Homework week 1

Thiago Dias Defendi

Financial ratios for Chico Electronics:

a. Acid-test ratio:(Cash + Accounts receivable) Total current liabilities($325 + $3,599)

$3,945 = 0.99
Interpretation: The most liquid assets can adequately cover current liabilities

b. Return on assets:[Net income + Interest expense (1-tax rate)] Average total

assets[$1,265 + $78 (1 - .40)] [($4,792 + $8,058) 2] = 20.4%
Interpretation: Return on each dollar invested in assets (this return would seem to be
good to very good)

c. Return on common equity:(Net income - Preferred dividends) Average common

equity[$1,265 - $45] [($2,868 - $500 + $3,803 - $450) 2] = 42.7%
Interpretation: Return on each dollar invested by equity holders (this return would seem
to be excellent)

d. Earnings per share:(Net income - Preferred dividends) Average common shares

outstanding[$1,265 - $45] [(550 + 829) 2] = $1.77
Interpretation: Net income earned per each share owned (difficult to assess this EPS
value in isolation)

e. Gross profit margin:(Net sales - Cost of goods sold) Net sales($12,065 - $8,048)
$12,065 = 33.3%
Interpretation: Gross profit for each dollar of net sales (difficult to assess this value in
isolation)

f. Times interest earned:(Net income before tax + Interest expense) Interest

expense($2,259 + $78) $78 = 30 times
Interpretation: Magnitude (multiple) that net income before tax exceeds interest
expense – a measure of safety, and a value of 30 is probably good to very good

g. Days to sell inventory: Average inventory (Cost of goods sold 360)[($2,423 + $1,415)
2] [$8,048 360] = 85.8 days
Interpretation: Time it would take to dispose of inventory (difficult to assess the value in
isolation)

h. Long-term debt to equity:(Long-term debt + Other liabilities) Shareholders'

equity($179 + $131) $3,803 = 8.2%
Interpretation: Percent contributed by long-term debt holders relative to equity
holders – this is not a highly averaged company in terms of long-term debt.

i.Total debt to total equity: Total liabilities Total shareholders' equity$4,255 $3,803 =
1.12
Interpretation: Total no owner financing relative to owner financing
j. Sales to end-of-year working capital: Net sales Working capital$12,065 ($6,360 -
$3,945) = 5
Interpretation: Sales as a multiple of working capital – measure of efficiency and safety

2-13

As per the words of Marsh in management's discussion and analysis, the company
decided to "take a big bath" in conjunction with the recgnition of large charge related to
the implementation of FAS 121. Marsh believes that the additional charges taken in the
quarter will be perceived less unfavorably by the market than if they had each been
recorded in separate quarters. Now the company has recognized all of its losses. These
items are no longer looming as losses that need to be recognized. Thus, in the future, net
income will be higher.

1-3

year 6 year 5 year 4 Cumulative Annual

Amount Average
Net Sale 6880 3490 2860 13200 2610
Cosf of Good Sold 3210 2810 1810 7830 1880
Gross Profit 3670 680 1050 5400 1880
Operating Expense 930 465 945 2340 780
Income before 2740 215 105 3060 1020
net income 1485 145 58 1688 563
Homework week 2
Thiago Dias Defendi

Chapter 4
Question

3 a. The two most important questions facing the financial analyst with respect to
receivables are: (1) Is the receivable genuine, due, and enforceable?, and (2) Has the
probability of collection been properly assessed? While the unqualified opinion of an
independent auditor lends some assurance with regard to these questions, the financial
analyst must recognize the possibility of an error of judgment as well as the lack of
complete independence.

b. Description of the receivables in the notes to financial statements usually do not

contain sufficient clues to allow a reliable judgment as to whether a receivable is genuine,
due, and enforceable. Consequently, knowledge of industry practices and supplementary
sources of information must be used for additional assurance, e.g.:
 In some industries, such as compact discs, toys, or books, a substantial right of
merchandise return exists and allowance must be made for this.
 Most provisions for uncollectible accounts are based on past experience although
they should also make allowances for current and emerging industry conditions.
In practice, the accountant is likely to attach more importance to the former than
to the latter. The analyst must, in such cases, use one’s own judgment and
knowledge of industry conditions to assess the adequacy of the provision for
uncollectible accounts.
 Information that would be helpful in assessing the general level of collection risks
with receivables is not usually found in published financial statements. Such
information can, of course, be sought from the company directly. Examples of
such information are: (1) What is customer concentration? What percent of total
receivables is due from one or a few major customers? Would failure of any one
customer have a material impact on the company's financial condition? (2) What
is the age pattern of the receivables? (3) What proportion of notes receivable
represent renewals of old notes? (4) Have allowances been made for trade
discounts, returns, or other credits to which customers are entitled?
 The analyst, in assessing current financial position and a company's ability to meet
its obligations currently—as expressed by such measures as the current ratio—
must recognize the full impact of accounting conventions that relate to
classification of receivables as "current." For example, the operating cycle concept
allows the inclusion of installment receivables, which may not be fully collectible
for years. In balancing these against current obligations, allowance for such
differences in timing of cash flows should be made.

a. Factoring or securitization of receivables refers to the practice of selling all or a

portion of a company’s receivables to a third party.
b. When receivables are sold with recourse, the third party purchaser of the receivables
retains the right to collect from the company that sold the receivable if the receivable
proves uncollectible. When receivables are sold without recourse, the purchaser of the
receivables assumes the collection risk.

c. When receivables are sold with recourse, the balance sheet reports the cash received
from the sale of the receivable. However, the balance sheet may or may not report the
contingent liability to the receivables purchaser for uncollectible receivables purchased
with recourse—this depends on who assumes the risk of ownership.

7. The major objective of the LIFO method of inventory accounting is to charge cost of
goods sold with the most recent costs incurred. When the price level is stable, the results
under either the FIFO or the LIFO method will be the same. When price levels change, the
use of these different methods can yield significantly different financial results. One of
the primary aims of LIFO is to obtain a better matching of costs and revenues in times of
inflation. Under the LIFO method, the income statement is given priority over the balance
sheet. This means that while a matching of more current costs with revenues occurs in
times of price inflation (deflation), the inventory carrying amounts in the balance sheet
will be unrealistically low (high). Note that use of the LIFO method is encouraged by its
acceptance for tax purposes. The tax law stipulates that its use for tax purposes makes
mandatory its adoption for financial reporting.

8. In most annual reports, insufficient information is given to allow the analyst to convert
inventories accounted for under one method to a figure reflecting a different method of
inventory accounting. Most analysts want such information to better compare the
financial statements of companies that use different inventory accounting methods.
Converting an inventory figure from one method to another is made even more difficult
by the use of different methods for various components of inventory. Still, analysts must,
in most cases, make an overall assessment of the impact of different inventory methods
on the comparability of inventory figures. Such an assessment should be based on a
thorough understanding of the inventory methods in use and the effect they are likely to
have on inventory values. The differences that arise between informed approximations
and exact figures using additional data generally are not materially different.

To be most useful, disclosures of inventory methods must give, in addition to methods

used, an identification of the inventory components (in amounts) where such methods
are used. More important, disclosure of the dollar difference between the method in use
and the method most prevalent in the industry would be very useful.

10. LIFO tends to yield lower reported earnings when prices rise as compared to FIFO.
The following illustration highlights these effects:

Period Units in Inventory Cost per Unit Total Cost

Period 1……………… 5 $5 $25

Period 2……………… 5 10 50

Period 3……………… 5 15 75
 Under LIFO, if 10 units are sold, then cost of goods sold is $125, computed as (5 x $15)
+ (5 x $10). Also, the LIFO inventory value is $25, computed as 5 x $5. If units are sold
for $20, then gross profit is $75, computed as (10 x $20) - $125. Under FIFO, if 10
units are sold, then cost of goods sold is $75, computed as (5 x $5) + (5 x $10). Gross
profit would be $125, computed as $200 - $75. Inventory would be valued at $75,
computed as 5 x $15—inflating the balance sheet. This shows that FIFO tends to
increase income and taxes in inflationary periods.

12. The observation is correct in pointing out that an analyst must subject the data
regarding an entity's depreciation policies to critical analysis and scrutiny. The
company can choose among several acceptable but vastly different depreciation
methods. The reasons a particular choice(s) is made by the company and the effect
on reported depreciation expense and accumulated depreciation should be assessed.

15. One of the more common solutions applied by analysts to the analysis of goodwill
is to simply ignore it. That is, they ignore the asset shown on the balance sheet. As for
the income statement, under current accounting standards, goodwill is no longer
amortized, but is subjected to an impairment test annually and written down if
required. Often, however, the write-down expense is treated with skepticism and is
frequently ignored. By ignoring goodwill, analysts ignore investments of very
substantial resources in what may often be a company's most important and valuable
asset. Ignoring the impact of goodwill on reported income is no solution to the
analysis of this complex item. Even considering the limited information available, an
analyst is better off evaluating the accounting numbers for goodwill rather than
dismissing them altogether.

Goodwill is measured by the excess of cost over the fair market value of tangible
net assets acquired in a transaction accounted for as a purchase. It is the excess of the
purchase price over the fair value of all the tangible assets acquired, arrived at by
carefully ascertaining the value of such assets—at least in theory. The analyst must be
alert to the makeup and the method of valuation of Goodwill as well as to the
method of its ultimate disposition. One way of disposing of the Goodwill account,
frequently preferred by management, is to write it off at a time when it would have
the least impact on the market's assessment of the company's performance. (for
example, in a period of losses or reduced earnings).

Exercises

4;a. (i) The average cost method is based on the assumption that the average
costs of the goods in the beginning inventory and the goods purchased during the
period should be used for both the inventory and the cost of goods sold computation.
(ii) The FIFO (first-in, first-out) method is based on the assumption that the first goods
purchased are the first sold. As a result, inventory is reported at the most recent
purchase prices, while cost of goods sold is at older purchase prices. (iii) The LIFO
(last-in, first-out) method is based on the assumption that the latest goods purchased
 are the first sold. As a result, the inventory is at the oldest (less recent) purchase
prices, while cost of goods sold is at more recent purchase prices.

b. In an inflationary economy, LIFO provides a better matching of current costs with

current revenue on the income statement because cost of goods sold is at more
recent purchase prices. Also, net cash inflow is generally increased because taxable
income is generally decreased, resulting in payment of lower income taxes.

c. Where there is evidence that the value of inventory to be disposed of in the ordinary
course of business will be less than cost, the difference should be recognized as a loss
in the current period. This is done by restating inventory to its market value in the
financial statements. The concept of conservatism, yielding inventory reported at the
lower of cost or market, is the primary justification of this approach.

Exercise 4-4
a. The inventory asset is more meaningful for analysis purposes when calculated using
the FIFO cost flow assumption. This is because the costs assigned to units remaining
in ending inventory are the more recent costs.
b. Cost of goods sold is usually more meaningful for analysis purposes when calculated
using the LIFO cost flow assumption. This is because the costs assigned to units sold
are the costs from the more recently purchased units.
c. When a company uses LIFO, the costs assigned to units in ending inventory are the
costs from older (less recent) units. As a result, analysts would prefer to calculate
what ending inventory would have been had FIFO been used. This can be
accomplished by adding the LIFO reserve value to the LIFO ending inventory value.

Exercise 4-7

Examples of potentially unrecorded assets on balance sheets include:

 Excess of replacement values over costs for plant assets.
 LIFO inventory reserve.
 Excess of market value over adjusted cost of equity in nonconsolidated subsidiaries
and in affiliates.
 Intangibles--recognized firm name, product name, or brand name not capitalized.
 Successful R&D such as a new drug that has passed all but final FDA clearance.
 Proved reserves of extractive-type companies carried at substantially less than
market value of the product less extraction costs.
 Human (intellectual) capital.
 Value of savings on short-term credit lines where maximum interest payable is
currently below bank prime rate.

The analyst must remember that book values are only the starting point for
accounting-based valuation. If unrecorded assets have economic value, they will
eventually be recognized through higher future abnormal earnings (residual income).
This means the analyst must consider the impact of unrecorded assets when
projecting future profitability for valuation purposes.
 Exercise 4-9

a. 1. Average total life span of plant and equipment:

2006

$5549a = 16.87 years

$329b

2. Average age of plant and equipment:

2006

$2999 = 9.12 years

$329a

3. Average remaining life of plant equipment:

2005

$2550 = 7.76 years

$329b

b. Generally, these ratios can be used to assess a company's depreciation policies both
over time (temporal) and for comparative purposes with other companies in the
same industry. An analyst must take care whenever comparisons are made between
companies. There often are economic reasons for different depreciation methods and
assumptions, which can be obscured in a simple restatement of results. For example,
Colgate uses straight-line depreciation for plant and equipment; another company
may use an accelerated method such as double-declining-balance. The selection of
different methods may reflect fundamental differences in management philosophy
and action toward capital financing and maintenance. Also, with capital intensive
companies, profit margins may not reflect the higher costs that may be expended to
replace existing plant assets.
Problem 4-3

a. Ending Inventory Adjusted from LIFO to FIFO:

At Jan. 29, 1999: = LIFO Inventory + LIFO Reserve

= $219,686 + $26,900

= $246,586

At Jan. 30, 1998: = LIFO Inventory + LIFO Reserve

= $241,154 + $25,100

= $266,254
b. Net Income as Adjusted from LIFO to FIFO:

Year ended Jan. 29, 1999: = LIFO Income + After-Tax Change in LIFO Reserve
= $31,185 + [ ($26,900 – $25,100) x (1 - .37) ]

= $32,319

c. The primary analysis objective when making a LIFO to FIFO restatement is to (1)
achieve better comparability between firms using different inventory methods, and
(2) obtain better measures, using more recent costs, of the value of inventory on the
balance sheet.