CHAPTER 18. Financial Statement Analysis. Brief Exercises Exercises 4, 5, 6, 7 3, 4, 5 2, 3, , 9, 10, 11, 12, 13, 14, 15, 16

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1 CHAPTER 18 Financial Statement Analysis ASSIGNMENT CLASSIFICATION TABLE Study Objectives 1. Explain and apply horizontal analysis. Questions 1, 2, 3, 4, 5 Brief Exercises Exercises Problems Set A Problems Set B 1, 2 3 1, 3, Explain and apply vertical analysis. 4, 5, 6, 7 3, 4, 5 2, 3, Identify and use ratios to analyze a company s liquidity, profitability, and solvency. 8, 9, 10, 11, 12, 13, 14, 15, 16 6, 7, 8, 9, 10, 11 5, 6, 7, 8, 9, 10, 11 2, 3, 4, 5, 6, 7, 8, 9 2, 3, 4, 5, 6, 7, 8, 9 4. Recognize and illustrate the limitations of financial statement analysis. 17, 18, 19, 20, 21, 22 12, 13, 14 12, 13 9, 10 9, 10 Solutions Manual 18-1 Chapter 18

2 ASSIGNMENT CHARACTERISTICS TABLE Problem Number Description Difficulty Level Time Allotted (min.) 1A Prepare horizontal analysis and comment. Simple A Prepare vertical analysis, calculate profitability ratios, and comment. Moderate A Calculate ratios. Moderate A Calculate and evaluate ratios for two years. Moderate A Calculate and evaluate ratios for two companies. Moderate A Analyze ratios. Moderate A Analyze ratios. Moderate A Determine impact of transactions on ratios. Complex A 10A Calculate and evaluate profitability ratios with discontinued operations. Prepare income statement and statement of retained earnings, with irregular items. Moderate Moderate B Prepare horizontal analysis and comment. Simple B Prepare vertical analysis, calculate profitability ratios, and comment. Moderate B Calculate ratios. Moderate B Calculate and evaluate ratios for two years. Moderate B Calculate and evaluate ratios for two companies. Moderate B Analyze ratios. Moderate B Analyze ratios. Moderate B Determine impact of transactions on ratios. Complex B 10B Calculate and evaluate profitability ratios with discontinued operations. Prepare income statement and statement of retained earnings, with irregular items. Moderate Moderate Solutions Manual 18-2 Chapter 18

3 BLOOM S TAXONOMY TABLE Correlation Chart between Bloom s Taxonomy, Study Objectives and End-of- Chapter Material Study Objectives Knowledge Comprehension Application Analysis Synthesis Evaluation 1. Explain and apply horizontal analysis. Q18-2 Q18-1 Q18-3 Q18-4 Q18-5 BE18-1 BE18-2 BE18-3 E18-1 E18-3 E18-4 P18-1A P18-1B 2. Explain and apply vertical analysis. Q18-6 Q18-4 Q18-5 Q18-7 BE18-3 BE18-4 BE18-5 E18-2 E18-3 E18-4 P18-2A P18-2B 3. Identify and use ratios to analyze a company s liquidity, profitability, and solvency. Q18-8 Q18-9 Q18-12 Q18-14 BE18-6 E18-5 BE18-7 BE18-10 BE18-11 E18-10 P18-3A P18-9A P18-3B P18-9B Q18-10 Q18-11 Q18-13 Q18-15 Q18-16 BE18-8 BE18-9 E18-6 E18-7 E18-8 E18-9 E18-11 P18-2A P18-4A P18-5A P18-6A P18-7A P18-8A P18-2B P18-4B P18-5B P18-6B P18-7B P18-8B 4. Recognize and illustrate the limitations of financial statement analysis. Broadening Your Perspective Q18-17 Q18-18 Q18-20 Q18-21 Q18-22 BE18-12 Q18-19 BE18-13 BE18-14 E18-12 E18-13 P18-9A P18-10A P18-9B P18-10B BYP18-1 Continuing Cookie Chronicle BYP18-2 BYP18-3 BYP18-4 BYP18-5 Solutions Manual 18-3 Chapter 18

4 ANSWERS TO QUESTIONS 1. (a) Comparison of financial information can be made on an intracompany basis, an intercompany basis, and an industry average basis. (1) An intracompany basis compares the same item with prior periods, or with other financial items in the same period, for one company. A store may compare this year s sales to last year s sales, for example. (2) An intercompany basis compares the same item with one or more other company s financial statements. The intercompany basis of comparison provides insight into a company's competitive position in relation to other companies. (3) The industry average basis compares an item with the average of that item for the industry. For example, a department store may compare its sales per square foot of floor space with the average sales per square foot of floor space for department stores. (b) The intracompany basis of comparison is useful in detecting changes in financial relationships and significant trends within a company. The intercompany basis of comparison provides insight into a company's competitive position in relation to other companies. The industry average basis provides information as to a company's relative position within the industry. The use of all three comparisons, when combined with economic and non-financial measures provides the investor with an in-depth analysis of the investment potential of the company. 2. Percentage of base period amount: The amount for the period in question is divided by the base-year amount, and the result is multiplied by 100 to express the answer as a percentage. Percentage change for a period: The amount from the previous period is subtracted from the current period amount. The result is divided by the amount from the previous period and then multiplied by 100 to express the answer as a percentage. 3. (a) An answer cannot be calculated when there is no value in a base year, because division by 0 is mathematically impossible. (b) An answer cannot be calculated when there is a negative value in a base year and a positive value in the next year. Solutions Manual 18-4 Chapter 18

5 QUESTIONS (Continued) 4. Horizontal analysis (also called trend analysis) measures the dollar and percentage increase or decrease of an item over a period of time. In this approach, the amount of the item on one statement is compared with the amount of that same item on one or more earlier statements. Vertical analysis expresses each item within a financial statement in terms of a percent of a relevant total or other common basis within the same statement, for the same time period. 5. A comparison of the first quarter in 2006 after Tim Hortons became a public company to the first quarter in 2005 when Tim Hortons was part of Wendy s International would be of limited value. A vertical analysis of the income statement and balance sheet might be useful to determine the company s performance since it separated from Wendy s. However, any horizontal analysis would not be comparable with the prior period(s). 6. (a) On a balance sheet, total assets and total liabilities and shareholders equity are assigned a value of 100%. (b) On an income statement, net sales is assigned a value of 100%. 7. Yes, it can. By converting the accounting numbers to percentages, companies of vastly different sizes with different currencies can be compared. 8. (a) Liquidity ratios measure the short-term ability of a company to pay its maturing obligations and to meet it unexpected needs for cash. (b) Profitability ratios measure the income or operating success of a company for a specific period of time. (c) Solvency ratios measure the ability of the company to survive over a long period of time. 9. (a) Asset turnover (b) Inventory turnover or days sales in inventory (c) Return on shareholders' equity (d) Interest coverage (e) Current ratio Solutions Manual 18-5 Chapter 18

6 QUESTIONS (Continued) 10. A high current ratio does not always mean that a company is liquid. A high current ratio might be hiding liquidity problems with regards to inventory or accounts receivable. For example, a high level of inventory will cause the current ratio to increase. Increases in inventory can be due to the fact that inventory is not selling and may be obsolete. Increases in the current ratio will also occur if the company s accounts receivable increase. An increase in accounts receivable could indicate the company is having trouble collecting its overdue accounts, which again would mean liquidity problems for the business. 11. Aubut Corporation is collecting its receivables much more slowly than the industry average. Aubut collects its receivables, on average, every 81 days ( ), compared to the industry average of 56 days ( ). This could indicate that Aubut is not using the same credit checks or collection policies as the rest of the industry. However, a slower receivables turnover than the industry does not always indicate a problem. The receivables turnover ratio can be misleading in that some companies encourage credit and revolving charge sales and slow collections, in order to earn a healthy return on the outstanding receivables in the form of high rates of interest. 12. Wong s solvency is better than that of the industry. It is carrying a slightly lower percentage of debt than the industry (37% versus 39%) and has a higher interest coverage ratio (3 versus 2.5). 13. The company s free cash low may have fallen because it used the cash for capital expenditures. A company that has a lower free cash flow has less cash available for expansion and other expenditures and therefore, is often considered to be less solvent. 14. Yes, Saputo has made effective use of leverage. Saputo earned a higher return using borrowed money (12%) than it paid on the borrowed money. This enabled Saputo to use money supplied by creditors to increase the return to the shareholders (19%). Solutions Manual 18-6 Chapter 18

7 QUESTIONS (Continued) 15. An investor interested in growth would want to invest in a company with a high price-earnings ratio and a low dividend payout. The high priceearnings ratio indicates that investors expect this company s earnings to grow and are willing to pay for this anticipated future growth. A low payout ratio generally indicates that the company has growth opportunities and is choosing to reinvest earnings to finance this future growth rather than paying earnings out as dividends. An investor interested in shares with income potential would likely choose a company that pays out its earnings as dividends and therefore has a higher dividend payout ratio. 16. No, the president should not be overly concerned about the decrease in the ratios. They declined because of the price decrease. Since net income has risen, the increase in sales quantity is more than making up for the unit price decrease. The company is making fewer dollars profit for each item sold, but is selling sufficiently more items to increase its net income. However, this practice may not be sustainable in the long-term, particularly if higher sales in the current period will end up reducing sales in a future period. In addition, operating expenses may increase because of the additional sales so the president should continue to closely watch both cost of goods sold and operating expenses in relation to sales Use of estimates which may be inaccurate. To the extent that these estimates may be inaccurate or biased, the financial ratios and percentages are inaccurate or biased as well. 2. Use of cost which is not adjusted for price-level changes. Failing to adjust for the effect of general price level changes may lead to inaccurate conclusions about information such as the company s rate of growth. 3. Use of alternative accounting methods. Differences in accounting principles make intercompany comparisons difficult and often misleading. 4. Quality of earnings. Management may try to manipulate income by choosing estimates and accounting policies to manage income. (Note: Question 17 continues on the next page) Solutions Manual 18-7 Chapter 18

8 QUESTIONS (Continued) 17. (Continued) 5. Earning power and irregular items. Financial statements often include non-recurring items that are not typical of normal business operations. If such items are not presented separately on the income statement, investors may make false assumptions concerning a company s ongoing earning potential. 6. Diversification of firms. Today, many firms are so diversified that intercompany comparisons or the use of industry statistics becomes impossible, as these companies cannot be classified into one industry. 18. If management wanted to increase income, it could decrease the amortization expense by increasing the estimated useful life of the asset. Management of income through, for example, the changing of accounting estimates may lead to reported income that is confusing and misleading to users. For example, if a company changes its estimate of an asset s useful life, amortization expense will change. The clarity and thoroughness of the income may be reduced which would lead to a lower quality of earnings. Note to the instructor: Other accounting estimates might include residual value, bad debts, and warranties, amongst others. 19. (a) The use of FIFO in periods of rising prices causes cost of goods sold to be lower and income to be higher. (b) Reducing the machinery s life from five years to three years causes a higher amortization expense per year, which reduces net income. (c) Declining-balance amortization is higher than straight-line amortization in the early years of an asset s life, but becomes lower in the later years. Therefore, if straight-line amortization is used, net income will be higher initially but will be lower in later years. 20. Lai s profit margin has improved. When comparing the company s profit margin before considering atypical items, we see that the profit margin has improved from 5% to 8%. Discontinued operations are a nonrecurring item and should be excluded for analysis purposes. Solutions Manual 18-8 Chapter 18

9 QUESTIONS (Continued) 21. The concept of earning power is defined as net income adjusted for irregular or non-typical items. It is the amount of income that a company can expect to earn from its normal operations. In order to distinguish a company s net income from its earning power, irregular items, such as discontinued operations and extraordinary items, are reported separately on the income statement. Investors trying to get a picture of the company s future growth potential should not include these items in their analysis of future earnings potential because they are not expected to occur on an ongoing basis. 22. Discontinued operations refer to the disposal of an identifiable reporting or operating segment of the business. It is important to report discontinued operations separately because they represent atypical items. Investors trying to get a picture of the company s future growth potential should not include this item in their analysis of future earnings potential because it is not expected to occur on an ongoing basis. Solutions Manual 18-9 Chapter 18

10 SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 18-1 Increase (Decrease) c d a b Amount Percentage (a - b) (c b) Cash $ 24 $ 45 ($21) (46.7)% Accounts receivable % Inventory % Prepaid expenses n/a Property, plant, and 3,216 3,246 (30) (0.9)% equipment Intangible assets % Total assets $4,561 $4, % BRIEF EXERCISE 18-2 Comparing the percentages presented results in the following conclusions: The net income for Tilden Ltd. decreased in 2008 because of the combination of a decrease in sales and an increase in both cost of goods sold and operating expenses. However, the reverse was true in 2007 as sales increased, while both cost of goods sold and expenses decreased. This resulted in an increase in net income. Solutions Manual Chapter 18

11 BRIEF EXERCISE 18-3 Horizontal Analysis Increase (Decrease) Dec. 31, 2008 Dec. 31, 2007 Amount Percentage Cash $150,000 $175,000 $(25,000) (14.3)% 1 Accounts receivable 600, , , % 2 Inventory 780, , , % 3 Noncurrent assets 3,130,000 2,800, , % 4 1 $(25,000) (14.3)% 2 $175,000 $200,000 50% $400,000 3 $180,000 30% 4 $330,000 = 11.8% $600,000 $2,800,000 Vertical Analysis Dec. 31, 2008 Dec. 31, 2007 Amount Percentage Amount Percentage Cash $ 150, % $ 175, % Accounts receivable 600, % 400, % Inventory 780, % 600, % Noncurrent assets 3,130, % 2,800, % Total assets $4,660, % $3,975, % 2008 Calculations: 2007 Calculations $150,000 $4,660,000 = 3.2% $175,000 $3,975,000 = 4.4% $600,000 $4,660,000 = 12.9% $400,000 $3,975,000 = 10.1% $780,000 $4,660,000 = 16.7% $600,000 $3,975,000 = 15.1% $3,130,000 $4,660,000 = 67.2% $2,800,000 $3,975,000 = 70.4% Solutions Manual Chapter 18

12 BRIEF EXERCISE Amount Percentage Amount Percentage Net sales $1, % $2, % Cost of goods sold 1, % 1, % Gross profit % % Operating expenses % % Income before income tax % % Income tax expense % % Net income $ % $ % BRIEF EXERCISE Sales 100% 100% 100% Cost of goods sold 59% 62% 64% Operating expenses 25% 27% 28% Income tax expense 3% 2% 2% Net income 13% 9% 6% Net income as a percentage of sales for Waubons increased over the three-year period, because cost of goods sold and operating expenses both decreased as a percentage of sales every year. Solutions Manual Chapter 18

13 BRIEF EXERCISE 18-6 (a) Deterioration: A decrease in the receivables turnover would be viewed as deterioration. It is taking longer to collect the accounts. (b) Deterioration: The increase in the days sales in inventory turnover would be viewed as deterioration. It is taking the company longer to sell the inventory and consequently there is a greater chance of inventory obsolescence, and higher carrying costs. (c) Improvement: The decrease in debt to total assets would be viewed as an improvement because it means that the company has reduced its obligations to creditors and has raised its equity "buffer." However, the lower leverage will not be to the advantage of the shareholders if operations are sufficiently profitable. (d) Deterioration: A decrease in interest coverage would be viewed as deterioration because it means that the company's ability to meet interest payments as they come due has weakened. (e) (f) Improvement: An increase in the gross profit margin would be viewed as an improvement because it means that a greater percentage of net sales is going towards income. Deterioration: A decrease in asset turnover would be viewed as deterioration because it means the company has become less efficient at using its assets to generate sales. (g) Improvement: An increase in the return on equity would be viewed as an improvement because it means more net income was generated per dollar of equity investment. Solutions Manual Chapter 18

14 BRIEF EXERCISE 18-6 (Continued) (h) Improvement: An increase in the payout ratio would normally be viewed as an improvement. However, some shareholders may view this as a deterioration if they prefer that the company retain its earnings to fuel growth. BRIEF EXERCISE 18-7 Holysh s liquidity is deteriorating even though its current ratio is higher. The receivables are being collected more slowly, and it is taking longer to sell the inventory. These less-liquid assets are a higher proportion of the current assets than last year. BRIEF EXERCISE (a) Receivables turnover Net credit sales Average net receivables $6,462,581 = ($247,014 + $292,462)? = 24.0 times $6,364,983 = ($292,462 + $242,306)? = 23.8 times (b) Collection period 365 days Receivables turnover 365 days = 24.0 = 15.2 days 365 days = 23.8 = 15.3 days Management should be pleased with the effectiveness of its credit and collection policies. The collection period of 15.2 days is well within the 30 days allowed in the credit terms. Solutions Manual Chapter 18

15 BRIEF EXERCISE 18-9 (a) Inventory turnover Cost of goods sold Average inventory $4,540,000 $960,000 $1,020,000 2 = 4.6 times (b) Days sales in inventory $4,550,000 $840,000 + $960,000 2 = 5.1 times days 71.6 days Management should be concerned with the fact that inventory is moving more slowly in 2008 than it did in The decrease in the turnover ratio could be because of poor pricing decisions or because the company has obsolete inventory, for example. BRIEF EXERCISE ($ in thousands) (a) Debt to total assets (b) Interest coverage $1,872,374 = 42.8% $4,375,383 $364,494 + $48,649 + $186,102 = 12.3 times $48,649 (c) Free cash flow $450,575 - $274,182 = $176,393 Solutions Manual Chapter 18

16 BRIEF EXERCISE (US$ in millions) (a) Asset turnover = Net sales Average total assets (b) Profit margin = $16,078.1 = $7, $7, = 2.2 times Net income Net sales $834.4 = $16,078.1 = 5.2% BRIEF EXERCISE (a) 4 (b) 1 (c) 6 (d) 2 (e) 1 (f) 3 (g) 5 (h) 2 (i) 6 (j) 5 Solutions Manual Chapter 18

17 BRIEF EXERCISE (a) Income tax on continuing operations = $500,000 X 25% = $125,000 (b) Tax savings on loss from operations of discontinued operations = ($154,000) X 25% = ($38,500) Tax on gain on sale of discontinued operations = $60,000 X 25% = 15,000 ($23,500) (c) LIMA CORPORATION Income Statement (Partial) For the Current Year Income before income tax... $500,000 Income tax expense ,000 Income from continuing operations ,000 Discontinued operations Loss from operations of discontinued operations, net of $38,500 income tax savings... ($115,500) Gain on disposal of discontinued operations, net of $15,000 income tax 45,000 (70,500) Net income... $304,500 Solutions Manual Chapter 18

18 BRIEF EXERCISE OSBORN CORPORATION Income Statement (Partial) Year Ended December 31, 2008 Income before income tax... $950,000 Income tax expense ($950,000 X 25%) ,500 Income from continuing operations ,500 Discontinued operations Loss from operations of Mexico facility, net of $75,000 ($300,000 X 25%) income tax savings... $225,000 Loss on disposal of Mexico facility, net of $40,000 ($160,000 X 25%) income tax savings ,000 (345,000) Net income... $367,500 Solutions Manual Chapter 18

19 EXERCISE 18-1 SOLUTIONS TO EXERCISES DRESSAIRE INC Current assets $120,000 $ 80,000 $100,000 Noncurrent assets 400, , ,000 Current liabilities 90,000 70, ,000 Noncurrent liabilities 145,000 95, ,000 Shareholders' equity 285, , ,000 (a) Current assets 120% 80% 100% Noncurrent assets 133% 117% 100% Current liabilities 90% 70% 100% Noncurrent liabilities 145% 95% 100% Shareholders' equity 143% 133% 100% (b) Current assets 50% (20%) Noncurrent assets 14% 17% Current liabilities 29% (30%) Noncurrent liabilities 53% (5%) Shareholders' equity 8% 33% Solutions Manual Chapter 18

20 EXERCISE 18-2 FLEETWOOD CORPORATION Income Statement Year Ended December Amount Percent Amount Percent Sales $800, % $600, % Cost of goods sold 500, % 390, % Gross profit 300, % 210, % Operating expenses 200, % 156, % Income before income tax 100, % 54, % Income tax expense 25, % 13, % Net income $ 75, % $ 40, % Solutions Manual Chapter 18

21 EXERCISE 18-3 (a) OLYMPIC CORPORATION Income Statement Year Ended December 31 Increase or (Decrease) Amount Percentage Net sales $600,000 $550,000 $50, % Cost of goods sold 460, ,000 60, % Gross profit 140, ,000 (10,000) (6.7%) Operating expenses 55,000 50,000 5, % Income before income tax 85, ,000 (15,000) (15.0%) Income tax 34,000 40,000 (6,000) (15.0%) Net income $ 51,000 $ 60,000 $ (9,000) (15.0%) (b) OLYMPIC CORPORATION Income Statement Year Ended December Amount Percent Amount Percent Net sales $600, % $550, % Cost of goods sold 460, % 400, % Gross profit 140, % 150, % Operating expenses 55, % 50, % Income before income tax 85, % 100, % Income tax 34, % 40, % Net income $ 51, % $ 60, % Solutions Manual Chapter 18

22 EXERCISE 18-4 (a) MOUNTAIN EQUIPMENT CO-OPERATIVE Balance Sheet December 31 (in thousands) Increase (Decrease) Amount Percent Assets Current assets $ 69,237 $58,150 $11, % Property, plant, and equipment 37,587 39,225 (1,638) (4.2%) Deferred store opening costs (296) (100.0%) Total assets $106,824 $97,671 $ 9, % Liabilities and Members' Equity Current liabilities $ 21,271 $18,873 $2, % Long-term liabilities 641 4,113 (3,472) (84.4%) Total liabilities 21,912 22,986 (1,074) (4.7%) Members' Equity 84,912 74,685 10, % Total liabilities and members' equity $106,824 $97,671 $ 9, % Solutions Manual Chapter 18

23 EXERCISE 18-4 (Continued) (b) MOUNTAIN EQUIPMENT CO-OPERATIVE Balance Sheet December 31 (in thousands) Amount Percent Amount Percent Current assets $ 69, % $58, % Property, plant, and equipment 37, % 39, % Deferred site operating costs 0 0.0% % Total assets $106, % $97, % Liabilities and Members' Equity Current liabilities $ 21, % $18, % Long-term liabilities % 4, % Total liabilities 21, % 22, % Members' Equity 84, % 74, % Total liabilities and members' equity $106, % $97, % (c) During 2005, the percentage of current assets increased and the percentage of property, plant and equipment decreased compared to Also, debt to total assets decreased indicating that, compared to 2004, Mountain Equipment Co-op is financing its assets more with equity than debt. Solutions Manual Chapter 18

24 EXERCISE 18-5 Ratio Asset turnover Collection period Current ratio Days sales in inventory Debt to total assets Earnings per share Free cash flow Gross profit margin Interest coverage Inventory turnover Payout ratio Price-earnings ratio Profit margin Receivables turnover Return on assets Return on equity Classification P L L L S P S P S L P P P L P P Solutions Manual Chapter 18

25 EXERCISE 18-6 ($ in millions) (a) Working capital = $1,395 - $710 = $685 Current ratio = 1.96:1 ($1,395 $710) Receivables turnover = 6.2 times ($3,894 [($676 + $586) 2]) Collection period = 58.9 days ( times) Inventory turnover = 4.3 times ($2,600 [($628 + $586) 2]) Days sale in inventory = 84.9 days ( times) Solutions Manual Chapter 18

26 EXERCISE 18-6 (Continued) (b) Ratio Nordstar Canadian Tire Industry Average Working capital $685 $160 N/A Current ratio 1.96:1 1.6:1 2.1:1 Receivables turnover 6.2x 15.2x 66.1x Collection period 58.9 days 24 days 6 days Inventory turnover 4.3x 9.6x 6.8x Days sales in inventory 84.9 days 38 days 54 days Nordstar is less liquid than Canadian Tire and the industry. One must be cautious in interpreting Nordstar s current ratio. It is artificially high because the company is having problems in its receivables collection and inventory turnover. The collection period is significantly is higher than Canadian Tire, and more importantly, the industry in general. The inventory turnover is also well below the industry average. Nordstar needs to focus its efforts on increasing its turnover of receivables and inventory. Solutions Manual Chapter 18

27 EXERCISE 18-7 (a) The company s collection of its accounts receivables has deteriorated over the past three years. It is taking the company longer to collect its outstanding receivables as evidenced by the decrease in the accounts receivable turnover. (b) The company is selling its inventory slower as the inventory turnover is declining. (c) Overall, the company s liquidity has deteriorated. The increase in the current ratio is caused by the increase in inventory and receivables due to the slowdown in the movement of these assets. Even though the company s current ratio is higher, if the underlying assets cannot be converted to cash to repay current liabilities, then liquidity has deteriorated. EXERCISE 18-8 (a) (b) (c) The debt to total assets has weakened over the past three years. The interest coverage has improved over the past three years. The company s solvency initially appears to be worsening as evidenced by its increased reliance on debt. However, its interest coverage ratio is improving, so the company appears to be able to handle this increasing level of debt. I would conclude that the solvency is not really worse. Solutions Manual Chapter 18

28 EXERCISE 18-9 (a) (b) (c) Petro-Canada is more profitable. Its earnings per share and profit margin are both higher than Imperial Oil s. Investors favour Imperial Oil. It has a higher price-earnings ratio. Investors would purchase shares in Imperial Oil and Petro- Canada primarily for growth reasons. The payout ratio is not overly large, so shareholders would expect to purchase shares for future profitable resale while still earning a reasonable dividend, but not primarily for the dividend income. Solutions Manual Chapter 18

29 EXERCISE ($ in thousands) (a) Asset turnover (P) $849,616 $391,103 + $393,085 2 = 2.2 times (b) Debt to total assets (S) $275,447 = 70.4% $391,103 (c) Earnings per share (P) $25,337 = $ ,134 (d) Free cash flow (S) $67,106 - $17,407 = $49,699 (e) Interest coverage (S) $25,337 + $3,917 + $360 = 7.6 times $3,917 (f) Price-earnings ratio (P) $14.10 $1.05 = times (g) Profit margin (P) (h) Return on assets (P) $25,337 $849,616 = 2.98% $25,337 $391,103 + $393,085 2 = 6.5% (i) Return on equity (P) $25,337 $115,656 + $88,868 2 = 24.8% Solutions Manual Chapter 18

30 EXERCISE (Continued) Note: (L) stands for liquidity ratio, (P) for profitability ratio, and (S) for solvency ratio. Solutions Manual Chapter 18

31 EXERCISE (a) (b) (c) Suncor is more liquid. It has a higher current ratio, and although that may be partially due to its level of receivables, Suncor s receivable turnover is well above the industry average. Husky has only $0.60 of current assets for every $1 of current liabilities. Husky is more solvent. It has a lower proportion of debt and covers its interest cost more times. Husky is more profitable. It has a higher profit margin and a higher return on assets than Suncor. (d) Investors favour Suncor. Its shares are trading at 26.9 times its EPS. This is not consistent with the findings in (b) and (c). Share price is often based, to a large extent, upon expectations about future earnings. It seems as though investors see a brighter future for Suncor. Solutions Manual Chapter 18

32 EXERCISE (a) DAVIS LTD. Income Statement (Partial) Year Ended December 31, 2008 Income from continuing operations... $270,000 Discontinued operations Gain from operations of division, net of $33,000 income taxes... $77,000 Loss from disposal of division, net of $21,000 income tax savings... (49,000) 28,000 Net income... $298,000 (b) The net-of-tax effect of the cumulative change in accounting principle (item 2) would be presented in the Statement of Retained Earnings as an adjustment to opening retained earnings. Solutions Manual Chapter 18

33 EXERCISE PETRIE LTD. Income Statement Year Ended May 31, 2008 Sales... $1,000,000 Cost of goods sold ,000 Gross profit ,000 Operating expenses ,000 Operating income ,000 Other revenue Investment revenue... $20,000 Other expenses Loss on sale of available-for-sale securities... (10,000) Interest expense... (50,000) (40,000) Income before income tax ,000 Income tax expense ($260,000 X 25%)... 65,000 Income from continuing operations ,000 Discontinued operations Loss on operations of division, net of $10,000 income tax savings... $(30,000) Gain on disposal of division, net of $25,000 income tax savings... 75,000 45,000 Net income... $ 240,000 Solutions Manual Chapter 18

34 SOLUTIONS TO PROBLEMS PROBLEM 18-1A (a) Operating revenues 290.3% 220.1% 179.7% 142.1% 100.0% Operating expenses 307.8% 246.2% 177.2% 141.8% 100.0% Interest expense % % 929.8% 176.1% 100.0% Income tax expense 132.7% 5.7% 174.8% 147.4% 100.0% Net income (loss) 65.4% (46.8%) 164.9% 141.1% 100.0% Current assets 372.8% 227.5% 322.9% 166.8% 100.0% Total assets 562.5% 477.2% 375.4% 199.3% 100.0% Current liabilities 396.3% 320.2% 250.4% 184.1% 100.0% Total liabilities 898.5% 749.7% 521.8% 249.5% 100.0% Share capital 376.5% 319.1% 290.9% 163.7% 100.0% Retained earnings 218.0% 192.0% 221.5% 156.0% 100.0% Calculations: Current value base year value X 100 (b) Noncurrent assets and noncurrent liabilities are primarily responsible for changes in WestJet s financial position. They have grown much faster than current assets and current liabilities. Operating expenses have been growing faster than operating revenues. That, combined with a massive increase in interest expense, has caused net income to decline during the five-year period. (c) WestJet has been increasingly relying on long-term debt to finance its operations. Total liabilities are up 898.5% while current liabilities are only up 396.3%. Total shareholders equity is up about 310% [($486,706 + $201,447) ($129,268 + $92,412) X 100]. Solutions Manual Chapter 18

35 PROBLEM 18-2A (a) Income Statement Year Ended December 31, 2008 Manitou Ltd. Muskoka Ltd. Dollars Percent Dollars Percent Net sales $350, % $1,400, % Cost of goods sold 200, % 720, % Gross profit 150, % 680, % Operating expenses 50, % 272, % Income from operations 100, % 408, % Interest expense 3, % 10, % Income before income taxes 97, % 398, % Income tax expense 23, % 100, % Net income $ 74, % $ 298, % Solutions Manual Chapter 18

36 PROBLEM 18-2A (Continued) (b) Gross Profit Margin: Gross profit margin Net sales Manitou Muskoka = $150,000 $350,000 = $680,000 $1,400,000 = 42.9% = 48.6% Profit Margin: Net income Net sales Manitou Muskoka = $74,000 $350,000 = $298,000 $1,400,000 = 21.1% = 21.3% Return on Assets: Net income Average total assets Manitou: Muskoka $74,000 $457,500 $298,000 $1,625,000 = 16.2% = 18.3% Asset Turnover: Net sales Average total assets Manitou: Muskoka $350,000 $457,500 $1,400,000 $1,625,000 = 0.77 times = 0.86 times Return on Equity: Net income Average shareholders equity Manitou: Muskoka $74,000 $392,500 $298,000 $1,112,500 = 18.9% = 26.8% (c) Muskoka appears to be more profitable. All of its ratios are better than Manitou s, although the profit margins are almost the same. Muskoka s return on equity is significantly higher than Manitou s. Solutions Manual Chapter 18

37 PROBLEM 18-3A Working capital $250,500 $190,150 = $60,350 Current ratio $250,500 $190,150 = 1.3:1 Inventory turnover $540,000 $86,400 + $64,000 2 = 7.2 times Days sales in inventory 365 days 7.2 = 50.7 days Receivables turnover $780,000 $116,200 + $5,500 + $93,800 + $4,500 2 = 7.1 times Collection period 365 days 7.1 = 51.4 days Gross profit margin $240,000 $780,000 = 30.8% Profit margin $59,650 $780,000 = 7.6% Asset turnover $780,000 $715,800 + $672,000 2 = 1.1 times Solutions Manual Chapter 18

38 PROBLEM 18-3A (Continued) Return on assets $59,650 ($715,800 + $672,000)? = 8.6% Return on equity Earnings per share $59,650 $445,650 + $396,000 2 $59,650 15,000 = $3.98 = 14.2% Payout ratio $1,800 $59,650 = 3.0% Debt to total assets Interest coverage $270,150 $715,800 = 37.7% $59,650 +$9,920 + $26,550 $9,920 = 9.7 times Free cash flow $89,000 - $53,500 = $35,500 Solutions Manual Chapter 18

39 PROBLEM 18-4A (a) Working capital $515,000 - $337,750 = $177,250 $460,000 - $315,000 = $145,000 Current ratio $515,000 $337,750 = 1.5:1 $460,000 $315,000 = 1.5:1 Inventory turnover $650,000 $340,000 + $300,000 2 = 2.0 times $635,000 $300,000 + $350,000 2 = 2.0 times Days sales in inventory = days = days Receivables turnover $1,000,000 $105,000 + $91,000 2 = 10.2 times $940,000 $91,000 + $83,000 2 = 10.8 times Collection period = 35.8 days = 33.8 days Debt to total assets $537,750 $1,340,000 = 40.1% $515,000 $1,235,000 = 41.7% Solutions Manual Chapter 18

40 PROBLEM 18-4A (Continued) (a) (Continued) Interest coverage $145,000 $30,000 = 4.9 times $120,000 $30,000 = 4.0 times Free cash flow $92,000 - $80,000 = $12,000 $65,000 - $50,000 = $15,000 Profit margin $86,250 $1,000,000 = 8.6% $67,500 $940,000 = 7.2% Gross profit margin $350,000 $1,000,000 = 35.0% $305,000 $940,000 = 32.4% Asset turnover $1,000,000 $1,340,000 + $1,235,000 2 = 0.8 times Return on assets $86,250 $1,340,000 + $1,235,000 2 = 6.7% $940,000 $1,235,000 + $1,175,000 2 = 0.8 times $67,500 $1,235,000 + $1,175,000 2 = 5.6% Solutions Manual Chapter 18

41 PROBLEM 18-4A (Continued) (a) (Continued) Return on equity $86,250 $802,250 + $720,000 2 = 11.3% $67,500 $720,000 + $656,600 2 = 9.8% Earnings per share $86, ,000 = $0.86 $67, ,000 = $0.68 Payout $4,000 $86,250 = 4.6% $4,000 $67,500 = 5.9% (b) Star Track s liquidity has deteriorated. Two-thirds of its current assets are inventory, which is only turning over twice a year. Solvency is largely unchanged although the interest coverage is better in Almost of all of the profitability ratios are improved in Solutions Manual Chapter 18

42 PROBLEM 18-5A ($ in thousands) Liquidity The Brick Leon s Industry Current ratio $284,373 $278,213 = 1.0:1 $189,690 $99,579 = 1.9:1 1.2:1 Receivables turnover $1,214,405 $45,862 = 26.5 times $547,744 $19,234 = 28.5 times 8.3 times Inventory turnover $739,505 $181,266 = 4.1 times $323,629 $71,962 = 4.5 times 4.9 times Overall, Leon s liquidity is better than the Brick s and better than the industry average. Solvency The Brick Leon s Industry Debt to total assets $445,511 $923,900 = 48.2% $121,264 $381,702 = 31.8% 40.1% Interest coverage $34,697 + $1,087 $5,233 = 6.8 times n/a 2.0 times Solutions Manual Chapter 18

43 PROBLEM 18-5A (Continued) Based solely on the debt to total assets ratio since the interest coverage ratio is not available for Leon s, Leon s is more solvent than The Brick. The Brick has a higher portion of debt than the industry average. Profitability The Brick Leon s Industry Profit margin $32,004 $1,214,405 = 2.6% $48,964 $547,744 = 8.9% 1.6% Asset turnover $1,214,405 $892,200 = 1.4 times $547,744 $376,316 = 1.5 times 0.6 times Return on assets $32,004 $892,200 = 3.6% $48,964 $376,613 = 13.0% 0.8% Return on equity $32,004 $494,890 = 6.5% $48,964 $255,152 = 19.2% 2.3% Leon s is more profitable than The Brick, and The Brick is more profitable than the industry average. Solutions Manual Chapter 18

44 PROBLEM 18-6A (a) Accounts receivable management can be assessed by reviewing each company s receivables turnover ratio and average collection period. Refresh s average collection period of 32 days ( ) days is reasonable when compared to its credit terms of 30 days. Flavour s average collection period of 37 days ( ) days is worse than that of Refresh, but still better than the average firm in the industry ( = 39 days). (b) Each company s ability to manage its inventory can be measured by the inventory turnover ratio. Currently Refresh is turning over its inventory 5.8 times per year, which can also be expressed as days in inventory of approximately 63 days ( times). When compared to the turnover for Flavour and the industry average, it appears that Refresh is turning over its inventory at a slower rate than the competition. (c) Refresh appears to be the more solvent of the two companies. Refresh has a lower debt to total assets ratio, indicating that Refresh has a lower percentage of its assets financed by debt. As well, Refresh has a higher times interest earned ratio indicating that Refresh has a better ability to service its debt as interest payments become due. (d) Refresh s higher gross profit margin may be attributable to a number of factors: The company may be selling its products at a higher price. The company may be paying less for its inventory than the competition. This may occur if, for example, Refresh is able to purchase inventory in large volumes and receives purchase discounts. Solutions Manual Chapter 18

45 PROBLEM 18-6A (Continued) (e) The asset turnover is the same for both companies. Therefore, Refresh s higher return on assets seems to be attributable to Refresh s higher profit margin. (f) Market price per share Refresh = Price earnings ratio x Earnings per share = 50.3 x $0.98 = $49.29 Flavour = Price earnings ratio x Earnings per share =24.3 x $1.37 = $33.29 (g) The price-earnings ratio reflects investors assessment of the future prospects of a company. As indicated by its higher price-earnings ratio, investors appear to believe that Refresh has the better possibility for growing its earnings and dividends. Solutions Manual Chapter 18

46 PROBLEM 18-7A (a) It is difficult to say which company is more liquid. Snap-on has a higher current ratio and turns its inventory over more quickly than Black and Decker, but collects its receivables more slowly. (b) Snap-on is more solvent. Snap-on has significantly less debt than Black and Decker and is more in line with the industry average. However, both companies are able to cover their interest better than the industry average. (c) Both companies appear to be profitable. Snap-on has a higher gross margin than Black and Decker but Black and Decker has a higher profit margin, earns a higher return on assets, and offers a much better return on equity. All of this would indicate that Black and Decker is the more profitable company. (d) Investors seem to favour Snap-on as it has the higher price-earnings ratio. This is consistent with (b) as investors would likely favour a company with a better solvency position. However, this is not consistent with (c), as you would expect investors to favour the more and profitable company. Investors must be anticipating better future profitability from Snap-on. Solutions Manual Chapter 18

47 PROBLEM 18-8A (a) Transaction 1. Issues common shares 2. Collects an account receivable 3. Issues a mortgage note payable 4. Sells equipment at a loss 5. Share price increases from $10 per share to $12 per share Receivables Turnover (10X) Profit Margin (10%) Earnings per Share ($2) Debt to Total Assets (40%) Free Cash Flow ($25,000) NE NE D D NE I NE NE NE I NE D NE I NE NE D D I I NE NE NE NE NE (b) A change in the profit margin ratio or the earnings per share would have no impact on the above changes. Solutions Manual Chapter 18

48 PROBLEM 18-9A (a) Before Discontinued Operations Profit margin $700 $3,932 = 17.8% Asset turnover $3,932 $13,486 = 0.3 times Return on assets $700 $13,486 = 5.2% Return on equity $700 $3,438 = 20.4% $710 $2,944 = 24.1% $2,944 $10,050 = 0.3 times $710 $10,050 = 7.1% $710 $2,471 = 28.7% $507 $2,632 = 19.3% $2,632 $7,191 = 0.4 times $507 $7,191 = 7.1% $507 $1,832 = 27.7% After Discontinued Operations Profit margin $1,152 $3,932 = 29.3% Asset turnover $3,932 $13,486 = 0.3 times Return on assets $1,152 $13,486 = 8.5% Return on equity $1,152 $3,438 = 33.5% $793 $2,944 = 26.9% $2,944 $10,050 = 0.3 times $793 $10,050 = 7.9% $793 $2,471 = 32.1% $578 $2,632 = 22.0% $2,632 $7,191 = 0.4 times $578 $7,191 = 8.0% $578 $1,832 = 31.6% Solutions Manual Chapter 18

49 PROBLEM 18-9A (Continued) (b) Overall, profitability is declining when calculated before discontinued operations and increasing when calculated after discontinued operations. Return on equity is the most graphic example. (c) Investors are interested in the future. Analysis based on continuing operations is therefore more relevant to them. Solutions Manual Chapter 18

50 (a) PROBLEM 18-10A ZURICH CORPORATION Income Statement Year Ended December 31, 2008 Net sales... $1,700,000 Cost of goods sold... 01,100,000 Gross profit ,000 Operating expenses ,000 Income from operations ,000 Other revenues... $20,000 Other expenses ,000 0 (12,000 Income before income tax ,000 Income tax expense ($352,000 X 25%)... 88,000 Income from continuing operations ,000 Discontinued operations Gain from operations of discontinued division, net of $5,000 income tax expense... $15,000 Loss on sale of discontinued division, net of $17,500 income tax saving... (52,500) (37,500) Net income... $ 226,500 Earnings per share: Continuing operations... $2.64 Discontinued operations... (0.38) Net income... $2.26 Solutions Manual Chapter 18

51 PROBLEM 18-10A (Continued) (b) ZURICH CORPORATION Statement of Retained Earnings Year Ended December 31, 2008 Balance, January 1 as originally reported... $ 940,000 Add: Cumulative effect of change in amortization method, net of $15,000 income tax... 45,000 Balance, January 1 as adjusted ,000 Add: Net income ,500 1,211,500 Less: Cash dividends... 25,000 Retained earnings, December $1,186,500 Solutions Manual Chapter 18

52 PROBLEM 18-1B (a) BIG ROCK BREWERY INCOME TRUST Income Statement Horizontal Analysis Year ended December (12 months) (12 months) (9 months) Revenues 142.3% 136.1% 100.0% Cost of sales 148.1% 133.0% 100.0% Gross profit 139.0% 137.8% 100.0% Operating expenses 137.7% 136.4% 100.0% Income before income taxes 142.2% 141.3% 100.0% Income tax expense 126.4% 104.2% 100.0% Net income 145.3% 148.5% 100.0% BIG ROCK BREWERY INCOME TRUST Balance Sheet Horizontal Analysis December Assets Current assets 127.6% 99.4% 100.0% Noncurrent assets 94.2% 100.6% 100.0% Total assets 102.4% 100.3% 100.0% Liabilities & Unitholders Equity Current liabilities 78.6% 81.0% 100.0% Noncurrent liabilities 87.9% 80.7% 100.0% Total liabilities 84.6% 80.8% 100.0% Unitholders' equity 111.8% 110.6% 100.0% Total liabilities & equity 102.4% 100.3% 100.0% Solutions Manual Chapter 18

53 PROBLEM 18-1B (Continued) (b) One would expect to see about a 33% increase for all income statement items between 2003 and 2004 due to the different time frames. That seems to be the case for everything except income tax, which was largely unchanged. Cost of sales rose faster than sales in 2005, which led to a lower net income. On the balance sheet, current assets have increased significantly while current liabilities have decreased. This should mean the company s liquidity is improved. (c) The different time frames should not impact the balance sheet analysis. The income statement analysis must consider the time frame in order to be meaningful. One can compare 2004 and 2005 without any problems, but the comparison with 2003 data is not very meaningful. Solutions Manual Chapter 18

54 PROBLEM 18-2B (a) CHEN AND CHUAN COMPANIES Income Statements Year Ended December 31, 2008 Chen Inc. Chuan Ltd. Dollars Percent Dollars Percent Net sales $1,849, % $539, % Cost of goods sold 1,080, % 338, % Gross profit 768, % 201, % Operating expenses 502, % 79, % Income from operations 266, % 122, % Interest expense 6, % 1, % Income before income tax 259, % 120, % Income tax expense 103, % 48, % Net income $ 155, % $ 72, % (b) Gross Profit Margin: Gross profit margin Net sales Chen Chuan = $768,545 $1,849,035 = $201,032 $539,038 = 41.6% = 37.3% Profit Margin: Net income Net sales Chen Chuan = $155,670 $1,849,035 = $72,480 $539,038 = 8.4% = 13.4% Solutions Manual Chapter 18

55 PROBLEM 18-2B (Continued) (b) (Continued) Asset Turnover: Net sales Average total assets Chen Chuan s = $1,849,035 $894,750 = $539,038 $251,313 = 2.1 times = 2.1 times Return on Assets: Net income Average total assets Chen Chuan = $155,670 $894,750 = $72,480 $251,313 = 17.4% = 28.9% Return on Equity: Net income Average shareholders equity Chen Chuan = $155,670 $724,430 = $72,480 $186,238 = 21.5% = 38.9% (c) Chuan seems to be a much more profitable company. Although Chen has a higher gross profit margin, Chuan has a better profit margin, which means it can generate more net income per dollar of sales. Chuan s assets are returning more even though the asset turnover is the same as Chen s. Finally Chuan s shareholders are enjoying a much better return on their investment. Solutions Manual Chapter 18

56 PROBLEM 18-3B Working capital $310,900 - $208,500 = $102,400 Current ratio $310,900 $208,500 = 1.5:1 Inventory turnover $1,005,500 $115,500 2 $143,000 = 7.8 times Days sales in inventory 365 days 7.8 = 46.8 days Receivables turnover $1,918,500 $107,800 + $5,400 + $102,800 + $5,100 2 = 17.4 times Collection period 365 days 17.4 = 21.0 days Gross profit margin $913,000 = 47.6% $1,918,500 Profit margin $265,300 = 13.8% $1,918,500 Asset turnover $1,918,500 $852,800 2 $990,200 = 2.1 times Solutions Manual Chapter 18

57 PROBLEM 18-3B (Continued) Return on assets $265,300 ($990,200 $852,800) 2 = 28.8% Return on equity $265,300 $695,700 + $465,400 2 = 45.7% Earnings per share $265,300 60, ,000 = $4.57 Debt to total assets $294,500 $990,200 = 29.7% Interest coverage $265,300 $28,000 $113,700 $28,000 = times Free cash flow = $313,900 - $161,000 = $152,900 Solutions Manual Chapter 18

58 PROBLEM 18-4B Liquidity Working capital Current ratio $364,000 - $185,000 = $179,000 $343,000 - $182,000 = $161,000 $364,000 $185,000 = 2.0:1 $343,000 = 1.9:1 $182,000 Receivables Turnover* $900,000 x 75% $96,500 = 7.0 times $840,000 x 75% $92,500 = 6.8 times * Average gross receivables for 2008 = ($94,000 + $5,000 + $90,000 + $4,000) 2 Average gross receivables for 2007 = ($90,000 + $4,000 + $88,000 + $3,000) 2 Collection period 365 days 7.0 = 52.1 days 365 days 6.8 = 53.7 days Inventory turnover Days sales in inventory $620,000 $127,500 = 4.9 times 365 days 4.9 = 74 days $575,000 $120,000 = 4.8 times 365 days 4.8 = 76 days Solutions Manual Chapter 18

59 PROBLEM 18-4B (Continued) Profitability Gross profit $280,000 = 31.1% $900,000 $265,000 = 31.5% $840,000 Profit margin $56,000 $55,000 = 6.2% = 6.5% $900,000 $840,000 Asset turnover $900,000 $754,000 + $648,000 2 = 1.3 times $840,000 $648,000 $630,000 2 = 1.3 times $56,000 Return on assets $754,000 +$648,000 2 = 8.0% $55,000 $648,000 $630,000 2 = 8.6% Return on equity $56,000 $369,000 + $316,000 2 = 16.4% $55,000 $316,000 + $269,000 2 = 18.8% EPS Payout ratio $56,000 $55,000 = $2.80 = $ ,000 20,000 $8,000 $56,000 = 14.3% $8,000 $55,000 = 14.5% Solutions Manual Chapter 18