31
Chapter 4
Review of Accounting
Overview:
This chapter provides a review of accounting principles and practices. The
components of the balance sheet, income statement, and cash flow statements are
reviewed. You also learn to calculate depreciation and taxes. An understanding
of these financial statements enables the financial manager to analyze the cash
needs of his/her firm, enabling him/her to help the firm achieve financial success.
What You Should Know From This Chapter:
1. Explain how financial managers use the three basic accounting financial
statements: the income statement, the balance sheet, and the statement of
cash flows:
Income Statement: The items on the income statement that you should understand
include revenue items such as sales; and expenses which are listed as follows:
a. Cost of goods sold (labor, materials, overhead expenses)
b. Selling and administrative expenses (marketing salaries, office support,
insurance, etc.)
c. Depreciation (allocation of cost of plant and equipment)
d. Interest (payments associated with any interest-bearing liabilities of the
company)
You should also understand the difference between operating income (EBIT),
earnings before taxes (EBT), and net income. The importance of earnings per
share is also discussed.
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Balance Sheet: The items on the balance sheet that you should understand include the
categories of assets, liabilities, and equity and are described as follows:
Assets:
Current Assets are short-term liquid assets and include such items as:
Cash, marketable securities, inventory, accounts receivable, and prepaid
expenses.
Fixed Assets include assets that are expected to provide a benefit to the
firm for more than one year.
Liabilities:
How the assets are financed.
Current Liabilities are short-term debt obligations and include such items
as notes payable, accounts payable, and wages payable.
Long-term Liabilities include bonds payable and other debt not due in less
than one year.
Equity: How the assets are financed other than by debt.
Common Stock is the stated value on the stock certificate times the number
of shares issued.
Capital in excess of par is the total of the original market price per share
for each stock sold minus the par value of the stock.
Retained Earnings represents the sum of all the net income of a business
that has not been paid out in dividends.
Statement of Cash Flows: This statement shows how cash flows into and out of a
company over a given period of time.
2. Discuss how depreciation affects cash flow, and compute depreciation
expense:
Depreciation expense for a given period is determined by calculating the total
amount to be depreciated and then calculating the percentage of that total to be
allocated to a given time period.
Methods used include straight-line where you divide the cost of the asset by the
number of years of life for the asset according to classification rules, and charge
off the result as depreciation expense each year.
The Modified Accelerated Cost Recovery System (MACRS) specifies that some
percent of the cost of assets will be charged each year as depreciation expense
during the asset’s life. Larger percentages are allocated to early years under this
system. The table of deduction percentages allowed is given in Table 4-1 on page
73 of the text.
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3. Explain how to explain how taxes affect a firm’s value, and calculate
marginal and average tax rates:
The marginal tax rate generally increases as the level of taxable income
increases. This pattern reflects the progressive tax rate structure imposed by the
federal government. The marginal tax rate is the rate applied to the next dollar of
taxable income.
The average tax rate is calculated by dividing tax dollars paid by earnings before
taxes:
34
Terminology and Concept Review
4-1. The ________________________shows the firm’s assets, liabilities, and equity at
a given point in time.
4-2. _______________________ are assets that are expected to provide a benefit to
the firm for more than one year.
4-3. The _____________________________ contains audited financial statements
submitted annually to the SEC for distribution to the public.
4-4. The tax rate that applies to the next dollar of taxable income earned, the
_____________________________, changes as the level of taxable income
changes.
4-5. _____________________________ specifies the percent of the cost of assets that
will be charged each year as depreciation expense during the asset’s life as
dictated by the Tax Reform Act of 1986.
4-6. In addition to the income statement, many firms prepare a short
____________________________ that records dividend and retained earnings
information.
4-7. Which of the following would be considered either current assets or liabilities?
Cash, Fixed Assets, Retained Earnings, Accounts Payable, Inventory
4-8. What statement measures a firm’s profitability over a period of time?
___________________________________________________________
4-9. What is the formula for EPS? ____________________________________
4-10. Current assets minus current liabilities = ___________________________.
4-11. Give the formula for calculating the effective tax rate. ________________
4-12. Finish the following statement: The matching principle says that
____________________________________________________________.
4-13. True or False: Net profit is equivalent to net cash flow at the end of an
accounting period. ___
4-14. The stated value printed on the stock certificate is called the ____________.
4-15. Finish the following statement: Depreciation basis is equal to
____________________________________________________________.
35
Problems and Short-Answer Questions
4-16. What is the difference between capital in excess of par and common stock?
4-17. Explain the difference between a prepaid expense and an accrued expense; why is
one considered an asset and one a liability?
4-18. Retained earnings includes net income before any dividends are deducted.
Comment on this statement.
4-19. You have a net income of $76,000; taxes are paid at a rate of 40%; common stock
dividends paid are $40,000; and shares of stock outstanding are 50,000. Calculate
the EPS.
4-20. Cash at the end of 2011 was $100,000 and cash at the end of 2012 was $105,000.
Your cash flow statement shows a net cash position of zero. Is this possible?
Explain.
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4-21. The following information corresponds to Flynn Corporation’s 2012 operations.
COGS $400,000
S&A Expenses 50,000
Depreciation 400,000
Sales 1,000,000
Interest Expense 10,000
Tax Rate 35%
Calculate the following income statement items:
a. Gross Profit
b. EBIT
c. EBT
d. Taxes
e. Net Income
4-22. The following information corresponds to AREO Corporation’s 2012 operations.
Sales $13,000,000
Net Income 400,000
Interest Expense 100,000
Preferred Dividends 200,000
Common Stock Dividends 300,000
Beginning Retained Earnings 900,000
Calculate Ending Retained Earnings:
4-23. Explain why the change in retained earnings is not included on the cash-flow
statement.
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Use the following information for Questions 4-24 to 4-29:
Balance Sheet Dec-12 Dec-11 Dec-12 Dec-11
Assets Liabilities
Cash 4750 3614 Notes Payable 0 0
Marketable Securities 398 626 Accounts Payable 563 324
Net Receivables 581 475 Taxes Payable 410 305
Inventories 88 102 Accrued Expenses 374 284
Prepaids 201 121 Long-Term Debt 530 0
Gross Plant & Equip 1907 1445 Stockholders'
Equity
Accumulated Dep. 715 515 Common Stock 2005 2005
Net Plant & Equip. 1192 930 Retained Earnings 3328 2950
4-24. Compute the following totals for Dec of 2011 and 2012.
a. Current Assets
b. Total Assets
c. Current Liabilities
d. Total Liabilities
e. Total Stockholders’ Equity
4-25. Show whether or not the basic accounting equation is satisfied in problem 4-24.
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4-26. Calculate the cash flows from the changes in the following from the end of 2011
to the end of 2012. Indicate inflow or outflow.
a. Accumulated Depreciation
b. Net Receivables
c. Inventories
d. Prepaids
e. Plant and Equipment
f. Accounts Payable
g. Accrued Expenses
h. Long-Term Debt
i. Common Stock
j. Taxes Payable
k. Marketable Securities
4-27. Prepare a statement of cash flows in proper form using the inflows and outflows
from question 4-24. Assume net income from the 2012 income statement was
$1,396.80
4-28. Show whether or not your net cash flow matches the change in cash between the
end of 2011 and end of 2012 balance sheets.
4-29. Show whether or not the retained earnings equation balances.
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4-30. A firm expects to have earnings before depreciation and taxes of $200,000 in each
of the next three years. There are no interest payments and taxes are at a rate of
35%. It is considering the purchase of an asset costing $200,000 requiring
$20,000 in installation costs and having a MACRS recovery period of three years.
a. Calculate the annual depreciation for each year using the MACRS depreciation
percentages. (Schedule on page 73)
b. If common stock dividends paid are $20,000 and shares of common stock
outstanding are 25,000, what is the EPS in year two?
4-31. Calculate earnings per share for the following:
Net income 575,000
Interest expense 40,000
Common dividends paid 125,000
Common shares outstanding 450,000
4-32. Silverun, Inc., has before tax income of $500,000.
a. Using the corporate progressive tax rate schedule, calculate its tax obligation.
(Schedule in Table 4-2 on page 74)
b. What is its marginal tax rate?
c. What is Silverun’s average (effective) tax rate?
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4-33. Hibbert Inc. had retained earnings at the end of 2011 of $3,500,000. 2012 net
income was $500,000 and retained earnings for the end of 2012 was $3,700,000.
What was the amount paid in dividends to common stockholders in 2012?
4-34. Wilmot Manufacturing bought new equipment in 2012 for $500,000 (total cost).
The equipment falls into the MACRS seven-year class. What would be the
depreciation taken on this equipment in year 3 using MACRS rules?
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Answers
4-1. Balance sheet (Page 72)
4-2. Fixed assets (Page 72)
4-3. 10 K report (Page 68)
4-4. Marginal tax rate (Page 79)
4-5. MACRS (Page 78)
4-6. Statement of retained earnings (Page 71)
4-7. Cash, accounts payable, inventory (Page 72)
4-8. Income Statement (Page 68)
4-9. Net Income
Number of shares of common stock outstanding (Page 71)
4-10. Net Working Capital (Page 72)
4-11. Effective taxes paid
EBT (Page 80)
4-12. Expenses should be matched to the revenues they help to generate. (Page 78)
4-13. False (Page 77)
4-14. Par value (Page 74)
4-15. The cost of the asset plus any setup or delivery costs that may be incurred.
(Page 78)
4-16. The common stock reflects the par value printed on the stock certificate times the
number of shares issued which is usually very low. Capital in excess of par is the
total of the original market price per share value for each stock sold minus the par
value. (Page 74)
4-17. A prepaid expense represents future expenses expected but that have been paid in
advance. The benefit is owed to the company and is considered an asset.
Accrued expenses are business expenses that have not been paid yet and are owed
by the company and are considered liabilities. (Page 72)
4-18. Retained earnings represent the accumulation of earnings after dividends have
been paid out that have been retained for reinvestment in the firm. Dividends
paid out by definition are not retained. (Page 74).
4-19. EPS: $76,000/50,000 shares = $1.52 (Page 71)
4-20. No, this is not possible. The statement of cash flows shows the changes in the
cash position; thus the change in the actual cash account should be equal to the
change in cash position as reflected on the cash-flow statement. (Page 74)
4-21. a. GP = $600,000
b. EBIT = $150,000
c. EBT = $140,000
d. Taxes = $ 49,000
e. Net Profit = $ 91,000 (Page 69)
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4-22. Beginning retained earnings plus net income minus dividends = ending retained
earnings: 900,000 + 400,000 - 200,000 - 300,000 = $800,000 (Page 71)
4-23. If the change in retained earnings is included on the cash-flow statement, there
would be a problem with double counting as income has already been added at the
beginning of the statement. Retained earnings reflects net income (less dividends
paid). (Page 71)
4-24. 2012 2011
a. CA = $6,018 $4,938
b. TA = $7,210 $5,868
c. CL = $1,347 $ 913
d. TL = $1,877 $ 913
e. TE = $5,333 $4,955 (Page 72)
4-25. $7,210 = $1,877 + $5,333
$5,868 = $913 + $4,955 (Page 73)
4-26. a. Depreciation 200 inflow
b. Net Receivables 106 outflow
c. Inventory 14 inflow
d. Prepaids 80 outflow
e. Plant/Equipment 462 outflow
f. Accounts Payable 239 inflow
g. Accrued Expenses 90 inflow
h. Long-Term Debt 530 inflow
i. Common Stock 0
j. Taxes Payable 105 inflow
k. Marketable Sec. 228 inflow (Page 74)
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4-27.
Operations Net Income $1,396.80
Plus:
Depreciation 200.00
Marketable Sec. 228.00
Inventory 14.00
Accounts Payable 239.00
Taxes Payable 105.00
Accrued Expenses 90.00
Minus:
Net Receivables 106.00
Prepaids 80.00
Total Operating Cash Flow +$2,086.80
Investments Minus:
Increase in Plant/Equipment $ 462.00
Total Cash Flow from Invest. -$ 462.00
Financing Plus:
Increase in Long-Term Debt $ 530.00
Minus:
Dividends 1,018.80
Total Financing Cash Flow -$ 488.80
Net Cash Flow +$1,136.00
(Page 77)
4-28. Beginning cash: $3,614
Ending cash: 4,750
Change $1,136 (page 77)
4-29. Beginning Retained Earnings: $2,950 + Net Income: $1,396.80 - Dividends:
$1,018.80 = Ending Retained Earnings: $3,328. (Page 74)
4-30. a.
Year Depreciation
1 $ 73,260
2 97,900
3 32,560
4 16,280
b. EPS: Revenues $200,000
Depreciation 97,900
EBT 102,100
Taxes 35,735
Net Income 66,365
66,365/25,000 = $2.65 (Page 70)
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4-31.
= $1.28 (Page 70)
4-32. a. $50,000 @ 15% $7,500
25,000 @ 25% 6,250
25,000 @ 34% 8,500
235,000 @ 39% 91,650
165,000 @ 34% 56,100
$170,000
b. 34%
c. 170,000/500,000 = 34% (Page 80)
4-33. $3,500,000 + 500,000 – 3,700,000 = $300,000 (Page 74)
4-34. $400,000 x 17.5% = $87,500 (Page 78).
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Chapter 5
Analysis of Financial Statements
Overview:
In order to understand how a firm is doing from a financial perspective, it is
useful to do a financial analysis. This is accomplished through the construction of
a series of financial ratios. These ratios help the manager to analyze the firm in
terms of its profitability, liquidity levels, debt load, and asset utilization. By
comparing these ratios over a series of years, the analyst can get a picture of the
firm’s overall financial strength. The analyst can also compare these ratios with
those of other firms in the industry to see how well the firm is doing compared to
its peers.
After reading this chapter and working through the problems, you should feel
comfortable in doing your own analysis of a firm and should be able to tell a story
about the firm’s ability to remain a going concern.
What You Should Know From This Chapter:
1. Explain how financial ratio analysis helps financial managers assess the
health of a company:
Financial ratios are numbers that express the value of one financial variable
relative to another. They are comparative measures because they show relative
value and allow the financial analysts to compare information that could not be
compared in its raw form. Ratios may be used to compare:
One ratio to a related ratio
The firm’s performance to management’s goals
The firm’s past and present performance
The firm’s performance to that of similar firms.
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2. Compute profitability, liquidity, debt, asset utilization, and market value
ratios:
Profitability ratios measure how much company revenue is eaten up by expenses,
how much a company earns relative to sales generated, and the amount earned
relative to the value of the firm’s assets and equity.
Liquidity Ratios measure the ability of a firm to meet its short-term obligations.
Current Ratio = Current Assets
Current Liabilities
Quick Ratio = Current Assets Less Inventory
Current Liabilities
Debt Ratios assess the relative size of a firm’s debt load and the firm’s ability to
pay off the debt.
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Asset Activity Ratios measure how efficiently a firm uses its assets.
Market Value Ratios measure the market’s perception of the future earning power
of a company as reflected in the stock share price.
Economic Value Added (EVA) measures the amount of profit remaining after
accounting for the return expected by the firm’s investors and is said to be an
“estimate of the true economic profit.”
EVA = EBIT(1-TR) – (IC x Ka)
Where EBIT = earnings before interest and taxes
TR = the effective or average income tax rate
IC = invested capital
Ka = investors’ required rate of return on their investment.
Market Value Added (MVA) is the market value of the firm, debt plus equity,
minus the total amount of capital invested in the firm and is similar to the market
to book (M/B) ratio. MVA, however focuses on total market value and total
invested capital, whereas M/B focuses on the per share stock price and invested
equity capital.
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The Du Pont System of ratio analysis examines the relationships between ratios.
Du Pont Equation:
Return on Assets = Net Profit Margin x Total Asset Turnover
Modified Du Pont Equation:
ROE = Net Profit Margin x Total Asset Turnover x Equity Multiplier
3. Compare financial information over time and among companies:
Trend analysis uses computed ratio values for several time periods and compares
them.
Industry analysis (Cross-Sectional analysis) judges whether a firm’s ratio is too
high or too low in comparison with other firms in the industry.
4. Locate ratio value data for specific companies and industries:
Analysts can gather information about publicly traded corporations at most
libraries, on CD-ROM databases, and on the Internet.
49
Terminology and Concept Review
5-1. The ___________________compares all the current assets of the firm to all the
company’s current liabilities.
5-2. The difference between the firm’s future earnings and liquidation value is the
_____________________ of the firm.
5-3. In the modified Du Pont equation, ROE is the product of net profit margin, total
asset turnover, and the ________________________.
5-4. One way to judge whether a firm’s ratio is too high or too low is to compare it to
the ratios of other firms in the industry. This is sometimes called ____________.
5-5. The ___________________________tells us how efficiently the firm converts
inventory to sales.
5-6. The ___________________________is the percentage of debt relative to the
amount of equity of the firm.
5-7. The ____________________________measures how much profit out of each
sales dollar is left after all expenses are subtracted.
5-8. The ____________________________measures the average return on the firm’s
capital contributions from its owners.
5-9. The ___________________________measures how many days, on average, the
company’s credit customers take to pay their accounts.
5-10. The ___________________________is the market price per share of a
company’s common stock divided by the accounting book-value-per-share ratio.
5-11. The ___________________________measures how efficiently a firm utilizes its
assets.
5-12. Explain trend analysis. _______________________________________________
_________________________________________________________________
5-13. What is meant by the leverage effect? ___________________________________
_________________________________________________________________
5-14. Explain the difference between the current and the quick ratio. _______________
_________________________________________________________________
5-15. What is a mixed ratio? _______________________________________________
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5-16. Why is the EVA an important new tool in financial analysis?
__________________________________________________________________
________________
5-17. Why are M/B and MVA highly correlated? ______________________________
_________________________________________________________________
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Problems and Short-Answer Questions
5-18. Use the following information to construct and solve the Du Pont and Modified
Du Pont equations for Ace International: (Hint: Solve for equity)
Sales $18,530,000
Net Income 377,900
Total Assets 11,097,510
Debt/Total Assets 64.20%
5-19. Given $2,044,000 in total assets, $1,351,000 in total stockholders’ equity, and
debt-to-total-asset ratio of 33.90%, calculate the debt to equity ratio.
52
Use the following information to answer questions 5-20 to 5-24:
Computer Whiz, Inc. Dec 31, 2012
Income Statement Balance Sheet
Sales 5,937,000 Assets
Cost of Goods Sold 608,000 Cash 4,750,000 Gross Profit 5,329,000 Net Receivables 581,000 Selling & Ad. Expenses 3,022,000 Inventories 88,000
Depreciation 269,000 Prepaid
Operating Income (EBIT)
2,038,000 Other Current 201,000
Interest Expense 221,000 Total Current Assets 5,620,000 Other Expense 177,000
EBT 1,640,000 Gross Plant & Equip.. 1,907,000 Taxes 714,000 Accumulated Dep. 715,000 Net Income 926,000 Net Plant & Equip.. 1,192,000
Other Assets 398,000
Total Assets 7,210,000
Liabilities
Accounts Payable 563,000 Taxes Payable 410,000 Accrued Expenses 130,000 Other Current Liabilities 244,000 Total Current Liabilities 1,347,000 Long-Term Debt 530,000 Total Liabilities 1,877,000
Equity
Preferred Stock 0 Common Stock 2,005,000 Capital in Excess of Par 0 Retained Earnings 3,328,000 Total Common Equity 5,333,000 Total Equity 5,333,000 Total Liabilities & Equity 7,210,000
Year 2012
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5-20. Calculate the following profitability ratios for 2012.
a. Gross Profit Margin
b. Operating Profit Margin
c. Net Profit Margin
d. Return on Assets
e. Return on Equity
5-21. Calculate the following liquidity ratios for the end of 2012.
a. Current Ratio
b. Quick ratio
5-22. Calculate the following debt ratios for the end of 2012.
a. Debt to Total Assets
b. Times Interest Earned
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5-23. Calculate the following asset activity ratios for the end of 2012.
a. Average Collection Period
b. Inventory Turnover
c. Total Asset Turnover
5-24. Construct and solve Computer Whiz, Inc.’s, Modified Du Pont equation for 2012.
55
Use the following information to answer questions 5-25 to 5-29:
5-25. Calculate the following profitability ratios for 2012.
a. Gross Profit Margin
b. Operating Profit Margin
c. Net Profit Margin
ABC Fitness Company
Dec 31, 2012
Income Statement Balance Sheet
Sales 1,968,016 Assets Cost of Goods Sold 1,466,733 Cash 89,469 Gross Profit 501,283 Net Receivables 55,514
Selling/G&A 361,402
Inventories 322,433
Depreciation 35,700 Prepaid eeEExpen
8,775 Operating Income (EBIT) 104,181
Total Current Assets 476,191
Interest Expense 6,234 Other Expense 14,124 Gross Plant & Equip.. 955,661 EBT 83,823 Accumulated Dep. 338,513 Taxes 24,701 Net Plant & Equip.. 617,148 Net Income 59,122 Other Assets 24,621
Total Assets 1,117,960
Liabilities Notes Payable 1,127 Accounts Payable 144,638 Taxes Payable 16,797 Accrued Expenses 98,233 Total Current Liabilities 260,795
Long-Term Debt 415,138 Deferred Taxes 20,396 Total Liabilities 696,329
Equity Common Stock 200,320 Capital in Excess of Par 42,843 Retained Earnings 178,468 Total Equity 421,631 Total Liab. & Equity 1,117,960
Year 2012
56
d. Return on Assets
e. Return on Equity
5-26. Calculate the following liquidity ratios for the end of 2012.
a. Current Ratio
b. Quick Ratio
5-27. Calculate the following debt ratios for the end of 2012.
a. Debt to Total Assets
b. Times Interest Earned
5-28. Calculate the following asset activity ratios for the end of 2012.
a. Average Collection Period
b. Inventory Turnover
c. Total Asset Turnover
57
5-29. Construct and solve ABC Fitness Company’s Modified Du Pont equation for
2012.
5-30. From the values of the different ratios given, calculate the missing balance sheet
and income statement items of XYZ Inc. (round up the figures to nearest tens).
Average Collection Period 8.29 days
Inventory Turnover 4.63x
Debt to Asset Ratios 64.20%
Current Ratio 1.67
Return on Equity 9.51%
Return on Assets 3.41%
Operating Profit Margin 4.27%
Gross Profit Margin 26.34%
58
Use the following information to answer questions 5-30 to 5-37:
5-31. What must net income be in 2012 if XYZ Inc. wants to maintain a net profit
margin of 12% on net sales of $100,000?
5-32. Explain what a debt to equity ratio of 10 means.
5-33. A high inventory turnover ratio is always good. Comment on this statement.
XYZ Inc. Dec 31, 2012
Income Statement Balance Sheet
Assets Sales 1,852,929 Cash Cost of Goods Sold Net Receivables Gross Profit Inventories Selling & Ad. Expenses Prepaids
13,001 Depreciation ExExpense
53,474 Total Current Assets 468,289 Operating Income (EBIT)
Interest Expense Gross Plant & Equip.. 920,841 Other Expense 13,742 Accumulated Dep. 302,777 EBT
Net Plant & Equip.. 618,064
Taxes 24,628 Other Assets 21,857 Net Income Total Assets
Liabilities Notes Payable Accounts Payable 149,293 Taxes Payable 30,000 Accrued Expenses 86,470 Total Current Liabilities 281,476
Long-Term Debt Deferred Taxes 17,423 Total Liabilities 710,839
Equity Common Stock 200,320 Capital in Excess of Par 42,843 Retained Earnings Total Equity Total Liab. & Equity 1,108,210
Year: 2012
59
5-34. Explain the purpose of the Du Pont model.
5-35. Explain what a P/E ratio of 18 means.
5-36. Given the following information, calculate the current ratio and the ROE.
Total Equity $10,000
Total Liabilities 15,000
Total Sales 20,000
Current Assets 10,000
Long-Term Liabilities 5,000
Net Profit Margin 8%
60
5-37. Assume the Riddley Venture Corporation has:
Total Common Stock Equity at Year-End 2012 $10,000,000
Number of Common Shares Outstanding 750,000
Market Price per share $200
Calculate the following:
a. Book value per share
b. Market to book value ratio
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5-38.
a. For ABC Fitness Company, calculate the economic value added (EVA) if
the weighted average rate of return expected by the suppliers of the firm’s
capital is 11%, and the market price of the firm’s stock is $12, and there are
100,000 shares outstanding.
ABC Fitness Company Dec 31, 2012
Income Statement Balance Sheet
Sales 1,968,016 Assets Cost of Goods Sold 1,466,733 Cash 89,469 Gross Profit 501,283 Net Receivables 55,514 Selling & Ad. Expenses
361,402 Inventories 322,433
Depreciation 35,700 Prepaids 8,775 Operating Income (EBIT) 104,181
Total Current Assets 476,191
Interest Expense 6,234 Other Expense 14,124 Gross Plant & Equip.. 955,661 EBT 83,823 Accumulated Dep. 338,513 Taxes 29,338 Net Plant & Equip.. 617,148 Net Income 54,485 Other Assets 24,621
Total Assets 1,117,960
Liabilities Notes Payable 1,127 Accounts Payable 144,638 Taxes Payable 16,797 Accrued Expenses 98,233 Total Current Liabilities 260,795
Long-Term Debt 415,138 Deferred Taxes 20,396 Total Liabilities 696,329
Equity Common Stock 200,320 Capital in Excess of Par 42,843 Retained Earnings 178,468 Total Equity 421,631 Total Liab. & Equity 1,117,960
Year 2012
62
b. Calculate the market value added (MVA) for ABC Fitness.
c. Comment on your two answers.
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Answers
5-1. Current ratio (Page 100)
5-2. Going concern value (Page 105)
5-3. Equity multiplier (Page 108)
5-4. Cross-sectional analysis (Page 110)
5-5. Inventory turnover ratio (Page 103)
5-6. Debt to equity ratio (Page 101)
5-7. Net profit margin (Page 98)
5-8. Return on equity (Page 99)
5-9. Average collection period (Page 102)
5-10. Market to book value ratio (Page 104)
5-11. Total asset turnover Ratio (Page 103)
5-12. Trend analysis uses ratios to compare a firm’s past and present performance.
(Page 111)
5-13. The leverage effect is a result of debt on the balance sheet. By using borrowed
funds, the firm can increase its ROE. (Page 101)
5-14. The quick ratio is similar to the current ratio but is a more rigorous measure of
liquidity because it excludes inventory from current assets. (Page 100)
5-15. A mixed ratio is a ratio that uses both income statement and balance sheet
variables as inputs. (Page 99)
5-16. It enables the investors to see whether the income earned was sufficient to cover
their expected return. It is an estimate of the amount that earnings exceed or fall
short of the required minimum rate of return investors could get investing in other
securities of comparable risk. (Page 106)
5-17. Both focus on the value of the stock: MVA focuses on total market value while
M/B focuses on per share stock price and both focus on total invested capital.
(Page 105)
5-18. Debt/Total Assets = 64.20%; Equity/Total Assets = 35.80%; Total Assets/Equity
= 2.79. Du Pont Model = .0204 x 1.67 = 3.41%
Modified Model = .0204 x 1.67 x 2.79 = 9.52%.
(Page 108)
5-19. x/2044000 = .3390; x(debt) = 692,916; Debt/Equity = 692,916/1351000 = 51%.
(Page 101)
5-20. a. $5,329/5,937 = 89.76%
b. $2,038/5,937 = 34.33%
c. $926/5,937 = 15.60%
d. $926/7,210 = 12.84%
e. $926/5,333 = 17.36%
(Pages 96-99)
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5-21. a. $5,620/1,347 = 4.17
b. $5,532/1,347 = 4.11
(Page 100)
5-22. a. $1,877/7,210 = 26.03%
b. $2,038/221 = 9.22
(Page 101)
5-23. a. $581/($5,937/365) = 35.72 days
b. $5,937/88 = 67.47
c. $5,937/7,210 = 0.823
(Page 102)
5-24. ROE = profit margin x total asset turnover x equity multiplier:
17.36% = 15.6% x .823 x 1.352
(Page 108)
5-25. a. $501.283/1,968.016 = 25.47%
b. $104.181/1,968.016 = 5.29%
c. $59.122/1,968.016 = 3.00%
d. $59.122/1,117.96 = 5.29%
e. $59.122/421.631 = 14.02%
(Page 96-100)
5-26. a. $476.191/260.795 = 1.83
b. $153.758/260.795 = .59
(Page 100)
5-27. a. $696.329/1,117.96 = 62.29%
b. $104.181/34.482 = 3.02
(Page 101)
5-28. a. $55.514/(1,968.016/365) = 10.3 days
b. $1,968.016/322.433 = 6.10
c. $1,968.016/1,117.96 = 1.76
(Page 102)
5-29. ROE = net profit margin x total asset turnover x equity multiplier:
14.02% = 3% x 1.76 x 2.652 (Page 108)
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5-30.
5-31. .12 x 100,000 = $12,000 (Page 98)
5-32. This means that the firm has 10 times as much debt as equity. (Page 101)
5-33. While the firm may want to see inventory turning over which means good sales;
perhaps the firm is not maintaining enough inventory on hand which could mean
a loss of potential sales. (Page 103)
5-34. The Du Pont model enables the firm to look at the components of both ROA and
ROE to see what impact individual ratios have upon these returns. For example,
is profitability too low, or are turnover ratios too low. The firm can look at the
factors comprising their various returns to better analyze their effectiveness.
(Page 104)
5-35. A P/E ratio of 18 measures how much investors are willing to pay for claim to one
dollar of the earnings per share of the firm. It would take 18 years of the
company’s current earnings rate for the investor to earn net profits of $18 per
share. (Page 104)
Balance Sheet Income Statement
Assets
Cash 13,008 Sales 1,852,929
Net Receivables 42,080 Cost of Goods Sold 1,364,868
Inventories 400,200 Gross Profit 488,061
Prepaids 13,001 Selling & Ad. Expenses 355,467
Total Current Assets 468,289 Depreciation 53,474
Operating Profit 79,120
Gross Plant & Equip. 920,841 Interest Expense 2,960
Accumulated Dep. 302,777 Other Expense 13,742
Net Plant & Equip.. 618,064 PreTax Income 62,418
Other Assets 21,857 Taxes (39.46%) 24,628
Total Assets 1,108,210 Net Profit 37,790
Liabilities
Notes Payable 15,710
Accounts Payable 149,293
Taxes Payable 30,000
Accrued Expenses 86,473
Total Current Liabilities 281,476
Long-Term Debt 411,940
Deferred Taxes 17,423
Total Liabilities 710,839
Equity
Common Stock 200,320
Capital in Excess of Par 42,843
Retained Earnings 154,208
Total Equity 397,371
Total Liabilities & Equity 1,108,210
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5-36. Current ratio = 10,000/10,000 = 1. (Page 100)
ROE = 1,600/10,000 = 16%. (Page 99)
5-37. a. $10,000,000/750,000 = $13.33 per share
b. $200/$13.33 = $15.00 per share (Page 104)
5-38. a. EVA = 104,181(1-0.35) – ((120,000 + 416,268 x 0.11)) = ($110,071)
b. MVA = ($1,200,000 + 416,268) – (421,631 + 416,268) = $778,366
c. Although the EVA is negative, the MVA is positive which could mean that for
this year, there might have been some unusual happening in the firm which
caused a lower than average EBIT, in turn causing a low EVA. It would be
important to review trends before becoming too alarmed at this point. (Pages
105-107)
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Chapter 6
Forecasting for Financial Planning
Overview:
Once you have completed the financial analysis of your firm, you are ready to
forecast the financial needs for the future. An estimate of sales is prepared, and
the financial manager must determine the future financial needs of the firm based
on the change in forecasted sales. Increased levels of sales will necessitate
growth in other assets and liabilities and could affect the future financial standing
of the firm. It is up to the financial manager to determine those needs so that the
firm is not faced with an unexpected demand for new funds; a demand which
could over-burden the firm with debt or liquidity problems if not properly
addressed.
What You Should Know From This Chapter:
1. Explain why forecasting is vital to business success:
Forecasting in business is especially important because failing to anticipate future
trends can be devastating. Financial decisions are based on forecasts of situations
a business expects to confront in the future. There are three general approaches
discussed in this chapter: experience, probability, and correlation.
Experience means that we think things will happen a certain way in the future
because they happened that way in the past. Probability means things will happen
a certain way in the future because the laws of probability indicate that it will be
so. Correlation means we think things will happen a certain way in the future
because there is a high correlation between the behavior of one item and the
behavior of another item that we know more about.
2. Describe the financial statement forecasting process:
The forecasting process depends on the demand for a firm’s products and the
strength of the competition. Sales, marketing, and production personnel all
usually provide estimates for top management to use in their strategic decisions
affecting the firm as a whole. Sales forecasting is a group effort.
68
3. Prepare pro forma (projected) financial statements:
The cash budget and capital budget are used in the preparation of pro forma
financial statements. The cash budget shows the projected flow of cash in and out
of the firm for specified time periods, while the capital budget shows planned
expenditures for major asset acquisitions.
The pro forma income statement projects values for sales, costs and expenses
associated with sales, general and administrative expenses, depreciation, interest,
taxes, dividends paid, and addition to retained earnings.
Items which tend to move spontaneously with changes in the sales level include
COGS and selling and marketing expenses. General and administrative expenses
are more fixed in nature and tend to change as levels of fixed expenditures
change. Depreciation changes according to the depreciation schedule—not
directly with changes in sales. Interest expense will change only as debt levels
change. Dividends paid can be as a percent of sales and thus move with sales, but
this is also a discretionary item decided upon by management. Retained earnings
is calculated by adding net income after dividends paid to beginning retained
earnings.
The pro forma balance sheet is created by examining each individual line-item
account. Most current assets and current liabilities (with the exception of notes
payable) move spontaneously with sales. Usually it is assumed that notes payable
will be paid off at year end and new financing needs will be plugged into this
account to balance the statement. Plant and equipment changes will be based on
the capital budget expenditures. Long-term debt and new stock issues will
depend on the calculated financial needs when the pro forma statements are
completed.
Additional funds needed is one of the most important reasons for producing pro
forma financial statements. Additional funds needed occurs when forecast assets
exceed forecast liabilities and equity. It is called excess financing when forecast
liabilities and equity exceed forecast assets. With this knowledge, financial
managers can make the necessary financing arrangements in the financial markets
before a crisis occurs.
Once additional funds needed have been calculated, forecasters should revise the
pro forma income statement to reflect the new interest charges. However, if they
make the revision, it will reduce the next year’s net income, which in turn will
reduce the new year’s retained earnings on the balance sheet forecast. Everything
is thrown out of balance. This is known as the balancing problem. You need to
recast the financial statements several times over until the additional amount of
interest expense becomes negligible.
69
4. Explain the importance of analyzing forecasts:
The forecasts enable the financial manager to see where current trends are leading
the firm in the future, what effect management’s current plans and budgets will
have on the firm, and what actions to take to avoid problems revealed in the pro
forma statements. These points are discussed in detail in this chapter.
70
Terminology and Concept Review
6-1. The ___________________________shows the projected flow of cash in and out
of the firm for specified time periods.
6-2. The difference between forecasted assets and forecasted liabilities and equity
before external financing is called ___________________________________.
6-3. Forecasted financial statements are commonly referred to as_______________
_________________________.
6-4. The _______________________shows planned expenditures for major asset
acquisitions.
6-5. True or False: General and Administrative Expenses usually move spontaneously
with sales. _______
6-6. When forecasted liabilities and equity exceed forecasted assets, it is called
_______________.
6-7. The balancing problem refers to what variable? _________________________
6-8. List eight items from the balance sheet and income statement, which would
probably move spontaneously with sales.
_________________________ ___________________________
_________________________ ___________________________
_________________________ ___________________________
_________________________ ___________________________
6-9. What are the most important reasons for doing pro forma statements?
________________________
6-10. Write the equation for ending retained earnings.
_______________________________________________________________
6-11. What is the forecasted value for notes payable when a first pass pro forma balance
sheet is prepared? ________________________________________________
6-12. True or False: Cash rarely moves with changes in sales forecasts. __________
71
Problems and Short-Answer Questions
Use the following information to answer questions 6-13 through 6-16:
Income Statement Balance Sheet
December 31, 2012 December 31, 2012
(in thousands) (in thousands)
Sales $40,000 Assets:
COGS 18,200 Total Current Assets $100,000
21,800 Net Plant & Equipment 70,000
Total Assets $170,000 Selling Expenses 4,000
Depreciation 3,000 Liabilities & Equity:
Fixed Expenses 4,000 Accounts Payable $40,000
Notes Payable 10,000
EBIT 10,800 Accrued Expenses 10,000
Taxes (40%) 4,320
Bonds Payable 40,000
Net Income 6,480 Common Stock 40,000
Paid-in-Surplus 20,000
Common Stock Div. 1,200 Retained Earnings 10,000
$ 5,280
Total Liabilities & Equity $170,000
Sales for 2013 are projected to be $60,000; the firm currently uses straight line
depreciation. No new equipment purchases are planned for 2013. There will be a 10%
earnings distribution for 2013. Notes Payable will be paid off at the end of 2012.
6-13. Forecast net income for 2013.
6-14. Forecast retained earnings for 2013.
6-15. Forecast total assets for 2013.
72
6-16. Forecast additional funds needed in 2013.
Use the following information to answer question 6-17:
2012
Cash $20,000
Accounts Receivable 30,000
Inventory 70,000
Fixed Assets, gross 110,000
Accumulated Depreciation 30,000
Fixed Assets, net 80,000
6-17. The firm currently uses straight line depreciation. Depreciation in 2012 was
$4,000. Sales are expected to grow by 50% in 2013. All net income is paid out in
dividends and no new stock issues are planned. Calculate total assets for 2013.
6-18. Explain what is meant by the balancing problem in forecasting.
6-19. Explain which of the following items would move spontaneously with sales and
which would not.
a. Retained Earnings
b. Notes Payable
c. Accounts Receivable
d. Long-Term Debt
e. Accounts Payable
73
Use the following information to answer questions 6-20 through 6-23:
Balance Sheet
December 31, 2012
(in thousands)
Assets: Liabilities:
Cash 10,000 Accounts Payable $30,000
Accounts Receivable 40,000 Notes Payable 20,000
Inventory 30,000 Accrued Expenses 10,000
Total Current 80,000 Total Current 60,000
Fixed Assets, net 40,000 Long-Term Debt 20,000
Common Stock 32,000
Total assets $120,000 Retained Earnings 8,000
Total Liability
and Equity $120,000
Net income for 2012 was $20,000. Sales for 2013 are projected to increase by 20%. No
new equipment purchases are planned for 2013; the dividend payout ratio will be 100%
in 2013. Notes Payable are paid off at the end of 2012. Net income for 2013 is projected
to be $24,000.
6-20. Project net profits for 2013.
6-21. Projected Additional Funds Needed in 2013 will be:
6-22. Project retained earnings for 2013.
6-23. Project total assets for 2013.
74
6-24. Explain the importance of knowing additional funds needed.
Use the following information to answer question 6-25:
2012
Total Assets $37,500
Accounts Payable $ 1,500
Notes Payable 2,500
Long-Term Debt 10,000
Common Stock 12,500
Retained Earnings 11,000
Total Liabilities/Equity $37,500
Total sales in 2012were $50,000, resulting in a net income of $5,000. Sales are expected
to grow by 10% in 2013; the dividend payout ratio is 15% of net income. Net income for
2013 is projected to be $5,500.
6-25. Project common equity for 2013.
Use the following information to answer question 6-26:
2012
Total Assets $150,000
Accounts Payable $ 6,000
Notes Payable 10,000
Long-Term Debt 40,000
Common Stock 50,000
Retained Earnings 44,000
Total Liabilities/Equity $ 150,000
Total sales in 2012 were $200,000 resulting in a net income of $20,000. Sales are
expected to grow by 50% in 2013, the dividend payout ratio is 0% of net income. Net
income is projected to be $30,000 in 2013.
75
6-26. Project common equity for 2013.
6-27. Why is it important to consider the current ratio and debt ratio if additional funds
are needed?
76
Use the following information to answer questions 6-28 and 6-29.
2011 2012
Sales 400 800
Variable Costs 200 400
Fixed Costs 160 200
Net Income 40 200
Dividends 30 100
Current Assets 240 480
Fixed Assets 400 500
Total Assets 640 980
Current Liabilities 80 320
Long-Term Debt 80 80
Common Stock 80 80
Retained Earnings 400 500
Total Liabilities & Equity 640 980
6-28. Compute the following ratios for 2011 and 2012:
2011 2012
a. Current Ratio
b. Debt to Assets Ratio
c. Net Profit Margin
d. Return on Assets
e. Return on Equity
6-29. Comment on any trends revealed by your ratio analysis.
77
6-30. EBIT has been 20% of sales for the past three years and is expected to continue at
this level. If sales in 2013 are projected at $1,000,000, what would EBIT be?
6-31. Sales are expected to double in 2013 to $200,000. General and Administrative
expenses were $25,000 in 2012. Calculate General and Administrative expenses
for 2013.
78
Answers
6-1. Cash budget (Page 138)
6-2. Additional funds needed (Page 145)
6-3. Pro forma financial statements (Page 138)
6-4. Capital budget (Page 138)
6-5. False (Page 141)
6-6. Excess financing (Page 145)
6-7. Interest expense (Page 146)
6-8. COGS, selling expense, cash, marketable securities, inventory, accounts
receivable, accounts payable, accrued expenses. (Comprehensive)
6-9. The importance of knowing additional funds needed (Page 145)
6-10. Beginning Retained Earnings + Net Income - Dividends Paid. (Page 144)
6-11. Zero (Page 144)
6-12. False (Page 142)
6-13 to 6-16: Income Statement Balance Sheet
December 31, 2013 December 31, 2013
(in thousands) (in thousands)
Sales $60,000 Assets:
COGS 27,300 Total Current Assets $150,000
32,700 Net Plant & Equipment 67,000
Total Assets $217,000 Selling Expenses 6,000
Depreciation 3,000 Liabilities & Equity:
Fixed Expenses 4,000 Accounts Payable $ 60,000
Notes Payable -0-
EBIT 19,700 Accrued Expenses 15,000
Taxes (40%) 7,880
Bonds Payable 40,000
Net Income 11,820 Common Stock 40,000
Paid-in-Surplus 20,000
Common Stock Div. 1,182 Retained Earnings 20,638
To Retained Earnings 10,638
Total Liabilities & Equity $195,638
6-13. Net Income = $11,820
6-14. Retained Earnings = $20,638
6-15. Total Assets = $217,000
6-16. Additional Funds Needed = $217,000 – $195,638 = $21,362
(Comprehensive)
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6-17. 2012 2013
Cash $20,000 $30,000
Accounts Receivable 30,000 45,000
Inventory 70,000 105,000
Fixed Assets, gross 110,000 110,000
Accumulated Depreciation 30,000 34,000
Fixed Assets, net 80,000 76,000
$256,000 Total Assets (Page 147)
6-18. If a company borrows the additional funds needed, then the firm will incur new
interest charges that were not included in the original pro forma income
statement. To be accurate, forecasters should revise the pro forma income
statement to include the new interest. However, this will reduce net income and
retained earnings, which will throw the balance sheet out of balance again. (Page
146)
6-19. As sales increase, there will be more accounts receivable as customers buy more
goods, and accounts payable will increase as the firm purchases more goods to
accommodate new sales; thus, both move spontaneously with sales.
Notes payable typically is paid off at year end and can be a plug for additional
funds needed. Long-term debt by definition is not a short-term item and will be
changed only if the change in sales causes some new long-term new needs on the
balance sheet. Retained earnings increases by net income but depends on the
dividend payout ratio and thus does not move spontaneously with sales. (Pages
142–145)
6-20 through 6-23:
Balance Sheet
December 31, 2013
(in thousands)
Assets: Liabilities:
Cash 12,000 Accounts Payable $36,000
Accounts Receivable 48,000 Notes Payable -0-
Inventory 36,000 Accrued Expenses 12,000
Total Current 96,000 Total Current 48,000
Other Assets 40,000 Long-Term Debt 20,000
Common Stock 32,000
Total assets $136,000 Retained Earnings 8,000
Total Liability
and Equity $108,000
80
6-20. Net Profits = $24,000
6-21. Additional Funds Needed = $28,000
6-22. Retained Earnings = $8,000
6-23. Total Assets = $136,000
(Comprehensive)
6-24. The determination of additional funds needed is one of the most important reasons
for producing pro forma financial statements. With this knowledge, the financial
manager can make the necessary financing arrangements in the financial markets
before a crisis occurs. (Page 145)
6-25. Beginning Retained Earnings: $11,000 + Net Income: $5,500 – Dividends paid:
$825 = Ending Retained Earnings: $15,675 + Common Stock: $12,500 = Total
Common Equity: $28,175. (Page 144)
6-26. Beginning Retained Earnings: $44,000 + Net Income: $30,000 – Dividends paid:
$0 = Ending Retained Earnings: $74,000+ Common Stock: $50,000 = Total
Common Equity: $124,000. (Page 144)
6-27. You need to consider the liquidity level of the firm as well as the overall debt
position. Debt financing increase the risk level of the firm if the financial
manager is not careful. Liquidity decreases as the firm may be unable to meet its
debt payments. (Page 146)
6-28.
2012 2013
a. Current Ratio 3 1.5
b. Debt to Assets Ratio 25% 41%
c. Net Profit Margin 10% 25%
d. Return on Assets 6.25% 20.4%
e. Return on Equity 8.33% 34.48% (Comprehensive)
6-29. Profitability is obviously up by a great deal. The financial manager, however,
should consider the price of this increase. The large increase in the debt level
could make bankers and investors nervous. The decrease in liquidity levels
should also be addressed. Of course, more years of statements as well as industry
analysis is needed to do a good job of financial analysis. (Comprehensive)
6-30. $200,000 (Pages 142-143)
6-31. Without any additional information, we would assume that G & A Expenses
would remain unchanged as they do not typically move spontaneously with sales.
(Page 141)