PRINT Name: Brief Answer Key.

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1 Financial & Managerial Accounting Fall 2009 Exam 2 General Instructions. Make sure you write answers clearly. Make sure to show your work when appropriate partial credit can be given for work shown. Finally, the work you do on this exam must be your own and performed without any additional materials (i.e., notes, etc.) except for a calculator. Cheating will be dealt with by following Earlham policy unconditionally. Please take a moment to PRINT your name below. PRINT Name: Brief Answer Key.

2 1. (20 points). Use the following information to construct appropriately formatted income statement and balance sheet. In addition, use your income statement and balance sheet to construct common-size versions of each in the spaces provided (feel free to use the back of the page) note, you can do the common-size versions right next to the statements themselves (like we ve done on quizzes, etc.). Account Amount Account Amount Cost of Goods Sold 700 Accounts Receivable 130 Inventory 70 Capital Stock 75 Long-Term Debt 200 Revenue 1,000 SGA Expenses 100 Accounts Payable 20 Current portion of Long-Term Debt 80 Interest Income 50 Interest Expense 100 Beginning Retained Earnings 100 Property, Plant, & Equipment 200 Tax 100 Revenue 1, % COGS % G.P % SGA % EBIT % Int Inc 50 5% Int exp % EBT % Tax % NI 50 5% Cash % A/R % Inv 70 14% C.A % PPE % T.A % A/P 20 4% C.LTD 80 16% C.L % LTD % T.L % CS 75 15% RE 125 = % T.E % Dividends 25 Cash 100

3 2. (20 points). Based upon the information in question 1, calculate the following financial ratios and provide a simple interpretation of the ratio (remember, I m not looking for an evaluation of the ratio, only a simple statement of what the number means). Very important, you must show your work on all ratios in order to get any credit at all. 300 (a) Gross Profit Margin = =.30 30% 1,000 For every $1 in sales, they made 30 cents in gross profit 365 (b) Days in Inventory = = 36.5days 10 On average, inventory remained within the business for 36.5 days 700 Inventory Turnover = = (c) Current Ratio = = For every $1 in current liabilities, they had $3 in current assets 200 (d) Return on Assets = =.40 40% 500 For every $1 in assets, they made 40 cents in EBIT 200 (e) Times Interest Earned Ratio = = For every $1 in interest expense, they had $2 in EBIT to cover the expense.

4 3. (20 points). We are interested in evaluating the performance of Company ABC. To do this, five financial ratios have been calculated for the past 5 years for ABC as well as the industry averages. For each ratio, provide a brief evaluation of the performance of ABC during the time period. (a) Net Profit Margin year Company ABC 2.41% 2.55% 2.51% 2.67% Industry Average 1.85% 2.04% 2.32% 2.44% This is a very positive sign. Not only is ABC s profit margin increasing (for the most part), but it is above the industry average --- the only concern being that the industry average seems to be creeping up on ABC. (b) Debt Ratio year Company ABC 82% 77% 79% 74% Industry Average 30% 32% 29% 31% It appears that ABC has been attempting to decrease their debt ratio if so, they ve been successful. However, their debt ratio is well above the industry average causing us some concern. (c) Asset Turnover year Company ABC Industry Average ABC s AT is rising, which is a good sign. However, it has been well below the industry average. Interestingly, while ABC has been able to turn its assets into sales more rapidly during the period the industry as a whole has been less successful. (d) Quick Ratio year Company ABC Industry Average This is causing some concern here. Although we might like to see relatively high and/or rising quick ratios, ABC s is rising rapidly and is greatly above a more or less constant industry average. Our question is what are they doing with all that cash?

5 4. (10 points) A corporation expects $100 in sales revenue next year. In addition, the corporation expects the following to hold true for next year. Tax Rate = 50% Times Interest Earned Ratio = 5 Gross Profit Margin = 50% SGA as % of Revenue = 20% Based upon the above information, construct the forecasted income statement for next year (note, you must use the proper format for the income statement). Revenue 100 COGS 50 G.P. 50 SGA 20 EBIT 30 Int.Exp. 6 EBT 24 Tax 12 NI 12

6 5. (10 points). A corporation has the following forecasts for next year. Sales Revenue = 800 Return on Assets = 40% Current Ratio = 2 Earnings Before Interest & Taxes (EBIT) = 400 Return on Equity = 25% Long-Term Debt Ratio = 40% Net Profit Margin = 10% Based upon the above information, forecast the following balance sheet accounts: current assets, longterm (fixed) assets, total assets, current liabilities, long-term liabilities, Shareholder equity. ROA = 400/Assets =.40, Assets = 1,000 NI = 80 ROE = 80/Equity =.25, Equity = 320 Assets Equity = 1, = 680 = Liabilities L-T Liabilities = 400 = 1,000 x.40 C.L. = 280 = C.A. = 560 = 2 x 280 L-T Assets = 440 = 1, Current Assets = 560 PPE = 440 Total Assets = 1,000 Current Liabilities = 280 LTD = 400 Total Liabilities = 680 Equity = 320 Total Liab. & Equity = 1,000

7 6. (5 points) An owner of a small, local restaurant is concerned about her ability to pay suppliers and make good on her bank loan. What ratios might the owner construct in order to help understand the situation? How should she evaluate these ratios? Either the quick and/or current ratio will help determine if she has the needed liquidity. She would want to see either of these at least above 1 most likely in any event a low ratio would indicate a problem For the bank loan, we might look at times interest earned ratio to see if she s making enough profit (EBIT) to meet interest expense on the loan a low ratio would be a sign of trouble. We might also look at say the debt ratio, long-term debt ratio, and/or debt-equity ratio. If any of these ratios appear high, then it might be a sign of trouble. 7. (5 points) The finance department of a corporation is considering paying off the balance of a bank loan early. What will be the impact of this decision on the current ratio, times interest earned ratio, and equity ratio? Provide a very brief explanation of each. The current ratio would most likely fall assuming the majority of the bank loan is listed as long-term debt (though this is an assumption --- if current portion of LTD is significant then we d need to take this into account) Times interest earned ratio will eventually rise because of this that is, the interest expense would no longer exist. However, one could imagine that the immediate impact would be a decline for this year if the payoff included a larger than otherwise amount of interest expense. The equity ratio will rise due to the fall in assets (cash). This would lower liabilities and assets, the increase in the equity ratio would indicate that a larger percentage of the resulting assets have been financed from equity.

8 8. (10 points) For the current year, a corporation has Sales Revenue of $1,000. The corporation expects next year to be very good with sales revenue increasing by 50%. The corporation realizes that the increase in sales will require the financing of additional assets. Executives at the corporation are anxious about how they will finance the additional assets. In order to begin planning, the corporation makes the following additional assumptions about next year: (i) the net profit margin will remain steady at 10%, (ii) the asset turnover ratio will remain steady at 2, (iii) the corporation plans to pay out $50 in dividends periodically throughout the year. (a) Based upon this information, how much total additional financing should the corporation plan to raise next year? Demonstrate your calculations and briefly explain them. (b) The corporation can raise additional financing by either issuing new interestingbearing liabilities (e.g., bank loans, bonds) or additional equity (i.e., capital stock, ownership shares). Discuss these two options of financing in terms of their longer-term impact on appropriate financial ratios and financial statements. (note, please do not attempt to evaluate the options but rather simply discuss the probable impact on the financial statements and ratio thus stick to the accounting issues.) (a) They must expect an additional $500 in sales. If the asset turnover ratio remains constant at 2,, then they should plan for an additional $250 in assets. In other words, this year total assets must have been $500 ($1,000/$500 = 2), while next year total assets are likely to be $750 ($1,500/$750 = 2). So, they should plan to have $250 in additional assets. Thus, liabilities plus shareholder equity will need to increase by $250. However, given the information, we can expect net income to be $150 (=$1,500 x 10%) with $50 paid out as dividends. Thus, we can expect that shareholders equity will increase by $100. Hence, the corporation will need to raise additional financing of $ this number ignores any natural changes that may arise within the liabilities, such as in the current liabilities, but we have no information to determine that amount. Also, we are of course ignoring any changes in cash that will occur as assets increase, but again we do not have information on this. We have the following: Assets will increase by $250 = liabilities + equity must increase by 250 So far, Assets +250 = Liabilities +0 and equity +100 Leaving a deficit of $150. (b) OPTION 1: If they raise $150 from liabilities (e.g., bank loan) then the debt ratio and debt-equity might increase though they would not have to, it all depends upon where they are now. In the future, they will have more interest expense from this option, so times interest earned ratio may fall but depends on what happens to EBIT. Also, because interest expense reduces net income, the return on equity may fall---but again, this depends on what happens to EBIT and the tax rate as well. OPTION 2: This option will leave ROE unchanged from what it would ve been. However, if they issue more equity, will that mean greater dividend payments? If so, equity will not increase at the same rate as it would have. But, keep in mind, we will not get the tax benefit of the interest expense.