Solution manual accounting 21e by warreni ch 17

The event-related revenues such as concessions declined as a percent of total revenues by three percentage points, while the percent of NASCAR broadcasting revenues to total revenues inc

FINANCIAL STATEMENT ANALYSIS

CLASS DISCUSSION QUESTIONS

1 Horizontal analysis is the percentage

analysis of increases and decreases in

corresponding statements The percent

change in the cash balances at the end of

the preceding year from the end of the

current year is an example Vertical

analysis is the percentage analysis

showing the relationship of the component

parts to the total in a single statement The

percent of cash as a portion of total assets

at the end of the current year is an

example.

2 Comparative statements provide

information as to changes between dates

or periods Trends indicated by

comparisons may be far more significant

than the data for a single date or period.

3 Before this question can be answered, the

increase in net income should be

compared with changes in sales, expenses,

and assets devoted to the business for the

current year The return on assets for both

periods should also be compared If these

comparisons indicate favorable trends, the

operating performance has improved; if

not, the apparent favorable increase in net

income may be offset by unfavorable

trends in other areas.

4 You should first determine if the expense

amount in the base year (denominator) is

significant A 100% or more increase of a

very small expense item may be of little

concern However, if the expense amount in

the base year is significant, then over a

100% increase may require further

investigation.

5 Generally, the two ratios would be very

close, because most service businesses

sell services and hold very little inventory.

6 The amount of working capital and the

change in working capital are just two

indicators of the strength of the current

position A comparison of the current ratio

and the quick ratio, along with the amount

of working capital, gives a better analysis of

the current position Such a comparison

shows:

Current Preceding

Year Year Working capital $42,500 $37,500 Current ratio 2.0 2.5 Quick ratio 0.8 1.2

It is apparent that, although working capital has increased, the current ratio has fallen from 2.5 to 2.0, and the quick ratio has fallen from 1.2 to 0.8.

7 The bulk of Wal-Mart sales are to final

customers that pay with credit cards or cash In either case, there is no accounts receivable Procter and Gamble, in contrast, sells almost exclusively to other businesses, such as Wal-Mart Such sales are “on account,” and thus, create accounts receivable that must be collected A recent financial statement showed Wal-Mart’s accounts receivable turning 109 times, while Procter and Gamble’s turned only 13 times.

8 No, an accounts receivable turnover of 6

with sales on a n/30 basis is not satisfactory It indicates that accounts receivable are collected, on the average, in one-sixth of a year, or approximately 60 days from the date of sale Assuming that some customers pay within the 30-day term, it indicates that other accounts are running beyond 60 days It is also possible that there is a substantial amount of past- due accounts of doubtful collectibility on the books.

9 a A high inventory turnover minimizes the

amount invested in inventories, thus freeing funds for more advantageous use Storage costs, administrative expenses, and losses caused by obsolescence and adverse changes in prices are also kept to a minimum.

b Yes The inventory turnover could be

high because the quantity of inventory

on hand is very low This condition might result in the lack of sufficient goods on hand to meet sales orders.

3

the “turnover” of inventory during the

year, while the number of days’ sales in

inventory relates to the amount of

inventory on hand at the end of the

year Therefore, a business could have

a high inventory turnover for the year,

yet have a high number of days’ sales

in inventory at the end of the year.

10 The ratio of fixed assets to long-term

liabilities increased from 2 for the preceding

year to 2.5 for the current year, indicating

that the company is in a stronger position

now than in the preceding year to borrow

additional funds on a long-term basis.

11 a Due to leverage, the rate on

stockholders’ equity will often be

greater than the rate on total assets.

This occurs because the amount

earned on assets acquired through the

use of funds provided by creditors

exceeds the interest charges paid to

creditors.

b Higher The concept of leverage applies

to preferred stock as well as debt The

rate earned on common stockholders’

equity ordinarily exceeds the rate earned

earned on assets acquired through the use of funds provided by preferred stockholders normally exceeds the dividends paid to preferred stockholders.

12 The earnings per share in the preceding

year were $20 per share ($40/2), adjusted for the stock split in the latest year.

13 A share of common stock is currently

selling at 10 times current annual earnings.

14 The dividend yield on common stock is a

measure of the rate of return to common stockholders in terms of cash dividend distributions Companies in growth industries typically reinvest a significant portion of the amount earned in common stockholders’ equity to expand operations rather than to return earnings to stockholders in the form of cash dividends.

15 During periods when sales are increasing,

it is likely that a company will increase its inventories and expand its plant Such situations frequently result in an increase in current liabilities out of proportion to the increase in current assets and thus lower the current ratio.

4

Ex 17–1

a.

HOME-MATE APPLIANCE CO.

Comparative Income Statement For the Years Ended December 31, 2006 and 2005

b The vertical analysis indicates that the cost of goods sold as a percent of sales increased by 3 percentage points (55% – 52%) between 2005 and 2006 However, the selling expenses and administrative expenses improved by 5 percentage points Thus, the net income as a percent of sales improved by 2 percentage points.

Speedway Motorsports, Inc.

Comparative Income Statement (in thousands of dollars) For the Years Ended December 31, 2002 and 2001

Revenues:

Expenses and other:

b While overall revenue did not change much between the two years, the overall mix of revenue sources did change somewhat The event-related revenues (such as concessions) declined as a percent of total revenues by three percentage points, while the percent of NASCAR broadcasting revenues to total revenues increased by nearly three (2.7) percentage points The expenses as a percent of total revenues shifted the most between the direct event expenses and NASCAR purse and sanction fees That is, the direct expenses as a percent of total revenues declined nearly two percentage points, while the NASCAR purse and sanction fees as a percent of total revenues increased by nearly two (1.8) percentage points Overall, the income from continuing operations increased a modest 1.1 percentage points of total revenues between the two years, which is a favorable trend As a further note, the income from continuing operations as a percent of sales exceeds 25% in both years, which is excellent Apparently, owning and operating motor speedways is a business that produces high operating profit margins.

Note to Instructors: The high operating margin is probably necessary to

compensate for the extensive investment in speedway assets This is confirmed by the rate of operating income return on total assets of nearly 9%.

HORIZON PUBLISHING COMPANY Common-Size Income Statement For the Year Ended December 31, 20—

b The cost of goods sold is 4 percentage points lower than the industry average, but the selling expenses and administrative expenses are 2.5 percentage points higher than the industry average The combined impact is for net income as a percent of sales to be 1.5 percentage points better than the industry average Apparently, the company is managing the cost of publishing books better than the industry but has slightly higher selling and administrative expenses relative to the industry The cause of the higher selling and administrative expenses as a percent of sales, relative to the industry, can be investigated further.

SANTA FE TILE COMPANY Comparative Balance Sheet December 31, 2006 and 2005

Comparative Income Statement For the Years Ended December 31, 2006 and 2005

b The net income for Scribe Paper Company decreased by approximately 77.5% from 2005 to 2006 This decrease was the combined result of a decrease in sales of 22% and higher expenses The cost of goods sold decreased at a slower rate than the decrease in sales, thus causing gross profit to decrease more than the decrease in sales In addition, selling and administrative expenses increased by 1.61% between 2005 and 2006.

a (1) Working capital = Current assets – Current liabilities

Current liabilities 2006:

Ex 17–7

Current liabilities Dec 28, 2002:

052 , 6

$

413 , 6

$

998 , 4

$

853 , 5

$

= 1.17

Current liabilities Dec 28, 2002:

052 , 6

$

376 , 4

$

998 , 4

$

791 , 3

$

= 0.76

b The liquidity of PepsiCo has declined significantly over this time period Both the current and quick ratios have declined The current ratio declined from 1.17 to 1.06, and the quick ratio declined from 0.76 to 0.72 Neither of these declines is worrisome, however PepsiCo is a strong company with ample resources for meeting short-term obligations.

a The working capital, current ratio, and quick ratio are calculated incorrectly The working capital and current ratio incorrectly include Goodwill as a part of current assets Goodwill is an intangible asset and is noncurrent The quick ratio has the correct numerator (quick assets) but does not include accrued liabilities in the denominator The denominator of the quick ratio should be total current liabilities.

The correct calculations are as follows:

Working capital = Current assets – Current liabilities

$123,000 +

$275,000

= 0.912

b Unfortunately, the working capital, current ratio, and quick ratio are all below the minimum threshold required by the bond indenture This may require the company to renegotiate the bond contract, including a possible unfavorable change in the interest rate.

a (1) Accounts receivable turnover:

receivable accounts

monthly Average

account on

sales Net

Average daily sales on account

a (1) Accounts receivable turnover:

receivable accounts

Average

account on

sales Net

Sears:

2 / ) 759 , 30

$ + 155 , 28 ($

698 , 35

$

= 1.2

Federated:

2 / ) 945 , 2

$ + 379 , 2 ($

434 , 15

$

= 5.8

(2) Number of days’ sales in receivables:

account

on sales daily Average

year of end , receivable

Accounts

8 97

$

759 , 30

$

= 314.5 days

3 42

$

945 , 2

vs 69.6 days for Federated) These differences must be interpreted with care Sears has significant MasterCard receivables with customers who have not made purchases from Sears, which represent receivables that do no correspond to Sears’ sales Thus, it is not surprising that Sears has a much lower turnover than does Federated, since the accounts receivable include receivables that are outside of the Sears retail network In addition, we do not know how much of the Sears or Federated sales are on credit; thus, it is not possible to accurately compare the number of days’ sales in receivables with credit terms.

Note to Instructors: The annual 10-K for Federated indicated that the sales

through its proprietary credit card was $4,128 Thus, the accounts receivable turnover based on this number would be 1.6 ($4,128 ÷ $2,662), while the number of days’ sales in receivables would be 260.6 days ($2,945 ÷ $11.3) Thus, the calculations in part a above actually overstate Federated’s accounts receivable turnover and understates Federated’s credit card days’ sales in receivables This exercise helps the student see the importance of interpreting these ratios carefully In the case of Sears, much of the receivables are not related to Sears’ sales, which distorts the ratio In the case

of Federated, only $4,128 million in sales were on account, thus actually overstating its accounts receivable turnover and understating its days’ sales

in receivable, relative to the sales on account.

a (1) Inventory turnover: Cost of goods sold

a (1) Inventory turnover: Cost of goods sold

in and out of the computer industry Indeed, at the time of this writing, HP and Gateway are changing their practices to mirror those of Dell Apple Computer also employs similar manufacturing techniques, and thus enjoys excellent inventory efficiency.

a Ratio of liabilities to stockholders’ equity: Total stockholders' equity Total liabilities

b Number of times bond

expense Interest

+ tax before

Income

Dec 31, 2006:

$96,000

* 000 ,

a Ratio of liabilities to stockholders’ equity: Total liabilities

Total stockholders' equity

charges interest

times of

Number

expense Interest

expense Interest

tax before

a Ratio of liabilities to stockholders’ equity: Total liabilities

Total stockholders' equity

a Ratio of net sales to total assets: Net sales

of assets This is because Union Pacific is very asset intensive That is, Union Pacific must invest in locomotives, railcars, terminals, tracks, right-of-way, and information systems in order to earn revenues These investments are significant Yellow Corp is able to earn $2.55 for every dollar of assets, and thus, is able to earn more revenue for every dollar of assets than the railroad This is because the motor carrier invests in trucks, trailers, and terminals, which require less investment per dollar of revenue than does the railroad Moreover, the motor carrier does not invest in the highway system, because the government owns the highway system Thus, the motor carrier has no investment in the transportation network itself unlike the railroad The transportation arranger hires transportation services from motor carriers and railroads, but does not own these assets itself The transportation arranger has assets in accounts receivable and information systems but does not require transportation assets; thus, it is able to earn the highest revenue per dollar of assets

Note to Instructors: Students may wonder how asset intensive companies

overcome their asset efficiency disadvantages to competitors with better asset efficiencies, as in the case between railroads and motor carriers Asset efficiency is part of the financial equation; the other part is the profit margin made on each dollar of sales Thus, companies with high asset efficiency often operate on thinner margins than do companies with lower asset efficiency For example, the motor carrier must pay highway taxes, which lowers its operating margins when compared to railroads that own their right- of-way, and thus do not have the tax expense of the highway In this exercise the railroad has the highest profit margins, the motor carrier is in the middle, while the transportation arranger operates on very thin margins

$ +

$150,000

*

$1,200,000

000 , 15

$ +

$180,000

common stockholders' equity:

Net income less preferred dividends Average common stockholders' equity 2007:

of debt However, this leverage is greater in 2006 because the rate of return

on assets exceeds the cost of debt by a greater amount in 2006.

a Rate earned on total assets:

assets total

Average

expense interest

income

2002:

)/2

$1,010,826 +

($883,166

$6,886 +

$80,158

2

$848,115)/ +

($883,166

869 ,

$6 +

$29,105

4.2%

b Rate earned on stockholders’ equity:

equity

rs' stockholde

Average

income Net

2002:

)/2

$1,010,826 +

($883,166

$80,158

= 12.1% 2001:

2

$848,115)/ +

($883,166

$29,105

4.9%

c Both the rate earned on total assets and the rate earned on stockholders’ equity have improved over the two-year period The rate earned on total assets improved from 4.2% to 9.2%, which is over twice the return of the prior year The rate earned on stockholders’ equity improved from 4.9% to 12.1% The rate earned on stockholders’ equity exceeds the rate earned on total assets due to the positive use of leverage.

d Fiscal year 2002 was a difficult time for the apparel industry The rate earned

on total assets for Ann Taylor, however, exceeded the industry average (9.2%

vs 6%) The rate earned on stockholders’ equity was also greater than the industry average (12.1% vs 7.8%) These relationships suggest that Ann Taylor has more leverage than the industry, on average.

a Ratio of fixed assets to long-term liabilities: Fixed assets

*

$2,100,000

$51,000 +

common stockholders' equity:

Net income less preferred dividends Average common stockholders' equity

a Number of times bond

interest charges were earned:

Income before tax + Interest expense

Interest expense

$180,000

$180,000 +

Common shares outstanding

−

shares 125,000

Earnings

share per price Market

a Earnings per share: Net income Preferred dividends

Common shares outstanding

−

shares 200,000

Earnings

share per price Market

Earnings before extraordinary items per share on common stock:

Common shares outstanding

−

shares 500,000

$320,000

= $0.96 per share

Common shares outstanding

−

shares 500,000

$320,000

= $1.14 per share

a Price-earnings ratio: Market price per share

Earnings per share

Market price per share

price-of 2% The price-earnings ratio is near 24, which is close to the market average at this writing Thus, Coca-Cola is expected to produce shareholder returns through a combination of some share price appreciation and a small dividend.

Prob 17–1A

1.

TURNBERRY COMPANY Comparative Income Statement For the Years Ended December 31, 2006 and 2005

Increase (Decrease)

by approximately 14%.

AUDIO TONE COMPANY Comparative Income Statement For the Years Ended December 31, 2006 and 2005

*Rounded to next lowest hundredth of a percent

2 The vertical analysis indicates that the costs (cost of goods sold, selling expenses, and administrative expenses) as a percent of sales improved from

2005 to 2006 As a result, net income as a percent of sales increased from 16.61% to 21.20% The sales promotion campaign appears successful The selling expenses as a percent of sales declined, suggesting that the increased cost was more than made up by increased sales.

1 a Working capital = Current assets – Current liabilities

$110,000 +

$240,000

= 1.24

2.