Chapter 8 Financial Statements and Financial Statement AnalysisMultiple Choice Questions1. A2. C3. B4. B5. D6. C7. B8. D9. A 10. B 11. A 12. C 13.D 14. A 15. A 16. A 17. B 18. B 19. B 20. DDiscussion Questions1. Is the measurement of net income absolutely accurate? Why or why not?The measurement of net income is not absolutely accurate due to the assumptions and estimates in the accounting process. An Income Statement has certain limitations. For example, the amounts shown for depreciation expense are based upon estimates of the useful lives of the company’s tool, equipment, and building. In addition, the Income Statement includes only those events that have been evidenced by actual business transactions. Perhaps during the year, the company’s advertising has caught the attention of many potential customers, who may be the sources of future income. However, the Income Statement cannot reflect the unrealized revenue. Only after the real transactions take place, can the sales revenues be recognized.2. What are the three types of business activities? Give examples of each type of activity.The three types of business activities include operating, investing, and financing activities. Operating activities include the cash effects of transactions that create revenues and expenses in normal course of business. This category is the most important. It shows the cash provided by company operations, which is generally considered to be the best measure of a company’s ability to generate sufficient cash to continue as a going concern. They include sales of goods and services, payments to supplies of merchandise and services.Investing activities include the cash effects of transactions involving plant assets, intangible assets, and investments. They include purchase of property, plant, andequipment, investments in debt or equity securities of other entities.Financing activities involve liability and owners’ equity items. They include: (1) obtaining resources from owners and providing them with a return on their investments, and (2) borrowing money from creditors and repaying the amounts borrowed.3. What types of information are presented in the notes to the financial statements?A set of financial statements is normally accompanied by several notes. Notes to the financial statements are the means of explaining the items presented in the main body of financial statements. Notes disclose information useful in interpreting the statements and are an integral part of the financial statements.Many items are disclosed in notes accompanying the financial statements. Among the most useful are the followings:(1) Accounting policies and methods;(2) Unused lines of credit;(3) Significant commitments and loss contingencies;(4) Dividends in arrears;(5) Assets pledged to secure specific liabilities;(6) Changes in accounting policies and methods.4. Distinguish between trend change analysis and component percentage analysis. Which will be better suited for analyzing the changes in sales over several years?Trend changes are the changes in financial statement items from a base year to the following or preceding years. To compute trend change, a base year is firstly selected and each item in the financial statements for the base year is given a weight of 100 percent. Then, each item in the financial statements for the following or preceding years is expressed as a percentage of the base-year amount.Component percentage analysis is the proportional expression of each financial statement item in a given period to a base amount within the financial statement.Trend change analysis is better for analyzing the changes in sales over several years.5. Explain the ratios used to evaluate profitability. Explain briefly how each is computed.Profitability ratios measure the degree of success or failure of a company in a given year. Usually the key ratios include gross profit ratio, profit margin on sales, return on assets, return on equity, earnings per share, price-earnings ratio, and payout ratio.(1) Gross profit ratio.Gross profit ratio is computed by dividing gross profit by net sales. Gross profit (also known as gross margin) is the difference between net sales and the cost of goods sold.Gross profit = Net sales - Cost of goods soldGross profit ratio = Gross profitNet sales(2) Profit margin on sales.Profit margin on sales is computed as dividing net income by net sales. Net income is the difference between net sales and all expenses (including cost of goods sold). A company can improve its profit margin on sales by increasing its gross profit rate and/or by controlling its operating expense and other expenses.Profit margin on sales = Net incomeNet sales(3) Return on assets (ROA).ROA is computed by dividing net income by average total assets. Average total assets are computed by adding the beginning and ending values of total assets and dividing the total by two.ROA = Net incomeAverage total assets(4) Return on common owners equity (ROE).ROE equals net income less preferred dividends, divided by average common owners’ equity. Average common owners’ equity is computed by adding the beginning and ending values of total common owners’ equity and dividing the total by two.ROE = Net income-PreferreddividendsAverage common owners’ equity(5) Earnings per share (EPS).EPS equals net income less preferred dividends, divided by weighted-average number of shares outstanding in the same year. The weighted-average number of shares outstanding for the year is determined by multiplying the number of shares outstanding by the fraction of the year in which the number of shares outstanding remained unchanged.EPS = Net income-PreferreddividendsWeighted-average number ofshares outstanding(6) Price-earnings ratio (P/E ratio).P/E ratio is computed by dividing the current market price per share of a company’s stock by its annual EPS.P/E ratio = Stock price pershareEarning pershare(7) Payout ratio.Payout ratio equals cash dividends paid to common stockholders divided by net income (less preferred dividends).Payout ratio = Cash dividendsNet income -Preferreddividends6. Why might earnings per share be more significant to a stockholder in a large corporation than the total amount of net income?Earnings per share shows the dollars earned by each share of common stock. EPS equals net income less preferred dividends, divided by weighted-average number of shares outstanding in the same year. That is, a stockholder can know the net income he earns on the share of common stocks he owns.However, based on the total amount of net income, a stockholder cannot know how much he earns from his shares.7. Company C has a current ratio of 3 to pany D has a current ratio of 2 to 1. Does this mean that company C’s operating cycle is longer than company D’s? Why or why not?No, this does not mean that company C’s operating cycle is longer than company D’s. A company’s operating cycle is calculated as”Operating cycle=days to collect accounts receivable + days to sell inventoryDays to collect accounts receivable = 365Accounts receivable turnover rateDays to sell inventory = 365Inventory turnover rateAlthough Company C has a higher current ratio, we cannot calculate days to Days to collect accounts receivable and Days to sell inventory based on the information.8. Which ratio or ratios do you think should be of the greatest interest to:(1) A bank contemplating a short-term loan?A bank contemplating a short-term loan should be interested in such financial ratios as working capital, current ratio, quick ratio, and current cash debt coverage ratios.(2) An investor in common stock?An investor in common stock should be interested in such financial ratio as gross profit ratio, profit margin on sales, return on assets, return on equity, return on investment, earnings per share, price-earnings ratio, and payout ratio.9. Mr. Wang, the chief marketing officer, wants to reduce the selling price of his company’s products by 10% to increase market share. He says, “I know this will reduce our gross profit rate, but the increased number of units sold will make up for the lost margin.” Before this action is taken, what other factors does the company need to consider?Gross profit rate = Gross profitNet salesGross profit = Net sales - Cost of goods soldFrom the above, we know that gross profit rate is determined both by net sales and cost of goods sold. Reducing the net sales does not always lead to a reduced gross profit rate. If cost of goods sold greatly reduces, it is possible that gross profit ratio increases. If cost of goods sold increases, it is possible that the increased number of units sold will not make up for the lost margin. Therefore, before this action is taken, the company needs to consider cost of goods sold of his company’s products.10. Mr. Gao, the chief executive officer (CEO), is puzzled. During last year,his company experienced a net loss of $960,000, yet its cash increased by $540,000in the same year. Explain to the CEO how this could occur.Profit is the difference between revenues and expenses for a specified period oftime. If expenses are greater than revenues, the difference is net loss. Net income/netloss is measured on an accrual basis, while cash flows are measured on a cash basis.Under accrual basis of accounting, companies report revenue when earned, even if cashhas not been received, and they report expenses when incurred, even if cash has notbeen paid. As a result, net income/net loss is not the same as net cash.In this case, the net loss of $960,000 is the result of revenues minus expensesduring last year. It is measured on an accrual basis. However, the increased cash of $540,000 is the net cash from operating, investing, and financing activities during lastyear. It is measured on a cash basis. So, it is not strange that his company experienceda net loss of $960,000, and its cash increased by $540,000 in the same year.ProblemsProblem 8-1A condensed balance sheet for Company E prepared at the end of the year is as follows:AssetsCash $ 90,000Accounts receivable 168,000 Accounts payable 85,000 Inventory 350,000 Long-term liabilities 300,000 Prepaid expenses 75,000 Capital stock ($3 par) 330,000 Plant and equipment (net) 520,000 Retained earnings 563,000 Other assets 105,000Total $1,308,000 Total $1,308,000During the year the company earned a gross profit of $1,550,000 on sales of$3,200,000. Accounts receivables, inventory, and plant assets remained almost constantin amount through the year, so year-end figures may be used rather than the average.This company issued no preferred stocks. (红字标黄色是更正信息)RequiredCompute the following: (Carry to two decimal places)(1) Current ratioCurrent assets = cash + accounts receivable + inventory + prepaid expenses = $90,000+$168,000+$350,000+$75,000= $683,000Current liabilities = notes payable + accounts payable= $30,000 + $85,000= $115,000Current ratio = Current assets Current liabilities = $683,000$115,000 = 5.94(2) Quick ratioQuick assets = cash + accounts receivable= $90,000 + $168,000= $258,000Current liabilities = notes payable + accounts payable= $30,000 + $85,000= $115,000Quick ratio = Quick assets Current liabilities = $258,000$115,000 = 2.24(3) Working capitalCurrent assets = cash + accounts receivable + inventory + prepaid expenses = $90,000 + $168,000 + $350,000 + $75,000= $683,000Current liabilities = notes payable + accounts payable= $30,000 + $85,000= $115,000Working capital = current assets - current liabilities= $683,000 - $115,000= $568,000(4) Debt ratioTotal assets = $1,308,000Total liabilities = notes payable + accounts payable + long-term liabilities = $30,000 + $85,000 + $300,000= $415,000Debt ratio = Total liabilitiesTotal assets = $415,000$1,308,000= 31.72%(5) Accounts receivable turnover (all sales were on credit) Net sales = $3,200,000Average accounts receivable = $168,000Accounts receivable turnover rate = Net salesAverage (net) accounts receivable=$3,200,000$168,000=19.05 times per year(6) Inventory turnoverCost of goods sold = net sales – gross profit= $3,200,000 - $1,550,000= $1,650,000Average inventory = $350,000Inventory turnover rate = Cost of goods soldAverage (net) inventory= $1,650,000$350,000= 4.71 times per year(7) Profit margin on salesNet sales = $3,200,000Net income = retained earnings = $563,000Profit margin on sales = Net incomeNet sales = $563,000$3,200,000= 17.59%(8) Return on assetsNet income = retained earnings = $563,000 Average total assets = $1,308,000ROA = Net incomeAverage total assets = $563,000$1,308,000= 43.04%(9) Return on equity (this company issued no preferred stocks) Net income = retained earnings = $563,000Average common owners’ equity = capital stock + retained earnings= $330,000 + $563,000= $893,000ROE = Net income-Preferreddividends Average common owners’ equity = $563,000$893,000= 63.05%(10) Earnings per share (this company issued no preferred stocks)Net income = retained earnings = $563,000Weighted-average number of shares outstanding = $330,000/$3 = 110,000 sharesEPS = Net income-PreferreddividendsWeighted-average number ofshares outstanding =$563,000110,000= $5.12 per shareProblem 8-2The following selected data are from a recent annual report of company F. Dollar amounts are stated in millions.Beginning of the year End of the yearTotal current assets $9,230 $9,378Total current liabilities 4,836 5,902Total assets 31,125 33,561Total owners’ equity16,028 17,162Operating income 4,280Net income $3,735The company has long-term liabilities that bear interests at annual rate from 7 percent to 10 percent.Required1. Compute the company’s current ratio at: (1) the beginning of the year and, (2) the end of the year. (Carry to two decimal places)(1) Current ratio at the beginning of the yearTotal current assets = $9,230Total current liabilities = $4,836Current ratio = Current assetsCurrent liabilities = $9,230$4,836= 1.91(2) Current ratio at the end of the year Total current assets = $9,378Total current liabilities = $5,902Current ratio = Current assetsCurrent liabilities = $9,378$5,902= 1.592. Compute the company’s working capital at: (1) the beginning of the year and, (2) the end of the year. (Express dollar amounts in thousands)(1) Working capital at the beginning of the yearTotal current assets = $9,230Total current liabilities = $4,836Working capital = current assets - current liabilities= $9,230 - $4,836= $4,394(2) Working capital at the end of the yearTotal current assets = $9,378Total current liabilities = $5,902Working capital = current assets - current liabilities= $9,378 - $5,902= $3,4763. Is the company’s short-term, debt-paying ability improving or deteriorating? Company F’s short-term debt-paying ability has declined, as evidenced by its lower current ratio at the end of the year (1.59 vs. 1.91). The dollar amount of working capital has also decreased ($4,394 million to $3,476 million) which means that the company has a lesser ‘cushion’ between its currently-maturing obligations and its most liquid assets.4. Compute the company’s (1) return on average total assets and (2) return on average total owners’ equity. (Round the average assets and average equity to the nearest dollar and final computations to the nearest 1 percent)(1) Return on average total assetOperating income = $4,280Average total assets = ($31,125 + $33,561)/2 = $32,343ROA = Net incomeAverage total assets = $4,280$32,343= 13.23%(2) Return on average total owners’ equity Net income = $3,735Average owners’ equity = ($16,028 + $17,162)/2= $16,595ROE = Net income-Preferreddividends Average common owners’ equity = $3,735$16,595= 22.51%e. As an equity investor, do you think that company F’s management is utilizing the company’s resources in a reasonably efficient manner? Explain.Yes, company F’s management is using the company’s assets to generate a strong return on both assets (13.23%) and owners’ equity (22.51%), while maintaining strong liquidity with which to satisfy its obligations as they mature.Problem 8-3The following selected data for company M and company N for the year end are as follows:company M company NNet credit sales $1,600,000 $1,500,000Cost of goods sold 1,250,000 1,120,000Cash 175,000 89,000 Accounts receivable (net) 180,000 155,000 Inventory 72,000 218,000Current liabilities $210,000 $190,000Assume that the year-end balances shown for accounts receivable and for inventory also represent the average balances of these items throughout the year.Required1. For each of the two companies, compute the following:(1) Working capitalCompany M:Total current assets = cash + accounts receivable + inventory= $175,000 + $180,000 + $72,000= $427,000Total current liabilities = $210,000Working capital = current assets - current liabilities= $427,000 - $210,000= $217,000Company N:Total current assets = cash + accounts receivable + inventory= $89,000 + $155,000 + $218,000= $462,000Total current liabilities = $190,000Working capital = current assets - current liabilities= $462,000 - $190,000= $272,000(2) Current ratio Company M:Total current assets = $427,000 Total current liabilities = $210,000Current ratio = Current assetsCurrent liabilities = $427,000$210,000 = 2.03 Company N:Total current assets = $462,000 Total current liabilities = $190,000Current ratio = Current assetsCurrent liabilities = $462,000$190,000 = 2.43(3) Quick ratio Company M:Total quick assets = cash + accounts receivable= $175,000 + $180,000 = $355,000Total current liabilities = $210,000Quick ratio = Quick assetsCurrent liabilities = $355,000$210,000 = 1.69 Company N:Total quick assets = cash + accounts receivable= $89,000 + $155,000 = $244,000Total current liabilities = $190,000Quick ratio = Quick assetsCurrent liabilities = $244,000$190,000 = 1.28(4) Number of times inventory turned over during the year and the average number of days required to turn over inventory (round computation the nearestday)Company M:Cost of goods sold = $1,250,000 Average inventory = $72,000Inventory turnover rate = Cost of goods soldAverage (net) inventory = $1,250,000$72,000= 17.36 times per yearDays to sell inventory = 365Inventory turnover rate = 36517.36= 21 daysCompany N:Cost of goods sold = $1,120,000 Average inventory = $218,000Inventory turnover rate = Cost of goods soldAverage (net) inventory = $1,120,000$218,000= 5.14 times per yearDays to sell inventory = 365Inventory turnover rate = 3655.14= 71 days(5) Number of times accounts receivable turned over during the year and the average number of days required to collect account receivable (round computation the nearest day)Company M:Net credit sales = $1,600,000Average accounts receivable = $180,000Accounts receivable turnover rate = Net salesAverage (net) accounts receivable=$1,600,000$180,000=8.89 times per yearDays to collect accounts receivable = 365Accounts receivable turnover rate =3658.89= 41 daysCompany N:Net credit sales = $1,500,000Average accounts receivable = $155,000Accounts receivable turnover rate = Net salesAverage (net) accounts receivable=$1,500,000$155,000= 9.68 times per yearDays to collect accounts receivable = 365Accounts receivable turnover rate =3659.68= 38 days2. From the viewpoint of short-term creditor, comment on the quality of each company’s working capital. To which company would you prefer to sell $65,000 in merchandise on a 30-day open account?As Company M’s working capital ($217,000) is more than company N’s working capital ($272,000), from the viewpoint of short-term creditor, the quality of company N’s working capital is better than that of company M’s.I prefer to sell $65,000 in merchandise on a 30-day open account to company M,as company M spends less days (21 days) to sell inventory than company N (71 days).Problem 8-4The following data are selected from the financial statements of company G, a retail store:From the balance sheet:AssetsCash $46,000 Accounts receivable (net) 205,000 Inventory (at cost) 295,000 Plant & equipment (net of depreciation) 605,000 Current liabilities 210,000 Total owners’ equity600,000 Total assets 1,700,000 From the income statement:Net sales $3,000,000 Cost of goods sold 2,250,000 Operating expenses 525,000 Interest expense 85,000 Income tax expense 22,400 Net income 117,600 From the statement of cash flows:Net cash provided by operating activities $62,000 (including interest paid of $65,000) (68,000) Net cash used in investing activitiesFinancing activities:Amounts borrowed$52,000 Repayment of amounts borrowed (23,000) Dividends paid(21,000)Net cash provided by financing activities 8,000 Net increase in cash during the year$2,000Assume that the year-end balances shown for total assets and total owners’ equity also represent the average balances of these items throughout the year. This company issued no preferred shares. Required1. Explain how the interest expense shown in the income statement could be $85,000, when the interest payment appearing in the statement of cash flows is only $65,000.In the statement of cash flows, amounts are reported on a cash basis, whereas in the income statement, they are reported under the accrual basis. Apparently $20,000 of the interest expense incurred during the year had not been paid as of year-end. This amount should be included among the accrued expenses appearing as a current liability in the company’s balance sheet.2. Compute the following ratios/Dollar Amounts (round to one decimal place): (1) Current ratioTotal current assets = = cash + accounts receivable + inventory= $46,000 + $205,000 + $295,000 = $546,000Total current liabilities = $210,000Current ratio = Current assetsCurrent liabilities = $546,000$210,000 = 2.6(2) Working capitalTotal current assets = = cash + accounts receivable + inventory= $46,000 + $205,000 + $295,000= $546,000Total current liabilities = $210,000Working capital = Total current assets - Total current liabilities= $546,000 - $210,000= $336,000(3) Quick ratioTotal quick assets = = cash + accounts receivable= $46,000 + $205,000= $251,000Total current liabilities = $210,000Quick ratio = Quick assetsCurrent liabilities = $251,000$210,000= 1.2(4) Debt ratioTotal liabilities = total assets – total owners’ equity= $1,700,000 - $600,000= $1,100,000Total assets = $1,700,000Debt ratio = Total liabilitiesTotal assets = $1,100,000$1,700,000=64.7%(5) Times interest earnedIncome before income taxes and interest expense= net income + income taxes + interest expense= $117,600 + $22,400 + $85,000= $225,000Interest expense = $85,000Times interest earned = Income before income taxes and interestexpenseInterestexpense= $225,000$85,000= 2.6 times(6) Cash debt coverage ratioNet cash provided by operating activities = $62,000Average total liabilities = $1,100,000Cash debt coverage ratio = Net cashprovided by operating activitiesAverage total liabilities=$62,000$1,100,000= 0.06 times3. Comment on these measurements and evaluate Company G’s short-term debt-paying ability.By traditional measures, company G’s current ratio (2.6 to 1) and quick ratio (1.2 to 1) appear quite adequate. The company also generates a positive cash flow from operating activities ($62,000) which is about triple the amount of its dividend payments to stockholders ($21,000).4. Compute the following ratios:(1) Gross profit rateGross profit = Net sales - Cost of goods sold = $3,000,000 - $2,250,000 = $750,000 Net sales = $3,000,000Gross profit ratio = Gross profitNet sales = $750,000$3,000,000= 25%(2) Profit margin on sales Net income = $117,600 Net sales = $3,000,000Profit margin on sales = Net incomeNet sales = $117,600$3,000,000= 3.9%(3) Return on assetsNet income = $117,600 Average total assets = $1,700,000ROA = Net incomeAverage total assets = $117,600$1,700,000= =6.9%(4) Return on equityThis company issued no preferred shares. Net income = $117,600Average common owners’ equity = $600,000ROE = Net income-Preferreddividends Average common owners’ equity = $117,600$600,000= 19.6%(5) Payout ratioThis company issued no preferred shares. Net income = $117,600Cash dividends = $21,000Payout ratio = Cash dividendsNet income -Preferreddividends = $21,000$117,600= 17.9%5. Comment on Company G’s performance under these measurements.Company G’s profit margin on sales is 3.9%, indicating that one dollar of net sales results in net income of 3.9 cents. Investors and management can assess the company’s profitability by comparing its profit margin ratio with its competitors’ in the same industry. Profit margin on sales vary across industries. Retail stores generally experience lower profit margins.The 6.9% return on assets is not adequate by traditional standards to a retail store. However, the 19.6% return on equity is high. The problem arises because of company G’s relatively large interest expense, which is stated as $85,000 for the year.At year-end, company G has total liabilities of $1,100,000 ($1,700,000 total assets less $600,000 in owners’ equity). But $210,000 of these are current liabilities, most of which do not bear interest. Thus, company G has about $890,000 in interest-bearing debt.Interest expense of $85,000 on $890,000 of interest-bearing debt indicates an interest rate of approximately 9.55%. Obviously, it is not profitable to borrow moneyat 9.55%, and then reinvest these borrowed funds to earn a pretax return of only 6.9%. If company G cannot earn a return on assets that is higher than the cost of borrowing, it should not borrow money.Company G has a payout ratio of 17.9%, indicating that it has decided that it can and should pay 17.9% of its earnings to its owners. A higher percentage could mean that it has more cash than it has business opportunities to use that cash. A lower percentage could mean that it has very little cash to spare due to a declining business, or, very little cash to spare because it has many internal opportunities to invest that same cash.6. Discuss the safety of long-term creditors’ claims.Long-term creditors do not appear to have a high margin of safety. The debt ratio of 64.7% is high for American (or Chinese) industry. Also, debt is continuing to rise. During the current year, the company borrowed an additional $52,000, while repaying only $23,000 of existing liabilities. In the current year, interest payments alone ($65,000) was more than the net cash flow from operating activities ($62,000).A general rule of thumb is that a cash debt coverage ratio below 0.20 times is cause for additional examination. Company G’s cash debt coverage ratio is 0.06 times, below the 0.20 threshold, suggesting that the company is not solvent.。
