Measures of liquidity include the following three required: Current ratio current assets divided by current liabilities.. Quick ratio quick assets divided by current liabilities.. The re
Trang 1Financial Statements Analysis
Review Questions
1 A ratio is a mathematical expression of the relation of one figure to another.
The purpose in computing a ratio is simply to draw attention to this relationship The reader of a financial statement may observe, for example, that sales were P12 million and accounts receivable P1 million If he or she states this relationship as a ratio—that is, that receivables turn over about 12 times per year—the information may become more useful
2 Measures of liquidity include the following (three required):
Current ratio (current assets divided by current liabilities).
Quick ratio (quick assets divided by current liabilities).
Working capital (current assets less current liabilities).
Net cash provided by operating activities (appears in a statement of cash
flows)
3 Current assets are expected to be converted into cash (or substituted for cash)
within one year or an operating cycle, whichever is the longer period of time.
The receivables of a company that regularly sells merchandise on 24- or
36-month installment plans are current assets, because the collection of these receivables is part of the company’s operating cycle.
4 The quick ratio is quick assets (cash, marketable securities, and receivables)
divided by current liabilities Short-term creditors may consider the quick ratio more useful than the current ratio if inventories consist of slow-moving merchandise, or are unusually large in peso amount
5 The debt ratio is computed by dividing total liabilities by total assets It is
considered a measure of the long-term safety of creditors’ claims, rather than
a measure of short-term liquidity
Trang 26 Ratios and other measures used in evaluating profitability include (four required):
Percentage change in net income from the prior year (peso amount of the
change divided by the amount in the prior year)
Gross profit rate (peso gross profit divided by net sales).
Operating income (revenue from primary business activities less the cost of
goods sold and operating expenses)
Net income as a percentage of net sales (net income divided by net sales) Earnings per share (in the simplest case, net income divided by the number
of shares of share capital outstanding)
Return on assets (operating income divided by average total assets).
Return on equity (net income divided by average equity).
7 A large corporation may have thousands or even millions of individual shareholders The extent of each shareholder’s ownership of the business is determined by the number of shares that he or she owns Thus, the earnings per share measurement helps shareholders relate the total earnings of the business to their ownership investments
8 If the company’s earnings are very low, they may become almost
insignificant in relation to share price While this means that the p/e ratio becomes very high, it does not necessarily mean that investors are optimistic
In fact, they may be valuing the company at its liquidation value rather than a value based upon expected future earnings
9 A corporate net income of P1 million would be unreasonably low for a large 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 of this size would suggest that the owners could do much better by investing in insured bank savings accounts or in government bonds which would be virtually risk-free and would pay a higher return
10 The current ratio would probably be higher during July At this time the amount of both current assets and current liabilities are likely to be at a minimum, and the ratio of current assets to current liabilities is thus likely to
be larger In general, it would be advisable for the company to end its fiscal year as of July 31 At this time inventories and receivables will be at a minimum; therefore, the chance of error in arriving at a valuation for these
Trang 3assets will be minimized, the work of taking inventories will be reduced, and
a more accurate determination of net income is probable
Exercises
Exercise 1
(Pesos in Millions)
a (1) Quick assets:
Cash and short-term investments P 94.6 Receivables 319.4 Total quick assets P414.0 (2) Current assets:
Quick assets [part a (1)] P414.0 Inventories 144.6 Prepaid expenses and other current assets 64.0 Total current assets P622.6
b (1) Quick ratio:
Total quick assets (part a) P414.0 Current liabilities 260.2 Quick ratio (P414 P260.2) 1.6 to 1 (2) Current ratio:
Total current assets (part a) P622.6 Current liabilities 260.2 Current ratio (P622.6 P260.2) 2.4 to 1 (3) Working capital:
Total current assets (part a) P622.6 Less: Current liabilities 260.2 Working capital P362.4
c By traditional standards, Shin Toys seems to be quite solvent Both its quick ratio and current ratio are well above rule-of-thumb levels, and its working capital balance is substantial As a large and well-established company, it is quite possible that Shin Toys might be able to remain solvent even if its
liquidity measures became lower than normal.
Trang 4Exercise 2
Requirement (a)
(Pesos in thousands, except per share amounts)
WANSO, INC
Statement of Earnings For the Year Ended December 31, 2007 Net sales P8,790,506 Less: Cost of goods sold 5,642,910 Gross profit P3,147,596 Less: Operating expenses 2,008,792 Operating income P1,138,804 Nonoperating items:
Interest revenue P 31,594
Income taxes (462,320 ) (430,726 ) Net earnings P 708,078 Earnings per share P3.16
Requirement (b)
(1) Gross profit rate:
(2) Net income as a percentage of net sales:
Net income as a percentage of net sales
(3) Return on assets:
(4) Return on equity:
Requirement (c)
Trang 5The sale of retail clothing represents the company’s primary source of revenue
from operations Thus, interest revenue is a nonoperating source of revenue To
include interest revenue in the gross profit computation would overstate both gross profit and operating income
Exercise 3
a Percentage change in earnings per share:
In 2007:
Peso change from prior year (P9.06 – P6.16) +P2.90 Earnings per share in 2006 P6.16 Percentage change (+P2.90 P6.16) +47.1%
In 2008:
Peso change from prior year (P10.96 – P9.06) +P1.90 Earnings per share in 1987 P9.06 Percentage change (+P1.90 P9.06) +21.0%
b 2.5 to 1 (P27.50 market price divided by P10.96 earnings per share.)
c The low p/e ratio, especially in the face of rapidly accelerating earnings, indicates that investors expected Auto Max’s future earnings to decline from the 2008 levels It appears that the market was right, as earnings per share levels for 2009 through 2013 were far below the 2008 level
Note to instructor: All earnings per share figures shown in the problem have
been adjusted to reflect the effect of a 2-for-1 share split which occurred subsequent to 2008
Exercise 4
Trang 6Requirement (a)
Return on assets = Operating income
Average total assets
[(P29,096 + P30,392) 2] P29,744
Requirement (b)
Return on equity = Average total equityNet income
[(P9,124 + P9,348) 2] = P9,236
Requirement (c)
Equity figures shown in the balance sheet are reported at book value, not market
value Thus, the increase in Happy Talk’s total equity for the year did not result
from an increase in the market value of the company’s shares
Exercise 5
a (1) Gross profit percentage:
2007: 32% [(P1,200,000 P816,000) P1,200,000]
2008: 34% [(P1,500,000 – P990,000) P1,500,000]
(2) Inventory turnover:
2007: 4 times (P816,000 P204,000 average inventory)
2008: 4.5 times (P990,000 P220,000 average inventory)
(3) Accounts receivable turnover:
2007: 6 times (P1,200,000 P200,000 average accounts receivable) 2008: 5 times (P1,500,000 P300,000 average accounts receivable)
b There are three highly favorable trends First, the growth in net sales from
P1,200,000 to P1,500,000 This represents an increase of 25% (P300,000
increase, divided by P1,200,000 in the prior year) Next, the gross profit rate increased from 32% in 2007 to 34% in 2008 Not only is Spectrum’s selling more, but it is selling its merchandise at a higher profit margin Finally, the inventory turnover has increased, indicating that the company has increased
Trang 7its sales without having to proportionately increase its investment in
inventories
There is only one negative trend The accounts receivable turnover rate has declined One question immediately should come to mind: Has Spectrum’s liberalized its credit policies as part of its strategy to increase sales? If so, the
“slowdown” in the receivables turnover may have been expected and be no
cause for concern On the other hand, if the company has not changed its
credit policies, it apparently is encountering more difficulty in collecting its accounts receivable on a timely basis
Exercise 6
a Current ratio: 3.6 to 1 (P1,080,000 P300,000)
b Quick ratio: 1.4 to 1 (P420,000 P300,000)
c Working capital: P780,000 (P1,080,000 – P300,000)
d Debt ratio: 40% (P960,000 P2,400,000)
e Accounts receivable turnover: 18 times (P5,580,000 P310,000)
f Inventory turnover: 6.2 times (P3,348,000 P540,000)
g Book value per share of capital stock: P24.00 (P1,440,000 60,000 shares)
Exercise 7
Trang 8b The current ratio is 2.8 to 1 It is computed by dividing the current assets of P1,274,380 by the current liabilities of P455,200 The amount of working capital is P819,180, computed by subtracting the current liabilities of P455,200 from the current assets of P1,274,380
The company appears to be in a strong position as to short-run debt-paying ability It has almost three pesos of current assets for each peso of current liabilities Even if some losses should be sustained in the sale of the merchandise on hand or in the collection of the accounts receivable, it appears probable that the company would still be able to pay its debts as they fall due
in the near future Of course, additional information, such as the credit terms
on the accounts receivable, would be helpful in a careful evaluation of the company’s current position
Exercise 8
Current ratio (P3,029.6
Trang 9Working capital P(848.4)
c No It is difficult to draw conclusions from the above ratios Makati’s
current ratio and quick ratio are well below “safe” levels, according to
traditional rules of thumb On the other hand, some large companies with
steady cash flows are able to operate successfully with current ratios lower
than Makati’s
d Due to characteristics of the industry, supermarkets tend to have smaller amounts of current assets and quick assets than other types of merchandising companies An inventory of food has a short shelf life
Therefore, the inventory of a supermarket usually represents only a few
weeks’ sales Other merchandising companies may stock inventories representing several months’ sales Also, supermarkets sell primarily for
cash Thus, they have relatively few receivables Although supermarkets may 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
e In evaluating Makati’s liquidity, it would be useful to review the company’s financial position in prior years, statements of cash flows, and
the financial ratios of other supermarket chains One might also ascertain the company’s credit rating from an agency such as Dun & Bradstreet
Exercise 9
Requirement 1
Net income P324,000 P240,000 Less preference dividends 16,000 16,000 Net income remaining for ordinary (a) P308,000 P224,000 Average number of ordinary shares (b) 50,000 50,000 Earnings per share (a) ÷ (b) P6.16 P4.48
b Ordinary dividend per share (a)* P2.16 P1.20
Market price per share (b) P45.00 P36.00 Dividend yield ratio (a) ÷ (b) 4.8% 3.33%
*P108,000 ÷ 50,000 shares = P2.16;
P60,000 ÷ 50,000 shares = P1.20
Trang 10This Year Last Year
c Ordinary dividend per share (a) P2.16 P1.20
Earnings per share (b) P6.16 P4.48 Dividend payout ratio (a) ÷ (b) 35.1% 26.8%
d Market price per share (a) P45.00 P36.00
Earnings per share (b) P6.16 P4.48 Price-earnings ratio (a) ÷ (b) 7.3 8.0 Investors regard Metro Building Supply less favorably than other firms in the
industry This is evidenced by the fact that they are willing to pay only 7.3
times current earnings for a share of the company’s stock, as compared to 9
times current earnings for the average of all stocks in the industry If
investors were willing to pay 9 times current earnings for Metro Building
Supply’s stock, then it would be selling for about P55 per share (9 × P6.16),
rather than for only P45 per share
Equity P2,150,000 P1,950,000 Less preference shares 200,000 200,000 Ordinary equity (a) P1,950,000 P1,750,000 Number of ordinary shares (b) 50,000 50,000 Book value per share (a) ÷ (b) P39.00 P35.00
A market price in excess of book value does not mean that the price of a
stock is too high Market value is an indication of investors’ perceptions of
future earnings and/or dividends, whereas book value is a result of already
completed transactions and is geared to the past
Requirement 2
Net income P 324,000 P 240,000 Add after-tax cost of interest paid:
[P90,000 × (1 – 0.40)] 54,000 54,000 Total (a) P 378,000 P 294,000 Average total assets (b) P3,650,000 P3,000,000 Return on total assets (a) ÷ (b) 10.4% 9.8%
Trang 11Net income P 324,000 P 240,000 Less preference dividends 16,000 16,000 Net income remaining for ordinary
shareholders (a) P 308,000 P 224,000 Average total equity* P2,050,000 P1,868,000 Less average preference shares 200,000 200,000 Average ordinary equity (b) P1,850,000 P1,668,000
*1/2(P2,150,000 + P1,950,000); 1/2(P1,950,000 + P1,786,000)
Return on ordinary equity (a) ÷ (b) 16.6% 13.4%
c Financial leverage is positive in both years, since the return on ordinary
equity is greater than the return on total assets This positive financial
leverage is due to three factors: the preference shares, which has a dividend
of only 8%; the bonds, which have an after-tax interest cost of only 7.2%
[12% interest rate × (1 – 0.40) = 7.2%]; and the accounts payable, which may
bear no interest cost
Requirement 3
We would recommend keeping the stock The stock’s downside risk seems small,
since it is selling for only 7.3 times current earnings as compared to 9 times
earnings for the average firm in the industry In addition, its earnings are strong
and trending upward, and its return on ordinary equity (16.6%) is extremely
good Its return on total assets (10.4%) compares favorably with that of the
industry
The risk, of course, is whether the company can get its cash problem under
control Conceivably, the cash problem could worsen, leading to an eventual
reduction in profits through inability to operate, a reduction in dividends, and a
precipitous drop in the market price of the company’s stock This does not seem
likely, however, since the company can easily control its cash problem through
more careful management of accounts receivable and inventory If this problem
is brought under control, the price of the stock could rise sharply over the next
few years, making it an excellent investment
Test Materials