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Chapter 13

Financial Statement Analysis


Exercises
(10-15 min.)

E 13-14

Stamps Music Ltd.


Horizontal Analysis of Comparative Income Statement
Years Ended December 31, 2011 and 2010
INCREASE (DECREASE)

2011
Total revenue..........................................

2010

AMOUNT

PERCENT

$403,000

$430,000

$(27,000)

(6.3)%

$188,000

$202,000

$(14,000)

(6.9)

expenses....................................

93,000

90,000

3,000

3.3

Interest expense.................................

4,000

10,000

(6,000)

(60.0)

expense......................................

37,000

42,000

(5,000)

(11.9)

Total expenses...................................

322,000

344,000

(22,000)

(6.4)

Net income..............................................

$ 81,000

$ 86,000

$ (5,000)

(5.8)

Expenses:
Cost of goods sold.
Selling and general

Income tax

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(10-15 min.)

E 13-16

Cobra Golf Limited


Vertical Analysis of Balance Sheet
December 31, 2011
AMOUNT

PERCENT

ASSETS
Total current assets.............................................................................

$ 92,000

24.6%

Property, plant, and equipment, net....................................................

247,000

66.0

Other assets........................................................................................

35,000

9.4

Total assets.........................................................................................

$374,000

100.0%

Total current liabilities..........................................................................

$ 48,000

12.8%

Long-term debt....................................................................................

108,000

28.9

Total liabilities......................................................................................

156,000

41.7

218,000

58.3

$374,000

100.0%

LIABILITIES

SHAREHOLDERS EQUITY
Total shareholders equity....................................................................
Total liabilities and shareholders equity

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(10-15 min.)

E 13-17

Stamps Music Ltd.


Comparative Common-Size Income Statement
Years Ended December 31, 2011 and 2010
2011
Total revenue.............................................................................................

2010

100.0%

100.0%

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

46.6

47.0

Selling and general expenses..............................................................

23.1

20.9

Interest expense...................................................................................

1.0

2.3

Income tax expense.............................................................................

9.2

9.8

Total expenses.....................................................................................

79.9

80.0

20.1%

20.0%

Expenses:

Net income................................................................................................

(10-15 min.)

E 13-18

1. Operations provided very little cash. The company is selling property, plant, and equipment to generate
cash.

2. Selling property, plant, and equipment and purchasing no new property, plant, and equipment suggests
financial weakness.

3. Holland Marsh Farms paid dividends equal to its net income. The business cant grow by paying such
high dividends.

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(10-15 min.)

E 13-21

(Dollars in thousands)
a. Return on net sales:
2011:

$17,000
$174,000

0.098

2010:

$13,000
$158,000

= 0.082

b. Return on total assets:


2011:

_____

$17,000 + $9,000
$197,500*

= 0.132

2010:

_____

$13,000 + $10,000
$181,000**

= 0.127

*($204,000 + $191,000) / 2 = $197,500.**($191,000 + $171,000) / 2 = $181,000.

c.

Return on common shareholders equity:


2011:

$17,000 $3,000
$92,500***

= 0.151

_____

2010:

$13,000 $3,000
$84,000****

= 0.119

$13,000 $3,000
20,000

= $0.50

_____

***($96,000 + $89,000) / 2 = $92,500.

****($89,000 + $79,000) / 2 = $84,000.

d. Earnings per share of common stock:


2011:

$17,000 $3,000
21,000

= $0.67

2010:

The companys operating performance improved during 2011. All four profitability measures increased.

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Problems
Group A

P 13-39A
Comairs statement of cash flows reveals only one strong point, a continuing purchase of property, plant, and
equipment. The companys weaknesses include the following:
1. Net income is down significantly, with the company incurring a net loss during 2011.
2. Operating activities provided a much smaller proportion of cash in 2011 than in 2010. In both years,
borrowing not operations was the primary source of cash inflows, which is an unfavourable signal
about the company.
3. The large payments on notes payable suggest that the company has a lot of debt. Coupled with the loss
during 2011 and the decrease in net cash provided by operations, the payments on notes payable may
indicate that the company has too much debt.
4. Purchases of property, plant, and equipment were down significantly from the previous year.
5. The companys cash balance decreased by $83,000 during 2011 to $9,000, which is dangerously low.

Jetways statement of cash flows reveals the following strengths (no significant weaknesses):
1. During both years, operating activities were the major source of cash.
2. The companys heavy investments in property, plant, and equipment suggest expansion. The use of cash,
coupled with increasing income and net cash provided by operations, suggests successful operations.
3. The cash balance is much higher than that of the other company and is increasing.
Conclusion:

Jetway appears to be the strongest company and thus the best investment.

Student wording may vary.

Chapter 13 Financial Statement Analysis


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901

(40-50 min.)

P 13-41A

Req. 1
(Dollar Amounts and Share Quantities in Thousands)
2011
a. Current ratio:

b. Inventory turnover:

c. Times-interestearned ratio:

$402
$286

$378
($152 + $186) / 2
$160
$37

2010
= 1.41

= 2.24

= 4.32

$397
$217

$313
($186 + $144) / 2
$139
$41

= 1.83

= 1.90

= 3.39

d. Return on assets:

$79 + $37
($689 + $653) / 2

= 0.173

$55 + $41
($653 + $607) / 2

= 0.152

e. Return on

$79 $21
($208 + $201) / 2

= 0.377

$55 $21
($201 + $198) / 2

= 0.266

common shareholders' equity:

f. Earnings per share:

g. Price/earnings
ratio:

$79 $21
15
$61*
$5.13*

= $5.13*

= 11.9

$55 $21
14
$45.50*
$3.79*

= $3.79*

= 12.0

_____

*Not in thousands.
1

Preferred shares dividend: 500 shares @ $4 = $2,000

Req. 2
Decisions:
a. The companys financial position improved during 2011 as shown by increases in the inventory turnover
and in the times-interest-earned ratio. Of all the ratios, only the current ratio deteriorated.

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b. The common shares attractiveness increased during 2011, as shown by the increase in the market price
of the common shares. This increase is consistent with the increase in return on assets, return on
common shareholders equity, and earnings per share. The price/earnings ratio is essentially unchanged.
Req. 3
This problem gives you practice in computing and evaluating several of the ratios used in investment analysis.
By analyzing the two-year trends in the ratios, you can see whether the companys abilities to pay its debts,
sell its inventory, and generate profits have improved or deteriorated during this period. Improving ratio values
generally indicate an attractive investment, and deteriorating ratio values usually signal an unattractive
investment.

Horizontal / Comparative Analysis


Crest Optical Inc.
Income Statements
For Years Ended
December 31,

Increase/
(Decrease)
2011

2010

Amount

Net Sales

667,000

599,000

68,000

COGS

378,000

313,000

65,000

Gross Profit

289,000

286,000

3,000

Operating exp

129,000

147,000

(18,000)

Income from operations

160,000

139,000

21,000

Interest expense

37,000

41,000

(4,000)

Income before income tax

123,000

98,000

25,000

Income tax expense

44,000

43,000

1,000

Net Income

79,000

55,000

24,000

Perc
ent
11.4
%
20.8
%
1.0%
12.2
%
15.1
%
-9.8%
25.5
%
2.3%
43.6
%

Vertical Analysis / Common Size Statements


Chapter 13 Financial Statement Analysis
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903

Crest Optical Inc.


Income Statements
For Years Ended
December 31,
Net Sales
COGS
Gross Profit
Operating exp
Income from operations
Interest expense
Income before income tax
Income tax expense
Net Income

2011
667,000
378,000
289,000
129,000
160,000
37,000
123,000
44,000
79,000

2010
599,000
313,000
286,000
147,000
139,000
41,000
98,000
43,000
55,000

2011
100%
57%
43%
19%
24%
6%
18%
7%
12%

2010
100%
52%
48%
25%
23%
7%
16%
7%
9%

P13-41A Data - Additional ratios:


2011
Acid-test (quick)
ratio)

Accounts
receivable
turnover

Days's sales in
receivables

Cash + Short term


investments + Net
receivables
Current liabilities

Net Sales
Average net accounts
receivable
Average net accounts
receivable
One day's sales

2010

245
286

0.86

191
217

0.88

667

3.72

599

4.15

179.5

144.5

179.5
1.8273
97

98.23

144.5
1.6410
96

88.05

Debt ratio

Total liabilities
Total assets

431
689

0.63

402
653

0.62

Return on sales

Net income
Net sales

79
667

11.8%

55
599

9.2%

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(45-60 min.)

P 13-42A

Req. 1
(Dollar Amounts and Share Quantities in Thousands)
Express

Video

a. Acid-test ratio:

$25 + $6 + $189
$366

b. Inventory
turnover:

c. Days sales
in average

$454
($211 + $209) / 2

($189 + $142) / 2
$603 / 365

$39 + $13 + $164

= 0.60

$338
$387

= 2.16

($183 + $197) / 2

($164 + $193) / 2

= 100

$519 / 365

0.64

2.04

126

0.74

receivables:

d. Debt ratio:

$667
$974

$691
$938

= 0.68

Note: Students need to recognize that debt ratio is calculated on Total Liabilities/Total Assets and the proportion of Long-Term Debt to
Total Liabilities is not important.

e. Times-interestearned ratio:

Ratio is not meaningful

$72
$12

because Video has

=
6.00

no interest expense.

f. Return on common
shareholders'
equity:

$56

$38
=

share:

h. Price/earnings
ratio:

$56
150
$9.00*
$0.37*

$4.00

250
1,000

0.196

($307 + $263) / 2

g. Earnings per

)=

0.180

[($247 $25) +
($215 $25)] / 2

$38
=

$0.37*

= 24.3

$4.00

250
1,000

)=

$1.85*

20
$47.50*
$1.85*

= 25.7

_____
*Not in thousands.

Decision:

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The common shares of Video.com seem to fit the investment strategy better. Videos price/earnings ratio is a little lower
than that of On-Line Express, and Video appears to be in slightly better shape financially than Express. On several of the
ratios, the two companies are relatively close. The ratios that tip the decision in favour of Video are days sales in
receivables, the debt ratio, and the return on common shareholders equity.

906

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(15-20 min.)
TO:

Merrill Lynch Investment Committee

FROM:

Student Name

P 13-43A

SUBJECT: Investment Recommendation


I recommend that we invest in Message Direct Inc. for the following reasons:
1. Message Directs return on equity (ROE) is 7% higher than Fast Mails. An investment in Message Direct
should therefore produce a higher return than an investment in Fast Mails shares.
2. Message Directs ROE exceeds its return on assets by a far wider margin than does Fast Mails. This
means that Message Direct is earning more with its borrowed funds than Fast Mail is earning.
3. Message Direct can cover its interest expense with operating income 18 times compared to 12 times for Fast
Mail.
4. Message Direct collects receivables faster than Fast Mail does. This suggests that cash flow is stronger at
Message Direct.
5. Message Directs gross profit percentage is higher than Fast Mail.
6. Fast Mail is better than Message Direct on inventory turnover and net income as a percentage of sales.
These ratios provide insight about companies operations, but ROE and interest coverage are more
bottom-line oriented. And days sales in receivables give an indication about cash flow. For these
reasons, I place more importance on ROE, interest-coverage, and days sales in receivables, and
Message Direct outstrips Fast Mail on these measures.

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Problems
Group B

(20-30 min.) P 13-45B


Req. 1

Pathfinder Inc.
Common-Size Income Statement Compared
to Industry Average
For the Year Ended December 31, 2011
PATH-FINDER INDUSTRY
AVERAGE

Net sales................................................................................

100.0%

100.0%

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

71.0

65.8

Gross profit.............................................................................

29.0

34.2

Operating expenses...............................................................

23.3

19.7

Operating income...................................................................

5.7

14.5

Other expenses......................................................................

0.4

0.4

Net income.............................................................................

5.3%

Pathfinder Inc.
Common-Size Balance Sheet Compared to Industry Average
December 31, 2011
PATH-FINDER

14.1%

INDUSTRY
AVERAGE

Current assets...........................................................................

75.0%

70.9%

Fixed assets, net.......................................................................

18.5

23.6

Intangible assets, net.................................................................

1.0

0.8

Other assets..............................................................................

5.5

4.7

Total assets...............................................................................

100.0%

100.0%

Current liabilities........................................................................

51.5%

48.1%

Long-term liabilities...................................................................

16.0

16.6

Shareholders equity..................................................................

32.5

35.3

100.0%

100.0%

Total liabilities and shareholders equity


Req. 2

908

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Pathfinders common-size income statement shows that its ratios of (a) gross profit to net sales, (b)
operating income to net sales, and (c) net income to net sales are worse than the industry
averages. Overall, the companys profit performance is worse than the average for the industry.
Req. 3
Pathfinders common-size balance sheet shows that its (a) ratio of current assets to total assets
exceeds that of the industry average. Pathfinders (b) ratio of shareholders equity to total assets is
worse than the industry average. Overall, the companys financial position is worse than the industry
average.
(20-30 min.) P 13-46B
Norfolks statement of cash flows reveals few strengths. About the only bright spot is that cash
increased. The companys weaknesses include the following:
1. Net Income and cash provided by operations are down significantly.
2. Operating activities provided less cash than selling property, plant, and equipment during both
years. This shows that operations are not the prime source of cash inflow. Selling property,
plant, and equipment as the major source of cash can be a sign of trouble.
3. The company is not investing much in new property, plant, and equipment. This is not
necessarily a weakness, for the company may have acquired property, plant, and equipment in
earlier years and may now be paying the debts incurred to purchase those assets. However, the
companys downward trends of income and net cash flow from operations suggest that its
operations are not very successful.
4. Payments on debt are high. This, coupled with the decrease in income, indicates that the debt
burden may have hurt the company.

Stafford Crystals statement of cash flows reveals the following strengths (no significant
weaknesses):
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1. During both years, operating activities generated the bulk of the companys cash. Furthermore,
the trend of net income is up, a favourable sign.
2. The company is steadily increasing its investments in property, plant, and equipment, which
suggests the company is expanding. This investing activity, coupled with increasing income and
increasing net cash flow from operating activities, suggests successful operations.
3. The cash balance is higher than that of the other company, and cash increased during the
current year.
Conclusion: Stafford Crystal appears to be the strongest
company and thus the best investment.

Student wording may vary.

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(40-50 min.)

P 13-48B

Req. 1
(Dollar Amounts and Share Quantities in Thousands)
2011
a. Current ratio:

b. Inventory
turnover:
c. Times-interestearned ratio:
d. Return on
common shareholders' equity:
e. Earnings per share:

f.

Price/earnings
ratio:

$421
$206
$429
($147 + $162) / 2

2010
= 2.04

$382
$223

= 1.71

= 2.78

$318
($162 + $207) / 2

= 1.72

= 10.8

$75
$8

= 9.4

$58 $6
($210 + $120) / 2

= 0.315

$40 $6
($120 + $90) / 2

$58 $6
10

= $5.20*

$40 $6
9

= $3.78*

= 16

$62.50*
$3.78*

= 16.5

$97
$9

$83*
$5.20*

= 0.324

____
*Not in thousands.

Req. 2
Decisions:
a. The companys financial position improved during 2011, as shown by increases in the current ratio,
inventory turnover, and times-interest-earned ratio.
b. The common shares attractiveness improved a little during 2011, as shown by the rise in the share
market price. This increase in market price is consistent with the increase in earnings per share. Return
on common shareholders equity is high.

Req. 3
This problem gives you practice in computing and evaluating several of the ratios used in investment analysis.
By analyzing the two-year trends in the ratios, you can see whether the companys abilities to pay its debts,
sell its inventory, and generate profits have improved or deteriorated during this period. Improving ratio values
Chapter 13 Financial Statement Analysis
Copyright 2012 Pearson Canada Inc.

911

generally indicate an attractive investment, and deteriorating ratio values usually signal an unattractive
investment.

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(45-60 min.)

P 13-49B

Req. 1
(Dollar Amounts and Share Quantities in Thousands)

a. Acid-test ratio:

Thrifty Nickel
$22 + $20 + $42
= 0.78
$108

b. Inventory
turnover:

$209
($87 + $93) / 2

2.32

$258
($100 + $88) / 2

= 2.74

c. Days sales in
average
receivables:

($42 + $40) / 2
$371 / 365

40

($46 + $48) / 2
$497 / 365

= 35

d. Debt ratio:

$108
$265

Village Cryer
$19 + $18 + $46
$98

$131
$328

= 0.41

= 0.85

= 0.40

Note: Students need to recognize that debt ratio is calculated on Total Liabilities/Total Assets and the proportion of LongTerm Debt to Total Liabilities is not important.
e. Times-interestearned ratio:

$138
$19

Ratio is not meaningful


because Thrifty Nickel
has no interest expense.

f. Return on common
shareholders'
equity:

g. Earnings per share:


h. Price/earnings
ratio:
_____
*Not in thousands.

$48
($157 + $118) / 2

$48
10
$51.00*
$4.80*

0.349

200
$72
1000
( $5
[($197 $20) +
($126 $20)] / 2

200

$72
= $4.80*

= 10.6

= 7.26

( $5

1000

= 0.502

= $14.20*

5
$112.00*
$14.20*

= 7.9

Decision:
Village Cryers common shares seem to fit the investment strategy better. Its price/earnings ratio is lower than
that of Thrifty Nickel, and Village Cryer appears to be in better shape financially than Thrifty Nickel, as
indicated by all the ratio values.

Chapter 13 Financial Statement Analysis


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