Financial Reporting and Analysis Chapter 5 …

1 Financial Reporting and AnalysisChapter 5 SolutionsEssentials of Financial Statement turnover(AICPA adapted)Inventory turnover = Cost of goods soldAverage inventory = $2,200,000$550,000 = $550,000 = $500, 000 + $600, and inventory turnover(AICPA adapted)Accounts receivable turnover= Net credit salesAverage trade receivables = $2,500,000$462,500 = $462,500 = $475, 000 + $450, 0002 Inventory turnover = Cost of goods goldAverage inventory = $2,000,000$575,000=348.$575,000 = $600,000 + $550, turnover(AICPA adapted)Inventory turnover = Cost of goods soldAverage inventory = $1,800,000$450,000=40.$1,800,000= $400,000 + $1,900,000 - $500,000$450,000 = $400, 000 + $500, turnover(AICPA adapted)Total net sales equals total credit sales plus total cash sales. The accountsreceivable turnover ratio is used to find total credit sales:Accounts receivable turnover = Total credit salesAverage =Total credit sales$275,000$275,000 = $250, 000 + $300, 0002 Total credit sales = $275,000 = $1,375,000 Total net sales = $1,375,000 + $100,000 = $1,475, and quick ratios(AICPA adapted)The write-off of obsolete inventory would decrease Todd Corporation scurrent assets, thus decreasing the current ratio.

2 The quick ratio would beunaffected by the inventory write-off because it takes only the most liquidassets (cash, marketable securities, and receivables) into ratio(AICPA adapted)1) The refinancing of a $30,000 long-term mortgage with a short-term notewould increase Gil s current liabilities, decreasing the current ratio to .43. 2) Purchasing $50,000 of inventory with a short-term account payable wouldincrease Gil s current assets to $140,000, and increase the currentliabilities to $230,000, making the current ratio .61. 5-33) Paying $20,000 of short-term accounts payable decreases both thecurrent assets and liabilities by $20,000, making the current ratio .44. 4) Collection of $10,000 of short-term accounts receivable has no effect onGil s current coverage(AICPA adapted)The number of times that bond interest was earned can be calculated byusing the following ratio:Times interest earned = Income before interest charges & taxesInterest charges= $800, 000 + $600, 000 + $120, 000$120, 000 = inventory turnover increased(AICPA adapted)(4) The gross profit margin decreased.

3 Sales were unchanged, so the grossprofit margin decline would be due to increased cost of goods sold. Ifinventory were also unchanged, the higher cost of goods sold would result ingreater inventory sales outstanding(AICPA adapted)Requirement 1:Gross margin equals net sales minus cost of goods sold. Net sales can befound by using the accounts receivable turnover ratio:Accounts receivable turnover = Net salesAverage receivables5 =Net sales$950,000$950,000 = $900, 000 + $1, 000, 0002 Net sales = $950,000 5 = $4,750,0005-4 Cost of goods sold can be found by using the inventory turnover ratio:Inventory turnover =Cost of goods soldAverage inventory4 =Cost of goods sold$1,150,000$1,150,000 = $1,100, 000 + $1, 200, 0002 Cost of goods sold = 1,150,000 4 = $4,600,000 Gross margin = $4,750,000 - $4,600,000= $150,000 Requirement 2:Days sales in average receivables = 3605 = 72 daysDays sales in average inventories = 3604 = 90 days5-5 Financial Reporting and AnalysisChapter 5 SolutionsEssentials of Financial Statement AnalysisProblemsProblemsP5-1.

4 Ratio Analysis : Alpine Chemical(CFA adapted)Requirement 1:a) EBIT/interest expense = 1,629 + 318318 = ) Long-term debt/total capitalization = 1,491(1,491 + 3,075)=33% Note: Some students may include the $1,900 note payable as part oflong-term debt and total capitalization. This approach is quite appropriate ifthe note is a permanent component of borrowed capital. Observe in (c) below,that all debt is included. c) Funds from operations/total debt:(Net income + Depreciation expense)/(Long-term debt + Notes payable)=(1,479 + 511)(1,900 + 1,491)=59%d) Operating income/sales = 2,45819,460=12 2:a) EBIT/interest expense measures Alpine Chemical s ability to make itsinterest payments from pre-tax earnings. A ratio of less than 1 would indicatethat Alpine must sell assets or seek financing to make its interest payments. b) Long-term debt/total capitalization measures Alpine s Financial leverage. Ahighly leveraged company can find issuing new debt difficult or , a highly leveraged company is more sensitive to a business downturn.

5 C) Funds from operations/total debt measures Alpine s ability to generateenough working capital from continuing operations to meet its debt obligationsand future growth needs. 5-6d) Operating income/sales measures Alpine s profitability. Deterioration inthis ratio would indicate that sales volume must be increased, or costsreduced, to generate the same level of operating income. If Alpine cannotraise sales volume or reduce costs, then its ability to issue new debt withoutadversely affecting current debt holders is 3:a) EBIT/interest expense. With the exception of 1997, interest coverage hasbeen consistently above 4X. The year 2001 shows the best (highest) interestcoverage of the past six years and is consistent with a rating of an A AArated bond. b) Long-term debt/total capitalization. The trend in this leverage measure hasbeen stable in the past three years. During the six-year period, leverage hasdeclined erratically from 44% to 33%. At a leverage ratio of 33%, based on the2001 Financial statements, Alpine would appear to be a weak A ratedcompany.

6 C) Funds from operations/total debt. The cash flow ratio has been relativelysteady during the past three years and, at 59% in 2001, would reflect a ratingbetween A and AA. d) Operating income/sales. Operating margins remain stable but low. , this ratio would indicate that Alpine should be a summary, these four credit ratios appear stable or improving. Despite a lowoperating margin, the four ratios indicate that Alpine should be rated A, basedon a comparison with the data in Table Financial statement Analysis (AICPA adapted)1) $39,000 This value can be derived from the equation that total assets(prior to the restatement) equals total liabilities and stockholders equity,which is $140,000 (computation follows). Total stockholders equity is$80,000 ($66,000 + $13,000 + $16,000 - $6,000 - $9,000). The given ratioindicates that total stockholders equity divided by total liabilities is 4 to 3,making total liabilities equal to $60,000 ($80,000 4/3). Now that we knowthe total liabilities and stockholders equity equals $140,000, the balancefor land can be calculated as follows: $140,000 - $12,000 + $25,000 -$92,000 - $22,000 = $39, ) $5,500 Current liabilities = Current assets - Beginning working capital, or($22,000 - $16,500).

7 5-73) $50,000 The face value of the bonds is equal to the stated interestdivided by the interest rate. The stated interest is equal to bond interestexpense plus bond premium amortization ($3,500 + $500). Thus, the facevalue of the bonds is equal to $4,000/.08 = $50, ) $1,900 Deferred income taxes can be found by summing the closingbalance on the balance sheet and the debit to the deferred income taxesaccount during the year (from the statement of cash flows).($1,700 + $200 = $1,900)5) $26,100 Year-end working capital is $17,400, or $16,500 beginningworking capital plus $700 increase in noncash working capital + $200cash increase. Working capital is equal to current assets minus currentliabilities. At year end, current assets are 3 times current liabilities (currentratio of 3:1). We can substitute current assets = 3 current liabilities into the working capital equation so that 3 current liabilities minus current liabilities equals $17,400.

8 Current liabilities must be $8,700 andcurrent assets must be $26, ) $77,000 The balance for buildings and equipment is equal to the openingbalance in this account minus the cost of equipment sold during the year($92,000 - $15,000). The $15,000 is equal to 3/2 the $10,000 book value ofthe equipment ($10,000 2/3 = $15,000). If the equipment cost $15,000and had a book value of $10,000, then its accumulated depreciation musthave been $5, ) ($23,000) See (6). The accumulated depreciation is equal to the openingbalance plus depreciation expense, less $5,000 accumulated depreciationon equipment sold. ($25,000 + $3,000 - $5,000)8) $53,715 The balance in the land account is equal to the opening balanceplus the acquisition cost of new land. ($39,000 from balance sheet +$14,715 from statement of cash flows)9) $8,000 The ending balance of goodwill is equal to the opening balance(prior to restatement) minus goodwill amortization for 2000 and 2001.($12,000 - $2,000 - $2,000)10) $8,700 See (5)11) $42,800 The closing balance of bonds payable is equal to the openingbalance derived in (3) less the current maturity of long-term debt (fromthe statement of cash flows).

9 ($50,000 - $7,200)12) $2,100 The bond premium can be calculated by subtracting the bondpremium amortization (statement of cash flows) from the opening balance($2,600 - $500).5-813) $73,500 The balance of common stock at year end is equal to theopening balance plus the par value of common stock issued to reacquirepreferred stock (statement of cash flows), ($66,000 + $7,500).14) $15,400 The ending balance of paid-in capital is equal to the openingbalance plus the excess of proceeds from reissue of treasury stock($13,000 + $2,400). The excess of proceeds from reissue of treasurystock is equal to the proceeds from the reissue less the opening balanceof treasury stock from the balance sheet ($11,400 - $9,000).15) $8,500 The balance of preferred stock is equal to the opening amounton the balance sheet less the par value of preferred stock reacquired bythe issue of common stock ($16,000 - $7,500).16) ($10,885) The retained earnings balance is equal to the openingbalance as shown on the balance sheet prior to the restatement plus the2001 net loss (after tax) adjustment plus the prior period adjustment.

10 ($6,000 + $2,885 + $2,000)5-9 The current ratio on January 1, 2001 was 4-to-1, and the total stockholders equity divided by total liabilities ratio at year end was (rounded). Here isa correct comparative balance sheet for the company:Woods Company Balance Sheet1-Jan-0131-Dec-01 Current assets$22,000$26,100 Building and equipment92,00077,000 Accumulated depreciation(25,000)(23,000)Land39,00053 ,715 Goodwill 12,000 8,000 Total assets $140,000 $141,815 Current liabilities$5,500$8,700 Bonds payable (8%)50,00042,800 Bond premium2,6002,100 Deferred income taxes1,9001,700 Common stock66,00073,500 Paid-in capital13,00015,400 Preferred stock16,0008,500 Retained earnings (deficit)(6,000)(10,885)Treasury stock (at cost) (9,000 ) - Total liabilities and stockholders equity $140,000 $141,815P5-3. Explaining changes in Financial ratios(AICPA adapted)1) a,b,d Inventory turnover is defined as the cost of goods sold divided byaverage inventory.