2001: $.20/$2.06 = 9.7%
The amount of dividends paid per share was unchanged and the earnings per
share was higher in 2002, resulting in a decrease in the dividend payout ratio in
2002.
Monaco Coach did not pay any dividends on its stock in either 2001 or 2002 and
thus has a dividend payout ratio of zero in both years.
13-50
This page is intentionally left blank
13-51
SOLUTION TO INTEGRATIVE PROBLEM

GALLAGHER, INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2004
Cash Flows from Operating Activities
Net income
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense
Increase in accounts receivable
Increase in inventories
Decrease in prepaid insurance
Increase in accounts payable
Increase in taxes payable
Net cash provided by operating activities
Cash Flows from Investing Activities
Acquisition of buildings and equipment
Net cash used by investing activities
Cash Flows from Financing Activities
Issuance of additional notes payable
Payment of cash dividends
Payment of bonds
Net cash provided by financing activities
Net decrease in cash
Cash balance, December 31, 2003
Cash balance, December 31, 2004
3,440
700
(3,500)
(2,500)
300
2,300
400
$ 1,140
$ (3,000)
$ (3,000)
$
800
(600)
(200)
$
0
$ (1,860)
2,700
$
840
2. a. Current ratio = Current assets/Current liabilities

= $21,440/$14,500 = 1.479 to 1
b. Acid-test ratio = (Cash + Accounts Receivable)/Current liabilities
= ($840 + $12,500)/$14,500 = $13,340/$14,500 = .92 to 1
c. Cash flow from operations to current liabilities ratio = Net cash provided
by operating activities/Average current liabilities
= $1,140/[($14,500 + $11,000)/2] = $1,140/$12,750 = 8.9%
d. Accounts receivable turnover ratio = Net credit sales/Average accounts
receivable
= $48,000/[($12,500 + $9,000)/2] = $48,000/$10,750 = 4.465
e. Number of days sales in receivables = Number of days in the
period/Accounts receivable turnover ratio = 360/4.47 = 80.54
f. Inventory turnover ratio = Cost of goods sold/Average inventory
= $36,000/[($8,000 + $5,500)/2] = $36,000/$6,750 = 5.33
13-52
g. Number of days sales in inventory = Number of days in period/Inventory

turnover ratio = 360/5.33 = 67.54
h. Debt-to-equity ratio = Total liabilities/Total stockholders equity
= $15,900/$17,840 = .9 to 1
i. Debt service coverage ratio = Cash flow from operations, before interest
and tax payments/Interest and principal payments
= ($1,140 + $280 + $2,280 - $400*)/($280 + $200) = $3,300/$480 =
6.88 to 1
* Increase in taxes payable account
j. Cash flow from operations to capital expenditures ratio = (Cash flow from
operations Total dividends paid)/Cash paid from acquisitions
= ($1,140 $600)/$3,000 = $540/$3,000 = 18%
3. Gallaghers current ratio decreased from 1.6 in 2003 to 1.48 in 2004 and its
acid-test ratio also decreased from 1.06 in 2003 to .92 in 2004. For many
companies, an acid-test ratio below 1 is not desirable because it may signal
the need to liquidate marketable securities to pay bills, regardless of the
current trading price of the securities. Gallagher currently doesnt own
marketable securities and therefore it may have difficulty in paying its bills.
Its cash flow from operations to current liabilities ratio is low also. The
number of days sales in receivable indicates it should increase collection
efforts while the number of days sales in inventory may indicate a large
amount of obsolete inventory or problems in the sales department.
Gallaghers debt-to-equity ratio indicates that for every $1 of capital that
stockholders provided, creditors provided $.90. Gallagher generated almost
$7 of cash from operations during 2004 to cover every $1 of required
interest and principal payments. The cash flow from operations to capital
expenditures ratio (18%) of less than 100% indicates that it is not able to
finance all of its capital expenditures from operations and cover its dividend
payments. Overall, Gallagher appears to have low liquidity and solvency
ratios. However, these ratios should be compared to ratios in its industry as
well as to ratios from prior years to get a better idea of how it is doing. Its
credit policies should also be examined to determine its policy on
collections. It should consider putting off future dividend payments until it
gets its liquidity problems under control.

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13-1

1. Explain the various limitations and considerations in financial

3. Use common-size financial statements to compare various

4. Compute and use various ratios to assess liquidity.

5. Compute and use various ratios to assess solvency.

6. Compute and use various ratios to assess profitability.

7. Explain how to report on and analyze other income statement

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

1. Explain the various limitations and considerations in financial

5. Compute and use various ratios to assess solvency.

6. Compute and use various ratios to assess profitability.

7. Explain how to report on and analyze other income statement

CHAPTER 13 FINANCIAL STATEMENT ANALYSIS

2. Use comparative financial statements to analyze a company over 1

3. Use common-size financial statements to compare various

4. Compute and use various ratios to assess liquidity.

5. Compute and use various ratios to assess solvency.

6. Compute and use various ratios to assess profitability.

1. Explain the various limitations and considerations in financial

7. Explain how to report on and analyze other income statement

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

The inventory valuation method used by a company will have a significant

One of the difficulties in comparing a companys ratios with industry

Published financial statements, as well as those often used by

The analysis of financial statements over a series of years is called

CHAPTER 13 FINANCIAL STATEMENT ANALYSIS

Rising costs to either manufacture or purchase inventory could be

The composition of current assets indicates the relative size of cash,

Ratios can be categorized according to their use in performing three types

Current assets are reported on a balance sheet in the order of their

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

An accounts receivable turnover of nine times translates to an average

A manufacturers operating cycle runs from the purchase of raw materials,

CHAPTER 13 FINANCIAL STATEMENT ANALYSIS

A return on stockholders equity that is lower than the return on assets

The price/earnings ratio is sometimes used as an indicator of the quality of

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

The inventory turnover ratio is meaningless to a service business such as

25. Separate reporting of discontinued operations, extraordinary items and the

EXERCISE 13-1 ACCOUNTS RECEIVABLE ANALYSIS

1. Accounts receivable turnover:

CHAPTER 13 FINANCIAL STATEMENT ANALYSIS

EXERCISE 13-2 INVENTORY ANALYSIS

EXERCISE 13-3 ACCOUNTS RECEIVABLE AND INVENTORY

1. Calculations (all dollar amounts in millions):

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

d. Days Sales in Inventory:

EXERCISE 13-4 LIQUIDITY ANALYSES FOR COCA-COLA AND

1. Calculations (all dollar amounts in millions):

$2,126 + $219 + $2,097

$1,638 + 207 + $2,531

CHAPTER 13 FINANCIAL STATEMENT ANALYSIS

EXERCISE 13-5 LIQUIDITY ANALYSES FOR

2. Both McDonalds and Wendys have negative working capital. Wendys

FINANCIAL ACCOUNTING SOLUTIONS MANUAL

EXERCISE 13-6 SOLVENCY ANALYSES FOR

Cash flow from

EXERCISE 13-7 SOLVENCY ANALYSIS

Debt-to-equity ratio: Total liabilities/Total stockholders equity

Times interest earned for 2004 (Net income + Interest expense +

CHAPTER 13 FINANCIAL STATEMENT ANALYSIS

2. The companys debt-to-equity ratio has decreased because of the

EXERCISE 13-8 RETURN RATIOS AND LEVERAGE

Return on sales = (Net income + Interest expense, net of tax)/Net sales