Solution manual Financial accounting 6th kieso kimmel ch14

a The base amount assigned a 100% value in a vertical analysis of a statement of financial position is total assets.. a Asset turnover b Inventory turnover, days in inventory c Return on

CHAPTER 14

Performance Measurement

ASSIGNMENT CLASSIFICATION TABLE

Study Objectives Questions

Brief Exercises Exercises

A Problems

B Problems BYP

1 Understand the

concept of sustainable

income and indicate

how discontinued items

4 Identify and calculate

ratios that are used to

2, 3, 4,

5, 7

5 Identify and calculate

ratios that are used to

analyze solvency

13, 14, 15 11 5, 8, 9, 13 5A, 6A, 7A,

8A, 9A

5B, 6B, 7B, 8B, 9B

2, 3, 4,

5, 7

6 Identify and calculate

ratios that are used to

ASSIGNMENT CHARACTERISTICS TABLE

Problem

Number Description

Difficulty Level

Time Allotted (min.)

1A Prepare horizontal analysis Moderate 30-40

2A Prepare vertical analysis Moderate 25-35

3A Interpret horizontal and vertical analysis Moderate 20-30

4A Calculate and evaluate profitability ratios with

discontinued operations

Moderate 30-40

5A Calculate and evaluate ratios Moderate 40-50

6A Calculate and evaluate ratios Moderate 50-60

7A Evaluate ratios Moderate 50-60

8A Evaluate liquidity, solvency, and profitability Moderate 40-50

9A Discuss impact of accounting policies on financial

analysis

Moderate 30-40

1B Prepare horizontal analysis Moderate 30-40

2B Prepare vertical analysis, with discontinued

operations

Moderate 25-35

3B Interpret horizontal and vertical analysis Moderate 20-30

4B Calculate and evaluate profitability ratios with

discontinued operations

Moderate 30-40

5B Calculate and evaluate ratios Moderate 40-50

6B Calculate and evaluate ratios Moderate 50-60

ANSWERS TO QUESTIONS

1 Sustainable income is the level of income that is most likely to be maintained in the future

It differs from profit by the amount of irregular or non-typical items (e.g., from non-recurring

or unusual revenues, expenses, gains, or losses) included In other words, it is the amount

of profit that a company can expect to earn from its normal, recurring operations

2 (a) Discontinued operations refers to disposal, or availability for sale, of an identifiable component or segment of a business, which comprises a major line of business or geographical area of operations

(b) A component of an entity is a separate major line of business or major geographical area of operations It must be clearly distinguishable, operationally and financially, from the rest of the company

3 (a) Statement of financial position: If discontinued operations are being held for sale, the assets held for sale are reported separately on the statement of financial position, and they are valued and reported at the lower of their carrying amount and fair value, less costs to sell Any liabilities relating to the discontinued operations are also shown separately as current liabilities

(b) Income statement: The results from a company’s discontinued operations and the gain (loss) on disposal are shown separately on the income statement after profit from continuing operations Note that the results from discontinued operations usually contains two parts; the first being the operating results attributable to the discontinued component and the second being the gain or loss (if any) on disposal of the component The amounts for the discontinued component are presented net of any income tax expense or savings In addition, earnings per share must be reported separately for continuing operations and for discontinued operations

4 (a) An answer cannot be calculated for the percentage change when there is no value in

a base year, because division by 0 is mathematically impossible However, the absolute dollar value of the change from the base year can be determined

(b) An answer cannot be calculated for the percentage change when there is a negative value in a base year and a positive value in the next year However, the absolute dollar value of the change from the base year can be determined

5 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 Horizontal analysis measures items across years (or periods)

Vertical analysis (also called common size analysis) expresses each item within a financial statement in terms of a percent of a relevant total, usually the largest item within the same

Answers to Questions (Continued)

6 (a) Horizontal percentage of a base-period amount is accomplished by using a base

year for comparative purposes, which is assumed to be 100 The results of any subsequent year are compared to the base year by dividing the results from the year in question by the results from the base year For example, assume that XYZ Inc reported profit of $200,000 and $220,000 for 2014 and 2015 respectively If

2014 is assumed to be the base year, the percent of base period amount is calculated as follows: $220,000 ÷ $200,000 = 110%, and expressed as a percentage

(b) Horizontal percentage change for a period is calculated by dividing the dollar amount of the change between the specific year under analysis and the base year

by the base-year amount In calculating the percentage change for a period, each prior year is set as the base year in order to assess trends in changes between years In the above example discussed in (a), the horizontal percentage change for

a period would be 10% (110% – 100%)

(c) In vertical percentage of a base amount, each item in a financial statement is expressed as a percentage of a base amount in the same financial statement, providing analysis of data within the same year The base amount commonly used for the statement of financial position is total assets and the base amount commonly used for the income statement is net sales or revenues For example, assume that XYZ Inc reported merchandise inventory of $200,000 and total assets

of $5,000,000 for 2012 The percent of base amount is calculated as follows:

$200,000 ÷ $5,000,000 = 4%, and expressed as a percentage

7 Trend analysis is made difficult when a limited amount of information is available to the general public concerning a business In the case of Facebook, the first fiscal period is less than a full year Horizontal analysis of 2012 and 2013 would not be useful since apples would be compared to oranges Vertical analysis may be less problematic

8 (a) The base amount assigned a 100% value in a vertical analysis of a statement of

financial position is total assets

(b) The base amount assigned a 100% value in a vertical analysis of an income

Answers to Questions (Continued)

10 (a) Comparison of financial information can be made on an intracompany basis,

intercompany basis, and industry average basis (using predetermined norms)

• The intracompany basis compares an item or financial relationship within the current year or with one or more prior periods, within the same company

• The intercompany basis compares the same item or relationship with one or more competing companies

• The industry average basis compares an item or relationship with that of the industry

These three bases of comparison should be used together

(b) Horizontal analysis is useful in detecting significant trends within a company and in

assessing the impact of economic changes that affect the industry It is best used

in intracompany comparisons, although it can also be used to compare with one or more competing companies Vertical analysis is useful in detecting changes in financial relationships between years, with competitors and between companies in the same industry It is best used in intercompany comparisons, although it can also be used to compare the company’s data on an intracompany basis Ratio analysis is useful to evaluate the significance of financial data within the same company across different years and to provide insight into a company's position relative to other companies and to the industry Ratio analysis can be used with all three bases of comparisons—intracompany, intercompany and industry averages

11 A high current ratio is usually a good indicator of a company’s liquidity However, it might be hiding liquidity problems with regard to inventory or accounts receivable For example, a high level of inventory will cause the current ratio to increase Increases in inventory can be because 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

12 A lower result is better in the case of the following liquidity ratios: average collection period and days in inventory The longer assets are held before they are converted to cash, the longer the business needs to finance these assets

13 A lower result is better in the case of the debt to total assets solvency ratio because debt gives rise to servicing charges such as interest and also requires principal repayments, which will have to be paid with the use of cash

14 Tim Hortons’ has a lower debt to total assets ratio than the industry average Even though its times interest earned is lower than average, it is quite acceptable As a result, Tim Hortons’ solvency is probably better than other businesses in the same the industry

Answers to Questions (Continued)

15 (a) Asset turnover

(b) Inventory turnover, days in inventory

(c) Return on common shareholders’ equity

(d) Times interest earned

(e) Current ratio, cash current debt coverage

16 The difference between CIBC’s return on assets of 0.8% and the return on common shareholders’ equity of 21.8% means that the company must be using a substantial amount of debt to finance their assets This debt is likely in the form of customers’ bank accounts, which are in turn lent out to others to earn a higher rate of interest than the one paid to customers on their deposits

17 The profit margin and the asset turnover ratio combine mathematically to equal the return on assets ratio To increase its return on assets, a company can increase its profit margin or increase its asset turnover

The return on common shareholders’ equity is affected by both the return on assets and the debt to total assets ratio To increase its return on common shareholders’ equity, a company can increase its return on assets or increase its leverage (as measured by the debt to total assets ratio) Leverage, however, should only be increased if the increased interest expense on the increased level of debt can be covered by higher profits

18 Lai’s profit margin has improved When comparing the company’s profit margin before considering irregular items, we see that the profit margin has improved from 5% to 6.5% Discontinued operations are a nonrecurring item and should be excluded for analysis purposes

19 (a) To consider how investors view a company’s growth potential, investors would

focus primarily on the price-earnings ratio If this ratio is high it means that the market expects the company to grow rapidly

(b) To consider income potential, this generally refers to the receiving dividends from the company Investors would focus on the payout ratio to determine the extent to which the company pays dividends from the profits earned and consider the dividend yield to measure the rate of return that a dividend gives the investor

Answers to Questions (Continued)

20 (a) Yum Brands’ profitability has improved as its profit margin excluding other

comprehensive income increased from 10.6% to 11.8%

(b) It is common practice to calculate profitability ratios using profit rather than comprehensive income Typically, items recorded in OCI are not largely significant and may not be a reflection of the operations of a company Sometimes they consist of non-recurring items Another reason for excluding OCI from ratios is because companies reporting under ASPE do not use OCI so comparing a profitability ratio of a public company based on comprehensive income with a private company that reports only profit would not give a fair comparison Nonetheless, if a public company does have a significant amount of OCI, we should strive to understand its impact on the company

21 The factors that can limit the usefulness of financial analysis are the use of alternative accounting policies, professional judgement, comprehensive income, diversification, inflation, and economic factors The use of different accounting policies can impact a company’s results and, therefore, lessen comparability The use of professional judgement may introduce the possibility of bias and impacts the many estimates made

in preparing financial statements Significant sources of comprehensive income should

be considered in assessing a company’s profitability, even though OCI is not typically used in ratios Many companies are diversified, which makes it difficult to compare them since they cannot be classified to a single industry Inflation is not considered in the preparation of financial statements so assessment of growth rates and trends may not

be accurate if inflation is significant Understanding the effect of the economy is also important in correctly interpreting financial information

22 Management must use professional judgement to choose the most appropriate accounting policy and in preparing estimates This can impact the financial statements through bias (since management is often under pressure to meet company objectives) and inaccuracies in the estimates

23 The use of IFRS and ASPE consist of several areas where accounting policies are different and where certain ratios are not available (e.g., price-earnings ratio for a private company) This limits comparability between companies and for comparison of a company’s results to industry averages

SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 14-1

Profit from continuing operations before income tax $1,040,000

Less: Interest expense $125,000

Income tax expense 260,000 385,000

(d) 1 Cost of goods sold

(e) 3 Dividend revenue

(f) 4 A loss from operations of a discontinued wholesale business

(g) 3 Interest expense

(h) 1 A write-down of obsolete inventory

(i) 4 A gain on the sale of assets of a discontinued wholesale business

BRIEF EXERCISE 14-3

(a) Horizontal percentage of a base-year amount

2015 2014 2013 Cash

—

233.3%188.9%285.7%398.2%4

BRIEF EXERCISE 14-3 (Continued)

(b) Horizontal percentage change for each year

2015 2014 2013 Cash

133.3%1(11.1)%2(14.3)%3(1.8)%4

BRIEF EXERCISE 14-4

Comparing the percentages presented results in the following conclusions:

The profit for Coastal decreased in 2014 over 2013 Cost of goods sold and operating expenses increased faster than net sales In addition, income tax expense declined indicating that profit from operations also declined, assuming no change in the income tax rate

Profit in 2015 increased over 2014 Sales increased faster than did cost of goods sold and operating expenses, which actually declined Income tax expense increased indicating that profit from operations also increased, assuming no change in the income tax rate

BRIEF EXERCISE 14-5

Basis of Comparison Tool of Analysis

(a) Intracompany Horizontal

(b) Intercompany Vertical

(c) Intercompany Vertical

(d) Intracompany Horizontal

BRIEF EXERCISE 14-6

(a)

2015 2014 2013 Current assets 125% 96% 100%

Property, plant, and equipment 110% 98% 100%

Property, plant, and equipment 3,130,000 65.9%

Goodwill 90,000 1.9%

Total assets $4,750,000 100.0%

2014 Amount Percentage Current assets $ 1,175,000 28.8%

Property, plant, and equipment 2,800,000 68.7%

Total assets $ 4,075,000 100.0%

2013

BRIEF EXERCISE 14-7

Amount Percentage Amount Percentage Net sales $1,914 100.0% $2,073 100.0% Cost of goods sold 1,612 84.2% 1,674 80.8% Gross profit 302 15.8% 399 19.2% Operating expenses 218 11.4% 210 10.1% Profit before income tax 84 4.4% 189 9.1% Income tax expense 17 0.9% 38 1.8% Profit $ 67 3.5% $ 151 7.3%

BRIEF EXERCISE 14-8

Profit as a percentage of sales for Waubon decreased in 2014 because cost of goods sold and operating expenses increased The decrease in income tax expense was too small to offset the increase in the other expenses

Profit as a percentage of sales increased in 2015 as both cost of goods sold and operating expenses as a percentage of sales decreased The increase in income tax expense was too small to offset the decrease in other expenses

For information, the calculated profit as a percentage of sales is:

2013 = 16% (100% – 60% – 20% – 4%)

2014 = 15.3% (100% – 60.5% – 20.4% – 3.8%)

2015 = 16.8% (100% – 59.4% – 19.6% – 4.2%)

BRIEF EXERCISE 14-9

Current ratio 2.1 : 1 1 1.8 : 1 2

Receivables turnover 8.0 times 3 8.9 times 4

Inventory turnover 4.5 times 5 5.0 times 6

3

$6,420,000 ($850,000 + $750,000) ÷ 2 = 8.0 times

6

$4,550,000 ($980,000 + $840,000) ÷ 2 = 5.0 times

(b)

The company’s current ratio has improved from 2014 to 2015 However, the receivables turnover and inventory turnover have both deteriorated Even though at first glance, the company’s liquidity seems to have improved based on the improvement of the current ratio,

an examination of the liquidity of the major current assets, accounts receivable and inventory, indicates that liquidity has deteriorated The deterioration of the turnover of receivables and inventory leads to an increase in these assets and increases the current ratio

BRIEF EXERCISE 14-10

Holysh’s liquidity is probably deteriorating The increase in the current ratio is likely caused by the deteriorating turnover of receivables and inventory This may mean that the company is not collecting its accounts receivable on as timely a basis as in the past, or that some balances may be uncollectible The decrease in the inventory turnover ratio implies the company is not selling its inventory as quickly as in the past or that it has too much inventory

on hand at year end, or has increasing amounts of obsolete inventory Further investigation

BRIEF EXERCISE 14-11

Manulife’s solvency appears to have deteriorated slightly The company’s reliance on debt did not change in 2012 as evidenced by the very high but identical debt to total assets ratio There has been deterioration in the times interest earned ratio but offsetting this trend has been a small increase in its free cash flow Cash total debt coverage also stayed the same These changes are marginal however The decrease in Manulife’s times interest earned ratio was more significant, moving from a 1.0 times in 2011 to 0.8 times in 2012 The overall conclusion is that Manulife’s solvency has deteriorated slightly

BRIEF EXERCISE 14-12

(a) The Wolastoq’s profitability is deteriorating

(b) Its return on common shareholders’ equity, return on assets and profit margin have all deteriorated, whereas the debt to total assets, and asset turnover have remained the same Return on common shareholders’ equity is affected by return on assets and debt

to total assets Since the return on assets has deteriorated while the debt to total asset ratio has remained stable, the return on assets has driven the decline in return on common shareholders’ equity

Return on assets, in turn, is driven by profit margin and asset turnover The decline in profit margin has decreased the return on assets and consequently the decrease in the return on common shareholders’ equity

BRIEF EXERCISE 14-13

For growth, I would purchase the shares of Loblaws as the price-earnings ratio is higher, suggesting investors are willing to pay more for the shares because the company has higher prospects for growth and profits in the future For income, I would purchase the shares of the Bank of Montreal as the dividend yield is higher It should be noted that if a company pays out a larger portion of its profit as a dividend, less funds are available to invest in assets and grow the size of the company so it is more likely that a company that pays out high dividends will tend to have a lower price-earnings ratio

margin

$1,868

= 14.1% $(1,690) = (12.2%) $816 = 6.2% $13,278 $13,807 $13,070

Without

(b)

Most financial ratios exclude total comprehensive income, or other comprehensive income, from the analysis Profitability ratios, including industry averages, generally use data from the income statement and not from the statement of comprehensive income, which includes both profit and other comprehensive income In addition, there are no standard ratio formulas incorporating comprehensive income Consequently, the profit margin without other comprehensive loss should be used in reliable financial analysis

entity being held

for immediate and

probable sale

Irregular Statement of

Financial Position

EXERCISE 14-2

Horizontal Analysis of Statement of Financial Position

(% of base-year amount)

EXERCISE 14-2 (Continued)

(b)

DRESSAIRE INC

Horizontal Analysis of Statement of Financial Position

(% change between periods)

2015 Increase (Decrease) 2014 Increase (Decrease) 2013

0

4 0 0, 0 0

0

$520,000

$ 40,000 50,000

$100, 00

0 300,000

$400,000

EXERCISE 14-2 (Continued)

(b) (Continued)

Liabilities and Shareholders’ Equity

iabilities

Current liabilities

Non-current liabilities

Total liabilities

$ 70,000 165,000 235,000

$(20,000) 60,000 40,000

(22.2)%

57.1%

20.5%

$ 90,000 105,000 195,000

$ 25,000 (45,000) (20,000)

38.5%

(30.0%) (9.3%)

$ 65,000 150,000 215,000

0 135,000 285,000

$520,000

35,000 15,000 50,000

$430,000

15,000

35,000 50,000

00 85,000 185,000

$400,000

EXERCISE 14-3

FLEETWOOD CORPORATION Vertical Analysis of Income Statement

Amount Percent Amount Percent Sales $800,000 100.0% $600,000 100.0% Cost of goods sold 550,000 68.8% 375,000 62.5% Gross profit 250,000 31.3% 225,000 37.5% Operating expenses 175,000 21.9% 125,000 20.8% Profit before

income tax 75,000 9.4% 100,000 16.7% Income tax expense 15,000 1.9% 20,000 3.3% Profit $60,000 7.5% $80,000 13.3%

Note: The percentages shown in the above table do not add perfectly because of rounding

discrepancies that occur from rounding the results to one decimal place

EXERCISE 14-4

(a) POSTMEDIA NETWORK CANADA CORP

Horizontal Analysis of Income Statement

(% of base-year amount) Year Ended August 31

2012 2011 2010 Revenues 681.3 736.2 100.0

Operating expenses 593.1 613.5 100.0

Other expenses 231.5 275.6 100.0

Loss from continuing operations before

income tax 83.5 27.2 100.0

Income tax expense - - -

Loss from continuing operations 83.5 27.2 100.0

Income from discontinued operations,

net of income tax - -

-

Because there was no income from discontinued operations in 2010, no percentage change is calculated for 2011 and 2012 even though in those years, income from discontinued

operations was recorded

EXERCISE 14-4 (Continued)

(b)

POSTMEDIA NETWORK CANADA CORP

Vertical Analysis of Income Statement

2010 Amount Percent

Operating expenses 133,650 109.5%

Loss from continuing operations before income tax (44,618) (36.5%)

Loss from continuing operations (44,618) (36.5%)

Income from discontinued operations, net of income tax 0 0.0%

2011 Amount Percent

Operating expenses 819,921 91.2%

Loss from continuing operations before income tax (12,154) (1.4%)

Loss from continuing operations (12,154) (1.4%)

Income from discontinued operations, net of income tax 2,565 0.3%

2012 Amount Percent

Operating expenses 792,619 95.3%

Loss from continuing operations before income tax (37,275) (4.5%)

Loss from continuing operations (37,275) (4.5%)

Income from discontinued operations, net of income tax 14,053 1.7%

Note: The percentages shown in the above table do not add perfectly because of rounding

discrepancies that occur from rounding the results to one decimal place

EXERCISE 14-4 (Continued)

(c) Comparing 2011 to 2010, we can use the horizontal analysis of part (a) which

demonstrates to us how extensive the increase in revenues was in 2011 over 2010 The increase was more than 7 times the level of revenue of 2010 With the increase in revenue came corresponding increases in expenses, with operating expenses coming in

at 6 times the level of 2010, and other expenses increasing to a lesser extent Other expenses also rose in 2011 but not by as much as revenues We can see this effect when we look at the vertical analysis for 2011 versus 2010 Notice how the operating expenses and other expenses as a percentage of revenues fell in 2011 Because the expenses did not rise as much as the revenues,the loss from continuing operations fell

a great deal in 2011 and represented only 1.4% of revenues in 2011 compared to 36.5% in 2010 In 2011, unlike 2010, there was income from discontinued operations that lowered the overall loss for that year

In 2012, both revenues and operating expenses fell but revenues fell by a greater extent

as evidenced by the fact that operating expenses in 2012 were 95.3% of revenues compared to 91.2% in 2011 as we can see in the vertical analysis Other expenses fell

in 2012 and represented only 9.2% of sales in that year compared to 10.1% in the prior year Despite this however, the loss from continuing operations in 2012 rose to 4.5% of revenues compared to only 1.4% of revenues in 2011 Fortunately, in 2012, income from discontinued operations grew but not by enough to prevent the overall loss for the year from being more than twice the amount in 2011

EXERCISE 14-5

(a) (b)

Average collection period L W

Cash current debt coverage L B

Cash total debt coverage S B

Debt to total assets S W

Gross profit margin P B

Return on common shareholders’ equity P B

Times interest earned S B

Days sales in inventory

= 73 days (365 ÷ 5.0 times) = 76 days (365 ÷ 4.8 times)

(b)

Working capital Better

Current ratio Better

Acid-test ratio Worse

Receivables turnover Worse

Collection period Worse

Inventory turnover Better

Days sales in inventory Better

EXERCISE 14-7

(a) The company’s collection of its accounts receivable has deteriorated over the past

several years as it is taking the company longer to collect 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 14-8

(a)

2015 Debt to total

(b) Debt to total assets Worse

Free cash flow Better

Interest coverage Better

EXERCISE 14-9

(a) The debt to total assets ratio has deteriorated over the last three years as the proportion

of total debt to total assets has increased

(b) The increase in the times interest earned ratio indicates that it has improved over the

last three years This means that the company’s profit before interest and taxes has risen more than the increase in interest expense

(c) The company’s solvency initially appears to be worsening as evidenced by its increased

reliance on debt However, the company’s times interest earned and cash total debt coverage ratios are improving, so the company appears to be able to handle this increasing level of debt Because of the impact of these latter two ratios, solvency has not deteriorated

($500 -

$375) = 25.0% ($400 - $290) = 27.5%

$500 $400

$400

= 1.46 times turnover ($350 + $275) ($275 + $274)

(b) Gross profit margin Worse

Profit margin Worse

Asset turnover Better

Return on assets Worse

Return on equity Worse

EXERCISE 14-12

(a) Return on assets is influenced by the profit margin and asset turnover The main driver

of the company’s return on assets is its profit margin This is because the profit margin has decreased, whereas the asset turnover has remained constant

(b) Return on common shareholders’ equity is influenced by return on assets and debt to

total assts The return on assets ratio, more specifically the profit margin, was the primary driver of the deterioration in the return on common shareholders’ equity ratio

The profit margin has shown an increase from 2010 to 2011 and a substantial decrease from 2011 to 2012 This same pattern is reflected in the return on common shareholders’ equity The debt to total assets ratio rose in 2011 and then remained constant from 2011 to 2012 so it is less of an influence on return on common shareholders’ equity

EXERCISE 14-13

(a) Nyarboro is the more liquid of the two despite Rogers’s current ratio being higher than

that of Nyarboro and closer to the industry average Nyarboro’s receivables and inventory turnover ratios are substantially higher than Archers’, which essentially means that it converts its receivables and inventory to cash much more quickly than does Archers Although more information would be helpful before concluding, Archers’ higher current ratio could be the result of higher accounts receivable (possible collection problem) and higher inventory (slow moving due to lower demand)

(b) It appears that Archers is the more solvent of the two Because Nyarboro has a lower

debt to total assets ratio, which is indicative of greater solvency, one would expect it to have a higher times interest earned ratio indicating a greater ability to meet its interest commitments (because of the lower debt level) yet it is Archers that has a higher times interest earned ratio despite having a higher level of debt

(c) Archers is clearly the more profitable of the two, as all of its profitability ratios are

superior to those of Nyarboro and exceed the industry average

(d) Investors seem to favour Nyarboro as indicated by the price-earnings ratio This ratio is

higher than Archers’ although, not as high as the industry average This finding is not

2012 2011 2010 Assets

Total liabilities and

shareholders’ equity 106.7 108.3 100.0

PROBLEM 14-1A

PROBLEM 14-1A (Continued)

(a) (Continued)

CLUBLINK ENTERPRISES LIMITED Horizontal Analysis of Income Statement

(% of base-year amount) Year Ended December 31

2012 2011 2010

Operating expenses 104.3 107.0 100.0 Profit from operations 107.5 98.4 100.0 Interest expense 95.8 98.2 100.0

(b) By expressing the amounts in the statements as a percentage of a base year amount,

we can see that in the statement of financial position the most substantial change was the decline in current assets in 2012 and the increase in current liabilities and shareholders’ equity in 2011 The latter arose due the large increase in retained earnings arising from other revenues in 2011 The remaining elements on the statement

of financial position show increases in line with the increased volume of business demonstrated on the income statement

The most significant change on the income statement arose from the decrease in revenue in 2012 likely due to the decline in the number of members as revealed in the footnote to the income statement The increase in operating expenses increased by

(a)

BIG ROCK BREWERY Vertical Analysis of Statement of Financial Position

December 31 (in thousands)

Current assets 10,895 23.5 8,089 17.9 7,426 21.5 Non-current assets 35,409 76.5 37,081 82.1 27,035 78.5 Total assets 46,300 100.0 45,170 100.0 34,461 100.0

Liabilities and Shareholders’ Equity

Liabilities

Current liabilities 6,318 13.6 5,575 12.3 4,322 12.5 Non-current liabilities 7,911 17.1 7,146 15.8 4,786 13.9 Total liabilities 14,229 30.7 12,721 28.2 9,108 26.4 Shareholders’ equity 32,071 69.3 32,449 71.8 25,353 73.6 Total liabilities and

shareholders’ equity 46,300 100.0 45,170 100.0 34,461 100.0

BIG ROCK BREWERY Vertical Analysis of Income Statement Year Ended December 31 (in thousands)

Net sales 46,057 100.0 45,183 100.0 45,130 100.0 Cost of sales 21,149 45.9 21,385 47.3 19,418 43.0 Gross profit 24,908 54.1 23,798 52.7 25,712 57.0 Operating expenses 19,290 41.9 20,455 45.3 20,054 44.4 Profit from operations 5,618 12.2 3,343 7.4 5,658 12.5 Interest expense 93 0.2 141 0.3 147 0.3 Other income (204) (0.4) (288) (0.6) (327) (0.7) Profit before income tax 5,729 12.4 3,490 7.7 5,838 12.9 Income tax expense (recovery) 1,594 3.5 957 2.1 (279) (0.6) Profit 4,135 9.0 2,533 5.6 6,117 13.6

PROBLEM 14-2A

PROBLEM 14-2A (Continued)

Note: The percentages shown in the above table do not add perfectly because of rounding

discrepancies that occur from rounding the results to one decimal place

(b) The most significant change in Big Rock’s statement of financial position has been a expansion of the business, which occurred in 2011 giving rise to non-current assets that increased by over $10 million This increase was financed partially from debt as seen in the increase in non-current liabilities of $2.4 million and by a more substantial increase in equity of $6.9 million There probably was a large issuance of shares as the increase in shareholders’ equity can only partially be explained by an increase in retained earnings arising profit of $2.5 million Consequently, most of the increase in shareholders’ equity likely arose from share issuances that were used to finance the purchase of the non-current assets

The company’s gross profit decreased significantly in 2011 compared to 2010 but this improved somewhat in the following year The decrease in gross profit percentage was counterbalanced somewhat in 2012 with a decline in operating expenses so that overall there was an improvement in the profit margin percentage in 2012 compared to 2011 (c) Big Rock has primarily financed its assets through equity, but as indicated by the gradually increasing debt to total assets ratio of 26.4% in 2010, 28.2% in 2011, and 30.7% in 2012, the company is relying less on equity financing than it has in the past

PROBLEM 14-3A

(a) Although the operating expenses have been increasing over the last four years, when

these are expressed as a percentage of revenues in the vertical analysis, it is clear that their proportion as a percentage of revenue is smaller in 2015 than in 2012, demonstrating that the company has a good control over the operating expenses

(b) The change in profit before income tax, income tax expense and profit is the same

because the income tax rate has not changed Therefore the absolute amount of the tax expense will change in the same proportion as the change in profit before income taxes

As demonstrated in the vertical analysis statement, when compared to revenues, the absolute amount of income tax expense will change since other variables, such as operating expenses, reduce revenues in different amounts and proportions each year (c) Although most expenses have grown in similar proportions to the increase in revenue,

this is not the case for interest expense Interest expense is decreasing over the four year period This reduction is likely due to the reduction in interest rates charged and the amount of the debt on the statement of financial position

Although the horizontal analysis draws attention to a major increase in the other revenues, that attention is later diminished when inspecting the vertical analysis income statement This statement reveals that in absolute terms, the amount of other revenue involved is very small and so a major increase of 240% over a three year period turns out to have a modest effect on the profit

(d) Horizontal and vertical analysis of the statement of financial position, as well as the

financial statements themselves, can be useful in assessing this company’s performance and financial position In addition, ratio analysis would help complete the picture Comparisons of this company to other businesses in the industry, as well as understanding any external economic or other factors, would also be useful

($ in millions)

(a) Before Discontinued Operations

Ratio 2012 2011 2010 2009 2008 Profit margin $333

PROBLEM 14-4A (Continued)

(b) Nexen’s revenues declined sharply in 2009 but steadily arose afterwards However, despite this, profit margin before discontinued operations deteriorated gradually over the five year period Return on assets and return on equity improved slightly in 2010, but showed significant declines in 2011 and 2012

If we analyze profitability using profit after continuing operations, the pattern is similar – a sharp decline in 2009, significant improvements in 2010, followed by declines in 2011 and

2012 All 3 ratios for 2010 and 2011 are much higher than those calculated without the discontinued operations because the discontinued operations gave rise to higher profit due to the disposal of the assets held by these operations

(c) An analysis on profitability before discontinued operations is more relevant to investors as

it provides a better indication as to how the company will perform in future periods

PROBLEM 14-5A (Continued)

(b) 1 Current ratio Favourable

2 Receivables turnover Favourable

3 Inventory turnover Favourable

4 Debt to total assets Unfavourable

5 Times interest earned Unfavourable

6 Cash total debt coverage Unfavourable

7 Gross profit margin Favourable

8 Profit margin Unfavourable

9 Asset turnover Favourable

10 Return on assets Favourable

Average

collection

period

365 7.0 = 52 days 365 6.8 = 54 days

Inventory

Days in

inventory

365 4.7 = 78 days 365 4.8 = 76 days

PROBLEM 14-6A