Chapter 4 Analyzing and Interpreting Financial Statements

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1 Analyzing and Interpreting Financial Statements Solutions to Even-Numbered Problems and Cases 4.2 Northern Electric Corporation (a) (b) (c) Price Earnings 60 Earnings Earnings Earnings Therefore EPS is $3.00. Dividend per share Dividend yield Price Dividend per share 4% 60 4% 60 Dividend per share $2.40 Dividend per share Dividend payout ratio Annual dividends to common shareholders for the year Net income available to common shareholders Dividend per share EPS $2.40 $ % Copyright 2009 Pearson Education Canada 1

2 4.4 Albinitree Corporation (a) Current assets Current ratio Current liabilities (b) Current assets Inventory Acid test ratio 1.00 Current liabilities (c) Sales revenue $500,000,000 Sales revenue per employee $125, 000 Number of employees 4,000 (d) Leverage ratio Shareholders' equity % Long-term (non-current) debt + Long-term (non-current) debt (e) Sales revenue to capital employed Sales revenue Total shareholders' equity + Long-term liabilities $ times (f) ($ million) Sales 500 Cost of goods sold xxx Gross profit 220 Working backwards, cost of goods sold is Opening inventory yyy Plus: Purchases 300 Goods available for sale zzz Less: Closing inventory 65 Cost of goods sold (calculated above) 280 Working backwards, goods available for sale was Opening inventory was Copyright 2009 Pearson Education Canada 2

3 (g) From part (f), average inventory was 45. Average inventory turnover period Average inventory held 365 Cost of goods sold days (h) (i) (j) Gross profit margin Gross profit Sales revenue % Average collection period for receivables Accounts receivable 365 Credit sales revenue % 73 days Average payment period for payables Accounts payable 365 Credit purchases % 43.5 days Copyright 2009 Pearson Education Canada 3

4 4.6 Three businesses A Co. operates a supermarket chain. The grocery business is highly competitive and, to generate high sales volumes, it is usually necessary to accept low operating profit margins. Thus, we can see that the operating profit margin of A Co. is the lowest of the three businesses. The inventory turnover periods of supermarket chains also tend to be quite low. Most supermarket chains have invested heavily in inventory control and logistical systems over the years and, as a result, are often efficient in managing inventory. The average collection period for receivables is very low, as most sales are for cash or debit card; where a customer pays by credit card, there is usually a small delay before the supermarket receives the amount due. A low inventory turnover period and average collection period for receivables usually means that the investment in current assets is low. Hence, the current ratio (current assets divided by current liabilities) is also low. B Co. is the holiday tour operator. We can see that the sales revenue to capital employed ratio is the highest of the three businesses. This is because tour operators do not usually require a large investment of capital: they do not need a large asset base in order to conduct their operations. The inventory turnover period ratio does not apply to B Co. It is a service business and does not hold inventory for resale. We can see that the average collection period for receivables is low. This may be because customers are invoiced close to the holiday date for any amounts outstanding and must pay before going on vacation. The lack of inventory held and low average collection period for receivables leads to a very low current ratio. C Co. is the food manufacturing business. We can see that the sales revenue to capital employed ratio is the lowest of the three businesses. This is because manufacturers tend to invest heavily in both current and non-current assets. The inventory turnover period is the highest of the three businesses. Three different kinds of inventory raw materials, work in progress, and finished goods are held by manufacturers. The average receivables collection period is also the highest of the three businesses. Manufacturers tend to sell to other businesses rather than to the public, and their customers will normally demand credit. A one-month credit period for customers is fairly common for manufacturing businesses, although customers may receive a discount for prompt payment. The relatively high investment in inventory and receivables usually results in a high current ratio. Copyright 2009 Pearson Education Canada 4

5 4.8 Conday Ltd. (a) Return on capital employed Earnings before long-term loan interest and tax Long-term capital ( *) 26.7% 1,265 * interest on debentures (only interest on long-term capital used in calculation) Return on common equity Net income Common shares + retained earnings 100% % 1, % Gross profit margin Gross profit 100% Sales revenue % 2, % Operating profit margin Earnings before interest and tax Sales revenue 100% ( ) 14.5% 2,600 Sales revenue to capital employed (asset turnover) Sales revenue Capital employed 2,600 (1, ) Average collection period for accounts receivable Accounts receivable 365 days Credit sales revenue 2.1 times days 115 days 2,600 Copyright 2009 Pearson Education Canada 5

6 Inventory turnover period Inventory 365 days Cost of goods sold days 135 days 1,620 The above ratios reveal that Conday Ltd. is profitable. In particular, the return on equity and ROCE ratios seem to be high in relation to the returns achieved by more secure forms of investment such as government securities. However, whether this level of return is sufficient in relation to the risks involved is difficult to judge from the information available. The collection period for receivables seems very high, which may be due to the nature of the business. However, this high ratio, combined with the fact that the bad debts of the business account for more than 6 per cent of total sales revenue, suggests that some tightening of credit control procedures may be required. The inventory turnover period also seems high. The business is carrying more than four months inventory. This may indicate a need to improve inventory control procedures. At present, the business has a large bank overdraft and so major improvements in inventory control and credit control procedures may have a significant effect on both the liquidity and the profitability of the business. Given the high level of bank borrowing, it is difficult to understand why such a high proportion of the profits generated for the year was paid out in the form of dividends. This is not a very prudent policy. The sales revenue to capital employed ratio seems quite low. This is due, at least in part, to the high levels of inventory and receivables that are being carried. (b) Though the business is profitable, there are some doubts as to the quality of its management. The business has high levels of inventory and receivables and a large overdraft. It is possible that better management would not have allowed this situation to arise. It is possible, too, that better management of existing assets would remove the need for external sources of funds for expansion. It is interesting to speculate how $200,000 received from the issue of shares might be used by the managers. Would it be used to finance even higher levels of inventory and receivables without a corresponding increase in sales revenue? The share price of $6.40 is much higher than the net asset value of the shares. At present, the net assets (assets less liabilities) are $1,065,000 and there are 700,000 shares outstanding. This gives a net asset value per share of $1.52 ($1,065/700). To justify paying $6.40, the investor would have to be convinced the business would generate high profits in the future. Copyright 2009 Pearson Education Canada 6

7 4.10 Threads Limited (a) ROCE ( * )/( ) 19.8% 234/ % Operating profit 167/ % 234/ % margin Gross profit 450/ % 500/ % margin Current ratio 396/ :1 253/ :1 Acid test ratio 160/ :1 105/ :1 Collection period for receivables Payment period for payables Inventory turnover period (156/1200) days (76/750 ) days 236/ days (102/1180) days (60/680) days 148/ days * Assuming that this is long-term interest only in the absence of further information Credit purchases figure not available (b) A supplier seeking to sell a substantial amount of goods to the business will be concerned with both liquidity and longer-term viability (where there is a continuing relationship) as measured by profitability ratios. The supplier will also be interested in the average time taken by the business to pay its current suppliers. The liquidity ratios reveal an apparent improvement over the two years. However, for a manufacturing business, the liquidity ratios seem low and the supplier may feel some concern. The increase in inventory over the period has led to a greater improvement in the current ratio than in the acid test ratio. The improvement in the acid test ratio has not been very great and some concern over the business s liquidity position must remain. The average credit period allowed to customers has increased substantially in This may be a deliberate policy. However, if this is the case, the effect of a more liberal credit policy has not proved to be very successful as there has only been a slight increase in sales revenue in The credit period increase may be due, on the other hand, to other factors such as poor credit control or particular customers experiencing financial difficulties. The effect of this change in the collection period for receivables ratio should be carefully noted by the supplier as the increase in receivables outstanding seems to be partly financed by an increase in the average period taken to pay suppliers. The inventory turnover period has increased significantly in This might be due to inventory building in anticipation of future sales revenue. However, it might indicate that certain products are not selling as well as expected and are therefore remaining in inventory. The gross profit margin and operating profit margins are both lower in Copyright 2009 Pearson Education Canada 7

8 Lower margins have, in turn, led to a lower return on capital employed. The lower profit margins, the increase in the average credit period allowed to customers and the increase in the inventory turnover period may suggest that the business has a product range that is becoming obsolete and therefore more difficult to sell. It might, however, also suggest a more competitive business environment. The ratios calculated above do not indicate any serious problems for the business. However, it is clear that 2008 proved to be a more difficult year than Things may well improve in the future though. At this point, however, the supplier would be well advised to be cautious in his/her dealings with the business: certainly, the supplier should not rely too heavily on Threads Limited for future sales revenue Genesis Ltd. (a) and (b) These parts have been answered in the text of the chapter and you are referred to it for a discussion on overtrading and its consequences. 232 (c) Current ratio Acid test ratio Average inventory turnover period days 1, Average collection period for receivables days 1, Average payment period for payables days 1,260 Genesis certainly has liquidity problems as evidenced by very low current and acid test ratios. Overtrading is also shown by the fast inventory turnover period and the slow payment of creditors with an average payment period of nearly two months. (d) Overtrading must be dealt with either by increasing the level of funding in order to match the level of activity, or by reducing the level of activity to match the funds available. The latter option may result in a reduction in profits in the short term but may be necessary to ensure long-term survival. Copyright 2009 Pearson Education Canada 8