Prepare and interpret common-size financial statements.

ACCOUNTING FINANCIAL STATEMENTS

Last week you selected a publicly traded company and found their annual report. Now that you have their financial information I would like you to perform a ratio analysis on the financial statements. Focus on the financial statement analysis chapter (PDF) you are reading this week. You will want to compute ratios for your company for the last two years. Do not compute each ratio you learned about for your company. There may be some that are not relevant. Rather focus on those eight ratios that you feel are the most important and relevant to analyze how your company is doing. Make sure to justify the ratios that you choose for your analysis. Compare how your company has done to the industry averages. Do you notice any trends that are positive or negative? Does anything look good or bad that is notable? Do you have any suggestions on things they could be doing to improve these ratios? Please analyze what you found for each of the eight ratios. Then organize your findings into a 15 minute presentation that you will work on during virtual residency. Be sure to include some background on your company in your presentation.

Company: Walmart Inc.

Include matter on separate word doc to prepare for presentation (should be enough to talk at least 15 minutes).

analyzing_financial_statements-Chapter.pdf

21 Analyzing Financial Statements

Chapter Twenty-One

After completing this chapter, you should be able to:

1 Explain the objectives of financial statement analysis.

2 Describe and use the following four analytical techniques: horizontal analysis, trend analysis, vertical analysis, and ratio analysis.

3 Explain the importance of comparisons and trends in financial statement analysis.

4 Prepare and interpret common-size financial statements.

5 Define and compute the various financial ratios discussed in the chapter.

Chicago, IL—Contemporary Interiors, a Chicago tradition in Scandinavian furniture and contemporary design, has announced a decision to go national. Although Contempo- rary Interiors has opened stores throughout the Midwest in recent years, the company has remained a regional busi- ness with the bulk of its sales in the greater Chicago area. Yesterday, however, a company spokesman announced that Contemporary Interiors’ Board of Directors had decided the time was right to make the

next move. Marc Janson, spokesman for the firm’s pres- ident and CEO, pointed to the strong economy and consumer confidence as being key to the decision. “Disposable income is up, and we’re seeing that in our business,” said Janson. “Even more important, though, is our company’s strong finan- cial position. The analysts tell us that our financial state- ments look good. Our working capital, inventory turnover, return on assets, and so forth are all strong. This will be important, because in order to

expand, the company’s going to have to raise capital. And the bankers and potential investors are going to need to see those strong financial indi- cators. The board hasn’t decided yet how much of our new capital needs should be debt and how much should be in stock. I’m sure they’ll keep a close eye on the debt-equity ratio.” When asked where Contemporary Interiors’ next store would appear, Janson replied that New York, Atlanta, and San Francisco were all under consideration.

CONTEMPORARY INTERIORS TO GO NATIONAL

Financial statements provide the primary means for managers to communicate about the financial condition of their organization to outside parties. Managers, investors, lenders, financial analysts, and government agencies are among the users of financial statements. Substantial information is conveyed by financial statements about the financial strength and current performance of an enterprise. Although financial state- ments are prepared primarily for users outside an organization, managers also find their organization’s financial statements useful in making decisions. As managers develop operating plans, they think about how those plans will affect the performance of the organization, as conveyed by the financial statements. In this chapter, we explore how to analyze financial statements to glean the most information about an organization.

Overview of Financial Statements There are four primary financial statements:

1. Balance sheet 2. Income statement 3. Retained earnings statement 4. Statement of cash flows

Exhibit 21–1 presents the basic structure of each of these statements and the relation- ships between them. The balance sheet presents an organization’s financial position at a point in time. It shows the balances in the organization’s assets, liabilities, and owners’ equity, as of the balance sheet date.

The other three financial statements depicted in Exhibit 21–1 relate to a period of time. The income statement reports the income for the period between two balance sheet dates. The retained earnings statement shows how income and dividends for the period have changed the organization’s retained earnings. The statement of cash flows shows how cash was obtained during the period and how it was used.

In this chapter, we will concentrate on analyzing the data conveyed by the balance sheet, the income statement, and the retained earnings statement. In the preceding chapter, we explored how the statement of cash flows is prepared and used.

Objectives of Financial Statement Analysis Financial statements are based on historical accounting information, which reflects the transactions and other events that have affected the firm. Managers and other users of the firm’s financial statements are interested in

the future. The objective of financial statement analysis is to use historical accounting data to help in predicting how the firm will fare in the future. The aspects of an organi- zation’s future performance that are of most interest depend on the needs of the user. A manager in the firm would be interested in the company’s overall financial strength, its income and growth potential, and the financial effects of pending decisions. A potential lender, such as a bank loan officer, would be concerned primarily about the firm’s ability to pay back the loan. Potential investors would be interested not only in the company’s ability to repay its loan obligations, but also its future profit potential. Potential customers would want to assess the firm’s ability to carry out its operations effectively and meet delivery schedules. Thus, the needs of the analyst dictate the sort of financial statement analysis that is most appropriate.

Analytical Techniques Used Four analytical tools are in widespread use in analyzing financial statements:

1. Horizontal analysis 2. Trend analysis

44 Chapter 21 Analyzing Financial Statements

Overview of Financial Statements

Objectives of Financial Statement Analysis LO 1 Explain the objectives of financial

statement analysis.

LO 2 Describe and use the following four analytical techniques: horizontal

analysis, trend analysis, vertical analysis, and ratio analysis.

3. Vertical analysis 4. Ratio analysis

Each of these techniques is defined, discussed, and illustrated in the following sections of the chapter.

Importance of Comparisons and Trends No single measure of a company’s financial condition or performance can tell us much. The single most important point to remember about financial statement analysis is that every financial measure should be compared across time and across other companies to be meaningful. For example, an airline’s profit for the current year should be compared with the same company’s profit for several previous years. Moreover, the company’s profit should be compared with the profit reported by other airlines of similar size and operational

Chapter 21 Analyzing Financial Statements 45

BALANCE SHEET

12/31/x0

� �

Liabilities

Owner’s Equity

Assets

BALANCE SHEET

12/31/x1

� �

Liabilities

Owner’s Equity

Assets

INCOME STATEMENT

For the Year Ended 12/31/x1

Revenues

� Expenses

� Gains

� Losses

Income

RETAINED EARNINGS STATEMENT

For the Year Ended 12/31/x1

Retained earnings on 12/31/x0

� Income

� Dividends

Retained earnings on 12/31/x1

STATEMENT OF CASH FLOWS

For the Year Ended 12/31/x1

Cash inflows during 20×1

� Cash outflows during 20×1

Change in cash during 20×1

These three state- ments refer to a period of time, the year 20×1. They help reconcile the account balances on the balance sheets as of 12/31/x0 and 12/31/x1.

                            

12/31/x0 12/31/x1 Time

Exhibit 21–1

Overview of Financial Statements

LO 3 Explain the importance of com- parisons and trends in financial statement analysis.

characteristics. Comparing key financial data with industry norms also adds meaning to the reported profit for the company being analyzed.

To reemphasize the point, every financial measure discussed in this chapter should be compared with other analogous measures to be meaningful.

Sources of Data Published financial statements provide the primary source of data about any organi- zation’s financial condition and performance. A company’s annual report, quarterly reports, and financial news releases provide a wealth of information about the firm.

Other sources of financial information also are available, both for individual com- panies and for entire industries. The Securities and Exchange Commission requires that every publicly held company file a detailed financial report with the commission annually. These reports are available to the public. The financial press, such as The Wall Street Journal, Barron’s, Business Week, Fortune, Forbes, and various industry trade publications, provides in-depth coverage of specific companies and industries. Other important sources of financial data include financial advisory services, such as Dun & Bradstreet, Moody’s Investors Service, Dow Jones, Standard & Poor’s, and Robert Morris Associates. A wealth of financial information is also available on the Internet.

Doing a good job of financial statement analysis is not a trivial task. It requires a solid knowledge of accounting, familiarity with the analytical techniques to be dis- cussed in this chapter, and substantial research using data from a variety of sources.

Comparative Financial Statements To illustrate each of the techniques used in analyzing financial statements, we will focus on a retail business. Contemporary Interiors, Inc., headquartered in Chicago, operates a chain of furniture stores in the Midwest. The company specializes in con- temporary furniture, much of it imported from the Scandinavian countries. The firm also sells handcrafted furnishings, such as ceramic lamps and handwoven wall hangings.

Contemporary Interiors’ balance sheets for December 31, 20×0 and 20×1, are dis- played in Exhibit 21–2. The company’s income statements and retained earnings state- ments for 20×0 and 20×1 are presented in Exhibit 21–3.

Horizontal Analysis Exhibits 21–2 and 21–3 display comparative financial statements, which show the company’s financial results for two successive years. These state- ments highlight the change in each financial item between 20×0 and 20×1. For example, Exhibit 21–2 shows that Contemporary Interiors’ cash balance increased by $100,000 between December 31, 20×0, and December 31, 20×1. Notice that the changes highlighted in Exhibits 21–2 and 21–3 are

shown in both dollar and percentage form. Thus, Contemporary Interiors’ $100,000 increase in cash represents an increase of 14.3 percent of the December 31, 20×0, amount (14.3% � $100,000 � $700,000).

Comparative financial statements and change data enable managers and financial analysts to do horizontal analysis, which is an analysis of the year-to-year change in each financial statement item. The purpose of horizontal analysis is to determine how each item changed, why it changed, and whether the change is favorable or unfa- vorable. This is a tall order, and it requires substantial additional information. Suppose, for example, that a business periodical recently published a story about a growing demand for Danish furniture. A glance at Contemporary Interiors’ comparative balance

46 Chapter 21 Analyzing Financial Statements

Comparative Financial Statements

LO 2 Describe and use the following four analytical techniques: horizontal

analysis, trend analysis, vertical analysis, and ratio analysis.

Comparative financial statements show the company’s financial results for two successive years and highlight changes.

Horizontal analysis is an analysis of the year-to- year change in each financial statement item.

sheet reveals that its cash, accounts receivable, and inventory have all increased during 20×1. These changes are consistent with expanded operations in response to increased demand for the company’s goods. The comparative income statement helps to confirm this supposition, since sales and cost of goods sold increased from 20×0 to 20×1.

Thus the analyst’s job is like putting together a jigsaw puzzle. The analyst first gathers all the puzzle pieces (financial data) and then tries to fit them together to create a meaningful picture (the firm’s financial condition and performance).

Chapter 21 Analyzing Financial Statements 47

Contemporary Interiors, Inc. Comparative Balance Sheets December 31, 20×1 and 20×0

(in thousands)

Year Increase or (Decrease)

Assets 20×1 20×0 Amount Percentage Current assets:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 800 $ 700 $ 100 14.3

Marketable securities . . . . . . . . . . . . . . . . . . . . . . 450 300 150 50.0

Accounts receivable, net . . . . . . . . . . . . . . . . . . . . 12,000 11,000 1,000 9.1

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 17,000 3,000 17.6

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . 250 300 (50) (16.7)

Total current assets . . . . . . . . . . . . . . . . . . . . . . $ 33,500 $ 29,300 $4,200 14.3

Long-term investments . . . . . . . . . . . . . . . . . . . . . . . $ 500 $ 550 $ (50) (9.1)

Property, furnishings, and equipment:

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000 $ 6,000 $ –0– –0–

Buildings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . 55,000 52,000 3,000 5.8

Equipment and furnishings, net . . . . . . . . . . . . . . . 25,000 23,000 2,000 8.7

Total property, furnishings, and equipment . . . . . $ 86,000 $ 81,000 $5,000 6.2

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000 $110,850 $9,150 8.3

Liabilities and Stockholders’ Equity Current liabilities:

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,500 $ 7,050 $ 450 6.4

Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . 2,200 2,100 100 4.8

Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 3,200 (200) (6.3)

Total current liabilities . . . . . . . . . . . . . . . . . . . . $ 12,700 $ 12,350 $ 350 2.8

Long-term liabilities:

Bonds payable ($1,000 face value; 10%) . . . . . . . . 37,300 35,700 1,600 4.5

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000 $ 48,050 $1,950 4.1

Stockholders’ equity:

Preferred stock ($100 par value; 8%) . . . . . . . . . . . $ 6,000 $ 6,000 $ –0– –0–

Common stock ($10 par value)* . . . . . . . . . . . . . . . 25,000 24,000 1,000 4.2

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . 4,000 3,800 200 5.3

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . 35,000 29,000 6,000 20.7

Total stockholders’ equity . . . . . . . . . . . . . . . . . $ 70,000 $ 62,800 $7,200 11.5

Total liabilities and stockholders’ equity . . . . . . . . . . . $120,000 $110,850 $9,150 8.3

*100,000 shares of common stock were issued on January 1, 20×1. Since these shares were outstanding during the entire year, the weighted-average number of shares outstanding in 20×1 was 2,500,000 shares.

Exhibit 21–2

Comparative Balance Sheets

Trend Analysis The comparative financial statements in Exhibits 21–2 and 21–3 allow a comparison of only two years’ data. When the comparison is extended to three or more years, the technique is called trend analysis. Trends can be shown in both dollar and percentage form by designating the first year in the sequence as the base year. Then the amounts in subsequent years are shown

as a percentage of the base-year amount. Exhibit 21–4 displays a trend analysis of Contemporary Interiors’ sales and net income data over a six-year period.

Contemporary Interiors’ sales and net income both have risen steadily over the six- year period. However, the growth in sales has been greater than the growth in net income. The increase in income between year 5 and year 6 is quite small, despite a large increase in sales. The relationship between the trend in sales and the trend in net income could be cause for concern. Why has Contemporary Interiors’ management been unable to convert a relatively larger growth in sales into an equally large growth in net income? While the trend analysis does not answer this question, it does serve an attention-directing role for the analyst. An alert financial analyst will delve more deeply into this issue and try to come up with an explanation.

Vertical Analysis Horizontal and trend analyses focus on the relationships between the amounts of each financial item across time. In contrast, vertical analysis concentrates on the relationships between various financial items on a par- ticular financial statement. To show these relationships, each item on the

48 Chapter 21 Analyzing Financial Statements

Contemporary Interiors, Inc. Comparative Income and Retained Earnings Statements

For the Years Ended December 31, 20×1 and 20×0 (in thousands)

Year Increase or (Decrease)

20×1 20×0 Amount Percentage Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $87,000 $82,000 $5,000 6.1

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,930 56,350 4,580 8.1

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $26,070 $25,650 $ 420 1.6

Operating expenses:

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 $ 4,600 $ 400 8.7

Administrative expenses . . . . . . . . . . . . . . . . . . . . 2,000 2,100 (100) (4.8)

Total operating expenses . . . . . . . . . . . . . . . . . . $ 7,000 $ 6,700 $ 300 4.5

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,070 $18,950 $ 120 .6

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,030 3,890 140 3.6

Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . $15,040 $15,060 $ (20) (.1)

Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . 3,760 3,800 (40) (1.1)

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,280 $11,260 $ 20 .2

Dividends on preferred stock . . . . . . . . . . . . . . . . . . . 480 480 –0– –0–

Net income available to common stockholders . . . . . . $10,800 $10,780 $ 20 .2

Dividends on common stock . . . . . . . . . . . . . . . . . . . 4,800 4,600 200 4.3

Net income added to retained earnings . . . . . . . . . . . . $ 6,000 $ 6,180 $ (180) (2.9)

Retained earnings, January 1 . . . . . . . . . . . . . . . . . . . 29,000 22,820 6,180 27.1

Retained earnings, December 31 . . . . . . . . . . . . . . . . $35,000 $29,000 $6,000 20.7

Exhibit 21–3

Comparative Income and Retained Earnings Statements

LO 2 Describe and use the following four analytical techniques: horizontal

analysis, trend analysis, vertical analysis, and ratio analysis.

LO 2 Describe and use the following four analytical techniques: horizontal

analysis, trend analysis, vertical analysis, and ratio analysis.

Trend analysis is a comparison of three or more years’ data.

Vertical analysis concentrates on the relationships between various financial items on a financial statement.

statement is expressed as a percentage of a base item that also appears on the statement. On the balance sheet, each item is expressed as a percentage of total assets. On the income statement, each item is stated as a percentage of sales. Financial statements prepared in terms of percentages of a base amount are called common-size financial statements. Contemporary Interiors’ common-size balance sheets and income state- ments for 20×0 and 20×1 are displayed in Exhibits 21–5 and 21–6.

Financial analysts use vertical analysis to gain insight into the relative importance or magnitude of various items on the financial statements. Using common-size state- ments, prepared in a comparative format, analysts can discern changes in a firm’s financial condition and performance from year to year.

To illustrate, notice that Contemporary Interiors’ composition of current assets remained quite stable from 20×0 to 20×1. Although the various asset amounts changed, each asset represents roughly the same proportion of total assets on December 31, 20×1, as on December 31, 20×0. The largest change is in inventory, which increased from 15.3 percent to 16.7 percent of total assets. This could be merely a reflection of increased sales, and the required working capital. Alternatively, it could indicate overstocking.

Ratio Analysis:The Balance Sheet The balance sheet is like a snapshot. It records the company’s financial position at an instant in time. Several key relationships between the balance sheet items can help an analyst gain insight into the strength of a business.

Working Capital Current assets are assets that, under normal business operations, will be converted into cash within a reasonably short time period, usually a year. Contemporary Interiors’ current assets include cash, marketable securities, accounts receivable, inventory, and prepaid expenses. The expectation is that the inventory will be sold within a year, the accounts receivable will be collected within a year, and so forth. Current liabilities are obligations due within a year.

A key financial measure is a company’s working capital, which is defined as follows:

Working capital � Current assets � Current liabilities

Contemporary Interiors’ working capital as of December 31, 20×1, amounts to $20,800,000 ($33,500,000 � $12,700,000). Working capital is a key concept in oper- ating a business. It is important to keep a reasonable amount of working capital to

Chapter 21 Analyzing Financial Statements 49

Year 6 Year 5 Year 4 Year 3 Year 2 Year 1 A. Trend Analysis in Dollars

(Measured in Thousands)

Sales . . . . . . . . . . . . . . $87,000 $82,000 $78,000 $74,800 $73,000 $72,000

Net income . . . . . . . . . . 11,280 11,260 11,000 10,500 10,200 9,900

Year 6 Year 5 Year 4 Year 3 Year 2 Year 1 B. Trend Analysis in Percentages

Sales . . . . . . . . . . . . . . 121* 114† 108 104 101 100

Net income . . . . . . . . . . 114 114 111 106 103 100

*121% � $87,000 � $72,000 †114% � $82,000 � $72,000

Exhibit 21–4

Trend Analysis: Contemporary Interiors, Inc.

Common-size financial statements are prepared in percentages of a base amount.

Working capital is current assets minus current liabilities.

LO 4 Prepare and interpret common- size financial statements.

LO 5 Define and compute the various financial ratios discussed in the chapter.

ensure that short-term obligations can be paid on time, opportunities for volume expansion can be seized, and unforeseen circumstances can be handled easily. Contemporary Interiors has a comfortable balance of working capital.

Current Ratio Another way of viewing a company’s working capital position is in terms of the current ratio, defined as follows:

Current ratio � Current assets

Current liabilities

50 Chapter 21 Analyzing Financial Statements

Contemporary Interiors, Inc. Common-Size Balance Sheets December 31, 20×1 and 20×0

Common-Size Statements

Assets 20×1 20×0 Current assets:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .7 .6

Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 .3

Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.0 9.9

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16.7 15.3

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .2 .3

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 28.0 26.4

Long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .4 .5

Property, furnishings, and equipment:

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.0 5.4

Buildings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 45.8 47.0

Equipment and furnishings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20.8 20.7

Total property, furnishings, and equipment . . . . . . . . . . . . . . . . . 71.6 73.1

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100.0 100.0

Liabilities and Stockholders’ Equity

Current liabilities:

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.3 6.3

Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.8 1.9

Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.5 2.9

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10.6 11.1

Long-term liabilities:

Bonds payable ($1,000 face value; 10%) . . . . . . . . . . . . . . . . . . . . 31.1 32.2

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 41.7 43.3

Stockholders’ equity:

Preferred stock ($100 par value; 8%) . . . . . . . . . . . . . . . . . . . . . . . 5.0 5.4

Common stock ($10 par value) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20.8 21.7

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.3 3.4

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 29.2 26.2

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 58.3 56.7

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . 100.0 100.0

Exhibit 21–5

Common-Size Balance Sheets

Contemporary Interiors’ current ratio as of December 31, 20×1, is computed below:

Current ratio (12/31/x1) � � 2.64, or 2.64 to 1

A popular rule of thumb is that a company’s current ratio should be at least 2 to 1. Thus, Contemporary Interiors’ current ratio is quite healthy. Indeed, it may be too large, once again indicating a possible excess of inventory. It is naïve and somewhat dangerous to place too much faith in a rule of thumb such as “Keep a current ratio of 2 to 1.” The appropriate magnitude for this ratio (and all financial ratios) varies widely among industries, companies, and the specific circumstances of individual firms.

Limitation of the Current Ratio The current ratio does not tell the whole story of a company’s ability to meet its short-term obligations. Consider the following balance sheet data for Contemporary Interiors and its chief competitor, Trends in Teak.

Contemporary Trends Interiors in Teak

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 800 $ 100

Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450 150

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 2,950

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 30,000

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250 300

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $33,500 $33,500

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,700 $12,700

Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.64 to 1 2.64 to 1

Each of these companies exhibits a current ratio of 2.64 to 1. However, are the two firms in equally strong positions regarding payment of their current obligations? The answer is no. Trends in Teak has most of its current assets tied up in inventory, which may take close to a year to convert into cash through normal business operations. In contrast, Contemporary Interiors can cover all of its current debts with cash, mar- ketable securities, and accounts receivable, which typically will be converted to cash more quickly than inventory.

$33,500,000

$12,700,000

Chapter 21 Analyzing Financial Statements 51

Contemporary Interiors, Inc. Common-Size Income Statements

For the Years Ended December 31, 20×1 and 20×0

Common-size Statements

20×1 20×0 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100.0 100.0

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70.0 68.7

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30.0 31.3

Operating expenses:

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5.8 5.6

Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.3 2.6

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8.1 8.2

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21.9 23.1

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.6 4.7

Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17.3 18.4

Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.3 4.6

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13.0 13.8

Exhibit 21–6

Common-Size Income Statements

Acid-Test Ratio To get a better picture of a company’s ability to meet its short-term obligations, many analysts prefer the acid-test ratio (or quick ratio), defined as follows:

Acid-test ratio �

Quick assets are defined as cash, marketable securities, accounts receivable, and current notes receivable. These assets typically can be converted into cash much more quickly than inventory or prepaid expenses can. Therefore, inventory and prepaid expenses are excluded from quick assets. The acid-test ratios for Contemporary Interiors and Trends in Teak are computed as follows:

Contemporary Interiors Trends in Teak

Acid-test ratio � � 1.04 to 1 � .25 to 1

For every dollar of current liabilities, Contemporary Interiors has $1.04 available in quick assets. In contrast, Trends in Teak has only $.25 in quick assets available to pay every dollar of its current liabilities.

Accounts Receivable Turnover This ratio measures the number of times the average balance in accounts receivable has been converted into cash during the year. The accounts receivable turnover ratio is defined as follows:

Accounts receivable turnover �

For Contemporary Interiors, the ratio is computed as follows:

Accounts receivable turnover � � 7.6

*All of Contemporary Interiors’ sales were on account.

†Average balance in accounts receivable � ($11,000,000 � $12,000,000)/2.

The accounts receivable turnover often is used to assess the effectiveness of a company’s credit terms and collection policies. The higher the ratio, the more effective the company is in collecting its receivables. Of course, a firm can establish too stringent a credit policy, resulting in lost sales.

Average Collection Period Another ratio, which is derived from the accounts receivable turnover, is the average collection period, defined as follows:

Average collection period �

For Contemporary Interiors, this ratio is computed as follows:

Average collection period � � 48 days 365 days

7.6

365 days

Accounts receivable turnover

$87,000,000*

$11,500,000†

Sales on account

Average balance in accounts receivable

$3,200,000

$12,700,000

$13,250,000

$12,700,000

Quick assets

Current liabilities

52 Chapter 21 Analyzing Financial Statements

Quick assets are cash, marketable securities, accounts receivable, and current notes receivable.

The average collection period measures the average number of days required to collect accounts receivable. Contemporary Interiors’ collection period of 48 days is quite long, particularly if the company’s credit payment terms are the usual 30 days. This rela- tively long collection period may reflect lax credit terms, ineffective collection policies, or some accounts receivable of doubtful collectibility.

Inventory Turnover How much inventory should a company keep? The answer, which requires a delicate trade-off of ordering, holding, and shortage costs, varies widely among industries. One measure of the appropriateness of a company’s inventory level is its inventory turnover, which is defined as follows:

Inventory turnover �

For Contemporary Interiors, this ratio is computed as follows:

Inventory turnover � � 3.3

*Average balance in inventory � � $18,500,000

Contemporary Interiors sold its average inventory 3.3 times during 20×1.

Average Number of Days per Inventory Turnover To determine how many days, on average, are required to sell a piece of furniture, the analyst computes the following measure.

For Contemporary Interiors, we have the following computation.

� � 111 days

It takes 111 days, on average, for Contemporary Interiors to sell a piece of furniture. This is fairly typical for the quality furniture retail business. What would you expect this ratio to be in a grocery store? How about an art gallery?1

The sum of the average collection period and the average number of days per inventory turnover measures how long it takes a dollar invested in inventory to come back into the cash account. This cash cycle provides management with a gauge of the company’s effectiveness in carrying its operations through from inventory purchase to collection of cash. Contemporary Interiors’ cycle is 159 days (48 � 111).

365 days

3.3

Average number of days per inventory turnover

365 days

Inventory turnover

Average number of days per inventory turnover

$17,000,000 � $20,000,000

2

$60,930,000

$18,500,000*

Cost of goods sold

Average balance in inventory

Chapter 21 Analyzing Financial Statements 53

1 Grocery stores have short periods for the average number of days per inventory turnover. None of us would want a loaf of bread that has been in the store for 111 days. An art gallery, on the other hand, would require a rather long period to sell a typical piece of fine art.

Book Value of Securities Contemporary Interiors has three types of securities outstanding: bonds, preferred stock, and common stock. The number of shares outstanding is calculated as follows for each type of security.

(c) Face Value per (d) � (b) � (c)

(a) (b) Bond or Number Type of Value on Par Value per of Shares Security Balance Sheet Share of Stock Outstanding

Bonds . . . . . . . . . . . . $37,300,000 . . . . . . . . . . . . $1,000 . . . . . . . . . . . . 37,300

Preferred stock . . . . . 6,000,000 . . . . . . . . . . . . 100 . . . . . . . . . . . . 60,000

Common stock . . . . . . 25,000,000 . . . . . . . . . . . . 10 . . . . . . . . . . . . 2,500,000

Some analysts compute the book value of each of a company’s securities, as a measure of the assets available to back up the firm’s debt and ownership obligations. In the event that a company is liquidated, the short-term creditors and bondholders typically have legal precedence over the stockholders in the settlement of claims. The preferred stockholders are next, and the common stockholders come last. Thus, calcu- lation of the book value of securities must be done in steps, as shown in Exhibit 21–7. First, assume that the short-term debt of $12,700,000 would be paid off. This leaves $107,300,000 in assets to meet the bondholders’ claims, or $2,877 per $1,000 bond. Second, after the short-term and long-term debt is repaid, there would be $70,000,000 in assets available to back the preferred stock, or $1,167 for each share of $100 par value preferred stock. Finally, Contemporary Interiors would have $25.60 remaining to back each share of $10 par value common stock.

Contemporary Interiors has more than sufficient assets to back its securities.

Capitalization Ratios A capitalization ratio is the proportion of the face value of a particular type of security to the company’s total equity. Contemporary Interiors’ capitalization ratios are com- puted as follows:

Bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 37,300,000 35%*

Preferred stock . . . . . . . . . . . . . . . . . . . . . 6,000,000 5%

Common stock . . . . . . . . . . . . . . . . . . . . . $25,000,000

Additional paid-in capital . . . . . . . . . . . . . . 4,000,000 64,000,000 60%

Retained earnings . . . . . . . . . . . . . . . . . . . 35,000,000

Total capitalization . . . . . . . . . . . . . . . . . . . $107,300,000 100%

*35% � $37,300,000/$107,300,000

5% � $6,000,000/$107,300,000

60% � $64,000,000/$107,300,000

Contemporary Interiors’ capitalization consists of 35 percent debt, 5 percent pre- ferred stock, and 60 percent common stock. Notice that the additional paid-in capital and retained earnings are combined with the common stock in a single category. In the event of liquidation, these amounts would be available to back the common stock, after the claims of bondholders and preferred stockholders were met.

Debt-Equity Ratio This is another measure of a firm’s capitalization.

Debt-equity ratio �

Contemporary Interiors’ debt-equity ratio for 20×1 is computed as follows:

Total liabilities

Total stockholders’ equity

54 Chapter 21 Analyzing Financial Statements

  

Debt-equity ratio � � .71 to 1

The debt-equity ratio measures the relationship between the firm’s resources pro- vided through debt and those provided through ownership. In general, the greater the debt-equity ratio is, the riskier the company is as an investment. Greater debt means larger obligations to be satisfied before the claims of the company’s owners can be met.

Ratio Analysis:The Income Statement The income statement also provides valuable information that can provide insight into the financial condition and performance of an enterprise. Some key income-statement relationships are discussed next.

Operating Income Operating income is a key number on the income statement because it represents the net result of the company’s operations for the period. Financing decisions, which result in interest expense and income-tax issues, are largely separate from operating deci- sions. Thus, operating income focuses on the operations of the business, exclusive of financing and tax considerations. Contemporary Interiors’ operating income for 20×1 was $19,070,000.

$50,000,000

$70,000,000

Chapter 21 Analyzing Financial Statements 55

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000,000

Less: Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,700,000

Net assets backing the claims of bondholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $107,300,000

Book value per bond �

� � $2,877 per $1,000 bond

Net assets backing bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $107,300,000

Less: Bonds payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 37,300,000

Net assets backing preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 70,000,000

� �

Net assets backing preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 70,000,000

Less: Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000,000

Net assets backing common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 64,000,000

� � $25.60 per share of $10 par value common stock

$64,000,000

2,500,000

Net assets available

Number of shares of common stock outstanding

Book value per share of common stock

$1,167 per share of $100 par value preferred stock

$70,000,000

60,000

Net assets available

Number of shares of preferred stock outstanding

Book value per share of preferred stock

$107,300,000

37,300

Net assets available

Number of bonds outstanding

Exhibit 21–7

Book Value of Securities: Contemporary Interiors, Inc.

LO 5 Define and compute the various financial ratios discussed in the chapter.

Coverage of Interest and Preferred Stock Dividends Before investing in a company’s bonds, a long-term creditor will want to be assured that the firm can pay the interest on the debt. Interest coverage provides a measure of the company’s ability to meet its contractual obligation to pay bond interest.

Interest coverage �

Contemporary Interiors’ 20×1 interest coverage is computed as follows:

Interest coverage � � 4.7 times

Contemporary Interiors’ interest coverage is healthy, and long-term creditors should be reassured as to the firm’s ability to pay bond interest.

Coverage of Dividends on Preferred Stock Preferred stock dividends must be paid before any dividends can be paid on common stock. Thus, potential investors are inter- ested in whether a company’s net income is sufficient to pay the stated dividend rate on its preferred stock. The following ratio provides a pertinent measure.

Notice that net income is used in this measure, because interest on bonds and income taxes must be paid before any dividends can be declared. Contemporary Interiors’ cov- erage of preferred stock dividends is computed as follows:

� � 23.5 times

Earnings per Share Investors in common stock hope to earn a return on their investment through dividends or increases in the stock price. Both payment of dividends and stock price appreciation are related to a firm’s ability to earn income. A key measure that relates a company’s earnings to its common stock is the firm’s earnings per share.

Contemporary Interiors’ earnings per share for 20×1 is computed as follows:2

Net income available to common stockholders

Weighted-average number of shares of common stock outstanding

Earnings per share

$11,280,000

$480,000

Coverage of dividends on preferred stock

Net income

Stated dividends on preferred stock

Coverage of dividends on preferred stock

$19,070,000

$4,030,000

Operating income

Interest expense

56 Chapter 21 Analyzing Financial Statements

2 The weighted-average number of shares for the year is computed by weighting the number of shares out- standing during each portion of the year by the fraction of the year during which the shares were outstanding. To illustrate, if Example Company had 100 shares outstanding for the first three months and 200 shares outstanding for the last nine months, the company’s weighted-average number of shares would be (100)(1⁄4) � (200)(3⁄4), or 175 shares.

Since Contemporary Interiors had 2,500,000 shares outstanding during the entire year 20×1, its weighted- average number of shares is 2,500,000 shares. (See Exhibit 21–2.)

� � � $4.32 per share

Notice that the dividends on the preferred stock ($480,000) are subtracted from net income to compute net income available to common stockholders.

Extraordinary Items Suppose a company had an extraordinary gain or loss on its income statement. These gains or losses result from events outside the normal realm of the firm’s business operations. Examples include losses due to natural disasters, fires, or the expropriation of assets by a foreign government. Accepted practice requires that earnings per share be computed exclusive of the effect of any extraordinary gains or losses and their related tax effect. To illustrate, assume the following set of facts for Trends in Teak, Inc.

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $70,000,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 49,000,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $21,000,000

Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000,000

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $16,000,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000,000

Income before taxes and extraordinary item . . . . . . . . . . . . . . . . $13,000,000

Income tax (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,900,000

Income before extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . $ 9,100,000

Extraordinary Extraordinary item: loss due to flood . . . . . . . . . . $1,000,000

item Less applicable income tax reduction (30%) . . 300,000

Net impact on income from extraordinary loss . . . . . . . . . . . . . . 700,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,400,000

Dividends on preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Net income available to common stockholders . . . . . . . . . . . . . . $ 8,000,000

Common stock outstanding . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,900,000 shares

It would not be correct to compute the earnings per share for Trends in Teak as $2.76 ($8,000,000 � 2,900,000). The $8,000,000 of available income used in this erro- neous calculation includes the extraordinary loss due to the flood. This would be mis- leading to investors, because the flood loss is a rare event that will not likely be repeated. The correct approach to computing the company’s earnings per share is shown below.

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $8,400,000

Add: Extraordinary loss, net of its tax effect:

Extraordinary loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000

Tax effect (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000

Net impact on income from extraordinary loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 700,000

Net income, excluding extraordinary loss and related tax effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,100,000

Dividends on preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400,000

Net income available to common stockholders, excluding extraordinary loss and related tax effect . . . . . $8,700,000

Earnings per share � � $3.00 per share

The correct statement of earnings per share for Trends in Teak is $3.00 per share.

$8,700,000

2,900,000

$10,800,000

2,500,000 $11,280,000 � $480,000

2,500,000

Earnings per share

Chapter 21 Analyzing Financial Statements 57

Diluted Earnings per Share One other complication often arises in computing earnings per share. Some securities are convertible, which means that they can be converted into a specified number of shares of common stock. Suppose, for example, that each share of Contemporary Interiors’ preferred stock can be converted into 10 shares of common stock. If all 60,000 of the preferred shares were converted, there would be an additional 600,000 shares of common stock outstanding. To reflect this possibility, diluted earnings per share is computed under the assumption that all convertible securities are converted into common shares. This measure is defined as follows:

For Contemporary Interiors we have the following calculation.

� � $3.64 per share

Shares already outstanding Shares that could result from conversion of preferred stock

Notice that the dividends on the preferred stock were not subtracted from net income in the numerator. This reflects the assumption that the preferred stock has been con- verted to common stock. Contemporary Interiors’ diluted earnings per share, $3.64, is lower than its $4.32 basic earnings per share computed earlier. The $4.32 amount does not reflect the potential conversion of preferred stock.

Price-Earnings Ratio Of particular interest to investors is the relationship between a company’s stock price and its income. Income, after all, is the key to both dividends and stock price appreciation. A common measure of the relationship between stock price and income is the price-earnings ratio, defined as follows:

Price-earnings ratio �

To illustrate, suppose Contemporary Interiors’common stock price is $65 per share:

Price-earnings ratio � � 15

*Notice that the basic earnings per share is used rather than the diluted earnings per share.

Thus, Contemporary Interiors’ common stock is currently selling for 15 times the firm’s earnings per share. Some investors use the price-earnings ratio to help determine the appropriate price for a company’s stock. Of course, the most critical issues in deter- mining a fair stock price are the investor’s estimates of the company’s future earnings potential and the riskiness of the stock.

Return on Assets The management of a company has a responsibility to use the firm’s assets as effec- tively as possible in generating income for the owners. The rate of return on assets is a measure of how effectively management has fulfilled this responsibility.

$65.00 per share

$4.32 per share*

Market price per share

Earnings per share

$11,280,000

2,500,000 � 600,000

Diluted earnings per share

Net income

Weighted-average number of shares of common stock outstanding, assuming full

conversion of all convertible securities

Diluted earnings per share

58 Chapter 21 Analyzing Financial Statements

Return on assets �

Notice that the interest expense, net of its tax effect, has been added back to net income. The reason for this is to make a distinction between operating management and financial management. The operating managers of a business should use total assets, irrespective of how they have been financed, to generate income. Moreover, operating managers typically do not make financing decisions that would affect interest expense. Thus, interest expense is added back to net income to obtain a measure of the income resulting from the operating management of the business. The required calculations for Contemporary Interiors are as follows:

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,030,000

Income-tax effect (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,209,000

Interest expense, net of tax effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,821,000

Return on assets � � 12.2%

*$115,425,000 � ($120,000,000 � $110,850,000)/2

Focusing on only the operating part of the business, Contemporary Interiors’ man- agement generated a 12.2 percent return on assets in 20×1.

Return on Equity A different rate-of-return measure which is commonly used by analysts is the return on equity (or return on common stockholders’equity). This measure is defined as follows:

Return on equity �

Notice that the denominator is average common stockholders’ equity, which is found by subtracting preferred stock from total stockholders’ equity. Contemporary Interiors’ return on equity for 20×1 is computed as follows:

20×0 20×1 Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $62,800,000 $70,000,000

Less: Preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000,000 6,000,000

Common stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $56,800,000 $64,000,000

Average common stockholders’ equity $60,400,000

Return on equity � � 17.9%

The income available to Contemporary Interiors’ common stockholders provided a 17.9 percent return on their investment in 20×1.

Return on Sales The proportion of each sales dollar that results in net income is one measure of the effi- ciency of a business. Return on sales provides such a measure.

Return on sales �

Contemporary Interiors’ return on sales is computed as follows for 20×1.

Net income

Sales

$10,800,000

$60,400,000

Net income available to common stockholders

Average common stockholders’ equity

$11,280,000 � $2,821,000

$115,425,000*

Net income � Interest expense, net of its tax impact

Average total assets

Chapter 21 Analyzing Financial Statements 59

Return on sales � � 13%

Return on sales, along with all financial ratios, must be compared with the ratios for other companies in the industry to be meaningful.

Financial Leverage In physics, leverage means the ability of a relatively small force to move a heavy object. Likewise, the concept of financial leverage refers to the situation where a rela- tively small increase in income can provide a proportionately much larger increase in return to the common stockholders. How is this financial magic worked? It hinges on having a relatively large proportion of financing through debt or preferred stock, which pays interest or dividends at a fixed rate. When income increases, the bond interest and preferred stock dividends remain constant, leaving most of the increase in income available to the common stockholders.

An illustration will help to clarify the concept of financial leverage. Suppose a company has $10,000,000 in outstanding bonds payable which bear interest at 5 percent. The company’s operating income is $550,000, and its tax rate is 30 percent. The calculations for case A in Exhibit 21–8 show that there will be $35,000 of after-tax income available to the common stockholders.

Now consider what will happen if operating income increases by a modest 10 percent. As case B in Exhibit 21–8 shows, the income available to common stock- holders increases to $73,500, a 110 percent increase. By financing a large portion of the firm with bonds, the company is able to direct the increase in income to the common stockholders.

Now consider the risky side of financial leverage. What will happen if operating income declines by 10 percent? As case C demonstrates, the firm cannot even cover its bond interest, let alone direct any profit to the common stockholders.

In summary, high financial leverage carries with it the possibility of great return, but it also entails high risk. A glance at Contemporary Interiors’ balance sheet reveals that the company is not highly leveraged. This fact also is indicated by the company’s low debt-equity ratio, which was calculated to be .71 to 1.

Ratio Analysis:The Statement of Retained… The retained earnings statement reconciles the year’s beginning and ending balances in retained earnings. Net income increases retained earnings, while dividends decrease retained earnings. Two ratios often are computed using data on this statement.

$11,280,000

$87,000,000

60 Chapter 21 Analyzing Financial Statements

Financial leverage means that a relatively small increase in income provides a proportionately much larger increase in return to common stockholders.

Bonds payable (5%) . . . . . . . . . . $10,000,000 � 5% � $500,000 in interest expense

Case A Case B Case C Status Quo 10% Increase 10% Decrease

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . $550,000 $605,000 $495,000 Less: Bond interest . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 500,000 500,000

Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . $ 50,000 $105,000 $ (5,000)

Income-tax expense (30%) . . . . . . . . . . . . . . . . . . . . 15,000 31,500

Income available to common stockholders . . . . . . . . . $ 35,000 $ 73,500

110% increase



Exhibit 21–8

Financial Leverage

LO 5 Define and compute the various financial ratios discussed in the chapter.

Ratio Analysis:The Statement of Retained Earnings

Dividend Payout Ratio The dividend payout ratio shows the proportion of earnings per share that is paid to the common stockholders in the form of dividends.

Dividend payout ratio �

Contemporary Interiors paid dividends of $1.92 per share of common stock in 20×1 ($4,800,000 � 2,500,000.) The company’s dividend payout ratio is computed as follows:

Dividend payout ratio � � 44.4%

*Notice that the regular earnings per share is used rather than the diluted earnings per share.

Contemporary Interiors paid out to its common stockholders almost half of the income available for that purpose. The remainder was reinvested in the business. The dividend payout ratio that is best for a company depends on its opportunities for growth, the needs of the company for reinvestment funds, and the ease with which the firm can attract capital.

Dividend Yield Ratio One of the factors affecting a company’s stock price is the amount of dividends paid on the stock. The dividend yield ratio focuses on the relationship between dividends and stock price:

Dividend yield ratio �

Contemporary Interiors’ common stock sells for $65.00 per share, so the following cal- culation is made.

Dividend yield ratio � � 3.0%

By comparing dividend payout ratios and dividend yield ratios across

companies, investors can judge whether a firm’s stock is fairly priced, given the dividends paid.

Notes to Financial Statements Published financial statements almost always are accompanied by notes. These nar- ratives provide greater detail about much of the information that is included very concisely in the financial statements. Many people find the notes to be dull and com- plicated. Nevertheless, they can be extremely important and should be viewed as an integral part of the financial statements. Information typically disclosed in the notes includes:

� Details of the inventory and depreciation methods used. � Contingent liabilities and pending lawsuits. � Long-term leases. � Terms of executive employment contracts, profit-sharing programs, pension plans,

and stock options granted to employees.

$1.92 per share

$65.00 per share

Dividends per share of common stock

Market price per share

$1.92 per share

$4.32 per share*

Dividends per share of common stock

Earnings per share

Chapter 21 Analyzing Financial Statements 61

Remember, if you want to analyze a set of financial statements thoroughly, don’t pass over the notes.

Summary of Financial Statement Analysis Exhibit 21–9 summarizes the key financial ratios discussed in the chapter.

62 Chapter 21 Analyzing Financial Statements

Ratio Definition

Analyzing the Balance Sheet Acid-test ratio (or quick ratio) Quick assets � current liabilities

Accounts receivable turnover Sales on account � average balance in accounts receivable

Average collection period 365 days � accounts receivable turnover

Average number of days per inventory turnover 365 days � inventory turnover

Capitalization ratio Proportion of the face value of a particular type of security to the company’s total equity (e.g., bonds payable � total liabilities and stockholders’ equity)

Current ratio Current assets � current liabilities

Debt-equity ratio Total liabilities � total stockholders’ equity

Inventory turnover Cost of goods sold � average balance in inventory

Analyzing the Income Statement Coverage of dividends on preferred stock Net income � stated dividends on preferred stock

Earnings per share (also called basic Net income available to common stockholders � weighted-average earnings per share) number of shares of common stock outstanding

Diluted earnings per share Net income � weighted-average number of shares of common stock outstanding, assuming full conversion of all convertible securities

Interest coverage Operating income � interest expense

Price-earnings ratio Market price per share � earnings per share

Return on assets (Net income � interest expense net of income-tax effect) � average total assets

Return on equity Net income available to common stockholders � average common stockholders’ equity

Return on sales Net income � sales

Analyzing the Retained Earnings Statement Dividend payout ratio Dividends per share of common stock � earnings per share

Dividend yield ratio Dividends per share of common stock � market price per share

Exhibit 21–9

Summary of Key Financial Ratios

Corning Glass Concepts from financial statement analysis often are used by management in setting goals for an enterprise. The following example of financial goals comes from a Corning Glass annual report.

� Performance: We will be consistently in the top 25 percent of the Fortune 500 in financial performance as measured by return on equity.

� Growth: We will grow at an annual rate in excess of 5 percent in real terms.

We will maintain a debt-to-capital ratio of approximately 25 percent and a long-term dividend payout of 33 percent.

We will issue new shares of stock on a limited basis in connection with employee ownership programs and acquisitions with a clear strategic fit.

M .A

.P . Management

Accounting Practice

Limitations of Financial Statement Analysis Financial statements and the financial ratios derived from them are but a single source of information about a company. As is true of any managerial-accounting information, financial ratios serve only as an attention-directing device. The ratios raise questions more often than they answer them. An analyst must follow up the financial statement analysis with in-depth research on a company’s management, its history and trends, the industry, and the national and international economies in which the firm operates.

Financial statement analysis is subject to the limitations inherent in financial state- ments. First, financial statements are based on historical accounting data, which may not be indicative of the future. Second, historical cost values provide the basis for accounting valuation, even though price levels are constantly changing. Third, although comparisons across companies are critical to meaningful financial statement analysis, such comparisons are not always easy. Generally accepted accounting prin- ciples allow considerable flexibility in accounting for many financial events. When companies use different accounting methods, their accounting numbers may not be comparable.

Chapter Summary Financial statements provide the primary means for communicating financial information about a company to interested parties outside the organization. The purpose of financial statement analysis is to highlight key relationships between various accounting numbers in the financial statements to provide insight into the financial condition and performance of the firm. The objective is to assist analysts in pre- dicting the future performance of the company. A company’s managers also use tools from financial statement analysis to help them understand the implications of their decisions for the company’s financial condition and performance.

Horizontal analysis and trend analysis are two of the analytical techniques used in financial statement analysis. Both of these tools involve comparisons of accounting data across time. Another widely used analytical tool is vertical analysis, in which component percentages are computed for the numbers on the balance sheet and income statement. Financial statements prepared in terms of these percentages are called common-size statements. Ratio analysis involves the calculation of numerous ratios between the numbers on the financial statements to indicate the relationships between those numbers. For ratio analysis to be meaningful, the analyst should draw comparisons across time and across other companies in the industry.

Key Terms

Chapter 21 Analyzing Financial Statements 63

common-size financial statements, pg. 49

comparative financial statements, pg. 46

financial leverage, pg. 60

horizontal analysis, pg. 46

quick assets, pg. 52

trend analysis, pg. 48

vertical analysis, pg. 48

working capital, pg. 49

For each term’s definition refer to the indicated page, or turn to the glossary at the end of the text. Note: The various ratios defined in the chapter are summarized in Exhibit 21–9.

21–1. Why would a company’s management be interested in the information conveyed in the firm’s financial statements published for outside parties? How could management use the tools of financial statement analysis?

21–2. List the four major financial statements, and briefly describe the relationships between them.

21–3. What is wrong with these statements? “The company’s cash for 20×0 was $50,000. Its income on December 31, 20×0, was $150,000.”

Review Questions

Exercises The following data are available for Slattery Corporation, a manufacturer of scientific equipment. The amounts refer to December 31 of each year.

Year 5 Year 4 Year 3 Year 2 Year 1 Current assets . . . . $2,842,000 $2,200,000 $1,900,000 $1,600,000 $1,400,000

Inventory . . . . . . . . 2,042,000 1,300,000 1,150,000 820,000 700,000

Current liabilities . . . 1,100,000 1,000,000 900,000 790,000 700,000

Required:

1. Restate the trend data in terms of percentages, using Year 1 as the base year.

2. Prepare a table showing the trend in the company’s current ratio and acid-test ratio from Year 1 through Year 5. The firm has no prepaid expenses.

3. What conclusions can you draw from the trend data? Explain your answer.

The following data are available for The Gridiron, a small sandwich shop located near the Los Angeles Coliseum.

Year 5 Year 4 Year 3 Year 2 Year 1 Sales . . . . . . . . . . . $52,000 $47,200 $44,520 $42,000 $40,000

Net income . . . . . . . 15,100 12,600 11,450 10,600 10,000

Required:

1. Restate the trend data in terms of percentages using Year 1 as the base year.

2. Comment on the trends in the company’s sales and net income.

Party Animal Company produces frozen pizzas, which are sold primarily on college campuses. The firm’s financial statements provide the following information.

Balance Sheet December 31, 20×1 and 20×0

20×1 20×0 Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000 $ 50,000

Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 220,000 200,000

Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 260,000 230,000

64 Chapter 21 Analyzing Financial Statements

21–4. Explain why comparisons and trends are important in financial statement analysis.

21–5. What other sources of financial data are available in addition to published financial statements?

21–6. How are comparative financial statements used in financial statement analysis? What is meant by hori- zontal analysis?

21–7. What is meant by vertical analysis? How are common- size financial statements used by analysts?

21–8. What is the significance of a company’s current ratio?

21–9. What is the main limitation of the current ratio?

21–10. What is the significance of the acid-test ratio?

21–11. Alpha Company has an accounts receivable turnover ratio of 5.1. Beta Company, in the same industry, has a ratio of 2.2. What can you conclude about these two firms?

21–12. What does it imply for a company to have a low inventory turnover? Would you expect this ratio to differ much across industries? Why?

21–13. What is the significance of a high debt-equity ratio?

21–14. Jeffries Corporation covered its bond interest 1.2 times. What does this mean, and what conclusion can you draw?

21–15. Briefly explain the treatment of extraordinary items in the calculation of earnings per share. Do you agree with this treatment? Why?

21–16. What is meant by diluted earnings per share?

21–17. Contrast the following two ratios and their interpreta- tions: return on assets versus return on equity.

21–18. What kinds of information are conveyed in the notes to financial statements?

21–19. Briefly describe three limitations of financial state- ments which are reflected in financial statement analysis.

21–20. Assume you are deciding whether your bank should make a short-term loan to a company. List the financial ratios in which you would be most interested. Then assume instead that you are a potential investor in the company’s stock.

Exercises Exercise 21–21

Trend Analysis (LO 2, LO 3)

Exercise 21–22 Trend Analysis (LO 2, LO 3)

Exercise 21–23 Ratio Analysis (LO 2, LO 5)

Chapter 21 Analyzing Financial Statements 65

20×1 20×0 Property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 730,000 $ 650,000

Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . (330,000) (260,000)

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 940,000 $ 870,000

Current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 270,000 $ 330,000

Stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 670,000 540,000

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 940,000 $ 870,000

Income Statement For the Year Ended December 31, 20×1

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,200,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 780,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 420,000

Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 240,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 180,000

Required:

1. Assuming that all sales are on account, what is the company’s accounts receivable turnover for 20×1?

2. What is the rate of return on assets for 20×1? The company had no interest expense in 20×1.

(CPA, adapted)

Refer to the data given in the preceding exercise for Party Animal Company.

Required:

1. Restate the comparative balance sheet and the income statement in common-size format.

2. For what purpose are common-size statements useful?

Selected data for two companies in the soccer equipment industry are as follows (all data in thousands).

Terry Habecker Corporation Enterprises

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400 $ 1,400

Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 200 1,200

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500 8,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 3,700

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 800

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,100 $15,100

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,000 $ 4,000

Accrued expenses payble . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,000 2,100

Note payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 900

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,000 $ 7,000

Required:

1. Calculate each company’s working capital amount, current ratio, and acid-test ratio.

2. Comment on each firm’s ability to pay its short-term debts.

The following selected financial data pertain to Across the Miles, Inc., a manufacturer of greeting cards. (The information is continued on the next page.)

December 31, 20×1 and 20×0 20×1 20×0

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 10,000 $ 80,000

Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 30,000 10,000

Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000 150,000

Chapter 21 Analyzing Financial Statements 65

Exercise 21–24 Common-size Financial Statements (LO 4)

Exercise 21–25 Current and Acid-Test Ratios; Comparing Firms (LO 2, LO 5)

Exercise 21–26 Ratio Analysis (LO 2, LO 5)

66 Chapter 21 Analyzing Financial Statements

20×1 20×0 Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 90,000 $ 150,000

Land and buildings (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 345,000 360,000

Mortgage payable (no current portion) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 275,000 280,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70,000 110,000

Short-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 40,000

For the Year Ended December 31, 20×1 and 20×0 Cash sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,800,000 $1,600,000

Credit sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 500,000 800,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000 1,400,000

Required:

Compute the following ratios.

1. Acid-test ratio as of December 31, 20×1.

2. Accounts receivable turnover for 20×1.

3. Inventory turnover for 20×1.

4. Current ratio as of December 31, 20×1.

(CPA, adapted)

The following data relate to Sky World, Inc., a theme park located near Kitty Hawk, North Carolina.

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $680,000

Less: Bond interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000*

Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000

Income-tax expense (25%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Income available to common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 60,000

*Bonds payable, $5,000,000; interest rate, 12%; bond interest, $600,000 � $5,000,000 � 12%.

Required:

1. Calculate the percentage change in income available to the common stockholders if operating income (a) increases by 10 percent or (b) decreases by 10 percent.

2. Is Sky World a heavily leveraged company? Explain.

The following facts relate to Contented Critters, Inc., a manufacturer of cat food and pet supplies.

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 40,000,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,000,000

Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000,000

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $13,000,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000,000

Income before taxes and extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000,000

Income tax (25%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000,000

Income before extraordinary item . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,000,000

Extraordinary item: loss due to fire . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $800,000

Less applicable income tax reduction (25%) . . . . . . . . . . . . . . . . . . . . . . . 200,000

Net impact on income from extraordinary loss . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,400,000

Dividends on preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100,000

Net income available to common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,300,000

Common stock outstanding (weighted-average) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,825,000 shares

Exercise 21–27 Financial Leverage (LO 2, LO 5)

Exercise 21–28 Earnings per Share (LO 2, LO 5)

Chapter 21 Analyzing Financial Statements 67

Tom Katz, the company president, made a calculation of earnings per share, as follows:

Earnings per share � � $4 per share

Required:

Did Katz make the earnings per share calculation correctly? If not, prepare an analysis determining the correct earnings per share.

Problems Living History Travel Guides, Inc. publishes travel books focusing on historical sites in the United States and Canada. The firm’s condensed financial statements for 20×0 are as follows:

Living History Travel Guides, Inc. Income Statement

For the Year Ended December 31, 20×0 (in thousands)

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,190

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 690

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500

Operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 250

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 250

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50

Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200

Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 100

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100

Living History Travel Guides, Inc. Balance Sheet

December 31, 20×0 (in thousands)

Assets Liabilities and Stockholders’ Equity Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 100 Accounts payable . . . . . . . . . . . . . . . . . . . . . $ 120

Marketable securities . . . . . . . . . . . . . . . . . . 150 Short-term note payable . . . . . . . . . . . . . . . . 180

Accounts receivable (net of $15 Accrued liabilities . . . . . . . . . . . . . . . . . . . . . 100 allowance for uncollectible accounts) . . . . . 200 Bonds payable . . . . . . . . . . . . . . . . . . . . . . . 400

Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . 400 Preferred stock . . . . . . . . . . . . . . . . . . . . . . . 200

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . 50 Common stock . . . . . . . . . . . . . . . . . . . . . . . 200

Property, plant, and equipment (net of Additional paid-in capital . . . . . . . . . . . . . . . . 100

$220 accumulated depreciation) . . . . . . . . 530 Retained earnings . . . . . . . . . . . . . . . . . . . . . 200

Patents . . . . . . . . . . . . . . . . . . . . . . . . . . . . 70 Total liabilities and stockholders’ equity . . . $1,500

Total assets . . . . . . . . . . . . . . . . . . . . . . . $1,500

Additional Information

� Gross accounts receivable amounted to $200,000, and the allowance for uncollectible accounts was $20,000 as of January 1, 20×0.

� Total assets amounted to $1,300,000, and common stockholders’ equity amounted to $300,000 on January 1, 20×0.

� The liquidation value of the preferred stock is equal to par value. Preferred dividends are paid at the rate of 8 percent.

� The company’s income tax rate was 50 percent.

$7,300,000

1,825,000

Chapter 21 Analyzing Financial Statements 67

Problem 21–29 Ratio Analysis (LO 2, LO 5)

68 Chapter 21 Analyzing Financial Statements

Required:

Compute the following ratios.

1. Current ratio on December 31, 20×0.

2. Debt-equity ratio on December 31, 20×0.

3. Return on assets for 20×0.

4. Return on equity for 20×0.

5. Interest coverage for 20×0.

6. Average collection period in 20×0. (Assume that all sales were on account.)

(CMA, adapted)

The balance sheet and income statement for Jason’s of Chicago, Inc., a clothing manufacturer, for 20×1 are as follows:

Jason’s of Chicago, Inc. Balance Sheet

December 31, 20×1 (in thousands)

Assets Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $12,000

Accounts receivable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $47,900

Less: Accumulated depreciation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,400 36,500

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $65,500

Liabilities and Stockholders’ Equity Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,700

Short-term notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,300

Bonds payable (due in 20×4) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,500

Common stock ($10 par value; 4,500,000 shares authorized; 2,500,000 shares issued and outstanding during the entire year) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $65,500

Jason’s of Chicago, Inc. Income Statement

For the Year Ended December 31, 20×1 (in thousands)

Sales in cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,000

Sales on account . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 60,000

Total sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $70,000

Cost of goods sold:

Inventory of finished goods 1/1/x1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,000

Cost of goods manufactured . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 50,000

Cost of goods available for sale . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $54,000

Inventory of finished goods 12/31/x1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 49,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $21,000

Operating expenses:

Selling . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000

Administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,800 13,800

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,200

Problem 21–30 Ratio Analysis (LO 2, LO 5)

Chapter 21 Analyzing Financial Statements 69

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000

Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,400

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,600

Required:

Compute the following ratios for Jason’s of Chicago, Inc.

1. Current ratio.

2. Average collection period. (Assume there was no change in the accounts receivable balance between January 1 and December 31, 20×1.)

3. Inventory turnover.

4. Ratio of total debt to stockholders’ equity.

5. Earnings per share.

6. Return on equity. (Assume there was no change in total stockholders’ equity during 20×1.)

7. Interest coverage.

(CMA, adapted)

Kazarinoff Corporation manufactures ukuleles. The company’s recent financial statements are presented here.

Kazarinoff Corporation Balance Sheet

December 31, 20×1 and 20×0 (in thousands)

Assets 20×1 20×0 Current assets:

Cash and marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 400 $ 380

Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,700 1,500

Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,200 2,120

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,300 $4,000

Long-lived assets:

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 500 $ 500

Buildings and equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,700 4,000

Total long-lived assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,200 $4,500

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,500 $8,500

Liabilities and Stockholders’ Equity Current liabilities:

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,400 $ 700

Current portion of long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 500

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $2,400 $1,200

Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 4,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $5,400 $5,200

Stockholders’ equity:

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $3,000 $3,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,100 300

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $4,100 $3,300

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $9,500 $8,500

Chapter 21 Analyzing Financial Statements 69

Problem 21–31 Ratio Analysis (LO 2, LO 5)

70 Chapter 21 Analyzing Financial Statements

Kazarinoff Corporation Income and Retained Earnings Statement

For the Year Ended December 31, 20×1 (in thousands)

Sales (all on account) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $28,800

Less: Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $15,120

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,180

Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,100

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 800 27,600

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,200

Retained earnings, January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300

Subtotal . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,500

Cash dividends declared and paid . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400

Retained earnings, December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,100

Required:

Compute the following ratios for 20×1.

1. Acid-test ratio on December 31, 20×1.

2. Average collection period.

3. Interest coverage.

4. Inventory turnover.

5. Operating income as a percentage of sales.

6. Dividend payout ratio.

(CMA, adapted)

Refer to the data given in the preceding problem for Kazarinoff Corporation.

Required:

Prepare a common-size balance sheet as of December 31, 20×1, and a common-size income statement for 20×1.

Several of Ballard Company’s transactions during the most recent year are described below. Assume that total quick assets exceeded total current liabilities both before and after each transaction described. Further, assume that Ballard has positive net income for the year and a credit balance throughout the year in its retained earnings account.

Required:

Choose the best answer to complete each statement.

1. Payment of accounts payable of $59,000 would

a. increase the current ratio, but the acid-test ratio would not be affected

b. increase the acid-test ratio, but the current ratio would not be affected

c. increase both the current and acid-test ratios

d. decrease both the current and acid-test ratios

e. have no effect on the current and acid-test ratios

2. The purchase of raw materials for $78,000 on account would

a. increase the current ratio

b. decrease the current ratio

c. increase working capital

d. decrease working capital

e. increase both the current ratio and working capital

Problem 21–32 Common-Size Financial Statements (LO 4)

Problem 21–33 Financial Statement Analysis; Multiple Choice (LO 2, LO 5)

Chapter 21 Analyzing Financial Statements 71

3. The collection of current accounts receivable of $31,000 would

a. increase the current ratio

b. decrease the current ratio

c. increase the acid-test ratio

d. decrease the acid-test ratio

e. not affect the current and acid-test ratios

4. Obsolete inventory of $95,000 was written off. This would

a. decrease the acid-test ratio

b. increase the acid-test ratio

c. increase working capital

d. decrease the current ratio

e. decrease both the current and acid-test ratios

5. The early liquidation of a long-term note with cash would

a. affect the current ratio to a greater degree than the acid-test ratio

b. affect the acid-test ratio to a greater degree than the current ratio

c. affect the current and acid-test ratios to the same degree

d. affect the current ratio but not the acid-test ratio

e. affect the acid-test ratio but not the current ratio

(CMA, adapted)

Yucatan Imports, Inc., imports and distributes ceramic pottery and woven goods handcrafted in Mexico. Comparative balance sheets and income statements covering the last two years are shown here. The market price of Yucatan’s common stock was $20 per share on December 31, 20×1.

Yucatan Imports, Inc. Comparative Balance Sheets December 31, 20×1 and 20×0

(in thousands) Assets 20×1 20×0

Current assets:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,000 $ 2,000

Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 1,000

Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 11,000

Merchandise inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24,000 16,000

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,000 $ 30,000

Property, plant, and equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 68,000 60,000

Long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 10,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000 $100,000

Liabilities and Stockholders’ Equity Current liabilities:

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,000 $ 4,000

Wages payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 1,000

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 6,000 $ 5,000

Bonds payable (10%, due 20×9) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000 20,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 26,000 $ 25,000

Stockholders’ equity:

Common stock (10,000,000 shares, no par value) . . . . . . . . . . . . . . . . . . . . . . . . . $ 25,000 $ 25,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 69,000 50,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 94,000 $ 75,000

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000 $100,000

Chapter 21 Analyzing Financial Statements 71

Problem 21–34 Ratio Analysis (LO 2, LO 5)

72 Chapter 21 Analyzing Financial Statements

Yucatan Imports, Inc. Comparative Income Statements

For the Years Ended December 31, 20×1 and 20×0 (in thousands)

20×1 20×0 Sales (all made on account) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $200,000 $140,000

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120,000 80,000

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 80,000 $ 60,000

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 38,000 30,000

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 42,000 $ 30,000

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 2,000

Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 40,000 $ 28,000

Income-tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15,000 11,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 25,000 $ 17,000

Required:

Compute the following ratios.

1. Current ratio as of December 31, 20×1.

2. Acid-test ratio as of December 31, 20×1.

3. Accounts receivable turnover for 20×1.

4. Inventory turnover for 20×1.

5. Interest coverage for 20×1.

6. Book value per share of common stock as of December 31, 20×1.

7. Dividend yield ratio for 20×1.

8. Return on equity for 20×1.

(CMA, adapted)

Radatron, Inc. is a manufacturer of highly specialized electronic components used in radar systems. The company’s financial position is being reviewed by its bank, an important potential customer, and a new supplier of raw materials. As part of the review process, Radatron was required to provide its latest financial statements, along with information on selected financial ratios. A summary of the information provided by Radatron follows.

Selected Financial Ratios Radatron, Inc. Current

Industry 20×1 20×0 Average

Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.02 2.11 2.16

Interest coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4.9 3.8 4.5

Net profit as a percentage of sales . . . . . . . . . . . . . . . . . . . . . . . . . . 13.2% 12.1% 12.0%

Debt-equity ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.16 1.04 1.10

Radatron, Inc. Income Statement

For the Year Ended December 31, 20×2 (in thousands)

Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,100

Less: Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,060

Selling and administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,340

Depreciation expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,120

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,200

Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,380

Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,760

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,620

Problem 21–35 Interpretation and Use of Financial Ratios (LO 1, LO 5)

Chapter 21 Analyzing Financial Statements 73

Radatron, Inc. Balance Sheet

December 31, 20×2 (in thousands)

Assets Current assets:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 450

Accounts receivable (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,050

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,300

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,800

Property, plant, and equipment (net) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,600

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,400

Liabilities and Stockholders’ Equity Current liabilities:

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,770

Income taxes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 245

Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 960

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,975

Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,720

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,695

Stockholders’ equity:

Common stock ($10 par value) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,800

Paid-in-capital in excess of par . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,250

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,655

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 4,705

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,400

Each of the following parties must recommend an action based on its evaluation of Radatron’s financial position.

� Northwest Bank is currently reviewing a request from Radatron for additional financing. While Northwest has been Radatron’s primary bank for the past several years, bank regulations require that Northwest evaluate a company’s financial position before each major transaction.

� Wilson Aviation has recently received a substantial government contract and is considering sub- contracting a portion of the work to Radatron. The contract would result in a significant increase in Radatron’s annual sales over the next three years.

� Allied Electronics, a manufacturer of transistors and diodes, has recently been asked by Radatron to bid on a contract requiring the shipment of approximately $10,000 of components per month for 12 months. Allied has not previously done business with Radatron and must decide whether to respond to the request for a bid, and if the company does respond, what terms it should offer.

Required:

1. Explain the analytical use of each of the ratios presented in the problem.

2. Calculate a new set of ratios for 20×2 for Radatron, Inc. based on the financial statements pre- sented. (Assume total assets were unchanged throughout the year.)

3. For each of the parties reviewing Radatron’s financial position.

a. Select two ratios, from those ratios presented, that would be most valuable as a basis for its decision regarding Radatron.

b. Using the ratios given in the problem, explain what the two ratios reveal about Radatron’s financial performance.

(CMA, adapted)

Chapter 21 Analyzing Financial Statements 73

74 Chapter 21 Analyzing Financial Statements

The accounting staff of Des Moines Container Corporation has completed the preparation of financial statements for 20×1. The income statement for the current year and the comparative balance sheet for 20×0 and 20×1 are shown here. The company’s income tax rate is 40 percent.

Des Moines Container Corporation Income Statement

For the Year Ended December 31, 20×1 (in thousands)

Revenue:

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $795,000

Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000

Total revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $860,000

Expenses:

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $540,000

Research and development . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25,000

Selling and administrative . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 155,000

Interest . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 20,000

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $740,000

Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000

Income tax expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,000

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 72,000

Des Moines Container Corporation Comparative Balance Sheets December 31, 20×1 and 20×0

(in thousands) Assets 20×1 20×0

Current assets:

Cash and marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 26,000 $ 21,000

Receivables, less allowance for doubtful accounts ($1,100 in 20×1 and $1,400 in 20×0) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 48,000 50,000

Inventories . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 65,000 62,000

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 3,000

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $144,000 $136,000

Long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $116,000 $114,000

Property, plant, and equipment

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 12,000 $ 12,000

Buildings and equipment, less accumulated depreciation ($126,000 in 20×1 and $122,000 in 20×0) . . . . . . . . . . . . . . . . . . . . . . . . . . . . 268,000 248,000

Total property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280,000 $260,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $540,000 $510,000

Liabilities and Stockholders’ Equity 20×1 20×0

Current liabilities:

Short-term loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 22,000 $ 24,000

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 72,000 71,000

Salaries, wages, and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 26,000 27,000

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $120,000 $122,000

Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 160,000 171,000

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $280,000 $293,000

Problem 21–36 Ratio Analysis and Discussion (LO 1, LO 5)

Chapter 21 Analyzing Financial Statements 75

20×1 20×0 Stockholders’ equity:

Common stock, at par . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 44,000 $ 42,000

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 64,000 61,000

Total paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $108,000 $103,000

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 152,000 114,000

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $260,000 $217,000

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $540,000 $510,000

The accounting staff calculates selected financial ratios after the financial statements are prepared. Financial ratios that were calculated for 20×0 are as follows:

� Interest coverage, 5.16 times. � Return on assets, 12.5%. � Return on equity, 29.1%.

Required:

1. Explain how the use of financial ratios can be advantageous to management.

2. Calculate the following financial ratios for 20×1.

a. Interest coverage. c. Return on equity. e. Current ratio.

b. Return on assets. d. Debt-equity ratio. f. Acid-test ratio.

(CMA, adapted)

AutoSound, Inc. manufactures radios, tape players, and compact disk players for automobiles. Comparative balance sheets and income statements for 20×0 and 20×1 are presented here.

AutoSound, Inc. Comparative Balance Sheets December 31, 20×1 and 20×0

(in thousands) Assets 20×1 20×0

Current assets:

Cash . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 200 $ 170

Marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 90

Accounts receivable, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,000 2,500

Inventory . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,000 4,200

Prepaid expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 75 60

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,395 7,020

Long-term investments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 450 500

Property, furnishings, and equipment:

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,000 2,000

Buildings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14,000 12,000

Equipment and furnishings, net . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7,000 6,000

Total property, furnishings, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23,000 20,000

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $31,845 $27,520

Liabilities and Stockholders’ Equity Current liabilities:

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,500 $ 1,400

Accrued expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 600 500

Notes payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 780 900

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,880 2,800

Long-term liabilities:

Bonds payable ($1,000 face value; 10%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9,000 8,500

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,880 11,300

Chapter 21 Analyzing Financial Statements 75

Problem 21–37 Comprehensive Problem on Ratio Analysis (LO 2, LO 5)

76 Chapter 21 Analyzing Financial Statements

20×1 20×0 Stockholders’ equity:

Preferred stock ($100 par value; 8%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,500 $ 1,500

Common stock ($10 par value) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 5,500

Additional paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,000 900

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,465 8,320

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19,965 16,220

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $31,845 $27,520

AutoSound, Inc. Comparative Income and Retained Earnings Statements

For the Years Ended December 31, 20×1 and 20×0 (in thousands)

20×1 20×0 Sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $26,700 $25,550

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18,000 17,500

Gross margin . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,700 8,050

Operating expenses:

Selling expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,400 1,350

Administrative expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 400 350

Total operating expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800 1,700

Operating income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,900 6,350

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 900 850

Income before taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6,000 5,500

Income-tax expense (30%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,800 1,650

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,200 3,850

Dividends on preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 120 120

Net income available to common stockholders . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,080 3,730

Dividends on common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 935 730

Net income added to retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,145 3,000

Retained earnings, January 1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,320 5,320

Retained earnings, December 31 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,465 $ 8,320

Additional Information

� All sales were made on account. � Each share of preferred stock is convertible into five shares of common stock. � The market price per share of common stock is $50 per share. � 50,000 shares of common stock were issued on January 1, 20×1. Therefore, the weighted-average

number of shares during 20×1 was 600,000 shares.

Required:

Compute each of the following amounts or ratios for 20×1.

1. Working capital, 12/31/x1.

2. Current ratio, 12/31/x1.

3. Quick assets, 12/31/x1.

4. Acid-test ratio, 12/31/x1.

5. Accounts receivable turnover.

6. Average collection period.

7. Inventory turnover.

8. Average number of days per inventory turnover.

9. Number of bonds and number of shares of stock outstanding, 12/31/x1.

10. Book value of securities: (a) per bond, (b) per share of preferred stock, and (c) per share of common stock, 12/31/x1.

Chapter 21 Analyzing Financial Statements 77

11. Capitalization ratios, 12/31/x1.

12. Debt-equity ratio, 12/31/x1.

13. Interest coverage.

14. Coverage of dividends on preferred stock.

15. Earnings per share.

16. Diluted earnings per share.

17. Return on assets.

18. Return on equity.

19. Return on sales.

20. Dividend payout ratio.

21. Dividend yield ratio.

Refer to the data given in the preceding problem for AutoSound, Inc.

Required:

Prepare a common-size balance sheet as of December 31, 20×1, and a common-size income and retained earnings statement for 20×1.

Refer to the data given in Problem 21–37 for AutoSound, Inc.

Required:

Prepare two additional columns for each financial statement, which show the dollar change and per- centage change from 20×0 to 20×1.

Finn Company’s capital structure is as follows: December 31

20×4 20×3 Outstanding shares of:

Common stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 300,000 shares 300,000 shares

Convertible preferred stock . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10,000 shares 10,000 shares

8% nonconvertible bonds . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $1,000,000 $1,000,000

The following additional information is available:

� Net income for the year ended December 31, 20×4, was $750,000. � During 20×4 Finn Company paid dividends of $3.00 per share on its convertible preferred stock. � Each share of preferred stock is convertible into four shares of common stock.

Required:

1. Compute the number of shares that should be used for the computation of diluted earnings per share for the year ended December 31, 20×4.

2. Compute the diluted earnings per share for the year ended December 31, 20×4.

(CPA, adapted)

Cases ElectroStar Corporation is a manufacturer of electronic components with total assets of $20,000,000. Selected financial ratios for ElectroStar and the industry averages for firms of similar size are as follows:

ElectroStar Industry 20×2 20×1 20×0 Average

Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.61 2.32 2.09 2.28

Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.21 1.12 1.15 1.22

Inventory turnover . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2.02 2.18 2.40 3.50

Return on equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 0.17 0.15 0.14 0.11

Debt-equity ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.44 1.37 1.41 0.95

Chapter 21 Analyzing Financial Statements 77

Problem 21–38 Common-size Financial Statements (LO 4)

Problem 21–39 Dollar and Percentage Changes (LO 2)

Problem 21–40 Diluted Earnings per Share (LO 2, LO 5)

Case 21–41 Interpretation and Use of Financial Ratios; Ethics (LO 1, LO 5)

78 Chapter 21 Analyzing Financial Statements

ElectroStar is under review by several entities whose interests vary, and the company’s financial ratios are part of the data being considered. Each of the following parties must recommend an action based on its evaluation of ElectroStar’s financial position. ElectroStar has given the requested infor- mation to each party on a confidential basis.

� MidCoastal Bank. The bank is processing ElectroStar’s application for a new five-year note. MidCoastal has been ElectroStar’s banker for several years, but must evaluate the company’s financial position for each major transaction.

� Ozawa Company. Ozawa is a new supplier to ElectroStar and must decide on the appropriate credit terms to extend to the company.

� Drucker & Denon. A brokerage firm specializing in the stock of electronics firms, Drucker & Denon must decide if it will include ElectroStar in a new mutual fund being established for sale to Drucker & Denon’s clients.

� Working Capital Management Committee. This is a committee of ElectroStar’s management personnel chaired by the chief operating officer. The committee is charged with the responsibility of periodically reviewing the company’s working capital position, comparing actual data against budgets, and recommending changes in strategy as needed.

Required:

1. Describe the analytical use of the given ratios.

2. For each of the four entities described above, identify two financial ratios from those ratios pre- sented that would be most valuable as a basis for its decision regarding ElectroStar.

3. Discuss what the financial ratios presented in the problem reveal about ElectroStar. Support your answer by citing specific ratio levels and trends as well as the interrelationships among the ratios.

4. Mark Damon is the assistant controller for Ozawa Company, and he has been given the job of evaluating ElectroStar. Martha Jenkins is the analyst at Drucker & Denon who has been charged with the responsibility for analyzing ElectroStar. As luck would have it the two friends ran into each other at a Little League game. After the usual chitchat about the weather and the prospects for their kids’ baseball teams, the talk turned to business. Damon mentioned that sales were up for Ozawa and that his firm had just picked up ElectroStar as a new customer.

Jenkins: That’s interesting. Drucker & Denon is looking at ElectroStar right now, too. We may include their stock in a new mutual fund we’re putting together. What do you think of ElectroStar?

Damon: Well, I’m glad to have their business. I am a little concerned, though, about their inventory turnover the last couple of years. It’s heading downhill, and it’s way below the industry average.

Jenkins: Have you checked it out? Damon: Actually, we did. It seems they’ve got some components that were earmarked for a gov-

ernment satellite program that’s been delayed by Congress. I don’t think ElectroStar’s going to be able to move the stuff.

Jenkins: Doesn’t sound good. Hey, look! Your son’s up to bat.

Comment on any ethical issues you see in this scenario.

(CMA, adapted)

Tioga Chemical Corporation has a line of credit from the Southern Tier National Bank that is due to be renewed February 1, 20×2. The bank has requested the current income statement and comparative balance sheets for December 31, 20×0 and 20×1, which follow:

Tioga Chemical Corporation Income and Retained Earnings Statement

For the Year Ended December 31, 20×1 (in thousands)

Revenue:

Net sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $60,000

Other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,500

Total revenue . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $64,500

Case 21–42 Interpretation and Use of Financial Ratios (LO 1, LO 5)

Chapter 21 Analyzing Financial Statements 79

Expenses:

Cost of goods sold . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40,500

Selling and administrative expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,625

Depreciation and amortization expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,875

Interest expense . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,500

Total expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $55,500

Income before income taxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,000

Income tax expense (40%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600

Net income . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 5,400

Less: Dividends to common stockholders ($3.86 per share) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2,550

Net income added to retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 2,850

Retained earnings, 1/1/x1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8,550

Retained earnings, 12/31/x1 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $11,400

Earnings per share . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8.18

Tioga Chemical Corporation Comparative Balance Sheets December 31, 20×1 and 20×0

(in thousands) Assets 20×1 20×0

Current assets:

Cash and marketable securities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,950 $ 1,575

Receivables, less allowance for doubtful accounts ($84 in 20×1 and $105 in 20×0) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3,600 3,750

Inventories (at lower of cost or market) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,875 4,650

Prepaid items and other current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 375 225

Total current assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $10,800 $10,200

Other assets:

Investments (at cost) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 7,950 $ 7,950

Deposits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 750 600

Total other assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,700 $ 8,550

Property, plant, and equipment:

Land . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 900 $ 900

Buildings and equipment, less accumulated depreciation ($9,450 in 20×1 and $9,150 in 20×0) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $20,100 $18,600

Total property, plant, and equipment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $21,000 $19,500

Total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40,500 $38,250

Liabilities and Stockholders’ Equity 20×1 20×0 Current liabilities:

Short-term loans . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 1,650 $ 1,800

Accounts payable . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5,400 5,325

Salaries, wages, and other . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1,950 2,025

Total current liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 9,000 $ 9,150

Long-term debt . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12,000 12,825

Total liabilities . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $21,000 $21,975

Stockholders’ equity:

Common stock, at par . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 3,300 $ 3,150

Paid-in capital in excess of par . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 4,800 4,575

Total paid-in capital . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $ 8,100 $ 7,725

Retained earnings . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11,400 8,550

Total stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $19,500 $16,275

Total liabilities and stockholders’ equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . $40,500 $38,250

Chapter 21 Analyzing Financial Statements 79

The bank also has requested that Tioga Chemical Corporation calculate several ratios and report the latest industry ratios. The firm’s ratios have not been calculated for 20×1. However, the accounting staff has gathered the following industry ratios, which are the latest available.

Current ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.86

Acid-test ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .85

Debt-equity ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 1.23

Interest coverage . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7.78

Dividend payout ratio . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 39.57%

Return on sales . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3.42%

Return on assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6.37%

Return on equity . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12.48%

Required:

1. Explain why the bank would be interested in the comparative financial statements and the pre- ceding financial ratios.

2. Calculate the following financial ratios for 20×1 for Tioga:

a. Return on sales.

b. Return on assets.

c. Return on equity.

d. Current ratio.

e. Acid-test ratio.

f. Debt-equity ratio.

g. Interest coverage.

h. Dividend payout ratio.

3. By comparing the ratios calculated in requirement 2 with the industry ratios, evaluate Tioga’s operations.

(CMA, adapted)

80 Chapter 21 Analyzing Financial Statements