Solution manual managerial accounting concept and applications by cabrera chapter 05 answer

By definition, astock with current earnings of P4 and a price-earnings ratio of 20would be selling for P80 per share.. Its quick and current ratios are well above normal rules of thumb,

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 financialstatements

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’sfuture prospects Current reported earnings are generally considered to

be useful 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 havingvery favorable prospects for earnings in future years By definition, astock with current earnings of P4 and a price-earnings ratio of 20would be selling for P80 per share

4 A manager’s financing responsibilities relate to the acquisition ofassets for use in his or her company The acquisition of assets can befinanced in a number of ways, including through issue of ordinaryshares, through issue of preference shares, through issue of long-termdebt, through leasing, etc A manager’s operating responsibilities relate

to how these assets are used once they have been acquired The return

on total assets ratio is designed to measure how well a manager isdischarging his or her operating responsibilities It does this by looking

at a company’s income before any consideration is given as to how theincome will be distributed among capital resources, i.e., before interestdeductions

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

of the ordinary shareholders If the return on assets is less than thereturn required by the suppliers of the funds, then leverage is negative

in the sense that part of the earnings from the assets provided by theordinary shareholders will have to go to make up the deficiency

6 How a shareholder would feel would depend in large part on thestability of the firm and its industry If the firm is in an industry thatexperiences wide fluctuations in earnings, then shareholders might bevery pleased that no interest-paying debt exists in the firm’s capitalstructure In hard times, interest payments might be very difficult tomeet, or earnings might 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 evaluatedusing historical prices The market value of the stock reflectsinvestors’ beliefs about the company’s future earning prospects Formost companies market value exceeds book value because investorsanticipate future growth 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-term debt is tax deductible, whereas dividends paid on preferenceshares are not 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 andreceivables 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

of obsolete goods Second, the receivables may be large and ofdoubtful collectibility, or the receivables may be turning very slowlydue to poor collection 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,

if any, is paid for the use of funds supplied by current creditors, andonly 11% interest is being paid to long-term bondholders Togetherthese two sources supply 40% of the total assets Since the firm earns

an average return of 16% on all assets, the amount by which the return

on 40% of the assets exceeds the fixed-interest requirements onliabilities will accrue to the residual equity holders – the ordinaryshareholders – raising the 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

by the purchase price of the investment (P5 ÷ P50 = 10%) A moremeaningful figure for rate of return on investment is determined byrelating 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

sense the 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 inassets, and P40 million in equity A return of only P1 million for acompany of this size would suggest that the owners could do muchbetter by investing in insured bank savings accounts or in governmentbonds which would be virtually risk-free and would pay a higherreturn

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

of operations and the amount invested

II True or False

2 True 4 False 6 True 8 True 10 False

III Problems

Problem 1 (Common Size Income Statements)

Common size income statements for 2005 and 2006:

2006 2005

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 29cents 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 current ratio is 2.8 to 1 It is computed by dividing the current assets

of P637,280 by the current liabilities of P227,600 The amount of workingcapital is P409,680, computed by subtracting the current liabilities ofP227,600 from the current assets of P637,280

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 asthey fall due in the near future Of course, additional information, such asthe credit 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

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 32.1

Net operating income 5.2 7.9Interest expense 1.4 1.0Net income before taxes 3.8 % 6.9 %

Requirement 2

The company’s major problem seems to be the increase in cost of goodssold, which increased from 60.0% of sales in 2005 to 63.2% of sales in

2006 This suggests that the company is not passing the increases in costs

of its products on to its customers As a result, cost of goods sold as apercentage of sales has increased and gross margin has decreased Sellingexpenses and interest expense have both increased slightly during the year,which suggests that costs generally are going up in the company The onlyexception is the administrative expenses, which have decreased from14.6% of sales in 2005 to 13.6% of sales in 2006 This probably is a result

of the company’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:

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 pointshigher than the industry average (21% compared to 16%) However, thesehigher expenses may explain Ms Freeze’s ability to command a premiumprice for its products Since the company’s gross profit rate exceeds theindustry average by 8 percentage points, the higher-than-average sellingcosts may be part of a successful marketing strategy The company’sgeneral and administrative expenses are significantly lower than theindustry average, which indicates that Ms Freeze’s management is able tocontrol expenses effectively.

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:

30.1 15.2Prepaid expenses

1.0 1.3

Plant and equipment 51.9 68.4

Total 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 19.0

Total 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 reasonthe company’s profits showed so little increase between the two years.Some benefits were realized from the company’s cost-cutting efforts, asevidenced by the fact that operating expenses were only 26.3 percent ofsales in 2006 as compared to 30.4 percent in 2005 Unfortunately, thisreduction in operating expenses was not enough to offset the increase incost of goods sold As a result, the company’s net income declined from5.6 percent of sales in 2005 to 5.3 percent of sales in 2006

Problem 6 (Solvency of Alabang Supermarket)

Requirement (a)

(Pesos in Millions)

Current assets:

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 ofmerchandising companies An inventory of food has a short shelf life.Therefore, the inventory of a supermarket usually represents only a fewweeks’ sales Other merchandising companies may stock inventoriesrepresenting several months’ sales Also, supermarkets sell primarily forcash Thus, they have relatively few receivables Although supermarketsmay generate large amounts 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,and the financial ratios of other supermarket chains One might alsoascertain the company’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 itsfinancial statements is also worrisome

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

Accrued liabilities (short-term) 21,532

Requirement (b)

(1) Quick ratio:

Current liabilities (Req a) P 55,306Quick ratio (P127,003 ÷ P55,306) 2.3 to 1(2) Current ratio:

Current liabilities (Req a) P 55,306Current 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 arealmost 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 andliquidate its assets, it would have to raise only 23 cents from everypeso 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) 420,000Working capital P 780,000

b The current ratio would rise:

Acid-test ratio = Cash + Marketable securities + Accounts receivableCurrent liabilities

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

Current ratio = Current liabilitiesCurrent assets

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

Problem 9 (Selected Financial Ratios)

1 Gross margin percentage:

=

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)

Total liabilities

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

Earnings before interest

and income taxes

Interest expense = P180,000P30,000 = 6.0 times

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:

Problem 11 (Selected Financial Ratios for Ordinary Shareholders)

1 Return on total assets:

2 Return on ordinary shareholders’ equity:

EquityOrdinary shares outstanding = 20,000 shares*P800,000 = P40 per share

Net income to ordinary

sharesAverage 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

=

Return on

total assets =

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

P1,200,000 = 10.5%

=

Net income – preference dividends

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

Problem 12 (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

Current assets (P1,300,000 – P100,000) P1,200,000Current liabilities (P520,000 – P100,000) 420,000Working capital P  780,000

b The current ratio would increase if the company makes a P100,000payment on accounts payable:

Problem 13 (Effects of Transactions on Various Financial Ratios)

1 Decrease Sale of inventory at a profit will be reflected in an

increase in retained earnings, which is part ofshareholders’ equity An increase in shareholders’ equitywill result in a decrease in the ratio of assets provided bycreditors as compared to assets provided by owners

2 No effect Purchasing land for cash has no effect on earnings or on

the number of ordinary shares outstanding One asset isexchanged for another

3 Increase A sale of inventory on account will increase the quick

assets (cash, accounts receivable, marketable securities)but have no effect on the current liabilities For thisreason, the acid-test ratio will increase

4 No effect Payments on account reduce cash and accounts payable

by equal amounts; thus, the net amount of working capital

is not affected

5 Decrease When a customer pays a bill, the accounts receivable

balance is reduced This increases the accounts receivableturnover, which in turn decreases the average collectionperiod

6 Decrease Declaring a cash dividend will increase current liabilities,

Current

Current assetsCurrent liabilities

= P1,200,000P420,000 = 2.9 (rounded)

but have no effect on current assets Therefore, thecurrent ratio will decrease.

7 Increase Payment of a previously declared cash dividend will

reduce both current assets and current liabilities by thesame amount An equal reduction in both current assetsand current liabilities will always result in an increase inthe current ratio, so long as the current assets exceed thecurrent liabilities

8 No effect Book value per share is not affected by the current market

price of the company’s stock

9 Decrease The dividend yield ratio is obtained by dividing the

dividend per share by the market price per share If thedividend per share remains unchanged and the marketprice goes up, then the yield will decrease

10 Increase Selling property for a profit would increase net income

and therefore the return on total assets would increase

11 Increase A write-off of inventory will reduce the inventory

balance, thereby increasing the turnover in relation to agiven level of cost of goods sold

12 Increase Since the company’s assets earn at a rate that is higher

than the rate paid on the bonds, leverage is positive,increasing the return to the ordinary shareholders

13 No effect Changes in the market price of a stock have no direct

effect on the dividends paid or on the earnings per shareand therefore have no effect on this ratio

14 Decrease A decrease in net income would mean less income

available to cover interest payments Therefore, thetimes-interest-earned ratio would decrease

15 No effect Write-off of an uncollectible account against the

Allowance for Bad Debts will have no effect on totalcurrent assets For this reason, the current ratio willremain unchanged

16 Decrease A purchase of inventory on account will increase current

liabilities, but will not increase the quick assets (cash,accounts receivable, marketable securities) Therefore,

the ratio of quick assets to current liabilities willdecrease.

17 Increase The price-earnings ratio is obtained by dividing the

market price per share by the earnings per share If theearnings per share remains unchanged, and the marketprice goes up, then the price-earnings ratio will increase

18 Decrease Payments to creditors will reduce the total liabilities of a

company, thereby decreasing the ratio of total debt tototal equity

Problem 14 (Interpretation of Financial Ratios)

a The market price is going down The dividends paid per share over thethree-year period are unchanged, but the dividend yield is going up.Therefore, the market price per share of stock must be decreasing

b The earnings per share is increasing Again, the dividends paid pershare have remained constant However, the dividend payout ratio isdecreasing In order for the dividend payout ratio to be decreasing, theearnings per share must be increasing

c The price-earnings ratio is going down If the market price of the stock

is going down [see part (a) above], and the earnings per share are going

up [see part (b) above], then the price-earnings ratio must bedecreasing

d In Year 1, leverage was negative because in that year the return on totalassets exceeded the return on ordinary equity In Year 2 and in Year 3,leverage was positive because in those years the return on ordinaryequity exceeded the return on total assets employed

e It is becoming more difficult for the company to pay its bills as theycome due Although the current ratio has improved over the three years,the acid-test ratio is down Also note that the accounts receivable andinventory are both turning more slowly, indicating that an increasingportion of the current assets is being made up of those items, fromwhich bills cannot be paid

f Customers are paying their bills more slowly in Year 3 than in Year 1.This is evidenced by the decline in accounts receivable turnover

g Accounts receivable is increasing This is evidenced both by aslowdown in turnover and in an increase in total sales