Solution manual managerial accounting by cabrera 2010 chapter 05 answer

The length of operating cycle of the two companies cannot bedetermined from the fact the one company’s current ratio is higher.. The companywith the higher current ratio might have eithe

CHAPTER 5 FINANCIAL STATEMENTS ANALYSIS - II

I Questions

1 By looking at trends, an analyst hopes to get some idea of whether asituation is improving, remaining the same, or deteriorating Suchanalyses can provide insight into what is likely to happen in the future.Rather than looking at trends, an analyst may compare one company toanother or to industry averages using common-size financial statements

2 Ratios highlight relationships, movements, and trends that are verydifficult to perceive looking at the raw underlying data standing alone.Also, ratios make financial data easier to grasp by putting the data intoperspective As to the limitation in the use of ratios, refer to page 129

3 Price-earnings ratios are determined by how investors see a firm’s futureprospects Current reported earnings are generally considered to beuseful only so far as they can assist investors in judging what willhappen in the future For this reason, two firms might have the samecurrent earnings, but one might have a much higher price-earnings ratio

if investors view it to have superior future prospects In some cases,firms with very small current earnings enjoy very high price-earningsratios This is simply because investors view these firms as having veryfavorable prospects for earnings in future years By definition, a stockwith current earnings of P4 and a price-earnings ratio of 20 would beselling for P80 per share

4 A manager’s financing responsibilities relate to the acquisition of assetsfor use in his or her company The acquisition of assets can be financed

in a number of ways, including through issue of ordinary shares, throughissue of preference shares, through issue of long-term debt, throughleasing, etc A manager’s operating responsibilities relate to how theseassets are used once they have been acquired The return on total assetsratio is designed to measure how well a manager is discharging his orher operating responsibilities It does this by looking at a company’s

income before any consideration is given as to how the income will bedistributed among capital resources, i.e., before interest deductions.

5 Financial leverage, as the term is used in business practice, meansobtaining funds from investment sources that require a fixed annual rate

of return, in the hope of enhancing the well-being of the ordinaryshareholders If the assets in which these funds are invested earn at arate greater that the return required by the suppliers of the funds, thenleverage is positive in the sense that the excess accrues to the benefit ofthe ordinary shareholders If the return on assets is less than the returnrequired by the suppliers of the funds, then leverage is negative in thesense that part of the earnings from the assets provided by the ordinaryshareholders will have to go to make up the deficiency

6 How a shareholder would feel would depend in large part on the stability

of the firm and its industry If the firm is in an industry that experienceswide fluctuations in earnings, then shareholders might be very pleasedthat no interest-paying debt exists in the firm’s capital structure In hardtimes, interest payments might be very difficult to meet, or earningsmight be so poor that negative leverage would result

7 No, the stock is not necessarily overpriced Book value represents thecumulative effects on the balance sheet of past activities evaluated usinghistorical prices The market value of the stock reflects investors’ beliefsabout the company’s future earning prospects For most companiesmarket value exceeds book value because investors anticipate futuregrowth in earnings

8 A company in a rapidly growing technological industry probably wouldhave many opportunities to invest its earnings at a high rate of return;thus, one would expect it to have a low dividend payout ratio

9 It is more difficult to obtain positive financial leverage from preferenceshares than from long-term debt due to the fact that interest on long-termdebt is tax deductible, whereas dividends paid on preference shares arenot tax deductible

10 The current ratio would probably be highest during January, when bothcurrent assets and current liabilities are at a minimum During peakoperating periods, current liabilities generally include short-termborrowings that are used to temporarily finance inventories and

receivables As the peak periods end, these short-term borrowings arepaid off, thereby enhancing the current ratio

11 A 2-to-1 current ratio might not be adequate for several reasons First,the composition of the current assets may be heavily weighted towardslow-turning inventory, or the inventory may consist of large amounts ofobsolete goods Second, the receivables may be large and of doubtfulcollectibility, or the receivables may be turning very slowly due to poorcollection procedures

12 Expenses (including the cost of goods sold) have been increasing at aneven faster rate than net sales Thus Sunday is apparently havingdifficulty in effectively controlling its expenses

13 If the company’s earnings are very low, they may become almostinsignificant in relation to stock price While this means that the p/eratio becomes very high, it does not necessarily mean that investors areoptimistic In fact, they may be valuing the company at its liquidationvalue rather than a value based upon expected future earnings

14 From the viewpoint of the company’s shareholders, this situationrepresents a favorable use of leverage It is probable that little interest, ifany, is paid for the use of funds supplied by current creditors, and only11% interest is being paid to long-term bondholders Together these twosources supply 40% of the total assets Since the firm earns an averagereturn of 16% on all assets, the amount by which the return on 40% ofthe assets exceeds the fixed-interest requirements on liabilities willaccrue to the residual equity holders – the ordinary shareholders – raisingthe return on equity

15 The length of operating cycle of the two companies cannot bedetermined from the fact the one company’s current ratio is higher Theoperating cycle depends on the relationships between receivables andsales, and between inventories and cost of goods sold The companywith the higher current ratio might have either small amounts ofreceivables and inventories, or large sales and cost of sales, either ofwhich would tend to produce a relatively short operating cycle

16 The investor is calculating the rate of return by dividing the dividend bythe purchase price of the investment (P5  P50 = 10%) A moremeaningful figure for rate of return on investment is determined by

relating dividends to current market price, since the investor at thepresent time is faced with the alternative of selling the stock for P100and investing the proceeds elsewhere or keeping the investment Adecision to retain the stock constitutes, in effect, a decision to continue

to invest P100 in it, at a return of 5% It is true that in a historical sensethe investor is earning 10% on the original investment, but this isinteresting history rather than useful decision-making information

17 A corporate net income of P1 million would be unreasonably low for alarge corporation, with, say, P100 million in sales, P50 million in assets,and P40 million in equity A return of only P1 million for a company ofthis size would suggest that the owners could do much better byinvesting in insured bank savings accounts or in government bondswhich would be virtually risk-free and would pay a higher return

On the other hand, a profit of P1 million would be unreasonably high for

a corporation which had sales of only P5 million, assets of, say, P3million, and equity of perhaps one-half million pesos In other words,the net income of a corporation must be judged in relation to the scale ofoperations and the amount invested

II True or False

III Problems

Problem 1 (Common Size Income Statements)

Common size income statements for 2005 and 2006:

Sales 100% 100%Cost of goods sold 66 67 Gross profit 34% 33%Operating expenses 28 29 Net income 6% 4%The changes from 2005 to 2006 are all favorable Sales increased and thegross profit per peso of sales also increased These two factors led to asubstantial increase in gross profit Although operating expenses increased

in peso amount, the operating expenses per peso of sales decreased from 29

cents to 28 cents The combination of these three favorable factors causednet income to rise from 4 cents to 6 cents out of each peso of sales.

Problem 2 (Measures of Liquidity)

The company appears to be in a strong position as to short-run debt-payingability It has almost three pesos of current assets for each peso of currentliabilities Even if some losses should be sustained in the sale of themerchandise on hand or in the collection of the accounts receivable, itappears probable that the company would still be able to pay its debts as theyfall due in the near future Of course, additional information, such as thecredit terms on the accounts receivable, would be helpful in a carefulevaluation of the company’s current position

Problem 3 (Common-Size Income Statement)

Requirement 1

2006 2005

Sales 100.0 % 100.0 %Less cost of goods sold 63.2 60.0Gross margin 36.8 40.0Selling expenses 18.0 17.5Administrative expenses 13.6 14.6Total expenses 31.6 32.1Net operating income 5.2 7.9Interest expense 1.4 1.0Net income before taxes 3.8 % 6.9 %

of sales in 2005 to 13.6% of sales in 2006 This probably is a result of thecompany’s efforts to reduce administrative expenses during the year

Problem 4 (Comparing Operating Results with Average Performance in the Industry)

Requirement (a)

Ms Freeze, Inc.

Industry Average

Operating expenses:

Net income 7% 4%

Requirement (b)

Ms Freeze’s operating results are significantly better than the averageperformance within the industry As a percentage of sales revenue, Ms.Freeze’s operating income and net income after nearly twice the average forthe industry As a percentage of total assets, Ms Freeze’s profits amount to

an impressive 23% as compared to 14% for the industry

The key to Ms Freeze’s success seems to be its ability to earn a relativelyhigh rate of gross profit Ms Freeze’s exceptional gross profit rate (51%)probably results from a combination of factors, such as an ability tocommand a premium price for the company’s products and productionefficiencies which lead to lower manufacturing costs

As a percentage of sales, Ms Freeze’s selling expenses are five points higherthan the industry average (21% compared to 16%) However, these higherexpenses may explain Ms Freeze’s ability to command a premium price forits products Since the company’s gross profit rate exceeds the industryaverage by 8 percentage points, the higher-than-average selling costs may bepart of a successful marketing strategy The company’s general andadministrative expenses are significantly lower than the industry average,which indicates that Ms Freeze’s management is able to control expenseseffectively

Problem 5 (Common-Size Statements)

Requirement 1

The income statement in common-size form would be:

2006 2005

Sales 100.0% 100.0%Less cost of goods sold 65.0 60.0Gross margin 35.0 40.0Less operating expenses 26.3 30.4Net operating income 8.7 9.6Less interest expense 1.2 1.6Net income before taxes 7.5 8.0Less income taxes (30%) 2.3 2.4Net income 5.3% 5.6%The balance sheet in common-size form would be:

2006 2005

Current assets:

Cash 2.0% 5.1%Accounts receivable, net 15.0 10.1Inventory 30.1 15.2Prepaid expenses 1.0 1.3Total current assets 48.1 31.6Plant and equipment 51.9 68.4Total assets 100.0% 100.0%Liabilities:

Current liabilities 25.1% 12.7%Bonds payable, 12% 20.1 25.3Total liabilities 45.1 38.0Equity:

Preference shares, 8%, P10 par 15.0 19.0Ordinary shares, P5 par 10.0 12.7Retained earnings 29.8 30.4Total equity 54.9 62.0Total liabilities and equity 100.0% 100.0%

Note: Columns do not total down in all cases due to rounding differences.

Requirement 2

The company’s cost of goods sold has increased from 60 percent of sales in

2005 to 65 percent of sales in 2006 This appears to be the major reason thecompany’s profits showed so little increase between the two years Somebenefits were realized from the company’s cost-cutting efforts, as evidenced

by the fact that operating expenses were only 26.3 percent of sales in 2006 ascompared to 30.4 percent in 2005 Unfortunately, this reduction in operatingexpenses was not enough to offset the increase in cost of goods sold As aresult, the company’s net income declined from 5.6 percent of sales in 2005

to 5.3 percent of sales in 2006

Problem 6 (Solvency of Alabang Supermarket)

Requirement (a)

(Pesos in Millions)

Quick ratio (P227.5  P1,939.0) 0.1 to 1(3) Working capital:

Requirement (c)

No It is difficult to draw conclusions from the above ratios AlabangSupermarket’s current ratio and quick ratio are well below “safe” levels,according to traditional rules of thumb On the other hand, some largecompanies with steady ash flows are able to operate successfully withcurrent ratios lower than Alabang Supermarket’s

Requirement (d)

Due to characteristics of the industry, supermarkets tend to have smalleramounts of current assets and quick assets than other types of merchandisingcompanies An inventory of food has a short shelf life Therefore, theinventory of a supermarket usually represents only a few weeks’ sales.Other merchandising companies may stock inventories representing severalmonths’ sales Also, supermarkets sell primarily for cash Thus, they haverelatively few receivables Although supermarkets may generate largeamounts of cash, it is not profitable for them to hold assets in this form.Therefore, they are likely to reinvest their cash flows in business operations

as quickly as possible

Requirement (e)

In evaluating Alabang Supermarket’s liquidity, it would be useful to reviewthe company’s financial position in prior years, statements of cash flows, andthe financial ratios of other supermarket chains One might also ascertain thecompany’s credit rating from an agency such as Dun & Bradstreet

Note to Instructor: Prior to the year in which the data for this problem was

collected, Alabang Supermarket had reported a negative retained earningsbalance in its balance sheet for several consecutive periods The fact thatAlabang Supermarket has only recently removed the deficit from its financialstatements is also worrisome

Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk)

Requirement (b)

(1) Quick ratio:

Quick ratio (P127,003  P55,306) 2.3 to 1(2) Current ratio:

Current ratio (P164,949  P55,306) 3.0 to 1

(3) Working capital:

Less: Current liabilities (Req a) 55,306

(4) Debt ratio:

Requirement (c)

(1) From the viewpoint of short-term creditors, Bonbon Sweets’ appear

highly liquid Its quick and current ratios are well above normal rules of

thumb, and the company’s cash and marketable securities alone are

almost twice its current liabilities

(2) Long-term creditors also have little to worry about Not only is the

company highly liquid, but creditors’ claims amount to only 23.1% of

total assets If Bonbon Sweets’ were to go out of business and liquidate

its assets, it would have to raise only 23 cents from every peso of assets

for creditors to emerge intact

(3) From the viewpoint of shareholders, Bonbon Sweets’ appears overly

liquid Current assets generally do not generate high rates of return

Thus, the company’s relatively large holdings of current assets dilutes its

return on total assets This should be of concern to shareholders If

Bonbon Sweets is unable to invest its highly liquid assets more

productively in its business, shareholders probably would like to see the

money distributed as dividends

Problem 8 (Selected Financial Measures for Short-term Creditors)

Requirement 1

Current assets (P80,000 + P460,000 + P750,000 +

P10,000) P1,300,000Current liabilities (P1,300,000 ÷ 2.5) 520,000Working capital P   780,000

Requirement 2

Requirement 3

a Working capital would not be affected:

Current assets (P1,300,000 – P100,000) P1,200,000Current liabilities (P520,000 – P100,000) 420,000Acid-test ratio = Cash + Marketable securities + Accounts receivableCurrent liabilities

Acid-test ratio = P80,000 + P0 + P460,000P520,000 = 1.04 to 1 (rounded)

Working capital P 780,000

b The current ratio would rise:

Problem 9 (Selected Financial Ratios)

1 Gross margin percentage:

2 Current ratio:

3 Acid-test ratio:

4 Accounts receivable turnover:

5 Inventory turnover:

Current ratio = Current liabilitiesCurrent assets

Current rate = P1,200,000P420,000 = 2.9 to 1 (rounded)

Gross margin

Sales

P840,000P2,100,000 = 40%

=

Current assets

Current liabilities

P490,000P200,000 = 2.45 to 1

=

Quick assets

Current liabilities

P181,000P200,000 = 0.91 to 1 (rounded)

=

SalesAverage accounts receivables

P2,100,000P150,000 = 14 times

=

365 days

14 times = 26.1 days (rounded)

Cost of goods sold

Average inventory

P1,260,000P280,000 = 4.5 times

=

365 days4.5 times = 81.1 days to turn (rounded)

6 Debt-to-equity ratio:

7 Times interest earned:

8 Book value per share:

* P100,000 total par value ÷ P5 par value per share = 20,000 shares

Problem 10 (Selected Financial Ratios for Ordinary Shareholders)

1 Earnings per share:

2 Dividend payout ratio:

3 Dividend yield ratio:

4 Price-earnings ratio:

Total liabilitiesTotal equity

P500,000P800,000 = 0.63 to 1 (rounded)

=

Earnings before interest

and income taxesInterest expense = P180,000P30,000 = 6.0 times

EquityOrdinary shares outstanding

P800,00020,000 shares* = P40 per share

=

Net income to ordinary shares

Average ordinary shares

outstanding

P105,00020,000 shares = P5.25 per share

=

Dividends paid per share

Earnings per share

P3.15P5.25 = 60%

=

Dividends paid per share

Market price per share

P3.15P63.00 = 5%

=

Market price per shareEarnings per share

P63.00P5.25 = 12.0

=

Problem 11 (Selected Financial Ratios for Ordinary Shareholders)

1 Return on total assets:

2 Return on ordinary shareholders’ equity:

3 Financial leverage was positive, since the rate of return to the ordinaryshareholders (13.8%) was greater than the rate of return on total assets(10.5%) This positive leverage is traceable in part to the company’scurrent liabilities, which may carry no interest cost, and to the bondspayable, which have an after-tax interest cost of only 7%

10% interest rate × (1 – 0.30) = 7% after-tax cost

Net income + [Interest expense x (1 – Tax rate)]

Average total assets

= P105,000 + [P30,000 x (1 – 0.30)]

½ (P1,100,000 + P1,300,000)P126,000

P762,500 = 13.8% (rounded)

=