CHAPTER 12 FINANCIAL STATEMENT ANALYSIS PROBLEM SOLUTIONS

Assessing Your Recall

12.1 A retrospective analysis is one in which historical data are used to analyze the performance and liquidity of a company. A prospective analysis is one in which data are used to forecast the future (performance and liquidity) of a company. A time-series analysis is one in which financial statement data for a single company is analyzed across time. A cross-sectional analysis is one in which financial statement data from several companies are compared. The companies may be from the same industry or they may be from various sectors of the economy. Another version of the cross-sectional analysis would be to compare the company with industry average statistics. The cross-sectional analysis could also be conducted over time for a combined time-series, cross-sectional analysis. So time-series analyses are useful to study the trends of a company over time while cross-sectional analyses are used to compare one company to others. The three major types of data that can be used in a time-series or a cross-sectional analysis are: Raw Data The raw financial statement data can be used, such as sales revenues, expenses, etc. Common Size Data common size data are obtained by comparing the raw data components to some common denominator. For instance, a common size income statement could be calculated by comparing each line item with the sales revenue for the period. On the balance sheet the common denominator is usually the total assets. Ratio Data. Ratios that compare various components of the raw financial statement data can be used as the inputs for these types of analyses. 12.4 The formula for each ratio is as follows: a) ROA ROA = Net Income + Interest Expense * (1 Tax Rate) Average Total Assets Net Income + Interest Expense * (1 Tax Rate) Sales Revenue x Sales Revenue Average Total Assets

12.2

12.3

Profit Margin Ratio x Total Asset Turnover

b) ROE

ROE =

Net Income Preferred Dividends Average Shareholders Equity

c) Accounts Receivable Turnover

Accounts Receivable Turnover

d) Inventory Turnover

Sales On Account Average Accounts Receivable

Inventory Turnover

Cost of Goods Sold Average Inventory

e) Accounts Payable Turnover

Accounts Payable Turnover

f) Current Ratio

Cost of Goods Sold Average Accounts Payable

Current Ratio

Current Assets Current Liabilities

g) Quick Ratio

Quick Ratio

Current Assets Inventories Current Liabilities

h) D/E (I)

D/E (I)

Total Liabilities Total Liabilities + Shareholders Equity Total Liabilities Total Assets

or

i)

D/E (II)

D/E(II)

Total Liabilities Total Shareholders Equity

j) D/E (III)

D/E(III)

Total Long-term Liabilities Total Long-term Liabilities and Shareholders Equity

k) Times Interest Earned

Times Interest Earned (TIE) =

Income before Interest and Taxes Interest Expense Net Income + Taxes + Interest Expense Interest Expense

12.5

The amount of cash produced from operations depends upon several factors. Three of those factors are the accounts receivable, inventory, and accounts payable policies. The leads and lags between the cash outflows for production and the cash inflows from collections on sales are important in understanding the companys cash generating capabilities. The turnover ratios, when converted into the number of days form, provide some insight into how long these lags are for a company. Changes in these ratios also provide information about whether there have been significant changes in these policies or in enforcing these policies. The accounts receivable turnover, for instance, tells you how long, on average, it takes to collect an account receivable. Comparing this ratio with a companys stated receivables policy allows you to assess whether or not they are doing a good job of collecting.

The shareholders of the company leverage their investment when they borrow some of the money needed to invest in the assets of the company. This works to the advantage of the shareholders if the cost to borrow the money is less than the return that they can earn by investing in the assets of the company. It works to their disadvantage if the cost to borrow exceeds the return on the assets invested. ROA provides a measure of the return on the assets of the company. As long as this return is higher than the after tax cost of the debt the shareholders return (ROE) should be higher than the ROA. This higher return will be evidenced by a higher ROE for the company (higher than ROA). If the after tax, cost of borrowing exceeds the ROA then ROE will be lower than ROA. 12.6 The ROA ratio can be broken down into two ratios: a profit margin ratio and a total asset turnover ratio. The ratios are as follows:

ROA

= Net Income + Interest Expense * (1 Tax Rate) Average Total Assets = Net Income + Interest Expense * (1 Tax Rate) Sales Revenue x Sales Revenue Average Total Assets

Profit Margin Ratio x Total Asset Turnover

A retail clothing store could employ two different strategies of obtaining a particular ROA. One strategy would be to set prices to achieve a relatively high profit margin. Because of the high prices the total asset turnover might not be as high as it would otherwise be because the company may have to invest more in its stores to attract the kind of clientele that will pay the high prices. The volume of sales per dollar of investment (total asset turnover) may, therefore, be lower. Another store in the same industry may adopt a different strategy in which it charges lower prices (lower profit margin ratio) but make up for it by not investing as much in its stores and, hopefully, makes up for the lower profit margin with a higher volume per dollar of investment. 12.7 The advantage of common size statements are that they make it easy to make proportionate comparisons that are not as easy using the raw data. For instance, in a given year both the revenues and the cost of goods sold may increase, as evidenced by the raw data. If, however, the cost of goods sold increases faster than the revenues the profit margin of the company will decline. This decline could easily be seen in a common size set of statements.

12.8

The current ratio is subject to manipulation because at year-end the company can adjust its spending and payment patterns to produce a current ratio that is desired. Paying off accounts payable with cash at year-end will improve the current ratio, for instance, but may not be a sign of improved liquidity. The accounts payable turnover ratio is ideally calculated as follows:

12.9

Accounts Payable Turnover

Credit Purchases Average Accounts Payable

The problem with this calculation is that credit purchases is not a readily available number. As a surrogate for credit purchases the cost of goods sold number is often used. How good a surrogate this is depends on the type of company and its credit policies. In a retail company the cost of goods sold number will be a good surrogate for the credit purchases if most goods are bought on credit and there is relatively little change in the balance of accounts payable from the beginning of the period to the end. If not all goods are purchased on credit this surrogate will tend to overstate the turnover. There is a further problem with this ratio in a manufacturing company. In this case, the cost of goods sold number includes many costs other than those associated with purchases during the period. For example salaries, amortization, etc. Therefore, in a manufacturing company this ratio tends to be overstated. 12.11 The earnings per share of a company is calculated by dividing the earnings of the company by the average number of shares that were outstanding during the period. In some companies there exists the possibility that more shares may be issued (other than those currently outstanding) due to agreements such as stock option plans and convertible securities (securities such as convertible debt or convertible preferred shares) that can, at the option of the holder, be converted into common shares. Because of the potential to issue more shares the calculated earnings per share based on the actual number of shares outstanding may not truly reflect the earnings per share of the company since it may be likely that some investors will exercise their options or convert their debt or preferred shares into common shares. This will have the effect of diluting earnings per share. The purpose of basic and fully diluted earnings per share is to give the reader of the financial statement some idea of the effect that these conversions might have on the earnings per share number. Basic earnings per share is a reflection of the current earnings and fully diluted earnings per share is a reflection of the worst case scenario assuming outstanding issuances or conversions occurred.

12.12

The lower the times interest earned ratio, the greater is the credit risk of the company. This relationship exists because a company that is experiencing difficulties meeting its interest payments on existing debt has a greater potential to default on an additional loan. From the perspective of lenders, this greater default risk translates into a higher assessed credit risk.

Applying Your Knowledge

12.13 a) Year 1: Year 2: Year 3 Year 4 Current Ratio $1,500 / $1,000 = 1.5 $2,000 / $1,250 = 1.6 $2,500 - $1,485 = 1.7 $3,000 / $1,500 = 2.0 Quick Ratio ($1,500 - $600) / $1,000 = 0.9 ($2,000 - $1,100) / $1,250 = 0.7 ($2,500 - $1,700) / $1,485 = 0.5 ($3,000 - $2,200) / $1,500 = 0.5

b) The current ratio has shown an increasing trend over the four years and can be considered respectable as seen in year 4. However, this 4 year upward trend has been at the cost of stocking more inventory and this has resulted in a downward trend in the quick ratio, which has become 0.5 in Year 4. 12.14 a) Current Ratio 20x1 20x2 b) Quick Ratio 20x1 20x2 ($62,595 + $96,242) / $239,789 = 0.7 ($67,834 + $98,666) / $160,345 = 1.0 $300,991 / $239,789 = 1.3 $310,739 / $160,345 = 1.9

c) Sundry incurred a net loss in 20x2 because the balance in retained earnings decreased, although no dividends were declared. The amount of the net loss is equal to the change in retained earnings from the prior year, or $1,461. d) Debt / equity 20x1 20x2 $532,764 / $866,036 = 62% $549,130 / $885,194 = 62%

e) Declaring a dividend is possible because the company has a reasonable cash balance, and is in a comfortable position regarding short-term liquidity. This can be seen from the current and quick ratios. The debt to equity ratio is unchanged from the prior year, and indicates that 62% of the companys assets are financed through debt. However, because long-term debt increased in 20x2, interest payments can be expected to rise in the future.

In addition, since the company incurred a net loss for the year, declaring a dividend is not recommended. 12.15 a) Accounts receivable Turnover Campton Electric: $3,893,567 / [($542,380 + $628,132) / 2 ] = 6.65 Johnson Electrical: $1,382,683 / [($168,553 + $143,212) / 2] = 8.87 b) Average number of days required to collect Accounts Receivable: Campton: 365 / 6.65 = 55 days Johnson: 365 / 8.87 = 41 days c) Given that these companies are in the same industry, Johnson would appear to be more efficient in collecting its accounts receivable. d) In order to assess managements handling of the collection of accounts receivable, it would be helpful to know the credit terms that each company offers to its customers. This could then be compared against the turnover in days to determine whether the credit terms are being enforced. 12.16 a) Accounts receivable Turnover 20x0: $3,218,449 / $350,672 = 9.18 20x1: $3,585,391 / [($350,672 + $362,488) / 2] = 10.05 20x2: $3,988,432 / [($362,488 + $358,562) / 2] = 11.06 b) Average number of days required to collect Accounts Receivable: 20x0: 365 / 9.18 = 40 days 20x1: 365 / 10.05 = 36 days 20x2: 365 / 11.06 = 33 days c) Accounts receivable turnover is increasing each year, and collection seems to be occurring faster. To help understand these trends, information regarding changes in credit terms, the sales mix, or the types of customers would be helpful.

12.17

a) Year 1: Year 2: Year 3 Year 4: Year 5: Inventory Turnover $463,827 / $65,537 = 7.08 $511,125 / $81,560 = 6.27 $593,350 / $110,338 = 5.38 $679,686 / $166,672 = 4.08 $708,670 / $225,895 = 3.14 Number of days 365 / 7.08 = 52 days 365 / 6.27 = 58 days 365 / 5.38 = 68 days 365 / 4.08 = 89 days 365 / 3.14 = 116 days

b) The inventory Turnover has decreased over the 5 year period suggesting a periodic increase in the time that the inventory is held. This is not favorable. It is possible that this change could be due to a change in the type of inventory that is being sold by the company and, therefore, might not indicate a major problem. Information on such changes is needed in order to comment on the management of inventories. 12.18 a) Inventory turnover: Green Grocers: $8,554,921 / [($582,633 + $547,925) / 2] = 15.13 Fast Lane Foods: $2,769,335 / [($174,725 + $195,446) / 2] = 14.96 b) Average number of days inventory is held: Green Grocers: 365 / 15.13 = 24 days Fast Lane Foods: 365 / 14.96 = 24 days c) The inventory turnover for a food store should be high because food is perishable, and must be turned over frequently so that spoilage does not occur. Therefore, considering that inventory for these companies is held for less than one month, this appears to be reasonable. Both companies appear to be managing their inventory to more or less the same degree, although Green Grocers has a slightly higher turnover. d) Fast inventory turnovers could be an indication that not enough inventory is being held. Because inventory is held in order to support the sales function, potential sales can be lost or shortages might result in the loss of current customers if not enough inventory is maintained.

12.19

a) Current liabilities are $664,892, using the current ratio to compute the amount:
Current ratio = Current assets / Current liabilities Current ratio x Current liabilities = Current assets Current liabilities = Current assets / Current ratio Current liabilities = $1,462,763 / 2.20 = $664,892 b) Total debt is $2,073,399, using the debt to equity ratio (I) to compute the amount: Debt to equity ratio (I) = Total debt / Total assets Total debt = Debt to equity ratio (I) x Total assets Total debt = .58 x $3,574,825 = $2,073,399 c) Total equity is, $1,501,426 using total assets minus total liabilities ($3,574,825 $2,073,399). d) The company has a quick ratio of only 0.89 compared to a current ratio of 2.20. This indicates that the company has a significant amount of inventory or prepaid assets as a current asset on its balance sheet. Financial institutions tend to have larger balances in cash and near cash items, which would tend to result in a higher quick ratio and normally do not carry large balances of inventory. This would appear to rule out classifying the company as a financial institution. It also appears that the company is not a service organization. Service organizations normally do not have large amounts invested in noncurrent assets. Since only $497,645 of the $1,431,123 increase in total assets is attributable to an increase in current assets, $933,478 has been added to noncurrent assets during the year. Because of the increase in noncurrent assets and the large inventory balance, it appears the company is a merchandising or manufacturing company. e) Net income for the year was $247,530 (1,650,200 shares x $0.15 earnings per share). f) The companys liquidity is largely dependent upon the nature of the inventory it holds, and the speed at which this inventory can be sold, and the cash collected. If the inventory is liquid, then the current ratio of 2.20 indicates that the company is in good shape for the short-term. If the inventory is not liquid, then the quick ratio of 0.89 suggests that cash might not be present to extinguish the current liabilities as these fall due. The overall financial position of the company appears to be deteriorating. The quick ratio and earnings per share have declined. The amount of debt relative to assets and equity has increased, indicating a larger proportion of debt financing which increases the riskiness of the company. A more thorough analysis would be necessary to determine if the company is in serious financial trouble. g) Significant changes from Year 1 to Year 2 include the discrepancy between the current and quick ratios, the use of debt to finance total assets, the increase in noncurrent assets, and the decline in earnings per share. The quick ratio declined although the current ratio increased. This indicates that the company has increased its investment in inventory or prepaids, also apparent from the large increase in current assets. The companys use of debt has also increased in Year 2 such that debt is being relied upon to a greater extent than equity, which is not the case in Year 1. This is the result of increased debt financing, and possible share redemptions. Noncurrent assets also increased, and were likely financed through the issuance of additional debt. Finally, earnings per share decreased. While the gross margin on sales did not change significantly, the increased debt burden undoubtedly had a major impact, resulting in a reduction in net income and earnings per share.

12.20 a) Return on Shareholders Equity:

Year 1: Year 2: Year 3: Year 4:

ROE $200 / $6,278 = 3.2% $503 / $9,614 = 5.2% $1,105 / $13,619 = 8.1% $2,913 / $24,729 = 11.8%

b) Return on assets: Profit Margin Ratio [$200 + $50(0.6)] / $15,472 = 1.5% [$503 + $55(0.6)] / $19,558 = 2.7% [$1,105 + $96(0.6)] / $21,729 = 5.4% [$2,913 + $89(0.7)] / $28,493 = 10.4% Total Asset Turnover $15,472 /$19,745 = .78 $19,558 / $25,227 = .77 $21,729/ $33,146 = .66 $28,493 / $67,185 = .42 ROA 1.17% 2.08% 3.56% 4.37%

Year 1: Year 2: Year 3: Year 4:

c) ROA and ROE have been positive and increasing over the four year period. This would indicate improved performance over time. The actual performance depends upon what other companies in the same industry have been able to do in the same time period. The improvement has come from improved profit margins for the four years, although the asset turnover has been declining over the same period. The company has effectively applied leverage since the ROE exceeds the ROA in all four years.

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12.21 a) Return on Shareholders Equity: Year 1: Year 2: Year 3: ROE $1,533 / $24,664 = 6.2% $3,830 / $32,415 = 11.8% $6,755 / $51,415 = 13.1%

b) Return on assets: Year 1: Year 2: Year 3: Profit Margin Ratio [$1,533 + $896(0.75)] / $42,798 = 5.2% [$3,830 + $1,441(0.7)] / $54,061 = 9.0% [$6,755 + $2,112(0.7)] / $76,023 = 10.8% Total Asset Turnover $42,798 / $48,744 = 0.88 $54,061 / $65,258 = 0.83 $76,023 / $98,654 = 0.77 ROA 4.6% 7.5% 8.3%

c) ROA and ROE have been positive and increasing over the three year period. This would indicate improved performance over time. The actual performance depends upon what other companies in the same industry have been able to do in the same time period. The improvement has come from improved profit margins as evidenced from the change in the profit margin ratio and the slightly declining asset turnover. The company is also effectively applying leverage since the ROE exceeds the ROA.

ROE Net Income 400,000 $600,000 x NI $600,000 x NI $200,000 x NI Net income

= = = = = =

ROA NI + [($200,000 x 0.08) x 0.7] $600,000 $400,000 x [NI + $11,200] $400,000 x NI + $4,480,000 $4,480,000 $22,400

b) ROE = $22,400 / $400,000 = 5.6% c) After tax income = $22,400 Before tax income ($22,400 / 0.7) Interest = $200,000 x 8% Income before interest and taxes d) ROA 0.056 = Net income ROE = = = = $32,000 16,000 $48,000

NI + [Interest expense x (1 - tax rate)] Average total assets

NI + [($300,000 x 0.06) x 0.7] $600,000 = $21,000 $21,000 / $300,000 = 7.0%

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e) Under the original assumptions, the ROA is 5.6%. In the second set of assumptions the company can borrow at an after-tax interest cost of 4.2% (6% x 0.7). Because the company is borrowing at a cost of 4.2% to invest in assets that generate a return of 5.6%, the ROE climbed to 7.0%.

12.23a) Year 1: Year 2: Year 3: D/E (I) $1,025 / $2,225 = 46% $1,525 / $3,325= 46% $2,150 / $4,350 = 49% Times Interest Earned $500 / $80 = 6.3 $800 / $100 = 8.0 $1,000 / $135 = 7.4 D/E (II) $1,025 / $1,200 = 85% $1,525 / $1,800 = 85% $2,150 / $2,200 = 98% D/E(III) $600 / $1,800 = 33% $1,000 / $2,800 = 36% $1,400 / $3,600 = 39%

Year 1: Year 2: Year 3:

b) The company seems to be in a fairly comfortable position with regard to its long-term debt/equity ratio (D/E III), which is increasing slightly over the years, but not at a significant rate. There would be some concern if this trend continues and if it accelerates. The times interest earned ratio also indicates that the company is earning a sufficient amount of income to meet its interest obligations. There is no trend in either direction with the TIE ratio.

12.24 a) D/E (I) $1,090 / $2,590 = 42% $1,530 / $3,030 = 51% $1,720 / $3,520 = 49% D/E (II) $1,090 / $1,500 = 73% $1,530 / $1,500 = 102% $1,720 / $1,800 = 96% D/E(III) $700 / $2,200 = 32% $1,100 / $2,600 = 42% $1,200 / $3,000 = 40%

Year 1: Year 2: Year 3:

Year 1: Year 2: Year 3:

Times Interest Earned $1,000 / $120 = 8.3 $1,300 / $150 = 8.7 $1,600 / $165 = 9.7

b) The company seems to be in a fairly comfortable position with regard to its long-term debt/equity ratio (D/E III), which has increased 10% in Year 2 and then decreased slightly. There would be concern if the ratio continued to increase in future years as the rate that it did in Year 2. The times interest earned ratio also indicates that the company is earning a sufficient amount of income to meet its interest obligations. Since Year 1, the TIE has increased to 9.7 in Year 3, the company can quite comfortably pay the interest out of earnings.

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12.25Key:

Decrease Increase No Effect

+ NE Quick Ratio + * + + + Inventory Turnover + NE NE NE NE + ROE NE + NE NE + D/E(I) + + +

Transaction 1 2 3 4 5 6 7

Current Ratio * + * + + -

* The ratio will be affected, but the direction of the effect cannot be determined from the information given. Since the same amount will be added or subtracted from the numerator as well as the denominator; the change in the ratio will depend on what the ratio was to begin with.

12.26 Transaction 1 2 3 4 5 6 7 Current Ratio + NE * + NE + ROA + NE NE AR Turnover + NE NE NE NE NE ROE + NE NE NE NE D/E (I) NE + + + NE -

*The ratio will be affected but the direction of the effect cannot be determined from the information given. Since the same amount will be added or subtracted from the numerator as well as the denominator, the change in the ratio will depend on what the ratio was to begin with.

12.27 a) The amount that should be reported as basic earnings per share for the year is Calculation of earnings per share: Net income Less preferred share dividends [100,000 x $1.00] Earnings available to common Number of common shares Earnings per share $720,000 (100,000) $ 620,000 900,000 $0.69

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b) The convertibility of the preferred shares has relevance for reporting earnings per share because the preferred shares might be converted to common shares. This means that the companys net income might have to be spread over more common shares. This possible effect is called dilution of earnings per share. If all of the preferred shares converted, net income would not need to be reduced by the preferred dividends and the number of common shares would increase by 200,000. The fully diluted earnings per share would be $0.65 ($720,000/1,100,000).

12.28 a) Net income for 2000 = $0.46 per share x 28,500 shares = $13,110 b) Earnings per share for 2001 = $14,800 / 28,500 = $0.52 per share
c) Earnings per share figures are usually included in the annual report on the face of the income statement for each year reported. They are usually reported just below net income. They could also be reported in the notes to the financial statements although very few companies will report earnings per share in this manner. d) If Signal decides to split its common shares 2 for 1, then the earnings per share must also be split in 2, because the same net income must be spread out over twice as many shares. The 2000 earnings per share amount is also affected, because the comparative income statement must present both earnings per share figures as though the split had occurred in 2000. This retroactive treatment is provided so that comparability is maintained.

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12.29a) Working capital = ($218,000 + $320,000 + $32,000) - $165,000 = $405,000

The working capital is quite high, and indicates that there are more than enough current assets to satisfy current liabilities. In addition, since the company maintains a reasonably high cash balance of $218,000, cash required to finance operations is not a concern.

b) Current ratio = $570,000 / $165,000 = 3.5 Quick ratio = ($218,000) / $165,000 = 1.3
The quick ratio assumes that the other assets are prepaid assets. Both the current ratio and the quick ratio exceed the criteria of 2.0 and 0.8 respectively. Based on these ratios, the companys current asset position is strong, and short-term liquidity is not a concern. In fact, these ratios suggest that perhaps the companys investment in current assets is more than what is required in order to support the sales function and finance operations. c) A change from cash to credit sales would not affect the current ratio or quick ratio if previous cash sale customers now purchased on account. The cash balance would decrease, and a receivable balance would be created. In reality, if the company starts to sell on credit, its total sales are likely to increase as it attracts new customers who would not buy before because of the cash only policy. This would cause both the current ratio and the quick ratio to increase. The company will now have to manage collection of its receivables, and establish credit terms for its customers. The accounts receivable turnover ratio, which indicates how quickly accounts receivable are collected, will now be affected. d) If these balances existed following the completion of the primary business, then most of the current assets held would be unnecessary, and reflect poor cash and inventory management. Cash and inventory are short-term investments that a company must make in order to facilitate sales to customers. If sales are decreasing, then the company should decrease its current assets.

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12.30a) Ratios for A-Tec and B-Sci:

A-Tech 2001 1.16 $11 31.7 times 16.6 times 2.4 times 86.9% 13.1% 30% 10% 24.5% 186.3% 2000 .95 ($2) 45 times 22.5 times 3.2 times 81.7% 18.3% 33% 11.9% 38.5% 210.5% Bi-Sci 2001 2.25 $30 30 times 15 times 3.6 times 14.2% 85.8% 25% 10% 35.5% 41.4$ 2001 78/67 78-67 950/30 665/40 950/388 337/388 51/388 (950-665) /950 95/950 95/388 95/51 2001 54/24 54-24 600/20 450/30 600/169 24/169 145/169 (600-450) /600 60/600 60/169 60/145 2000 2.17 $28 30 times 15 times 3.8 times 15.4% 84.6% 25% 10% 38.5% 45.5% 2000 38/40 38-40 675/15 450/20 675/208 170/208 38/208 (675-450) /675 80/675 80/208 80/38 2000 52/24 52-24 600/20 450/30 600/156 24/156 132/156 (600-450) /600 60/600 60/156 60/132

(1) (2) (3) (4) (5) (6)

Current ratios Working capital Rec. turnover Inv. Turnover Asset turnover Total debt to total assets (7) Sh. Equity to total assets (8) Gross margin ratio (9) Return on sales (10) Return on assets (11) Return on equity Supporting calculations:

A-Tech: (1) Current ratio (current assets/current liabilities) (2) Working capital (current assets current Liabilities) (3) Acc. receivables turnover (sales-net acc. rec.) (4) Inventory turnover (cost of goods sold/inv.) (5) Asset turnover (sales/total assets) (6) Total debt to total assets (total liab./total assets) (7) Sh. equity to total assets (Sh. equity/total assets) (8) Gross margin ratio [(sales cost of goods sold) /sales] (9) Return on sales (net income/sales) (10) Return on assets (net income/total assets) (11) Return on equity (net income/Sh. Equity) Bi-Sci: (1) Current ratio (current assets/current liabilities) (3) Working capital (current assets current Liabilities) (3) Acc. receivables turnover (sales-net acc. rec.) (4) Inventory turnover (cost of goods sold/inv.) (5) Asset turnover (sales/total assets) (6) Total debt to total assets (total liab./total assets) (7) Sh. equity to total assets (Sh. equity/total assets) (8) Gross margin ratio [(sales cost of goods sold) /sales] (9) Return on sales (net income/sales) (10) Return on assets (net income/total assets) (11) Return on equity (net income/Sh. Equity)

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b) The following analysis is separated into liquidity, solvency, leverage and profitability analysis. Liquidity: Bi-Sci appears to be in a better liquidity position. Its current ratio is much higher than A-Techs and its working capital is also higher. A-Tecs current ratio and working capital have improved but they are still lower. The accounts receivable turnover and inventory turnover also measure liquidity because they measure the amount of time before these items will be converted to cash in the operating cycle. Both of these ratios remained constant for Bi-Sci in 2001. A-Tecs ratios declined in 2001 and are now closer to Bi-Scis. It may be that A-Tecs ratios in 2000 were unusually high and are now closer to those of other companies. Solvency: Bi-Sci is in a much better solvency position as measured by the total debt to total assets and total shareholders equity to total assets ratios. Bi-Sci is financed mostly by shares while A-Tec is financed mostly by borrowing. Leverage: A-Tec is using much more leverage than Bi-Sci. Since A-Tec is financed mostly by debt, its return on equity (net income/shareholders equity) will be much higher when the rate of earnings exceeds the interest rate on the debt. Leverage is best measured by comparing the return on assets to the return on equity. With high leverage, and a return on assets in excess of interest rates, the return on equity for a company like A-Tec will be very high. The returns of the two companies are computed as follows: A-Tech 2001 2000 24.5% 38.5% 186.3% 210.5% Bi-Sci 2001 35.5% 41.4% 2000 38.5% 45.5%

Return on assets Return on equity

Profitability: The companies are very similar in profitability measures. The return on sales is about the same both years for both companies. While the return on assets is the same in 2000, Bi-Sci is a little better in 2001. However, A-Tec increased its sales by 40% in 2001 to go along with the expansion in assets and Bi-Sci had no growth in 2001. Determining which company is the better investment for a shareholder depends on the amount of risk the shareholder is willing to absorb. The return on equity for A-Tec is very high. As long as the return on assets stays high, there will be a good return to shareholders. An important question is will the growth in sales continue. On the other hand, the high leverage makes A-Tec much more risky for shareholders. Bi-Sci appears to be a much better credit risk from a lenders standpoint. It has a much better liquidity and solvency position, less leverage, and less risk that debts will not be paid.

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Management Perspective Problems

12.31 The debtholder is very interested in the ability of the company to pay off its debts. The debt/equity ratios measure the extent to which the company utilizes debt to finance its operations. The more debt it incurs the higher the risk of default on a particular loan. The debtholder would be interested in restricting the level of debt in the company to limit the risk of default. The current ratio measures short-term liquidity and is a measure of the companys ability to pay its debts in the short-term. The debtholder would be very interested in assuring that this ratio is maintained at some minimum level to insure that payments are made on a timely basis. Perhaps the easiest way to influence the ratio is to try to increase net income. A change in the revenue recognition method to recognize revenue earlier in the companys cash to cash cycle could have this impact. Accelerating the recognition of revenue under existing methods could also cause an increase in net income. Companies might speed up shipments of goods, for instance, if revenues are recognized at the time of shipment. Management could also decide to delay the acquisition of new capital assets. When new assets replace old ones, total assets usually increases which lowers the ROA. From the perspective of a potential investor, the following four ratios might be helpful: a) ROE: This ratio indicates the rate of return that the company is earning for its common shareholders. Potential investors should compare the ROE for the company to the rate of return that could be earned on a similar risk investment in another company. b) Current ratio: This ratio tells potential investors whether the company is likely to experience financial difficulties in the short-term. c) Debt to equity (I): This ratio reflects the extent of debt in the companys capital structure. Debt use imposes additional risk on shareholders, because the company is contractually committed to making fixed interest and principal repayments at definite points in the future. Such commitments assume that the company is able to generate sufficient cash from operations. In addition, as a potential investor, a large amount of debt means that assets of the company must first be distributed to debtholders, creating the potential that no assets remain to satisfy the claims of shareholders. On the other hand, the use of debt can result in increased returns to shareholders through the use of leverage. d) Price earnings ratio: This ratio indicates the market price of a share per one dollar of earnings that the company generates. For a potential investor, a high price-earnings ratio means that the market price is based on future predicted earnings, rather than on current earnings. Thus, the greater the price-earnings ratio, the higher earnings must be in the future in order to justify the current market price.

12.32

12.33

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12.34

From the perspective of an auditor, the following ratios might be helpful in identifying abnormalities: a) ROA: This ratio reflects the rate of return that a company earns on all assets. If this ratio is significantly different from that of other companies in the same industry, abnormalities or fraud might exist. This ratio should be examined through its component parts - the profit margin ratio and the asset turnover. b) Accounts receivable turnover: This ratio indicates the speed at which receivables are collected. If the company has created fictitious sales, then turnover would be much lower than expected, because the accounts receivable associated with the fake sales are not collected. This can alert the auditor to fraud. c) Accounts payable turnover: This ratio reflects the speed at which payables are paid. If the company is creating fictitious sales, then this ratio would be much higher than expected, because the cost of goods sold associated with the fake sales does not correspond to a portion of accounts payable. In general, auditors use both time-series analysis and cross-sectional analysis to alert them to irregularities or fraud. Auditors focus on areas where significant changes occurred from the prior year, and on those areas that differ materially from industry averages.

12.35

Being a potential supplier that grants 30 day credit terms, you would be most interested in the ability of the dealership to generate cash in the short-term to satisfy its current liabilities. Thus, ratios that might be helpful include the current ratio, quick ratio, times interest earned ratio, and accounts payable turnover. Ratios that would help the decision maker in arriving at a decision or to identify areas for further analysis include: a) Decrease in net income from: 1. a decrease in sales or an increase in cost of sales: Gross Profit Margin 2. an increase in total operating expenses: Gross Profit Margin and Return on Sales Horizontal and Vertical Analysis 3. an increase in an individual operating expense: Horizontal and Vertical Analysis b) Sufficient cash to pay dividends and make debt payments: Dividends to Cash Flow from Operations Current Ratio Quick Ratio c) Long-term debt higher than the industry as a whole: Debt to Equity Long-term Debt to Assets

12.36

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d) Comparison of profitability in relation to invested capital: Return on Equity e) Whether the decline in economic activity affected accounts receivable collections: Accounts Receivable Turnover f) Whether the company was successful in reducing inventory investment: Inventory Turnover g) Determining which company provides more earnings per share: Earnings Per Share Price/earnings Ratio h) Efficient management of inventory: Inventory turnover

Reading and Interpreting Published Financial Statements 12.37 a) ROA = = X = = = ROE = = = Net income + [Interest expense x (1 - Tax Rate)] Average Total Assets Net income + [Interest expense x (1 - Tax Rate)] Sales Revenue Sales Revenue Average Total Assets {[$10,105 + $27,559(1-0.43)] / $354,125} X {$354,125 / [($616,027 + $500,748) / 2]} 0.0729 x 0.6342 4.6% Net Income - Preferred Dividends Average shareholders equity $10,105 / [($158,173 + $104,664) / 2] 7.7%

Inventory turnover = Cost of goods sold Average inventory = = Accounts receivable = turnover = =
b)

($300,935 x 50%) / [($116,770 + $87,477) / 2] 1.47 Sales Average accounts receivable $354,125 / [($74,812 + $56,292) / 2] 5.4

1. Current ratio

1998 $233,793 / $141,614

1997 $169,107 / $110,710

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2. Quick ratio 3. D/E (I) 4. Times interest earned

= 1.65 ($684 + $74,812) / $141,614 = 0.53 ($616,027 - $158,173)/ $616,027 = 74% $46,162 / $27,559 = 1.68

= 1.53 ($883 + $56,292) / $110,710 = 0.52 ($500,748 - $104,664) / $500,748 = 79% $45,391 / $26,114 = 1.74

c) CHC is using leverage to its benefit, as reflected in the fact that its ROE exceeds its ROA. This means that the after-tax cost of borrowing is less than the return it is able to generate through investing in operating assets. The resulting benefit accrues to shareholders in the form of a higher ROE. d) The pros of investing in CHC include the fact that it is generating cash from operations and net income has increased slightly from 1997. The cons are that it could encounter financial difficulties in the short-term because of its weak quick ratio and low inventory turnover. Combined, these ratios signal that because its inventory turns over less than 1.5 times a year, the quick ratio is a better predictor of short-term liquidity. Also, the debt to equity ratio is high which imposes additional long-term risk upon shareholders. Although the company appears to be currently using leverage to the benefit of shareholders, this could quickly change if its cost of borrowing increases or if it is unable to generate enough of a return in order to meet debt obligations. e) If the Canadian dollar continues to fall relative to other currencies, CHC can maximize profits by paying expenses in Canadian dollars and earnings revenues in foreign currencies. Similarly CHC should hold monetary assets in foreign currencies and owe liabilities in Canadian dollars. Of course, financial institutions in other countries may not want to have debt repaid in Canadian dollars. If CHC could achieve these holdings, it would benefit from the falling Canadian dollar.

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12.38 a) ROA = = X = = =
1

Net income + [Interest expense x (1 - Tax Rate)] Average Total Assets Net income + [Interest expense x (1 - Tax Rate)] Sales Revenue Sales Revenue Average Total Assets $324 + [$21,189 x (1 - .251)] X $1,552,272 $1,552,272 ($783,124 + $734,080)/2 .01 x 2.0462 2% Net Income - Preferred Dividends Average shareholders equity $324 ($228,117 + $230,931)/2 0.14%

Tax rate was calculated from 1997 at 25% ($11,325/$45,315)

ROE

= = =

Inventory turnover = Cost of goods sold Average inventory = = Accounts receivable = turnover =
= b)

$1,423,248 ($237,312 + $182,157)/2 6.79 Sales Average accounts receivable $1,552,272 ($201,218 + $203,196)/2
7.68

1. Current ratio 2. Quick ratio 3. D/E (I) 4. Times interest earned

1998 $536,038 / $383,039 = 1.40 $286,385 / $383,039 = 0.75 $555,007/ $783,124 = 71% $19,298 / $21,189 = 0.91

1997 $510,024 / $309,771 = 1.65 $316,246 / $309,771 = 1.02 $503,149 / $734,080 = 69% $53,464 / $8,149 = 6.56

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c) Western Star Trucks does not appear to be in particularly good financial condition. The company incurred a net loss before taxes, compared to a net income of $33,990 and $36,523 in 1997 and 1996 respectively. The reasons for the sharp decline in income seem to be large selling and administrative expenses and a large interest expense. The times interest earned ratio reflects this increase in interest expense, and earnings before interest and taxes are insufficient to make interest payments in 1998. The quick ratio has also declined in1998, serving as a further indication of possible cash flow problems. This is also confirmed through an examination of the cash flow statement, which reveals a net decrease in cash of $92,027. d) Assuming a tax rate of 25%, the ROA is 2% whereas the ROE is .14%. The fact that the ROE is lower than the ROA is an indication of negative leverage. Western Star Trucks is earning 2% on its assets. Because its cost of borrowing is more than 2%, the ROE is less than 2%. e) If the Canadian dollar were to strengthen relative to the U.S. dollar, the Canadian production with Canadian dollar costs would increase relative to foreign currencies. As it exports much of its products, these products would tend to be priced higher and Western Star could lose markets and sales. These trends would tend to be reduced by the parts purchased outside Canada, and they would cost less in Canadian dollar terms. If the Canadian dollar weakened relative to the U.S. dollar, the exact opposite would occur. The Canadian production costs would be relatively cheaper and sales in foreign currencies would be worth more. These trends would be reduced by the parts purchased outside Canada.

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12.39 a) ROA

= = X = = =

Net income + [Interest expense x (1 - Tax Rate)] Average Total Assets Net income + [Interest expense x (1 - Tax Rate)] Sales Revenue Sales Revenue Average Total Assets $6,754,540 + ($2,112,129 x .72) X $76,022,656 $76,022,656 ($105,654,710 +$71,257,880)/2 0.1089 X 0.8594 9.4% Net Income - Preferred Dividends Average shareholders equity $6,754,540 ($51,414,975 + $32,460,890)/2 16.1%

ROE

= = =

Inventory turnover = Cost of goods sold Average inventory = = Accounts receivable = turnover = =
b)

$34,574,580 ($11,972,472 + $8,466,950)/2 3.38 Sales Average accounts receivable $76,022,656 ($10,298,798 + $10,341,943)/2 7.37 1997 $19,281,998 / $18,131,277 = 1.06 $10,341,943 / $18,131,277 = 0.57 $38,796,990 / $71,257,880 = 54% $6,182,659 / $1,441,847 = 4.29

1. Current ratio 2. Quick ratio 3. D/E (I) 4. Times interest earned

1998 $23,573,581 / $24,774,714 = 0.95 $10,298,798 / $24,774,714 = 0.42 $54,239,735/ $105,654,710 = 51% $11,448,881 / $2,112,129 = 5.42

c) Sleeman Breweries appears to be in very good financial condition. It is making high profits and its net income nearly doubled from 1997 to 1998. Its risk from debt appears to be quite moderate, since it is able to pay its interest expense 5.4 times from before-

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interest operating income in 1998. It is, however, operating without any cash. Instead, it appears to be making use of a line of credit. It is generating a positive cash flow from operations, $6,901,849 but it is spending more than that on acquisitions. Its debt has therefore increased. To decide if we should invest in this company, we would want to know the future prospects of its industry, including new products and competition. d) Sleeman breweries uses leverage well, as its ROE is 16.1% compared to an ROA of 9.4%. This means that the company is able to borrow at a lower rate than it earns through investing in operating assets. The resulting benefit accrues to shareholders in the form of a higher ROE. The companys average interest rate is 3.89% ($2,112,129 / $54,239,735). Since it is able to earn 9.4% on its assets, it is beneficial for the company to include debt in its financial structure.

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e) Big Rock Brewery ROA = Net income + [Interest expense x (1 - Tax Rate)] Average Total Assets = X = = = ROE = = = Net income + [Interest expense x (1 - Tax Rate)] Sales Revenue Sales Revenue Average Total Assets ($556,745) + ($661,640 x .554) X $26,466,241 -0.0072 X 0.8665 -0.62% Net Income - Preferred Dividends Average shareholders equity ($556,745) ($16,447,657 + $17,731,383)/2 -3.3% $26,466,241 ($29,165,835 +$31,919,676)/2

Inventory turnover = Cost of goods sold Average inventory = = Accounts receivable = turnover = = $7,691,231 ($2,050,703 + $2,270,909)/2 3.56 Sales Average accounts receivable $16,644,881 ($1,548,486 + $1,302,336)/2 11.7

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1. Current ratio 2. Quick ratio 3. D/E (I) 4. Times interest earned

1999 $4,115,116 / $2,294,778 = 1.79 $1,630,628 / $2,294,778 = 0.71 $12,718,178/ $29,165,835 = 44% ($123,605) / $661,640 = -0.19

1998 $4,887,382 / $1,972,393 = 2.48 $2,213,275 / $1,972,393 = 1.12 $14,188,293 / $31,919,676 = 44% $1,347,546 / $841,565 = 1.60

Because of the loss suffered by Big Rock in 1999, its ROE and ROA are both negative. On this measure alone, Sleeman Breweries appears to be doing much better. The inventory turnover for the two companies is very similar. Big Rock appears to be more efficient in its collection of accounts receivable with a ratio of 11.7 compared to Sleemans 7.37. Big Rocks short-term liquidity is better at 1.79 and .71 for its current and quick ratios compared to Sleemans at .95 and .42. Both companies carry similar amounts of debt with Big Rock at about 44% and Sleeman just over 50%. Sleemans times interest earned ratio is much healthier than Big Rocks although Big Rock has been trying to remedy this situation by paying down its debt. Its interest expense dropped approximately 25% in the last year. At the time of the financial statements Sleeman Breweries was healthier. It had positive earnings and a good use of leverage. Big Rock, because of its net loss for the year, needs to do some financial rebuilding.

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12.40 a) ROA = = X = = = ROE = = = Net income + [Interest expense x (1 - Tax Rate)] Average Total Assets Net income + [Interest expense x (1 - Tax Rate)] Sales Revenue Sales Revenue Average Total Assets $14,455 + ($4,045 x .554) X $328,565 0.0508 X 1.1431 5.8% Net Income - Preferred Dividends Average shareholders equity $14,455 ($126,456 + $114,073)/2 12% $328,565 ($347,339 + $227,525)/2

Inventory turnover = Cost of goods sold Average inventory = = Accounts receivable = turnover = =
b)

$254,441 ($45,376 + $37,082)/2 6.17 Sales Average accounts receivable $328,565 ($81,394 + $56,966)/2 4.75

1. Current ratio 2. Quick ratio 3. D/E (I) 4. Times interest earned

1998 $137,914 / $119,398 = 1.16 $89,799 / $119,398 = 0.75 $220,883/ $347,339 = 64% $29,503 / $4,045 = 7.29

1997 $110,722 / $53,432 = 2.07 $71,946 / $53,432 = 1.35 $113,452 / $227,525 = 50% $23,556 / $1,311 = 17.97

c) Tritech appears to be in fairly good financial condition. It is earning 5.8% on total assets, which, with good use of leverage, results in a return on shareholders equity of

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12%. It does not appear to have high risk from liabilities as evidenced by the 7.29 times interest earned ratio. Both the current and quick ratios are reasonable, and the operating activities are producing a net inflow of cash. Tritech has a net cash shortage for1998 which appears to result from investing in fixed assets. We should learn more about the companys industry, its products, plans, markets, and competition before we decide to invest. d) Tritech currently has positive benefits from leverage, which increases its ROA of 5.8% to an ROE of 12%. The interest rate paid on long-term debt in 1998 appears to be $3,652 / ($69,682 + $10,924) = 4.5%. Interest on current bank indebtedness appears to be $393 / $39,257 = 1%. e) (i.) If the Canadian dollar strengthened against the US dollar by 5%, and if the product prices remained the same, the effect would be to lower the Canadian value of the US sales. The effect would be to lower sales and Income before Minority Interest and Income Taxes by (75% x $328,565) x 5% = $12,321. (ii) If the Canadian dollar weakened against the US dollar by 5%, and if the product prices remained the same, the effect would be to increase the Canadian value of the US sales. The effect would be to increase sales and Income before Minority Interest and Income Taxes by (75% x $328,565) x 5% = $12,321.

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12.41 a) ROA = = X Net income + [Interest expense x (1 - Tax Rate)] Average Total Assets Net income + [Interest expense x (1 - Tax Rate)] Sales Revenue Sales Revenue Average Total Assets

Note: Since interest expense is not disclosed separately, it is assumed to be zero for the purposes of this calculation.

= = = ROE = = =

$22,568 x $314,496 15%

$314,496 ($159,506 + $142,727)/2

0.0718 X 2.0811 Net Income - Preferred Dividends Average shareholders equity $22,568 ($100,056 + $86,965)/2 24%

Inventory turnover = Cost of goods sold Average inventory = = Accounts receivable = turnover = =
b)

$244,065 ($45,094 + $26,057)/2 6.86 Sales Average accounts receivable $314,496 ($54,125 + $66,096)/2 5.23

1. Current ratio 2. Quick ratio 3. D/E (I)

1998 $99,219 / $43,190 = 2.30 $54,125 / $43,190 = 1.25 $59,450/ $159,506 = 37%

1997 $111,731 / $53,760 = 2.08 $85,674 / $53,760 = 1.59 $55,762 / $142,727 = 39%

c) Enerflex appears to be in strong financial condition. However, net income decreased slightly from 1997 to 1998, which is attributable to a decline in revenues. Other than

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this, the company is healthy. The current ratios and quick ratios are strong, indicating that short-term liquidity is not a concern. The debt to equity ratios are also low, and interest expense is more than offset from interest income on investments. The companys cash position is negative in 1998, mainly as the result of investments in property, plant, and equipment. Before investing in Enerflex, we would want to know more about its markets, products, and competitors. Furthermore, the reason for the decline in revenues should be identified to determine whether this is a trend. d) If Enerflex had used common shares rather than long-term debt, it would have issued an additional 7,922,078 shares [Average issue price is $34,678,000 / 15,019,000 = $2.31. Additional shares = $18,300,000 / $2.31 = 7,922,078]. Total common shares would have been 7,922,078 + 15,019,000 = 22,941,078. New earnings per share would be $22,568,000/22,941,078 = $0.98. This compares to the actual EPS of $1.50. With a multiple of 20, the market price per share would have been reduced by ($1.50 - $0.98) x 20 = $10.40. Thus, Enerflex appears to have made a decision to use some long-term debt financing instead of common shares and that decision results in a higher market price per share of its stock.

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12.42 a) ROA = = X Net income + [Interest expense x (1 - Tax Rate)] Average Total Assets Net income + [Interest expense x (1 - Tax Rate)] Sales Revenue Sales Revenue Average Total Assets

Note: Since interest expense is not disclosed separately, it is assumed to be zero for the purposes of this calculation.

= = = ROE = = =

$5,211 $40,672 9.5%

$40,672 ($60,751 + $48,456)/2

0.1281 X 0.7449 Net Income - Preferred Dividends Average shareholders equity $5,211 ($47,041 + $41,435)/2 11.8% Sales Average accounts receivable = = $40,672 ($9,489 + $11,250)/2 3.92

Accounts receivable = turnover

b) There is no Finished Goods Inventory as Mosaid designs for custom orders. Thus it does not produce for inventory, it only produces for specific orders. As soon as the chips are finished, they belong to the customer and become expenses. Thus inventory turnover is not meaningful. Inventory turnover is meaningful only for companies that produce for stockpiling for later sale. c)

1. Current ratio 2. Quick ratio 3. D/E (I)

1998 $39,105 / $7,407 = 5.28 $33,117 / $7,407 = 4.47 $13,710/ $60,751 = 23%

1997 $38,309 / $6,308 = 6.07 $33,243 / $6,308 = 5.27 $7,021 / $48,456 = 14%

d) Mosaid uses very little leverage, as evidenced by the ROA being 9.5% and ROE 11.8%. In contrast, Enerflex has a relatively higher leverage, with ROA of 15% and ROE of 24%. Note that Mosaid does not need debt as it has substantial cash and shortterm marketable securities. Enerflex is in a cash deficit position. The comparison

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between the two companies may not be appropriate because they are not manufacturing the same products. e)
(i.) If Mosaid will earn that same ROA, it cannot pay a higher interest rate than its ROA,

so it should not pay more than 9.5% after tax.

(ii.) To raise $10,000,000 from new shares, assuming a multiple of 20, it should be able to

sell these shares at 20 x $0.73 earnings per share = $14.60 each. Thus Mosaid would need to sell $10,000,000 / $14.60 = 684,932 shares at $14.60.
(iii.) New net income would be 9.5% x (60,751 + 10,000) = $6,721 with shares and

$6,721 - [(10% x 10,000) x (1 - 3,012 / 8,560)] = $6,073 with 10% debt. New ROE would be $6,721 / [(47,041 + 6,721 - 5,211 + 10,000) + 41,435] / 2 = $6,721 / $49,993 = 13.4% with shares and $6,073 / [(47,041 + 6,073 - 5,211) + 41,435] / 2 = $6,073 / $44,669 = 13.6% with debt. Thus the new debt would increase the leverage to the benefit of shareholders. To decide if new equity or debt should be used is not an easy choice in this case. It appears to be slightly preferable to use debt to benefit from the additional leverage.

12.43 a) ROA = = X = = = Net income + [Interest expense x (1 - Tax Rate)] Average Total Assets Net income + [Interest expense x (1 - Tax Rate)] Sales Revenue Sales Revenue Average Total Assets $13,525 + ($135,191 x .31) X $783,800 .07 x 0.2774 1.9% Sales Average accounts receivable = = $783,800 ($59,632 + $45,550)/2 14.9 $783,800 ($3,201,224 + $2,450,201)/2

Accounts receivable = turnover

b) Inventory turnover would not be meaningful as Shaw Cable does not produce for inventory. Its main business is distributing cable television signals. Inventory turnover is meaningful only for companies that produce for stockpiling for later sale. c)

1. Current ratio 2. Quick ratio

1998 $116,838 / $306,143 = 0.38 $85,686 / $306,143 = 0.28

1997 $62,582 / $261,123 = 0.24 $45,550 / $261,123 = 0.17

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3. D/E (I)

$1,785,627/ $3,201,224 = 56%

$1,870,825 / $2,450,201 = 76%

d) This company appears to be a risky investment from a short-term perspective because its current and quick ratios are very poor, and indicate that the company might experience cash flow problems when its current liabilities become due. In particular, the total of its current assets are insufficient to cover either accounts payable and accrued liabilities or the current portion of long-term debt. This means that additional short-term financing must be obtained for the company to remain solvent. In addition, the return on assets of 1.9% is unlikely to compensate debtholders and shareholders for the risk that they bear. Finally, cash provided from operations of $128,737 does not even offset the interest expense of $135,191, meaning that the company could have difficulty meeting its contractual obligations relating to debt. Beyond the Book 12.44 Answers to this question will depend on the company selected.

Critical Thinking Questions 12.45 General Comments The purpose of this question is to increase the students awareness that the current GAAP guidelines that allow alternative ways of recording transactions and reporting elements reduce the comparability between entities. Students are asked to discuss the prop and cons of comparability with reference to financial statement analysis. Solution Outline One of the benefits of the comparability occurs in ratio analysis. If you are analyzing the financial statements of two or more companies by undertaking a ratio analysis, the ratios will be comparable among the companies only if the original data are comparable. The original data will be comparable only if they were produced using the same accounting methods. Thus, for accounting information to be most useful to users, companies must be forced to use the same set of accounting methods. However, if all companies are forced to use the same accounting methods, the resulting accounting numbers may not give an accurate portrayal of the underlying economic events. No two companies have identical sets of economic transactions, so their financial statements, which are intended to be summarized numeric portrayals of a companys activities, cannot be expected to be identical. Different economic transactions require different accounting treatments, so restricting the accounting methods that companies are permitted to use will inevitably result in some transactions not being portrayed accurately in the financial statements. This situation would result in comparable ratios that are misleading as the accounting information that produced the ratios may not be properly portraying the underlying economic events. On the basis of this argument, regulators should not attempt to restrict the number or types of accounting methods that companies can use. 12.46 General Comments

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The purpose of this question is to require students to examine nonfinancial issues that may impact the interpretation of the analysis of financial statement amounts. The specific issue addressed in this question is the creation of captive finance subsidiaries and their impact on the leverage that the company can achieve. A major reason that a company forms a finance subsidiary is the potential for increasing leverage at both the time of formation and in subsequent years. Upon forming a finance subsidiary, the probability that a parent company will exceed the limits imposed by existing debt covenants will be lessened. In fact, a parent company should be able to borrow more because it is further from violating debt covenants than before the finance subsidiary was formed. Furthermore, the initial increase in leverage from forming a finance subsidiary is continued beyond the term of existing debt because the parent company transfers much of its debt (usually only short-term) and high quality short-term receivables to the subsidiary. The parent company reduces its debt/equity ratio in this transfer and the subsidiary is able to sustain a high or higher than normal debt/equity ratio because it now has higher quality assets dedicated solely to service that debt. A captive finance subsidiary primarily finances its own parent companys operations.

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