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Administrative Studies
ADMS 2510
John Parkinson

CHAPTER 12 Analyzing and Interpreting Financial Statements EXERCISES E12-1. a. This is a transitory element since reorganizations are infrequent events. b. The increase will apply in future periods so this is a permanent element. c. Could be either. Inventory writedowns are common in many industries. Whether it’s permanent or transitory depends on the nature of the business and the size of the writedown. (Even in a business where inventory writedowns are expected, an usually large one would be considered transitory. d. Losses on the sale of land are generally transitory since they won’t likely be recurring events, unless the entity is a real estate company. E12-3. a. The income of the new business isn’t included in the year’s financial statements (because it was purchased near the end of the year) so predicting the next year’s income based on those statements would be difficult. It would be necessary to include an estimate of the new division’s income into the IFRS statements. b. By expanding into a new market revenues and expenses will increase. Because the expansion occurred late in the year the full impact isn’t reflected in the financial statements and so they aren’t fully useful to predict the next year’s income. c. There is no established track record of past performance and the rapid change ensures that the insights that can be gained from the historical IFRS financial statements are very limited. d. The earnings in the future may be greater or less than in the past since the closing of the plants will eliminate costs, but the market is shrinking and competitors will likely drive down prices to maintain market share. The impact of the contraction won’t appear in the financial statements until later, after the company has operated for a period under the new situation. e. Software products tend to have very short life cycles and new products can easily displace existing ones. The predictive value of financial statements in industries where change is rapid is limited. Copyright © 2010 McGraw-Hill Ryerson Ltd. 1 E12-5. a. Amqui Inc. Trend Balance Sheets As of December 31, 2014 2013 2012 Cash 0.90 1.20 1.00 0 0 0 Accounts receivable 1.50 1.32 1.00 3 6 0 Inventory 1.31 1.02 1.00 7 2 0 Other current assets 1.50 1.37 1.00 0 5 0 Total current assets 1.35 1.17 1.00 6 8 0 Property, plant, and equipment (net of depreciatio1.37 1.13 1.00 8 5 0 Total assets 1.37 1.15 1.00 0 0 0 Bank loans 2.10 1.19 1.00 0 1 0 Accounts payable and accrued liabilities 1.20 1.07 1.00 8 9 0 Total current liabilities 1.54 1.12 1.00 4 1 0 Long-term liabilities 1.40 1.24 1.00 0 0 0 Capital shares 1.00 1.00 1.00 0 0 0 Retained earnings 2.09 1.48 1.00 9 9 0 Total liabilities and shareholders' equity 1.37 1.15 1.00 0 0 0 Amqui Inc. Trend Income Statements For the years ended December 31, 2014 2013 2012 Revenue 1.21 1.12 1.00 Copyright © 2010 McGraw-Hill Ryerson Ltd. 2 0 0 0 Cost of sales 1.17 1.09 1.00 2 0 0 Gross margin 1.24 1.14 1.00 6 9 0 Selling and marketing expenses 1.14 1.05 1.00 5 0 0 General and administrative expenses 1.14 1.05 1.00 5 0 0 Depreciation 1.30 1.21 1.00 4 7 0 Miscellaneous expenses 1.31 1.22 1.00 8 0 0 Interest expense 1.87 1.50 1.00 5 0 0 Income before taxes 1.28 1.24 1.00 8 6 0 Income tax expense 1.09 1.25 1.00 8 0 0 Net income 1.35 1.24 1.00 4 5 0 b. From the trend financial statements, we see that cost of sales is increasing more slowly than sales and, as a result, the gross margin has increased over the three year period. Also, selling, general, and administrative expenses are growing slightly more slowly than revenues but interest expense, depreciation and other expenses are growing more rapidly. The overall effect is that net income has increased over 35% over the three years while sales have increased 21%. This indicates that the company has managed its costs effectively. The major reason that net income has increased faster than revenues is that cost of goods sold and selling, general, and administrative expenses have increased at a slower rate than sales. On the trend balance sheets, we see that liabilities are increasing faster than assets, which is related to the fact that capital assets are increasing faster than revenues. We might suppose that the increased capital expenditure has brought efficiencies that have increased gross margins but that has been at the cost of higher interest expense. The amount of bank loans has increased sharply, as has long-term debt, which could be related purchases of capital assets. Also, inventory has increased faster than cost of sales (you would expect them to grow at about the same rate) and accounts receivable have grown much faster than sales, which is a cause for concern because this indicates difficulty collecting receivables (or perhaps a relaxing of credit terms to boost sales). c. These financial statements enable us to see the trends in various accounts without the absolute size of the numbers obscuring the changes. The trend statements also make it Copyright © 2010 McGraw-Hill Ryerson Ltd. 3 possible to compare changes in the individual accounts over time. It’s more difficult to infer changes from the original statements. d. Without the original financial statements, the trends have little explanatory power. When we try to rely on the trend statements alone to understand what is happening, we can easily draw faulty conclusions. So while eliminating absolute size from the statements makes trends and changes clearer, without perspective on the significance of each of the numbers, the ability to draw conclusions is impaired. For example, from the trend statements alone, one could become very concerned about a large percentage increase when the absolute dollar amount makes the concern unimportant. E12-7. a. Lameque Corp. Common Size Income Statements For the Years Ended March 31 2015 2014 2013 Sales 1.00 1.00 1.000 0 0 Cost of sales 0.52 0.52 0.548 6 8 Gross margin 0.47 0.47 0.452 4 2 Expenses Selling and marketing 0.06 0.07 0.070 4 1 Advertising and promotion 0.09 0.09 0.106 5 9 General and administrative 0.04 0.03 0.045 0 9 Depreciation 0.05 0.05 0.052 3 4 Interest 0.06 0.07 0.070 4 1 Unusual income (0.087 ) n/a n/a Income before income taxes 0.15 0.13 0.196 8 8 Income tax expense 0.03 0.03 0.035 1 1 Net income 0.12 0.10 0.161 7 7 Lameque Corp. Trend Income Statements Copyright © 2010 McGraw-Hill Ryerson Ltd. 4 For the Years Ended March 31 2015 2014 201 3 Sales 1.18 1.07 6 7 1.00 Cost of sales 1.23 1.07 0 4 1.00 Gross margin 1.13 1.08 6 1 1.00 Expenses Selling and marketing 1.17 0.96 6 8 1.00 Advertising and promotion 1.27 1.03 2 5 1.00 General and administrative 1.35 1.10 8 5 1.00 Depreciation 1.15 1.05 4 8 1.00 Interest 1.17 0.96 6 8 1.00 Unusual income n/a n/a n/a Income before income taxes 1.67 1.23 2 2 1.00 Income tax expense 1.33 1.06 3 7 1.00 Net income 1.77 1.28 0 0 1.00 b. Lameque Corp. has generally performed quite well over the three year period. Gross margin has increased over the three-year period, although we can’t tell how that compares to other firms in the industry. From the common-sized financial statements, we observe that the cost of sales was approximately constant in 2013 and 2014, but increased as a percentage of sales by almost 2% in 2015, which suggests that the company has experienced cost increases that it isn’t able to pass on to customers. Most other expenses increased as a percentage of sales in 2015 versus 2014 (the exception is depreciation). The increased profit margin is due to the unusual income, which at 8.7% to the bottom line. As a result the improvement should be interpreted carefully since ongoing costs have increased on a proportional basis over the three years for almost all accounts. The trend statements reinforce this analysis, with cost of sales, selling and marketing expenses, and advertising and promotion expenses increases more quickly than sales. This suggests that costs in these categories aren’t being well controlled. Without more details, it isn’t possible to arrive at a definite conclusion about the performance of the company. However, all the trends are consistent with a company that is growing and expanding capacity for future growth. The increased selling and Copyright © 2010 McGraw-Hill Ryerson Ltd. 5 marketing costs could reflect the costs of hiring additional sales representatives to generate the additional sales, perhaps with the expectation that sales will increase while these costs remain constant in future. On the other hand, the increased general and administrative costs are consistent with a company that has previously been operated efficiently with careful control of costs but where the managers are now indulging themselves with more luxurious offices, support staff, and more expensive company- owned automobiles. Another interpretation is that, with the growth of the company (as reflected by the increase in sales), there has been a decrease in efficiency and control over costs because the managers are more distant from the actions of certain employees. Which of these scenarios is more accurate can be determined by a visit to the firm and an interview with the owners. (Different interpretations of the data are possible and should be interpreted on their merit.) c. The ability to interpret overall performance from the commons size and trend statements is impaired by the unusual income. Net income and income before taxes would be higher than they otherwise would as a result of the unusual gain. Fortunately, an adjustment is easy to perform. Without the unusual income, the trend analysis would indicate a 19% decrease in income before income taxes from 2013 to 2015 rather than a 77% increase. Similarly, the common size statements show that income before taxes and unusual items was 11% of sales in 2015, which is significantly lower than in the previous two years. Note: Other “unusual events” may not be isolated. For example, the reduced gross margin in 2015 could have been caused by an unwise purchasing decision that required a significant segment of the inventory being sold at much lower prices than expected. E12-9. Note: the following answers assume that the event occurs on the day before the end of the period for which the financial statements are prepared. Also, it is necessary in some cases to make assumptions. Students should recognize and make their assumptions explicit and those who do so should be rewarded. Quick ratio Inventory turnover Return on assets (quick (cost of sales/average (net income + after tax assets/current inventory) interest exp/average total (net income – (after liabilities) assets) a. Accrual of wages Decrease No effect Decrease owed to employees (current liabilities (expenses increase, net (expenses increase, at the end of a increase) income decreases) period. b. Write down of No effect Increase Decrease inventory to net (average inventory (income decreases, assets realizable value. decreases, cost of sales decrease) increases) (assumes the Copyright © 2010 McGraw-Hill Ryerson Ltd. 6 writedown is included in cost of sales) c. Payment of a Decrease (cash No effect Increase previously declared decreases) (assets decrease) dividend. d. Purchase of land No effect No effect Decrease in exchange for a (long-term assets (assets increase) long-term note increase) payable. e. Depreciation of No effect No effect Decrease equipment. (long-term assets (assets decrease, income (income decreases) decrease) decreases) f. Repurchase of Decrease No effect Increase common shares for (cash decreases) (assets decrease) cash. Copyright © 2010 McGraw-Hill Ryerson Ltd. 7 E12-11. It is necessary in some cases to make assumptions. Students should recognize and make their assumptions explicit and those who do so should be rewarded. Current Average payables Return on Assets Gross margin Ratio payment period (net income + after tax percentage (current assets ÷ (365 ÷ interest exp/average total ((sales – cost of sales) current liabilities) (purchases ÷ assets) average accounts payable)) a. Early retirement of Decrease No effect Increase (assets decrease) long-term debt (assume (assets decrease) no gain or loss on retirement; assume repaid with cash b. Writedown of No effect No effect Decrease property, plant, and (assets and net income both equipment decrease but net income by more) c. 2:1 stock split No effect No effect No effect d. Repayment of a long- Decrease No effect Increase term liability (assets decrease) e. Payment of an Increase Decrease Increase amount owing to a (payables (payables decrease, (assets decrease) supplier decrease) accounts payable turnover increases) f. Credit sale of Increase No effect Increase merchandise to a (accounts (assets and net income both (assumes a constant customer receivable increase but net income by margin maintained on increase) more) E12-13 a. 2013 2014 2015 Beginning inventory $109,688 $123,188 $121,500 Ending inventory 123,188 121,500 141,375 Average inventory 116,438 122,344 131,438 7,087,50 7,969,50 9,463,78 Cost of sales 0 0 1 Inventory turnover 60.87 65.14 72.00 Average days in inventory 6.00 5.60 5.07 Copyright © 2010 McGraw-Hill Ryerson Ltd. 8 b. The company appears to be managing its inventory fairly well as turnover is increasing. This is the result of average inventory increasing at a much slower rate than cost of sales (although ending inventory in 2015 showed only slightly slower growth than cost of sales). We would expect a high turnover of inventory in the produce business since the merchandise is perishable. In 2015 it appears that cost of sales increased significantly, indicating that the company has increased its sales, Careful inventory management is crucial for perishable goods since once spoiled they have to be disposed of. Increasing inventory turnover serves that purpose, although a balance must be struck to ensure that enough inventory is on hand to meet customers’ needs. c. Many explanations are possible. Students should try to generate many explanations and then try to rank them in credibility for the circumstances that are given in the question. One probable cause is that the company has increased its sales either through competitive pricing, increased promotion, or decreased competition. Another cause could be in regards to the timing of inventory shipments. The company could have sold a significant amount of produce at near end (perhaps near the holiday season) but had not yet received a new shipment of inventory (thus resulting in a lower average inventory than may have been otherwise reported). Note: For most companies, the quantity of inventory on hand at a balance sheet date is somewhat representative of the average inventory for the year. However, Zawale’s inventory likely fluctuates significantly each day. A stakeholder, particularly a banker, would be better served with an average based on monthly rather than annual counts. Monthly counts would also reduce the incentive to mislead the stakeholders by allowing inventory to run down at the end of the year. Any company with very high turnover would find it very easy to reduce purchases as the year-end nears to ensure that the inventory count is low and the turnover appears high. In contrast, a jewellery store or a hardware store would find it much more difficult to achieve the same result. d. The implications of the results found in part (a) and (b) depend on other impacts to financial statements. For example, if sales increased due to lower margins the company may not be as profitable before (or they may be more profitable due to increased volumes). E12-15. a. Basic EPS = ($22,750,000 - $2,000,000)/25,000,000 = $0.83—each common share earned $0.83 after deducting the preferred dividend. b. Price-to-earnings ratio = $8.75/0.83 = 10.54 to 1 —the market is paying $10.54 for each dollar of accounting earnings. c. Dividend payout ratio = (25,000,000  $0.08  4)/22,750,000 = 35.2% — 35.2% of earnings is being paid out in common dividends. Preferred dividends are ignored. Copyright © 2010 McGraw-Hill Ryerson Ltd. 9 E12-17. a. a. The debt-to-equity ratio is 1.78. (($368,000 + $1,690,000)/$1,155,000) b. The company could have additional liabilities of $21,000 on July 31 (which would result in a debt-to-equity ratio of 1.8). (This is solved by determining the maximum amount of liabilities the could be on hand on July 31 while maintaining a debt-to-equity ratio of 1.8 or less ($1,155,000  1.8 = $2,079,000) and subtract from that amount the current amount of liabilities ($2,079,000 – ($368,000 + $1,690,000) = $21,000)) c. The company could have reduced equity by paying a dividend of $11,667 without breaching their debt covenant. (Liabilities/1.8 – shareholders equity = $1,155,000/1.8 – $1,155,000 = $11,667.) d. The dividend would reduce shareholders’ equity by $150,000 to $1,005,000. It would increase liabilities by $150,000 to $2,208,000 and increase the debt/equity ratio to 2.2:1, which would put Husavick in violation of the covenant. To solve this problem the dividend could be deferred to the next fiscal year or declare and pay a dividend of up to $11,667. Declaring but not paying the dividend makes the situation worse. E12-19. a, b. 2013 2012 2011 2010 Sales $2,625,00 $3,273,600 $3,059,440 $2,913,750 0 Net income (before interest) 133,750 128,495 110,725 91,875 Total liabilities (at year end) 865,685 816,685 735,750 681,250 Shareholders’ equity (at year end) 954,200 813,440 684,940 574,220 Interest expense 87,500 75,000 37,500 87,500 Tax rate 16% 16% 16% 16% Average total assets 1,725,005 1,525,408 1,338,080 1,181,408 Asset turnover ratio 1.90 2.01 2.18 2.22 After tax interest expense 73,500 63,000 31,500 73,500 Profit margin percentage 0.018 0.021 0.027 0.007 Return on assets 0.035 0.043 0.059 0.016 Average equity 883,820 749,190 629,580 528,283 Return on equity 0.07 0.09 0.13 0.03 *ROE = Net income - after tax interest expense / average shareholders' equity) Copyright © 2010 McGraw-Hill Ryerson Ltd. 10 c. The net income of the company has steadily decreased from 2011 to 2013 as have profits relative to sales (profit margin). Asset turnover has decreased, meaning that sales have increased more slowly than total assets and so assets are being used less efficiently to produce sales. Possible explanations include large capital investments that will benefit future years or a substantial accumulation of inventory and receivables without corresponding increases in sales. There could also be assets that are obsolete, ones that are inefficient, or excessive amounts of certain assets. The interpretation would differ significantly depending on the actual causes, which would be evident with complete financial statements. Return on equity has decreased from 2011 to 2013 because shareholders’ equity has increased while net income (after interest has decreased. This indicates that the company has been issuing shares but so far hasn’t earned a return on that investment by shareholders. E12-21 The information suggests that Business A is in a better liquidity position the Business A. At first glance the B’s current ratio of 1.75 suggests a strong liquidity position, but the low quick ratio of 0.38 (compared with 0.75 for A) indicates that B has more less liquid assets, such as inventory. A has few current assets relative to current liabilities than B but more of its current assets are highly liquid—cash, investments, and receivables. It isn’t surprising that both businesses have quick ratios below 1 because as retailers they have to carry a lot of inventory. An important question is, what is the nature of B’s inventory? An inventory that’s easy to sell would be less of liquidity concern that an inventory that’s hard to sell. The inventory turnover ratio indicates that B turns its inventory over 2.6 times per year or in 140 days, meaning that it takes B on average 140 days to sell inventory and convert it to cash (assuming it doesn’t offer its own credit). In contrast, A holds its inventory on average for 117 days, which means it gets its cash 23 days sooner than B. Finally, A pays its payable much faster than B, on average paying its bills in 80 days, versus 100 days for B. This suggest that A has is able to meet its obligations on a more timely basis than B (although difference in the payable period could be due to many factors). Copyright © 2010 McGraw-Hill Ryerson Ltd. 11 PROBLEMS P12-1. Note: The ROA provided in the text is incorrect; it should be 9.92%, not 8.08%. The solution below uses the corrected amount. • Amounts in the solution are rounded as indicated in the question. Foxwarren Inc. Balance Sheets As of the Years Ended December 31, 2015 2014 1 Cash $50,000 $125,000 2 Accounts receivable 495,000 500,000 1 1 Inventory 825,000 750,000 8 1 Capital assets (net) 2,636,000 2,150,000 3 Total assets: $4,006,00 $3,525,00 1 0 0 3 Accounts payable 660,000 680,000 9 1 Long-term debt 1,561,000 1,250,000 0 Capital shares 1,000,000 1,000,000 7 Accumulated other comprehensive income 85,000 25,000 4 Retained earnings 700,000 570,000 7 $4,006,00 $3,525,00 Total liabilities and shareholders’ equity: 0 0 Foxwarren Inc. Income Statement For the Year Ended December 31, 2015 Revenue $7,000,00 1 0 Cost of sales 3,500,000 Given Gross margin 3,500,000 1 Selling, general, and administrative expenses 3,033,000 6 Interest expense 117,000 5 Income before taxes 350,000 3 Income tax expense 70,000 3 Net income 280,000 2 Other comprehensive income 60,000 4 Copyright © 2010 McGraw-Hill Ryerson Ltd. 12 Comprehensive income $340,000 Given Number of commo
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