Chapter 04 - Answer

MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual

CHAPTER 4 FINANCIAL STATEMENTS ANALYSIS - I I.

Questions 1. The objective of financial statements analysis is to determine the extent of a firm’s success in attaining its financial goals, namely: a. To earn maximum profit b. To maintain solvency c. To attain stability 2. Some of the indications of satisfactory short-term solvency or working capital position of a business firm are: 1. Favorable credit position 2. Satisfactory proportion of cash to the requirements of the current volume 3. Ability to pay current debts in the regular course of business 4. Ability to extend more credit to customers 5. Ability to replenish inventory promptly 3. These tests are: 1. Improvement in the financial position 2. Well-balanced financial structure between borrowed funds and equity 3. Effective employment of borrowed funds and equity 4. Ability to declare satisfactory amount of dividends to shareholders 5. Ability to withstand adverse business conditions 6. Ability to engage in research and development in an attempt to provide new products or improve old products, methods or processes

4. Some indicators of managerial efficiency are:

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Chapter 4 Financial Statements Analysis - I

1. Ability to earn a reasonable return on its investment of borrowed funds and equity 2. Ability to control operating costs within reasonable limits 3. No overinvestment in fixed assets, receivables and inventories 5. The techniques used in Financial Statement Analysis are: I.

Vertical analysis which shows the relationships of the items in the same year: also referred to as “static measure.” a. Financial ratios b. Common-size statements

II. Horizontal analysis which shows the changes or tendencies of an item for 2 or more years; also referred to as “dynamic measure.” a. Comparative statements - showing changes in absolute amount and percentages b. Trend percentages III. Use of special reports or statements a. Statements of Changes in Financial Position b. Gross Profit / Net Income Variation Analysis 6. Refer to page 133 of the textbook. 7. Horizontal analysis involves the comparison of items on financial statements between years. Analysis of comparative financial statements or the increase/decrease method of analysis and trend percentages are the two techniques that may be applied under horizontal analysis. Vertical analysis involves the study of items on a single statement for a single year, such as the analysis of an income statement for some given year. Common-size statement and financial ratios are techniques used in vertical analysis. 8. Trends can indicate whether a situation is improving, remaining the same or deteriorating. They can also give insight to the probable future course of events in a firm. 9. Trend percentages represent the expression of several years’ financial data in percentage form in terms of a base year. 10. Refer to page 133 of the textbook.

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Financial Statements Analysis - I Chapter 4

11. Observation of trends is useful primarily in determining whether a situation is improving, worsening, or remaining constant. By comparing current data with similar data of prior periods we gain insight into the direction in which future results are likely to move. Some other standards of comparison include comparison with other similar companies, comparison with industry standards, and comparison with previous years’ information. By comparing analytical data for one company with some independent yardstick, the analyst hopes to determine how the position of the company in question compares with some standard of performance. 12. Trend percentages are used to show the increase or decrease in a financial statement amount over a period of years by comparing the amount in each year with the base-year amount. A component percentage is the percentage relationship between some financial amount and a total of which it is a part. Measuring the change in sales over a period of several years would call for use of trend percentages. The sales in the base year are assigned a weight of 100%. The percentage for each later year is computed by dividing that year’s sales by the sales in the base year. 13. Expenses (including the cost of goods sold) have been increasing at an even faster rate than net sales. Thus Premiere is apparently having difficulty in effectively controlling its expenses. 14. 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. 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, P3 million, 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 1. True

3. True

5. False 4-3

7. True

9. True

Chapter 4 Financial Statements Analysis - I

2. False

4. True

6. False

8. False

10. True

III. Problems Problem 1 (Percentage Changes) a. Accounts receivable decreased 16% (P24,000 decrease  P150,000 = 16% decrease). b. Marketable securities decreased 100% (P250,000 decrease  P250,000 = 100% decrease). c. A percentage change cannot be calculated because retained earnings showed a negative amount (a deficit) in the base year and a positive amount in the following year. d. A percentage change cannot be calculated because of the zero amount of notes receivable in 2005, the base year. e. Notes payable increased 7 ½% (P60,000 increase  P800,000 = 7 ½% increase). f. Cash increased 3% (P2,400 increase  P80,000 = 3% increase). g. Sales increased 10% (P90,000 increase  P900,000 = 10% increase). Problem 2 (Computing and Interpreting Rates of Change) Requirement (a) Computation of percentage changes: 1. Net sales increased 10% (P200,000 increase  P2,000,000 = 10% increase). 2. Total expenses increased 11% (P198,000 increase  P1,800,000 = 11% increase). Requirement (b) 1. Total expenses grew faster than net sales. Net income cannot also have grown faster than net sales, or the sum of the parts would exceed the size of the whole. 2. Net income must represent a smaller percentage of net sales in 2006 than it did in 2005. Again, the reason is that the expenses have grown at a faster rate than net sales. Thus, total expenses represent a larger percentage of total sales in 2006 than in 2005, and net income must represent a smaller percentage.

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Financial Statements Analysis - I Chapter 4

Problem 3 (Financial Statement Analysis using Comparative Statements or Increase-Decrease Method) Requirement 1 XYZ Corporation Balance Sheet As of December 31

Change Peso

Assets Cash and equivalents Receivables Inventories Prepayments and others Total current assets Property, plant & equipment - net of dep. Total assets Liabilities and Equity Notes payable to banks Accounts payable Accrued liabilities Income taxes payable Total current liabilities Share capital Retained earnings Total equity Total liabilities and equity XYZ Corporation Income Statement Years ended December 31 (P thousands)

%

2005

2006

14,000 28,800 54,000 4,800 101,600

16,000 55,600 85,600 7,400 164,600

2,000 26,800 31,600 2,600 63,000

14.29% 93.06% 58.52% 54.17% 62.01%

30,200 131,800

73,400 238,000

43,200 106,200

143.05% 80.58%

10,000 31,600 4,200 5,800 51,600 44,600 35,600 80,200 131,800

54,000 55,400 6,800 7,000 123,200 44,600 70,200 114,800 238,000

44,000 23,800 2,600 1,200 71,600 0 34,600 34,600 106,200

440.00% 73.32% 61.90% 20.69% 138.76% 0.00% 97.19% 43.14% 80.58%

Change Peso Net sales Cost of goods sold Gross profit Selling, general and administrative expenses Income before income taxes Income taxes Net income

%

2005 266,400 191,400 75,000

2006 424,000 314,600 109,400

157,600 123,200 34,400

59.16% 64.37% 45.87%

35,500 39,500 12,300 27,200

58,400 51,000 16,400 34,600

22,900 11,500 4,100 7,400

64.51% 29.11% 33.33% 27.21%

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Chapter 4 Financial Statements Analysis - I

Requirement 2 Short-term financial position 1. Current increased by 62.01% Assets  Unfavorable 2. Quick increased by 62.40% Assets  Unfavorable 3. Net increased by 59.16% Sales  Unfavorable 4. Cost of increased by 64.37% Goods Sold  Favorable Leverage 5. Total increased by 80.58% Assets  Unfavorable 6. Total increased by 138.76% Liabilities  Unfavorable Profitability 7. Net increased by 59.16% Sales  Unfavorable 8. Net Sales

increased by 59.16%

while

Current Liabilities

increased by 138.76%

while

Current Liabilities

increased by 138.76%

while

Accounts Receivable

increased by 93.06%

while

10. Net Income

increased by 59.16%

Total Liabilities

increased by 138.76%

while

Total Equity

increased by 43.14%

while

Cost of Goods Sold

increased by 64.37%

while

Selling, General & increased by 64.51% Administrative Expenses

while

Net Income

increased by 27.21%

while

Total Assets

increased by 80.58%

 Unfavorable increased by 27.21%

increased by 58.52%

while

 Unfavorable 9. Net Sales

Inventories

 Unfavorable

Problem 4 (Trend Percentages) Requirement (1) The trend percentages are: 4-6

Financial Statements Analysis - I Chapter 4

Year 5 Year 4 Year 3 Year 2 Year 1 125.0 120.0 110.0 105.0 100.0

Sales Cash Accounts receivable Inventory Total current assets

80.0 140.0 112.0 118.8

90.0 124.0 110.0 113.1

105.0 108.0 102.0 104.1

110.0 104.0 108.0 106.9

100.0 100.0 100.0 100.0

Current liabilities

130.0

106.0

108.0

110.0

100.0

Requirement (2) Sales:

The sales are increasing at a steady rate, with a particularly strong gain in Year 4.

Assets:

Cash declined from Year 3 through Year 5. This may have been due to the growth in both inventories and accounts receivable. In particular, the accounts receivable grew far faster than sales in Year 5. The decline in cash may reflect delays in collecting receivables. This is a matter for management to investigate further.

Liabilities:

The current liabilities jumped up in Year 5. This was probably due to the buildup in accounts receivable in that the company doesn’t have the cash needed to pay bills as they come due. Problem 5 (Use of Trend Percentages) a. 1. An unfavorable tendency could be observed in Receivables in relation to Net Sales from 2003 – 2005 because receivables had been increasing at a much faster rate than Net Sales. This could indicate inefficiency in the collection of receivables or simply poor company credit policy. The situation however, improved in 2006 and 2007 when sales started to move up at a faster rate than accounts receivable. This would indicate improvement in the credit and collection policy or more cash sales were being generated. 2. Unfavorable tendency in inventory persisted from 2003 to 2007 because it had been going up at a much faster rate than Net Sales. If this continues, the company will end up with over-investment in inventory because the buying rate is faster than the selling price. 3. Favorable tendencies could be noted in Fixed Assets in relation to Net Sales because inspite of the minimal additions to fixed assets made by 4-7

Chapter 4 Financial Statements Analysis - I

the company from 2003 through 2007, sales had been increasing at a very encouraging rate. 4. Net Income had likewise been increasing at a much faster rate than net sales. This is favorable because this would indicate that the company had been successfully controlling the increases in Cost of Sales and Operating Expenses. b. Review computations of the Trend Percentages. It will be noted that the Trend Percentages in Total Noncurrent Liabilities and Equity from 2005 to 2007 were interchanged. Correction should be made first before interpretation is done. 1. The upward tendency in current assets had been accompanied by an upward trend in current liabilities. It could be noted that current assets had been moving up at a much faster rate than current liabilities. This is favorable because the margin of safety of the shortterm creditors is widened. 2. Favorable tendencies could also be observed in noncurrent assets which had been increasing and which increases had been accompanied by downward trend in noncurrent liabilities. This would mean better security on the part of creditors and stronger financial position. 3. There is an unfavorable tendency in Net Sales in relation to noncurrent assets. Sales had not been increasing at the same rate as the increases in fixed assets. This could indicate that more investments are made in noncurrent assets without considering whether or not they could sell the additional units of product they are producing. c. The unfavorable trend in net income could be attributed to the following tendencies: 1. Higher rates of increases in cost of sales as compared to sales. 2. Higher rates of increases in selling, general and administrative expenses in relation to net sales. 3. Higher rates of increases in other financial expenses than the rates of increases in net sales. IV. Multiple Choice Questions 1. 2. 3. 4. 5.

D A A B D

11. A, C, D 12. B*

13. D

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Financial Statements Analysis - I Chapter 4

6. 7. 8. 9. 10.

C C A D C

* (P400,000 – P160,000)  P160,000 = 150%

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