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Kimmel, Weygandt, Kieso, Trenholm Financial Accounting, Second Canadian Edition

CHAPTER 14
Performance Measurement

ASSIGNMENT CLASSIFICATION TABLE

Brief A B
Study Objectives Questions Exercises Exercises Problems Problems

1. Understand the con- 1, 2, 3, 4 1, 2, 3 1, 2


cept of sustainable
earnings and indicate
how irregular items are
presented.

2. Discuss the need for 5


comparative analysis
and identify the tools
of financial statement
analysis.

3. Explain and apply 6, 7 4, 5 3, 5, 6 1A 1B


horizontal analysis.

4. Explain and apply 6, 7 6, 7, 8 4, 6 2A 2B


vertical analysis.

5. Identify and calculate 8, 9, 10, 9, 10, 11, 2, 7, 8, 9, 2A, 3A, 4A, 2B, 3B, 4B,
ratios used to analyse 11, 12, 13, 12, 13, 14 10, 11, 12, 5A, 6A, 7A, 5B, 6B, 7B,
liquidity, solvency, 14, 15, 16, 13, 14 8A, 9A, 10A, 8B, 9B, 10B,
and profitability. 17, 18, 19 11A, 12A 11B, 12B

6. Understand the concept 20, 21, 22 15 15 10A, 11A, 10B, 11B,


of quality of earnings. 12A 12B

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ASSIGNMENT CHARACTERISTICS TABLE

Problem Difficulty Time


Number Description Level Allotted (min.)

1A Perform horizontal analysis and comment. Simple 20-30

2A Prepare vertical analysis, calculate selected ratios, Moderate 20-30


and comment.

3A Calculate ratios. Simple 20-30

4A Calculate ratio and comment. Moderate 30-40

5A Calculate ratios. Moderate 50-60

6A Calculate ratios, and compare liquidity, profitability, Moderate 50-60


and solvency for two companies.

7A Calculate ratios and compare two companies, one on Moderate 50-60


the verge of bankruptcy.

8A Analyse ratios. Moderate 30-40

9A Calculate missing information using ratios. Moderate 50-60

10A Determine effect of transactions on ratios. Moderate 30-40

11A Analyse ratios. Moderate 50-60

12A Assess effect of alternate accounting principles on Complex 50-60


ratios.

1B Prepare horizontal analysis and comment. Simple 20-30

2B Prepare vertical analysis, calculate selected ratios, Moderate 20-30


and comment.

3B Calculate ratios. Simple 20-30

4B Calculate ratio and comment. Moderate 30-40

5B Calculate ratios. Moderate 50-60

6B Calculate ratios, and compare liquidity, profitability, Moderate 50-60


and solvency for two companies.

7B Calculate ratios and compare two companies, one on Moderate 50-60


the verge of bankruptcy.

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Problem Difficulty Time
Number Description Level Allotted (min.)

8B Analyse ratios. Moderate 30-40

9B Calculate missing information using ratios. Moderate 50-60

10B Determine effect of transactions on ratios. Moderate 30-40

11B Analyse ratios. Moderate 50-60

12B Assess effect of alternate accounting principles on Complex 50-60


ratios.

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ANSWERS TO QUESTIONS
1. The concept of sustainable earnings is defined as the normal level of earnings to be
obtained in the future. It is the amount of regular earnings that a company can expect to
earn from its normal operations. In order to distinguish a companys net earnings from
its earning power, irregular items, such as discontinued operations and extraordinary
items, are reported separately on the statement of earnings.

2. Item (f) would be reported as an extraordinary loss. Item (g) is debatable, depending on
whether or not earthquakes are frequent in the location in question.

3. This would not be considered a favourable trend for Ingots Inc. The relevant earnings
per share figures are the $3.26 in 2004 and the $2.99 in 2005. These figures indicate
that, unless there was a sale of common shares, the earnings from the continuing
operations of the company decreased during 2005. This should give the companys
management some concern because they will not always be able to count on revenue
or gains from irregular items.

4. (a) The effect will be negative for Robotics Inc., in that retained earnings is reduced.
The change to an accelerated method of amortization means that there will be an
increase in the amount of accumulated amortization. The journal entry will show a
credit to Accumulated Amortization and a debit to Retained Earnings for the
increased amortization expense (Cumulative Effect of Change in Accounting
Principle).
(b) Changes in accounting principles are reported as an adjustment of opening
retained earnings (net of income tax). The accelerated amortization method should
be used in reporting the operating results for the current year and any previous
periods reported for comparative purposes.

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


intercompany basis, and an industry average basis (or predetermined norms).
1. An intracompany basis compares the same item with prior periods, or with
other financial items in the same period.
2. An intercompany basis compares the same item with other companies
published reports.
3. The industry average and predetermined norm compare the item with the
industry average as compiled by Dun & Bradstreet or by trade associations.
(b) 1. The intracompany basis of comparison is useful in detecting changes in
financial relationships and significant trends within a company.
2. The intercompany basis of comparison provides insight into a companys
competitive position.
3. The industry average basis provides information as to a companys relative
performance within the industry.

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Questions (Continued)

6. Horizontal analysis (also called trend analysis) measures the dollar and percentage
increase or decrease of an item over a period of time. In this approach, the amount of
the item on one statement is compared with the amount of that same item on one or
more earlier statements. Vertical analysis expresses each item within a financial
statement in terms of a percent of a relevant total or other common basis within the
same statement.

7. (a) $540,000 X 1.05 = $567,000, 2005 net earnings


(b) $540,000 6% = $9,000,000, 2004 revenue

8. (a) Liquidity ratios measure the short-term ability of the enterprise to pay its maturing
obligations and to meet unexpected needs for cash.
(b) Solvency ratios measure the companys ability to survive over a long period of time.
(c) Profitability ratios measure the earnings or operating success of an enterprise for a
given period of time.

9. A high current ratio might be hiding liquidity problems with regards inventory or accounts
receivable. For example, a high level of inventory will cause the current ratio to increase.
Increases in inventory can be due to the fact that inventory is not selling and may be
obsolete. Increases in the current ratio will also occur if the companys accounts
receivable increase. An increase in accounts receivable could indicate the company is
having trouble collecting its overdue accounts, which again would mean liquidity
problems for the business.

10. The current ratio relates current assets to current liabilities. The acid-test ratio relates
cash, short-term investments, and net receivables to current liabilities. The acid-test
ratio provides additional information about short-term liquidity and is an important
complement to the current ratio. The cash current debt coverage ratio assesses the
ability of the entity to meet its current obligations and is a measure of the companys
liquidity. The cash total debt coverage ratio is a measure of the companys ability to
repay all its liabilities and is a measure of the companys solvency.

11. Bullock Ltd. likely has a collection problem with its receivables. However, the
receivables turnover needs to be reviewed in light of other liquidity measures for the
company. In addition, sometimes the receivables turnover for the industry can be
misleading in that some companies encourage credit and revolving charge sales and
slow collections in order to earn a healthy return on the outstanding receivables in the
form of high rates of interest.

12. Joan is correct. A single ratio by itself may not be very meaningful and is best
interpreted by comparison with (1) past ratios of the same enterprise, (2) ratios of other
enterprises, or (3) industry norms or predetermined standards. In addition, other ratios
of the enterprise are necessary to determine overall financial well-being.

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Questions (Continued)

13. The price earnings (P-E) ratio is a reflection of investors assessments of a companys
future earnings. The P-E ratio takes into account such factors as relative risk, stability
of earnings, trends in earnings, and the markets perception of the companys growth
potential. In this question, investors favour the Bank of Montreal because it has the
higher P-E ratio. The investors feel that the Bank of Montreal will be able to generate
even higher future earnings and so the investors are willing to pay more for the shares.

14. The explanation for the difference relates to the fact that the company must be using
some debt to finance their assets. The cost of debt is lower than the return being
generated by the related assets. The extra return then accrues to the shareholders of
the business thereby increasing their return on common shareholders equity. This
concept is referred to as financial leverage.

15. In a growth company, the payout ratio is often low because the company is reinvesting
earnings in the business.

16. (a) Asset turnover


(b) Inventory turnover, days in inventory
(c) Return on common shareholders equity
(d) Times interest earned

17. (a) The increase in profit margin is good news because it means that a greater
percentage of net sales is going towards earnings.
(b) The decrease in inventory turnover signals bad news because it is taking the
company longer to sell the inventory and consequently there is a greater chance of
inventory obsolescence.
(c) An increase in the current ratio signals good news because the company improved
its ability to meet maturing short-term obligations.
(d) The earnings per share ratio is a deceptive ratio. The decrease might be bad news
to the company because it could mean a decrease in net earnings. Or the
decrease might be good news to the company because of an increase in
shareholders investment.
(e) The increase in the price earnings ratio is generally good news because it means
that the market price per share has increased and investors are willing to pay that
higher price for the shares.
(f) The increase in debt to total assets ratio is bad news because it means that the
company has increased its obligations to creditors and has lowered its equity
buffer.
(g) The decrease in the times interest earned is bad news because it means that the
companys ability to meet interest payments as they come due has weakened.

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Questions (Continued)

18. (a) The times interest earned ratio (not cash interest coverage ratio), which is an
indication of the companys ability to meet interest charges, and the debt to total
assets ratio, which indicates the companys ability to withstand losses without
impairing the interests of creditors.
(b) The current ratio and the acid-test ratio, which indicate a companys liquidity and
short-term debt-paying ability.
(c) The earnings per share and the return on common shareholders equity, both of
which indicate the earning power of the investment.

19. The cash current debt coverage ratio, cash total debt coverage ratio and the free cash
flow all depend on cash based data rather than accrual based data.

20. If management wanted to increase earnings, it could decrease the amortization expense
by increasing the estimated useful life of the asset used in the calculation of
amortization.

21. Management of earnings through, for example, the changing of accounting estimates
may lead to reported earnings that are confusing and misleading to users. For example,
if a company changes its estimate of an assets useful life, amortization expense will
change. The clarity and thoroughness of the earnings may be reduced which would
lead to a lower quality of earnings.

22. (a) During a period of inflation, net earnings will be less under the average inventory
cost flow assumption than it will be using the FIFO cost flow assumption because
average costing results in the larger cost of goods sold amount.
(b) Inflation does not affect the amount of amortization taken (except through its effect
on salvage) since the amortizable amount is based on the acquisition cost. A six-
year life produces greater amortization for the first six years (thus, less net
earnings) and less amortization in years 7, 8, 9 (thus, more net earnings in those
years) than a nine-year life.
(c) Inflation does not affect the amount of amortization taken. Use of the straight-line
method results in less amortization in the earlier years than the accelerated
declining balance method but more amortization in the later years.

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SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 14-1

OSBORN CORPORATION
Statement of Earnings (Partial)
Year Ended December 31, 2004
Discontinued operations
Loss from operations of Mexico facility, net
of $105,000 ($300,000 X 35%) income tax savings......... $195,000
Loss on disposal of Mexico facility, net of
$56,000 ($160,000 X 35%) income tax savings............... 104,000 ($299,000)

BRIEF EXERCISE 14-2

LIMA CORPORATION
Statement of Earnings (Partial)
Year Ended November 30, 2004

Earnings before income taxes................................................................................ $300,000


Income tax expense ($300,000 X 25%)................................................................. 75,000
Earnings before extraordinary item........................................................................ 225,000
Extraordinary loss from flood, net of $15,000
($60,000 X 25%) income tax savings................................................................. (45,000)
Net earnings........................................................................................................... $180,000

BRIEF EXERCISE 14-3

SHIRLI INC.
Statement of Retained Earnings (Partial)
For the Year Ended June 30, 2005

Retained earnings, July 1, 2004............................................................................. $350,000


Deduct: Cumulative effect on prior years of change in amortization
method, net of $16,000 ($40,000 X 40%) income tax savings..................... 24,000
Retained earnings, July 1, 2004, as adjusted........................................................ $326,000

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BRIEF EXERCISE 14-4

Horizontal analysis:
Dec. 31, 2004 Dec. 31, 2003
Cash $175,000
$150,000 100%
85.7%*
Accounts receivable $400,000
$600,000 100%
150%**
Inventory $600,000
$780,000 100%
130%***
Noncurrent assets $2,800,000
$3,220,000 100%
115%****

$150,000 $600,000
* $175,000 = 85.7% ** $400,000 = 150%
$780,000 $3,220,000
*** $600,000 = 130% **** $2,800,000 = 115%

BRIEF EXERCISE 14-5

Comparing the percentages presented results in the following conclusions: The net earnings
for Tilden increased in 2004 because of the combination of an increase in sales and a
decrease in both cost of goods sold and expenses. However, the reverse was true in 2005 as
sales decreased, while both cost of goods sold and expenses increased. This resulted in a
decrease in net earnings.

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BRIEF EXERCISE 14-6

Vertical analysis 2004 2003


Amount Percentage * Amount Percentage **
Cash $ 150,000 3.2% $ 175,000 4.4%
Accounts receivable 600,000 12.6% 400,000 10.0%
Inventory 780,000 16.4% 600,000 15.1%
Noncurrent assets 3,220,000 67.8% 70.4%
Total assets 100.0% 2,800,000 100.0%
$3,975,000

$4,750,000

* $150,000 $175,000
$4,750,000 = 3.2% ** $3,975,000 = 4.4%

$600,000 $400,000
$4,750,000 = 12.6% $3,975,000 = 10.0%

$780,000 $600,000
* $4,750,000 =16.4%** $3,975,000 = 15.1%

$3,220,000 $2,800,000
* $4,750,000 = 67.8%** $3,975,000 = 70.4%

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BRIEF EXERCISE 14-7

2005 2004 2003


Sales 100.0% 100.0% 100.0%
Less: Cost of goods sold 59.2% 62.4% 64.5%
Operating expenses 25.0% 26.6% 27.5%
Net earnings 15.8% 11.0% 8.0%

Net earnings as a percent of sales for Waubons increased over the three-year period
because cost of goods sold and operating expenses both decreased as a percent of sales
every year.

BRIEF EXERCISE 14-8

(a) Working capital = Current assets current liabilities


= $845,683 $448,606
= $397,077

(b) Current ratio:

Current assets
Current liabilities

$845,683
= $448,606

= 1.89:1

(b) Acid-test ratio:

Cash + Short-term investments


+ Accounts receivable
Current liabilities

$228,402
= $448,606

= 0.51:1

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BRIEF EXERCISE 14-9

Holyshs liquidity is likely deteriorating. The increase in the current ratio is likely caused by the
increase in receivables due to the decline in the receivables turnover. This may mean that the
company is not collecting its accounts receivable as effectively as in the past, or that some
balances may be uncollectible. Further investigation into the cause for the slowdown in
collections will have to be made before it is possible to assess the companys liquidity.

BRIEF EXERCISE 14-10

2002 2001

(a) Receivables turnover

= Net credit sales


Average accounts receivable

$1,268,710 $1,197,874
=
($263,135 $262,682) 2 ($262,682 $241,527) 2

= 4.8 times = 4.8 times

(b) Average collection period


= 365 days
Receivables turnover
365
= = 76 days
365 4.8
= = 76 days
4.8

Management has maintained a similar pattern of collections over the past year. The
company is taking 76 on the average to collect its accounts receivable, which is
considerably longer than the credit terms of 60 days. The company probably needs to
focus more effort on accounts receivable collection.

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BRIEF EXERCISE 14-11

Cost of goods sold


(a) Inventory turnover = Average inventory

2004 2003

$4,580,000 $4,538,000
$960,000 $1,020,000 $837,000 $960,000

2 2
= 4.6 times = 5.1 times

(b) Days in Inventory = 365


Inventory turnover

365 365
= 79 days = 72 days
4.6 5.1

Management should be concerned with the fact that inventory is moving slower in 2004
than it did in 2003. The decrease in the inventory turnover could be because of poor
pricing decisions or because the company is stuck with obsolete inventory.

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BRIEF EXERCISE 14-12

Net sales
(a) Asset turnover = Average total assets

$11,596.1
= $5,712.4 $4,093.0
2

= 2.37 times

Net earnings
(b) Return on assets = Average total assets

$446.1
= $5,712.4 $4,093.0
2

= 9%

Net earnings
(c) Profit margin =
Net sales

$446.1
= $11,596.1

= 3.8%

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BRIEF EXERCISE 14-13

Cash dividends

Cash dividends
Payout ratio = Net earnngs

X
0.20 = $56,000

X = $56,000 x 0.20

= $11,200

Average total assets

Net earnings
Return on assets= Average assets

$56,000
0.16 =
X

0.16X = $56,000

$56,000
X=
0.16

= $350,000

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BRIEF EXERCISE 14-14

$6,200
(a) $47,183 $42,259 = 0.14 times
2

$6,200
(b) $63,896 $64,860 = 0.10 times
2

(c) $6,200 $3,807 = $2,393

BRIEF EXERCISE 14-15

Increasing the estimated useful life will result in lower amortization expense and accumulated
amortization and higher net earnings and total assets.

(a) Increase
(b) Decrease
(c) Decrease

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SOLUTIONS TO EXERCISES

EXERCISE 14-1
(a)
DAVIS LTD.
Statement of Earnings (Partial)
Year Ended December 31, 2004

Earnings from continuing operations $270,000


Discontinued operations
Gain from operations of division, net of
$44,000 income taxes $66,000
Loss from disposal of division, net of
$28,000 income tax savings (42,000) 24,000
Earnings before extraordinary item 294,000
Extraordinary fire loss, net of $24,000 tax savings (36,000
)
Net earnings $258,000

(b) The effect of the cumulative change in accounting principle (item 3) would be
presented directly in the Statement of Retained Earnings as an adjustment to opening
retained earnings.

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EXERCISE 14-2

(a) These items are listed separately so that the reader can evaluate the companys results
on the basis of normal operations and also see the impact of irregular items. If only the
net income figure was disclosed, the reader would not be able to evaluate what portion
of the earnings came from operations and what portion came from irregular items.

(b) Revenue (in thousands):

$9,349 $11,029
(15)%
$11,029

Net income (in thousands):

$(8,980) - $107
(8,493)%
$107

(c) The profit margin should be based on the companys net income from its normal and
continuous operations. The net income figure should be a more conservative amount
and should not include any irregular items.
Profit margin (in thousands):
2002: (($10,317) + 8,100) $41,408 = -5.4%
2001: $1,111 $29,113 = 3.8%

These two figures are comparable because they are the end result of the companys
operations and do not include any irregular items which only affect the year of their
occurrence.

(d) Average number of shares = Net income EPS


2002: $(10,317,000) $(0.23) = 44,856,000 shares
2001: $1,111,000 $0.02 = 55,550,000 shares

Decrease in the average number of shares: 10,694,000 shares

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EXERCISE 14-3

MERCHANDISE.COM INC.
Condensed Balance Sheet
December 31

Increase or
(Decrease)
2004 2003 Amount %
Assets
Current assets $120,000 $ 80,000 $40,000) (50.0%)
Noncurrent assets (net) 400,000 350,000 50,000) (14.3%)
Total assets $520,000 $430,000 $90,000) (20.9%)

Liabilities
Current liabilities $91,000 $70,000 $21,000 (30.0%)
Long-term liabilities 144,000 95,000 49,000 (51.6%)
Total liabilities 235,000 165,000 70,000 (42.4%)

Shareholders Equity
Common shares 150,000 115,000 35,000 (30.4%)
Retained earnings 135,000 150,000 (15,000) (10.0%)
Total shareholders equity 285,000 265,000 20,000) (7.5%)
Total liabilities and share-
holders equity $520,000 $430,000 ($90,000) (20.9%)

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EXERCISE 14-4

FLEETWOOD CORPORATION
Condensed Statement of Earnings

2004 2003
Amount Percent Amount Percent
Sales $800,000 100.0% $600,000 100.0%
Cost of goods sold 500,000 62.5% 390,000 65.0%
Gross profit 300,000 37.5% 35.0%
Operating expenses 200,000 25.0% 210,000 26.0%
Earnings before income taxes 100,000 12.5% 156,000 9.0%
Income tax expense 25,000 3.1% 54,000 2.3%
Net earnings $ 75,000 9.4% 13,500 6.7%
$40,500

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EXERCISE 14-5

(a) OLYMPIC CORPORATION


Statement of Earnings
Year Ended December 31

Increase or (Decrease)
2004 2003 Amount Percentage
Net sales $550,000 $550,000
Cost of goods sold 440,000 450,000 $(10,000) (2.2%)
Gross profit 110,000 100,000 (10,000 (10.0%)
Operating expenses 58,000 55,000 3,000 (5.5%
Earnings before income tax 52,000 45,000 7,000 15.6%
Income tax 20,800 18,000 2,800 15.6%
Net earnings $ 31,200 $27,000 $ 4,200) 15.6%

(b) OLYMPIC CORPORATION


Statement of Earnings
Year Ended December 31

2004 2003

Amount Percent Amount Percent


Net sales $550,000 100.0% $550,000 100.0%
Cost of goods sold 440,000 80.0% 450,000 81.8%
Gross profit 110,000 20.0% 100,000 18.2%
Operating expenses 58,000 10.5% 55,000 10.0%
Earnings before income tax 9.5% 45,000 8.2%
Income tax 52,000 3.8% 18,000 3.3%
Net earnings 20,800 5.7% $27,000 4.9%
$31,200

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EXERCISE 14-6

(a) MOUNTAIN EQUIPMENT CO-OPERATIVE


Balance Sheet
December 31
(in thousands)

Percentage
Increase Change
2002 2001 (Decrease) from 2001
Assets
Current assets $40,927 $38,729 $2,198 5.7%
Deferred store pre-opening costs 417 417
Property, plant and equipment 38,197 39,015 (818) (2.1%)
Total assets $79,541 $77,744 $1,797 2.3%

Liabilities and members equity


Current liabilities $23,560 $25,110 ($1,550) (6.2%)
Long-term liabilities 348 399 (51) (12.8%)
Total liabilities 23,908 25,509 (1,601) (6.3%)
Members equity 55,633 52,235 3,398 6.5%
Total liabilities and
members equity $79,541 $77,744 $1,797 2.3%

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EXERCISE 14-6 (Continued)

(b)
MOUNTAIN EQUIPMENT CO-OPERATIVE
Balance Sheet
December 31
(in thousands)

2002 2001
Assets
Current assets $40,927 51.5% $38,729 49.8%
Deferred store pre-opening costs 417 0.5% 0.0%
Property, plant and equipment 38,197 48.0% 39,015 50.2%
Total assets $79,541 100.0% $77,744 100.0%

Liabilities and
members equity
Current liabilities $23,560 29.6% $25,110 32.3%
Long-term liabilities 348 0.4% 399 0.5%
Total liabilities 23,908 30.0% 25,509 32.8%
Members equity 55,633 70.0% 52,235 67.2%
Total liabilities and
members equity $79,541 100.0% $77,744 100.0%

(c) Current liabilities and long-term liabilities have decreased slightly and more assets are
now being financed through members equity.

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EXERCISE 14-7

(in thousands)
$79,275
(a) Current ratio = 0.99:1 = $80,186

$62,915 $15,182
Acid-test ratio = 0.97:1 = $80,186
$8,180
Cash current debt coverage = 0.11 times =
($80,186 $70,219) 2

$271,356
Receivables turnover = 17.7 times =
($15,182 $15,444) 2

365 days
Average collection period = 20.6 days =
17.7 times

(b) Carlton University appears to be in a healthy position with regard to its liquidity. Both
current and quick ratios are just under 1:1. Cash current debt coverage is perhaps a
little low at 0.11 times. Receivables turnover and average collection period are good.

EXERCISE 14-8

(a) Current ratio as of February 1, 2005 = 3.25:1 ($130,000 $40,000).

Feb. 3 3.25:1 No change in total current assets or liabilities


7 2.63:1 ($105,000 $40,000)
11 2.63:1 No change in total current assets or liabilities
14 3.50:1 ($91,000 $26,000)
18 3.27:1 ($85,000 $26,000)
24 3.34:1 ($86,800 $26,000)

(b) Acid-test ratio as of February 1, 2005 = 2.75:1 ($110,000 $40,000).

Feb. 3 2.75:1 No change in total quick assets or current liabilities


7 2.13:1 ($85,000 $40,000)
11 2.05:1 ($82,000 $40,000)
14 2.62:1 ($68,000 $26,000)
18 2.38:1 ($62,000 $26,000)
24 2.56:1 ($66,500 $26,000)

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EXERCISE 14-9

(a) The companys collection of its accounts receivables has deteriorated over the past
several years as it is taking the company longer to collect as evidenced by the
decrease in the accounts receivable turnover.

(b) The company is selling its inventory slower as the inventory turnover is declining.

(c) Overall, the companys liquidity has deteriorated. The increase in the current ratio is
caused by the increase in inventory and receivables due to the slowdown in the
movement of these assets. Even though the companys current ratio is higher, if the
underlying assets cannot be converted to cash to repay current liabilities, then liquidity
has deteriorated.

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EXERCISE 14-10

$145,000
(a) Current $50,000
= 2.9:1

$85,000
(b) Acid-test $50,000
= 1.7:1

$400,000
(c) Receivables turnover $75,000 $68,000 = 5.6 times
2

(d) Average collection period 365 days 5.6 = 65.2 days

$198,000
(e) Inventory turnover $60,000 $50,000 = 3.6 times
2

(f) Days in inventory 365 = 101.4 days


3.6

$41,000
(g) Cash current debt coverage $50,000 $60,000 = 0.75 times
2

$41,000
(h) Cash total debt coverage $150,000 $160,000 = 0.26
2

times

$150,000
(i) Debt to total assets $345,000
= 43.5%

$15,000
(j) Return on common shareholders equity $195,000 $160,000
2

= 8.5%

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EXERCISE 14-11

$208.6
(a) Profit margin $4,019.4
= 5.2%

$4,019.4
(b) Asset turnover $3,131.1 $3,043.3 = 1.30 times
2

$208.6
(c) Return on assets $3,131.1 $3,043.3 = 6.8%
2

$208.6
(d) Return on common $1,419.8 $1,418.6 = 14.7%
shareholders equity 2

$208.6 $79.0 $135.7


(e) Times interest earned = 5.36 times
$79.0

$208.6
(f) Earnings per share = $1.06
(209.6 183.3) 2

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EXERCISE 14-12

$45,000 $5,000
(a) Earnings per share 30,000
= $1.33

$15.00
(b) Price-earnings = 11.3 times
$1.33

$21,000
(c) Payout $45,000
= 47%

$45,000 $15,000 $36,000


(d) Times interest earned $15,000
$96,000
= $15,000 = 6.4 times

$195,000
(e) Gross profit margin $425,000
= 46%

$45,000
(f) Profit margin $425,000
= 10.6%

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EXERCISE 14-13

Current Cash current Debt to total Return on


Transaction ratio debt coverage assets assets
(1.5:1) (0.4 times) (30%) (20%)
(a) Purchased merchandise
inventory on account
from supplier (perpetual D D D D
inventory system).

(b) Paid cash on account. I D I I


(c) Sold merchandise on
I NE I I
account to customers.
(d) Customer paid its
NE I NE NE
account
(e) Purchased equipment
issuing long-term note NE NE D D
payable in payment.
(f) Paid interest expense
and a portion of principle D D D NE
on the note payable

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EXERCISE 14-14

Cost of goods sold


(a) Inventory turnover = 3.6 = $200,000 $180,000
2

3.6 X $190,000 = Cost of goods sold

Cost of goods sold = $684,000

Net sales (credit)


(b) Receivables turnover = 9.4 = $72,500 $126, 000
2

9.4 X $99,250 = Net sales (credit) = $932,950

(c) Return on common shareholders equity = 19% =

Net earnings
$400,000 $113,500 $400,000 $101,000
2

0.19 X $507,250 = Net earnings = $96,378

$96,378 [see (c) above]


(d) Return on assets = 14% =
Average assets

$96,378
Average assets = = $688,414
0.14

Total assets (Dec. 31, 2004) $605,000


= $688,414
2

Total assets (Dec. 31, 2004) = ($688,414 X 2) $605,000 = $771,828

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EXERCISE 14-15

(a) The fact that the earnings have been so close to analysts expectations would make
investors suspicious that management has selected accounting policies or made
estimates, which have manipulated earnings so that the analysts expectations are
met, and therefore the companys share price would not decline.

(b) Users are concerned that if management is manipulating the accounting figures to
meet analysts expectations, the information may not be reliable and useful for
decision-making.

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SOLUTIONS TO PROBLEMS
PROBLEM 14-1A

(a)
AIR CANADA
(in millions)
$ % $ % $ % $ %
2002 Change Change 2001 Change Change 2000 Change Change 1999 Change Change 1998
Operating revenues $ 9,826 $215 2.2 $ 9,611 $ 315 3.4 $9,296 $2,853 44.3 $6,443 $545 9.2 $5,898
Operating expenses 10,018 (324) (3.1) 10,342 1,307 14.5 9,035 2,969 48.9 6,066 63 4.5 5,803
(568.4
Nonrecurring expenses 31 52 247.6 (21) (199) (111.8) 178 216 ) (38) (37) (3,700.0) (1)
Interest expense 221 (54) (19.6) 275 65 31.0 210 56 36.4 154 (20) (11.5) 174
(137.2
Income tax 384 54 16.4 330 375 833.3 (45) (166) ) 121 155 455.9 (34)
$48 $(1,31 $(1,233 (1,503.
Net earnings (loss) $ (828) 7 37.0 5) ) 7) $ (82) $ (222) 158.6 $ 140 $184 418.2 $ (44)

Current assets $1,771 $(464) (20.8) $ 2,235 $ 6 0.3 $2,229 $ 971 77.2 $1,258 $ 166 15.2 $1,092
Total assets 7,416 (1,328) (15.2) 8,744 (988) (10.2) 9,732 3,027 45.1 6,705 283 4.4 6,422
Current liabilities 2,592 (277) (9.7) 2,869 (691) (19.4) 3,560 2,155 153.4 1,405 126 9.9 1,279
Total liabilities 9,704 (500) (4.9) 10,204 788 8.4 9,416 3,436 57.5 5,980 1,015 20.4 4,965
Share capital 992 0 0.0 992 0 0.0 992 2 0.2 990 (315) (24.1) 1,305
Retained earnings (3,280) (828) 33.8 (2,452) (1,776) (262.7) (676) (411) (155.1) (265) (417) (274.3) 152

(b) The primary drivers of the decline are the flattening of operating revenues combined with the increase in operating
expenses.

(c) Air Canada has been financing its operations primarily through debt.

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PROBLEM 14-2A

(a) Condensed Statement of Earnings


Year Ended December 31, 2004

Breau Ltd. Shields Ltd.


Dollars Percent Dollars Percent
Net sales $350,000 100.0% $1,400,000 100.0%
Cost of goods sold 180,000 51.4% 720,000 51.4%
Gross profit 170,000 48.6% 680,000 48.6%
Operating expenses 51,000 14.6% 272,000 19.4%
Earnings from operations 119,000 34.0% 408,000 29.2%
Other expenses and losses
Interest expense 3,000 0.9% 10,000 0.7%
Earnings before income taxes 116,000 33.1% 398,000 28.5%
Income tax expense 29,000 8.3% 100,000 7.2%
Net earnings $ 87,000 24.8% $ 298,000 21.3%

(b) Breau: Return on Assets

$87,000 $457,500 = 19%

$87,000 is Breaus 2004 net earnings. $457,5001 is Breaus 2004 average assets:

1
2004 2003
Current assets $130,000 $110,000
Noncurrent assets 405,000 270,000
Total assets $535,000 + $380,000 = $915,000 2

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PROBLEM 14-2A

(b) (Continued)

Shields: Return on Assets

$298,000 $1,550,000 = 19.2%

$298,000 is Shields 2004 net earnings. $1,550,0002 is Shields 2004 average assets:

2
2004 2003
Current assets $ 700,000 $ 650,000
Noncurrent assets 1,000,000 750,000
Total assets $1,700,000 + $1,400,000 = $3,100,000 2

Breau: Return on Common Shareholders Equity

$87,000 $342,500 = 25.4%

$87,000 is Breaus 2004 net earnings. $342,5003 is Breaus 2001 average shareholders
equity:
3
2001 2000
Common shares $288,000 $210,000
Retained earnings 137,000 50,000
SE $425,000 + $260,000 = $685,000 2

Shields: Return on Common Shareholders Equity

$298,000 $1,112,500 = 26.8%

$298,000 is Shields 2004 net earnings. $1,112,5004 is Shields 2004 average


shareholders equity:
4
2001 2000
Common shares $ 677,000 $700,000
Retained earnings 573,000 275,000
SE $1,250,000 + $975,000 = $2,225,000 2

(c) Shields Ltd. appears to be more profitable. Shields return on assets of 19.2% is
higher than Breaus return on assets of 19%, and Shields return on common share-
holders equity of 26.8% is higher than Breaus return on common shareholders equity
of 25.4%.

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PROBLEM 14-3A

$286,500
(a) Current ratio = 1.33:1
$216,150

$164,100
(b) Acid-test ratio = 0.76:1
$216,150

$780,000
(c) Receivables turnover $109,400 + $96,600 = 7.57 times
2

(d) Average collection period 365 days 7.57 = 48.22 days

$440,000
(e) Inventory turnover $122,400 + $64,000 = 4.72 times
2

(f) Days in inventory 365 days 4.72 = 77.33 days

$36,000
(g) Cash current debt coverage $216,150 + $156,000 = 0.19 times
2

$216,150
(h) Debt to total assets = 28.75%
$751,800

$196,120
(i) Times interest earned = 19.77 times
$9,920

$36,000
(j) Cash total debt coverage $216,150 + $276,000 = 0.15 times
2

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PROBLEM 14-3A (Continued)

$340,000
(k) Gross profit margin $780,000
= 43.6%

$139,650
(l) Profit margin $780,000
= 17.9%

$139,650
(m) Return on assets =
($751,800 $672,000) 2
19.62%

$780,000
(n) Asset turnover $751,800 $672,000 = 1.10 times
2

(o) Return on common shareholders equity


$139,650
$535,650 $396,000 =
2
29.98%

$139,650
(p) Earnings per share 15,000
= $9.31

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PROBLEM 14-4A

(a) 2004 2003

1. Profit margin
$80,300 $34,650
$760,000
= 10.6% $700,000
= 5.0%

2. Gross profit margin


$340,000 $300,000
$760,000
= 44.7% $700,000
= 42.9%

3. Asset turnover
$760,000 $700,000
$933,000 $614,000 $614,000 $540,000
2 2

= 0.98 times = 1.2 times

4. Earnings per share


$80,300 $34,650
7,500 = $2.22 4,000 = $1.14
32,500 2 28,500 2

5. Price-earnings
$8.00 $10.00
= 3.60 times = 8.77 times
$2.22 $1.14

6. Payout
$19,300 * $15,650 **
$80,300 = 24.0% $34,650 = 45.2%

*$124,000 + $80,300 - $185,000 = **$105,000 + $34,650 - $124,000 =


$19,300 $15,650

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PROBLEM 14-4A (Continued)

(a) (Continued)

7. Debt to total assets


$150,000
$348,000 = 37.3% $614,000
= 24.4%
$933,000

8. Current ratio

$193,000 $144,000
= 1.97:1 $75,000
= 1.92:1
$98,000

(b) The underlying profitability of the corporation has improved. For example, the profit
margin and gross profit margin have both increased. In addition, the corporations
earnings per share have increased, which suggests that investors will be looking more
favourably at the corporation. However, its payout ratio has decreased, which may
account for the decline in the price earnings ratio that occurred despite the increased
profitability. The company is also less solvent as its debt to total assets has increased.

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PROBLEM 14-5A
(a) Liquidity

2004 2003 Change

$695,000 $510,000
Current $333,750
= 2.08:1 $165,000
= 3.09:1 Deterioration

$230,000 $179,000
Acid-test $333,750
= 0.69:1 $165,000
= 1.08:1 Deterioration

$80,000 $65,000
Cash current debt Improvement
$249,375 $232,500
coverage
= 0.32 times = 0.28 times

$1,000,000 $940,000
Receivables turnover $98,000 $87,000 Deterioration
= 10.20 times = 10.80 times

$650,000 $635,000
Inventory turnover $370,000 $325,000 Deterioration
= 1.76 times = 1.95 times

An overall decrease in short-term liquidity occurred.

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PROBLEM 14-5A

(a) (Continued)

Profitability

2004 2003 Change


Return on common $86,250 $67,500
shareholders equity $763,125 $730,000 Improvement
= 11.3% = 9.2%

$86,250 $67,500
Return on assets $1,162,500 $1,080,000 Improvement
= 7.4% = 6.25%

$86,250 $67,500
Profit margin $1,000,000 $940,000 Improvement
= 8.63% = 7.18%

$1,000,000 $940,000
Asset turnover $1,162,500 $1,080,000 No change
= 0.86 times = 0.87 times

$350,000 $305,000
Gross profit margin $1,000,000 $940,000 Improvement
= 35.0% = 32.4%

$86,250 $67,500
Earnings per share 100,000
= $0.86 100,000
= $0.68 Improvement

Overall profitability has improved.

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PROBLEM 14-5A (Continued)

(a) (Continued)

Solvency

2004 2003 Change


Debt to total assets $533,750 $265,000
$1,340,000 $985,000 Deteriorated
= 39.8% = 26.9%

$80,000 $65,000
Cash total debt $350,000 * Improved
$399,375
coverage
= .20 = 0.19

Overall solvency has deteriorated

*Total assets total shareholders equity = 2002 total debt


= $1,175,000 $740,000 = $435,000

Average total liabilities = ($265,000 + $435,000) 2 = $350,000

(b) 2005 2004


1. Earnings per share $125,000 $86,250
103,250 *
= $1.21 100,000
= $0.86

2. Debt to total assets $408,750 $533,750


$1,450,000
= 28.2% $1,340,000
= 39.8%

3. Price-earnings $6.25 $5.00


= 5.0 times = 5.8 times
$1.25 * * $0.86

* 100,000 + (6,500 x 6/12) = 103,250


** $125,000 100,000 = $1.25 (independent of #1)

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PROBLEM 14-6A

(a) Ratio (Industry Average) INCO FALCONBRIDGE


(in millions) (in millions)
Liquidity
Current (1.2:1) 2.1:1 ($1,987 $930) 2.5:1
Acid-test (0.7:1) 1.4:1 ($1,338 $930) ($1,050 $424)
Receivables turnover (8.3x) 8.19 ($2,161 $264) 1.4:1 ($602 $424)
Average collection period (44 7.95 ($2,394 $301)
days) 44.6 (365 8.19)
Inventory turnover (4.9x) 2.6 ($1,377* $538) 45.9 (365 8.0)
Days in inventory (74.5 days) 140.4 (365 2.6) 3.8 ($1,733* $454)
96.1 (365 3.8)
Solvency
Debt to total assets (40.1%) 55.4% ($4,735 $8,540)
Times interest earned (2x) (41.4) [(($2,120) + $50) 56.1% ($2,918 $5,204)
Cash total debt coverage $50] 1.55 [($48 + $88) $88]
(N/A) 0.13 ($599 $4,514**) 0.12 ($341 $2,853**)

Profitability
Profit margin (1.6%)
Asset turnover (0.5 times) (68.5%) [($1,481) 3.0% [$73 $2,394]
Return on assets (0.8%) $2,161] 0.47 ($2,394 $5,136)
Return on common 0.24 ($2,161 $9,064) 1.4% [$73
shareholders equity (2.3%) (16.3%) [($1,481) $5,136]
Payout ratio (N/A) $9,064]
3.2% [$73 $2,283]
(32.5%) [($1,481) 114% ($83 $73)
$4,550]
(1.8%) [$26
($1,481)]

* Estimate, as operating expenses included

** Average total liabilities = Average total assets Average total shareholders equity

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PROBLEM 14-6A (Continued)

(b) The comparison of the two companies relative to the industry reveals the
following:

LiquidityFalconbridges liquidity is better than the industry average and


Inco. Its current ratio is higher although Inco and Falconbridge's acid test
ratios are nearly identical at double the industry average. The management
of its accounts receivable is worse than Incos and the industry average.
However, this is offset somewhat by its inventory performance, which is
better than Incos but still below that of the industry.

SolvencyThe companies are reasonably comparable in terms of debt to


total assets and cash total debt coverage solvency measures.
Falconbridges cash-based solvency is slightly lower than Incos, even
though it is carrying a higher proportion of debt to total assets than is Inco.
Both companies are less solvent than the average firm in the industry.

ProfitabilityFalconbridge is significantly more profitable than both Inco


and the average company in the industry. Inco is operating at a loss while
Falconbridge had positive net earnings.

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PROBLEM 14-7A

(a) Company A Company B


Ratio (in millions) (in millions)
1. Current ratio 0.78:1 1.21:1
($746.4 $953.6) ($60.5 $49.9)

2. Acid-test ratio 0.60:1 1.12:1


[($302.4 + $267.7) $953.6] [($50.7 + $5.2) $49.9]

3. Receivables turnover 12.95 times 39.15 times


[$3,171.3 (($267.7 + $221.9) [$203.6 (($5.2 + $5.2) 2)]
2)]

4. Average collection 28.2 days 9.3 days


period (365 12.95) (365 39.15)

5. Debt to total assets 107.61% 49.36%


($2,258.4 $2,098.6) ($92.1 $186.6)

6. Return on assets (6.86%) 10.72%


[($137.6) (($2,098.6 + $1,911.2) ($15.8 (($186.6 + $108.2)
2)] 2)]

7. Profit margin (4.3%) 7.8%


(($137.6) $3,171.3) ($15.8 $203.6)

8. Asset turnover 1.58 times 1.38 times


($3,171.3 (($2,098.6 + $1,911.2) ($203.6 (($186.6 + $108.2)
2)] 2)]

(b) It appears that Company A is in financial trouble. Its current ratio is less than
1, indicating that it cannot meet its current obligations with its current assets.
Its acid-test ratio is only 0.60:1. Company A has more debt than assetsits
debt to total asset ratio is over 100%. Its return on assets is negative and its
operating expenses are greater than revenue. The only ratio that it exceeds
Company B on is its asset turnover ratio.

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PROBLEM 14-8A

(a) Black and Decker appears to be more liquid. Even though its current ratio is
lower than both Snap-On and the industry, Black and Decker has a higher
receivables turnover and is also moving its inventory more quickly.

(b) By reviewing the debt to total assets we can see Snap-On has significantly
less debt than Black and Decker and is more in line with the industry
average. Snap-On also has a much better times interest earned which
again indicates that it is the more solvent of the two companies.

(c) Both companies appear to be very profitable. Snap-On has a higher gross
margin than Black and Decker but Black and Decker has a higher profit
margin, offers a better return on shareholders equity and earns a higher
return on assets. Black and Decker also has higher earnings per share. All
of this would indicate that Black and Decker is the more profitable company.

(d) Investors seem to favour Snap-On as it has the higher price-earnings ratio.
This is not consistent with (c) , as you would expect investors to favour the
more profitable company. Investors must be anticipating better future
profitability from Snap-On.

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PROBLEM 14-9A

VIENNA CORPORATION
Statement of Earnings
Year Ended December 31, 2004
Per
Question Calculation Solution
Sales $11,000,000 $11,000,000
Cost of goods sold (a) Step 3 $11,000,000 - $3,960,000 7,040,000
Gross profit (b) Step 2 $11,000,000 x 36% 3,960,000
Operating expenses 1,665,000 1,665,000
Earnings from operations (c) Step 4 $3,960,000 - $1,665,000 2,295,000
Interest expense (d) Step 7 $2,295,000 - $2,155,000 140,000
Earnings before income taxes (e) Step 6 $1,595,000 + $560,000 2,155,000
Income tax expense 560,000 560,000
Net earnings (f) Step 5 $11,000,000 x 14.5% $ 1,595,000

VIENNA CORPORATION
Balance Sheet
December 31, 2004

ASSETS
Current assets
Cash $ 450,000 Step 11 $2,630,000 $1,100,000 $ 650,000
$880,000
Accounts receivable (net) (g) Step 1 $11,000,000 10 1,100,000
Inventory (h) Step 8 $7,040,000 8 880,000
Total current assets (i) Step 10 $7,250,000 - $4,620,000 2,630,000
Property, plant and equipment 4,620,000 4,620,000
Total assets (j) Step 9 $1,595,000 0.22 $7,250,000

LIABILITIES
Current liabilities (k) Step 14 $2,630,000 3 $ 877,000
Long-term liabilities (l) Step 15 $3,850,000 - $877,000 2,973,000
Total liabilities (m) Step 13 $7,250,000 - $3,400,000 3,850,000

SHAREHOLDERS' EQUITY
Common shares 3,000,000 3,000,000
Retained earnings 400,000 400,000
Total shareholders' equity 3,400,000 3,400,000
Total liabilities and (n) Step 12 = Total assets $7,250,000
shareholders' equity

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PROBLEM 14-10A

(a) Decrease total debt will now increase causing the ratio to decrease.

(b) Decrease interest expense will increase causing the ratio to decrease.

(c) Increase Assuming the shares are cancelled; the shareholders equity
should decline causing the return to the remaining shareholders to
increase.

(d) No effect on payout ratio as this ratio only considers cash dividends. No
effect on return on common shareholders equity as there is no change in
total common shareholders equity as a result of a stock dividend.

(e) Decrease Assuming the current ratio is greater than 1:1; the increase in
payables will cause the current ratio to decrease. If the current ratio were
less than 1:1, the increase in payables would cause the current ratio to
increase.

(f) Increase the inventory turnover, as cost of goods sold will now be higher.
The effect on the gross profit margin will depend on the selling price of the
item compared to its cost.

(g) No effect as gross accounts receivables will remain the same.

(h) The average total assets will now be lower, causing return on assets to
increase.

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PROBLEM 14-11A

(a) Taste.com has greater liquidity than Refresh Corp. Its current ratio is
higher than Refresh Corp.s and, indeed, higher than the industry. Within
its current ratio, its acid-test ratio, receivables turnover, and inventory
turnover are all greater than the industry. All of these ratios, with the
exception of the receivables turnover, are also higher than Refresh
Corp.s. The receivables turnover ratio, while not as high as Refresh
Corp., is still a good ratio, with the collection period averaging 37 days
(365/9.8).

(b) No, investors would not be overly concerned with either companys debt
levels. Although Taste.com has a much higher debt position than does
Refresh Corp., they have sufficient earnings (see times interest earned
ratio) to cover their debt charges. Taste.coms times interest earned ratio,
although lower than Refresh Corp.s, is still better than the industrys.
Taste.com is, however, quite thin in terms of generating enough cash
annually (see cash total debt coverage ratio) to repay its debt. Still, over
time they may be okay. They should monitor their cash flow carefully,
however, to ensure that they dont over stress their cash demands (e.g.,
from large capital expansion requirements).

(c) Refresh Corp. is generating a better gross profit margin than Taste.com
(perhaps reducing its costs due to greater buying power). Refresh Corp.
is also more profitable than Taste.com in its profit margin. This means that
it is controlling all other expenses, in addition to cost of sales, much better
than Taste.com. Its return on assets (profitability of assets) is also well
done. Its asset turnover ratio is the same as Taste.coms, and it exceeds
the industry average for all these profitability ratios. Investors also believe
Refresh Corp. is more profitable, or has more future potential, than
Taste.com since its P-E ratio far exceeds both Taste.com and the industry.
The only profitability ratios for Refresh Corp. that are less than Taste.com
and the industry average are the return on equity and EPS ratios. These
could be influenced by the capital structure of each company. That is,
Refresh Corp. could have more common shares issued, proportionately,
than Taste.com.

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PROBLEM 14-11 (Continued)

(d) Examples of factors you should be aware of when using ratio analysis are

Management may be unduly affecting the results through estimates.


Historical cost basis of accounting ignores inflation.
Differences in choice of GAAP may affect interpretation.
One company may be highly diversified, which may affect
comparisons using consolidated data.
Qualitative factors ignored in traditional financial statements (e.g., goals,
motivation, intellectual capital, etc.).

(Note: Students were only required to identify two factors.)

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PROBLEM 14-12A

Gross Debt to Times Return


Current Earnings
profit total interest on total
Policy Choice ratio per share
margin assets earned assets
(1.5:1) ($1.50)
(40%) (25%) (20x) (10%)
(a) It is a period of
deflation and the
president would like
to use the average I I I D I I
inventory cost flow
assumption instead
of FIFO.
(b) The company is
considering using
straight-line
amortization, which NE NE I D I I
will produce a lower
expense than other
methods.
(c) The company is
leasing equipment
and is setting up the
lease as an
operating lease. Its
rent expense under
NE NE I D I I
an operating lease
will be lower than
interest expense
and amortization
expense under a
capital lease.

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PROBLEM 14-1B

NORTEL NETWORKS CORPORATION


(in U.S. millions)
(a)
$ % $ %
2002 Change Change 2001 Change Change 2000
Revenues $10,560 $ (6,951) (39.7) $17,511 $(10,437) (37.3) $27,948
Cost of revenues 6,953 (7,214) (50.9) 14,167 (947) (6.3) 15,114
Gross profit 3,607 263 7.9 3,344 (9,490) (73.9) 12,834
Operating expenses 5,184 (22,169) (81.0) 27,353 17,918 189.9 9,435
R&D expense 2,230 (1,009) (31.2) 3,239 (1,809) (35.8) 5,048
Interest expense 256 (55) (17.7) 311 142 84.0 169
85. (27,559 (25,741 (1415.9
Net loss from continuing operations before (4,063) 23,496 3 ) ) ) (1,818)
Income taxes (2,774
Income tax recovery (expense) 478 ) (85.3) 3,252 4,429 376.3 (1,177)
Net loss from continuing operations (3,585) 20,722 85.3 (24,307) (21,312) (711.6) (2,995)
Net loss from discontinued operations - (2,995) (2,520) (530.5) (475)
Net earnings (loss) $ (3,585) $23,717 86.9 $(27,302) $(23,832) (686.8) $(3,470)

Loss per share $(0.93) $6.69 87.8 $(7.62) $(6.61) (654.5) $(1.01)
Market price per share $2.52 $(9.38) (78.8) $11.90 $(36.35) (75.3) $48.25

$
Current assets of discontinued operations 223 $ (485) (68.5) $ 708 $ (814) (53.5) $ 1,522
Total current assets 8,476 (3,286) (27.9) 11,762 (4,768) (28.8) 16,530
Total assets 15,971 (5,166) (24.4) 21,137 (21,043) (49.9) 42,180
Current liabilities 6,982 (2,475) (26.2) 9,457 399 4.4 9,058
Total liabilities 14,011 (2,302) (14.1) 16,313 3,242 24.8 13,071
Common shares 35,696 721 2.1 34,975 3,140 9.9 31,835
Deficit 33,736 3,585 11.9 30,151 27,425 1,006.1 2,726

(b) The primary drivers of the companys deterioration are declining revenues,
increasing operating expenses in 2001 and higher debt as a proportion of total
assets.

(c) Nortel has been financing its operations through issuing common shares .

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PROBLEM 14-2B

(a) Condensed Statement of Earnings


Year Ended December 31, 2004

Chen Corporation Couric Ltd.


Dollars Percent Dollars Percent
Net sales $1,849,035 100.0% $539,038 100.0%
Cost of goods sold 1,080,490 58.4% 338,006 62.7%
Gross profit 768,545 41.6% 201,032 37.3%
Operating expenses 502,275 27.2% 79,000 14.7%
Earnings from operations 266,270 14.4% 122,032 22.6%
Interest expense 6,800 1,252 0.2%
Earnings before income taxes 259,470 0.4% 120,780 22.4%
Income tax expense 103,800 14.0% 48,300 9.0%
Net earnings $ 155,670 5.6% $ 72,480 13.4%
8.4%

(b)

Chen: Return on Assets

$155,670 $894,750 = 17.4%


$155,670 is Chens 2004 net earnings. $894,7501 is Chens 2004 average assets:

1
2004 2003
Current assets $325,975 $312,410
Noncurrent assets 651,115 500,000
$1,789,500
Total assets $977,090 + $812,410 =
2

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PROBLEM 14-2B (Continued)

(b) (Continued)

Couric: Return on Assets

$72,480 $251,313 = 28.8%

$72,480 is Courics 2004 net earnings. $251,3132 is Courics 2004 average assets:
2
2004 2003
Current assets $83,336 $79,467
$502,625
Capital assets 214,010 125,812
2
Total assets $297,346 + $205,279 =

Chen: Return on Common Shareholders Equity

$155,670 $724,430 = 21.5%

$155,670 is Chens 2004 net earnings. $724,4303 is Chens 2004


c
average shareholders equity:
3
2004 2003
Common shares $500,000 $500,000
$1,448,860
Retained earnings 302,265 146,595
2
Shareholders equity $802,265 + $646,595 =

Couric: Return on Common Shareholders Equity

$72,480 $191,238 = 37.9%

$72,480 is Courics 2004 net earnings. $191,2384 is Courics 2004 average


shareholders equity:

4
2004 2003
Common shares $120,000 $120,000
$382,476
Retained earnings 112,478 29,998
2
Shareholders equity $232,478 + $149,998 =

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PROBLEM 14-2B (Continued)

(c) Chen Corporation appears to be more profitable. In terms of total dollars it has higher
gross profit, earnings from operations, earnings before taxes, and net earnings.
However, when looking at relative values we see that Couric has a higher return on
assets and a higher return on shareholders equity. Chen is higher only in gross profit.
Therefore, once size differences have been eliminated, Couric is clearly the more
profitable of the two companies.

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PROBLEM 14-3B

$364,900
(a) Current ratio $213,500
= 1.71:1

$221,900
(b) Acid-test ratio $213,500
= 1.04:1

$1,918,500
(c) Receivables turnover $112,800 $108,100 = 17.37 times
2

(d) Average collection period 365 days 17.37 = 21 days

$1,005,500
(e) Inventory turnover $143,000 $115,500 = 7.8 times
2

(f) Days in inventory 365 days 7.8 = 47 days

$280,000
(g) Cash current debt coverage $213,500 $187,400 = 1.40 times
2

$279,500
(h) Debt to total assets $990,200
= 28.23%

$407,000
(i) Times interest earned $28,000
= 14.54 times

$280,000
(j) Cash total debt coverage $279,500 $387,400 = 0.84 times
2

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PROBLEM 14-3B (Continued)

$913,000
(k) Gross profit margin $1,918,500
= 47.6%

$265,300
(l) Profit margin $1,918,500
= 13.8%

$265,300
(m) Return on assets ($990,200 $852,800) 2
=
28.8%

$1,918,500
(n) Asset turnover $990,200 $852,800 = 2.08 times
2

(o) Return on common shareholders equity


$265,300
$710,700 $465,400 =
2
45.1%

$265,300
(p) Earnings per share 4,000 = $4.57
60,000 -
2

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PROBLEM 14-4B
(a) 2005 2004

1. Profit margin
$33,000 $24,000
$700,000
= 4.7% $650,000
= 3.7%

2. Gross profit margin


$280,000 $250,000
$700,000
= 40.0% $650,000
= 38.5%

3. Asset turnover
$700,000 $650,000
$720,000 $590,000 $590,000 $433,000
2 2

= 1.07 times = 1.27 times

4. Earnings per share


$33,000 $24,000
35,000
= $0.94
5,000 = $0.74
30,000 2

5. Price-earnings ratio
$8.00 $5.00
= 8.51 times = 6.76 times
$0.94 $0.74

6. Payout ratio
$3,000 * $2,000 **
$33,000 = 9.1% $24,000 = 8.3%

*$105,000 + $33,000 $x = $135,000; **$83,000 + $24,000 $x = $105,000;


x = $3,000 x = $2,000

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PROBLEM 14-4B (Continued)


(a) (Continued)

2004 2003

7. Debt to total assets


$260,000 * $160,000 * *
$720,000
= 36.1% $590,000
= 27.1%

* $90,000 + $170,000 = $260,000 **$75,000 + $85,000 = $160,000

8. Current

$165,000 * $150,000 * *
$90,000
= 1.8:1 = 2.0:1
$75,000

*$25,000 + $50,000 + $90,000 ** $20,000 + $45,000 + $85,000

(b) The underlying profitability of the corporation appears to have improved (see profit
margin, gross profit margin, and earnings per share and P-E ratio). The corporations
price-earnings ratio has increased, which suggests that investors may be looking more
favourably at the corporation. However, the corporations debt to total assets and
payout ratio have both increased which reduces the companys solvency. The
companys liquidity position has deteriorated as evidenced by the decline in the current
ratio.

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PROBLEM 14-5B

(a) Liquidity

2004 2003 Change

$464,000 $343,000
Current = 1.8:1 = 1.9:1 Deterioration
$255,000 $182,000

$209,000 $195,000
Acid-test = 0.8:1 = 1.1:1 Deterioration
$255,000 $182,000

Receivables $900,000 $840,000


Improvement
$96,500
= 9.3 times $92,500
= 9.1 times
turnover

Inventory $620,000 $575,000


Deterioration
$177,500
= 3.5 times $120,000
= 4.8 times
turnover

An overall decrease in short-term liquidity has occurred. All measures with the exception of
the collection of receivables have declined.

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PROBLEM 14-5B (Continued)

(a) (Continued)

Profitability

2004 2003 Change


$280,000 = 31.1% $265,000 = 31.5%
Gross profit Deterioration
$900,000 $840,000

$56,000 $55,000
Profit margin $900,000
= 6.2% $840,000
= 6.5% Deterioration

$900,000 $840,000
$854,000 $648,000 = $648,000 $630,000 Deterioration
Asset turnover 2 2
1.2 times = 1.3 times

$56,000 $55,000
$854,000 $648,000 $648,000 $630,000 Deterioration
Return on assets 2 2

= 7.5% = 8.6%

Return on
$56,000 $55,000 Deterioration
shareholders $332,500
= 16.8% $316,000
= 17.4%
equity

$56,000 $55,000
EPS 20,000
= $2.80 20,000
= $2.75 Improvement

Profitability has decreased slightly.

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PROBLEM 14-5B (Continued)

(a) (Continued)

Solvency
2004 2003 Change
Debt to total assets $505,000 $332,000
$854,000 $648,000 Deteriorated
= 59.1% = 51.2%

Overall solvency has deteriorated.

(b) 2005 2004


1. Return on common $40,000 $56,000
shareholders equity $379,800 (a) $332,500 (b)
= 10.5% = 16.8%

2. Debt to total assets $335,000 (c) $505,000 (d)


$900,000 $854,000
= 37% = 59.1%

3. Price-earnings $12.00 $10.00


$2.00 (e) $2.80 (f)
= 6.0 times = 3.6 times

(a) ($221,600* + $189,000** + $200,000 + $149,000) 2 = $379,800


**$200,000 + (1,800 X $12/share) = $221,600
**$149,000 + $40,000 = $189,000
(b) ($200,000 + $149,000 + $200,000 + $116,000) 2 = $332,500
(c) $45,000 + $40,000 + $250,000 = $335,000
(d) $170,000 + $45,000 + $40,000 + $250,000 = $505,000
(e) $40,000 20,000 = $2.00
(f) $56,000 20,000 = $2.80

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PROBLEM 14-6B

(a) Ratio (Industry average) FUTURE SHOP LTD. INTERTAN, INC.

1. Current (1.6:1) 0.88:1 ($241.7 $275.2) 3.0:1 ($192.7


$64.1)
2. Receivables turnover (23.7 147.1 times
times) ($1,985.2 $13.5) 36.9 times
($468.8 $12.7)
3. Average collection period (15 2.5 days
days) (365 147.1) 9.9 days
(365 36.9)
4. Inventory turnover (5.5 7.4 times
times) ($1,534.4 $207.2) 2.6 times
($281.0 $106.2)
5. Days in inventory (66 days) 49.3 days
(365 7.4) 140.4 days
(365 2.6)
6. Cash current debt coverage 0.13 ($34.9 $275.2*)
(n/a) 0.29 times ($18.8
$64.1*)
7. Debt to total assets (n/a) 74.0% ($326.7 $441.6)

33.0% ($71.2 $215.5)


8. Cash total debt coverage 0.11 ($34.9 $326.7*)
(n/a)
0.26 times ($18.8 $71.2*)
9. Profit margin (2.1%) 1.6%
($32.4 $1,985.2)
5.0%
($23.5 $468.8)
10. Asset turnover (2.6 X) 4.9 times
($1,985.2 $405.4)
2.2 times
11. Return on assets (5.2%) 8.0% ($32.4 $405.4) ($468.8 $211.8)

11.1% ($23.5 $211.8)


12. Return on common 33.2%
shareholders equity (9.8%) ($32.4 $97.6)
17.9%
13. Gross profit margin (27.4%) 22.7% ($23.5 $131.6)
($450.8 $1,985.2)
40.1%
($187.8 $468.8)

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* Average current and total liability figures were not included; ending current and total liability
amounts were used instead.

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PROBLEM 14-6B (Continued)


(b) The comparison of the two companies shows the following:

LiquidityInterTAN has a much higher current ratio than both the industry and Future
Shop. However, this is largely attributable to a large inventory balance (very high
number of days in inventory). Future Shop appears to be the more liquid of the two
when considering accounts receivable and inventory turnovers.

SolvencyIn terms of solvency, Future Shops debt to total assets ratio of 74.0% is
above InterTANs at 33.0%. InterTAN also has more cash from operating activities
available to pay its liabilities as evidenced by the companys higher cash total debt
coverage ratio.

ProfitabilityWhile both companies are profitable, InterTANs profit margin, return on


assets and gross profit margin are all higher than Future Shop and the industry
average. Future Shop has a high return on shareholders equity, which is likely due to
the financial leverage gained by using more debt financing.

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PROBLEM 14-7B

(a) Ratio Company A Company B

1. Current ratio 2.18:1 1.06:1


($2,688.1 $1,230.9) ($884.4 $837.8)

2. Acid-test ratio 0.74:1 0.08:1


($910.4 $1,230.9) ($64.2 $837.8)

3. Receivables turnover 8.25 times 39.82 times


[$7,075.0 (($718.7 + [$1,688.2 (($56.7 +
$169.7 + $645.0 + $28.1) 2)]
$181.9) 2)]

4. Average collection period 44 days 9 days


(365 8.25) (365 39.82)

5. Debt to total assets 55.29% 87.94%


($2,545.8 $4,604.1) ($953.9 $1,084.7)

6. Times interest earned 1.93 times (6.28) times


($187.2 $97.2) (($108.6) $17.3)

7. Return on assets 0.94% (24.45%)


[$39.7 (($4,604.1 + [($333.6) (($1,084.7 +
$3,880.2) 2)] $1,644.3) 2)]

8. Asset turnover 1.67 times 1.24 times


[$7,075 (($4,604.1 + [$1,688.2 (($1,084.7 +
$3,880.2) 2)] $1,644.3) 2)]

(b) Based on the current ratio, acid-test ratio and debt to total assets ratio, Company Bs
performance is far worse than Company A. Company B has had net losses for the last
two years. Company A showed positive earnings on the current statement of earnings.

[Note to instructor: Company A is actually the Hudson's Bay Company and its results
for January 31, 1999 and for January 31, 1998. Company B is actually The T. Eaton
Company Limited and its results for January 31, 1998 and January 25, 1997.

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PROBLEM 14-8B

(a) Wendys appears to be more liquid. Its current ratio, quick ratio and receivable
turnover are all higher than McDonalds. Wendys current and quick ratios are also
better than the industry average. McDonalds has a higher inventory turnover meaning
the company is able to move inventory more quickly than Wendys. However, Wendys
inventory turnover is still significantly better than the average company in the industry.

(b) By reviewing the debt to total asset we can see Wendys has significantly less debt
than both McDonalds and the industry. Wendys also has a much better times interest
earned which again indicates that it is the more solvent of the two companies.

(c) Both companies appear to be very profitable. Wendys has a higher profit margin than
McDonalds but McDonalds has a higher gross profit margin. Wendys also has a
better return on shareholders equity, a higher return on assets and higher earnings
per share. All of this would indicate that Wendys is the more profitable company.

(d) Investors seem to favour McDonalds as it has the higher price-earnings ratio; this is
not consistent with (c), as you would expect investors to favour the more profitable
company. Investors must anticipate that McDonalds will have better future profitability
than Wendys.

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PROBLEM 14-9B

SCHWENKE CORPORATION
Statement of Earnings
Year Ended December 31, 2004
Per Question Calculation Solution
Sales (a) Step 1 $125,000 0.10 $1,250,000
Cost of goods sold (b) Step 3 $1,250,000 - $500,000 750,000
Gross profit (c) Step 2 $1,250,000 x 40% 500,000
Operating expenses $287,500 287,500
Earnings from operations (d) Step 4 $500,000 - $287,500 212,500
Interest expense 4,167 4,167
Earnings before income taxes (e) Step 5 $212,500 - $4,167 208,333
Income tax expense (36.3%) (f) Step 6 $208,333 x 40% 83,333
Net earnings $125,000 $ 125,000

SCHWENKE CORPORATION
Balance Sheet
December 31, 2004
ASSETS
Current assets
Cash $ 54,000 $ 54,000
Accounts receivable (net) (g) Step 12 ($140,000 x 1.1) - 100,000
$54,000
Inventory (h) Step 13 $280,000 - $54,000 - 126,000
$100,000
Total current assets (i) Step 11 $140,000 x 2 280,000
Property, plant and equipment (j) Step 14 $1,000,000 - $280,000 720,000
(net)
Total assets (k) Step 7 $1,250,000 1.25 $1,000,000

LIABILITIES
Current liabilities (l) Step 10 $350,000 - $210,000 $ 140,000
Long-term liabilities 210,000 210,000
Total liabilities (m) Step 9 $1,000,000 - $650,000 350,000

SHAREHOLDERS' EQUITY
Common shares 320,000 320,000
Retained earnings 330,000 330,000
Total shareholders' equity 650,000 650,000
Total liabilities and (n) Step 8 (from Step 7) $1,000,000
shareholders' equity

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PROBLEM 14-10B

(a) Increase/Decrease total debt will now increase causing the debt to total assets ratio
to increase and the additional interest on the debt will cause the times interest earned
ratio to decline.

(b) Decrease The additional shares capital will cause the return on common
shareholders equity to decline.

(c) Increase The payment of dividends (assuming they are cash) will cause the payout ratio
to increase.

(d) Decrease - The purchase of inventory will cause inventory and current liabilities to
increase. This will cause the current ratio to deteriorate (provided that the current ratio
is greater than 1:1) and the inventory turnover ratio to decline.

(e) Decrease - The sale of the inventory on credit will cause accounts receivable to increase,
which will improve the acid test ratio. The effect on the gross profit margin will depend
on the selling price of the inventory compared to its cost.

(f) No effect - The increase in the allowance for doubtful accounts does not affect this ratio as
it is calculated using gross, not net receivables.

(g) No effect/Increase Current assets will remain the same as net receivables are
unchanged due to the write-off. The write off will cause gross accounts receivable to
decline, which will improve the accounts receivable turnover.

(h) Total assets will now be higher which will cause the return on assets to decrease.

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PROBLEM 14-11B

(a) Current ratio Favourable


Collection period Unfavourable
Inventory turnover Favourable
Return on shareholders' equity Favourable
Debt to total assets Favourable
Times interest earned Favourable

(b) Nextecs collection period is higher than the industry average. Even
though it has improved some since 2003, Nextec must review its credit
policies and place more effort on collecting receivables.

(c) Do not lend money

Borrowing $1,000,000 will cause Nextecs debt to total assets ratio to


increase to 73% [($1,000,000 + $294,200) ($1,000,000 + $773,000)]
well above the industry average.
The increase in interest burden increases risk of loss to the company if it
experiences a downturn.
The collection period is too long compared to the industry. Therefore, the
risk of exposure to bad debts is greater than it should be.

(d) They must increase their equity position before the bank will lend them
money. This can be done by:

Issuing more shares


Raising venture capital
Accessing government assistance programs

(e) Two other factors to consider:


Strength of management team
Marketability of product

Alternative responses are also acceptable. They may include:


Future cash flows expected
Is there a proper business plan in place

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PROBLEM 14-12B

Gross Debt to Times


Current Earnings Return
profit total interest
Policy Choice ratio per share on assets
margin assets earned
(1.5:1) (1.50) (10%)
(40%) (25%) (20x)
(a) It is a period of I I I D I I
inflation and the (During times (Net
president would of inflation, earnings
like to use the FIFO will will
FIFO inventory produce the increase
cost flow highest as will
assumption inventory total
instead of average value; lowest assets)
cost. cost of goods
sold expense,
and highest
net earnings.)
(b) The company is NE NE D I D D
considering using (Total (Net
double-declining assets will earnings
balance decrease. will
amortization which ) decrease
will produce a as will
higher expense total
than other assets.)
methods.
(c) The company will D NE D I D D
be leasing (A portion of
automobiles and the liability for
is setting up the the capital
lease as a capital lease will be
lease. Its interest classified as a
expense and current
amortization liability.)
expense under
the capital lease
will be higher this
year than would
be rent expense
under an
operating lease.

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BYP 14-1 FINANCIAL REPORTING PROBLEM

(a) LOBLAW COMPANIES LIMITED


Horizontal Trend Analysis
2002 ($ in millions)

$ %
2002 Change Change 2001
Sales $23,082 $1,596 7.4 $21,486
Operating expenses 21,779 1,429 7.0 20,350
Interest expense 161 3 1.9 158
Income tax 414 42 11.3 372
Net earnings (loss) $ 728 $ 165 29.3 $ 563

Current assets $ 3,526 $ 440 14.3 $ 3,086


Total assets 11,110 1,085 10.8 10,025
Current liabilities 3,154 358 12.8 2,796
Total liabilities 6,986 530 8.2 6,456
Share capital 1,195 1 0.1 1,194
Retained earnings 2,929 554 23.3 2,375

There have been no significant changes in Loblaws results during 2002. Sales and expenses
both increased by around 7%. Current assets increased at a faster rate than current liabilities,
which indicates the company is more liquid.

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BYP 14-1 (Continued)


(b) ($ in millions)

Cash total debt


Debt to total assets Times interest earned
coverage

2002 63%
($6,986 $11,110) $1,303 $161
= 8.1 times $981
($6,986 + $6,456) 2
= 0.15 times

Loblaws long-term solvency is not in jeopardy. Even with a high debt to total assets
indicating that creditors are providing 63% of Loblaws total assets, Loblaw has the
ability to pay interest payments when they come due as indicated by the times interest
earned ratio of 8.1 times.

(c) ($ in millions)

Profit margin $728 $23,082 = 3.2%

Asset turnover $23,082 [($11,110 + $10,025) 2] = 2.2 times

Return on assets $728 [($11,110 + $10,025) 2] = 6.9%

Return on common shareholders equity


$728 [($4,124 + $3,569) 2] = 18.9%

Loblaw is a profitable corporation. Shareholders are earning 18.9% on their investment.


Considering that Loblaw is primarily in a high-volume business where the margin above
costs is historically low, the profit margin is acceptable.

(d) Substantial amounts of important information about a company are not in its financial
statements. Events involving such things as industry changes, management changes,
competitors actions, technological developments, governmental actions, and union
activities are often critical to the successful operation of a company. Financial reports in
the media and publications of financial service firms (Standard & Poors, Dun &
Bradstreet) will provide sufficient relevant information not usually found in the annual
report.

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BYP 14-2 COMPARATIVE ANALYSIS PROBLEM

(a) ($ in millions) Loblaw Sobeys

1. Percentage increase in sales $23,082 $21,486 $10,414.5 $9,732.5


$21,486 $9,732.5
= 7.4% = 7.0%

Percentage increase in net $728 - $563 $179.0 - $210.6


earnings $563 $210.6
= 29.3% = (15.0%)

2. Percentage increase in total assets $11,110 $10,025 $3,192.5 $2,875.2


$10,025 $2,875.2
= 10.8% = 11.0%

Percentage increase in total $4,124 $3,569 $1,436.8 $1,283.3


shareholders equity $3,569 $1,283.3
= 15.6% = 12.0%

3. Earnings per share* 2002: $2.64 2003: $2.72


2001: $2.04 2002: $1.76

*Given on statement of earnings

(b) Both companies had significant increase in sales. Loblaw also had a corresponding
increase in earnings, while Sobeys experienced a slight decline in 2003. However, the
entire decline in earnings was due to the loss on the discontinued operations. Sobeys
earnings from continuing operations actually increased in 2003. In terms of total assets
and shareholders equity, both Sobeys and Loblaw experienced healthy increases
during the most recent fiscal year.

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BYP 14-3 RESEARCH CASE

(a) As an investor you would be better informed of the magnitude of the attacks by using
financial statements prepared in Canada since Canadian standard setters plan to allow
the effects of September 11 to be treated as an extraordinary item and disclosed
separately on the financial statements. American standard setters believe such
treatment would be misleading and therefore have recommended that the effects of
September 11 be included as regular business activities.

(b) Air Canada might report the multi-million-dollar aid package as revenue or as a
reduction in any extraordinary loss reported as a result of the September 11 attacks.

(c) Air Canada might report losses due to severe weather as unusual. The
frequency of bad weather in Canada would not allow the company to classify such
losses as extraordinary.

(d) Quebecor has provided extra disclosure by showing separately the effects of all
nonrecurring activities. For example the company has presented separately, before
tax, the effect of items such as a reserve for restructuring and gains on dilution from
the issuance of capital stock by subsidiaries. These provide users with additional
information to allow them to make more informed decisions concerning the future
profitability of the business.

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BYP 14-4 INTERPRETING FINANCIAL STATEMENTS

(a) Liquidity Ratios Coca-Cola PepsiCo

1.0:1 1.06:1
1. Current ratio
($7,352 $7,341) ($6,413 $6,052)

0.61:1 0.72:1
2. Acid-test ratio
($4,442 $7,341) ($4,376 $6,052)

9.83 times 10.75 times


3. Receivables turnover
($19,564 $1,990) ($25,112 $2,337)

4. Average collection 37.1 days 34.0 days


period (365 9.83) (365 10.75)

6.0 times 8.7 times


5. Inventory turnover
($7,105 $1,175) ($11,497 $1,326)

60.8 days 42.0 days


6. Days in inventory
(365 6.0) (365 8.7)

7. Cash current debt 0.60 0.84


coverage ratio ($4,742 $7,885) ($4,627 $5,525)

PepsiCo is slightly more liquid than Coca-Cola as it is higher in all of the liquidity ratios
prepared above.

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BYP 14-4 (Continued)

(b) Solvency Ratios Coca-Cola PepsiCo


$12,701 $14,183
1. Debt to total assets = 51.8% = 60.4%
$24,501 $23,474

$3,050 $199 $1,523 $3,313 $178 $1,555


Times interest $199 $178
2.
earned = 28.3 times
= 24.0 times
$4,742 $4,627
Cash total debt
3. $11,876 $13,602
coverage
= 0.40 times = 0.34 times

Coca-Cola has a lower debt to total assets ratio than PepsiCo and its cash total debt
coverage is higher than PepsiCos. However, both companies appear to have sufficient
earnings to repay all debts as evidenced by the high times interest earned ratios.
Overall, Coca-Cola is slightly more solvent than PepsiCo.

(c) Profitability Ratios Coca-Cola PepsiCo

15.6% 13.2%
1. Profit margin
($3,050 $19,564) ($3,313 $25,112)

63.7% 54.2%
2. Gross profit margin
($12,459 $19,564) ($13,615 $25,112)

0.83 times 1.11 times


3. Asset turnover
($19,564 $23,459) ($25,112 $22,585)

13.0% 14.7%
4. Return on assets
($3,050 $23,459) ($3,313 $22,585)

5. Return on common 26.3% 36.9%


shareholders equity ($3,050 $11,583) ($3,313 $8,973)

The Coca-Cola Company is more profitable than PepsiCo, Inc. It is better in terms of
profit margin and gross profit. However, PepsiCo is turning over its assets better and
providing a better return on assets and shareholders equity.

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BYP 14-5 A GLOBAL FOCUS

(a) Ratio CN BNSF


(Industry Average) ($ in millions CND) ($ in millions US)

1. Current ratio (0.7:1) $1,163 $791


$2,134
= 0.54:1 $2,091
= 0.38:1

2. Acid-test ratio (0.4:1) $25 $722 $28 $141


$2,134
= 0.35:1 $2,091
= 0.08:1

3. Cash current debt $1,173 $2,106


coverage (n/a) ($2,134 $1,638) 2 ($2,091 $2,161) 2
= 0.62 times = 0.99 times

4. Receivables $6,110 $8,979


turnover (13x) ($722 $645) 2 ($141 $172) 2
= 8.9 times = 57.4 times

In terms of liquidity, both companies have relatively low current ratios relative to the
industry. BNSFs and CNs current ratio are similar, but their acid-test ratios differ. CN
has better immediate liquidity than BNSF, however, much of this is due to the fact that
BNSF collects its receivables significantly quicker than CN and the industry.

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BYP 14-5 (Continued)

(b) Ratio CN BNSF


(Industry Average) ($ in millions) (US$ in millions)

1. Debt to total assets $12,297 $17,835


= 65% = 69%
(46.8%) $18,924 $25,767

2. Times interest $571 $353 $268 $760 $428 456


earned (3.3x) $353 $428
= 3.4 times = 3.8 times

3. Cash total debt $1,173 $2,106


coverage (n/a) ($12,297 $12,427) 2 ($17,835 $16,872) 2
= 0.09 times = 0.12 times

4. Free cash flow (n/a) $1,173 - $571 - $179 $2,106 - $1,358 - $183
= $423 = $565

The comparison here is mixed. The debt to total assets ratio shows
that BNSF relies more heavily on debt, suggesting it is less solvent. BNSF has a higher
times interest earned ratio, suggesting that, even though it relies on a significant
amount of debt financing, it has a better ability to service its debt. Finally, the cash total
debt coverage ratio and free cash flow continue to support our assertion that BNSF is
more solvent.

Both companies appear well able to support their capital expenditure growth as they
both have positive free cash flow.

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BYP 14-5 (Continued)

(c) Ratio CN BNSF


(Industry Average) ($ in millions) (US$ in millions)

1. Asset turnover (0.4x) $6,110 $8,979


($18,924 $18,788) 2 ($25,767 $24,721) 2
= 0.32 times = 0.36 times

2. Profit margin (8.1%) $571 $760


$6,110
= 9.3% $8,979
= 8.5%

3. Return on assets $571 $760


(2.9%) ($18,924 $18,788) 2 ($25,767 $24,721) 2
= 3.0% = 3.0%

4. Return on common $571 $760


shareholders equity ($6,627 $6,034) 2 ($7,932 $7,849) 2
(8.8%) = 9% = 9.6%

The companies are similar in their ability to generate sales from their assets, as
evidenced by their asset turnover. This is also consistent with the industry average.
However, CN reports a slightly higher profit margin. Overall both companies are
performing well when compared to the industry.

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BYP 14-5 (Continued)

(d) We have done this comparison without giving consideration to the fact that these two
companies prepare their financial statements using the accounting principles of different
countries. If there are significant differences in these principles, then the ratios may
differ even though the underlying economics are the same.

In addition to differences in accounting practices, other non-accounting issues need to


be considered. For example, if bankruptcy laws differ across the two countries, it may
make reliance on debt more or less desirable in one country than the other. Also, the
railroad industry may be a protected industry in one country but not the other, enjoying
subsidies or an implied guarantee that it wont be allowed to fail. This would have
implications for analysis of the companys future. Or, railroads may be a regulated
industry in one of the countries, thus being allowed to earn only a prescribed level
of profit and being allowed to increase its fares only when the government says it can.
The bottom line is, to evaluate a company, one must know the industry well, and to
compare across countries, one must additionally know the factors that affect that
industry that are unique to each country.

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BYP 14-6 FINANCIAL ANALYSIS ON THE WEB

Due to the frequency of change with regard to information available on the World Wide
Web, the Accounting on the Web cases are updated as required. Their suggested solutions
are also updated whenever necessary, and can be found online in the Instructor Resources
section of our home page <www.wiley.com/canada/kimmel>.

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BYP 14-7 COLLABORATIVE LEARNING ACTIVITY

(a) Lenders prefer that financial statements are audited because an audit gives
independent assurance that the financial statements give a reasonable representation
of the companys financial position and results of operations. With this independent
assurance we feel more comfortable making a decision.

(b) The current ratio increase is a favourable indication as to liquidity, but tells little on its
own about the going concern prospects of the client. From this ratio change alone, it is
impossible to know the amount and direction of the changes in individual accounts, total
current assets, and total current liabilities. Also unknown are the reasons for the
changes.

The acid-test ratio is an unfavourable indication as to liquidity, especially when the


current ratio increase is also considered. This decline is also unfavourable to the going
concern prospects of the client because it reflects a declining cash position and raises
questions as to reasons for the increases in other current assets, such as inventories.

The change in asset turnover cannot alone tell anything about either profitability or
going-concern prospects. There is no way to know the amount and the direction of the
changes in the two items. An increase in sales would be favourable for going concern
prospects, while a decrease in assets could represent a number of possible scenarios
and would need to be investigated further.

The increase in net earnings is a favourable indicator for both solvency and going
concern prospects although much depends on the quality of receivables generated from
sales and how quickly they can be converted into cash. One possibility here may be
that despite a decline in sales the clients management has been able to reduce costs
to produce this increase. Indirectly, the improved earnings may have a favourable
impact on solvency and going concern potential by enabling the client to borrow
currently to meet cash requirements.

The 32% increase in earnings per common share, which is identical to the percentage
increase in net earnings, is an indication there has probably been no change in the
number common shares outstanding.

This in turn indicates that financing was not obtained through the issue of common
shares. It is not possible to reach conclusions about solvency and going concern
prospects without additional information about the nature and extent of financing.

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BYP 14-7 (Continued)

(b) (Continued)

The collective implications of these data alone are that the client entity is about as
solvent and as viable as a going concern at the end of the current year as it was at the
beginning, although there may be a need for short-term operating cash.

Although a quick evaluation of a reporting entity can be made using only a few ratios
and comparing these with past ratios and industry statistics, the creditors should realize
the limitations of such analysis even from the best prepared statements carrying an
unqualified opinion.

A limitation on comparisons with industry statistics or other companies within the


industry exists because material differences can be created through the use of
alternative (but acceptable) accounting methods. Further, when evaluating changes in
ratios or percentages, the evaluation should be directed to the nature of the item being
evaluated because very small differences in ratios or percentages can represent
significant changes in dollar amounts or trends.

The creditors should evaluate conclusions drawn from ratio analysis in light of the
current status of, and expected changes in, such things as general economic
conditions, the clients competitive position, the publics demand (for the product itself,
increased quality of the product, control of noise and pollution, etc.), and the clients
specific plans.

(c) 1. Cash current debt coverageindicates liquidity (short-term debt paying


ability).
2. Debt to total assetsindicates solvency (percentage of assets financed by
creditors).

3. Times interest earnedindicates solvency (ability to repay interest when due.)

Other answers are possible.

(d) The usefulness of analytical tools is limited by the use of estimates, the cost basis, the
application of alternative accounting methods, atypical data at year-end, and the
diversification of companies.

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BYP 14-8 COMMUNICATION ACTIVITY

Memorandum

To: Self

Re: Earnings Quality at Shifty.com

In evaluating the financial performance of an entity it is important to understand the quality of


the firms earnings, that is, does the information provide a full and complete picture of the
companys performance.

To assess the quality of earnings, we should inquire of the audit committee some of the
following questions:

1. What accounting policies are being used? Have any of these policies changed during
the year?

2. What estimates have been used in preparing the financial statements? How reliable
are these estimates?

3. Have pro forma numbers been presented? How have these numbers been
calculated?

4. Has management been pressured to increase earnings? Are there any bonus plans or
stock option plans, which would lead management to manipulate earnings?

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BYP 14-9 ETHICS CASE

(a) The stakeholders in this case are:


Vern Fairly, president of Fairly Industries
Anne Saint-Onge, public relations director
You, as controller of Fairly Industries
Shareholders of Fairly Industries
Potential investors in Fairly Industries
Any readers of the press release

(b) The presidents press release is deceptive and incomplete and to that extent his action
is unethical.

(c) As controller you should at least inform Anne Saint-Onge, the public relations
director, about the biased content of the release. She should be aware that the
information she is about to release, while factually accurate, is deceptive and
incomplete. Both the controller and the public relations director (if she agrees) have the
responsibility to inform the president of the bias of the about-to-be-released information.

Solutions Manual 14-85 Chapter 14


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Kimmel, Weygandt, Kieso, Trenholm Financial Accounting, Second Canadian Edition

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Solutions Manual 14-86 Chapter 14


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