www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition CHAPTER 14 Performance Measurement ASSIGNMENT CLASSIFICATION TABLE Brief Exercises Exercises Understand the 1, 2, 3, 18 concept of sustainable income and indicate how discontinued items are presented 1, 1, 4A 2B, 4B Explain and apply horizontal analysis 4, 5, 6, 7, 10, 3, 4, 5, 2, 1A, 3A 1B, 3B 1, Explain and apply vertical analysis 5, 6, 7, 8, 9, 10, 5, 6, 7, 3, 2A, 3A 2B, 3B 1, 4 Identify and calculate ratios that are used to analyze liquidity 10, 11, 12, 15 9, 10 5, 6, 7, 13 5A, 6A, 7A, 8A, 9A 5B, 6B, 7B, 2, 3, 4, 8B, 9B 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, 2, 3, 4, 8B, 9B 5, Identify and calculate ratios that are used to analyze profitability 15, 16, 17, 18, 19, 20 12, 13, 14 5, 10, 11, 12, 13 4A, 5A, 6A, 7A, 8A, 9A 4B, 5B, 6B, 2, 3, 4, 7B, 8B, 9B 5, 6, 7 Understand the limitations of financial analysis 20, 21, 22, 23 14 9A 9B Study Objectives Questions A Problems B Problems BYP Solutions Manual 14-1 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition 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 7B Evaluate ratios Moderate 50-60 8B Evaluate liquidity, solvency, and profitability Moderate 40-50 9B Discuss impact of accounting policies on financial analysis Moderate 30-40 Solutions Manual 14-2 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition ANSWERS TO QUESTIONS 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 (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 (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 (a) An answer cannot be calculated for the percentage change when there is no value in a base year, because division by 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 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 statement Vertical analysis measures items within the same year (or period) Solutions Manual 14-3 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition Answers to Questions (Continued) (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 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 (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 statement is net sales Yes Companies competing in the same industry that are different sizes and in different countries with different exchange rates can be compared For instance, a company may want to know whether its gross profit margin percentage is in line with that of its competition Vertical analysis uses percentages to place the results of both companies side by side, which allows for a comparison despite differences such as size and currency Solutions Manual 14-4 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition 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 Solutions Manual 14-5 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition Answers to Questions (Continued) 15 (a) (b) (c) (d) (e) Asset turnover Inventory turnover, days in inventory Return on common shareholders’ equity Times interest earned 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 relative to the share’s price Solutions Manual 14-6 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition 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 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 Manual 14-7 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition 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 Sustainable income $ 655,000 BRIEF EXERCISE 14-2 (a) (b) (c) (d) (e) (f) (g) (h) (i) 3 4 A realized gain on the sale of trading investments Sales revenue Salaries expense Cost of goods sold Dividend revenue A loss from operations of a discontinued wholesale business Interest expense A write-down of obsolete inventory A gain on the sale of assets of a discontinued wholesale business Solutions Manual 14-8 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition BRIEF EXERCISE 14-3 (a) Horizontal percentage of a base-year amount Cash Accounts receivable Inventory Property, plant, and equipment Intangible assets $175,000 = 233.3% $75,000 $400,000 = 88.9% $450,000 $600,000 = 85.7% $700,000 $2,800,000 = 98.2% $2,850,000 2015 2014 200.0%5 133.3%6 111.4%7 109.8%8 233.3%1 88.9%2 85.7%3 98.2%4 100% 100% 100% 100% — — — 2013 $150,000 = 200.0% $75,000 $600,000 = 133.3% $450,000 $780,000 = 111.4% $700,000 $3,130,000 = 109.8% $2,850,000 Solutions Manual 14-9 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition BRIEF EXERCISE 14-3 (Continued) (b) Horizontal percentage change for each year Cash Accounts receivable Inventory Property, plant, and equipment Intangible assets 2015 2014 (14.3)%5 50.0%6 30.0%7 11.8%8 (10.0)%9 133.3%1 (11.1)%2 (14.3)%3 (1.8)%4 ($175,000 – $75,000) = 133.3% $75,000 ($600,000 – $700,000) = (14.3)% $700,000 ($400,000 – $450,000) = (11.1)% $450,000 ($2,800,000 – $2,850,000) = (1.8)% $2,850,000 ($150,000 – $175,000) = (14.3)% $175,000 — 2013 0% 0% 0% 0% — ($600,000 – $400,000) = 50.0% $400,000 ($780,000 – $600,000) = 30.0% $600,000 ($3,130,000 – $2,800,000) = 11.8% $2,800,000 ($90,000 – $100,000) = (10.0)% $100,000 Solutions Manual 14-10 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition BYP 14-2 (Continued) (c) Profitability ratios Shoppers Drug Mart (millions) Jean Coutu (millions) Gross profit margin $4,172.6 = 38.7 % $10,781.8 $2,468.0 – $2,169.0 = 12.1% $2,468.0 Profit margin $608.5 = 5.6 % $10,781.8 $558.4 = 22.6 % $2,468.0 Asset turnover $10,781.8 $7,473.7 + $7,300.3 � � = 1.5 times $2,468.0 $1,392.7 + $1,072.8 � � = 2.0 times Return on assets $608.5 $7,473.7 + $7,300.3 � � = 8.2% $558.4 $1,392.7 + $1,072.8 � � = 45.3% Return on common shareholders’ equity $608.5 $4,323.3 + $4,267.8 � � = 14.2% $558.4 $1,110.8 + $649.2 � � = 63.5% Profitability: Although Shoppers has a much stronger gross profit margin compared to Jean Coutu based on their respective profit margins, we can see that Jean Coutu is more profitable than Shoppers The large difference in gross profit margin may be due to the product mix of each company or the allocation of costs between cost of goods sold and operating expenses Nonetheless, Jean Coutu appears to control its operating expenses better This has allowed the company to have a much healthier profit margin compared to Shoppers The return on assets ratio indicates that Shoppers is generating a much lower return than Jean Coutu based on the amount of assets invested in the business The asset turnover measures how efficiently a company uses its assets to generate sales Jean Coutu’s asset turnover was higher than Shoppers Solutions Manual 14-70 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition BYP 14-2 (Continued) (d) Other useful information would include the industry averages to determine each company’s performance in relation to other companies in the same industry In addition, previous years financial results would show any trends that are affecting the company’s performance Other useful information contained in the annual report, but not the financial statements, would indicate management’s assessment of financial performance, discussion of economic conditions, and discussion of strategies that would indicate the reasons behind some of the changes in the financial ratios Solutions Manual 14-71 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition BYP 14-3 COMPARING IFRS AND ASPE (a) FLL is reporting under IFRS because it uses the Other Comprehensive Income account, which is not used under ASPE It also reversed an impairment loss and revalued equipment to fair value, both of which are allowed only under IFRS Lastly, the company recorded a “provision”, which is term used only under IFRS Since DLL has recorded none of these items allowed under IFRS, it is logical to assume that it reports using ASPE (b) Not all of the differences that are described relate to the use of IFRS and ASPE The choice of inventory cost methods is available under both sets of standards (c) Current ratio: Due to the rising cost of inventory, FIFO will yield a higher value in inventory and so FLL will have a higher current ratio than DLL Inventory turnover: Cost of goods sold will be lower under FIFO in times of rising prices and ending inventory will be higher Therefore, FLL will likely experience a lower inventory turnover ratio Debt to total assets ratio: FLL will likely have a lower debt to total asset ratio because the equipment value has been increased to fair value, and because of the reversal of the impairment loss on some of the equipment has caused assets to increase Offsetting this increase in property, plant, and equipment may be the reduction of those assets involved in the other comprehensive loss recorded during the year which might not be triggered under ASPE Profit margin: FLL will have a higher profit margin because of its choice to use FIFO, as explained in the inventory turnover ratio above As well the reversal of the impairment loss on some of the equipment will increase profit Asset turnover: FLL will have higher total assets as explained in the debt to total assets ratio above Consequently its asset turnover ratio will be lower than DLL Solutions Manual 14-72 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition BYP 14-4 CRITICAL THINKING Company A is WestJet Airlines Ltd – clues to its identity include: • • • • • • • Discount airline would have a low gross profit Administrative costs would be minimal as most employees would work on the airplanes or in maintenance – salaries for pilots, attendants, mechanics etc would be included in cost of goods sold WestJet has a December 31 year-end, which is right after the very busy Christmas travel season so cash levels are very high Accounts receivable would be very low as most customers pay with credit cards Inventories would be minimal as products are not sold to customers except food on airplanes, and there may be some spare parts inventory for planes and equipment Property, plant and equipment would be high as the company operates airplanes Current liabilities would be high because a large portion of this would be unearned revenue as tickets are sold in advance Company B is Blackberry Limited – clues to its identity include: • • • • The only company with research and development costs Products are not sold to consumers but retailers, and these types of sales are more likely to be on credit so accounts receivable would be fairly high This is the company most likely to have intangible assets for the patents on its products High tech companies usually not rely as much on bank financing as other companies because they tend to have less tangible collateral, so we would expect to see lower levels of non-current liabilities Company C is Loblaw Companies Ltd – clues to its identity include: • • • • • The grocery industry is competitive so we would expect a lower gross profit margin and a lower profit margin ratio Despite lower margins, such a company is less likely to be unprofitable given the predictability of revenues and expenses and the constant demand for its products Selling costs should be a higher percentage of sales compared to other companies because grocery stores advertise (so furniture companies but they would have higher gross profits) Inventory would be high but not the highest of the five companies as inventory turnover would have to be high enough to prevent too much spoilage Because it has private labels, it should have some intangible assets Solutions Manual 14-73 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition BYP 14-4 (Continued) Company D is Canadian Natural Resources Limited – clues to its identity include: • • • • Oil prices are high this year so a high gross profit margin is expected along with a high profit margin Depreciation is the largest expense because the business is so capital intensive – oil sands plants are very expensive – this correlates with the large percentage of assets represented by property, plant and equipment Due to the large proportion of non-current assets, one would expect to see a correspondingly larger proportion of non-current liabilities compared to current liabilities Due to the riskiness of oil prices it is more likely for an oil and gas company to have lower debt relative to liabilities than companies with more stable revenue streams like an airline or grocery chain Company E is Leon’s Furniture – clues to its identity include: • • • • Large selling expenses due to significant advertising that occurs in this industry This company should have a reasonably high level of inventory as its turnover would be slower than the grocery chain Accounts receivable would be low as sales are made to individuals and any special sales where payment is not needed for a certain period of time give rise to receivables that are often sold to financial institutions A company that has operated for over 100 years, may be more likely to have a higher level of retained earnings and equity and be less in need of bank financing than the other companies and would not need as many non-current liabilities Solutions Manual 14-74 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition BYP 14-5 ETHICS CASE (a) The stakeholders in this case are: Vern Fairly, president of Flex Industries Anne Saint-Onge, vice-president of communications You, as controller of Flex Industries Shareholders of Flex Industries Potential investors in Flex Industries Any readers of the press release (b) The president’s press release is deceptive and incomplete and to that extent his action is unethical (c) As controller you should at least inform Anne Saint-Onge, the vice-president of communications, about the biased content of the release She should be aware that the information she is about to release, while factually accurate, is deceptive and incomplete Both the controller and the vice-president of communications (if she agrees) have the responsibility to inform the president of the bias of the about-to-be-released information Solutions Manual 14-75 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition BYP 14-6 “ALL ABOUT YOU” ACTIVITY (a) The software company should have a higher price-earnings ratio because the market expects this company to have opportunities to grow faster than a more established company (b) More established companies like this bank tend to have stable profits and cash flows and are not in the same growth phase that a newly public company would be in Consequently, such a company can distribute some of its cash flows to shareholders by paying out a dividend A newly public company typically obtains a listing on a stock exchange to raise capital from investors to expand their operations and would therefore, be using all available cash for expansion and would not want to diminish available cash by returning any to shareholders through dividends (c) The software company has yet to reach its normal levels of activity and profitability so one would expect such a company to have low profits (and perhaps even losses), which in turn will make any ratio based on profitability, such as return on common shareholders’ equity or return on assets, lower than more established companies with a record of profitability (d) A bank uses leverage (borrowed funds) extensively Every savings account that a bank has is a liability on the bank’s statement of financial position Therefore, the debt that a bank has is usually much larger than its equity Normally, the bank will earn a higher return on the borrowed money than it pays to its customers in interest Because of this, the return on common shareholders’ equity will be higher than the return on assets Solutions Manual 14-76 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition BYP 14-6 (Continued) (e) There really is no “right” answer to this question It really depends on how much risk an investor is willing to undertake The bank may provide a nice dividend and its share price may rise in the future but not at a very fast rate because the ability of a bank to grow rapidly is limited due to the large number of competing banks that exist On the other hand, if the software company makes a very good game and there exists a large demand for that game, then the software company’s share price will rise dramatically However, there is a risk that the game may not be popular and the share price may then collapse Such a drop in share price may not occur for the bank’s shares given the steady demand that exists for its services So, if you feel comfortable with the risk implicit in buying the software company’s shares and believe that their games will indeed be popular, buy those shares If you are more conservative and don’t mind earning a more modest profit or incurring a modest rather than severe loss, you may want to buy the bank shares Your aversion to risk may also be a function of age For example, a senior should probably not invest extensively in software company’s shares because if the price falls dramatically, that lost income can’t be replaced because the senior may be unable to work Furthermore, the senior may need dividend income to meet living expenses, whereas a younger person can take on more risk with their investments because they have alternative sources of income Solutions Manual 14-77 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition BYP 14-7 SERIAL CASE (a) Biscuits is more liquid than Cookies Are for Us Biscuits’ current ratio is higher and matches the industry ratio Its receivables turnover and inventory turnover are both higher than those of Cookies Are for Us and the industry average This indicates that the Biscuits’ current ratio is strong, and that it is collecting its accounts receivable and turning over its inventory more quickly than its competitor (b) It appears that Biscuits is the more solvent of the two companies The two ratios provide conflicting results Cookies Are for Us has a lower debt to total assets ratio, which is indicative of greater solvency However, despite having a higher debt to total assets ratio, Biscuits also has a higher times interest earned ratio Biscuits’ times interest earned ratio exceeds the industry average, which is also indicative of greater solvency Biscuits higher times interest earned ratio indicates that it can service its higher debt load (c) Biscuits is clearly the more profitable of the two, as all of its profitability ratios are superior to those of Cookies Are for Us Biscuits’ return on common shareholders’ equity and gross profit margin ratios also exceed the industry average However, its profit margin and return on assets ratios are lower than the industry average (d) Investors favour Biscuits as indicated by their higher price-earnings ratio Their P-E ratio is also higher industry average This could mean that Natalie and Daniel may have to pay more to purchases shares of Biscuits (e) Natalie and Daniel should be aware that financial statements prepared under IFRS can contain accounting policy choices and financial statement items (such as other comprehensive income) that are different from those applied by companies using ASPE They should also inquire whether the industry averages are applicable given that they likely relate only to publicly-traded competitors In preparing their analysis, they should also be aware of what items under IFRS will be subject to additional volatility and how they will interpret the change in the trends for the ratios affected Solutions Manual 14-78 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition BYP 14-7 (Continued) (f) Natalie and Daniel should consider some of the following factors related to making an investment in Biscuits: - their risk tolerance (can they tolerate the fluctuations inherent in share investments) - their profile as investors (are they investing for growth or income) - their goals for this investment (are they investing for short-term appreciation or longterm growth) - is this the right time to be purchasing the shares (are they currently overvalued by other investors)? - are they looking for dividend income or capital growth? In addition, before concluding their analysis, Natalie and Daniel should obtain additional information to supplement the ratio analysis This could include detailed financial statements, a horizontal and vertical analysis, as well as relevant non-financial information They likely already have a very good understanding of the business and the economy from their involvement with Koebel’s Family Bakery Solutions Manual 14-79 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition COMPREHENSIVE CASE: CHAPTERS 13 – 14 (a) MANUTECH LTD Vertical Analysis of Income Statement Year Ended December 31 2015 Amount Percent 2014 Amount $1,470,000 100.0% $1,100,000 100.0% Cost of goods sold 735,000 50.0% 655,000 59.5% Gross profit 735,000 50.0% 445,000 40.5% Operating expenses 313,500 21.3% 270,000 24.6% Profit from operations 421,500 28.7% 175,000 15.9% 61,500 4.2% 53,600 4.9% 360,000 90,000 24.5% 6.1% 121,400 30,350 11.0% 2.7% $ 270,000 18.4% 91,050 8.3% Net sales Interest expense Profit before income tax Income tax expense Profit $ Percent As demonstrated in the vertical analysis above, the profit margin has increased as a percentage of sales from 8.3% to 18.4% The most apparent explanation for the substantial increase in profit margin is the 9.5% reduction in cost of goods sold as a percentage of sales This may be a result of Manutech’s investment in a customer relationship management system It appears that the use of this system has resulted in a recovery from the decline in sales of the past The system should be able to provide management with the necessary feedback on purchasing trends and from repeat sales that have generated these positive results Solutions Manual 14-80 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition COMPREHENSIVE CASE: CHAPTERS 13 - 14(Continued) (b) Ratio Manutech Ltd $292,000 Current ratio Industry = 1.6:1 2.0:1 $185,000 Receivables turnover $1,470,000 ($150,000 + $105,000) 365 = 32 days 11.5 Average collection period Inventory turnover = 11.5 times $735,000 ($112,000 + $90,000) 28 days = 7.3 times Days in inventory 365 = 50 days 7.3 40 days Compared to the industry average, Manutech has a low current ratio, and is slower than the industry in collecting its accounts receivable and selling its inventory Manutech is less liquid than the industry average Solutions Manual 14-81 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition COMPREHENSIVE CASE: CHAPTERS 13-14 (Continued) (c) Ratio Debt to total assets Times interest earned Manutech Ltd $815,000 Industry = 53.9% 50.0% $1,512,000 $421,500 = 6.9 times $61,500 5.0 times Manutech slightly exceeds the industry average in the amount of assets financed by debt but can cover its interest costs more comfortably than others in its industry (d) Ratio Gross profit margin Manutech Ltd $735,000 Industry = 50.0% 44.5% = 18.4% 15.1% $1,470,000 Profit margin $270,000 $1,470,000 Asset turnover $1,470,000 ($1,512,000 + $1,359,500) = 1.0 times Return on assets $270,000 ($1,512,000 + $1,359,500) = 18.8% 0.8 times 12.5% Compared to the industry averages, Manutech is stronger on all profitability ratios Solutions Manual 14-82 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition COMPREHENSIVE CASE: CHAPTERS 13-14 (Continued) (e) MANUTECH LTD Statement of Cash Flows—Partial Year Ended December 31, 2015 Net cash provided by operating activities $355,500 Investing activities Purchase of management system Net cash used in investing activities $(300,000) Financing activities Issue of bank loan Repayment of mortgage payable Payment of dividends Net cash used in financing activities $ 85,000 (20,000) (170,000) Net decrease in cash Cash, January Cash, December 31 (300,000) (105,000) (49,500) 79,500 $ 30,000 As was explained in part (a), the major improvements in the profitability for Manutech were achieved following the $300,000 investment in a customer relationship management system Although some of this investment seems to have been financed through a bank loan, the remainder was obtained from operations In addition to this, almost half of the cash generated from operations was disbursed in dividends The total amount of the dividends is extremely high compared to profit These two factors are the main reasons why the cash position did not improve at the same pace as profit Solutions Manual 14-83 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition Legal Notice Copyright Copyright © 2014 by John Wiley & Sons Canada, Ltd or related companies All rights reserved The data contained in these files are protected by copyright This manual is furnished under licence and may be used only in accordance with the terms of such licence The material provided herein may not be downloaded, reproduced, stored in a retrieval system, modified, made available on a network, used to create derivative works, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise without the prior written permission of John Wiley & Sons Canada, Ltd (MMXIII xi FI) Solutions Manual 14-84 Chapter 14 Copyright © 2014 John Wiley & Sons Canada, Ltd Unauthorized copying, distribution, or transmission of this page is strictly prohibited ... prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition Answers to Questions (Continued) 10 (a) Comparison of financial information can... this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition SOLUTIONS TO BRIEF EXERCISES BRIEF EXERCISE 14-1 Profit... this page is strictly prohibited www.downloadslide.net Kimmel, Weygandt, Kieso, Trenholm, Irvine Financial Accounting, Sixth Canadian Edition SOLUTIONS TO EXERCISES EXERCISE 14-1 (a) (b) Statement