Chapter 16 “How Well Am I Doing?” Financial Statement Analysis Solutions to Questions 16-1 Horizontal analysis examines how a particular item on a financial statement such as sales or cost of goods sold behaves over time Vertical analysis involves analysis of items on an income statement or balance sheet for a single period In vertical analysis of the income statement, all items are typically stated as a percentage of sales In vertical analysis of the balance sheet, all items are typically stated as a percentage of total assets 16-2 By looking at trends, an analyst hopes to get some idea of whether a situation is improving, remaining the same, or deteriorating Such analyses can provide insight into what is likely to happen in the future Rather than looking at trends, an analyst may compare one company to another or to industry averages using common-size financial statements 16-3 Price-earnings ratios reflect investors’ expectations concerning future earnings The higher the price-earnings ratio, the greater the growth in earnings investors expect For this reason, two companies might have the same current earnings and yet have quite different price-earnings ratios By definition, a stock with current earnings of $4 and a priceearnings ratio of 20 would be selling for $80 per share 16-4 A rapidly growing tech company would probably have many opportunities to make investments at a rate of return higher than stockholders could earn in other investments It would be better for the company to invest in such opportunities than to pay out dividends and thus one would expect the company to have a low dividend payout ratio 16-5 The dividend yield is the dividend per share divided by the market price per share The other source of return on an investment in stock is increases in market value 16-6 Financial leverage results from borrowing funds at an interest rate that differs from the rate of return on assets acquired using those funds If the rate of return on the assets is higher than the interest rate at which the funds were borrowed, financial leverage is positive and stockholders gain If the return on the assets is lower than the interest rate, financial leverage is negative and the stockholders lose 16-7 If the company experiences big variations in net cash flows from operations, stockholders might be pleased that the company has no debt In hard times, interest payments might be very difficult to meet On the other hand, if investments within the company can earn a rate of return that exceeds the interest rate on debt, stockholders would get the benefits of positive leverage if the company took on debt 16-8 The market value of a share of common stock often exceeds the book value per share Book value represents the © The McGraw-Hill Companies, Inc., 2010 140 Managerial Accounting, 13th Edition cumulative effects on the balance sheet of past activities, evaluated using historical prices The market value of the stock reflects investors’ expectations about the company’s future earnings For most companies, market value exceeds book value because investors anticipate future earnings growth 16-9 A to current ratio might not be adequate for several reasons First, the composition of the current assets may be heavily weighted toward slow-turning and difficult-to-liquidate inventory, or the inventory may contain large amounts of obsolete goods Second, the receivables may be low quality, including large amounts of accounts that may be difficult to collect © The McGraw-Hill Companies, Inc., 2010 141 Managerial Accounting, 13th Edition Exercise 16-1 (15 minutes) Sales Cost of goods sold Gross margin Selling and administrative expenses: Selling expenses Administrative expenses Total selling and administrative expenses Net operating income Interest expense Net income before taxes This Year Last Year 100.0% 100.0% 62.3 58.6 37.7 41.4 18.5 8.9 18.2 10.3 27.4 10.3 1.2 9.1% 28.5 12.9 1.4 11.5% The company’s major problem seems to be the increase in cost of goods sold, which increased from 58.6% of sales last year to 62.3% of sales this year This suggests that the company is not passing the increases in costs of its products on to its customers As a result, cost of goods sold as a percentage of sales has increased and gross margin has decreased This change has been offset somewhat by reduction in administrative expenses as a percentage of sales Note that administrative expenses decreased from 10.3% to only 8.9% of sales over the two years However, this decrease was not enough to completely offset the increased cost of goods sold, so the company’s net income decreased as a percentage of sales this year © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 16 142 Exercise 16-2 (30 minutes) Calculation of the gross margin percentage: Gross margin Sales $27,000 = = 34.2% $79,000 Gross margin percentage = Calculation of the earnings per share: Net income - Preferred dividends Average number of common shares outstanding $3,540 - $120 = = $4.28 per share 800 shares Earnings per share = Calculation of the price-earnings ratio: Market price per share Earnings per share $18 = = 4.2 $4.28 Price-earnings ratio = Calculation of the dividend payout ratio: Dividends per share Earnings per share $0.25 = = 5.8% $4.28 Dividend payout ratio = Calculation of the dividend yield ratio: Dividends per share Market price per share $0.25 = = 1.4% $18.00 Dividend yield ratio = © The McGraw-Hill Companies, Inc., 2010 All rights reserved 143 Managerial Accounting, 13th Edition Exercise 16-2 (continued) Calculation of the return on total assets: Beginning balance, total assets (a) $45,960 Ending balance, total assets (b) 50,280 Average total assets [(a) + (b)]/2 $48,120 Net income + [Interest expense × (1 - Tax rate)] Return on total assets = Average total assets = $3,540 + [$600 × (1 - 0.40)] = 8.1% $48,120 Calculation of the return on common stockholders’ equity: Beginning balance, stockholders’ equity (a) $31,660 Ending balance, stockholders’ equity (b) 34,880 Average stockholders’ equity [(a) + (b)]/2 33,270 Average preferred stock 2,000 Average common stockholders’ equity .$31,270 Net income - Preferred dividends Return on common = stockholders' equity Average common stockholders' equity = $3,540 - $120 = 10.9% $31,270 Calculation of the book value per share: Book value per share = = Total stockholders' equity - Preferred stock Number of common shares outstanding $34,880 - $2,000 = $41.10 per share 800 shares © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 16 144 Exercise 16-3 (30 minutes) Calculation of working capital: Current assets $25,080 Current liabilities 10,400 Working capital $14,680 Calculation of the current ratio: Current assets Current liabilities $25,080 = = 2.4 $10,400 Current ratio = Calculation of the acid-test ratio: Cash + Marketable securities + Current receivables Acid-test ratio = Current liabilities $1,280 + $0 + $12,300 = = 1.3 $10,400 Calculation of accounts receivable turnover: Beginning balance, accounts receivable (a) $ 9,100 Ending balance, accounts receivable (b) 12,300 Average accounts receivable balance [(a) + (b)]/2 $10,700 Sales on account Accounts receivable = turnover Average accounts receivable balance $79,000 = = 7.4 $10,700 Calculation of the average collection period: 365 days Accounts receivable turnover 365 days = = 49.3 days 7.4 Average collection period = © The McGraw-Hill Companies, Inc., 2010 All rights reserved 145 Managerial Accounting, 13th Edition Exercise 16-3 (continued) Calculation of inventory turnover: Beginning balance, inventory (a) $8,200 Ending balance, inventory (b) 9,700 Average inventory balance [(a) + (b)]/2 $8,950 Cost of goods sold Average inventory balance $52,000 = = 5.8 $8,950 Inventory turnover = Calculation of the average sale period: 365 days Inventory turnover 365 days = = 62.9 days 5.8 Average sale period = © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 16 146 Exercise 16-4 (15 minutes) Calculation of the times interest earned ratio: Earnings before interest expense and income taxes Times interest = earned ratio Interest expense = $6,500 = 10.8 $600 Calculation of the debt-to-equity ratio: Total liabilities Stockholders' equity $15,400 = = 0.4 $34,880 Debt-to-equity ratio = © The McGraw-Hill Companies, Inc., 2010 All rights reserved 147 Managerial Accounting, 13th Edition Exercise 16-5 (15 minutes) The trend percentages are: Year Year Year Year Year Sales 125.0 120.0 115.0 110.0 100.0 Current assets: Cash 60.0 80.0 96.0 Accounts receivable 190.0 170.0 135.0 Inventory 125.0 120.0 115.0 Total current assets 142.1 133.7 120.3 130.0 115.0 110.0 112.6 100.0 100.0 100.0 100.0 Current liabilities 160.0 145.0 130.0 110.0 100.0 Sales: The sales are increasing at a steady and consistent rate Assets: The most noticeable thing about the assets is that the accounts receivable have been increasing at a rapid rate—far outstripping the increase in sales This disproportionate increase in receivables is probably the chief cause of the decrease in cash over the five-year period The inventory seems to be growing at a well-balanced rate in comparison with sales Liabilities : The current liabilities are growing more rapidly than the total current assets The reason is probably traceable to the rapid buildup in receivables in that the company doesn’t have the cash needed to pay bills as they come due © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 16 148 Exercise 16-6 (20 minutes) Return on total assets: Return on = Net income + [Interest expense × (1 - Tax rate)] total assets Average total assets = $280,000 + [$60,000 × (1 - 0.30)] 1/2 ( $3,000,000 + $3,600,000) = $322,000 = 9.8% (rounded) $3,300,000 Return on common stockholders’ equity: Average stockholders’ equity: ($2,200,000 + $2,400,000)/2 $2,300,000 Average preferred stock 900,000 Average common stockholders’ equity (b) $1,400,000 Return on common = Net income - Preferred dividends stockholders' equity Average common stockholders' equity = $280,000 - $72,000 =14.9% (rounded) $1, 400,000 Leverage is positive because the return on common stockholders’ equity (14.9%) is greater than the return on total assets (9.8%) This positive leverage arises from the long-term debt, which has an after-tax interest cost of only 8.4% [12% interest rate × (1 – 0.30)], and the preferred stock, which carries a dividend rate of only 8% Both of these rates of return are smaller than the return that the company is earning on its total assets; thus, the difference goes to the common stockholders © The McGraw-Hill Companies, Inc., 2010 All rights reserved 149 Managerial Accounting, 13th Edition Problem 16-18 (continued) Therefore, the total quick assets must be $400,000 Because there are no marketable securities and the accounts receivable are $330,000, the cash must be $70,000 g Current ratio = = Current assets Current liabilities Current assets $320,000 = 2.75 Therefore, the current assets must total $880,000 Because the quick assets (cash and accounts receivable) total $400,000 of this amount, the inventory must be $480,000 h Inventory turnover = Cost of goods sold Average inventory = Cost of goods sold 1/2 ($360,000 + $480,000) = Cost of goods sold $420,000 = 6.5 Therefore, the cost of goods sold for the year must be $2,730,000 i Gross margin = $4,200,000 – $2,730,000 = $1,470,000 j Net operating income = Gross margin - Operating expenses Operating expenses = Gross margin - Net operating income = $1,470,000 - $540,000 = $930,000 © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 16 180 Problem 16-18 (continued) k The interest expense for the year was $80,000 and the interest rate was 10%, the bonds payable must total $800,000 l Total liabilities = $320,000 + $800,000 = $1,120,000 Net income - Preferred dividends Earnings per share = m Average number of common shares outstanding $322,000 = Average number of common shares outstanding = $2.30 The stock is $5 par value per share, so the total common stock must be $700,000 n Debt-to-equity ratio = Total liabilities Stockholders' equity = $1,120,000 Stockholders' equity = 0.875 Therefore, the total stockholders’ equity must be $1,280,000 o Total stockholders' equity = Common stock + Retained earnings Retained earnings = Total stockholders' equity - Common Stock = $1,280,000 - $700,000 = $580,000 © The McGraw-Hill Companies, Inc., 2010 All rights reserved 181 Managerial Accounting, 13th Edition Problem 16-18 (continued) p Total assets = Liabilities + Stockholders' equity = $1,120,000 + $1,280,000 = $2,400,000 This answer can also be obtained using the return on total assets: Return on = Net income + [Interest expense × (1 - Tax rate)] total assets Average total assets = $322,000 + [$80,000 × (1 - 0.30)] Average total assets = $378,000 Average total assets = 18.0% Therefore the average total assets must be $2,100,000 Since the total assets at the beginning of the year were $1,800,000, the total assets at the end of the year must have been $2,400,000 (which would also equal the total of the liabilities and the stockholders’ equity) q Total assets = Current assets + Plant and equipment $2,400,000 = $880,000 + Plant and equipment Plant and equipment = $2,400,000 - $880,000 = $1,520,000 © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 16 182 Problem 16-19 (45 minutes) The loan officer stipulated that the current ratio prior to obtaining the loan must be higher than 2.0, the acid-test ratio must be higher than 1.0, and the interest on the loan must be less than four times net operating income These ratios are computed below: Current ratio = = Current assets Current liabilities $290,000 = 1.8 (rounded) $164,000 Acid-test ratio = = Cash + Marketable securities + Current receivables Current liabilities $70,000 + $0 + $50,000 = 0.7 (rounded) $164,000 Net operating income $20,000 = = 5.0 Interest on the loan $80,000 × 0.10 × (6/12) The company would fail to qualify for the loan because both its current ratio and its acid-test ratio are too low © The McGraw-Hill Companies, Inc., 2010 All rights reserved 183 Managerial Accounting, 13th Edition Problem 16-19 (continued) By reclassifying the $45 thousand net book value of the old machine as inventory, the current ratio would improve, but the acid-test ratio would be unaffected Inventory is considered a current asset for purposes of computing the current ratio, but is not included in the numerator when computing the acid-test ratio Current ratio = = Current assets Current liabilities $290,000 + $45,000 = 2.0 (rounded) $164,000 Acid-test ratio = = Cash + Marketable securities + Current receivables Current liabilities $70,000 + $0 + $50,000 = 0.7 (rounded) $164,000 Even if this tactic had succeeded in qualifying the company for the loan, we strongly advise against it Inventories are assets the company has acquired to sell to customers in the normal course of business Used production equipment is not inventory —even if there is a clear intention to sell it in the near future The loan officer would not expect used equipment to be included in inventories; doing so would be intentionally misleading © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 16 184 Problem 16-19 (continued) Nevertheless, the old machine is an asset that could be turned into cash If this were done, the company would immediately qualify for the loan because the $45 thousand in cash would be included in the numerator in both the current ratio and in the acid-test ratio Current ratio = = Current assets Current liabilities $290,000 + $45,000 = 2.0 (rounded) $164,000 Acid-test ratio = = Cash + Marketable securities + Current receivables Current liabilities $70,000 + $0 + $50,000 + $45,000 = 1.0 (rounded) $164,000 However, other options may be available The old machine is being used to relieve bottlenecks in the plastic injection molding process and it would be desirable to keep this standby capacity We would advise Russ to fully and honestly explain the situation to the loan officer The loan officer might insist that the machine be sold before any loan is approved, but she might instead grant a waiver of the current ratio and acid-test ratio requirements on the basis that they could be satisfied by selling the old machine Or she may approve the loan on the condition that the machine is pledged as collateral In that case, Russ would only have to sell the machine if he would otherwise be unable to pay back the loan © The McGraw-Hill Companies, Inc., 2010 All rights reserved 185 Managerial Accounting, 13th Edition Research and Application 16-20 The 5-year horizontal analysis in dollar and percentage form is summarized below (dollar amounts are in millions): Sales Earnings from continuing operations Sales Earnings from continuing operations 2004 2003 2002 $45,68 $40,928 $36,519 2001 $32,60 2000 $29,46 $1,885 $1,619 $1,376 $1,101 $962 2004 155% 2003 139% 2002 124% 2001 111% 2000 100% 196% 168% 143% 114% 100% The data reveal that Target has increased sales by 55% over the last five years More importantly, the sales growth has been profitable; Target’s earnings from continuing operations have increased 96% over the same time period Also, Target has consistently improved its performance There were no unexpected drops in sales or earnings This type of consistency is valued by investors © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 16 186 Research and Application 16-20 (continued) The common size comparative balance sheet is shown below (dollar amounts are in millions): Target Corporation Common-Size Comparative Balance Sheet January 29, 2005 and January 31, 2004 2004 Assets Current assets: Cash and cash equivalents Accounts receivable, net Inventory Other current assets Current assets—discontinued Total current assets Property and equipment: Land Buildings and improvements Fixtures and equipment Construction-in-progress Accumulated depreciation Property and equipment, net Other non-current assets Non-current assets—discontinued Total assets $ 2,245 5,069 5,384 1,224 13,922 2003 Common-Size Percentages 2004 2003 $ 708 4,621 4,531 1,000 2,092 12,952 6.9% 15.7% 16.7% 3.8% 0% 43.1% 2.2% 14.7% 14.4% 3.2% 6.7% 41.2% 3,804 3,312 11.8% 10.5% 12,518 11,022 38.8% 35.0% 4,988 4,577 15.4% 14.6% 962 969 3.0% 3.1% ( 5,412) ( 4,727) ( 16.8%) ( 15.0%) 16,860 15,153 52.2% 48.2% 1,511 1,377 4.7% 4.4% 1,934 0.0% 6.2% $32,29 $31,41 100.0% 100.0% © The McGraw-Hill Companies, Inc., 2010 All rights reserved 187 Managerial Accounting, 13th Edition © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 16 188 Research and Application 16-20 (continued) Liabilities and shareholders’ investment Current liabilities: Accounts payable Accrued liabilities Income taxes payable Current portion of long-term debt Current liabilities—discontinued Total current liabilities Long-term debt Deferred income taxes Other noncurrent liabilities Noncurrent liabilities—discontinued Total liabilities Shareholders’ investment: Common stock Additional paid-in-capital Retained earnings Accumulated other income Total shareholders’ investment Total liabilities and shareholders’ investment Common-Size Percentages 2004 2003 2004 2003 $ 5,779 1,633 304 504 8,220 9,034 973 1,037 19,264 $ 4,956 1,288 382 863 825 8,314 10,155 632 917 266 20,284 17.9% 5.1% 0.8% 1.6% 0.0% 25.5% 28.0% 3.0% 3.2% 0.0% 59.7% 74 1,810 11,148 ( 3) 13,029 $32,29 76 1,530 9,523 11,132 $31,41 0.2% 5.6% 34.5% ( 0.0%) 40.3% 100.0% 15.8% 4.1% 1.2% 2.8% 2.6% 26.5% 32.3% 2.0% 2.9% 0.9% 64.6% 0.2% 4.9% 30.3% 0.0% 35.4% 100.0% © The McGraw-Hill Companies, Inc., 2010 All rights reserved 189 Managerial Accounting, 13th Edition Research and Application 16-20 (continued) Target uses sales for its vertical analysis of profitability This can be confirmed by verifying how Target computed its gross margin rates (31.2% for 2004 and 30.6% for 2003) and selling, general and administrative (SG&A) expense rates (21.4% for 2004 and 21.2% for 2003) that are shown on pages 17-18 of the annual report The computations are shown below: Sales Cost of sales Gross margin Gross margin Sales Gross margin rate SG&A expense Sales SG&A rate 2004 $45,682 31,445 $14,237 2003 $40,928 28,389 $12,539 $14,237 ÷ $45,682 31.2% $12,539 ÷ $40,928 30.6% $9,797 ÷ $45,682 21.4% $8,657 ÷ $40,928 21.2% Target uses sales instead of total revenues as a base because total revenues include net credit card revenues Page 17 of the annual report says “Net credit card revenues represent income derived from finance charges, late fees and other revenues from use of our Target Visa and proprietary Target Card.” These sources of revenue not relate to the company’s primary business operations Computing common-size income statement percentages using total revenue as the baseline could potentially distort conclusions about operational performance The calculations for these ratios are shown below (all numbers except per share information and percentages are in millions): Earnings per share: Earnings from continuing operations Average number of common shares outstanding Earnings per share—continuing operations 2004 $1,885 ữ 903.8 $2.09 â The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 16 190 *Target did not have any preferred stock outstanding © The McGraw-Hill Companies, Inc., 2010 All rights reserved 191 Managerial Accounting, 13th Edition Research and Application 16-20 (continued) Price-earnings ratio: Market price per share Earnings per share—continuing operations Price-earnings ratio 2004 $49.49 ÷ $2.09 23.68 Dividend payout ratio: Dividends per share Earnings per share—continuing operations Dividend payout ratio $0.31 ÷ $2.09 14.8% Dividend yield ratio: Dividends per share Market price per share Dividend yield ratio $0.31 ÷ $49.49 0.6% Return on total assets: Earnings from continuing operations Add back interest expense: $570 × (1 − 0.378*) Total (a) Average total assets ($31,416 + $32,293)/2 (b) Return on total assets (a) ÷ (b) $1,885 355 $2,240 $31,855 7.0% *Provision for income taxes ($1,146) divided by earnings before income taxes ($3,031) = 37.8% Return on common stockholders’ equity: Earnings from continuing operations Average common stockholders’ equity ($13,029 + $11,132)/2 Return on common stockholders’ equity $1,885 ÷ $12,081 15.6% Book value per share: Common stockholders’ equity Number of common shares outstanding Book value per share $13,029 ữ 890.6 $14.63 â The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 16 192 Research and Application 16-20 (continued) The calculations for these ratios are shown below (all dollar figures are in millions): Working capital: Current assets Current liabilities Working capital 2004 $13,922 8,220 $ 5,702 Current ratio: Current assets Current liabilities Current ratio $13,922 ÷ $8,220 1.69 Acid-test ratio: “Quick” assets ($2,245 + $5,069) Current liabilities Acid-test ratio $7,314 ÷ $8,220 0.89 Inventory turnover: Cost of sales Average inventory ($5,384 + $4,531)/2 Inventory turnover Average sales period: Number of days in a year Inventory turnover Average sale period in days $31,445 ÷ $4,958 6.34 365 days ÷ 6.34 57.6 days Note to instructors: The accounts receivable turnover and average collection period are not calculated because it is impossible to determine the portion of Target’s total sales that are credit sales © The McGraw-Hill Companies, Inc., 2010 All rights reserved 193 Managerial Accounting, 13th Edition Research and Application 16-20 (continued) The calculations for these ratios are shown below (all dollar figures are in millions): Times interest earned ratio: Earnings before interest expense and income taxes Interest expense Times interest earned Debt-to-equity ratio: Total liabilities Stockholder’s equity Debt-to-equity ratio 2004 $3,601 ÷ $570 6.3 $19,264 ÷ $13,029 1.48 Target has better liquidity than Wal-Mart as measured by the current and acid-test ratios Target turns over its inventory less frequently than Wal-Mart which is renowned for its supply chain management practices While Wal-Mart’s times interest earned ratio is much higher than Target’s, both companies provide sufficient comfort to their long-term creditors in this regard The companies have comparable debt-to-equity ratios Target’s return on total assets is lower than Wal-Mart’s; however, Target’s slightly higher price-earnings ratio suggests that investors believe Target has modestly stronger earnings growth prospects than Wal-Mart © The McGraw-Hill Companies, Inc., 2010 All rights reserved Solutions Manual, Chapter 16 194 ... result, cost of goods sold as a percentage of sales has increased and gross margin has decreased This change has been offset somewhat by reduction in administrative expenses as a percentage of sales... increase in cost of goods sold, which increased from 58.6% of sales last year to 62.3% of sales this year This suggests that the company is not passing the increases in costs of its products on... large amounts of accounts that may be difficult to collect © The McGraw-Hill Companies, Inc., 2010 141 Managerial Accounting, 13th Edition Exercise 16-1 (15 minutes) Sales Cost of goods sold