FSA3e HW Answers Modules 1-4

Module 1 Q1-1.

Organizations undertake planning activities that shape three major activities: financing, investing, and operating. Financing is the means a company uses to pay for resources. Investing refers to the buying and selling of resources necessary to carry out the organization’s plans. Operating activities are the actual carrying out of these plans. Planning is the glue that connects these activities, including the organization’s ideas, goals and strategies. Financial accounting information provides valuable input into the planning process, and, subsequently, reports on the results of plans so that corrective action can be taken, if necessary.

Q1-2.

An organization’s financing activities (liabilities and equity = sources of funds) pay for investing activities (assets = uses of funds). An organization’s assets cannot be more or less than its liabilities and equity combined. This means: assets = liabilities + equity. This relation is called the accounting equation (sometimes called the balance sheet equation), and it applies to all organizations at all times.

Q1-3.

The four main financial statements are: income statement, balance sheet, statement of stockholders’ equity, and statement of cash flows. The income statement provides information about the company’s revenues, expenses and profitability over a period of time. The balance sheet lists the company’s assets (what it owns), liabilities (what it owes), and stockholders’ equity (the residual claims of its owners) as of a point in time. The statement of stockholders’ equity reports on the changes to each stockholders’ equity account during the period. The statement of cash flows identifies the sources (inflows) and uses (outflows) of cash, that is, where the company got its cash from and what it did with it. Together, the four statements provide a complete picture of the financial condition of the company.

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Q1-4.

The balance sheet provides information that helps users understand a company’s resources (assets) and claims to those resources (liabilities and stockholders’ equity) as of a given point in time.

Q1-5.

The income statement covers a period of time. An income statement reports whether the business has earned a net income (also called profit or earnings) or incurred a net loss. Importantly, the income statement lists the types and amounts of revenues and expenses making up net income or net loss.

Q1-6.

The statement of cash flows reports on the cash inflows and outflows relating to a company’s operating, investing, and financing activities over a period of time. The sum of these three activities yields the net change in cash for the period. This statement is a useful complement to the income statement, which reports on revenues and expenses, but which conveys relatively little information about cash flows.

Q1-7.

Retained earnings (reported on the balance sheet) is increased each period by any net income earned during the period (as reported in the income statement) and decreased each period by the payment of dividends (as reported in the statement of cash flows and the statement of stockholders’ equity). Transactions reflected on the statement of cash flows link the previous period’s balance sheet to the current period’s balance sheet. The ending cash balance appears on both the balance sheet and the statement of cash flows.

Q1-8.

External users and their uses of accounting information include: (a) lenders for measuring the risk and return of loans; (b) shareholders for assessing the return and risk in acquiring shares; and (c) analysts for assessing investment potential. Other users are auditors, consultants, officers, directors for overseeing management, employees for judging employment opportunities, regulators, unions, suppliers, and appraisers.

Q1-9.

Forecasting is a method of formally expressing our expectations of a company's future payoffs. When forecasting company

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payoffs, we need to consider the effects of their business environment on the company's ability to achieve those future payoffs. Competitive forces as well as opportunities and threats will impact what the company can pay in the future. This in turn affects what payoffs are expected. A better understanding of business environment and accounting information leads to more accurate forecasts of the future and more reliable valuation estimates. Q1-10.A Procter & Gamble’s independent auditor is Deloitte & Touche LLP. The auditor expressly states that “our responsibility is to express an opinion on these financial statements based on our audits.” The auditor also states that “these financial statements are the responsibility of the company’s management.” Thus, the auditor does not assume responsibility for the financial statements. Q1-11.B While firms acknowledge the increasing need for more complete disclosure of financial and nonfinancial information, they have resisted these demands to protect their competitive position. Corporate executives must weigh the benefits they receive from the financial markets as a result of more transparent and revealing financial reporting against the costs of divulging proprietary information to competitors and others. Q1-12.B Generally Accepted Accounting Principles (GAAP) are the various methods, rules, practices, and other procedures that have evolved over time in response to the need to regulate the preparation of financial statements. They are primarily set by the Financial Accounting Standards Board (FASB), a private sector entity with representatives from companies that issue financial statements, accounting firms that audit those statements, and users of financial information. Other bodies that contribute to GAAP are the AICPA, the EITF, and the SEC.

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Q1-13.B Corporate governance is the system of policies, procedures and mechanisms that protect the interests of stakeholders in the business. These stakeholders include investors, creditors, regulatory bodies, and employees, to name a few. Sound corporate governance involves the maintenance of an effective internal auditing function, an independent and effective external auditing function, an informed and impartial board of directors, governmental oversight (such as from the SEC), and the oversight of the courts. Q1-14.B The auditor’s primary function is to express an opinion as to whether the financial statements fairly present the financial condition of the company and are free from material misstatements. Auditors do not prepare the financial statements; they only audit them and issue their opinion on them. The auditors provide no guarantees about the financial statements or about the company’s continued performance. Q1-15.

Financial accounting information is frequently used in order to evaluate management performance. The return on equity (ROE) and return on assets (ROA) provide useful measures of financial performance as they combine elements from both the income statement and the balance sheet. Financial accounting information is also frequently used to monitor compliance with external contract terms. Banks often set limits on such items as the amount of total liabilities in relation to stockholders’ equity or the amount of dividends that a company may pay. Audited financial statements provide information that can be used to monitor compliance with these limits (often called covenants). Regulators and taxing authorities also utilize financial information to monitor items of interest.

Q1-16.

Managers are vitally concerned about disclosing proprietary information that might benefit the company’s competitors. Of most concern, is the “cost” of losing some competitive advantage. There has traditionally been tension between companies and the financial professionals (especially investment analysts) who press firms for more and more financial and nonfinancial information.

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Q1-17.

Net income is an important measure of financial performance. It indicates that the market values the company’s products or services, that is, it is willing to pay a price for the products or services enough to cover the costs to bring them to market and to provide the company’s investors with a profit. Net income does not tell the whole story, however. A company can always increase its net income with additional investment in something as simple as a bank savings account. A more meaningful measure of financial performance comes from measuring the level of net income relative to the investment made. One investment measure is the balance of stockholders’ equity, and the comparison of net income to average stockholders’ equity (ROE) is a fundamental measure of financial performance.

Q1-18.

Borrowed money must be repaid, both the principal amount borrowed, as well as interest on the borrowed funds. These payments have contractual due dates. If payments are not prompt, creditors have powerful legal remedies, including forcing the company into bankruptcy. Consequently, when comparing two companies with the same return on equity, the one using less debt would generally be viewed as a safer (less risky) investment.

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M1-21 ($ millions)

Hewlett-Packard General Mills Target

Assets

=

Liabilities

+

Equity

$124,503

$83,722

(a) $40,781

$18,674

(b) $12,062

$6,612

(c) $43,705

$28,218

$15,487

The percent of owner financing for each company follows: Hewlett-Packard ..................... 32.8%

($40,781 million / $124,503 million)

General Mills ........................... 35.4%

($6,612 million / $18,674 million)

Target ...................................... 35.4%

($15,487 million / $43,705 million)

General Mills and Target are more owner financed, while Hewlett-Packard is more nonowner financed, but all are financed with roughly the same level of debt and equity. All three enjoy relatively stable cash flows and can, therefore, utilize a greater proportion of debt vs. equity. As the uncertainty of cash flows increases, companies generally substitute equity for debt in order to reduce the magnitude of contractual payment obligations.

M1-24 a. BS and SCF

d. BS and SE

g. SCF and SE

b. IS

e. SCF

h. SCF and SE

c. BS

f. BS and SE

i. IS, SE, and SCF

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E1-27 a. Target has a proprietary credit card (the Target Card). Customers’ unpaid credit card balances at the end of the reporting period are similar to accounts receivable. b. Target’s inventories consist of the product lines it carries: clothing, electronics, home furnishings, food products, and so forth. c. Target’s PPE assets consist of land, buildings, store improvements such as lighting, flooring, HVAC, store shelving, shopping carriages, and cash registers. d. Although Target sells some of its merchandise via its Website, the majority of its sales activity is conducted in its retail locations. These stores represent a substantial and necessary capital investment for its business model.

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P1-36 a. General Mills, Inc. Income Statement ($ millions) For Year Ended May 29, 2011 Revenue ............................................................................... $14,880.2 Cost of goods sold .............................................................. 8,926.7 Gross profit .......................................................................... 5,953.5 Total expenses .................................................................... 4,155.2 Net income ........................................................................... $ 1,798.3

General Mills, Inc. Balance Sheet ($ millions) May 29, 2011 Cash .................................. $ 619.6 Noncash assets ................ 18,054.9 Total assets ...................... $18,674.5

Total liabilities ........................ $12,062.3 Stockholders’ equity .............. 6,612.2 Total liabilities and equity ..... $18,674.5

General Mills, Inc. Statement of Cash Flows ($ millions) For Year Ended May 29, 2011 Cash from operating activities Cash from investing activities Cash from financing activities Net change in cash Cash, beginning year Cash, ending year

$ 1,526.8 (715.1) (865.3) (53.6) 673.2 $ 619.6

b. A negative amount for cash from investing activities reflects further investment by the company in its long-term assets, which is generally a positive sign of management’s commitment to future business success. A negative amount for cash from financing activities reflects the reduction of long-term debt, which is often a positive sign of the company’s ability to retire debt obligations.

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P1-47A

a. The auditors address their report to the company’s board of directors and the shareholders of Apple Inc. This is an important point. Auditors work for the benefit of the shareholders and report directly to the board of directors, the elected representatives of the shareholders whose job it is to protect shareholder interests. It would not be appropriate for the external auditors to report directly to management because the auditors are examining management’s activities as described in the company’s financial statements. Reporting to the board preserves the auditor’s independence. b. The audit process consists of two components. First the auditors assess the company’s system of internal controls to ensure the information in the financial statements was gathered, recorded, aggregated in accordance with GAAP. This involves an assessment of the company’s accounting policies together with the assumptions used and estimates made in the preparation of the financial statements. Second, the auditors examine, on a test basis, evidence supporting the amounts and disclosures in the statements. The key word is test. Auditors do not examine each transaction. They take a sample from the transactions. If that sample does not uncover any irregularities, they go no further. If it does, they expand the sample until they are confident that the amounts presented in the statements fairly present the company’s performance and condition in accordance with GAAP. c. The nature of the independent auditors’ opinion is that the financial statements “present fairly, in all material respects, the financial condition of the company.” Because this is standard audit-report language, any deviations should raise a flag. “Present fairly” does not mean absolute assurance that the financials are error-free. It means that a reasonable person would conclude that the financial statements reasonably describe the financial condition of the company. d. KPMG also rendered an opinion on the company’s system of internal controls. Internal controls are designed to insure the integrity of the financial reporting system and the preservation of the company’s assets. A well-functioning internal control system is a critical component of the company’s overall corporate governance system.

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D1-53 Financing can come from a number of sources, including operating creditors, borrowed funds, and the sale of stock. Each has its strengths and weaknesses. 1. Operating creditors – operating creditors are merchandise and service suppliers, including employees. Generally, these liabilities are noninterest bearing. As a result, companies typically use this source of credit to the fullest extent possible, often stretching payment times. However, abuse of operating creditors has a significant downside. The company may be unable to supply its operating needs and the damage to employee morale might have significant repercussions. Operating credit must, therefore, be used with care. 2. Borrowed funds – borrowed money typically carries an interest rate. Because interest expense is deductible for tax purposes, borrowed funds reduce income tax expense. The taxes saved are called the “tax shield.” The deductibility of interest reduces the effective cost of borrowing. The downside of debt is that the company must make principal and interest payments as scheduled. Failure to make payments on time can result in severe consequences – creditors have significant legal remedies, including forcing the company into bankruptcy and requiring its liquidation. The lower cost of debt must be balanced against the fixed payment obligations. 3. Sale of stock – companies can sell various classes of stock to investors. Some classes of stock have mandatory dividend payments. On other classes of stock, dividends are not a legal requirement until declared by the board of directors. Consequently, unlike debt payments, some dividends can be curtailed in business downturns. The downside of stock issuance is its cost. Because equity is the most expensive source of capital, companies use it sparingly.

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Module 2 Q2-1.

An asset represents resources a company owns or controls. Assets are expected to provide future economic benefits. Assets arise from past events or transactions. A liability is an obligation that will require a future economic sacrifice. Equity is the difference between assets and liabilities. It represents the claims of the company’s owners to its income and assets. The following are some examples of each: Assets

 Cash  Receivables  Inventories  Plant, property and equipment (PPE)

Liabilities

 Accounts payable  Accrued liabilities  Deferred revenue  Notes payable  Long-term debt

Equity

 Contributed capital (common and preferred stock)  Additional paid-in capital  Retained earnings  Accumulated other comprehensive income  Treasury stock

Q2-2.

A cost that creates an immediate benefit is reported on the income statement as an expense. A cost that creates a future benefit is added to the balance sheet as an asset (capitalized) and will be transferred to the income statement as the benefit is realized. For example, PPE creates a future benefit and the cost of the PPE is transferred to the income statement (as depreciation expense) over the life of the PPE.

Q2-3.

Accrual accounting means that we record revenues when earned, and record expenses when they are incurred. Accrual accounting does not rely on cash flows in determining when items are

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revenues or expenses. This is why net income (a GAAP measure) differs from cash from operations. Q2-4.

Transitory items are revenues and expenses that are not expected to recur. One objective of financial analysis is to predict future performance. Given that perspective, transitory (nonrecurring) items are not relevant except to the extent that they convey information about future financial performance.

Q2-5.

The statement of stockholders’ equity provides information about the events that impact stockholders’ equity during the period. It contains information relating to net income, stock sales and repurchases, option exercises, dividends and other accumulated comprehensive income.

Q2-6.

The statement of cash flows reports the company’s cash inflows and outflows during the period, and categorizes them according to operating, investing and financing activities. The income statement reports profit earned under accrual accounting, but does not provide sufficient information concerning cash flows. The statement of cash flows fills that void.

Q2-7.

Articulation refers to the fact that the four financial statements are linked to each other and that changes in one statement affect the other three. For example, net income reported on the income statement is linked to the statement of retained earnings, which in turn is linked to the balance sheet. Understanding how the financial statements articulate helps us to analyze transactions and events and to understand how events affect each financial statement separately and all four together.

Q2-8.

When a company purchases a machine it records the cost as an asset because it will provide future benefits. As the machine is used up, a portion of this cost is transferred from the balance sheet to the income statement as depreciation expense. The machine asset is, thus, reduced by the depreciation, and equity is reduced as the expense reduces net income and retained earnings. If the entire cost of the machine was immediately expensed, profit would be reduced considerably in the year the machine was purchased. Then, in subsequent years, net income would be far too high as none of the machine’s cost would be

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reported in those years even though the machine produced revenues during that period. Q2-9.

An asset must be “owned” or “controlled,” it must provide “future economic benefits,” and it must arise from a past transaction or event. Owning means having title to the asset (some leased assets are also recorded on the balance sheet as we will discuss in our Module 10 entitled, “Reporting and Analyzing Off-Balance-Sheet Financing”). Future benefits may mean the future inflows of cash, or an increase in another asset, or reduction of a liability. Past event means the company has purchased the asset or acquired it in some other cash or noncash transaction or event.

Q2-10.

Liquidity refers to the ready availability of cash. That is, how much cash the company has on hand, how much cash is being generated, and how much cash can be raised quickly. Liquidity is essential to the survival of the business. After all, firms must pay loans and employee wages with cash.

Q2-11.

Current means that the asset will be liquidated (converted to cash) within the next year (or the operating cycle if longer than one year).

Q2-12.

GAAP uses historical costs because they are less subjective than market values. Market values can be biased for two reasons: first, we may not be able to measure them accurately (consider our inability to accurately measure the market value of a manufacturing facility, for example), and second, managers may intervene in the reporting process to intentionally bias the results to achieve a particular objective (like enhancing the stock price).

Q2-13.

Generally, excluded intangible (unrecorded) assets are those that contribute to a company’s sustainable competitive advantage, but that cannot be measured accurately. Some examples include the value of a brand, the management of a company, employee morale, a strong supply chain, superior store locations, credibility with the financial markets, reputation, and so forth.

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Q2-14.

An intangible asset is an asset that is not physical in nature. To be included on the balance sheet, it has to meet two tests: the company must own or control the asset, it must provide future economic benefits, and the asset must arise from a past event or transaction. Some examples are goodwill, patents and trademarks, contractual agreements like royalties, leases, and franchise agreements. An intangible asset is only recorded on the balance sheet when it is purchased from an outside party. For example, goodwill arises when the company acquires (either with cash or stock) another company’s brand name or any of the other intangibles listed above.

Q2-15.

An accrued liability is an obligation for expenses that have been incurred but not yet paid for with cash. Examples include wages that have been earned by employees and not yet paid, interest owing on a bank loan, and potential future warranty claims for products sold to customers. When the liability is recognized on the balance sheet, a corresponding expense is recognized in the income statement.

Q2-16.

Net working capital = current assets – current liabilities. Increasing the amount of trade credit (e.g., accounts payable to suppliers) increases current liabilities and reduces net working capital. Trade credit is like borrowing from a supplier to make purchases. As trade credit increases, the supplier is lending more money than before. This frees up cash, which the company can use for other purposes such as paying down interest-bearing debt or purchasing additional productive assets. Thus, net working capital decreases. This can be a good thing. As a business grows, its net working capital grows because inventories and receivables generally grow faster than accounts payable and accrued liabilities do. Net working capital must be financed just like long-term assets.

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Q2-17. Book value is the amount at which an asset (or liability) is carried on the balance sheet. The book value of the company is the book value of all the assets less the book value of all the liabilities, that is, the book value of stockholders’ equity. Book values are determined in accordance with GAAP. Market value is the sale price of an asset or liability. Markets are not constrained by GAAP standards and, therefore, can consider a number of factors that accountants cannot. Market values, therefore, generally differ significantly from book values. Q2-18.

The arrow running from net income to earned capital in the financial statement effects template denotes that retained earnings (part of earned capital) have been updated for the profit earned during the period. Retained earnings are reconciled as follows: beginning retained earnings + profit (– loss) – dividends = ending retained earnings. The line, thus, represents the profits that have been added (or the losses subtracted) to retained earnings (dividends are recorded as a direct reduction of retained earnings in the template).

M2-20 a. Balance sheet b. Income statement c. Balance sheet d. Income statement e. Balance sheet f. Balance sheet g. Balance sheet h. Balance sheet i. Income statement j. Income statement k. Balance sheet l. Balance sheet

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M2-23 2011 Beginning retained earnings ..............................$89,089 Add: Net income (loss) ..................................... (19,455) Less: Dividends ................................................... 0 Ending retained earnings ....................................$69,634

2012 $ 69,634 48,192 (15,060) $102,766

E2-27 Barth Company Income Statement For Year Ended December 31, 2011 Sales revenue ................................................................. Expenses Cost of goods sold ..................................................... $180,000 Wages expense .......................................................... 40,000 Supplies expense ....................................................... 6,000 Total expenses ........................................................... Net income......................................................................

$400,000

226,000 $174,000

Barth Company Balance Sheet December 31, 2011 Assets Liabilities and equity Cash ....................................$ 48,000 Accounts payable ........................................................ $ 16,000 Accounts receivable .......... 30,000 Bonds payable ............................................................. 200,000 Supplies inventory ............. 3,000 Total liabilities .............................................................. 216,000 Inventory ............................. 36,000 Land .................................... 80,000 Common stock ............................................................. 150,000 Equipment .......................... 70,000 Retained earnings ....................................................... 60,000 Buildings.............................151,000 Total equity................................................................... 210,000 Goodwill .............................. 8,000 Total assets ........................ $426,000 Total liabilities and equity ........................................... $426,000

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P2-39 a. Balance Sheet

Income Statement

LiabilTransaction Beginning bal.

Cash Asset 0

+

Noncash Assets

=

0

=

ities

+150,000 1. Sefcik invested $50,000 into the business in exchange for common stock; company also borrowed $100,000 from a bank

2. Sefcik purchased equipment for $95,000 cash and purchased inventory of $40,000 on credit

Cash

=

-95,000

+95,000

Cash

PPE

+

0

0

+100,000

+50,000

Note

Common

Payable

Stock

= +40,000 +40,000 Accounts Inventory Payable

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Earned Contrib. Capital

+

Capital 0

Net Revenues

–

Expenses

= Income

–

=

–

=

–

=

P2-39 (continued)

Balance Sheet

Income Statement

LiabilTransaction

Cash Asset

+

Noncash Assets

Earned

= ities

+

Contrib. Capital

+

Capital

+50,000

Net Revenues

–

Expenses

= Income

+50,000 +50,000

Cash

Sales

+50,000

Retained 3. Sefcik Co. sold inventory costing $30,000 for $50,000 cash

Earnings =

–

-30,000

-30,000

Inventory

Retained

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= -30,000

Cost of Goods Sold

Earnings

4. Sefcik Co. paid -10,000 $10,000 cash for Cash wages owed employees for October work 5. Sefcik Co. paid -1,000 interest on the bank Cash loan of $1,000 cash

+30,000

-10,000

+10,000 -10,000

=

Retained

–

Wage

Earnings

Expense

-1,000

+1,000

=

-1,000 =

Retained Earnings

–

Interest Expense

=

P2-39 (continued) Balance Sheet

Income Statement

LiabilTransaction

Cash Asset

Earned

= ities

+

Contrib. Capital

+

Capital

Net Revenues

–

-500

6. Sefcik Co. recorded $500 depreciation expense related to equipment 7. Sefcik Co. paid a dividend of $2,000 cash

+

Noncash Assets

Expenses

= Income

+500

-500 =

Retained

–

Deprec.

=

-500

PPE Earnings -2,000

Exp

-2,000 =

–

Cash

Ending balance 92,000

=

Dividends 104,500

= 140,000

50,000

6,500

50,000

–

41,500

=

8,500

b.

b. Sefcik Co. Income Statement For Month of October Sales revenue ......................................................................................... $50,000 Total expenses ....................................................................................... 41,500 Net income.............................................................................................. $ 8,500 Sefcik Co. Retained Earnings Reconciliation For Month of October Retained earnings, October 1 ............................................................. $ 0 Add: Net income ................................................................................ 8,500 Less: Dividends ..................................................................................(2,000) Retained earnings, October 31 ........................................................... $ 6,500

Sefcik Co. Balance Sheet October 31 Cash .................................... $ 92,000 Liabilities ....................................................................... $140,000 Noncash assets.................. 104,500 Contributed capital ....................................................... 50,000 Retained earnings ......................................................... 6,500 ________ Total equity .................................................................... 56,500 Total assets ........................ $196,500 Total liabilities and equity ............................................ $196,500 Solutions Manual

P2-43 a. Depreciation is added back to undo the effect it had on the income statement. Wal-Mart deducted $7,641 million of depreciation (and amortization) expense in computing net income. Depreciation is a noncash expense so Wal-Mart did not actually use $7,641 million of cash to pay depreciation expense. Thus, to determine how much cash was generated, net income is too low by the depreciation amount of $7,641 million. The depreciation add-back is NOT a source of cash as some mistakenly believe. Cash is, ultimately, generated by profitable operations, not by depreciation. b. Revenue is recognized, and profit increased, when it is earned, whether or not cash is received. Sales on account, therefore, increase profit, and the deduction for the increase in receivables reflects the fact that cash has not yet been received. The negative sign on the increase in inventories reflects the outflow of cash when inventories are purchased. Inventories are typically purchased on account. As a result, payment is not made when the inventories are purchased. The positive sign on the increase in accounts payable offsets a portion of the negative sign on the inventory increase, and the net amount represents the net cash paid for the increase in inventories. Accounts payable are typically non-interest bearing, thus providing a cheap and important source of cash. Accruals relate to expenses that have been recognized in the income statement that have not yet been paid. A decrease in accrued liabilities means that cash paid out for expenses during the year was greater than the expenses recognized in the income statement. Therefore, a decrease in accrued expenses is shown as a cash outflow. c. Companies must continue to invest in their infrastructure, both for new additions and replacement, to remain competitive. Depreciation expense represents the using up of depreciable assets. In general, we should expect capital expenditures (CAPEX) to exceed depreciation expense. This indicates that the company is growing its infrastructure as well as replacing the portion that is wearing out.

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P2-43 (concluded) d. If Wal-Mart can make a better return on reinvesting its cash back into the business than the return shareholders can earn for themselves on the cash they would receive, Wal-Mart should forgo paying dividends or repurchasing shares. Many companies with large cash inflows, especially mature companies in relatively saturated markets, find it hard to uncover additional investment opportunities. In those cases, returning the cash to investors is better than investing it in marketable securities, because investors can do that for themselves. e. Wal-Mart is a large, mature, and profitable company. In fiscal 2011, the company generated 39% more operating cash flows than reported profits; $23.6 billion of operating cash flow compared to $17.0 billion in net income. It funds capital expenditures for new stores and remodels with operating cash flows with no need for external financing. In the financing area, the company is borrowing to repurchase stock and to pay dividends, a substitution of lower-cost debt for higher-cost equity. This is a typical profile for a large, well-capitalized company like WalMart. In sum, Wal-Mart is exceptionally strong, and the company will likely continue investing in its infrastructure.

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Module 3 Q3-1.

Return on investment measures profitability in relation to the amount of investment that has been made in the business. A company can always increase dollar profit by increasing the amount of investment (assuming it is a profitable investment). So, dollar profits are not necessarily a meaningful way to look at financial performance. Using return on investment in our analysis, whether as investors or business managers, requires us to focus not only on the income statement, but also on the balance sheet.

Q3-2.A

Increasing leverage increases ROE as long as the assets earn a greater operating return than the cost of the additional debt. Financial leverage is also related to risk: the risk of potential bankruptcy and the risk of increased variability of profits. Companies must, therefore, balance the positive effects of financial leverage against their potential negative consequences. It is for this reason that we do not witness companies entirely financed with debt.

Q3-3.

Gross profit margins can decline because 1) the industry has become more competitive, and/or the firm’s products have lost their competitive advantage so that the company has reduced selling prices or is selling fewer units or 2) product costs have increased, or 3) the sales mix has changed from highermargin/slowly turning products to lower-margin/higher turning products. Declining gross profit margins are usually viewed negatively. On the other hand, cost increases that reflect broader economic events or certain strategic product mix changes might not be viewed as negatively.

Q3-4.

Reducing advertising or R&D expenditures can increase current operating profit at the expense of the long-term competitive position of the firm. Expenditures on advertising or R&D often create long-term economic benefits.

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Q3-5.

Asset turnover measures the amount of revenue compared with the investment in an asset. Generally speaking, we want turnover to be higher rather than lower. Turnover measures productivity and an important company objective is to make assets as productive as possible. Because turnover is one of the components of ROE (via RNOA), increasing turnover increases shareholder value. Turnover is, therefore, viewed as a value driver.

Q3-6.

ROE>RNOA implies a positive return on nonoperating activities. This results from borrowed funds being invested in operating assets whose return (RNOA) exceeds the cost of borrowing. In this case, borrowing money increases ROE.

Q3-7.A

Once a business segment has been sold or designated for sale, it is classified as a discontinued operation. Consequently, sales and expenses related to the business segment are reported separately, Thus, the income statement reports income from continuing operations, discontinued operations, and net income (which includes both continuing and discontinued operations). On the balance sheet, the business segment’s assets and liabilities are similarly segregated. Because the business segment was or will be sold, it no longer contributes to the operating activities of the company. One of the primary uses of financial information is to project future financial results so that investors and others can properly price the company’s securities and evaluate strategic plans. The discontinued operations will not affect future results (other than via investment of the proceeds from the sale), and, therefore, should not be considered as a component of operating activities.

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Q3-9.

The “net” in net operating assets, means operating assets “net” of operating liabilities. This netting recognizes that a portion of the costs of operating assets is funded by third parties. For example, payables and accrued expenses help fund inventories, wages, utilities, and other operating costs. Similarly, long-term operating liabilities also help fund the cost of long-term operating assets. Thus, these long-term operating liabilities are deducted from longterm operating assets.

Q3-10.

Companies must manage both the income statement and the balance sheet in order to maximize RNOA. This is important, as too often managers look only to the income statement and do not fully appreciate the value added by effective balance sheet management. The disaggregation of RNOA into its profit and turnover components focuses analysis on both of these areas.

Q3-11.

There are an infinite number of possible combinations of profit margin and asset turnover that will yield a given level of RNOA. The relative weighting of profit margin and asset turnover is driven in large part by the company’s business model. As a result, since companies in an industry tend to adopt similar business models, industries will generally trend toward points along the margin/turnover continuum.

Q3-12.

Liquidity refers to cash: how much cash a company has, how much cash is coming in the door, and how much cash can be raised quickly. Companies must generate cash in order to pay their debts, pay their employees, and provide their shareholders a return on investment. Cash is, therefore, critical to a company’s survival.

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M3-20B ($ millions) a. ROE = Net income / Average equity = $847 / [($5,530 + $4,653)/2] = 16.64% b. PM AT

= Net income / Sales = $847 / $25,003 = 3.39% = Sales / Average assets = $25,003 / [($20,631 + $21,300)/2] = 1.19

FL

= Average assets / Average equity = [($20,631 + $21,300)/2] / [($5,530 + $4,653)/2] = 4.12

ROA

PM × AT × FL = 3.39% × 1.19 × 4.12 = 16.62% (0.02% rounding difference)

P3-36 ($ millions) a. 2010 NOPAT = $5,918 - [$1,592 + ($163 × 0.37)] = $4,266 b. 2010 NOA = ($30,156 - $3,377 - $1,101- $540 - $146) - ($6,089 - $1,269) - $2,013 - $1,854 = $16,305 2009 NOA = ($27,250 - $3,040 - $744 - $825 - $103) - ($4,897 - $613) - $2,227 - $1,727 = $14,300 c. 2010 RNOA = $4,266 / [($16,305 + $14,300) / 2] = 27.88%

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2010 NOPM = $4,266 / $26,662 = 16.00% 2010 NOAT = $26,662 / [($16,305 + $14,300) / 2] = 1.74 2010 RNOA = 16.00% × 1.74 = 27.84% (0.0004 rounding error) e. 2010 ROE = $4,085 / [($15,663 + $12,764) / 2] = 28.74% f. 2010 nonoperating return = ROE – RNOA = 28.74% - 27.88% = 0.86% g. ROE>RNOA implies that 3M is able to borrow money to fund operating assets that yield a return greater than the cost of the debt. The excess accrues to the benefit of 3M’s stockholders.

P3-39 ($ millions)

a. 2011 NOPAT = ($2,114 + $2) - [$714 + ($87 - $51) × 0.37)] = $1,389 b. 2011 NOA

= $17,849 - $1,103 - $22 - ($8,663 - $557 - $441) - $1,183 = $7,876

2010 NOA

= $18,302 - $1,826 - $90 - ($8,978 - $663 - $35) - $1,256 = $6,850

c. 2011 RNOA = $1,389 / [($7,876 + $6,850) / 2] = 18.86% 2011 NOPM = $1,389 / $50,272 = 2.76% 2011 NOAT = $50,272 / [($7,876 + $6,850) / 2] = 6.83 2011 RNOA = 2.76% × 6.83 = 18.85% (.0001 rounding error) BBY’s RNOA of 18.86% is significantly higher than the industry median of about 11%. It is driven primarily by the very high turnover of net operating assets of 6.83, well in excess of the industry median of 3.27. BBY’s NOPM is slightly below the median of 3.32%. BBY’s high performance is driven by its exceptional management of its balance sheet.

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P3-39 (concluded) e. 2011 ROE = $1,277 / [($6,602 + $6,320) / 2] = 19.76% f. 2011 nonoperating return = ROE – RNOA = 19.76% - 18.86% = 0.90% g.

ROE > RNOA implies that Best Buy is able to borrow money to fund operating assets that yield a return greater than the cost of its debt. The excess accrues to the benefit of BBY’s stockholders.

D3-55 a. Raising prices and/or reducing manufacturing costs are not necessarily independent solutions, and are likely related to other factors. The effect of a price increase on gross profit is a function of the demand curve for the company’s product. If the demand curve is relatively elastic, customers are sensitive to price hikes. Thus, a price increase could significantly reduce demand, thereby decreasing, rather than increasing, gross profit (an example is a 10% increase in price and a 20% decrease in demand). A price increase will have a more desired effect if the demand curve is relatively inelastic (an example is a 10% price increase with a 3% decrease in demand). Cutting manufacturing costs will increase gross profit (via reduction of COGS) if the more inexpensively made product is not perceived to be of lesser quality, thereby reducing demand. b. Raising prices is difficult in competitive markets. As the number of product substitutes increases, companies are less able to raise prices. Rather, they must be able to effectively differentiate their products in some manner in order to reduce consumers’ substitution. This can be accomplished, for example, by product design and/or advertising. These efforts, however, likely entail additional cost, and, while gross profit might be increased as a result, SG&A expense may also increase with little effect on the bottom line. Manufacturing costs consist of raw materials, labor and overhead. Each can be targeted for cost reduction. A reduction of raw materials costs generally implies some reduction in product quality, but not necessarily. It might be the case that the product contains features that are not in demand by consumers. Eliminating those features will reduce product costs with little effect on selling price. Solutions Manual

Similarly, companies can utilize less expensive sources of labor (offshore production, for example), that can significantly reduce product costs and increase gross profit, provided that product quality is maintained. Finally, manufacturing overhead can be reduced by more efficient production. Wages and depreciation expense are two significant components of manufacturing overhead. These are largely fixed costs, and the per unit product cost can often be reduced by increasing capacity utilization of manufacturing facilities (provided, of course, that the increased inventory produced can be sold). The bottom line is that increasing gross profit is a difficult process that can only be accomplished by effective management and innovation.

D3-56 a. Working capital management is an important component of the management of a company. By reducing the level of working capital, companies reduce the costs of carrying excess assets. This can have a significantly positive effect on financial performance. Common ways to decrease receivables and inventories, and increase payables, include the following:  Reduce receivables        

Constricting the payment terms on product sales Better credit policies that limit credit to high-risk customers Better reporting to identify delinquencies Automated notices to delinquent accounts Increased collection efforts Prepayment of orders or billing as milestones are reached Use of electronic (ACH) payment Use of third-party guarantors, including bank letters of credit

 Reduce inventories   

Reduce inventory costs via less costly components (of equal quality), produce with lower wage rates, eliminate product features (costs) not valued by customers Outsource production to reduce product cost and/or inventories the company must carry on its balance sheet Reduce raw materials inventories via just-in-time deliveries

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 

Eliminate bottlenecks in manufacturing to reduce work-in-process inventories Reduce finished goods inventories by producing to order rather than producing to estimated demand

 Increase payables 

Extend the time for payment of low or no-cost payables—so long as the relationship with suppliers is not harmed

b. Payment terms to customers are a marketing tool, similar to product price and advertising programs. Many companies promote payment terms separately from other promotions (no payment for six months or interest-free financing, for example). As companies restrict credit terms, the level of receivables will likely decrease, thereby reducing working capital. The restriction of credit terms may also have the undesirable effect of reducing demand for the company’s products. The cost of credit terms must be weighed against the benefits, and credit terms must be managed with care so as to optimize costs rather than minimize them. Credit policy is as much art as it is science. Likewise, the depth and breadth of the inventories that companies carry impact customer perception. At the extreme, inventory stock-outs result in not only the loss of current sales, but also the potential loss of future sales as customers are introduced to competitors and may develop an impression of the company as “thinly stocked.” Inventories are costly to maintain, as they must be financed, insured, stocked, moved, and so forth. Reduction in inventory levels can reduce these costs. On the other hand, the amount and type of inventories carried is a marketing decision and must be managed with care so as to optimize the level inventories, not necessarily to minimize them. One company’s account payable is another’s account receivable. So, just as one company seeks to extend the time of payment to reduce its working capital, so does the other company seek to reduce the average collection period to accomplish the same objective. Capable, dependable suppliers are a valuable resource for the company, and the supplier relation must be handled with care. All companies take as long to pay their accounts payable as the supplier allows in its credit terms. Extending the payment terms beyond that point begins to negatively impact the supplier relation, ultimately resulting in the loss of the supplier. The supplier relation must be managed with care so as to

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optimize the terms of payment, rather than necessarily to minimize them. D3-57 a. The parties affected by schemes to manage earnings is often much broader than first thought. It includes the following affected parties: 1. employees above and below the level at which the scheme is implemented 2. stockholders and elected members of the board of directors 3. creditors of the company (suppliers and lenders) and their employees, stockholders, and board of directors 4. competitors of the company 5. the company’s independent auditors 6. regulators and taxing authorities b. Managers often believe that earnings management activities will be short-lived, and will be curtailed once its operations “turn around.” Often, this does not prove to be the case. Interviews with managers and employees who have engaged in this activity often reveal that they started rather innocuously (just managing earnings to “make the numbers” in one quarter), but, quickly, earnings management became a slippery slope. Ultimately, the parties the company was trying to protect (shareholders, for example) are hurt more than they would have been had the company reported its results correctly, exposing problems early so that corrective action could be taken (possibly by removing managers) to protect the broader stakeholders in the company. c. Company managers are just ordinary people. They desire to improve their compensation, which is often linked to financial performance. Managers may act to maximize their current compensation at the expense of long-term growth in shareholder value. The reduction in the average employment period at all levels of the company has exacerbated the problem. d. Unfortunately, the separation of ownership and control often leads to less informed shareholders who are unable to effectively monitor the actions of the managers they have hired. To the extent that compensation programs are linked to financial measures, managers can use the flexibility given to them under GAAP to their benefit, even without violating GAAP per se. These actions can only be uncovered by Solutions Manual

effective auditing and enforced by an effective audit committee of the board. Corporate governance has grown considerably in importance following the accounting scandals of the early 2000s. The SarbanesOxley Act mandates new levels of corporate governance. The stock market and the courts are helping to enforce this mandate.

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Module 4 Q4-1.

Lenders distinguish between cyclical cash needs and cash needed to fund operating losses because the second type of cash is riskier. It is typical for firms such as retailers to experience cyclical cash flows during the year as they gear up for busy season (October – December for many retailers). This happens in the ordinary course of business. In contrast, operating losses are not routine and can signal ongoing liquidity problems, or at worst, bankruptcy.

Q4-2.

Younger firms typically face high start-up costs: economies of scale dictate large costs at the outset of business. Moreover, the set of positive net present value projects for young firms is typically greater and more diverse than that of a mature company. Mature companies exhibit more stable outlays of cash for both ongoing projects and capital outlays to replace deteriorating or obsolescent fixed assets. With regards to financing activities, firms may use cash borrowings to repay other maturing debt securities, pay dividends or repurchase stock.

Q4-3.

A number of parties supply credit; they include the following: i. Suppliers extend non-interest-bearing trade credit to regular customers. ii. Financial institutions, such as banks, extend many forms of credit to industrial firms, including lines of credit, letters of credit, revolving credit, term loans and mortgages. iii. Private financing can be obtained from nonbank entities such as venture capitalists who may be more willing to take on riskier loans because they have contextual expertise or deeper industry knowledge.

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iv. Lease financing is another form of “borrowing,” wherein firms may reap the benefits of fixed assets without an initial cash outlay to purchase the equipment outright. v. Publicly traded debt markets provide a cost-efficient manner to raise capital over the short term with commercial paper, or the long term with bond issuances. Q4-4.

Lines of credit are made available to a borrowing company over a period of time as a form of backup financing. In this arrangement, banks charge interest on both the used and unused portions of the credit line. Letters of credit effectively replace the borrowing companies’ credit ratings with the bank’s credit rating and guarantee the return of borrowed funds. While letters of credit are typically used in international transactions to reduce credit risk, lines of credit are more typically used as a source of financing to avoid default in the short run for domestic obligations.

Q4-5.

Banks provide numerous sources of credit to companies; they include the following: i. Revolving credit lines offer a flexible credit source by allowing the borrower to take money as needed and replace it as able. Usually, these terms are tied to floating interest rates in order to reduce the interest-rate risk of the bank. ii. Lines of credit are similar to revolving credit. They are typically negotiated with a bank or consortium of banks to provide shortrun liquidity. However, the amount of funding is stipulated and interest is charged on both the used and unused portions of the credit line. iii. Letters of credit are used to substitute the credit rating of a company with the bank’s credit rating, effectively making the bank the mediator between two parties of a transaction that guarantees the return of funds and assuages the risk of default.

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iv. Perhaps the most prevalent source of bank funding is term loans. These often involve a principal amount as well as a stipulated interest rate to be charged for borrowing the money. v. Banks may extend mortgages or real property to companies for agreed-upon interest payments. The mortgage holder becomes the entitled owner and may foreclose on the mortgage in the case of default, lowering the credit risk.

Q4-6.

Credit risk encapsulates the chance of loss resulting from a creditor’s default (either interest or principal). Assessing credit risk via a credit analysis allows suppliers of credit to determine 1) whether they wish to extend credit to a particular entity, and if so, 2) what the credit terms should be (e.g. interest rate, covenants, and other contractual restrictions). For example, a lender would be more likely to impose greater restrictions and a higher rate of interest for entities that posed a larger credit risk than those with lower credit risk ratings. The “junk bonds” of the 80s yielded high returns for the very reason these loans posed high credit risks.

Q4-7.

The four steps in assessing the chance of default are: i. Assess the nature and purpose of the loan. Is the loan needed? What was the purpose of the loan needed? ii. Assess the macroeconomic environment and industry conditions. Is the industry competitive? Are its consumers/suppliers powerful? How does the condition of the global economy impact this business? Is the market perfectly competitive with many substitutes? iii. Perform financial analysis being sure to adjust financial statements for more accurate ratios and forecasts of a company’s ability to timely meet payments. This includes analyzing the firm’s short-term liquidity, long-term solvency, and interest coverage ratios.

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iv. Perform prospective analysis. This analysis considers that the company’s current financial position and ratios may not predict the future. And it is future ability to generate cash and repay obligations that determines chance of default. Q4-8.

Credit analysis attempts to discern whether a company will be able to pay back its obligations. Because various methods exist for companies to obtain “off-balance-sheet” financing, it is imperative to adjust the financials for any obligations not listed on the balance sheet because these are real economic obligations that must be honored and may have senior claim in certain situations. Operating leases are an example of a financing vehicle with stipulated payment terms. Understanding the implications of operating leases may not be possible from a cursory glance at the financial statements.

Q4-9.

Liquidity refers to cash availability: how much cash the company has and how quickly it can generate more on short notice. Solvency refers to a company’s ability to meet its financial obligations over the short and long run. Both measures provide perspective on companies’ credit risks and thus measure the likelihood of default or potential bankruptcy. Coverage analysis differs from typical measures of liquidity and solvency because it uses flow variables (from the income statement and cash flow statement) to calculate how likely it is that the company will be able to make principal and interest payments.

Q4-10.

Two factors impact credit risk: potential for default, and the magnitude of loss given a default. Chance of default can be measured via credit analysis, which attempts to capture the probability that a company will not generate cash flows great enough to meet its obligations. The magnitude of loss captures the likelihood of receiving compensation when the company defaults. The magnitude of recovery can be based on the seniority of the debt in question

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amongst the other creditors that the company owes money. In the case of a junior claim, the loss given default is commonly the entire amount borrowed, whereas a more senior claim may recoup most if not all of its loan. Q4-11.

Creditors take collateral in order to increase the likelihood of recouping their loss in the case of default. The pledged asset can be used to repay the debt. Real and personal property is usually the basis of collateral where the creditor may take possession of a real estate mortgage or, in some cases, marketable securities, accounts receivable, and inventory.

Q4-12.

Covenants represent terms or conditions placed on the borrower to limit the loss given default by protecting cash flows the company will have to repay the loan. Loan covenants tied to financial ratios also aid creditors by providing evidence of deteriorating conditions within the firm. Three types of common covenants: those that require borrowers to take certain actions, those that restrict the borrower from taking certain actions, and those that require the borrower to maintain certain financial conditions.

Q4-13.

Credit ratings are the opinions of an entity’s creditworthiness provided by independent firms that professionally analyze and rate the credit risk of a company. Credit ratings impact the cost of debt and consequentially the credit terms (higher cost of debt implies higher interest rates attached to term loans). Credit ratings may also trigger a “noninvestment grade” classification that may limit the company from issuing in certain debt markets. Indeed, many investment firms will not invest in companies given a poor classification by credit rating agencies.

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M4-17 Pfizer, Inc., (PFE) demonstrates marked improvement in almost all aspects of financial health, making the company less risky to creditors in 2006. Its 2006 liquidity ratios (both current and quick) are higher than the prior year. In terms of solvency, leverage decreased in 2006, as the company seems to be drawing upon equity financing more than debt financing according to its liabilities-to-equity and long-term debt-to-equity ratios. Finally, although its factor of times interest earned decreased marginally, it is still clearly covering all interest expenses associated with debt obligations (nearly 30 times over), and its cash from operations to total debt and free operating cash flow to total debt increased markedly from 2005 to 2006. E4-27 a.

2006 Current ratio = $3,168.33 / $6,057.95 = 0.523 2004 Current ratio = $3,563.56 / $3,285.39 = 1.085 2006 Quick ratio = ($1,503.36 + $735.30) / $6,057.95 = 0.370 2004 Quick ratio = ($1,376.73 + $1,097.16) / $3,285.39 = 0.753 2006 Liabilities-to-equity = $25,743.17 / -$7,152.90 = -3.60 2004 Liabilities-to-equity = $22,628.42 / $4,587.67 = 4.93 2006 Long-term debt-to-equity = $3,351.63 / -$7,152.90 = -0.469 2004 Long-term debt-to-equity = $16,940.81 / $4,587.67 = 3.69 2006 Times interest earned = $1,877.84 / $1,288.29 = 1.46 2004 Times interest earned = $1,589.84 / $1,516.90 = 1.05 2006 Cash from operations to total debt = $155.98 / ($4,568.83 + $3,351.63) = 0.0197 2004 Cash from operations to total debt = $ 9.89 / ($1,033.96 + $16,940.81) = 0.0006 2006 Free operating cash flow to total debt = ($155.98 - $211.50) / ($4,568.83 + $3,351.63) = -0.007

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2004 Free operating cash flow to total debt = ($ 9.89 - $1,545.48) / ($1,033.96 + $16,940.81) = -0.085 b. Despite gaining slight ground on its interest coverage ratios, Calpine Corp. seems to be struggling with both liquidity and solvency issues in 2006 compared to two years prior. Moreover, the interest coverage ratios are exceedingly low. Both the quick ratio and current ratio are lower than 1.0 and have decreased in the past two years, suggesting the company does not have enough assets expected to be converted to cash in the current year to pay obligations due in the coming year. Equity became negative over the two years, suggesting a large share buyback or perhaps a large earnings loss in 2005. Either way, Calpine’s financing seems heavily stacked toward debt over equity, which may lead to an increase in the cost of equity capital for the firm. Overall, this results in a rather significant increase not only in the probability that the company will face default, but also in the magnitude of the loss if it does. Therefore, credit risk is higher in 2006 than it was in 2004.

P4-31 a. 2005 current ratio = $10,529 / $9,428 = 1.12 2004 current ratio = $8,953 / $8,566 = 1.05 2005 quick ratio = ($2,244 + $429 + $4,579) / $9,428 = 0.77 2004 quick ratio = ($1,060 + $396 + $4,094) / $8,566 = 0.65 Lockheed Martin is fairly liquid. Both the current and quick ratios have increased during 2005, but neither is particularly high. b. 2005 total liabilities to stockholders’ equity = ($9,428 + $4,784 + $2,097 + $1,277 + $2,291) / $7,867 = 2.53 2004 total liabilities to stockholders’ equity = ($8,566 + $5,104 + $1,660 + $1,236 + $1,967) / $7,021 = 2.64

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2005 long-term debt-to-equity = ($202 + $4,784) / $7,867 = 0.634 2004 long-term debt-to-equity = ($15 + $5,104) / $7,021 = 0.729 Lockheed Martin’s total liabilities to stockholders’ equity has decreased in 2005 but remains relatively high, while its long-term debt-to-equity ratio decreased from 2004 to 2005. The difference between these two measures reveals that any solvency concerns would be for the short run, as it has a more balanced portfolio of debt-to-equity when considering its long-term debt obligations. c. 2005 times interest earned = ($2,616 + $370) / $370 = 8.07 2004 times interest earned = ($1,664 + $425) / $425 = 4.92

2005 cash from operations to total debt = $3,194 / ($202 + $4,784) = 0.64 2004 cash from operations to total debt = $2,924 / ($ 15 + $5,104) = 0.57

2005 free operating cash flow to total debt = ($3,194 - $865) / ($202+ $4,784) = 0.47 2004 free operating cash flow to total debt = ($2,924 - $769) / ($15 + $5,104) = 0.42 Lockheed Martin’s times interest earned increased significantly during 2005, due to both an increase in profitability and a decrease in interest expense. Its cash to debt ratios also increased slightly over the year 2005 due to increased cash flow from operations and decreased levels of debt. However, both ratios remain rather low. d. Lockheed Martin is not particularly liquid and is financially leveraged. Its times interest earned ratio is high, thus lessening any immediate solvency concerns. The company’s ability to meet its debt requirements will depend on its continued profitability. Solutions Manual