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ITM 102
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Louis Pike
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Chapter 3

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Information Technology Management

ITM 102

Louis Pike

Fall

Description

CHAPTER 3
WORKING WITH FINANCIAL
STATEMENTS
Learning Objectives
LO1 The sources and uses of a firm’s cash flows.
LO2 How to standardize financial statements for comparison purposes.
LO3 How to compute and, more importantly, interpret some common ratios.
LO4 The determinants of a firm’s profitability.
LO5 Some of the problems and pitfalls in financial statement analysis.
Answers to Concepts Review and Critical Thinking Questions
1. (LO2)
a. If inventory is purchased with cash, then there is no change in the current ratio. If inventory is purchased
on credit, then there is a decrease in the current ratio if it was initially greater than 1.0.
b. Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0.
c. Reducing short-term debt with cash increases the current ratio if it was initially greater than 1.0.
d. As long-term debt approaches maturity, the principal repayment and the remaining interest expense
become current liabilities. Thus, if debt is paid off with cash, the current ratio increases if it was initially
greater than 1.0. If the debt has not yet become a current liability, then paying it off will reduce the current
ratio since current liabilities are not affected.
e. Reduction of accounts receivables and an increase in cash leaves the current ratio unchanged.
f. Inventory sold at cost reduces inventory and raises cash, so the current ratio is unchanged.
g. Inventory sold for a profit raises cash in excess of the inventory recorded at cost, sratio current
increases.
2. (LO2) The firm has increased inventory relative to other current assets; therefore, assuming current liability
levels remain unchanged, liquidity has potentially decreased.
3. (LO2) A current ratio of 0.50 means that the firm has twice as much in current liabilities as it does in current
assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and suppliers for immediate
payment, the firm might have a difficult time meeting its obligations. A current ratio of 1.50 means the firm
has 50% more current assets than it does current liabilities. This probably represents an improvement in
liquidity; short-term obligations can generally be met completely with a safety factor built in. A current ratio of
15.0, however, might be excessive. Any excess funds sitting in current assets generally earn little or no return.
These excess funds might be put to better use by investing in productive long-term assets or distributing the
funds to shareholders.
S3-1 4. (LO2)
a. Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects of
inventory, generally the least liquid of the firm’s current assets.
b. Cash ratio represents the ability of the firm to completely pay off its current liabilities with its most liquid
asset (cash).
c. Interval measure estimates how long a company could continue operating by depleting its existing current
assets at a rate that is consistent with its average daily operating costs.
d. Total asset turnover measures how much in sales is generated by each dollar of firm assets.
e. Equity multiplier represents the degree of leverage for an equity investor of the firm; it measures the dollar
worth of firm assets each equity dollar has a claim to.
f. Long-term debt ratio measures the percentage of total firm capitalization funded by long-term debt.
g. Times interest earned ratio provides a relative measure of how well the firm’s operating earnings can
cover current interest obligations.
h. Profit margin is the accounting measure of bottom-line profit per dollar of sales.
i. Return on assets is a measure of bottom-line profit per dollar of total assets.
j. Return on equity is a measure of bottom-line profit per dollar of equity.
k. Price-earnings ratio reflects how much value per share the market places on a dollar of accounting
earnings for a firm.
5. (LO1) Common size financial statements express all balance sheet accounts as a percentage of total assets and
all income statement accounts as a percentage of total sales. Using these percentage values rather than nominal
dollar values facilitates comparisons between firms of different size or business type. Common-base year
financial statements express each account as a ratio between their current year nominal dollar value and some
reference year nominal dollar value. Using these ratios allows the total growth trend in the accounts to be
measured.
6. (LO2) Peer group analysis involves comparing the financial ratios and operating performance of a particular
firm to a set of peer group firms in the same industry or line of business. Comparing a firm to its peers allows
the financial manager to evaluate whether some aspects of the firm’s operations, finances, or investment
activities are out of line with the norm, thereby providing some guidance on appropriate actions to take to
adjust these ratios if appropriate. An aspirant group would be a set of firms whose performance the company in
question would like to emulate. The financial manager often uses the financial ratios of aspirant groups as the
target ratios for his or her firm; some managers are evaluated by how well they match the performance of an
identified aspirant group.
7. (LO3) Return on equity is probably the most important accounting ratio that measures the bottom-line
performance of the firm with respect to the equity shareholders. The Du Pont identity emphasizes the role of a
firm’s profitability, asset utilization efficiency, and financial leverage in achieving an ROE figure. For
example, a firm with ROE of 20% would seem to be doing well, but this figure may be misleading if it were
marginally profitable (low profit margin) and highly levered (high equity multiplier). If the firm’s margins
were to erode slightly, the ROE would be heavily impacted.
8. (LO2) The book-to-bill ratio is intended to measure whether demand is growing or falling. It is closely
followed because it is a barometer for the entire high-tech industry where levels of revenues and earnings have
been relatively volatile.
9. (LO2) If a company is growing by opening new stores, then presumably total revenues would be rising.
Comparing total sales at two different points in time might be misleading. Same-store sales control for this by
only looking at revenues of stores open within a specific period.
10. (LO1)
a. For an electric utility such as Ontario Hydro, expressing costs on a per kilowatt hour basis would be a
way to compare costs with other utilities of different sizes.
b. For a retailer such as Sears, expressing sales on a per square foot basis would be useful in
comparing revenue production against other retailers.
S3-2 c. For an airline such as Air Canada, expressing costs on a per passenger mile basis allows for
comparisons with other airlines by examining how much it costs to fly one passenger one mile.
d. For an on-line service provider such as Bell Internet, using a per call basis for costs would allow for
comparisons with smaller services. A per subscriber basis would also make sense.
e. For a hospital such as Toronto General, revenues and costs expressed on a per bed basis would be
useful.
f. For a university textbook publisher such as McGraw-Hill Ryerson, the leading publisher of finance
textbooks for the university market, the obvious standardization would be per book sold.
11. (LO1) Reporting the sale of Treasury securities as cash flow from operations is an accounting “trick”, and as
such, should constitute a possible red flag about the companies accounting practices. For most companies, the
gain from a sale of securities should be placed in the financing section. Including the sale of securities in the
cash flow from operations would be acceptable for a financial company, such as an investment or commercial
bank.
12. (LO1) Increasing the payables period increases the cash flow from operations. This could be beneficial for the
company as it may be a cheap form of financing, but it is basically a one time change. The payables period
cannot be increased indefinitely as it will negatively affect the company’s credit rating if the payables period
becomes too long.
Solutions to Questions and Problems
NOTE: End of chapter problems were solved using a spreadsheet. Many problems require multiple steps. Due to
space and readability constraints, when these intermediate steps are included in this solutions manual, rounding
may appear to have occurred. However, the final answer for each problem is found without rounding during any
step in the problem.
Basic
1. (LO3) Using the formula for NWC, we get:
NWC = CA – CL
CA = CL + NWC = $1370 + 3,720 = $5,090
So, the current ratio is:
Current ratio = CA / CL = $5,090/$3,720 = 1.37 times
And the quick ratio is:
Quick ratio = (CA – Inventory) / CL = ($5,090 – 1,950) / $3,720 = 0.84 times
2. (LO3) We need to find net income first. So:
Profit margin = Net income / Sales
Net income = Sales x (Profit margin)
Net income = ($29,000,000) x (0.08) = $2,320,000
ROA = Net income / TA = $2,320,000 / $17,500,000 = .1326 or 13.26%
To find ROE, we need to find total equity.
TL & OE = TD + TE
TE = TL & OE – TD
TE = $17,500,000 – 6,300,000 = $11,200,000
ROE = Net income / TE = $2,320,000 / $11,200,000 = .2071 or 20.71%
S3-3 3. (LO3)
Receivables turnover = Sales / Receivables
Receivables turnover = $3,943,709 / $431,287 = 9.14 times
Days’ sales in receivables = 365 days / Receivables turnover = 365 / 9.14 = 39.93 days
The average collection period for an outstanding accounts receivable balance was 39.93 days.
4. (LO3)
Inventory turnover = COGS / Inventory
Inventory turnover = $4,105,612 / $407,534 = 10.07 times
Days’ sales in inventory = 365 days / Inventory turnover = 365 / 10.07 = 36.25 days
On average, a unit of inventory sat on the shelf 36.25 days before it was sold.
5. (LO3)
Total debt ratio = 0.63 = TD / TA
Substituting total debt plus total equity for total assets, we get:
0.63 = TD / (TD + TE)
Solving this equation yields:
0.63(TE) = 0.37(TD)
Debt/equity ratio = TD / TE = 0.63 / 0.37 = 1.70
Equity multiplier = 1 + D/E = 2.70
6. (LO3)
Net income = Addition to RE + Dividends = $430,000 + 175,000 = $605,000
Earnings per share = NI / Shares = $605,000 / 210,000 = $2.88 per share
Dividends per share = Dividends / Shares = $175,000 / 210,000 = $0.83 per share
Book value per share = TE / Shares = $5,300,000 / 210,000 = $25.24 per share
Market-to-book ratio = Share price / BVPS = $63 / $25.24 = 2.50 times
P/E ratio = Share price / EPS = $63 / $2.88 = 21.875 times
Sales per share = Sales / Shares = $4,500,000 / 210,000 = $21.43
P/S ratio = Share price / Sales per share = $63 / $21.43 = 2.94 times
7. (LO4)
ROE = (PM)(TAT)(EM)
ROE = (.055)(1.15)(2.80) = .1771or 17.71%
8. (LO4) This question gives all of the necessary ratios for the DuPont Identity except the equity multiplier, so,
using the DuPont Identity:
S3-4 ROE = (PM)(TAT)(EM)
ROE = .1827 = (.068)(1.95)(EM)
EM = .1827 / (.068)(1.95) = 1.38
D/E = EM – 1 = 1.38 – 1 = 0.38
9. (LO1)
Decrease in inventory is a source of cash
Decrease in accounts payable is a use of cash
Increase in notes payable is a source of cash
Increase in accounts receivable is a use of cash
Changes in cash = sources – uses = $375 + 210 - 105 – 190 = $290
Cash increased by $290
10. (LO3)
Payables turnover = COGS / Accounts payable
Payables turnover = $28,834 / $6,105 = 4.72 times
Days’ sales in payables = 365 days / Payables turnover
Days’ sales in payables = 365 / 4.72 = 77.33 days
The company left its bills to suppliers outstanding for 77.33 days on average. A large value for this ratio could
imply that either (1) the company is having liquidity problems, making it difficult to pay off its short-term
obligations, or (2) that the company has successfully negotiated lenient credit terms from its suppliers.
11. (LO1) New investment in fixed assets is found by:
Net investment in FA = (NFA end– NFA beg + Depreciation
Net investment in FA = $835 + 148 = $983
The company bought $983 in new fixed assets; this is a use of cash.
12. (LO4) The equity multiplier is:
EM = 1 + D/E
EM = 1 + 0.65 = 1.65
One formula to calculate return on equity is:
ROE = (ROA)(EM)
ROE = .085(1.65) = .14025 or 14.025%
ROE can also be calculated as:
ROE = NI / TE
So, net income is:
NI = ROE(TE)
NI = (.14025)($540,000) = $75,735
S3-5 13. through 15: (LO2)
2011 #13 2012 #13 #14 #15
Balance Sheets
Assets
Current assets
Cash $ 8,436 2.86% $ 10,157 3.13% 1.2040 1.0944
Accounts receivable 21,530 7.29% 23,406 7.21% 1.0871 0.9890
Inventory 38,760 13.12% 42,650 13.14% 1.1004 1.0015
Total $ 68,726 23.27% $ 76,213 23.48% 1.1089 1.0090
Fixed assets
Net plant and equipment 226,706 76.73% 248,306 76.52% 1.0953 0.9973
Total assets $ 295,432 100% $ 324,519 100% 1.0985 1.0000
Liabilities and Owners’ Equity
Current liabilities
Accounts payable $ 43,050 14.57% $ 46,821 14.43% 1.0876 0.9903
Notes payable 18,384 6.22% 17,382 5.36% 0.9455 0.8617
Total $ 61,434 20.79% $ 64,203 19.79% 1.0450 0.9519
Long-term debt 25,000 8.46% 32,000 9.86% 1.2800 1.1655
Owners' equity
Common stock and paid-in surplus $ 40,000 13.54% $ 40,000 12.32% 1.0000 0.9099
Accumulated retained earnings 168,998 57.21% 188,316 58.03% 1.1143 1.0143
Total $ 208,988 70.75% $ 228,316 70.35% 1.0925 1.0126
Total liabilities and owners' equity $ 295,432 100% $ 324,519 100% 1.0985 1.0000
The common-size balance sheet answers are found by dividing each category by total assets. For example, the
cash percentage for 2011 is:
$8,436 / $295,432 = .02856 or 2.86%
This means that cash is 2.86% of total assets.
The common-base year answers for Question 14 are found by dividing each category value for 2012 by the
same category value for 2011. For example, the cash common-base year number is found by:
$10,157 / $8,436 = 1.204
This means the cash balance in 2012 is 1.204 times as large as the cash balance in 2011.
The common-size, common-base year answers for Question 15 are found by dividing the common-size
percentage for 2011 by the common-size percentage for 2012. For example, the cash calculation is found by:
3.13% / 2.86% = 1.0944
This tells us that cash, as a percentage of assets, increased by:
1.0944 – 1 = .0944 or 9.44 percent.

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