RW7eCh03.docx

RW7eCh03.docx

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RW7eCh03

CHAPTER3

WORKINGWITHFINANCIALSTATEMENTS

LearningObjectives

LO1Thesourcesandusesofafirm’scashflows.

LO2Howtostandardizefinancialstatementsforcomparisonpurposes.

LO3Howtocomputeand,moreimportantly,interpretsomecommonratios.

LO4Thedeterminantsofafirm’sprofitability.

LO5Someoftheproblemsandpitfallsinfinancialstatementanalysis.

AnswerstoConceptsReviewandCriticalThinkingQuestions

1.（LO2）

a.Ifinventoryispurchasedwithcash,thenthereisnochangeinthecurrentratio.Ifinventoryispurchasedoncredit,thenthereisadecreaseinthecurrentratioifitwasinitiallygreaterthan1.0.

b.Reducingaccountspayablewithcashincreasesthecurrentratioifitwasinitiallygreaterthan1.0.

c.Reducingshort-termdebtwithcashincreasesthecurrentratioifitwasinitiallygreaterthan1.0.

d.Aslong-termdebtapproachesmaturity,theprincipalrepaymentandtheremaininginterestexpensebecomecurrentliabilities.Thus,ifdebtispaidoffwithcash,thecurrentratioincreasesifitwasinitiallygreaterthan1.0.Ifthedebthasnotyetbecomeacurrentliability,thenpayingitoffwillreducethecurrentratiosincecurrentliabilitiesarenotaffected.

e.Reductionofaccountsreceivablesandanincreaseincashleavesthecurrentratiounchanged.

f.Inventorysoldatcostreducesinventoryandraisescash,sothecurrentratioisunchanged.

g.Inventorysoldforaprofitraisescashinexcessoftheinventoryrecordedatcost,sothecurrentratioincreases.

2.（LO2）Thefirmhasincreasedinventoryrelativetoothercurrentassets;therefore,assumingcurrentliabilitylevelsremainunchanged,liquidityhaspotentiallydecreased.

3.（LO2）Acurrentratioof0.50meansthatthefirmhastwiceasmuchincurrentliabilitiesasitdoesincurrentassets;thefirmpotentiallyhaspoorliquidity.Ifpressedbyitsshort-termcreditorsandsuppliersforimmediatepayment,thefirmmighthaveadifficulttimemeetingitsobligations.Acurrentratioof1.50meansthefirmhas50%morecurrentassetsthanitdoescurrentliabilities.Thisprobablyrepresentsanimprovementinliquidity;short-termobligationscangenerallybemetcompletelywithasafetyfactorbuiltin.Acurrentratioof15.0,however,mightbeexcessive.Anyexcessfundssittingincurrentassetsgenerallyearnlittleornoreturn.Theseexcessfundsmightbeputtobetterusebyinvestinginproductivelong-termassetsordistributingthefundstoshareholders.

4.（LO2）

a.Quickratioprovidesameasureoftheshort-termliquidityofthefirm,afterremovingtheeffectsofinventory,generallytheleastliquidofthefirm’scurrentassets.

b.Cashratiorepresentstheabilityofthefirmtocompletelypayoffitscurrentliabilitieswithitsmostliquidasset（cash）.

c.Intervalmeasureestimateshowlongacompanycouldcontinueoperatingbydepletingitsexistingcurrentassetsataratethatisconsistentwithitsaveragedailyoperatingcosts.

d.Totalassetturnovermeasureshowmuchinsalesisgeneratedbyeachdollaroffirmassets.

e.Equitymultiplierrepresentsthedegreeofleverageforanequityinvestorofthefirm;itmeasuresthedollarworthoffirmassetseachequitydollarhasaclaimto.

f.Long-termdebtratiomeasuresthepercentageoftotalfirmcapitalizationfundedbylong-termdebt.

g.Timesinterestearnedratioprovidesarelativemeasureofhowwellthefirm’soperatingearningscancovercurrentinterestobligations.

h.Profitmarginistheaccountingmeasureofbottom-lineprofitperdollarofsales.

i.Returnonassetsisameasureofbottom-lineprofitperdollaroftotalassets.

j.Returnonequityisameasureofbottom-lineprofitperdollarofequity.

k.Price-earningsratioreflectshowmuchvaluepersharethemarketplacesonadollarofaccountingearningsforafirm.

5.（LO1）Commonsizefinancialstatementsexpressallbalancesheetaccountsasapercentageoftotalassetsandallincomestatementaccountsasapercentageoftotalsales.Usingthesepercentagevaluesratherthannominaldollarvaluesfacilitatescomparisonsbetweenfirmsofdifferentsizeorbusinesstype.Common-baseyearfinancialstatementsexpresseachaccountasaratiobetweentheircurrentyearnominaldollarvalueandsomereferenceyearnominaldollarvalue.Usingtheseratiosallowsthetotalgrowthtrendintheaccountstobemeasured.

6.（LO2）Peergroupanalysisinvolvescomparingthefinancialratiosandoperatingperformanceofaparticularfirmtoasetofpeergroupfirmsinthesameindustryorlineofbusiness.Comparingafirmtoitspeersallowsthefinancialmanagertoevaluatewhethersomeaspectsofthefirm’soperations,finances,orinvestmentactivitiesareoutoflinewiththenorm,therebyprovidingsomeguidanceonappropriateactionstotaketoadjusttheseratiosifappropriate.Anaspirantgroupwouldbeasetoffirmswhoseperformancethecompanyinquestionwouldliketoemulate.Thefinancialmanageroftenusesthefinancialratiosofaspirantgroupsasthetargetratiosforhisorherfirm;somemanagersareevaluatedbyhowwelltheymatchtheperformanceofanidentifiedaspirantgroup.

7.（LO3）Returnonequityisprobablythemostimportantaccountingratiothatmeasuresthebottom-lineperformanceofthefirmwithrespecttotheequityshareholders.TheDuPontidentityemphasizestheroleofafirm’sprofitability,assetutilizationefficiency,andfinancialleverageinachievinganROEfigure.Forexample,afirmwithROEof20%wouldseemtobedoingwell,butthisfiguremaybemisleadingifitweremarginallyprofitable（lowprofitmargin）andhighlylevered（highequitymultiplier）.Ifthefirm’smarginsweretoerodeslightly,theROEwouldbeheavilyimpacted.

8.（LO2）Thebook-to-billratioisintendedtomeasurewhetherdemandisgrowingorfalling.Itiscloselyfollowedbecauseitisabarometerfortheentirehigh-techindustrywherelevelsofrevenuesandearningshavebeenrelativelyvolatile.

9.（LO2）Ifacompanyisgrowingbyopeningnewstores,thenpresumablytotalrevenueswouldberising.Comparingtotalsalesattwodifferentpointsintimemightbemisleading.Same-storesalescontrolforthisbyonlylookingatrevenuesofstoresopenwithinaspecificperiod.

10.（LO1）

a.ForanelectricutilitysuchasOntarioHydro,expressingcostsonaperkilowatthourbasiswouldbeawaytocomparecostswithotherutilitiesofdifferentsizes.

b.ForaretailersuchasSears,expressingsalesonapersquarefootbasiswouldbeusefulincomparingrevenueproductionagainstotherretailers.

c.ForanairlinesuchasAirCanada,expressingcostsonaperpassengermilebasisallowsforcomparisonswithotherairlinesbyexamininghowmuchitcoststoflyonepassengeronemile.

d.Foranon-lineserviceprovidersuchasBellInternet,usingapercallbasisforcostswouldallowforcomparisonswithsmallerservices.Apersubscriberbasiswouldalsomakesense.

e.ForahospitalsuchasTorontoGeneral,revenuesandcostsexpressedonaperbedbasiswouldbeuseful.

f.ForauniversitytextbookpublishersuchasMcGraw-HillRyerson,theleadingpublisheroffinancetextbooksfortheuniversitymarket,theobviousstandardizationwouldbeperbooksold.

11.（LO1）ReportingthesaleofTreasurysecuritiesascashflowfromoperationsisanaccounting“trick”,andassuch,shouldconstituteapossibleredflagaboutthecompaniesaccountingpractices.Formostcompanies,thegainfromasaleofsecuritiesshouldbeplacedinthefinancingsection.Includingthesaleofsecuritiesinthecashflowfromoperationswouldbeacceptableforafinancialcompany,suchasaninvestmentorcommercialbank.

12.（LO1）Increasingthepayablesperiodincreasesthecashflowfromoperations.Thiscouldbebeneficialforthecompanyasitmaybeacheapformoffinancing,butitisbasicallyaonetimechange.Thepayablesperiodcannotbeincreasedindefinitelyasitwillnegativelyaffectthecompany’screditratingifthepayablesperiodbecomestoolong.

SolutionstoQuestionsandProblems

NOTE:

Endofchapterproblemsweresolvedusingaspreadsheet.Manyproblemsrequiremultiplesteps.Duetospaceandreadabilityconstraints,whentheseintermediatestepsareincludedinthissolutionsmanual,roundingmayappeartohaveoccurred.However,thefinalanswerforeachproblemisfoundwithoutroundingduringanystepintheproblem.

Basic

1.（LO3）UsingtheformulaforNWC,weget:

NWC=CA–CL

CA=CL+NWC=$1,570+4,380=$5,950

So,thecurrentratiois:

Currentratio=CA/CL=$5,950/$4,380=1.36times

Andthequickratiois:

Quickratio=（CA–Inventory）/CL=（$5,950–1,875）/$4,380=0.93times

2.（LO3）Weneedtofindnetincomefirst.So:

Profitmargin=Netincome/Sales

Netincome=Sales（Profitmargin）

Netincome=（$24,000,000）（0.08）=$1,920,000

ROA=Netincome/TA=$1,920,000/$18,000,000=.1067or10.67%

TofindROE,weneedtofindtotalequity.

TL&OE=TD+TE

TE=TL&OE–TD

TE=$18,000,000–7,000,000=$11,000,000

ROE=Netincome/TE=$1,920,000/$11,000,000=.1745or17.45%

3.（LO3）

Receivablesturnover=Sales/Receivables

Receivablesturnover=$2,945,600/$387,615=7.60times

Days’salesinreceivables=365days/Receivablesturnover=365/7.60=48.03days

Theaveragecollectionperiodforanoutstandingaccountsreceivablebalancewas48.03days.

4.（LO3）

Inventoryturnover=COGS/Inventory

Inventoryturnover=$2,987,165/$324,600=9.20times

Days’salesininventory=365days/Inventoryturnover=365/9.20=39.66days

Onaverage,aunitofinventorysatontheshelf39.66daysbeforeitwassold.

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