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Chapter 15
Financial Statement Analysis
Solutions to Questions
15-1 Horizontal analysis examines how a particular item on a
financial statement such as sales or cost of goods sold behaves over
time. Vertical analysis involves analysis of items on an income
statement or balance sheet for a single period. In vertical analysis
of the income statement, all items are typically stated as a
percentage of sales. In vertical analysis of the balance sheet, all
items are typically stated as a percentage of total assets.
15-2 By looking at trends, an analyst hopes to get some idea of whether a situation is
improving, remaining the same, or deteriorating. Such analyses can provide insight into
what is likely to happen in the future. Rather than looking at trends, an analyst may compare
one company to another or to industry averages using common-size financial statements.
15-3 Price-earnings ratios reflect investors expectations concerning future earnings. The
higher the price-earnings ratio, the greater the growth in earnings investors expect. For this
reason, two companies might have the same current earnings and yet have quite different
price-earnings ratios. By definition, a stock with current earnings of $4 and a price-earnings
ratio of 20 would be selling for $80 per share.
15-4 A rapidly growing tech company would probably have many opportunities to make
investments at a rate of return higher than stockholders could earn in other investments. It
would be better for the company to invest in such opportunities than to pay out dividends
and thus one would expect the company to have a low dividend payout ratio.
15-5 The dividend yield is the dividend per share divided by the market price per share.
The other source of return on an investment in stock is increases in market value.
15-6 Financial leverage results from borrowing funds at an interest rate that differs from
the rate of return on assets acquired using those funds. If the rate of return on the assets is
higher than the interest rate at which the funds were borrowed, financial leverage is positive
and stockholders gain. If the return on the assets is lower than the interest rate, financial
leverage is negative and the stockholders lose.
15-7 If the company experiences big variations in net cash flows from operations,
stockholders might be pleased that the company has no debt. In hard times, interest
payments might be very difficult to meet.
On the other hand, if investments within the company can earn a rate of return that
exceeds the interest rate on debt, stockholders would get the benefits of positive leverage if
the company took on debt.
15-8 The market value of a share of common stock often exceeds the book value per
share. Book value represents the cumulative effects on the balance sheet of past activities,
15-1
15-2
A 2 to 1 current ratio might not be adequate for several reasons. First, the
composition of the current assets may be heavily weighted toward slow-turning and difficultto-liquidate inventory, or the inventory may contain large amounts of obsolete goods.
Second, the receivables may be low quality, including large amounts of accounts that may
be difficult to collect.
This Year
Sales................................................... 100.0%
Cost of goods sold...............................
63.2%
Gross margin.......................................
36.8%
Selling and administrative expenses:
Selling expenses...............................
18.0%
Administrative expenses...................
13.6%
Total selling and administrative
expenses..........................................
31.6%
Net operating income.........................
5.2%
Interest expense.................................
1.4%
Net income before taxes.....................
3.8%
Last
Year
100.0%
60.0%
40.0%
17.5%
14.6%
32.1%
7.9%
1.0%
6.9%
15-3
15-4
$39,610
41,080
40,345
1,000
$39,345
$1,980 - $60
= 4.9%
$39,345
15-5
15-6
Current ratio =
$66,000
= 8.5
($6,500 + $9,000)/2
15-7
15-8
$4,100
= 5.1
$800
Total liabilities
Stockholders' equity
$27,400
= 0.67
$41,080
15-9
$1,300,00
0
520,000
$ 780,00
0
$80,000 + $0 + $460,000 + $0
=1.04 (rounded)
$520,000
Current assets
Current liabilities
$1,200,000
=2.9 (rounded)
$420,000
15-10
2. Current ratio:
Current ratio=
Current assets
$490,000
=
=2.45
Current liabilities $200,000
3. Acid-test ratio:
Cash + Marketable securities
+ Accounts receivable + Short-term notes
Acid test ratio=
Current liabilities
=
$21,000 + $0 + $160,000 + $0
=0.91 (rounded)
$200,000
Sales on account
Average accounts receivable
$2,100,000
=14
($160,000 + $140,000)/2
365 days
Accounts receivable turnover
365 days
=26.1 days (rounded)
14
15-11
$1,260,000
=4.5
($300,000 + $260,000)/2
365 days
=81.1 days (rounded)
4.5
6. Debt-to-equity ratio:
Debt-equity ratio=
=
Total liabilities
Stockholders' equity
$500,000
=0.63 (rounded)
$800,000
$180,000
= 6.0
$30,000
15-12
15-13
4. Price-earnings ratio:
Price-earnings ratio=
15-14
$105,000 +
$30,000 ( 1 - 0.30)
( $1,100,000 + $1,300,000) / 2
$126,000
=10.5%
$1,200,000
$105,000 - $0
( $725,000 + $800,000) /2 - $0
$105,000
=13.8% (rounded)
$762,500
15-15
$470,000 +
$90,000 ( 1 - 0.30)
( $5,000,000 +$4,800,000) / 2
$533,000
=10.9% (rounded)
$4,900,000
$470,000 - $56,000
=18.8% (rounded)
$2,200,000
15-16
Sales...............................
Current assets:
Cash.............................
Accounts receivable......
Inventory......................
Total current assets.........
Current liabilities.............
2. Sales:
Assets:
100.0
100.0
100.0
100.0
15-17
1.
a.
b.
c.
d.
$740,000
$1,100,00
Current liabilities (b).........................
0
Acid-test ratio (a) (b).....................
0.67
$650,000
$600,000
1.08
$7,000,00 $6,000,00
Sales on account (a)..........................
0
0
Average receivables (b).................... $525,000 $375,000
Accounts receivable turnover (a)
(b)...................................................
13.3
16.0
Average collection period: 365 days
accounts receivable turnover...... 27.4 days 22.8 days
e.
$5,400,00 $4,800,00
Cost of goods sold (a).......................
0
0
$1,050,00
Average inventory (b).......................
0 $760,000
Inventory turnover ratio (a) (b)......
5.1
6.3
Average sale period:
365 days inventory turnover....... 71.6 days 57.9 days
$1,850,00 $1,350,00
Total liabilities (a)..............................
0
0
$2,150,00 $1,950,00
Stockholders equity (b)....................
0
0
15-18
g.
0.86
0.69
$630,000
$90,000
7.0
$490,000
$90,000
5.4
15-19
Current assets:
Cash.................................
Marketable securities........
Accounts receivable, net. .
Inventory..........................
Prepaid expenses.............
Total current assets.............
Plant and equipment, net....
Total assets.........................
Liabilities:
Current liabilities..............
Bonds payable, 12%.........
Total liabilities.....................
Stockholders equity:
Preferred stock, $50 par,
8%..................................
Common stock, $10 par....
Retained earnings.............
Total stockholders equity. . .
Total liabilities and equity....
This
Year
Last
Year
2.3%
0.0%
16.3%
32.5%
0.5%
51.5%
48.5%
100.0%
6.1%
1.5%
12.1%
24.2%
0.6%
44.5%
55.5%
100.0%
27.5%
18.8%
46.3%
18.2%
22.7%
40.9%
5.0%
12.5%
36.3%
53.8%
100.0%
6.1%
15.2%
37.9%
59.1%
100.0%
15-20
Sales...........................................
Cost of goods sold.......................
Gross margin...............................
Selling and administrative
expenses..................................
Net operating income..................
Interest expense.........................
Net income before taxes.............
Income taxes...............................
Net income..................................
This
Year
100.0%
77.1%
22.9%
Last
Year
100.0%
80.0%
20.0%
13.9%
9.0%
1.3%
7.7%
3.1%
4.6%
11.8%
8.2%
1.5%
6.7%
2.7%
4.0%
15-21
15-22
b.
Net income......................................
Less preferred dividends..................
Net income remaining for common
(a).................................................
Average number of common shares
(b).................................................
Earnings per share (a) (b)............
Dividends per share (a)*..................
Market price per share (b)...............
Dividend yield ratio (a) (b)...........
50,000
$4.48
$2.16
$45.00
4.8%
$1.20
$36.00
3.33%
$2.16
$6.16
35.1%
$1.20
$4.48
26.8%
d.
$45.00
$6.16
7.3
$36.00
$4.48
8.0
15-23
Last Year
$1,950,00
e. Total stockholders equity............. $2,150,000
0
Less preferred stock......................
200,000
200,000
$1,750,00
Common stockholders equity (a). $1,950,000
0
Number of common shares
outstanding (b)...........................
Book value per share (a) (b)......
50,000
$39.00
50,000
$35.00
$ 240,00
Net income.................................... $ 324,000
0
Add after-tax cost of interest paid:
[$90,000 (1 0.40)]................
54,000
54,000
$ 294,00
Total (a)......................................... $ 378,000
0
$3,000,00
Average total assets (b)................ $3,650,000
0
Return on total assets (a) (b).....
10.4%
9.8%
b.
$ 240,00
Net income.................................... $ 324,000
0
Less preferred dividends...............
16,000
16,000
Net income remaining for
$ 224,00
common (a)................................ $ 308,000
0
Average total stockholders
$1,868,00
equity*........................................ $2,050,000
0
Less average preferred stock........
200,000
200,000
Average common stockholders
$1,668,00
equity (b).................................... $1,850,000
0
*1/2($2,150,000 + $1,950,000); 1/2($1,950,000 +
15-24
$1,786,000)
Return on common stockholders
equity (a) (b)...........................
15-25
16.6%
13.4%
15-26
15-28
$70,000
12,000
350,000
460,000
8,000
900,000
Current liabilities:
Accounts payable.................
Accrued liabilities.................
Notes due in one year..........
Total current liabilities (b).......
200,000
60,000
100,000
360,000
$540,000
Current ratio=
Current assets
$900,000
=
=2.5
Current liabilities $360,000
15-29
The Effect on
Workin Curren
Acidg
t
Test
Capital
Ratio
Ratio
Transaction
(a)
Decreas Decreas Decreas
Declared a cash dividend........... e
e
e
(b)
Increas
Paid accounts payable............... None
e
Increase
(c) Collected accounts receivable.... None
None
None
(d)
Decreas Decreas Decreas
Purchased equipment for cash... e
e
e
(e) Paid a cash dividend previously
Increas
declared.................................. None
e
Increase
(f)
Decreas Decreas
Borrowed on a short-term note. . None
e
e
(g)
Increas
Sold inventory at a profit............ Increase e
Increase
(h) Wrote off uncollectible
accounts.................................. None
None
None
(i) Sold marketable securities at a Decreas Decreas Decreas
loss
e
e
e
(j)
Increas
Issued common stock for cash... Increase e
Increase
(k)
Increas
Paid off short-term notes............ None
e
Increase
15-30
15-31
8. No
effect
15-32
14. Decreas
e
15. No
effect
16. Decreas
e
15-33
15-34
1.
a.
Net income......................................
Add after-tax cost of interest:
$120,000 (1 0.30)...................
$100,000 (1 0.30)...................
Total (a)...........................................
Last Year
$ 168,00
$ 280,000
0
84,000
70,00
0
$ 238,00
$ 364,000
0
$4,640,00
Average total assets (b).................. $5,330,000
0
Return on total assets (a) (b).......
6.8%
5.1%
b.
Net income......................................
Less preferred dividends.................
Net income remaining for common
(a).................................................
$ 168,00
$ 280,000
0
48,00
48,000
0
$ 120,00
$ 232,000
0
$3,028,00
Average total stockholders equity. . $3,120,000
0
600,00
Less average preferred stock..........
600,000
0
$2,428,00
Average common equity (b)............ $2,520,000
0
Return on common stockholders
equity (a) (b).............................
9.2%
4.9%
c.
2.
a.
$232,000
50,000
$120,000
50,000
b.
outstanding (b).............................
Earnings per share (a) (b)............
$4.64
$2.40
$1.44
$36.00
4.0%
$0.72
$20.00
3.6%
15-36
This Year
$1.44
$4.64
31.0%
d.
$36.00
$4.64
7.8
Last Year
$0.72
$2.40
30.0%
$20.00
$2.40
8.3
Notice from the data given in the problem that the typical P/E
ratio for companies in Hedricks industry is 10. Hedrick
Company presently has a P/E ratio of only 7.8, so investors
appear to regard it less well than they do other companies in
the industry. That is, investors are willing to pay only 7.8
times current earnings for a share of Hedrick Companys
stock, as compared to 10 times current earnings for a share
of stock for the typical company in the industry.
e.
Stockholders equity.......................
Less preferred stock........................
Common stockholders equity (a). . .
Number of common shares
outstanding (b).............................
Book value per share (a) (b)........
$3,040,00
$3,200,000
0
600,000
600,000
$2,440,00
$2,600,000
0
50,000
$52.00
50,000
$48.80
15-37
$1,050,000
$860,000
$4,160,00
$5,250,000
0
20.0%
20.7%
b.
$2,600,00 $1,980,00
Current assets (a).............................
0
0
$1,300,00
Current liabilities (b).........................
0 $920,000
Current ratio (a) (b).......................
2.0
2.15
c.
$1,220,00 $1,120,00
Quick assets (a)................................
0
0
$1,300,00
Current liabilities (b).........................
0 $920,000
Acid-test ratio (a) (b).....................
0.94
1.22
d.
$5,250,00 $4,160,00
Sales on account (a)..........................
0
0
Average receivables (b).................... $750,000 $560,000
Accounts receivable turnover (a)
(b)...................................................
7.0
7.4
Average collection period: 365 days
accounts receivable turnover......
52 days
49 days
e.
$4,200,00 $3,300,00
Cost of goods sold (a).......................
0
0
$1,050,00
Average inventory balance (b)..........
0 $720,000
Inventory turnover ratio (a) (b)......
4.0
4.6
Average sales period: 365 days
inventory turnover ratio..................
91 days
79 days
$2,500,00 $1,920,00
Total liabilities (a)..............................
0
0
15-38
$3,200,00 $3,040,00
Stockholders equity (b)....................
0
0
Debt-to-equity ratio (a) (b)............
0.78
0.63
g.
15-39
$520,000 $340,000
$120,000 $100,000
4.3
3.4
15-40
Hedrick Company
Comparative Balance Sheets
This
Year
Current assets:
Cash.........................................
5.6%
Marketable securities................
0.0%
Accounts receivable, net........... 15.8%
Inventory.................................. 22.8%
Prepaid expenses......................
1.4%
Total current assets..................... 45.6%
Plant and equipment, net............ 54.4%
Total assets................................. 100.0%
Current liabilities......................... 22.8%
Bonds payable, 10%.................... 21.1%
Total liabilities............................. 43.9%
Stockholders equity:
Preferred stock, 8%, $30 par
value...................................... 10.5%
Common stock, $40 par value. . 35.1%
Retained earnings..................... 10.5%
Total stockholders equity............ 56.1%
Total liabilities and equity............ 100.0%
Last
Year
8.5%
2.0%
12.1%
16.1%
1.2%
39.9%
60.1%
100.0%
18.5%
20.2%
38.7%
12.1%
40.3%
8.9%
61.3%
100.0%
15-41
Hedrick Company
Comparative Income Statements
Sales...........................................
Cost of goods sold.......................
Gross margin...............................
Selling and administrative
expenses...................................
Net operating income..................
Interest expense..........................
Net income before taxes..............
Income taxes (30%).....................
Net income..................................
This
Year
100.0%
80.0%
20.0%
Last
Year
100.0%
79.3%
20.7%
10.1%
9.9%
2.3%
7.6%
2.3%
5.3%
12.5%
8.2%
2.4%
5.8%
1.7%
4.0%
15-42
Current assets
Current liabilities
$435,000
= 1.8 (rounded)
$246,000
$105,000 + $0 + $75,000 + $0
= 0.7 (rounded)
$246,000
The company would not qualify for the loan because both its
current ratio and its acid-test ratio are too low.
15-43
Current assets
Current liabilities
$435,000 + $68,000
= 2.0 (rounded)
$246,000
$105,000 + $0 + $75,000 + $0
= 0.7 (rounded)
$246,000
15-44
Current assets
Current liabilities
$435,000 + $68,000
= 2.0 (rounded)
$246,000
= 1.0 (rounded)
However, other options may be available. The old equipment is
being used to relieve bottlenecks in the heat-treating process
and it would be desirable to keep this standby capacity. We
would advise Jurgen to fully and honestly explain the situation
to the loan officer. The loan officer might insist that the
equipment be sold before any loan is approved, but she might
instead grant a waiver of the current ratio and acid-test ratio
requirements on the basis that they could be satisfied by
selling the old equipment. Or she may approve the loan on the
condition that the equipment is pledged as collateral. In that
case, Jurgen would only have to sell the equipment if he would
otherwise be unable to pay back the loan.
15-45
Key
(h)
(i)
(j)
(a)
(b)
(c)
(d)
Tanner Company
Balance Sheet
December 31
Current assets:
Cash............................................... $ 80,000
Accounts receivable, net.................
200,000
Inventory........................................
320,000
Total current assets...........................
600,000
Plant and equipment.........................
900,000
Total assets....................................... $1,500,000
Current liabilities............................... $ 250,000
Bonds payable, 10%..........................
450,000
Total liabilities...................................
700,000
Stockholders equity:
Common stock, $2.50 par value.....
100,000
Retained earnings...........................
700,000
Total stockholders equity..................
800,000
Total liabilities and equity.................. $1,500,000
15-46
(f)
(e)
(g)
(g)
(q)
(p)
(k)
(l)
(m)
(o)
(n)
(p)
Therefore, the earnings before interest and taxes for the year
must be $315,000 (= $45,000 7.0).
b. Net income before taxes = $315,000 $45,000 = $270,000.
c. Income taxes = $270,000 40% tax rate = $108,000.
d. Net income = $270,000 $108,000 = $162,000.
e. Accounts receivable
Sales on account
=
turnover
Average accounts receivable balance
=
$2,700,000
= 15.0
Average accounts receivable balance
15-47
g
.
Current ratio=
=
Current assets
Current liabilities
Current assets
=2.4
$250,000
15-48
15-49
n
.
Debt-to-equity ratio =
=
Total liabilities
Stockholders' equity
$700,000
= 0.875
Stockholders' equity
15-50
$189,000
= 14.0%
Average total assets
15-51