Individual Assignment - SOX Paper

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Financial Statement Analysis

LEARNING OBJECTIVES After studying Chapter 15, you should be able to: LO15-1 Prepare and interpret financial

statements in comparative and common-size form.

LO15-2 Compute and interpret financial ratios that managers use to assess liquidity.

LO15-3 Compute and interpret financial ratios that managers use for asset management purposes.

LO15-4 Compute and interpret financial ratios that managers use for debt management purposes.

LO15-5 Compute and interpret financial ratios that managers use to assess profitability.

LO15-6 Compute and interpret financial ratios that managers use to assess market performance.

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S

Keeping an Eye on Dividends

When the economy sours, investors look closely at a company's ability to pay dividends. In 2008, 36 of the Standard & Poor's 500 companies suspended $33.3 billion of dividend payments. Citigroup sliced its dividend 41%, Washington Mutual (now part of JPMorgan Chase) reduced its quarterly dividend per share from 15 cents to a penny, and CIT Group slashed its dividend by 60%. Some companies increase their market appeal during difficult economic times by remaining committed to generous dividend payments. For example, in 2008 Adrian Darley, of Ignis Asset Management, recommended investing in Vivendi, France Telecom, and Deutsche Telekom because these companies committed to making scheduled dividend payments that ranged from 4.9% to 7.2% of their respective stock prices. Sources: Andrea Tryphonides, “Dividends Replace P/Es as Stock Guides,” The Wall Street Journal, November 24, 2008, p. C2; Tom Lauricella, “Keeping the Cash: Slowdown Triggers Stingy Dividends,” The Wall Street Journal, April 21, 2008, p. C1; and Annelena Lobb, “Investors Lick Wounds from Dividend Cuts,” The Wall Street Journal, November 7, 2008, p. C1.

tockholders, creditors, and managers are examples of stakeholders that use financial statement analysis to evaluate a company's financial health and future prospects. Stockholders and creditors analyze a company's financial statements to estimate its potential for earnings growth, stock price appreciation, making dividend payments, and paying principal and interest

on loans. Managers use financial statement analysis for two reasons. First, it enables them to better understand how their company's financial results will be interpreted by stockholders and creditors for the purposes of making investing and lending decisions. Second, financial statement analysis provides managers with valuable feedback regarding their company's performance. For example, managers may study trends in their company's financial statements to assess whether performance has been

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improving or declining. Or, they may use financial statement analysis to benchmark their company's performance against world-class competitors.

In this chapter, we'll explain how managers prepare financial statements in comparative and common-size form and how they use financial ratios to assess their company's liquidity, asset management, debt management, profitability, and market performance.

Limitations of Financial Statement Analysis This section discusses two limitations of financial statement analysis that managers should always keep in mind—comparing financial data across companies and looking beyond ratios when formulating conclusions. Comparing Financial Data across Companies Comparisons of one company with another can provide valuable clues about the financial health of an organization. Unfortunately, differences in accounting methods between companies sometimes make it difficult to compare their financial data. For example, if one company values its inventories by the LIFO method and another company by the average cost method, then direct comparisons of their financial data such as inventory valuations and cost of goods sold may be misleading. Sometimes enough data are presented in footnotes to the financial statements to restate data to a comparable basis. Otherwise, managers should keep in mind any lack of comparability. Even with this limitation in mind, comparing key ratios with other companies and with industry averages often helps managers identify opportunities for improvement. Looking beyond Ratios Ratios should not be viewed as an end, but rather as a starting point. They raise many questions and point to opportunities for further analysis, but they rarely answer any questions by themselves. In addition to financial ratios, managers should consider various internal factors, such as employee learning and growth, business process performance, and customer satisfaction as well as external factors like industry trends, technological changes, changes in consumer tastes, and changes in broad economic indicators.

Statements in Comparative and Common-Size Form LO15-1 Prepare and interpret financial statements in comparative and common-size form.

An item on a balance sheet or income statement has little meaning by itself. Suppose a company's sales for a year were $250 million. In isolation, that is not particularly useful information. How does that stack up against last year's sales? How do the sales relate to the cost of goods sold? In making these kinds of comparisons, three analytical techniques are widely used:

1. Dollar and percentage changes on statements (horizontal analysis). 2. Common-size statements (vertical analysis).

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3. Ratios.

The first and second techniques are discussed in this section; the third technique is discussed in the remainder of the chapter. Throughout the chapter, we will illustrate these analytical techniques using the financial statements of Brickey Electronics, a producer of specialized electronic components. Dollar and Percentage Changes on Statements Horizontal analysis (also known as trend analysis) involves analyzing financial data over time, such as computing year-to-year dollar and percentage changes within a set of financial statements. Exhibits 15-1 and 15-2 show Brickey Electronics' financial statements in this comparative form. The dollar changes highlight the changes that are the most important economically; the percentage changes highlight the changes that are the most unusual.

EXHIBIT 15-1

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EXHIBIT 15-2

Horizontal analysis can be even more useful when data from a number of years are used to compute trend percentages. To compute trend percentages, a base year is selected and the data for all years are stated as a percentage of that base year. To illustrate, consider the sales and net income of McDonald's Corporation, the world's largest food service retailer, with more than 31,000 restaurants worldwide:

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By simply looking at these data, you can see that sales increased every year except 2009 and net income increased every year except 2007. However, recasting these data into trend percentages aids interpretation:

In the above table, both sales and net income have been restated as a percentage of the 2002 sales and net income. For example, the 2008 sales of $23,522 are 162% of the 2002 sales of $14,527. This trend analysis is particularly striking when the data are plotted as in Exhibit 15-3. McDonald's sales growth was impressive throughout the 10-year period, but net income was far more erratic. Notice that net income plummeted in 2007 and then fully recovered by 2008. In 2011, McDonald's earned record sales and profits.

EXHIBIT 15-3 McDonald's Corporation: Trend Analysis of Sales and Net Income

Common-Size Statements Horizontal analysis, which was discussed in the previous section, examines changes in financial statement accounts over time. Vertical analysis focuses on the relations among financial statement accounts at a given point in time. A common-size financial statement is a vertical analysis in which each financial statement account is expressed as a percentage. In income statements, all items are usually expressed as a percentage of sales. In balance sheets, all items are usually expressed as a

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percentage of total assets. Exhibit 15-4 contains Brickey Electronics' common-size balance sheet and Exhibit 15-5 contains its common-size income statement.

Notice from Exhibit 15-4 that placing all assets in common-size form clearly shows the relative importance of the current assets as compared to the noncurrent assets. It also shows that significant changes have taken place in the composition of the current assets over the last year. For example, accounts receivable have increased in relative importance and both cash and inventory have declined in relative importance. Judging from the sharp increase in accounts receivable, the deterioration in the cash balance may be a result of an inability to collect from customers.

The common-size income statement in Exhibit 15-5 states each line item as a percentage of sales. For example, the administrative expenses were 12.7% of sales last year and 11.3% of sales this year. If the quality and efficiency of Brickey's administrative services is holding constant or improving over time, then these two percentages suggest that this year Brickey managed its administrative resources more cost-effectively than last year. Beyond administrative expenses, managers also have a keen interest in other percentages disclosed in a common-size income statement and those will be discussed in a later section related to profitability ratios.

EXHIBIT 15-4

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EXHIBIT 15-5

Ratio Analysis—Liquidity LO15-2 Compute and interpret financial ratios that managers use to assess liquidity.

Liquidity refers to how quickly an asset can be converted to cash. Liquid assets can be converted to cash quickly, whereas ill-liquid assets cannot. Companies need to continuously monitor the amount of their liquid assets relative to the amount that they owe short-term creditors, such as suppliers. If a

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company's liquid assets are not enough to support timely payments to short-term creditors, this presents an important management problem that, if not remedied, can lead to bankruptcy.

This section uses Brickey Electronics' financial statements to explain one measure and two ratios that managers use to analyze their company's liquidity and its ability to pay short-term creditors. As you proceed through this section, keep in mind that all calculations are performed for this year rather than last year. Working Capital The excess of current assets over current liabilities is known as working capital.

The working capital for Brickey Electronics is computed as follows:

Managers need to interpret working capital from two perspectives. On one hand, if a company has ample working capital, it provides some assurance that the company can pay its creditors in full and on time. On the other hand, maintaining large amounts of working capital isn't free. Working capital must be financed with long-term debt and

equity—both of which are expensive. Furthermore, a large and growing working capital balance may indicate troubles, such as excessive growth in inventories. Therefore, managers often want to minimize working capital while retaining the ability to pay short-term creditors. Current Ratio A company's working capital is frequently expressed in ratio form. A company's current assets divided by its current liabilities is known as the current ratio:

For Brickey Electronics, the current ratio is computed as follows:

Although widely regarded as a measure of short-term debt-paying ability, the current ratio must be interpreted with great care. A declining ratio might be a sign of a deteriorating financial condition, or it might be the result of eliminating obsolete inventories or other stagnant current assets. An improving ratio might be the result of stockpiling inventory, or it might indicate an improving financial situation. In short, the current ratio is useful, but tricky to interpret.

The general rule of thumb calls for a current ratio of at least 2. However, many companies successfully operate with a current ratio below 2. The adequacy of a current ratio depends heavily on the composition of the assets. For example, as we see in the table below, both Worthington

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Corporation and Greystone, Inc., have current ratios of 2. However, they are not in comparable financial condition. Greystone is more likely to have difficulty meeting its current financial obligations because almost all of its current assets consist of inventory rather than more liquid assets such as cash and accounts receivable.

Acid-Test (Quick) Ratio The acid-test (quick) ratio is a more rigorous test of a company's ability to meet its short-term debts than the current ratio. Inventories and prepaid expenses are excluded from total current assets, leaving only the more liquid (or “quick”) assets to be divided by current liabilities.

The acid-test ratio measures how well a company can meet its obligations without having to liquidate or depend too heavily on its inventory. Ideally, each dollar of liabilities should be backed by at least $1 of quick assets. However, acid-test ratios as low as 0.3 are common.

The acid-test ratio for Brickey Electronics is computed below:

Although Brickey Electronics' acid-test ratio is within the acceptable range, a manager might be concerned about several trends revealed in the company's balance sheet. Notice in Exhibit 15-1 that short-term debts are rising, while the cash balance is declining. Perhaps the lower cash balance is a result of the substantial increase in accounts receivable. In short, as with the current ratio, the acid- test ratio should be interpreted with one eye on its basic components.

Ratio Analysis—Asset Management

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LO15-3 Compute and interpret financial ratios that managers use for asset management purposes.

A company's assets are funded by lenders and stockholders, both of whom expect those assets to be deployed efficiently and effectively. In this section, we'll describe various measures and ratios that managers use to assess their company's asset management performance. All forthcoming calculations will be performed for this year. Accounts Receivable Turnover The accounts receivable turnover and average collection period ratios measure how quickly credit sales are converted into cash. The accounts receivable turnover is computed by dividing sales on account (i.e., credit sales) by the average accounts receivable balance for the year:

Assuming that all of Brickey Electronics' sales were on account, its accounts receivable turnover is computed as follows:

The accounts receivable turnover can then be divided into 365 days to determine the average number of days required to collect an account (known as the average collection period).

The average collection period for Brickey Electronics is computed as follows:

This means that on average it takes 35 days to collect a credit sale. Whether this is good or bad depends on the credit terms Brickey Electronics is offering its customers. Many customers will tend to withhold payment for as long as the credit terms allow. If the credit terms are 30 days, then a 35- day average collection period would usually be

viewed as very good. On the other hand, if the company's credit terms are 10 days, then a 35-day average collection period is worrisome. A long collection period may result from having too many old uncollectible accounts, failing to bill promptly or follow up on late accounts, lax credit checks, and so on. In practice, average collection periods ranging all the way from 10 days to 180 days are common, depending on the industry.

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IN BUSINESS THE CHALLENGE OF COLLECTING CASH FROM CUSTOMERS When the economy soured Caroline's Desserts saw the percentage of its customers who make late payments jump from 2% to 18%. These late payments decreased the company's accounts receivable turnover, which in turn forced the company's owner to delay hiring more employees, to delay new equipment purchases, and to pay bills using personal funds. Similarly, the weak economy caused a large portion of Quality Service Associates Inc.'s customers to begin paying for their purchases in 45–60 days instead of the normal 30–45 days. The company's president said the “extra 15 to 20 days that people are not paying has had a pretty significant impact on my ability to keep up with my vendors.” Source: Simona Covel and Kelly K. Spors, “To Help Collect the Bills, Firms Try the Soft Touch,” The Wall Street Journal, January 22, 2009, pp. B1 and B6.

Inventory Turnover The inventory turnover ratio measures how many times a company's inventory has been sold and replaced during the year. It is computed by dividing the cost of goods sold by the average level of inventory [(Beginning inventory balance + Ending inventory balance) ÷ 2]:

Brickey's inventory turnover is computed as follows:

The number of days needed on average to sell the entire inventory (called the average sale period) can be computed by dividing 365 by the inventory turnover:

The average sale period varies from industry to industry. Grocery stores, with significant perishable stocks, tend to turn over their inventory quickly. On the other hand, jewelry stores tend to turn over their inventory slowly. In practice, average sales periods of 10 days to 90 days are common, depending on the industry.

A company whose inventory turnover ratio is much slower than the average for its industry may have too much inventory or the wrong sorts of inventory. Some managers argue that they must buy in large quantities to take advantage of quantity discounts. But these discounts must be compared to the added costs of insurance, taxes, financing, and risks of obsolescence and deterioration that result from carrying added inventories.

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Operating Cycle The operating cycle measures the elapsed time from when inventory is received from suppliers to when cash is received from customers. It is computed as follows:

Brickey Electronics' operating cycle is computed as follows:

A manager's goal is to reduce the operating cycle because it puts cash receipts in the company's possession sooner. In fact, if a company can shrink its operating cycle to fewer days than its average payment period for suppliers, it means the company is receiving cash from customers before it has to pay suppliers for inventory purchases. For example, if a company's operating cycle is 10 days and its average payment period to suppliers is 30 days, the company is receiving cash from customers 20 days before it pays its suppliers. In this example, the company could earn interest income on cash collections for 20 days before paying a portion of those receipts to suppliers. Conversely, if a company's operating cycle is much longer than its average payment period for suppliers, it creates the need to borrow money to fund its inventories and accounts receivable. In the case of Brickey Electronics, its operating cycle is very high, thereby suggesting that it needs to borrow money to fund its working capital.

IN BUSINESS INVENTORY MANAGEMENT IN THE APPAREL INDUSTRY Many apparel retailers such as Aéropostale are practicing a three-step inventory management tactic known as chasing. First, the retailer orders very small quantities of its new clothing styles from its suppliers. Second, the retailer determines which of its new clothing styles are popular with customers. Third, the retailer chases consumer demand by asking suppliers to very quickly ramp-up production of its most popular clothing styles. This tactic, if properly executed, enables retailers to not only reduce their average sale period and operating cycle, but it also helps them minimize price markdowns related to excess inventories and forgone sales related to out-of-stock items. Of course, tension inevitably arises with suppliers who greatly prefer large order quantities and 6–9 month lead times. Source: Elizabeth Holmes, “Tug-of-War in Apparel World,” The Wall Street Journal, July 16, 2010, pp. B1–B2.

Total Asset Turnover The total asset turnover is a ratio that compares total sales to average total assets. It measures how efficiently a company's assets are being used to generate sales. This ratio expands beyond current assets to include noncurrent assets, such as property, plant, and equipment. It is computed as follows:

Brickey Electronics' total asset turnover is computed as follows:

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A company's goal is to increase its total asset turnover. To do so, it must either increase sales or reduce its investment in assets. If a company's accounts receivable turnover and inventory turnover are increasing, but its total asset turnover is decreasing, it suggests the problem may relate to noncurrent asset utilization and efficiency. It also bears emphasizing that if all else holds constant, a company's total asset turnover will increase over time simply because the accumulated depreciation on plant and equipment grows over time.

Ratio Analysis—Debt Management LO15-4 Compute and interpret financial ratios that managers use for debt management purposes.

Managers need to evaluate their company's debt management choices from the vantage point of two stakeholders—long-term creditors and common stockholders. Long-term creditors are concerned with a company's ability to repay its loans over the long-run. For example, if a company paid out all of its available cash in the form of dividends, then nothing would be left to pay back creditors. Consequently, creditors often seek protection by requiring that borrowers agree to various restrictive covenants, or rules. These restrictive covenants typically include restrictions on dividend payments as well as rules stating that the company must maintain certain financial ratios at specified levels. Although restrictive covenants are widely used, they do not ensure that creditors will be paid when loans come due. The company still must generate sufficient earnings to cover payments.

Stockholders look at debt from a financial leverage perspective. Financial leverage refers to borrowing money to acquire assets in an effort to increase sales and profits. A company can have either positive or negative financial leverage depending on the difference between its rate of return on total assets and the rate of return that it must pay its creditors. If the company's rate of return on total assets exceeds the rate of return the company pays its creditors, financial leverage is positive. If the rate of return on total assets is less than the rate of return the company pays its creditors, financial leverage is negative. We will explore whether Brickey Electronics has positive or negative financial leverage later in the chapter. For now, you need to understand that if a company has positive financial leverage, having debt can substantially benefit common stockholders. Conversely, if a company has negative financial leverage, common stockholders suffer. Given the potential benefits of maintaining positive financial leverage, managers do not try to avoid debt, rather they often seek to maintain a level of debt that is considered to be normal within their industry.

In this section, we explain three ratios that managers use for debt management purposes, times interest earned ratio, debt-to-equity ratio, and the equity multiplier. All calculations are performed for this year.

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Times Interest Earned Ratio The most common measure of a company's ability to provide protection to its long-term creditors is the times interest earned ratio. It is computed by dividing earnings before interest expense and income taxes (i.e., net operating income) by interest expense:

For Brickey Electronics, the times interest earned ratio for this year is computed as follows:

The times interest earned ratio is based on earnings before interest expense and income taxes because that is the amount of earnings that is available for making interest payments. Interest expenses are deducted before income taxes are determined; creditors have first claim on the earnings before taxes are paid.

A times interest earned ratio of less than 1 is inadequate because interest expense exceeds the earnings that are available for paying that interest. In contrast, a times interest earned ratio of 2 or more may be considered sufficient to protect long-term creditors. Debt-to-Equity Ratio The debt-to-equity ratio is one type of leverage ratio that indicates the relative proportions of debt and equity at one point in time on a company's balance sheet. As the debt-to-equity ratio increases, it indicates that a company is increasing its financial leverage.

In other words, it is relying on a greater proportion of debt rather than equity to fund its assets. The debt-to-equity ratio is measured as follows:

Brickey's debt-to-equity ratio for this year is computed as follows:

At the end of this year, Brickey Electronics' creditors were providing 85 cents for each $1 being provided by stockholders.

Creditors and stockholders have different views about the optimal debt-to-equity ratio. Ordinarily, stockholders would like a lot of debt to take advantage of positive financial leverage. On the other hand, because equity represents the excess of total assets over total liabilities, and hence a buffer of protection for creditors, creditors would like to see less debt and more equity. In practice, debt-to- equity ratios from 0.0 (no debt) to 3.0 are common. Generally speaking, in industries with little

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financial risk, managers maintain high debt-to-equity ratios. In industries with more financial risk, managers maintain lower debt-to-equity ratios. Equity Multiplier The equity multiplier is another type of leverage ratio that indicates the portion of a company's assets funded by equity. Similar to the debt-to-equity ratio, as the equity multiplier increases, it indicates that a company is increasing its financial leverage. In other words, it is relying on a greater proportion of debt rather than equity to fund its assets. Instead of measuring amounts in the numerator and denominator at one point in time (as is done with the debt-to-equity ratio), the equity multiplier focuses on average amounts maintained throughout the year and it is measured as follows:

Brickey's equity multiplier for this year is computed as follows:

The debt-to-equity ratio and the equity multiplier provide signals about how a company is managing its mix of debt and equity. We have introduced the equity multiplier because it will be used in the next section of the chapter to provide further insight into how companies measure and interpret what will be defined as return on equity (ROE).

IN BUSINESS

SMALL BUSINESS STRUGGLES TO MANAGE ITS DEBT Chuck Bidwell and Jennifer Guarino bought J.W. Hulme Company to expand the business into luxury briefcases, backpacks, and handbags. The co-owners planned to grow the company's catalog mailing list tenfold to 10,000 households while doubling its product assortment to 250 items. To finance this growth strategy, the company borrowed more than $2 million, causing its debt-to-equity ratio to jump from 2.94 to 5.53. When the company subsequently sought $250,000 in additional loans to finance its next round of catalogs, lenders were apprehensive. The company's most recent annual sales of $1.5 million fell $500,000 short of the owners' projections. Furthermore, inventory levels had ballooned to $1 million signaling declining demand for the company's products. Source: Julie Jargon, “On Front Lines of Debt Crisis, Luggage Maker Fights for Life,” The Wall Street Journal, January 9, 2009, pp. A1 and A8.

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Ratio Analysis—Profitability LO15-5 Compute and interpret financial ratios that managers use to assess profitability.

Managers pay close attention to the amount of profits that their companies earn. However, when analyzing ratios, they tend to focus on the amount of profit earned relative to some other amount such as sales, total assets, or total stockholder's equity. When profits are stated as a percentage of another number, such as sales, it helps managers draw informed conclusions about how the organization is performing over time. For example, if a company had profits in Years 1 and 2 of $10 and $20, respectively, it would be naïve to immediately assume that the company's performance has improved. In other words, if we further assume that sales in Year 1 are $100 and sales in Year 2 are $1,000, it would be troubling to see that the company converted $900 of additional sales into only $10 dollars of additional profit. In this section, we develop this idea further by discussing four profitability ratios commonly used by managers—gross margin percentage, net profit margin percentage, return on total assets, and return on equity. All forthcoming calculations are performed for this year. Gross Margin Percentage Exhibit 15-5 shows that Brickey's cost of goods sold as a percentage of sales increased from 65.6% last year to 69.2% this year. Or looking at this from a different viewpoint, the gross margin percentage declined from 34.4% last year to 30.8% this year. Managers and investors pay close attention to this measure of profitability. The gross margin percentage is computed as follows:

The gross margin percentage should be more stable for retailing companies than for other companies because the cost of goods sold in retailing excludes fixed costs. When fixed costs are included in the cost of goods sold, the gross margin percentage should increase and decrease with sales volume. With increases in sales volume, fixed costs are spread across more units and the gross margin percentage should improve.

IN BUSINESS WHERE'S THE BEEF?

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Fast-food restaurants such as McDonald's, Wendy's, and Burger King faced an interesting challenge—how do we hold our gross margin percentage steady in the face of climbing beef prices? One option was to pass the higher raw material cost on to customers in the form of higher prices; however, the slumping economy suggested that a price increase would diminish customer demand. Instead, the restaurants tried to encourage their diners to buy more profitable menu items such as chicken and salads. Wendy's, once known for its advertising slogan “Where's the Beef?” focused its advertising efforts on a new line of premium salads and a new flavor of boneless wings. Burger King planned to introduce bone-in-pork ribs for a limited time. Source: Paul Ziobro, “Fast-Food Joints Push Chicken as Beef Prices Hit New Highs,” The Wall Street Journal, May 20, 2010, p. B1.

Net Profit Margin Percentage Exhibit 15-5 shows that Brickey's net profit margin percentage decreased from 4.7% last year to 3.4% this year. The net profit margin percentage is widely used by managers and it is computed as follows:

The gross profit margin percentage and the net profit margin percentage state the gross margin and net income as a percentage of sales. The gross margin percentage focuses on only one type of expense (cost of goods sold) and its impact on performance, whereas the net profit margin percentage also looks at how selling and administrative expenses, interest expense, and income tax expense have influenced performance. The remaining ratios in this section look at profitability relative to amounts reported on the balance sheet rather than sales. Return on Total Assets The return on total assets is a measure of operating performance that is defined as follows:

Interest expense is added back to net income to show what earnings would have been if the company had no debt. With this adjustment, a manager can evaluate his company's return on assets over time without the analysis being influenced by changes in the company's mix of debt and equity over time. Furthermore, this adjustment enables managers to draw more meaningful comparisons with other companies that have differing amounts of debt. Notice that the interest expense is placed on an after-tax basis by multiplying it by the factor (1 − Tax rate).

The return on total assets for Brickey Electronics is computed as follows (from Exhibits 15-1 and 15-2):

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Brickey Electronics has earned a return of 7.3% on average total assets employed during this year. Return on Equity The return on total assets looks at profits relative to total assets, whereas the return on equity looks at profits relative to the book value of stockholder's equity. The return on equity is computed as follows:

Brickey Electronics' return on equity for this year would be computed as follows:

Now that we have computed return on total assets and return on equity, we can take a moment to see financial leverage in operation for Brickey Electronics. Notice from Exhibit 15-1 that the company pays 8% interest on its bonds payable. The after-tax interest cost of these bonds is only 5.6% [8% interest rate × (1 − 0.30) = 5.6%]. As shown earlier, the company's after-tax return on total assets is 7.3%. Because the return on total assets of 7.3% is greater than the 5.6% after-tax interest cost of the bonds, leverage is positive and the difference goes to the stockholders. This explains in part why the return on equity of 10.6% is greater than the return on total assets of 7.3%.

It also bears emphasizing that many managers and investors take a more in-depth look at return on equity using principles pioneered by E.I. du Pont de Nemours and Company (better known as DuPont). This approach recognizes that return on equity is influenced by three elements—operating efficiency (as measured by net profit margin percentage), asset usage efficiency (as measured by total asset turnover), and financial leverage (as measured by the equity multiplier). The following equation computes Brickey Electronics' return on equity using these three elements:

Notice that the sales and average total asset figures cancel, so we are left with net income divided by average stockholders' equity. While this equation is a little bit more complex, its return on equity of 10.6% agrees with the initial return on equity computation performed earlier. Also notice that this

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equation uses a net profit margin percentage of 3.37% rather than the rounded net profit margin percentage of 3.4% shown in Exhibit 15-5. The total asset turnover of 1.72 was previously computed on page 685 and the equity multiplier of 1.83 was previously computed on page 687.

Ratio Analysis—Market Performance LO15-6 Compute and interpret financial ratios that managers use to assess market performance.

This section summarizes five ratios that common stockholders use to assess a company's performance. Given that common stockholders are the ones who own the company, it logically follows that managers should have a thorough understanding of the measures that their owners will use to judge their performance. All calculations are performed for this year. Earnings per Share An investor buys a stock in the hope of realizing a return in the form of either dividends or future increases in the value of the stock. Because earnings form the basis for dividend payments and future increases in the value of shares, investors are interested in a company's earnings per share.

Earnings per share is computed by dividing net income by the average number of common shares outstanding during the year.

Using the data in Exhibits 15-1 and 15-2, Brickey Electronics' earnings per share would be computed as follows:

IN BUSINESS

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DO ANALYSTS BIAS THEIR EARNINGS FORECASTS? Research from Penn State University suggests that Wall Street analysts' earnings per share (EPS) forecasts are intentionally overstated. The study examined analysts' long-term (three to five years) and short-term (one year) EPS forecasts from 1984 through 2006. Over this 22-year period, the analysts' average estimated long-term EPS growth rate was 14.7% compared to an actual average long-term growth rate of 9.1%. The analysts' average short-term EPS projection was 13.8% compared with an actual annual EPS growth rate of 9.8%. The professors who conducted the study claim that “analysts are rewarded for biased forecasts by their employers, who want them to hype stocks so that the brokerage house can garner trading commissions and win underwriting deals.” Source: Andrew Edwards, “Study Suggests Bias in Analysts' Rosy Forecasts,” The Wall Street Journal, March 21, 2008, p. C6.

Price-Earnings Ratio The price-earnings ratio expresses the relationship between a stock's market price per share and its earnings per share. If we assume that Brickey Electronics' stock has a market price of $40 per share at the end of this year, then its price-earnings ratio would be computed as follows:

The price-earnings ratio is 11.43; that is, the stock is selling for about 11.43 times its current earnings per share.

A high price-earnings ratio means that investors are willing to pay a premium for the company's stock—presumably because the company is expected to have higher than average future earnings growth. Conversely, if investors believe a company's future earnings growth prospects are limited, the company's price-earnings ratio would be relatively low. In the late 1990s, the stock prices of some dot.com companies—particularly those with little or no earnings—were selling at levels that resulted in huge and nearly unprecedented price-earnings ratios. Many commentators cautioned that these price-earnings ratios were unsustainable in the long run—and they were right. The stock prices of almost all dot.com companies subsequently crashed. Dividend Payout and Yield Ratios Investors in a company's stock make money in two ways—increases in the market value of the stock and dividends. In general, earnings should be retained in a company and not paid out in dividends as long as the rate of return on funds invested inside the company exceeds the rate of return that stockholders could earn on alternative investments outside the company. Therefore, companies with

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excellent prospects of profitable growth often pay little or no dividend. Companies with little opportunity for profitable growth, but with steady, dependable earnings, tend to pay out a higher percentage of their cash flow from operations as dividends. The Dividend Payout Ratio The dividend payout ratio quantifies the percentage of current earnings being paid out in dividends. This ratio is computed by dividing the dividends per share by the earnings per share for common stock:

For Brickey Electronics, the dividend payout ratio is computed as follows:

There is no such thing as a “right” dividend payout ratio, although the ratio tends to be similar for companies within the same industry. As noted above, companies with ample growth opportunities at high rates of return tend to have low payout ratios, whereas companies with limited reinvestment opportunities tend to have higher payout ratios. The Dividend Yield Ratio The dividend yield ratio is computed by dividing the current dividends per share by the current market price per share:

Because the market price for Brickey Electronics' stock is $40 per share, the dividend yield is computed as follows:

The dividend yield ratio measures the rate of return (in the form of cash dividends only) that would be earned by an investor who buys common stock at the current market price. A low dividend yield ratio is neither bad nor good by itself. Book Value per Share Book value per share measures the amount that would be distributed to holders of each share of common stock if all assets were sold at their balance sheet carrying amounts (i.e., book values) and if all creditors were paid off. Book value per share is based entirely on historical costs. The formula for computing it is:

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The book value per share of Brickey Electronics' common stock is computed as follows:

If this book value is compared with the $40 market value of Brickey Electronics' stock, then the stock may appear to be overpriced. However, as we discussed earlier, market prices reflect expectations about future earnings and dividends, whereas book value largely reflects the results of events that have occurred in the past. Ordinarily, the market value of a stock exceeds its book value. For example, in one year, Microsoft's common stock often traded at over 4 times its book value, and Coca-Cola's market value was over 17 times its book value.

Summary of Ratios and Sources of Comparative Ratio Data Exhibit 15-6 contains a summary of the ratios discussed in this chapter. The formula for each ratio and a summary comment on each ratio's significance are included in the exhibit.

Exhibit 15-7 (page 694) contains a listing of public sources that provide comparative ratio data organized by industry. These sources are used extensively by managers, investors, and analysts. The EDGAR database listed in Exhibit 15-7 is a particularly rich source of data. It contains copies of all reports filed by companies with the SEC since about 1995—including annual reports filed as Form 10-K.

EXHIBIT 15-6 Summary of Ratios

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EXHIBIT 15-7 Sources of Financial Ratios

Source Content Almanac of Business and Industrial

Financial Ratios, Aspen Publishers; published annually

An exhaustive source that contains common-size income statements and financial ratios by industry and by the size of companies within each industry.

AMA Annual Statement Studies, Risk Management Association; published annually.

A widely used publication that contains common-size statements and financial ratios on individual companies; the companies are arranged by industry.

EDGAR, Securities and Exchange Commission; website that is continually updated; www.sec.gov

An exhaustive Internet database that contains reports filed by companies with the SEC; these reports can be downloaded.

FreeEdgar, EDGAR Online, Inc.; website that is continually updated; www.freeedgar.com

A site that allows you to search SEC filings; financial information can be downloaded directly into Excel worksheets.

Hoover's Online, Hoovers, Inc.; website that is continually updated; www.hoovers.com

A site that provides capsule profiles for 10,000 U.S. companies with links to company websites, annual reports, stock charts, news articles, and industry information.

Industry Norms & Key Business Ratios, Dun & Bradstreet; published annually

Fourteen commonly used financial ratios are computed for over 800 major industry groupings.

Mergent Industrial Manual and Mergent Bank and Finance Manual; published annually

An exhaustive source that contains financial ratios on all companies listed on the New York Stock Exchange, the American Stock Exchange, and regional American exchanges.

Standard & Poor's Industry Survey, Standard & Poor's; published annually

Various statistics, including some financial ratios, are given by industry and for leading companies within each industry grouping.

Summary The data contained in financial statements represent a quantitative summary of a company's operations and activities. A manager who is skillful at analyzing these statements can learn much about his company's strengths, weaknesses, emerging problems, operating efficiency, profitability, and so forth.

Many techniques are available to analyze financial statements and to assess the direction and importance of trends and changes. In this chapter, we have discussed three such analytical

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techniques—dollar and percentage changes in statements (horizontal analysis), common-size statements (vertical analysis), and ratio analysis. Refer to Exhibit 15-6 for a detailed listing of the ratios.

Review Problem: Selected Ratios and Financial Leverage

Mulligan Corporation's financial statements are as follows:

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Required: 1. Compute the return on total assets. 2. Compute the return on equity. 3. Is Mulligan's financial leverage positive or negative? Explain. 4. Compute the current ratio. 5. Compute the acid-test ratio. 6. Compute the inventory turnover. 7. Compute the average sale period. 8. Compute the debt-to-equity ratio. 9. Compute the total asset turnover.

10. Compute the net profit margin percentage. Solution to Review Problem

1. Return on total assets:

2. Return on equity:

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3. The company has positive financial leverage because the return on equity of 29.8% is greater than the return on total assets of 13.8%. The positive financial leverage was obtained from current and long-term liabilities.

4. Current ratio:

5. Acid-test ratio:

6. Inventory turnover:

7. Average sale period:

8. Debt-to-equity ratio:

Total asset turnover:

10. Net profit margin percentage:

9.

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Glossary (Note: Definitions and formulas for all financial ratios are shown in Exhibit 15-6. These definitions and formulas are not repeated here.) Common-size financial statements A statement that shows the items appearing on it in percentage form

as well as in dollar form. On the income statement, the percentages are based on total sales revenue; on the balance sheet, the percentages are based on total assets. (p. 679)

Financial leverage A difference between the rate of return on assets and the rate paid to creditors. (p. 686)

Horizontal analysis A side-by-side comparison of two or more years' financial statements. (p. 677) Trend analysis See Horizontal analysis. (p. 677) Trend percentages Several years of financial data expressed as a percentage of performance in a base

year. (p. 678) Vertical analysis The presentation of a company's financial statements in common-size form. (p. 679)

Questions 15-1 Distinguish between horizontal and vertical analysis of financial statement data. 15-2 What is the basic purpose for examining trends in a company's financial ratios and other data?

What other kinds of comparisons might an analyst make? 15-3 Assume that two companies in the same industry have equal earnings. Why might these

companies have different price-earnings ratios? If a company has a price-earnings ratio of 20 and reports earnings per share for the current year of $4, at what price would you expect to find the stock selling on the market?

15-4 Would you expect a company in a rapidly growing technological industry to have a high or low dividend payout ratio?

15-5 What is meant by the dividend yield on a common stock investment? 15-6 What is meant by the term financial leverage? 15-7 The president of a plastics company was quoted in a business journal as stating, “We haven't

had a dollar of interest-paying debt in over 10 years. Not many companies can say that.” As a stockholder in this company, how would you feel about its policy of not taking on debt?

15-8 If a stock's market value exceeds its book value, then the stock is overpriced. Do you agree? Explain.

15-9 A company seeking a line of credit at a bank was turned down. Among other things, the bank stated that the company's 2 to 1 current ratio was not adequate. Give reasons why a 2 to 1 current ratio might not be adequate.

Multiple-choice questions are provided on the text website at www.mhhe.com/garrison15e.

The Foundational 15 Available with McGraw-Hill's Connect® Accounting. LO15-2, LO15-3, LO15-4, LO15-5, LO15-6

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Markus Company's common stock sold for $2.75 per share at the end of this year. The company paid a common stock dividend of $0.55 per share this year. It also provided the following data excerpts from this year's financial statements:

Required: 1. What is the earnings per share? 2. What is the price-earnings ratio? 3. What is the dividend payout ratio and the dividend yield ratio? 4. What is the return on total assets (assuming a 30% tax rate)? 5. What is the return on equity? 6. What is the book value per share at the end of this year? 7. What is the amount of working capital and the current ratio at the end of this year? 8. What is the acid-test ratio at the end of this year? 9. What is the accounts receivable turnover and the average collection period?

10. What is the inventory turnover and the average sale period? 11. What is the company's operating cycle? 12. What is the total asset turnover? 13. What is the times interest earned ratio? 14. What is the debt-to-equity ratio at the end of this year? 15. What is the equity multiplier?

Exercises All applicable exercises are available with McGraw-Hill's Connect® Accounting.

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EXERCISE 15-1 Common-Size Income Statement [LO15-1]

A comparative income statement is given below for McKenzie Sales, Ltd., of Toronto:

Members of the company's board of directors are surprised to see that net income increased by only $38,000 when sales increased by two million dollars. Required:

1. Express each year's income statement in common-size percentages. Carry computations to one decimal place.

2. Comment briefly on the changes between the two years. EXERCISE 15-2 Financial Ratios for Assessing Liquidity [LO15-2]

Comparative financial statements for Weller Corporation, a merchandising company, for the fiscal year ending December 31 appear below. The company did not issue any new common stock during the year. A total of 800,000 shares of common stock were outstanding. The interest rate on the bond payable was 12%, the income tax rate was 40%, and the dividend per share of common stock was $0.40. The market value of the company's common stock at the end of the year was $18. All of the company's sales are on account.

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Required: Compute the following financial data and ratios for this year:

1. Working capital. 2. Current ratio. 3. Acid-test ratio.

EXERCISE 15-3 Financial Ratios for Asset Management [LO15-3]

Refer to the data in Exercise 15-2 for Weller Corporation. Required: Compute the following financial data for this year:

1. Accounts receivable turnover. (Assume that all sales are on account.) 2. Average collection period. 3. Inventory turnover. 4. Average sale period. 5. Operating cycle. 6. Total asset turnover.

EXERCISE 15-4 Financial Ratios for Debt Management [LO15-4]

Refer to the data in Exercise 15-2 for Weller Corporation. Required:

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Compute the following financial ratios for this year: 1. Times interest earned ratio. 2. Debt-to-equity ratio. 3. Equity multiplier.

EXERCISE 15-5 Financial Ratios for Assessing Profitability [LO15-5]

Refer to the data in Exercise 15-2 for Weller Corporation. Required: Compute the following financial data for this year:

1. Gross margin percentage. 2. Net profit margin percentage. 3. Return on total assets. 4. Return on equity.

EXERCISE 15-6 Financial Ratios for Assessing Market Performance [LO15-6]

Refer to the data in Exercise 15-2 for Weller Corporation. Required: Compute the following financial data for this year:

1. Earnings per share. 2. Price-earnings ratio. 3. Dividend payout ratio. 4. Dividend yield ratio. 5. Book value per share.

EXERCISE 15-7 Trend Percentages [LO15-1]

Rotorua Products, Ltd., of New Zealand markets agricultural products for the burgeoning Asian consumer market. The company's current assets, current liabilities, and sales have been reported as follows over the last five years (Year 5 is the most recent year):

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Required: 1. Express all of the asset, liability, and sales data in trend percentages. (Show percentages for each

item.) Use Year 1 as the base year and carry computations to one decimal place. 2. Comment on the results of your analysis.

EXERCISE 15-8 Selected Financial Ratios [LO15-2, LO15-3, LO15-4]

The financial statements for Castile Products, Inc., are given below:

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Account balances at the beginning of the year were: accounts receivable, $25,000; and inventory, $60,000. All sales were on account. Required: Compute the following financial data and ratios:

1. Working capital. 2. Current ratio. 3. Acid-test ratio. 4. Debt-to-equity ratio. 5. Times interest earned ratio. 6. Average collection period. 7. Average sale period. 8. Operating cycle.

EXERCISE 15-9 Financial Ratios for Assessing Profitability and Managing Debt [LO15-4, LO15-5]

Refer to the financial statements for Castile Products, Inc., in Exercise 15-8. Assets at the beginning of the year totaled $280,000, and the stockholders' equity totaled $161,600. Required: Compute the following:

1. Gross margin percentage. 2. Net profit margin percentage. 3. Return on total assets. 4. Return on equity. 5. Was financial leverage positive or negative for the year? Explain.

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EXERCISE 15-10 Financial Ratios for Assessing Market Performance [LO15-6]

Refer to the financial statements for Castile Products, Inc., in Exercise 15-8. In addition to the data in these statements, assume that Castile Products, Inc., paid dividends of $2.10 per share during the year. Also assume that the company's common stock had a market price of $42 at the end of the year and there was no change in the number of outstanding shares of common stock during the year. Required: Compute financial ratios as follows:

1. Earnings per share. 2. Dividend payout ratio. 3. Dividend yield ratio. 4. Price-earnings ratio. 5. Book value per share.

EXERCISE 15-11 Financial Ratios for Assessing Profitability and Managing Debt [LO15-4, LO15-5]

Selected financial data from the June 30 year-end statements of Safford Company are given below:

Total assets at the beginning of the year were $3,000,000; total stockholders' equity was $2,200,000. The company's tax rate is 30%. Required:

1. Compute the return on total assets. 2. Compute the return on equity. 3. Is financial leverage positive or negative? Explain.

EXERCISE 15-12 Selected Financial Measures for Assessing Liquidity [LO15-2]

Norsk Optronics, ALS, of Bergen, Norway, had a current ratio of 2.5 on June 30 of the current year. On that date, the company's assets were:

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Required: 1. What was the company's working capital on June 30? 2. What was the company's acid-test ratio on June 30? 3. The company paid an account payable of $40,000 immediately after June 30.

a. What effect did this transaction have on working capital? Show computations. b. What effect did this transaction have on the current ratio? Show computations.

Problems All applicable problems are available with McGraw-Hill's Connect® Accounting. PROBLEM 15-13 Effects of Transactions on Various Financial Ratios [LO15-2, LO15-3, LO15-4, LO15-5, LO15-6]

In the right-hand column below, certain financial ratios are listed. To the left of each ratio is a business transaction or event relating to the operating activities of Delta Company (each transaction should be considered independently).

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Required: Indicate the effect that each business transaction or event would have on the ratio listed opposite to it. State the effect in terms of increase, decrease, or no effect on the ratio involved, and give the reason for your answer. In all cases, assume that the current assets exceed the current liabilities both before and after the event or transaction. Use the following format for your answers:

PROBLEM 15-14 Effects of Transactions on Various Ratios [LO15-2] Denna Company's working capital accounts at the beginning of the year follow:

During the year, Denna Company completed the following transactions: x. Paid a cash dividend previously declared, $12,000. a. Issued additional shares of common stock for cash, $100,000. b. Sold inventory costing $50,000 for $80,000, on account. c. Wrote off uncollectible accounts in the amount of $10,000, reducing the accounts receivable balance

accordingly. d. Declared a cash dividend, $15,000. e. Paid accounts payable, $50,000. f. Borrowed cash on a short-term note with the bank, $35,000. g. Sold inventory costing $15,000 for $10,000 cash. h. Purchased inventory on account, $60,000. i. Paid off all short-term notes due, $30,000. j. Purchased equipment for cash, $15,000. k. Sold marketable securities costing $18,000 for cash, $15,000. l. Collected cash on accounts receivable, $80,000. Required:

1. Compute the following amounts and ratios as of the beginning of the year: a. Working capital. b. Current ratio. c. Acid-test ratio.

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2. Indicate the effect of each of the transactions given above on working capital, the current ratio, and the acid-test ratio. Give the effect in terms of increase, decrease, or none. Item (x) is given below as an example of the format to use:

PROBLEM 15-15 Comprehensive Ratio Analysis [LO15-2, LO15-3, LO15-4, LO15-5, LO15-6]

You have just been hired as a financial analyst for Lydex Company, a manufacturer of safety helmets. Your boss has asked you to perform a comprehensive analysis of the company's financial statements, including comparing Lydex's performance to its major competitors. The company's financial statements for the last two years are as follows:

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To begin your assigment you gather the following financial data and ratios that are typical of companies in Lydex Company's industry:

Required: 1. You decide first to assess the company's performance in terms of debt management and

profitability. Compute the following for both this year and last year: a. The times interest earned ratio. b. The debt-to-equity ratio. c. The gross margin percentage. d. The return on total assets. (Total assets at the beginning of last year were $12,960,000.) e. The return on equity. (Stockholders' equity at the beginning of last year totaled $9,048,000.

There has been no change in common stock over the last two years.) f. Is the company's financial leverage positive or negative? Explain.

2. You decide next to assess the company's stock market performance. Assume that Lydex's stock price at the end of this year is $72 per share and that at the end of last year it was $40. For both this year and last year, compute:

a. The earnings per share. b. The dividend yield ratio. c. The dividend payout ratio.

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d. The price-earnings ratio. How do investors regard Lydex Company as compared to other companies in the industry? Explain.

e. The book value per share of common stock. Does the difference between market value per share and book value per share suggest that the stock at its current price is a bargain? Explain.

3. You decide, finally, to assess the company's liquidity and asset management. For both this year and last year, compute:

a. Working capital. b. The current ratio. c. The acid-test ratio. d. The average collection period. (The accounts receivable at the beginning of last year totaled

$1,560,000.) e. The average sale period. (The inventory at the beginning of last year totaled $1,920,000.) f. The operating cycle. g. The total asset turnover. (The total assets at the beginning of last year totaled $14,500,000.)

4. Prepare a brief memo that summarizes how Lydex is performing relative to its competitors. PROBLEM 15-16 Common-Size Financial Statements [LO15-1]

Refer to the financial statement data for Lydex Company given in Problem 15-15. Required: For both this year and last year:

1. Present the balance sheet in common-size format. 2. Present the income statement in common-size format down through net income. 3. Comment on the results of your analysis.

PROBLEM 15-17 Interpretation of Financial Ratios [LO15-2, LO15-3, LO15-5, LO15-6]

Pecunious Products, Inc.'s financial results for the past three years are summarized below:

Your boss has asked you to review these results and then answer the following questions: a. Is it becoming easier for the company to pay its bills as they come due? b. Are customers paying their accounts at least as fast now as they were in Year 1?

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c. Is the total of the accounts receivable increasing, decreasing, or remaining constant? d. Is the level of inventory increasing, decreasing, or remaining constant?

Is the market price of the company's stock going up or down? f. Is the earnings per share increasing or decreasing? g. Is the price-earning ratio going up or down? h. Is the company employing financial leverage to the advantage of the common stockholders?

Required: Provide answers to each of the questions raised by your boss. PROBLEM 15-18 Common-Size Statements and Financial Ratios for a Loan Application [LO15-1, LO15-2, LO15-3, LO15-4]

Paul Sabin organized Sabin Electronics 10 years ago to produce and sell several electronic devices on which he had secured patents. Although the company has been fairly profitable, it is now experiencing a severe cash shortage. For this reason, it is requesting a $500,000 long-term loan from Gulfport State Bank, $100,000 of which will be used to bolster the Cash account and $400,000 of which will be used to modernize equipment. The company's financial statements for the two most recent years follow:

e.

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During the past year, the company introduced several new product lines and raised the selling prices on a number of old product lines in order to improve its profit margin. The company also hired a new sales manager, who has expanded sales into several new territories. Sales terms are 2/10, n/30. All sales are on account. Required:

1. To assist in approaching the bank about the loan, Paul has asked you to compute the following ratios for both this year and last year:

a. The amount of working capital. b. The current ratio. c. The acid-test ratio. d. The average collection period. (The accounts receivable at the beginning of last year totaled

$250,000.) e. The average sale period. (The inventory at the beginning of last year totaled $500,000.) f. The operating cycle. g. The total asset turnover. (The total assets at the beginning of last year were $2,420,000.) h. The debt-to-equity ratio. i. The times interest earned ratio. j. The equity multiplier. (The total stockholders' equity at the beginning of last year totaled

$1,420,000.) 2. For both this year and last year:

a. Present the balance sheet in common-size format. b. Present the income statement in common-size format down through net income.

3. Paul Sabin has also gathered the following financial data and ratios that are typical of companies in the electronics industry:

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Comment on the results of your analysis in (1) and (2) above and compare Sabin Electronics' performance to the benchmarks from the electronics industry. Do you think that the company is likely to get its loan application approved?

PROBLEM 15-19 Financial Ratios for Assessing Profitability and Market Performance [LO15-2]

Refer to the financial statements and other data in Problem 15-18. Assume that Paul Sabin has asked you to assess his company's profitability and stock market performance. Required:

1. You decide first to assess the company's stock market performance. For both this year and last year, compute:

a. The earnings per share. There has been no change in common stock over the last two years. b. The dividend yield ratio. The company's stock is currently selling for $40 per share; last year

it sold for $36 per share. c. The dividend payout ratio. d. The price-earnings ratio. How do investors regard Sabin Electronics as compared to other

companies in the industry if the industry norm for the price-earnings ratio is 12? Explain. e. The book value per share of common stock. Does the difference between market value and

book value suggest that the stock is overpriced? Explain. 2. You decide next to assess the company's profitability. Compute the following for both this year and

last year: a. The gross margin percentage. b. The net profit margin percentage.

The return on total assets. (Total assets at the beginning of last year were $2,300,000.) d. The return on equity. (Stockholders' equity at the beginning of last year was $1,329,000.) e. Is the company's financial leverage positive or negative? Explain.

3. Comment on the company's profit performance and stock market performance over the two-year period.

PROBLEM 15-20 Ethics and the Manager [LO15-2, LO15-4]

Venice InLine, Inc., was founded by Russ Perez to produce a specialized in-line skate he had designed for doing aerial tricks. Up to this point, Russ has financed the company with his own savings and with cash

c.

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generated by his business. However, Russ now faces a cash crisis. In the year just ended, an acute shortage of high-impact roller bearings developed just as the company was beginning production for the Christmas season. Russ had been assured by his suppliers that the roller bearings would be delivered in time to make Christmas shipments, but the suppliers were unable to fully deliver on this promise. As a consequence, Venice InLine had large stocks of unfinished skates at the end of the year and was unable to fill all of the orders that had come in from retailers for the Christmas season. Consequently, sales were below expectations for the year, and Russ does not have enough cash to pay his creditors.

Well before the accounts payable were due, Russ visited a local bank and inquired about obtaining a loan. The loan officer at the bank assured Russ that there should not be any problem getting a loan to pay off his accounts payable—providing that on his most recent financial statements the current ratio was above 2.0, the acid-test ratio was above 1.0, and net operating income was at least four times the interest on the proposed loan. Russ promised to return later with a copy of his financial statements.

Russ would like to apply for a $80,000 six-month loan bearing an interest rate of 10% per year. The unaudited financial reports of the company appear below:

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Required: 1. Based on the unaudited financial statements and the statement made by the loan officer, would the

company qualify for the loan? 2. Last year Russ purchased and installed new, more efficient equipment to replace an older plastic

injection molding machine. Russ had originally planned to sell the old machine but found that it is still needed whenever the plastic injection molding process is a bottleneck. When Russ discussed his cash flow problems with his brother-in-law, he suggested to Russ that the old machine be sold or at least reclassified as inventory on the balance sheet because it could be readily sold. At present, the machine is carried in the Property and Equipment account and could be sold for its net book value of $45,000. The bank does not require audited financial statements. What advice would you give to Russ concerning the machine?

PROBLEM 15-21 Incomplete Statements; Analysis of Ratios [LO15-2, LO15-3, LO15-4, LO15-5, LO15-6] Incomplete financial statements for Pepper Industries follow:

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The following additional information is available about the company: a. All sales during the year were on account. b. There was no change in the number of shares of common stock outstanding during the year. c. The interest expense on the income statement relates to the bonds payable; the amount of bonds

outstanding did not change during the year. d. Selected balances at the beginning of the current year were:

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e. Selected financial ratios computed from the statements above for the current year are:

Required: Compute the missing amounts on the company's financial statements. (Hint: What's the difference between the acid-test ratio and the current ratio?)

* $6,000,000 total par value ÷ $12 par value per share = 500,000 shares.

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