management accounting concept and application by cabrera pdf

MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual

CHAPTER 5 FINANCIAL STATEMENTS ANALYSIS - II I.

Questions 1. By looking at trends, an analyst hopes to get some idea of whether a situation is improving, remaining the same, or deteriorating. Such analyses can provide insight into what is likely to happen in the future. Rather than looking at trends, an analyst may compare one company to another or to industry averages using common-size financial statements. 2. Ratios highlight relationships, movements, and trends that are very difficult to perceive looking at the raw underlying data standing alone. Also, ratios make financial data easier to grasp by putting the data into perspective. As to the limitation in the use of ratios, refer to page 129. 3. Price-earnings ratios are determined by how investors see a firm’s future prospects. Current reported earnings are generally considered to be useful only so far as they can assist investors in judging what will happen in the future. For this reason, two firms might have the same current earnings, but one might have a much higher price-earnings ratio if investors view it to have superior future prospects. In some cases, firms with very small current earnings enjoy very high price-earnings ratios. This is simply because investors view these firms as having very favorable prospects for earnings in future years. By definition, a stock with current earnings of P4 and a price-earnings ratio of 20 would be selling for P80 per share. 4. A manager’s financing responsibilities relate to the acquisition of assets for use in his or her company. The acquisition of assets can be financed in a number of ways, including through issue of ordinary shares, through issue of preference shares, through issue of long-term debt, through leasing, etc. A manager’s operating responsibilities relate to how these assets are used once they have been acquired. The return on total assets ratio is designed to measure how well a manager is discharging his or her operating responsibilities. It does this by looking at a company’s income before any consideration is given as to how the income will be distributed among capital resources, i.e., before interest deductions.

5-1

Chapter 5 Financial Statement Analysis –II

5. Financial leverage, as the term is used in business practice, means obtaining funds from investment sources that require a fixed annual rate of return, in the hope of enhancing the well-being of the ordinary shareholders. If the assets in which these funds are invested earn at a rate greater that the return required by the suppliers of the funds, then leverage is positive in the sense that the excess accrues to the benefit of the ordinary shareholders. If the return on assets is less than the return required by the suppliers of the funds, then leverage is negative in the sense that part of the earnings from the assets provided by the ordinary shareholders will have to go to make up the deficiency. 6. How a shareholder would feel would depend in large part on the stability of the firm and its industry. If the firm is in an industry that experiences wide fluctuations in earnings, then shareholders might be very pleased that no interest-paying debt exists in the firm’s capital structure. In hard times, interest payments might be very difficult to meet, or earnings might be so poor that negative leverage would result. 7. No, the stock is not necessarily overpriced. Book value represents the cumulative effects on the balance sheet of past activities evaluated using historical prices. The market value of the stock reflects investors’ beliefs about the company’s future earning prospects. For most companies market value exceeds book value because investors anticipate future growth in earnings. 8. A company in a rapidly growing technological industry probably would have many opportunities to invest its earnings at a high rate of return; thus, one would expect it to have a low dividend payout ratio. 9. It is more difficult to obtain positive financial leverage from preference shares than from long-term debt due to the fact that interest on long-term debt is tax deductible, whereas dividends paid on preference shares are not tax deductible. 10. The current ratio would probably be highest during January, when both current assets and current liabilities are at a minimum. During peak operating periods, current liabilities generally include short-term borrowings that are used to temporarily finance inventories and receivables. As the peak periods end, these short-term borrowings are paid off, thereby enhancing the current ratio. 11. A 2-to-1 current ratio might not be adequate for several reasons. First, the composition of the current assets may be heavily weighted toward slow5-2

Financial Statement Analysis –II Chapter 5

turning inventory, or the inventory may consist of large amounts of obsolete goods. Second, the receivables may be large and of doubtful collectibility, or the receivables may be turning very slowly due to poor collection procedures. 12. Expenses (including the cost of goods sold) have been increasing at an even faster rate than net sales. Thus Sunday is apparently having difficulty in effectively controlling its expenses. 13. If the company’s earnings are very low, they may become almost insignificant in relation to stock 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. 14. From the viewpoint of the company’s shareholders, this situation represents a favorable use of leverage. It is probable that little interest, if any, is paid for the use of funds supplied by current creditors, and only 11% interest is being paid to long-term bondholders. Together these two sources supply 40% of the total assets. Since the firm earns an average return of 16% on all assets, the amount by which the return on 40% of the assets exceeds the fixed-interest requirements on liabilities will accrue to the residual equity holders – the ordinary shareholders – raising the return on equity. 15. The length of operating cycle of the two companies cannot be determined from the fact the one company’s current ratio is higher. The operating cycle depends on the relationships between receivables and sales, and between inventories and cost of goods sold. The company with the higher current ratio might have either small amounts of receivables and inventories, or large sales and cost of sales, either of which would tend to produce a relatively short operating cycle. 16. The investor is calculating the rate of return by dividing the dividend by the purchase price of the investment (P5  P50 = 10%). A more meaningful figure for rate of return on investment is determined by relating dividends to current market price, since the investor at the present time is faced with the alternative of selling the stock for P100 and investing the proceeds elsewhere or keeping the investment. A decision to retain the stock constitutes, in effect, a decision to continue to invest P100 in it, at a return of 5%. It is true that in a historical sense the investor is

5-3

Chapter 5 Financial Statement Analysis –II

earning 10% on the original investment, but this is interesting history rather than useful decision-making information. 17. 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 2. True

3. True 4. False

5. True 6. True

7. True 8. True

9. False 10. False

III. Problems Problem 1 (Common Size Income Statements) Common size income statements for 2005 and 2006:

2006 2005 Sales................................................. 100% 100% Cost of goods sold............................. 66 67 Gross profit....................................... 34% 33% Operating expenses........................... 28 29 Net income........................................ 6% 4% The changes from 2005 to 2006 are all favorable. Sales increased and the gross profit per peso of sales also increased. These two factors led to a substantial increase in gross profit. Although operating expenses increased in peso amount, the operating expenses per peso of sales decreased from 29 cents to 28 cents. The combination of these three favorable factors caused net income to rise from 4 cents to 6 cents out of each peso of sales. Problem 2 (Measures of Liquidity) Requirement (a) 5-4

Financial Statement Analysis –II Chapter 5

Current assets: Cash Marketable securities Accounts receivable Inventory Unexpired insurance Total current assets Current liabilities: Notes payable Accounts payable Salaries payable Income taxes payable Unearned revenue Total current liabilities

P 47,600 175,040 230,540 179,600 4,500 P637,280 P 70,000 125,430 7,570 14,600 10,000 P227,600

Requirement (b) The current ratio is 2.8 to 1. It is computed by dividing the current assets of P637,280 by the current liabilities of P227,600. The amount of working capital is P409,680, computed by subtracting the current liabilities of P227,600 from the current assets of P637,280. 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. Problem 3 (Common-Size Income Statement) Requirement 1 2006 2005 Sales........................................................................................................................ 100.0 % 100.0 % Less cost of goods sold............................................................................................ 63.2 60.0 Gross margin........................................................................................................... 36.8 40.0 Selling expenses....................................................................................................... 18.0 17.5 Administrative expenses.......................................................................................... 13.6 14.6 Total expenses......................................................................................................... 31.6 32.1 Net operating income............................................................................................... 5.2 7.9 Interest expense....................................................................................................... 1.4 1.0 5-5

Chapter 5 Financial Statement Analysis –II

Net income before taxes........................................................................................... 3.8 % 6.9 % Requirement 2 The company’s major problem seems to be the increase in cost of goods sold, which increased from 60.0% of sales in 2005 to 63.2% of sales in 2006. This suggests that the company is not passing the increases in costs of its products on to its customers. As a result, cost of goods sold as a percentage of sales has increased and gross margin has decreased. Selling expenses and interest expense have both increased slightly during the year, which suggests that costs generally are going up in the company. The only exception is the administrative expenses, which have decreased from 14.6% of sales in 2005 to 13.6% of sales in 2006. This probably is a result of the company’s efforts to reduce administrative expenses during the year. Problem 4 (Comparing Operating Results with Average Performance in the Industry) Requirement (a) Sales (net) Cost of goods sold Gross profit on sales Operating expenses: Selling General and administrative Total operating expenses Operating income Income taxes Net income........................................

Ms. Freeze, Inc. 100% 49 51% 21% 17 38% 13% 6 7%

Industry Average 100% 57 43% 16% 20 36% 7% 3 4%

Requirement (b) Ms. Freeze’s operating results are significantly better than the average performance within the industry. As a percentage of sales revenue, Ms. Freeze’s operating income and net income after nearly twice the average for the industry. As a percentage of total assets, Ms. Freeze’s profits amount to an impressive 23% as compared to 14% for the industry. The key to Ms. Freeze’s success seems to be its ability to earn a relatively high rate of gross profit. Ms. Freeze’s exceptional gross profit rate (51%) probably results from a combination of factors, such as an ability to command 5-6

Financial Statement Analysis –II Chapter 5

a premium price for the company’s products and production efficiencies which lead to lower manufacturing costs. As a percentage of sales, Ms. Freeze’s selling expenses are five points higher than the industry average (21% compared to 16%). However, these higher expenses may explain Ms. Freeze’s ability to command a premium price for its products. Since the company’s gross profit rate exceeds the industry average by 8 percentage points, the higher-than-average selling costs may be part of a successful marketing strategy. The company’s general and administrative expenses are significantly lower than the industry average, which indicates that Ms. Freeze’s management is able to control expenses effectively. Problem 5 (Common-Size Statements) Requirement 1 The income statement in common-size form would be:

Sales......................................................... Less cost of goods sold............................. Gross margin............................................ Less operating expenses............................ Net operating income................................ Less interest expense................................ Net income before taxes............................ Less income taxes (30%).......................... Net income...............................................

2006 100.0% 65.0 35.0 26.3 8.7 1.2 7.5 2.3 5.3%

2005 100.0% 60.0 40.0 30.4 9.6 1.6 8.0 2.4 5.6%

The balance sheet in common-size form would be: 2006 Current assets: Cash .......................................................... Accounts receivable, net .......................................................... Inventory .......................................................... Prepaid expenses .......................................................... Total current assets 5-7

2.0%

2005 5.1%

15.0

10.1

30.1

15.2

1.0

1.3

48.1

31.6

Chapter 5 Financial Statement Analysis –II

Plant and equipment................................. Total assets...............................................

51.9 100.0%

68.4 100.0%

25.1% 20.1 45.1

12.7% 25.3 38.0

15.0

19.0

Ordinary shares, P5 par

10.0

12.7

Retained earnings

29.8

30.4

54.9

62.0

100.0%

100.0%

Liabilities: Current liabilities............................... Bonds payable, 12%........................... Total liabilities............................. Equity: Preference shares, 8%, P10 par

Total equity Total liabilities and equity.........................

Note: Columns do not total down in all cases due to rounding differences. Requirement 2 The company’s cost of goods sold has increased from 60 percent of sales in 2005 to 65 percent of sales in 2006. This appears to be the major reason the company’s profits showed so little increase between the two years. Some benefits were realized from the company’s cost-cutting efforts, as evidenced by the fact that operating expenses were only 26.3 percent of sales in 2006 as compared to 30.4 percent in 2005. Unfortunately, this reduction in operating expenses was not enough to offset the increase in cost of goods sold. As a result, the company’s net income declined from 5.6 percent of sales in 2005 to 5.3 percent of sales in 2006. Problem 6 (Solvency of Alabang Supermarket) Requirement (a) (Pesos in Millions) Current assets: Cash Receivables Merchandise inventories Prepaid expenses Total current assets

P

74.8 152.7 1,191.8 95.5 P1,514.8 5-8

Financial Statement Analysis –II Chapter 5

Quick assets: Cash Receivables Total quick assets

P

74.8 152.7 P 227.5

Requirement (b) (1) Current ratio: Current assets (Req. a) Current liabilities Current ratio (P1,514.8  P1,939.0)

P1,514.8 P1,939.0 0.8 to 1

(2) Quick ratio: Quick assets (Req. a) Current liabilities Quick ratio (P227.5  P1,939.0)

P 227.5 P1,939.0 0.1 to 1

(3) Working capital: Current assets (Req. a) Less: Current liabilities Working capital

P1,514.8 P1,939.0 P(424.2)

Requirement (c) No. It is difficult to draw conclusions from the above ratios. Alabang Supermarket’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 ash flows are able to operate successfully with current ratios lower than Alabang Supermarket’s. Requirement (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 5-9

Chapter 5 Financial Statement Analysis –II

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. Requirement (e) In evaluating Alabang Supermarket’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. Note to Instructor: Prior to the year in which the data for this problem was collected, Alabang Supermarket had reported a negative retained earnings balance in its balance sheet for several consecutive periods. The fact that Alabang Supermarket has only recently removed the deficit from its financial statements is also worrisome.

Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk) Requirement (a) (1) Quick assets: Cash Marketable securities (short-term) Accounts receivable Total quick assets

P 47,524 55,926 23,553 P127,003

(2) Current assets: Cash Marketable securities (short-term) Accounts receivable Inventories Prepaid expenses Total current assets

P 47,524 55,926 23,553 32,210 5,736 P164,949

(3) Current liabilities: 5-10

Financial Statement Analysis –II Chapter 5

Notes payable to banks (due within one year) Accounts payable Dividends payable Accrued liabilities (short-term) Income taxes payable Total current liabilities

P 20,000 5,912 1,424 21,532 6,438 P 55,306

Requirement (b) (1) Quick ratio: Quick assets (Req. a) Current liabilities (Req. a) Quick ratio (P127,003  P55,306)

P127,003 P 55,306 2.3 to 1

(2) Current ratio: Current assets (Req. a) Current liabilities (Req. a) Current ratio (P164,949  P55,306)

P164,949 P 55,306 3.0 to 1

(3) Working capital: Current assets (Req. a) Less: Current liabilities (Req. a) Working capital

P164,949 55,306 P109,643

(4) Debt ratio: Total liabilities (given) Total assets (given) Debt ratio (P81,630  P353,816)

P 81,630 P353,816 23.1%

Requirement (c) (1) From the viewpoint of short-term creditors, Bonbon Sweets’ appear highly liquid. Its quick and current ratios are well above normal rules of thumb, and the company’s cash and marketable securities alone are almost twice its current liabilities. (2) Long-term creditors also have little to worry about. Not only is the company highly liquid, but creditors’ claims amount to only 23.1% of total assets. If Bonbon Sweets’ were to go out of business and liquidate

5-11

Chapter 5 Financial Statement Analysis –II

its assets, it would have to raise only 23 cents from every peso of assets for creditors to emerge intact. (3) From the viewpoint of shareholders, Bonbon Sweets’ appears overly liquid. Current assets generally do not generate high rates of return. Thus, the company’s relatively large holdings of current assets dilutes its return on total assets. This should be of concern to shareholders. If Bonbon Sweets is unable to invest its highly liquid assets more productively in its business, shareholders probably would like to see the money distributed as dividends. Problem 8 (Selected Financial Measures for Short-term Creditors) Requirement 1 Current assets (P80,000 + P460,000 + P750,000 + P10,000).............................................................................................................. P1,300,000 Current liabilities (P1,300,000 ÷ 2.5)...................................................................... 520,000 P  780,000 Working capital....................................................................................................... Requirement 2 Acid-test ratio =

Cash + Marketable securities + Accounts receivable Current liabilities

Acid-test ratio =

P80,000 + P0 + P460,000 P520,000

= 1.04 to 1 (rounded)

Requirement 3 a. Working capital would not be affected: Current assets (P1,300,000 – P100,000)................................................................. P1,200,000 Current liabilities (P520,000 – P100,000)............................................................... 420,000 Working capital....................................................................................................... P 780,000 b. The current ratio would rise: Current ratio

=

Current rate

=

Current assets Current liabilities P1,200,000 P420,000

Problem 9 (Selected Financial Ratios) 5-12

= 2.9 to 1 (rounded)

Financial Statement Analysis –II Chapter 5

1. Gross margin percentage: Gross margin Sales

P840,000 P2,100,000

=

2. Current ratio: Current assets Current liabilities

= 40%

P490,000 P200,000

=

= 2.45 to 1

3. Acid-test ratio: Quick assets Current liabilities

P181,000 P200,000

=

= 0.91 to 1 (rounded)

4. Accounts receivable turnover: Sales Average accounts receivables

=

365 days 14 times

P2,100,000 P150,000

= 14 times

= 26.1 days (rounded)

5. Inventory turnover: Cost of goods sold Average inventory

=

365 days 4.5 times

P1,260,000 P280,000

= 4.5 times

= 81.1 days to turn (rounded)

6. Debt-to-equity ratio: Total liabilities Total equity

=

P500,000 P800,000

= 0.63 to 1 (rounded)

7. Times interest earned: Earnings before interest and income taxes Interest expense

=

5-13

P180,000 P30,000

= 6.0 times

Chapter 5 Financial Statement Analysis –II

8. Book value per share: Equity Ordinary shares outstanding

=

P800,000 20,000 shares*

= P40 per share

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

Problem 10 (Selected Financial Ratios for Ordinary Shareholders) 1. Earnings per share: Net income to ordinary shares Average ordinary shares outstanding

2. Dividend payout ratio: Dividends paid per share Earnings per share 3. Dividend yield ratio: Dividends paid per share Market price per share 4. Price-earnings ratio: Market price per share Earnings per share

=

P105,000 20,000 shares

= P5.25 per share

=

P3.15 P5.25

= 60%

=

P3.15 P63.00

= 5%

=

P63.00 P5.25

= 12.0

Problem 11 (Selected Financial Ratios for Ordinary Shareholders) 1. Return on total assets: Return on total = assets = =

Net income + [Interest expense x (1 – Tax rate)] Average total assets P105,000 + [P30,000 x (1 – 0.30)] ½ (P1,100,000 + P1,300,000) P126,000 P1,200,000

5-14

= 10.5%

Financial Statement Analysis –II Chapter 5

2. Return on ordinary shareholders’ equity: Return on ordinary shareholders’ equity

=

Net income – preference dividends Average ordinary shareholders’ equity P105,000 ½ (P725,000 + P800,000)

= =

P105,000 P762,500

= 13.8% (rounded)

3. Financial leverage was positive, since the rate of return to the ordinary shareholders (13.8%) was greater than the rate of return on total assets (10.5%). This positive leverage is traceable in part to the company’s current liabilities, which may carry no interest cost, and to the bonds payable, which have an after-tax interest cost of only 7%. 10% interest rate × (1 – 0.30) = 7% after-tax cost. IV. Cases Case 1 (Common-Size Statements and Financial Ratios for Creditors) Requirement 1 This Year P2,060,000 1,100,000 P 960,000

Last Year P1,470,000 600,000 P 870,000

b. Current assets (a) Current liabilities (b) Current ratio (a) ÷ (b)

P2,060,000 P1,100,000 1.87 to 1

P1,470,000 P600,000 2.45 to 1

c. Quick assets (a) Current liabilities (b) Acid-test ratio (a) ÷ (b)

P740,000 P1,100,000 0.67 to 1

P650,000 P600,000 1.08 to 1

d. Sales on account (a) Average receivables (b) Turnover of receivables (a) ÷ (b)

P7,000,000 P525,000 13.3 times

P6,000,000 P375,000 16.0 times

a. Current assets Current liabilities Working capital

5-15

Chapter 5 Financial Statement Analysis –II

Average age of receivables: 365 ÷ turnover

27.4 days

22.8 days

e. Cost of goods sold (a) Average inventory (b) Inventory turnover (a) ÷ (b)

P5,400,000 P1,050,000 5.1 times

P4,800,000 P760,000 6.3 times

71.6 days P1,850,000 P2,150,000 0.86 to 1

57.9 days P1,350,000 P1,950,000 0.69 to 1

P630,000 P90,000 7.0 times

P490,000 P90,000 5.4 times

f.

Turnover in days: 365 ÷ turnover Total liabilities (a) Equity (b) Debt-to-equity ratio (a) ÷ (b)

g. Net income before interest and taxes (a) Interest expense (b) Times interest earned (a) ÷ (b) Requirement 2 a.

METRO BUILDING SUPPLY Common-Size Balance Sheets

Current assets: Cash Marketable securities Accounts receivable, net Inventory Prepaid expenses Total current assets Plant and equipment, net Total assets Liabilities: Current liabilities Bonds payable, 12% Total liabilities Equity: Preference shares, P50 par, 8% Ordinary shares, P10 par Retained earnings Total equity Total liabilities and equity 5-16

This Year

Last Year

2.3 % 0.0 16.3 32.5 0.5 51.5 48.5 100.0 %

6.1 % 1.5 12.1 24.2 0.6 44.5 55.5 100.0 %

27.5 % 18.8 46.3

18.2 % 22.7 40.9

5.0 12.5 36.3 53.8 100.0 %

6.1 15.2 37.9 59.1 100.0 %

Financial Statement Analysis –II Chapter 5

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

METRO BUILDING SUPPLY Common-Size Income Statements This Year 100.0 % 77.1 22.9 13.9 9.0 1.3 7.7 3.1 4.6 %

Sales Less cost of goods sold Gross margin Less operating expenses Net operating income Less interest expense Net income before taxes Less income taxes Net income

Last Year 100.0 % 80.0 20.0 11.8 8.2 1.5 6.7 2.7 4.0 %

Requirement 3 The following points can be made from the analytical work in parts (1) and (2) above: The company has improved its profit margin from last year. This is attributable to an increase in gross margin, which is offset somewhat by an increase in operating expenses. In both years the company’s net income as a percentage of sales equals or exceeds the industry average of 4%. Although the company’s working capital has increased, its current position actually has deteriorated significantly since last year. Both the current ratio and the acid-test ratio are well below the industry average, and both are trending downward. (This shows the importance of not just looking at the working capital in assessing the financial strength of a company.) Given the present trend, it soon will be impossible for the company to pay its bills as they come due. The drain on the cash account seems to be a result mostly of a large buildup in accounts receivable and inventory. This is evident both from the common-size balance sheet and from the financial ratios. Notice that the average age of the receivables has increased by 5 days since last year, and that it is now 9 days over the industry average. Many of the company’s customers are not taking their discounts, since the average collection period is 27 days and collection terms are 2/10, n/30. This suggests financial weakness on the part of these 5-17

Chapter 5 Financial Statement Analysis –II

customers, or sales to customers who are poor credit risks. Perhaps the company has been too aggressive in expanding its sales. The inventory turned only 5 times this year as compared to over 6 times last year. It takes three weeks longer for the company to turn its inventory than the average for the industry (71 days as compared to 50 days for the industry). This suggests that inventory stocks are higher than they need to be. In the authors’ opinion, the loan should be approved on the condition that the company take immediate steps to get its accounts receivable and inventory back under control. This would mean more rigorous checks of creditworthiness before sales are made and perhaps paring out of slow paying customers. It would also mean a sharp reduction of inventory levels to a more manageable size. If these steps are taken, it appears that sufficient funds could be generated to repay the loan in a reasonable period of time. Case 2 (Financial Ratios for Ordinary Shareholders) Requirement 1 a.

This Year P324,000 16,000

Last Year P240,000 16,000

P308,000

P224,000

Earnings per share (a) ÷ (b)

50,000 P6.16

50,000 P4.48

b. Ordinary dividend per share (a)* Market price per share (b) Dividend yield ratio (a) ÷ (b)

P2.16 P45.00 4.8%

P1.20 P36.00 3.33%

Net income Less preference dividends Net income remaining for ordinary (a) Average number of ordinary shares (b)

*P108,000 ÷ 50,000 shares = P2.16; P60,000 ÷ 50,000 shares = P1.20 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 5-18

Financial Statement Analysis –II Chapter 5

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. e.

This Year Last Year 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 a.

This Year Last Year P  324,000 P  240,000 Net income.............................................................................................................. Add after-tax cost of interest paid: [P90,000 × (1 – 0.40)]......................................................................................... 54,000 54,000 P   294,000 Total (a)................................................................................................................... P 378,000 Average total assets (b)............................................................................................ P3,650,000 P3,000,000 Return on total assets (a) ÷ (b)................................................................................ 10.4% 9.8%

b.

This Year Last Year P  324,000 P  240,000 Net income.............................................................................................................. Less preference dividends........................................................................................ 16,000 16,000 Net income remaining for ordinary P  308,000 P  224,000 5-19

Chapter 5 Financial Statement Analysis –II

shareholders (a)................................................................................................... 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. Case 3 (Comprehensive Ratio Analysis) Requirement 1 This Year Last Year P  280,000 P  168,000 a. Net income.............................................................................................................. Add after-tax cost of interest: P120,000 × (1 – 0.30)......................................................................................... 84,000 5-20

Financial Statement Analysis –II Chapter 5

P100,000 × (1 – 0.30)......................................................................................... 70,000 P   364,000 P   238,000 Total (a)................................................................................................................... Average total assets (b)............................................................................................ P5,330,000 P4,640,000 Return on total assets (a) ÷ (b)................................................................................ 6.8% 5.1% P  280,000 P  168,000 b. Net income.............................................................................................................. Less preference dividends........................................................................................ 48,000 48,000 P  232,000 P  120,000 Net income remaining for ordinary (a)..................................................................... Average total equity................................................................................................. P3,120,000 P3,028,000 Less average preference shares................................................................................ 600,000 600,000 Average ordinary equity (b)..................................................................................... P2,520,000 P2,428,000 Return on ordinary equity (a) ÷ (b).......................................................................... 9.2% 4.9% c. Leverage is positive for this year, since the return on ordinary equity (9.2%) is greater than the return on total assets (6.8%). For last year, leverage is negative since the return on the ordinary equity (4.9%) is less than the return on total assets (5.1%). Requirement 2 P  232,000 50,000 P4.64

P 120,000 50,000 P2.40

b. Ordinary dividend per share (a) Market price per share (b) Dividend yield ratio (a) ÷ (b)

P1.44 P36.00 4.0%

P0.72 P20.00 3.6%

c. Ordinary dividend per share (a) Earnings per share (b) Dividend payout ratio (a) ÷ (b)

This Year P1.44 P4.64 31.0%

Last Year P0.72 P2.40 30.0%

P36.00 P4.64 7.8

P20.00 P2.40 8.3

a. Net income remaining for ordinary (a) Average number of ordinary shares (b) Earnings per share (a) ÷ (b)

d. Market price per share (a) Earnings per share (b) Price-earnings ratio (a) ÷ (b)

Notice from the data given in the problem that the average P/E ratio for companies in Helix’s industry is 10. Since Helix Company presently has 5-21

Chapter 5 Financial Statement Analysis –II

a P/E ratio of only 7.8, investors appear to regard it less well than they do other companies in the industry. That is, investors are willing to pay only 7.8 times current earnings for a share of Helix Company’s stock, as compared to 10 times current earnings for a share of stock for the average company in the industry. e. Equity Less preference shares Ordinary equity (a) Number of ordinary shares (b) Book value per share (a) ÷ (b)

P3,200,000 600,000 P2,600,000

P3,040,000 600,000 P2,440,000

50,000 P52.00

50,000 P48.80

Note that the book value of Helix Company’s stock is greater than the market value for both years. This does not necessarily indicate that the stock is selling at a bargain price. 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. f.

Gross margin (a) Sales (b) Gross margin percentage (a) ÷ (b)

P1,050,000 P5,250,000 20.0%

P860,000 P4,160,000 20.7%

This Year P2,600,000 1,300,000 P1,300,000

Last Year P1,980,000 920,000 P1,060,000

b. Current assets (a) Current liabilities (b) Current ratio (a) ÷ (b)

P2,600,000 P1,300,000 2.0 to 1

P1,980,000 P920,000 2.15 to 1

c. Quick assets (a) Current liabilities (b) Acid-test ratio (a) ÷ (b)

P1,220,000 P1,300,000 0.94 to 1

P1,120,000 P920,000 1.22 to 1

d. Sales on account (a)

P5,250,000

P4,160,000

Requirement 3 a. Current assets Current liabilities Working capital

5-22

Financial Statement Analysis –II Chapter 5

Average receivables (b) Accounts receivable turnover (a) ÷ (b) Average age of receivables, 365 ÷ turnover

P750,000 7.0 times

P560,000 7.4 times

52 days

49 days

e. Cost of goods sold (a) Average inventory (b) Inventory turnover (a) ÷ (b) Number of days to turn inventory, 365 days ÷ turnover (rounded)

P4,200,000 P1,050,000 4.0 times

P3,300,000 P720,000 4.6 times

91 days

79 days

f.

P2,500,000 P3,200,000 0.78 to 1

P1,920,000 P3,040,000 0.63 to 1

P520,000 P120,000 4.3 times

P340,000 P100,000 3.4 times

Total liabilities (a) Equity (b) Debt-to-equity ratio (a) ÷ (b)

g. Net income before interest and taxes (a) Interest expense (b) Times interest earned (a) ÷ (b) Requirement 4

As stated by Meri Ramos, both net income and sales are up from last year. The return on total assets has improved from 5.1% last year to 6.8% this year, and the return on ordinary equity is up to 9.2% from 4.9% the year before. But this appears to be the only bright spot in the company’s operating picture. Virtually all other ratios are below the industry average, and, more important, they are trending downward. The deterioration in the gross margin percentage, while not large, is worrisome. Sales and inventories have increased substantially, which should ordinarily result in an improvement in the gross margin percentage as fixed costs are spread over more units. However, the gross margin percentage has declined. Notice particularly that the average age of receivables has lengthened to 52 days—about three weeks over the industry average—and that the inventory turnover is 50% longer than the industry average. One wonders if the increase in sales was obtained at least in part by extending credit to high-risk customers. Also notice that the debt-to-equity ratio is rising rapidly. If the P1,000,000 loan is granted, the ratio will rise further to 1.09 to 1. In the author’s opinion, what the company needs is more equity—not more debt. Therefore, the loan should not be approved. The company should be encouraged to make another issue of ordinary stock in order to provide a broader equity base on which to operate. 5-23

Chapter 5 Financial Statement Analysis –II

Case 4 (Statement Reconstruction Using Ratios) Bulacan Company Income Statement For the Year Ended December 31, 2005 Sales Less: Cost of Sales (4) Gross Profit Less: Expenses Net Income (1)

P140,800 84,480 P 56,320 46,320 P 10,000

Bulacan Company Balance Sheet December 31, 2005 As s e t s Current Assets: Cash Accounts Receivable (5) Merchandise Inventory (3) Total Current Assets (2) Fixed Assets (8) Total Assets

P 27,720 28,160 21,120 P 77,000 55,000 P132,000

Liabilities and Equity Current Liabilities: Accounts Payable (2) Equity: Share Capital (issued 20,000 shares) (6) Retained Earnings Total Liabilities and Equity

P 44,000 P40,000 48,000 5-24

88,000 P132,000

Financial Statement Analysis –II Chapter 5

Supporting Computations: (1) Earnings Per Share

=

Net Income Ordinary Shares Outstanding

P0.50

=

X 20,000

X (Net Income)

=

P10,000

(2) Current Assets Pxx Current Liabilities xx Working Capital P33,000

1.75 1 0.75

Current Liabilities (3) Current Ratio

=

P33,000  0.75

= =

P44,000 Current Assets Current Liabilities X 44,000

1.27

=

X (Current Assets)

=

P77,000

=

Quick Assets Current Liabilities

1.27

=

X 44,000

X (Current Assets)

=

P55,880

Quick Ratio

Current Assets Quick Assets Inventory

P77,000 55,800 P21,120

(4) Inventory turnover

=

4

=

X (Cost of Sales)

= 5-25

Cost of Sales Ave. Inventory X P21,120 P84,480

Chapter 5 Financial Statement Analysis –II

(5) Average age of outstanding Accounts Receivable

Quick Assets Current Liabilities

=

365 5

=

73 days (Average age of receivables)

Net Sales Average Receivables

=

5

P140,800 X

=

5

X (Receivables)

=

P28,160

Another Method: P140,800 365

=

73 days

=

P28,160 Accounts receivable

(6) Earnings for the year as a percentage of Share Capital P10,000 = 25% Share Capital Share Capital

=

P40,000

Fixed Assets

=

Current Liabilities + Equity

P77,000 + 0.625X

=

P44,000 + X

0.375X

=

P33,000

X

=

P88,000 Equity

(7) Current Assets

+

(8) Fixed Assets to Equity Fixed Assets Equity X P140,800 X (Fixed Assets)

=

0.625

=

0.625

=

P55,000

5-26

Financial Statement Analysis –II Chapter 5

Case 5 (Ethics and the Manager) Requirement 1 The loan officer stipulated that the current ratio prior to obtaining the loan must be higher than 2.0, the acid-test ratio must be higher than 1.0, and the interest on the loan must be no more than four times net operating income. These ratios are computed below: Current ratio Current rate Acid-test ratio =

=

Current assets Current liabilities

P290,000 = 1.8 (rounded) P164,000 Cash + Marketable securities + Accounts receivable Current liabilities =

P70,000 + P0 + P50,000 = 0.70 (rounded) P164,000 Net operating income P20,000 = P80,000 x 0.10 x (6/12) = 5.0 Interest on the loan

Acid-test ratio =

The company would fail to qualify for the loan because both its current ratio and its acid-test ratio are too low. Requirement 2 By reclassifying the P45 thousand net book value of the old machine as inventory, the current ratio would improve, but there would be no effect on the acid-test ratio. This happens because inventory is considered to be a current asset but is not included in the numerator when computing the acid-test ratio. Current ratio

=

Current rate

=

Acid-test ratio =

Current assets Current liabilities P290,000 + P45,000 = 2.0 (rounded) P164,000

Cash + Marketable securities + Current receivables Current liabilities

P70,000 + P0 + P50,000 = 0.70 (rounded) P164,000 Even if this tactic had succeeded in qualifying the company for the loan, we Acid-test ratio =

5-27

Chapter 5 Financial Statement Analysis –II

strongly advise against it. Inventories are assets the company has acquired for the sole purpose of selling them to outsiders in the normal course of business. Used production equipment is not considered to be inventory—even if there is a clear intention to sell it in the near future. Since the loan officer would not expect used equipment to be included in inventories, doing so would be intentionally misleading. Nevertheless, the old equipment is an asset that could be turned into cash. If this were done, the company would immediately qualify for the loan since the P45 thousand in cash would be included in the numerator in both the current ratio and in the acid-test ratio. Current ratio

=

Current rate

=

Current assets Current liabilities P290,000 + P45,000 = 2.0 (rounded) P164,000

Acid-test ratio =

Cash + Marketable securities + Current receivables Current liabilities

Acid-test ratio =

P70,000 + P0 + P50,000 + P45,000 P164,000

= 1.00 (rounded)

However, other options may be available. After all, the old machine is being used to relieve bottlenecks in the plastic injection molding process and it would be desirable to keep this standby capacity. We would advise Rome to fully and honestly explain the situation to the loan officer. The loan officer might insist that the machine be sold before any loan is approved, but he might instead grant a waiver of the current ratio and acid-test ratio requirements on the basis that they could be satisfied by selling the old machine. Or he may approve the loan on the condition that the equipment is pledged as collateral. In that case, Rome would only have to sell the machine if he would otherwise be unable to pay back the loan. V. Multiple Choice Questions 1. 2. 3. 4. 5. 6. 7. 8.

A C D B A D C D

11. 12. 13. 14. 15. 16. 17. 18.

C A C B D B A C

21. 22. 23. 24. 25. 26. 27. 28.

B D A C A C D A

31. 32. 33. 34. 35. 36. 37. 38. 5-28

C D C A A C A A

41. C

Financial Statement Analysis –II Chapter 5

9. A 10. B

19. A 20. C

29. D 30. A

39. C 40. C

5-29