To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Chapter 13 Analyzing and Interpreting Financial Statements QUESTIONS With comparative statements, financial statement items for two or more successive accounting periods are placed side by side on a single statement, with the change in each item expressed as both a dollar amount and a percent Common-size comparative statements express each financial statement item as a percent of some base amount that is assigned a value of 100% Total assets (or equivalently, the total of liabilities plus equity) are assigned a value of 100% on a common-size balance sheet Net sales (revenues) are assigned a value of 100% on a common-size income statement Financial reporting includes the entire process of preparing and issuing financial information about a company Financial statements are an important part of financial reporting but they are less than the whole The nature of a company's business, the composition of its current assets, and the turnover of its current assets are three important factors that should be considered in deciding whether a current ratio is good or bad A 2-to-1 current ratio may not be adequate if the company's current assets consist of a large proportion of slow-turning accounts, notes, and merchandise inventory The general nature of the business also may make the 2-to-1 rule of thumb inadequate Adequate working capital enables a company to carry sufficient inventories, meet current debts, take advantage of cash discounts, and extend favorable terms to customers Working capital is a major factor in determining the short-term liquidity position of a company When evaluated in light of a company's credit terms, the number of days' sales uncollected indicates how quickly accounts receivable are converted into cash This provides information about the relevance of accounts receivable balances in meeting the current obligations of the business A high accounts receivable turnover implies that accounts are collected quickly, thereby providing cash that can be used to meet obligations A high turnover also means that a given sales volume can be supported with a lower investment in accounts receivable ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 671 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Users are interested in the capital structure of a company, as measured by debt and equity ratios, for at least two reasons First, as a company includes more debt in its capital structure, the risk that it will be unable to meet interest and principal payments increases Second, the existence of debt introduces financial leverage If the company can earn a rate of return on its investments that exceeds the rate of interest paid to creditors, the debt will increase the rate of return to stockholders 10 Inventory turnover reflects on the efficiency of inventory management That is, a high inventory turnover means that a given sales volume can be supported with a smaller investment in inventory This insight into the speed with which inventory is sold determines the relevance of the available inventory in meeting the current obligations of the business, which is a focus of short-term liquidity 11 Since management is responsible for a company's performance, all ratios that are useful in evaluating a company are of some usefulness in assessing management performance Profit margin, total asset turnover, return on total assets, and return on stockholders' equity are especially useful for assessing management's responsibility for operating efficiently and profitably 12 The ratio of pledged assets to secured liabilities must be interpreted with care because the book value of the pledged assets is used in calculating the ratio, and the book value is unlikely to always approximate the assets‘ market value 13 Almost all companies have some liabilities Since total assets equals total liabilities plus equity, total assets is almost always higher than common stockholders' equity Thus, the denominator in return on total assets is larger than common stockholders' equity Since the numerator is the same for both, and return on total assets has a larger denominator, it yields a smaller percent [Instructor note: A more complete measure of return on assets would add back (Interest Expense x {1 – Tax Rate}) to net income in the numerator—reflecting the after-tax cost of debt We leave the rationale for this adjustment to advanced courses.] 14 This gain is considered to be unusual but not infrequent It would be included in the calculation of income from continuing operations, with other unusual or infrequent gains and losses—in a category often labeled Other Gains and Losses 15 Return on total assets (2005): $984 ($10,294 + $8,652)/2 = 10.4% Return on total assets (2004): $705 ($8,652 + $7,694)/2 = 8.6% 16 Equity ratio (2005): $2,087,434 $3,789,382 = 55.1% Equity ratio (2004): $2,223,961 $3,730,526 = 59.6% 17 Profit margin (2004): $276 $8,279 = 3.3% ©McGraw-Hill Companies, 2008 672 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com QUICK STUDY Quick Study 13-1 (5 minutes) Items not part of general-purpose financial statements: Stock price information and analysis Management discussions and analysis of financial performance Company news releases Prospectus Quick Study 13-2 (10 minutes) The four usual standards of comparisons are: Intracompany The company under analysis provides standards for comparisons based on prior performance and relations between its financial items Competitor One or more direct competitors of the company under analysis can provide standards for comparisons Industry Industry statistics can provide standards of comparisons Published industry statistics are available from several services such as Dun & Bradstreet, Standard and Poor's, and Moody's Guidelines (Rules of Thumb) General standards of comparisons can develop from past experiences Examples are the 2-to-1 level for the current ratio or 1-to-1 level for the acid-test ratio All of these standards of comparisons are useful when properly applied Yet, analysis measures taken from a selected competitor or group of competitors are often the best standards of comparisons Also, intracompany and industry measures are important parts of all analyses The standard that is least likely to provide a good basis for comparison is the use of guidelines, or rules of thumb Guidelines must be applied with care, and then only if they seem reasonable in light of past experience and industry's norms ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 673 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Quick Study 13-3 (10 minutes) Common-size percents 2008 54.5% ($110,600 / $202,800) 2007 52.8% ($61,400 / $116,200) Trend percents 2008 174.5% ($202,800 / $116,200) 2007 100.0% (the given base amount) Quick Study 13-4 (15 minutes) 2008 Dollar Change 2007 Short-term investments $220,000 $160,000 Accounts receivable 38,000 44,000 Notes payable 60,000 Percent Change $60,000 37.5% (6,000) -13.6% 60,000 (not calculable) Quick Study 13-5 (10 minutes) C A A B B 10 C A B C D Quick Study 13-6 (5 minutes) Accounts Receivable Turnover and the Days' Sales Uncollected Working Capital, also called net working capital Profit Margin and the Total Asset Turnover Return on Total Assets ©McGraw-Hill Companies, 2008 674 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Quick Study 13-7 (10 minutes) Ratio 2008 2007 Change Profit Margin Ratio 9% 8% Debt Ratio 47% 42% Unfavorable Gross Margin Ratio 34% 46% Unfavorable Acid-test Ratio 1.00 1.15 Unfavorable Accounts Receivable Turnover 5.5 6.7 Unfavorable Basic Earnings Per Share $1.25 $1.10 Favorable Inventory Turnover 3.6 3.4 Favorable Dividend Yield 2% 1.2% Favorable Favorable Quick Study 13-8A (5 minutes) This material error should be reported on the statement of retained earnings (and/or the statement of stockholders‘ equity) as a prior period adjustment to the beginning retained earnings balance Also, if prior year‘s financial numbers are reported, they should be revised to show the correct numbers ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 675 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com EXERCISES Exercise 13-1 (20 minutes) 2010 Sales 189 Cost of goods sold 191 Accounts receivable 201 2009 181 182 192 2008 168 172 182 2007 156 159 169 2006 100 100 100 Analysis: The trend in sales is positive While this is better than no growth, one cannot definitively say whether the sales trend is favorable without additional information about the economic conditions in which this trend occurred such as inflation rates and competitors‘ performances Given the trend in sales, the comparative trends in both cost of goods sold and accounts receivable are somewhat unfavorable In particular, for the most recent year, both are increasing at slightly faster rates (indexes for cost of goods sold is 191 and accounts receivable is 201) compared to sales (index is 189) Exercise 13-2 (25 minutes) Answer: Net income decreased Supporting calculations: When the sum of each year's common-size cost of goods sold and total expenses is subtracted from the common-size sales percent, the net income percent is as follows: 2007 net income percent: 100.0 - 59.1 - 15.1 = 25.8% of sales 2008 net income percent: 100.0 - 61.9 - 14.8 = 23.3% of sales 2009 net income percent: 100.0 - 63.4 - 15.3 = 21.3% of sales Next, notice that if 2007 sales are assumed to be $100, then sales for 2008 are $104.20 and the sales for 2009 are $105.40 If the net income percents for the three years are applied to these amounts, the net incomes are: 2007 net income: $100.00 x 25.8% = $25.80 2008 net income: $104.20 x 23.3% = $24.28 2009 net income: $105.40 x 21.3% = $22.45 This shows that net income decreased over the three-year period ©McGraw-Hill Companies, 2008 676 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 13-3 (25 minutes) 2008 Sales 100.0% Cost of goods sold 75.7 Gross profit 24.3 Operating expenses 17.3 Net income 7.0% 2007 100.0% 46.5 53.5 35.0 18.5% Analysis: Overall, this company‘s situation has worsened This is evident from the substantial decline in net income as a percent of sales for 2008 (7.0%) relative to 2007 (18.5%) The main culprit is the increase in cost of goods sold as a percent of sales from 46.5% in 2007 to 75.7% in 2008 On a somewhat positive note, the company has not experienced any increase in operating expenses as a percent of sales; indeed, declining from 35.0% in 2007 to 17.3% in 2008 Even more positive is the company‘s level of sales increase from $625,000 in 2007 to $740,000 in 2008 Exercise 13-4 (30 minutes) Parker has a greater amount of working capital This by itself does not indicate whether the company is more capable of meeting its current obligations However, support is provided by the current ratio and acid-test ratio, which show Parker is in a more liquid position than Morgan This evidence does not mean that Morgan's liquidity is inadequate Such a conclusion would require more information such as norms for the industry or its other competitors Notably, Morgan's acid-test ratios approximate the traditional rule of thumb (1 to 1) This evidence also shows that Parker's working capital, current ratio, and acid-test ratio all increased dramatically over the three-year period This trend toward greater liquidity may be positive, but it can also suggest that Parker holds an excess amount of highly liquid assets that typically earn low returns The accounts receivable turnover and inventory turnover indicate that Morgan is more efficient in collecting its accounts receivable and in generating sales from available inventory However, these statistics also may suggest that Morgan is too conservative in granting credit and investing in inventory This could have a negative impact on sales and net income Parker's ratios may be acceptable, but no definitive determination can be made without having information on industry (or other competitors‘) standards ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 677 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 13-5 (30 minutes) COMPARATIVE ANALYSIS REPORT Clay's profit margins are higher than Roak's However, Roak has significantly higher total asset turnover ratios As a result, Roak generates a substantially higher return on total assets The trends of both companies include evidence of growth in sales, total asset turnover, and return on total assets However, Clay's rates of improvement are better than Roak's These differences may result from the fact that Clay is only three years old, while Roak is a somewhat more established company Clay's operations are considerably smaller than Roak's, but that will not persist many more years if both companies continue to grow at their current rates To some extent, Roak's higher total asset turnover ratios may result from the fact that its assets may have been purchased years earlier If the turnover calculations had been based on current values, the differences might be less striking The relative ages of the assets also may explain some of the difference in profit margins Assuming Clay's assets are newer, they may require smaller maintenance expenses Finally, Roak successfully employed financial leverage in 2010 Its return on total assets is 9.0% compared to the 7% interest rate it paid to obtain financing from creditors In contrast, Clay's return is only 5.9% as compared to the 7% interest rate paid to creditors ©McGraw-Hill Companies, 2008 678 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 13-6 (20 minutes) Simeon Company Common-Size Comparative Balance Sheets December 31, 2007-2009 At December 31 2009 2008* 2007 Assets Cash 6.1% 8.0% 10.0% Accounts receivable, net 17.1 14.0 13.3 Merchandise inventory 21.5 18.5 14.3 Prepaid expenses 2.0 2.1 1.3 Plant assets, net 53.3 57.3 61.1 100.0% 100.0% Accounts payable 24.8% Long-term notes payable secured by mortgages on plant assets 18.8 16.9% 13.6% 22.9 22.1 Common stock, $10 par value 31.3 36.7 43.3 Total assets 100.0% Liabilities and Equity Retained earnings 25.1 Total liabilities and equity 100.0% * 23.5 21.0 100.0% 100.0% Column does not equal 100.0 due to rounding Analysis: Several observations can be made (1) Cash as a percent of assets has declined—this is favorable provided sufficient cash is available for operations (2) Accounts receivable have increased as a percent of assets—this may be unfavorable in that assets are tied up in an unproductive manner and there would be additional assets exposed to the risk of uncollection; it could be favorable if increased sales outweigh these costs and risk (3) Plant assets have declined as a percent of assets—this is favorable if the company is operating more efficiently; it could be unfavorable if the company is downsizing due to poor performance (4) Accounts payable have markedly increased as a percent of assets—this could reveal liquidity constraints ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 679 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Exercise 13-7 (25 minutes) Current ratio 2009: $31,800 + $89,500 + $112,500 + $10,700 $129,900 = 1.88 to 2008: $35,625 + $62,500 + $82,500 + $9,375 $75,250 = 2.52 to 2007: $37,800 + $50,200 + $54,000 + $5,000 $51,250 = 2.87 to Acid-test ratio 2009: $31,800 + $89,500 $129,900 = 0.93 to 2008: $35,625 + $62,500 $75,250 = 1.30 to 2007: $37,800 + $50,200 $51,250 = 1.72 to Analysis and Interpretation: Simeon's short-term liquidity position has deteriorated over this three-year period Both the current and acid-test ratios show declining trends Although we not have information about the nature of the company's business, the acid-test ratio shifts from ‗1.72 to 1‘ down to ‗0.93 to 1‘ and the current ratio shifts from ‗2.87 to 1‘ down to ‗1.88 to 1‘—both suggest a potential liquidity problem Still, we must recognize that industry standards could show that the 2007 ratios were too high (instead of 2009 ratios as being too low) ©McGraw-Hill Companies, 2008 680 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 13-3B (60 minutes) Transaction Current Assets Quick Assets Current Liabilities Beginning* $300,000 $168,000 $120,000 2.50 1.40 $180,000 June +120,000 +120,000 - 75,000 _ _ 345,000 288,000 120,000 2.88 2.40 225,000 + 88,000 + 88,000 - 88,000 - 88,000 _ 345,000 288,000 120,000 2.88 2.40 225,000 +150,000 +150,000 _ Bal June Bal June Bal June Bal June 10 Bal June 12 Bal June 15 Bal Current Acid-Test Ratio Ratio Working Capital 495,000 288,000 270,000 1.83 1.07 225,000 +100,000 +100,000 +100,000 _ 595,000 388,000 370,000 1.61 1.05 225,000 +120,000 +120,000 _ _ 715,000 508,000 370,000 1.93 1.37 345,000 - 275,000 - 275,000 _ 440,000 233,000 370,000 1.19 0.63 70,000 + 80,000 _ 440,000 233,000 450,000 0.98 0.52 (10,000) +0 +0 _ 440,000 233,000 450,000 0.98 0.52 (10,000) - 12,000 - 12,000 - 12,000 _ 428,000 221,000 438,000 0.98 0.50 (10,000) June 30 - 80,000 - 80,000 - 80,000 _ Bal $348,000 $141,000 $358,000 0.97 0.39 (10,000) June 19 Bal June 22 Bal *Beginning balances Current assets (given) $300,000 Current liabilities ($300,000 / 2.50) 120,000 Quick assets ($120,000 x 1.40) 168,000 ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 701 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 13-4B (50 minutes) Current ratio $6,100 + $6,900 + $12,100 + $3,000 + $13,500 + $2,000 = 2.5 to $11,500 + $3,300 + $2,600 Acid-test ratio $6,100 + $6,900 + $12,100 + $3,000 $11,500 + $3,300 + $2,600 = 1.6 to Days' sales uncollected $12,100 + $3,000 x 365 = 17.5 days $315,500 Inventory turnover $236,100 = 15.3 times ($13,500 + $17,400)/2 Days‘ sales in inventory $13,500 x 365 = 20.9 days $236,100 Debt-to-equity ratio ($11,500 + $3,300 + $2,600 + $30,000) / ($35,000 + $35,100) = 0.68 to Times interest earned $30,200 / $2,200 = 13.73 times Profit margin ratio $23,800 = 7.5% $315,500 ©McGraw-Hill Companies, 2008 702 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 13-4B (Concluded) Total asset turnover $315,500 = 3.0 times ($117,500 + $94,900)/2 10 Return on total assets $23,800 = 22.4% ($117,500 + $94,900)/2 11 Return on common stockholders' equity $23,800 ($70,100 + $54,300)/2 = 38.3% ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 703 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 13-5B (60 minutes) Part Fargo Company Ball Company a Current ratio $205,200 = 2.3 to $90,500 $208,100 = 2.1 to $97,000 $108,700 = 1.2 to $90,500 $116,000 = 1.2 to $97,000 b Acid-test ratio c Accounts (and notes) receivable turnover $393,600 = 4.9 times ($77,100 + $11,600 + $72,200)/2 $667,500 = 8.7 times ($70,500 + $9,000 + $73,300)/2 d Inventory turnover $290,600 = 3.0 times ($86,800 + $105,100)/2 $480,000 ($82,000 + $80,500)/2 = 5.9 times e Days‘ sales in inventory $86,800 x 365 = 109.0 days $290,600 $82,000 $480,000 x 365 = 62.4 days f Days' sales uncollected $77,100 + $11,600 x 365 = 82.3 days $393,600 $70,500 + $9,000 x 365 = 43.5 days $667,500 Short-term credit risk analysis: Fargo and Ball have nearly equal current ratios and equal acid-test ratios However, Ball both turns its merchandise and collects its accounts receivable much more rapidly than Fargo On this basis, Ball probably is the better short-term credit risk ©McGraw-Hill Companies, 2008 704 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 13-5B (Concluded) Part Fargo Company Ball Company a Profit margin ratio $33,850 = 8.6% $393,600 $61,700 $667,500 = 9.2% b Total asset turnover $393,600 ($382,100 + $383,400)/2 = 1.03 times $667,500 = 1.48 times ($460,400 + $443,000)/2 c Return on total assets $33,850 ($382,100 + $383,400)/2 = 8.8% $61,700 = 13.7% ($460,400 + $443,000)/2 d Return on common stockholders' equity $33,850 ($198,600 + $182,100)/2 = 17.8% $61,700 ($270,100 + $250,700)/2 = 23.7% e Price-earnings ratio $25 = 19.7 $1.27 $25 = 11.4 $2.19 f Dividend yield $1.50 = 6.0% $25 $1.50 = 6.0% $25 Investment analysis: Ball‘s profit margin, total asset turnover, return on total assets, and return on common stockholders' equity are all higher than Fargo's Also, Ball has a lower price-earnings ratio, while paying the same dividend These factors indicate that Ball stock is likely the better investment ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 705 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 13-6BA (60 minutes) Part Effect of income taxes (debits or losses in parentheses) Pretax 25% Tax Effect After-Tax e Loss on hurricane damage (64,000) (16,000) (48,000) l Loss from operating a discontinued segment (120,000) (30,000) (90,000) n Correction of overstatement of prior year‘s expense 48,000 12,000 36,000 p Loss on sale of discontinued segment‘s assets (180,000) (45,000) (135,000) Part c b j o h m g k i d Income from continuing operations (and its components) Net sales $2,640,000 Interest revenue 20,000 Gain from settling lawsuit 68,000 Total revenues and gains 2,728,000 Cost of goods sold $1,040,000 Depreciation expense—Equipment 100,000 Depreciation expense—Buildings 156,000 Other operating expenses 328,000 Loss on sale of equipment 24,000 Loss from settling lawsuit 36,000 Total expenses and losses 1,684,000 Income from continuing operations before taxes 1,044,000 Income taxes expense (25%) Income from continuing operations after taxes (261,000) $ 783,000 ©McGraw-Hill Companies, 2008 706 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Problem 13-6BA (Concluded) Part l p Income from discontinued segment Loss from operating a discontinued segment (after-tax) $ (90,000) Loss on sale of discontinued segment‘s assets (after-tax) (135,000) Loss from discontinued segment $(225,000) Part Income before extraordinary items Income from cont oper after taxes (from Part 2) $ 783,000 Loss from discontinued segment (from Part 3) (225,000) Income before extraordinary items $ 558,000 Part Net income Income before extraordinary items $ 558,000 Extraordinary item: e Loss on hurricane damage (after-tax) (48,000) Net income $ 510,000 ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 707 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com SERIAL PROBLEM — SP 13 Serial Problem — SP 13, Success Systems (45 minutes) Gross margin with services revenue Gross margin = Total revenue – Cost of goods sold = $52,195 - $14,272 = $37,923 Gross margin ratio = $37,923 / $52,195 = 72.7% Gross margin without services revenue Gross margin = Net (goods) sales – Cost of goods sold = $20,345 - $14,272 = $6,073 Gross margin ratio = $6,073 / $20,345 = 29.9% Profit margin ratio Current ratio Acid-test ratio Debt ratio Equity ratio = $24,336 / $52,195 = 46.6% = $116,371 / $1,050 = 110.8 = $111,666 / $1,050 = 106.3 = $1,050 / $147,621 = 0.7% = $146,571/$147,621= 99.3% Current assets are 79% of total assets ($116,371/$147,621) Long-term assets are 21% of total assets ($31,250/$147,621) ©McGraw-Hill Companies, 2008 708 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Reporting in Action — BTN 13-1 Trend percents for selected income statement accounts 2005 2004 2003 Revenues 131% 117% 100% Cost of goods sold 131 117 100 Selling, general and admin expense 128 116 100 Income taxes (provision for income taxes) 130 127 100 Net income 994 712 100 Common-size percents for asset categories and accounts 2005 2004 Total current assets 67.1% 66.2% Property and equipment, net 23.9 25.9 Intangible assets 5.4 5.9 For 2005 and 2004, revenues and cost of goods sold grew at the same rates Operating expenses grew more slowly than revenues Net income grew much more than revenues over the three year period (The main reason is that 2003 income was low due to losses on discontinued operations.) The common-size percent figures show a shift toward slightly more current assets (66.2% in 2004 vs 67.1% in 2005) and less property and equipment assets (25.9% in 2004 vs 23.9% in 2005) and less intangible assets (5.9% in 2004 vs 5.4% in 2005) Answers depend on the financial statement information obtained ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 709 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Comparative Analysis — BTN 13-2 Key figures ($ millions) Best Buy Cash and equivalents 4.6% Accounts receivable, net 3.6 Circuit City $470 375 23.2% 4.6 $ 880 173 Inventories 27.7 2,851 38.5 1,460 Retained earnings 32.2 3,315 32.9 1,247 Costs of sales .76.3 20,938 75.5 7,904 Revenues 100.0 27,433 100.0 10,472 Total assets 100.0 10,294 100.0 3,789 Circuit City‘s retained earnings make up a slightly greater percent of its assets (32.9%) as compared to Best Buy (32.2%) Best Buy‘s costs of sales percent is slightly higher at 76.3% compared to Circuit City‘s 75.5% Therefore, Best Buy has the lower gross margin ratio on sales (23.7%) versus Circuit City (24.5%) Circuit City has a higher percent of total assets in the form of inventory at 38.5%, compared to Best Buy‘s 27.7% ©McGraw-Hill Companies, 2008 710 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Ethics Challenge — BTN 13-3 The CEO appears to have selectively chosen from the 11 available ratios to present only the ones that show trends that are favorable to the company (However, some analysts may not interpret a decline in selling expenses as a percent of revenue as positive since it might imply a scaling back on advertising or promotion campaigns.) The CEO‘s motivation might be to make her performance, or the company‘s, or both, appear better than it is in the eyes of the analysts The consequences of this action by the CEO might be mixed It is likely that the analysts will ask other questions that may reveal some negative trends such as the trends in return and profit margins The CEO‘s actions may become transparent to the analysts as they discover the presence of less favorable trends through their questions If discovered, such a disclosure ploy by the CEO will not reflect favorably on the company Both the CEO and the company are likely to suffer losses in reputation and credibility Even if the CEO is able to succeed with this strategy in the short term, once the financial statements are issued all users can compile additional ratio information and see that some of the trends are unfavorable to the company This is likely to damage the credibility of the CEO Communicating in Practice — BTN 13-4 There is no set solution to this activity Each team‘s memorandum will vary based on the industry and companies chosen for analysis (Instructor: Consider making a transparency of each team‘s memorandum for use in a classroom discussion of the findings.) ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 711 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Taking It to the Net ($ thousands) — BTN 13-5 As of 12/31/2004 As of 12/31/2003 $590,879/$4,429,248 = 13.3% Profit margin ratio $457,584/$4,172,551 = 11.0% $1,749,717/ $4,429,248 = 39.5% $1,627,825/$4,172,551 = 39.0% Gross profit ratio $590,879 / ([$3,797,531 + $457,584 / ([$3,582,540 + Return on total $3,480,551]/2) = 13.0% assets $3,582,540]/2) = 16.0% $590,879 / ([$1,089,302 + $457,584 / ([$1,279,866 + Return on common $1,279,866]/2) = 49.9% $1,371,703]/2) = 34.5% stockholders‘ equity Basic earnings per share $2.17 $1.61 Analysis and Interpretation: Hershey‘s performance improved in all areas evaluated Teamwork in Action — BTN 13-6 Part Team reports should look something like the following: Horizontal Analysis Horizontal analysis is comparing a company‘s financial statement amounts across time We compare data from comparative statements that are horizontally aligned; that is, we compare the same items from one period to another period The change disclosed by the comparison is generally expressed as a dollar amount and/or as a percent For instance, we compare sales of one period to sales of another and determine the dollar amount of the increase or decrease We also determine the percent of increase or decrease in sales that this change represents This type of comparison is generally completed on a line-by-line basis for both income statement and balance sheet items (and sometimes for other financial statements) Example: Assume that prior year sales equal $240,000, and current year sales equal $300,000 Horizontal analysis of sales yields a $60,000 increase or a 25% increase in sales (Computation is defined as: Amount of change / Base year [or $60,000/$240,000].) ©McGraw-Hill Companies, 2008 712 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Teamwork in Action (Concluded) If a horizontal comparison is made over a number of periods, the comparisons are made to corresponding amounts in a selected period called the base period Each subsequent period‘s amount is compared to the base period The change is expressed as a percent of the base period This is commonly referred to as trend analysis Vertical Analysis Vertical analysis is comparing a company's financial statement amounts to a base amount Usually this base amount is a total or aggregate amount An income statement's base is usually total revenue and a balance sheet's base is usually total assets We analyze what percent of the total (or base) the individual statement items represent Example: Total assets for the period being analyzed = $500,000 (base number) Cash balance is $100,000 Cash is computed to be 20% of total assets (Computation is defined as: Individual amount / Aggregate amount [or $100,000/$500,000].) Part Explanations of the four categories or areas of ratio analysis follow: a Liquidity analysis measures the availability of resources to meet shortterm cash requirements Efficiency analysis measures how productive a company is in using its assets b Solvency analysis measures a company's long-run financial viability and its ability to cover long-term obligations c Profitability analysis measures a company's ability to generate an adequate return on invested capital d Market analysis measures the company‘s returns (for example, EPS and dividend) relative to its market price Note: Students will select various ratios to illustrate these categories Use Exhibit 13.16 to verify the category, measurement, and use of each ratio Part Each team member presents results to the entire team ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 713 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Business Week Activity — BTN 13-7 Lavelle suggests that there are several signs that a company has problems, and that stockholders should not ignore them Beware of CEOs with a controlling stake Often this leads to the lack of independent boards that are a check on management Keep an eye on executive pay This would include evaluating excessive executive perks The board matters Directors should keep an eye on management, but may not be independent if it is hand-picked by the top executive Complexity should set off alarms When it is difficult to understand transactions and relationships, it may be easy to hide fraud Entrepreneurial Decision — BTN 13-8 No Although the current ratio improved over the three-year period, the acid-test ratio declined and accounts receivable and merchandise inventory turned more slowly These conditions indicate that an increasing portion of the current assets consisted of accounts receivable and inventories from which current liabilities could not be paid No The decreasing turnover of accounts receivable indicates the company is collecting its receivables more slowly No Sales are increasing and accounts receivable are turning more slowly Either or both of these trends would produce an increase in accounts receivable, even if the other remained unchanged Yes To illustrate, if sales are assumed to equal $100 in 2006, the sales trend shows that they would equal $125 in 2007 and $137 in 2008 Then, dividing each sales figure by its ratio of sales to plant assets would give $33.33 for plant assets in 2006 ($100/ 3.0), $37.88 in 2007 ($125/ 3.3) and $39.14 in 2008 ($137/ 3.5) No The percent of return on equity declines from 12.25% in 2006 to 9.75% in 2008 The dollar amount of selling expenses increased in 2007 and decreased sharply in 2008 Again assuming sales figures of $100 in 2006, $125 in 2007, and $137 in 2008, and multiplying each by its selling expense to net sales ratio gives $15.30 of selling expenses in 2006, $17.13 in 2007, and $13.43 in 2008 ©McGraw-Hill Companies, 2008 714 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com Hitting the Road — BTN 13-9 One possible strategy to fulfill the requirements of this assignment is: Assume that a $37,500 salary will be earned upon graduation at age 25 Also, assume that the level of investment will be at 8% of your salary (or $3,000 annually) starting at age 25 By starting at age 25 there will be 40 annual compounding periods until age 65 If the annual amount invested does not change and you earn 10% for 40 years, then the investment will grow to $1,327,779 ($3,000 x 442.593 from Table B.4) at age 65 The $1,000,000 goal can also be reached at age 65 if the investment earns 9% ($3,000 x 337.882 = $1,013,646) Global Decision — BTN 13-10 Instructor note: Student answers will vary At least the following five differences in annual reports between Dixons and Best Buy (or Circuit City) exist: Dixons‘ statements are denominated in pounds Best Buy and Circuit City report in dollars Dixons‘ balance sheet is ordered in this manner: Fixed assets, Current assets, Creditors—falling due within one year (current liabilities), Creditors—falling due after more than one year (long-term liabilities) then Capital and reserves Best Buy and Circuit City‘s balance sheets show Current assets, long term assets, current liabilities, long-term liabilities, and equity, in that order Dixons prepares its statements in accordance with accounting standards that are generally accepted in the U.K Best Buy and Circuit City prepare statements in accordance with U.S GAAP Dixons‘ does not show revenues, but starts its income statement with ―Turnover‖ which is equivalent to gross profit Best Buy and Circuit City both show revenues and cost of sales Dixons‘ cash flow statement does not show any details for cash flows from operating activities Both Best Buy‘s and Circuit City‘s cash flow statements include details of the determination of cash flows from operations ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 715 ... year‘s financial numbers are reported, they should be revised to show the correct numbers ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 675 To download more slides, ebook, solutions... past experience and industry's norms ©McGraw-Hill Companies, 2008 Solutions Manual, Chapter 13 673 To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com... Turnover Return on Total Assets ©McGraw-Hill Companies, 2008 674 Financial Accounting, 4th Edition To download more slides, ebook, solutions and test bank, visit http://downloadslide.blogspot.com