Friedlan4e SM Ch12

8/9/2019 Friedlan4e SM Ch12

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CHAPTER 12

Analyzing and Interpreting Financial Statements

QUESTIOS

Q12-1From an entities perspective its not possible to identify the most important stakeholder; itdepends on the entitys circumstances. For example, a company needin e!uity capital "ouldconsider prospective shareholders most important. # company "ith fe" external stakeholdersmiht focus on tax minimi$ation. From the stakeholders perspective they "ould considerthemselves the most important as they rely of the financial statements to form their financialdecision i.e. "hether to invest or lend.

Q12-2%et &ncome is a measure of the extent to "hich economic benefits exceed economic costs. 'nder&F() and #)*+ it measures ho" much better off an entitys o"ners are. +conomic benefits are

defined as revenues and economic sacrifices as expenses. easurement of revenues andexpenses depend on the definitions provided by the accountin standards. 'nder &F() and to alesser extent under #)*+ net income reflects unreali$ed ains and losses as "ell as reali$edones. easurin net income and revenue and expenses re!uires /udement to determine "henand ho" much revenue and expenses belons in a particular period and estimates of uncertainfuture amounts.

Q12-0+liminatin choice from accountin standards "ould solve some problems but create differentones. y eliminatin choice a stakeholder could be confident about ho" an entity "as doin itsaccountin; everyone "ould reconi$e revenue at the same point and depreciate its assets the

same "ay. o"ever, eliminatin choice "ould result in accountin for all transaction of a certaintype even if the circumstances of those transactions "ere different sellin merchandise tocustomers "ho had a hih probability of payin versus ones that "ere hih risk of not payin. &fmanaers could be relied on 3to do the riht thin4 not behave self-interestedly then unlimitedchoice "ould make sense as they "ould al"ays choose the accountin method that best reflectedthe economic circumstances of the transaction.

Q12-5*ermanent earnins are expected to be repeated in the future, "hile transitory earnin arent. Forexample, sales may increase temporarily "hen a competitor is shut do"n by a strike. &f youexpect that most of those customers "ill resume purchasin from the competitor "hen the strikeis over, those earnins are transitory. 6he distinction is extremely important if you "ant topredict future profits and assess the value of the company.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-1)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


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Q12-=>ne of the ma/or concerns "ould be that the companies may have chosen different accountinpolicies. +ven if they use the same policies, they may implement the policies in different "aysand may use different estimates, such as the useful lives of store fixtures. For that reason, the netincome for the current period "ouldnt be comparable. Financial statements provide descriptions

and accountin policies and sinificant estimates, but these are often very vaue and theinformation needed to ad/ust financial statements to be more comparable isnt disclosed. 6heremiht also be differences in the nature of the businesses that make them not perfectlycomparable. 6hese differences could be the actual business activities of the entity, ho" each runsits business, the markets it operates in, the risks it takes, and so on. &nformation about these canbe found in the popular media, research reports, and the manaement discussion and analysis, toname a fe".

Q12-?&nformation is po"er. 'nderstandin an entity makes the financial statements more informative.6here are many items of information that could assist the reader to better understand the

financial statements or to assess the risk faced by the company or its future prospects. Forexample, if you kno" that a ma/or contract has been cancelled or that one customer represents@=A of the companys sales and receivables, your beliefs about the prospects of the firm couldchane sinificantly. &n particular, if you are an e!uity investor in a publicly traded company, youcant afford to be una"are of information that is broadly kno"n to other investors. &n eneral,more and better information leads to better, more informed decisions. 6he main constraintaainst atherin additional information is the cost time and money, in other "ords atherininformation must be assessed in a cost-benefit context.

Q12-@&ts not advisable to lend money based solely on the financial statements because the are manyaspects of the decision that arent reflect in the statements.


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Q12-Bore about each of these caveats can be found in the in the section called 3)ome ther sources ofinformation are available and should be consulted.

C &F() financial statements dont necessarily provide explanations for problems that areidentified. #nalysis of accountin information and other sources of information are needed toet to the root of the problem.

Q12-D6he problem for users is that because manaers make the accountin choices, they can choosemethods that suit their interests or the interests that are most important to them. 6he choices thatmanaers make are rarely transparent, "ith the result that it isnt possible to assess "hat biasesare present. >n the other hand, choice provides manaers "ith the ability to choose the mostappropriate "ay to accountin for a transaction.

For example, manaers can choose to expense or capitali$e certain expenditures, the useful livesor residual values of lon-lived assets, and "hen to reconi$e revenue. 6hey choose inventoryvaluation methods, depreciation methods, and make estimates like uncollectible amounts andobsolete inventory. any other examples can be offered.

Q12-1:&n one sense, more li!uidity is better since the ability of the entity to meet its obliations as theybecome due is essential to survival. o"ever, if li!uidity is attained by holdin excessiveamounts of cash or temporary investments, the company may be earnin a lo" return on thoseassets because cash in a non-productive asset and the "ealth of the shareholders may bereduced.



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Q12-116he current ratio includes assets such as inventory or prepaid expenses that may not be !uicklyconverted into cash and therefore arent available to pay suppliers and employees in the next fe""eeks. 6he !uick ratio is therefore a better indicator since it doesnt include these items.

Q12-12# prospective e!uity investor "ould "ant to be able to separate permanent from transitoryearnins to estimate the profitability of the company so he could determine the price he "ould be"illin to pay for the shares. 6ransitory earnins dont recur so its important for the prospectiveinvestor to separate them out so that they can et a sense of "hat future earnins "ill be.

Q12-10+arnins !uality is the usefulness of current earnins for predictin future earnins. Ehenearnins are hih in !uality, there is a close relationship bet"een current earnins and futureearnins. Ehen earnins !uality is lo" the correlation bet"een current and future earnins islo".

Q12-15a. +arnins !uality is reduced since the current period "ill be less predictive of future

earnins. 6he advertisin expense has been increased for one period only after "hichtime the expense "ill be reduced.

b. 6o a deree, earnins !uality is sacrificed, since the expense matched aainst revenuesdiffers bet"een past and future periods. &f the chane in estimate results in a betterrelationship bet"een expenses and revenue earnins !uality "ill ultimately be improved.

c. +arnins !uality at the transition is reduced, but earnins !uality in the future could beconsidered to be improved since the costs matched aainst revenues are more reflectiveof the current costs of the resources used.

Q12-1=8ommon si$e financial statements express amounts in a years financial statements as apercentae of another element of the same years statements for example, the income statementfor 2:1@ "ould restate all the amounts in the statement as a proportion of 2:1@ revenue. 6hesestatements help the users to see at a lance the proportions of each component of the statements.8ommon si$e financial statements eliminate the effect of si$e and make it easier in somerespects to make comparisons over time and amon entities. For example, one can readily seethat inventory has increased as a portion of total assets or ho" certain expenses have chanedrelative to sales.



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Q12-1?6rend financial statements sho" the proportional chane in each account relative to a base year.6he user is helped by bein able to compare chanes in various accounts. For example, the usercould see at a lance that inventory has increased by 2=A over three years "hile sales have onlyincreased by 1:A.

Q12-1@ther useful sources of information include the media, press releasesissued by the company, the GH#, reports by analysts, reports by credit aencies, amonothers.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-=)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


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Q12-2:# covenant is a restriction that imposes limits on the actions of an entity. For example, covenantscould restrict payment of dividends, limit the sale or purchase of capital assets, or re!uire certainlevels of financial ratios. 6hey are often included in lendin areements to provide lenders "ithassurance that certain actions "ont be taken that increase the risk of the loan. enerally, since

the covenants reduce the risk of the loan, a lo"er interest rate "ill be re!uired than "ould be thecase "ithout the covenants. any covenants involve areements to maintain certainrelationships, "hich are measured and reported on the financial statements. 6he financialstatements then serve as a basis for assessin "hether those covenants, such as the debt to e!uityratio, have been respected. 8ovenants are often stated in accountin terms because financialstatements must be prepared by entities, they are prepared on a standard basis, and they can becheck throuh an audit of the financial statements.

Q12-218ovenants on a borro"er mitiates risks of default by the borro"er. #s a result "hen a borro"erarees to covenants and abides by them & "ould be more likely to offer a loan and a lo"er

interest rate because the risk is lo"er.

Q12-228reditors "ant to kno" "hether the company has the ability to pay, "hich is a concern "ithli!uidity, "hat "ill occur if the payments arent made, "hich is a concern about the availabilityand value of security, and that the borro"er adheres to lendin areements by complyin "ithcovenants. any sources of information are available to the user about li!uidity, includin thecurrent assets and current liabilities, and cash flo" from operations. # schedule of expected cashreceipts and disbursements "ould also be very helpful. &nformation about the assets available tothe lender and their li!uidation value "ould be important information about the securityavailable. Getails about receivables, inventory, and plant, property, and e!uipment are theprimary items that the company could provide. For plant, property, and e!uipment it "ould beuseful to kno" their market values. &t "ould also be important for a lender to kno" "hether and"hich assets have been pleded to other creditors. &nformation could be obtained from the entityitself, people "ho value property to obtain market values of capital assets and credit aenciesthat could provide information about ho" reliable the entity has been about meetin itsobliations.


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Q12-25#ny information that is relevant to any other user of financial statements is also relevant toe!uity investors, since any chane in the "ay that other users vie" the prospects of the firmaffects the interests of the o"ner. For example, if the bank vie"s the company as lesscredit"orthy, the company "ill find it more difficult to obtain needed financin and "ill pay

hiher interest rates. 6he increased riskiness of the firm "ill have economic conse!uences for theshareholders more interest means less profit. #dditionally, since the share price of a publiclytraded company !uickly ad/usts to reflect all publicly available information, the e!uity investor"ho lacks some of that information "ill be misled in makin decisions about the value of thefirm.

Q12-2=a. &nformation about the competitive position of the firm is relevant to the lon-term

riskiness of the loan. For example, one cant assess the ability of (oers to make interestpayments on a 2:-year loan "ithout assessin the competitiveness of its products. 6hisinformation "ouldnt be available from the financial statements, althouh its often

available in the manaement discussion and analysis that is provided in the annual reportsof public companies.

b. &nformation about risks faced by the entity is extremely relevant to lon-term lenders.(isks have implications for the lon-term viability of the entity. For example, if a bank isprimarily lendin to a particular industry or eoraphic area, the loans are enerallyriskier than if they "ere more diversified. 6he information may be included in thesemented information in the financial statements and is often included in themanaement discussion and analysis. &n eneral, the GH# provides information aboutthe risks an entity faces.

c. 'ncertainties about supplies could be of concern, particularly in some industries, "heresupply is uncertain and prices can vary sinificantly. 6his information isnt included inthe financial statements but often discussed in the manaement discussion and analysis.

d. 6he reulatory environment affects the risk and is particularly of concern in someindustries. (eulation of rates in utility markets can make the loan less risky. 6hisinformation is publicly available in many industries but isnt addressed in the financialstatements.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-@)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


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Q12-2?a. 6he !uality and experience of the manaement is of sinificant value to investors "ho are

tryin to predict the success of the firm. 6he current performance of manaement also haspredictive value and is the basis for compensation and staffin decisions by the board ofdirectors. 6he financial statements can provide useful information on current performance

of manaement but financial statements and other parts of the annual report tend toprovide limited information about !uality and experience. >ther documents such as theprospectus and other filins such as those re!uired by securities reulators do re!uirecertain specific information. anaement is crucial for the success of an entity andkno"in about the manaers skills and abilities, successes and failures, and experiencecan be very important. &nformation about the manaers isnt explicitly reported in thefinancial statements.

b. &nvestors "ant to assess the likely success of the companys stratey for makin money.enerally such information is included explicitly or implicitly in the GH# and otherportions of the annual report other than the financial statements. )tratey is future

oriented and financial statements "ill report only the outcome of past strateies.

c. +!uity investors "ant to predict the future profits of the firm and "ill benefit frominformation on the competitive environment. enerally, this information is provided inthe annual report of a public company but not in the financial statements. For publiclytraded companies, assessments can often be obtained from analysts. 6he impact ofcompetition "ill be reflected in the financial statements but the specifics of the effect ofchanes "ont be explicitly addressed.

d. &nformation on lines of business helps e!uity investors to assess "here the company isearnin profits and assists them in predictin future performance. 6he information "ill beprovided by public companies in semented information but private companies arentre!uired to provide sement information.

Q12-2@6he GH# section of the annual report provides manaements vie"s on past results, currentposition, and future prospects of the firm. 6he GH# is intended to provide readers "ith a vie"of the entity throuh the eyes of manaement. )hareholders of private companies often havedirect access to manaement and can thus obtain direct information "hereas shareholders inpublic companies must depend on the information that manaement provides publicly.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-B)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


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Q12-2Banaement has access to a reat deal of information about such matters as impendin laresales and the plans for the future that independent analysts dont have. anaement is alsoclosest to the oins on of an entity and "ill therefore be most informed parties the entity. &tsunlikely that anyone could be better informed about an entity than its manaement. anaement

information can be extremely valuable but it has stron incentives to "ithhold or biasinformation. 6he vie"s of independent analysts are enerally more ob/ective and reflect abroader perspective but lack access to certain information that manaement may possess. &tshould be noted "hile independent analyst is more ob/ective they may also have biases to putcompanies in a positive liht to sell more shares or to lure future clients hence they may take amore optimistic approach in deliverin information.

Q12-2D6he main factors that make earnins manaement possible are accrual accountin and periodicreportin. Ehen financial statements are prepared, revenues and expenses are recorded eventhouh there is often uncertainty about the actual future amounts. 6he re!uirement for periodic

financial statements means that revenues and expenses have to be allocated to particular periods.6he flexibility exists because of uncertainty about future outcomes such as the life of assets, ho"assets are used, the amount of receivables that "ill be collected, and so on.6he flexibilityavailable to manaement permits them to ad/ust earnins and other financial statement numbersto achieve their reportin ob/ectives.

Q12-0:6he return on assets measures the performance of the entity "ithout the impact of ho" the assets"ere financed, "hile the return on e!uity relates the performance to the investment of the o"nersat book value. oth are useful. 6he return on assets assesses manaements performance inste"ardship over the assets by sho"in the return earned on the total asset base, reardless of"hether the assets "ere financed by debt or e!uity. 6he return on e!uity sho"s the impact of useof debt and e!uity on the "ealth of the o"ners. &t sho"s the return the common e!uity holdersearned on their investment. &t isnt possible to state that one is better than the other. +ach isappropriate dependin on the needs of the user.

Q12-01(atios have no meanin in absolute terms. >ne cant say that a particular ratio is ood or bad"ithout kno"in "hat the benchmarks are. enchmarks can vary from industry to industry, frommarket to market, from o"nership structure to o"nership structure and so on. 8omparisons canbe made "ith other similar entities, to the entity in !uestion itself over time, and to industrybenchmarks.

Q12-02Gifferent decisions re!uire different information and "ithout kno"in "hat decision is beinmade it isnt possible to provide an appropriate analysis. For example, the analysis that isappropriate for creditors differs from that for e!uity investors.


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+I+(8&)+)

+12-1.a. 6he "arehouse is on the shore of a river that overflo"s its banks periodically. 6his means

the cost occurs "ith some reularity so its permanent but not necessarily annual. )o

there is information for predictive purposes in the previous cost of flood damae.

b. )ales of e!uipment occur reularly in the course of business as an entity purchases andreplaces e!uipment. # lot depends on the si$e of the fleet. &f the fleet is lare andreplacements occur "ith some reularity then this is a permanent item. &f replacementsare infre!uent this could be classified as more of a transitory event.

c. Erite-do"ns of inventory that are on cyclical sellin cycles are permanent since its partof bein in a seasonal business.

d. &f the sinificant price increase carries to future periods then its a permanent event

ho"ever if prices are expected to stabili$e there after its transitory. 6his "ill depend onthe volatility of the markets.

+12-2.a. *ayments to settle la"suits are probably infre!uent and transitory.b. althouh they could be reular occurrences in some industries.

c. Gonations to charities if done every year may be considered as permanent, ho"ever ifthis is a one time donation then it "ould be transitory.

d. 6he revenues and expenses are transitory since the operations "ont continue in thefuture.

e. Gependin on the market and industry the drop in price maybe be either permanent ortransitory.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-1:)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


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+12-0.a. # strike that prevents a company from production for half a year "ouldnt be reflective of

future periods, therefore the financial statements produced in that year "ont be a oodindication of future periods.

b. Eith the ne" dru expected to reach the market in the future financial performanceshould improve. &F() statements "ouldnt capture the sales that "ill be enerated infuture in the current year no impact until actual sales occur so the statements "ouldprovide little insiht into the future performance of the company.

c. 6he income of the ne" restaurant isnt predictable from the historical financial statementsbecause the activities of the restaurant are ne". )ome insiht maybe ained from the pastt"o !uarters ho"ever it may not be representative of the rest of the year and yearsmovin for"ard.

d. Future earnins "ould be difficult because the company is openin stores in a ne" reion

so its difficult to determine "hether they "ill be successful amount of sales, operatincosts, profitability "ill be uncertain.



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+12-5

olin ther expenses :.0? :.51 :.5?

%et income :.12 :.11 :.:B

olin ther expenses 1.=2 1.0: 1.::

%et income 0.1: 2.1: 1.::

6he performance of the company over the three-year period is fairly ood. (evenues have almostdoubled and net income has more than tripled, but ross marin has decreased by five percentaepoints "hile profit marin has increased by 5.@ percentae points. >ther expenses has decreased

by =A year over year as a result of manaement takin action to offset the increase cost of salesresultin in an improvin net income. ased on this perspective, the company appears to havecontrolled their period costs "ell ho"ever the increase in cost of sales may be a result of pricereduction to boost sales and overall profits

From the trend financial statements, "e see that cost of sales is increasin faster than sales and,as a result, the ross marin has decreased over the three year period. >ther expenses on theother hand are ro"in slo"er than revenues. 6he overall effect is that net income has tripledover the three years "hile sales have only doubled. 6his indicates that the company has manaedits costs effectively. 6he ma/or reason that net income has increased faster than revenues is thatother expenses have increased at a slo"er rate than sales.



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+12-=.a.

Fairplay Inc!

C"mm"n#size $alance S%eets

As "& 'ecem(er )1

2*1+ 2*1, 2*1-

8ash :.:20 :.:0@ :.:0=

#ccounts receivable :.10? :.150 :.125

&nventory :.1=0 :.151 :.1=D

>ther current assets :.:01 :.:05 :.:2B

6otal current assets :.050 :.0== :.05?

8apital assets net :.?=@ :.?5= :.?=5

6otal assets 1.::: 1.::: 1.:::

ank loans :.12= :.:B5 :.:B1

#ccounts payable and accrued liabilities :.11B :.12? :.105

6otal current liabilities :.250 :.21: :.21=


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Fairplay Inc!

C"mm"n#size Inc"me Statements

F"r t%e year ended 'ecem(er )1

2*1+ 2*1, 2*1-

(evenue 1.::: 1.::: 1.:::

8ost of sales :.5@0 :.5@= :.5BB

ross marin :.=2@ :.=2= :.=12

)ellin, eneral H admin. :.252 :.25: :.2=?

Gepreciation :.:=B :.:=B :.:=0

>ther expenses :.122 :.122 :.112

&nterest expense :.:2D :.:2= :.:1D

&ncome before taxes :.:@@ :.:B: :.:@2

&ncome tax expense :.:1@ :.:21 :.:1D

%et income :.:?: :.:=D :.:=0

J8olumns may not add due to roundin.

b.6he performance of the company over the three year period is enerally favourable and stable.ost of the components of the income statement have varied "ithin a very narro" rane. 8ost ofoods sold is a decreasin percentae, so ross marin has increased in each year, "hichindicates that the value provided by the companys products and services is reconi$edfavourably by its customers. 6he sellin, eneral and administrative expenses are slihtlydecreasin and depreciation increased, "hich is the result of increased investment in capitalassets. &nterest expense is increasin, partly due to an increase in lon-term liabilities to finance

the capital ac!uisitions and possibly hiher interest rates. >verall, the company is benefitinfrom improved ross marins "hich are partially offset by increased depreciation and interestcost. %et income has increased as a proportion of sales over the three-year period. ased on thisperspective, the company appears to have a steady and viable future.

6he li!uidity of the company may be of some concern. 6he current assets in total are a fairlyconstant percentae of total assets and the composition of the current assets varies slihtly andno specific trend is obvious. o"ever, current liabilities have increased, in particular the bankloan althouh payables have decreased. 6he percentae of assets financed by e!uity hasdecreased slihtly from about ?:A in 2:1? and 2:1@ to =BA in 2:1B. 6he difference isnt initself dramatic but there is a limit to ho" fast the company can ro" by addin debt.



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c.6he common si$e statements eliminate the effect of si$e on financial statement numbers. Eiththe actual statements, its difficult to see the proportional impact of chanes in the accounts in thefinancial statements. 8hanes in manitude can be related to ro"th or to a proportional increaseor decrease relative to some benchmark amount.

d.Eithout the oriinal financial statements, "e cant "hether the chanes sho"n in the commonsi$e statements pertain to lare or small numbers and a reat deal of perspective is lost. # 1:Achane in a very small amount isnt very meaninful "hereas a 1:A chane in a lare amount"ill be very sinificant. Kou also cant see the manitude of different accounts. )inificantproportional chanes in accounts miht be identified from the common si$e statements but theactual amounts in the accounts may be small and immaterial. 6he common si$e statementsshould be examined in con/unction "ith the oriinal statements.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-1=)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


16/83

+12-?.

a. 2:1? as base year.

Fairplay Inc!

Trend $alance S%eets

As "& 'ecem(er )1

2*1+ 2*1, 2*1-

8ash :.D:: 1.2:: 1.:::

#ccounts receivable 1.=:0 1.02? 1.:::

&nventory 1.01@ 1.:22 1.:::

>ther current assets 1.=:: 1.0@= 1.:::

6otal current assets 1.0=? 1.1@B 1.:::

8apital assets net 1.0@B 1.10= 1.:::

6otal #ssets 1.0@: 1.1=: 1.:::

ank loans 2.1:: 1.1D1 1.:::

#ccounts payable and accrued liabilities 1.2:B 1.:@D 1.:::

6otal current liabilities 1.=55 1.121 1.:::


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Fairplay Inc!

Trend Inc"me Statements

F"r t%e year ended 'ecem(er )1

2*1+ 2*1, 2*1-

(evenue 1.21: 1.12: 1.:::

8ost of sales 1.1@2 1.:D: 1.:::

ross marin 1.25? 1.15D 1.:::

)ellin, eneral H admin. 1.15= 1.:=: 1.:::

Gepreciation 1.0:5 1.21@ 1.:::

>ther expenses 1.01B 1.22: 1.:::

&nterest expense 1.B@= 1.=:: 1.:::

&ncome before taxes 1.2BB 1.25? 1.:::

&ncome tax expense 1.:DB 1.2=: 1.:::

%et income 1.0=5 1.25= 1.:::

b.From the trend financial statements, "e see that cost of sales is increasin more slo"ly than salesand, as a result, the ross marin has increased over the three year period. #lso, sellin, eneraland administrative expenses are ro"in slihtly more slo"ly than revenues but interestexpense, depreciation and other expenses are ro"in more rapidly. 6he overall effect is that netincome has increased over 0=A over the three years "hile sales have increased 21A. 6hisindicates that the company has manaed its costs effectively. 6he ma/or reason that net incomehas increased faster than revenues is that cost of oods sold and sellin, eneral, andadministrative expenses have increased at a slo"er rate than sales.

>n the trend balance sheets, "e see that liabilities are increasin faster than assets. &n particular,bank loans have more than doubled and lon-term debt has increased by 5: percent. o"ever,capital assets "hich are often financed by lon-term debt have increased at about the same rateas lon-term debt. ank loans are often used to finance current assets but current assets haveincreased at a much slo"er rate than bank loans. #lso, inventory has increased sinificantlyfaster than cost of sales you "ould expect them to ro" at about the same rate and accountsreceivable have ro"n much faster than sales, "hich is a cause for concern because this indicatesdifficulty collectin receivables or perhaps a relaxin of credit terms to boost sales.

c.6hese financial statements enable us to see the trends in various accounts "ithout the absolutesi$e of the numbers obscurin the chanes. 6he trend statements also make it possible tocompare chanes in the individual accounts over time. &ts more difficult to infer chanes fromthe oriinal statements.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-1@)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


18/83

d.Eithout the oriinal financial statements, the trends have little explanatory po"er. Ehen "e tryto rely on the trend statements alone to understand "hat is happenin, "e can easily formnonsensical beliefs. )o "hile eliminatin absolute si$e from the statements makes trends andchanes clearer, "ithout perspective on the sinificance of each of the numbers, the ability to

dra" conclusions is impaired. For example, from the trend statements alone, one could becomevery concerned about a lare percentae increase "hen the absolute dollar amount makes theconcern unimportant.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-1B)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


19/83

[email protected].

2*1+ 2*1,

i. 8urrent ratio 1.51: 1.?B@

ii. Quick ratio :.?=5 :.B=5iii. #ccounts receivable turnover ratio 1:.=:B 11.B00iv. #verae collection period 05.@0@ 0:.B5?v. &nventory turnover 5.?@? =.:01vi. #verae days inventory @B.:?1 @2.==5vii #ccounts payable turnover =.D?B =.B2:viii #verae payment period ?1.1=B ?2.@12ix. 8ash la =1.?0D 5:.?BB

b.(eport to the manaementL

Ee are concerned "ith Fairplays ability to meet its financial obliations as they come due. >urtime hori$on is relatively short term since "e should expect to be paid bet"een 0: and D: daysdependin on the credit terms so our main concern is Fairplays short term and onoin li!uidity.From my analysis Fairplays li!uidity position has deteriorated slihtly in the last year, "ith boththe current and !uick ratios decreasin from 2:1@ to 2:1B. o"ever, neither ratio appears to beunreasonably lo" althouh examination of industry benchmarks "ould be appropriate. 6hecompany is collectin its receivables less !uickly and its inventory turnover is decreasin. 6hetime Fairplay takes to pay its supplier has decreased slihtly. &ts difficult to assess these ratios"ithout kno"in the industry and the specific terms offered and received by Fairplay. &f Fairplayoffers 0: days credit to its customers then it is very effective collectin, even if the collectionperiod has increased by about four days. &f customers are re!uired to pay in less than 0: daysthen a different conclusion may be necessary .&f the payment period is ?: days then the companyis meetin its obliation on time. &f the averae payment period is 0: or 5= days then payment isa problem. ore information is needed on the terms.


20/83

+12-B.

8urrent (atio 2.0=

Quick (atio 1.=5

ased on the li!uidity ratios #tluck is in a positive li!uidity position "ith current and !uick

assets exceedin current liabilities. 6his translates to the company bein able to meet its currentobliations. #lso cash on hand exceeds the amount of credit bein re!uested M1:,:::. Furtherinformation "ould be re!uired reardin the collectability of receivables and the saleability ofinventory. o"ever, based on the ratios plus the amount of cash credit of up to M1:,::: "ould bereasonable.

+12-Da.

.r"na/ C"rp!

C"mm"n size inc"me statements

F"r t%e years ended 0arc% )12*1, 2*1- 2*1

(evenueM2,B@=,::

:1::.::

AM2,?12,=:

:1::.::

AM2,52=,::

:1::.::

A

8ost of sales 1,=@=,::: =5.@BA 1,0@=,::: =2.?0A 1,2B:,=:: =2.B:A

ross marin 1,0::,::: 5=.22A 1,20@,=:: [email protected]@A 1,155,=:: [email protected]:A

)H# expenses ?@=,::: 20.5BA =@=,::: 22.:1A ===,=:: 22.D1A

Gepreciation expense 12D,::: 5.5DA 1:=,::: 5.:2A D=,::: 0.D2A

&nterest expense 1=:,::: =.22A 10@,=:: =.2?A 10:,::: =.0?A

%on-(ecurrin +xpense 2=:,::: B.@:A - - - -

&ncome before incometaxes D?,::: 0.05A 52:,::: 1?.:BA 0?5,::: 1=.:1A

&ncome tax expense 1B,::: :.?0A B:,::: 0.:?A @=,::: 0.:DA

%et income M@B,::: 2.@1A M05:,::: 10.:1A M2BD,::: 11.D2A



21/83

.r"na/ C"rp!

Trend inc"me statements

For the years ended arch 01

2*1, 2*1- 2*1

(evenue M2,B@=,::: 1.1D M2,?12,=:: 1.:B M2,52=,::: 1.::

8ost of sales 1,=@=,::: 1.20 1,0@=,::: 1.:@ 1,2B:,=:: 1.::ross marin 1,0::,::: 1.15 1,20@,=:: 1.:B 1,155,=:: 1.::

)H# expenses ?@=,::: 1.22 =@=,::: 1.:5 ===,=:: 1.::

Gepreciation expense 12D,::: 1.0? 1:=,::: 1.11 D=,::: 1.::

&nterest expense 1=:,::: 1.1= 10@,=:: 1.:? 10:,::: 1.::

%on-recurrin expense 2=:,::: - - - - -

&ncome before incometaxes D?,::: :.2? 52:,::: 1.1= 0?5,::: 1.::

&ncome tax expense 1B,::: :.25 B:,::: 1.:@ @=,::: 1.::

%et income M@B,::: :.2@ M05:,::: 1.1B M2BD,::: 1.::

b.Nronau 8orp. has enerally performed reasonably "ell over the three-year period "ith theexception of a transitory expense item in 2:1@ leadin to an abnormal drop in net income, "hichsinificantly decreased the profit marin. ross marin has increased over the three-year period,althouh "e cant tell ho" that compares to other firms in the industry. From the common-si$edfinancial statements, "e observe that the cost of sales "as approximately constant in 2:1= and2:1?, but increased as a percentae of sales by almost 2A in 2:1@, "hich suests that thecompany has experienced cost increases that it hasnt been able to pass on to customers. #s aresult the ross marin percentae decreased in 2:1@. )ellin, eneral and administrative costs asa percentae of sales have increased by 1.= percentae points in 2:1@, suestin that

manaement hasnt been effective in controllin costs. Gepreciation expense as a percentae ofsales has increased slihtly. #s a percentae of sales interest expense has been decreasin veryradually althouh the actual amount of interest has been increasin, "hich could be due toincreased debt or hiher interest rates. 6he do"nturn in net income in 2:1@ is due to the the non-recurrin expense and the impact should be interpreted carefully since onoin costs have alsoincreased on a proportional basis over the three years for almost all accounts except interest andtaxes in the year of the non-recurrin expense. 6he trend statements sho" that many expenseshave increased at rates faster than sales, suestin that costs arent bein "ell controlled. 6henon-recurrin item needs to be investiated but since its transitory it shouldnt used to makefuture predictions.

Eithout more details, it isnt possible to arrive at a definite conclusion about the performance ofthe company. o"ever, all the trends are consistent "ith a company that is ro"in andexpandin capacity for future ro"th. 6he increased sellin, eneral and administrative costscould reflect the costs of hirin additional sales representatives to enerate the additional sales,perhaps "ith the expectation that sales "ill increase "hile these costs remain constant in future.>n the other hand, the increased eneral and administrative costs are consistent "ith a companythat has previously been operated efficiently "ith careful control of costs but "here the manaersare no" indulin themselves "ith more luxurious offices, support staff and more expensive



22/83

company-o"ned automobiles. #nother interpretation is that, "ith the ro"th of the company asreflected by the increase in sales, there has been a decrease in efficiency and control over costsbecause the manaers are more distant from the actions of certain employees. Ehich of thesescenarios is more accurate can be determined by a visit to the firm and an intervie" "ith theo"ners at "hich point an explanation to the M2=:,::: expense "ould be re!uired also.

c.&ts very difficult to assess the performance of the company "ithout removin the non-recurrinexpense from the analysis presumin that this item is really transitory. Eith the inclusion ofthat amount in the analysis, the year-to-year comparisons arent meaninful nor are predictionsof future profitability appropriate. Fortunately, the ad/ustment is easy to perform. Eithout thenon-recurrin expense, the trend analysis "ould sho" a decrease in income before income taxesfrom 2:1? to 2:1@ of about 1:A rather than a B:A decrease. )imilarly, the common si$estatements sho" that income before taxes and unusual items "as 12A of sales in 2:1@, "hich isstill sinificantly lo"er than in the previous t"o years.

%oteL >ther 3unusual events4 may not be isolated. For example, the reduced ross marin in2:1@ could have been caused by an un"ise purchasin decision that re!uired a sinificantsement of the inventory bein sold at much lo"er prices than expected.

+12-1:.a., b.

2*1 2*1- 2*1,

einnin accounts payable M1,=0=,?0: M1,D1D,=0B M2,102,B2:+ndin accounts payable 1,D1D,=0B 2,102,B2: 2,=:D,2::#verae accounts payable 1,@2@,=B5 2,:2?,1@D 2,021,:1:

8ost of )ales D,?20,:2B 1:,51?,?D2 1:,112,:@?einnin &nventory 2,2@2,@02 2,BDB,=:2 0,1=?,=@5+ndin &nventory 2,BDB,=:2 0,1=?,=@5 0,2?1,D?:*urchases 1:,25B,@DB 1:,?@5,@?5 1:,21@,5?2#* 6urnover ratio =.D0 =.2@ 5.5:#verae payment period ?1.= ?D.0 B2.D

c.6he accounts payable turnover ratio is decreasin and the averae payment period is increasin.6his indicates that the company is takin more time to pay its suppliers.

d.6here are many possible explanationsL chanin credit terms from ma/or suppliers, cash flo"problems that make it difficult to meet its obliations so the company is tryin to 3stretch4 itspayables, or chanes in suppliers or the composition of suppliers.



23/83

+12-11.%oteL the follo"in ans"ers assume that the event occurs on the day before the end of the periodfor "hich the financial statements are prepared. #lso, its necessary in some cases to makeassumptions. )tudents should reconi$e and make their assumptions explicit and those "ho do soshould be re"arded.

Quick (atio &nventory6urnover

(eturn on #ssets *rofit marinA

Gebt

!uickassetscurrent

liabilities

cost ofsalesaverae

inventory

net income Oafter tax interestexpaverae total

assets

net incomesales

+!uity

Rati" (e&"re t%e

transacti"ns ec"n"mic

e3ents

*!+ )! 124 +4 1!51

a. +arly retirement oflon-term debtclassified as lon-term "hen retiredfor cash at a loss

Gecrease %o 8hane &ncrease Gecrease Gecrease

b. #ccrual of a "arrantyliability

Gecrease %o 8hane Gecrease Gecrease &ncrease

c. Geclaration of a cashdividend

Gecrease %o 8hane %o 8hane %o 8hane &ncrease

d. )ale of commonshares for cash

&ncrease %o 8hane Gecrease %o 8hane Gecrease

e. #rranement of acapital lease

%o 8hane %o 8hane Gecrease %o 8hane &ncrease

a. 8ash - ,


24/83

+12-12.%oteL the follo"in ans"ers assume that the event occurs on the day before the end of the periodfor "hich the financial statements are prepared. #lso, its necessary in some cases to makeassumptions. )tudents should reconi$e and make their assumptions explicit and those "ho do soshould be re"arded.

Interest

c"3erage

Recei3a(les

t/rn"3er

Price t" earnings Ret/rn "n e6/ity 'i3idend yield

7cas% &r"m

"perati"ns 8

interest paid

interest paid9

7credit sales a3g!

AR9

7mar:et

priceEPS9

net income Ppreferred

dividendsaveraetotal e!uity

7Cas%

di3idends

declareds%are

price9

Rati" (e&"re t%e

transacti"ns ec"n"mic

e3ents

;!12 ;!, 22!, 124 )!1*4

a. 'nexpected

announcement by a publiccompany of a ne" lon-term contract "ith a ne"customer. 8ontract oesinto effect next year.

%o effect %o effect &ncrease share price

"ill increase

%o effect Gecrease

share price"ill increase

b. Eritedo"n of impairedproperty, plant, ande!uipment

Gecrease %o effect %o effect assumesno effect on share

price

Gecrease %o effect

c. 2 for 1 stock split %o effect %o effect %o effect assumesshare price and epsdecrease by =:A

%o effect %o effect

d. *ayment of an amounto"in to a supplier%o effect %o effect %o effect %o effect %o effect

e. 8redit sale ofmerchandise to acustomer

&ncrease Gecrease Gecrease assumesno effect on share

price

&ncrease %o effect

a. #ssumption - +xecutory 8ontract. #ssume that none of b. throuh e.have an effect on share price. #ssume announcement in a. increasesshare price in anticipation of hiher future profits. Gifferentassumptions are possible.b. *roperty, plant and e!uipment - , %et income -

c. %o effect

d. #ccounts payable -, 8ash -

e. #ccounts receivable O, )alesO; &nventory -, 8ost of oods soldO #ssume sales "as for a profit



25/83

+12-10.&ts necessary in some cases to make assumptions. )tudents should reconi$e and make theirassumptions explicit and those "ho do so should be re"arded.

C/rrent A3erage

paya(les

payment peri"d

Ret/rn "n

Assets

)O, &nventory -

c. Gividend payable-, 8ash -

d.


26/83

+12-15a.

Gyce #uto *arts


27/83

+12-1=.a.

2*1- 2*1, 2*1+einnin accounts receivable M?@,=:: M@=,::: MB=,:::+ndin accounts receivable @=,::: B=,::: D0,@=:

#verae accounts receivable @1,2=: B:,::: BD,0@=)ales D=:,::: 1,::?,2=: 1,:D0,@=:A credit sales ?:A ??A @=A8redit sales =@:,::: ??5,12= B2:,010accounts receivable turnover B.:: B.0: D.1B8ollection period 5=.?0 50.D@ 0D.@@

b. 6he company appears to be improvin its manaement of its accounts receivable fairly"ell as they are, on averae, collected more promptly each year.

c. *ossible explanations include a >unre doesnt follo" up "ith customers on a reularbasis; b its inevitable that some customers dont pay or pay late; c some customers mayreceive more time to pay. *ossible "ays to accelerate collection are to be proactive "ithcustomers to ensure they pay on time; offer a discount for early payment; decline creditterms for customers "ho pay slo"ly; and tihten credit rantin standards so only verylo" risk customers receive credit. 6he problem is that in a competitive market such asprintin services, all of the above actions are likely to reduce the profitability of thecompany.

d. &f the collection period "as calculated based on total sales and not credit sales, thecompanys receivables turnover "ould be hiher, "hich could be confusin. Eithoutkno"in the proportion of cash sales accounts receivable turnover "ould chane becauseof the mix of cash and non-cash business, not because of chanes in the manaement ofreceivables.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-2@)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


28/83

+12-1?a.

2*1 2*1- 2*1,

einnin &nventory M5B,@=: M=5,@=: M?:,@=:+ndin &nventory =5,@=: ?:,@=: D@,=::

#verae &nventory =1,@=: =@,@=: @D,12=8ost of )ales 0,1=:,::: 0,?22,=:: 0,551,0@=&nventory turnover ?:.B@ ?2.@0 50.5D#verae days in inventory ?.:: =.B2 B.0D

b. 6he company appears to have maned its inventory fairly "ell in 2:1= and 2:1?.Ee"ould expect a hih turnover of inventory in the produce business since the merchandiseis perishable. &ts difficult to determine exactly "hat occurred in 2:1@ but cost of salesdecreased in 2:1@ "hile endin inventory increased by more than ?: percent. 8learly "eneed to kno" "hy endin inventory increased and "hy cost of sales decreased toappropriately interpret the 2:1@ performance. &ts a strane situation because hiher

inventory suests expansion or overbuyin, but in this type of business, the purchasincycle is very short because of the nature of inventory, so excessive overbuyin should notoccur. &ndustry benchmarks "ould be useful to see "hat is 3normal4 in this business as"ould be sales and other financial statement information.

c. any explanations are possible. )tudents should try to enerate many explanations andthen try to rank them in credibility for the circumstances that are iven in the !uestion.>ne probable cause is that the company has made specific recent inventory purchasesthat it has been unable to sell to retailers. )ome produce such as carrots and potatoes canbe stored for a sinificant lenth of time, so this may not sinify a crisis. >ther"ise theinventory may need to be "ritten do"n if its value is deterioratin. *erhaps the companyis cauht "ith bindin commitments to accept reular deliveries from its suppliers buthas lost a ma/or customer. #nother potential cause is that the year-end happened on a day"hen a M?:,::: special order "as "aitin t"o or three days until the customer "as readyto receive the shipment. &n that case, a year-end a "eek earlier or later "ould haveprovided a very different impression.

%oteL For most companies, the !uantity of inventory on hand at a balance sheet date issome"hat representative of the averae inventory for the year. o"ever, Sa"alesinventory likely fluctuates sinificantly each day. # user of financial statements,particularly a banker, "ould be better served "ith an averae based on monthly ratherthan annual counts. onthly counts "ould also reduce the incentive to mislead the usersof the financial statements by allo"in inventory to run do"n at the end of the year. #nycompany "ith very hih turnover "ould find it very easy to reduce purchases as the year-end nears to ensure that the inventory count is lo" and the turnover appears hih. &ncontrast, a /e"ellery store or a hard"are store "ould find it much more difficult toachieve the same result.

d. 6he additional inventory at year-end, if its to be held for more than a fe" days, "illre!uire financin and have sinificant neative cash flo" implications for the company.



29/83

6he overall implications of the observations from a and b really depend on "hetherthey represent a situation that "ill persist. &t seems unlikely that a ?:A increase ininventory from the beinnin to the end of 2:1@ reflects a deliberate decision to increaseinventory "hen sales arent increasin. +xcess produce in ood condition can easily besold in "holesale markets at some price, so the situation isnt really cause for rave

concern. >n the other hand, if the inventory cant be moved in ood time it "ill have tobe "ritten off, "hich "ill reduce net income.

[email protected].

2*1 2*1- 2*1,

einnin payables M?@,2:: M@2,B:: MB=,5::

+ndin payables @2,B:: B=,5:: 1::,B::

#verae payables @:,::: @D,1:: D0,1::

8redit purchases 55B,::: 5?2,::: 5==,:::

*ayables turnover ?.5: =.B5 5.BD

#verae payment period =@ ?2.= @5.@

b. 6he company has been payin more slo"ly on averae each year for the last three years,"hich isnt ood ne"s if "e are hopin that the company "ill pay us promptly in ?:days. &t "ould be very helpful to kno" "hether any of the companys suppliers havechaned the credit terms in the last t"o years. &ts possible that competitive pressureshave motivated a ne" supplier to offer D:-day terms to obtain uisachans business. >nthe other hand, there is likely only one supplier for a particular book, so that explanationdoesnt seem plausible in this case. ore likely is that uisachan is sufferin from cash

flo" problems and is simply unable to pay promptly. ank financin may be difficult toobtain in ade!uate amounts, so effectively the business is financed by its suppliers. &f thecompany is doin "ell and pays all its bills, even if it does so slo"ly, & may be "illin toextend the credit. #dditional information that "ould be useful "ould be credit reports onuisachans payment history as "ell as a complete set of financial statements and cashforecasts.

c. #n increase in accounts payable represents a source of cash, "hich "ould appearfavourable on the statement of cash flo"s because 8F> "ould increase. o"ever, as asupplier, & "ould prefer to see cash come from sources such as sellin merchandise. 6heproblem is that payables are increasin "hen sales arent purchases are relatively stable.6o obtain additional cash inflo"s in future years, the company "ill need to extend theaverae payment period even further, "hich is likely to be resisted by suppliers. )uppliersare often "illin to assist a ne" business, a ro"in business, or a business that isexperiencin temporary difficulties. o"ever, they expect to see the company decreaseits reliance on supplier financin as the company becomes established. 'nfortunately,small bookstores tend to strule financially for lon periods of time. +ventuallysuppliers may decide to not offer additional credit.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-2D)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


30/83

+12-1B.a. asic +*) R M11,B@D,=::- M=::,:::1::,:::,::: R M:.115Teach common share

earned M:.11 after deductin the preferred dividend.

b. *+ ratio R M=.@=:.11 R =:.=0 to 1 Tthe market is payin M=:.=0 for each dollar of

accountin earnins available to common shareholders.

c. Gividend payout ratio R 1::,:::,::: x M:.:B11,B@D,=:: -=::,:::R @:.0A - @:.0A ofearnins is bein paid out in common dividends.

d. Gividend yield R M:.:BM=.@= R 1.5A - each common share yielded 1.5A return fromdividends.

+12-1D.a. i. asic +*) R -M0@,=::,::: - M=,:::,:::25,:::,::: R -M1.@@Teach common share

lost M1.@@ after deductin the preferred dividend.

ii. *+ ratio R M?.@=-M1.@@ R -0.B1 to 1T6his ratio isnt meaninful "hen the entity islosin money. 6he market is pricin the company and factors other than the currentyears earnins alone. >ther"ise the company "ould have a neative share price.

iii. Gividend payout ratio R M:.:= x 25,:::,::: x 5-0@,=::,::: R -12.BATthis meansthat a dividend "as paid "hen the company incurred a loss. 6he interpretation isother"ise not meaninful.

iv. Gividend yield R M:.:= I5M?.@= R 2.D?A - each common share yielded 2.D?Areturn

b. # dividend re!uires cash, not earnins. # loss in a period doesnt preclude the payment ofa dividend, althouh losses over a number of periods could impair the ability of an entityto pay cash dividends since there is a correlation bet"een cash flo" and net income,especially over loner periods of time.

c. 6he value of a stock represents the &/t/recash flo"s that "ill be reali$ed by theshareholders. # loss in a iven year doesnt mean that future earnins and future cashflo"s "ill be neative. 8learly, in this case, the markets expectations about the futureperformance of the company are based on more than the current years earnins. 6hedividend yield is positive because it doesnt take into account profits earned by thecompany but rather the dividends declared. 6herefore dividend yield "ould never beneative and at "orst "ould be $ero meanin no dividends "as paid.



31/83

+12-2:.a. 6he debt-to-e!uity ratio is 1.@BL1.

b. 6he company could have liabilities of M?:,::: more than it has outstandin and stillmaintain the 2L1 covenant.

c. 6he company could have reduced e!uity by payin a dividend of M0:,::: "ithoutbreachin their debt covenant.

d. 6he dividend "ould reduce shareholders e!uity by M2=,::: to M2=:,:::. &t "ouldincrease liabilities by M2=,::: to M=1=,::: and increase the debte!uity ratio to 2.:?L1,"hich "ould put usavick in violation of the covenant. &f the divide "as paid before theyear end the covenant "oulnt be breached.

+12-21.a.

2*1, 2*1-i. ross marinpercentae 0?.5DA 0?.D:Aii. profit marinpercentae 0.:2A B.5?A

iii. earnins per share M:.?@ M1.B?

iv. "orkin capitalMD,=B@,::

:M1=,2=5,::

:

v. current ratio 1.00 1.?0

vi. !uick ratio :.2? :.02

vii. debt-to-e!uity ratio 1.:1 :.D5

viii. interest coveraeratio 5.15 B.00

ix. dividend payout ratio @0.2:A 2?.22A

b.

i. asset turnover 1.:5

ii. return on e!uity :.:?2

iii. return on assets :.:51 or :.:01 dependin on method used

iv. inventory turnover ratio 1.@D

v. averae days inventory 2:0.D0

vi. accounts receivable turnover 11.0=vii. averae collection period of#( 02.1=viii. accounts payable turnoverratio @.100

ix. averae payment period for #* =1.1@

x. cash la 1B5.D1



32/83



33/83

c. 6he most sinificant effect of the unusual items is on those calculations that directlyinclude net income, most specifically the profit marin, +*), return on assets and e!uity.6he profit marin for 2:1? is B.5?A if the unusual item is included but 5.D?A if itsexcluded the revised percentae is calculated after tax. &f the unusual item is subtracted"ithout considerin the tax effect the revised profit marin percentae is 0.:1A. 6he

impact on 2:1@ is much smaller but is about half a percent hiher "hen the unusual itemis included. )imilar impact occurs on return on assets and e!uity. )ince by definition theitem "ont likely recur, it "ould be misleadin to compare 2:1? and 2:1@ "ith theunusual items included, althouh it is relevant "hen considerin ho" urst"oodperformed as opposed to for predictive purposes. 'nusual items are transitory in naturebecause they should not recur "ith any reularity. 6hat said, some companies use unusualitems to try and manae their earnins so that users "ill discount the future impact ofcertain expenses. 6here is evidence that some companies report unusual items !uitereularly. &ndeed, urst"ood has unusual items reported in both years sho"n.

d. #s a "ine producer and distributor, "e "ould expect the company to have lare amounts

of inventory and a very slo" inventory turnover. &n fact, if all of the current liabilities"ere to come due in the first fe" "eeks follo"in the balance sheet date, its veryunlikely that the payments could be made "ithout acceptin distress prices for the "ineinventory. ore realistically, the receivables arent sufficient to cover the accountspayable. *resumably the bank indebtedness is a line of credit "hich the company canaccess to meet those obliations. &n summary, the company isnt very li!uid in terms ofits ability to meet its obliations by turnin its current assets !uickly into cash, eventhouh total current assets exceed current liabilities. 8ompanies of this sort "ith slo"inventory turnover re!uire access to bank loans secured by inventory and receivables.#ssumin that the company is established, the bank is likely to vie" the "ine as fairlyood collateral.



34/83

+12-22.a, b. 2*1, 2*1- 2*1 2*1; 2*1)

)ales M1,0:D,55: M1,220,@@? M1,1?=,=:: M1,:=:,::: M

%et income 1=?,0:? 1=1,0DB 155,2D: 10?,@=:

6otal liabilities at year-end 05?,2@5 02?,?@5 2D5,0:: 2@2,=:: 2=:,:::

)hareholders e!uity at year-end

0B1,?B: 02=,0@? 2@0,D@? 22D,?BB 1D2,D0B

&nterest expense =B,=:: =1,::: 52,=:: ?1,=::

6ax rate 1BA 1BA 1BA 1BA

#verae total assets M?D:,::2 M?1:,1?0 M=0=,202 M5@2,=?0#sset turnover ratio 1.D: 2.:1 2.1B 2.22#fter tax interest expense M5@,D@: M51,B2: M05,B=: M=:,50:

*rofit marin percentaead/usted for interest :.1=? :.1=B :.1=5 :.1@B*rofit marin percentaenet incomesales

:.11D

:.125

:.125

:.10:

(eturn on assets :.2D? :.01@ :.00= :.0D?#verae e!uity M0=0,=2B M2DD,?@? M2=1,B02 M211,010(eturn on e!uity :.552 :.=:= :.=@0 :.?5@J(>+ R %et income P preferred dividends averae shareholdersU e!uity

c. 'n"ins net income has steadily increased over the four-year interval but the profitmarin has declined since 2:1=, meanin the company is earnin less per dollar of sales.

6he asset turnover ratio has also decreased, meanin that sales have increased moreslo"ly than total assets and assets are bein used less efficiently to produce sales.*ossible explanations include lare capital investments that "ill benefit future years, asubstantial accumulation of inventory and receivables or capital assets not bein usedefficiently. 6here could also be assets that are obsolete, ones that are inefficient, orexcessive amounts of certain assets. 6he interpretation "ould differ sinificantlydependin on the actual causes, "hich "ould be evident "ith complete financialstatements. (># and (>+ both sho" declinin performance, decreasin across the fouryears.



35/83

+12-20a, b. 2*1+ 2*1, 2*1- 2*1 2*1;

)ales MD=@,2?5 MB=5,@:: M@?0,12= M?B@,=::

%et income 00,=:5 02,5@D 0:,=2= 2B,B@=

6otal liabilities at year end 1=D,=0= 1=1,D0B 155,@:0 10@,B10 101,2=:)hareholders e!uity at yearend

01B,?20 2B=,11D 2=2,?51 222,11? 1D0,251

#verae total assets M5=@,?:B M51@,2:1 M0@B,?0@ M052,21:

#sset turnover ratio 2.:D 2.:= 2.:2 2.:1

*rofit marin percentae :.:0 :.:5 :.:5 :.:5

(eturn on assets @.02A @.@BA B.:?A B.55A

#verae e!uity M0:1,B@1 M2?B,BB: M20@,0@D M2:@,?@D

(eturn on e!uity 11.1:A 12.:BA 12.B?A 10.D:A

c. 6he net income of the company has steadily increased over the four-year interval and theasset turnover has increased marinally. o"ever, profit marins have decreased,suestin either that cost of sales or some other expenses have increased relative tosales. 6his means that, "hile the company is usin its assets slihtly more efficiently, itsprofitability is declinin. #s a result, (># and (>+ have declined over the period. 6heincreased use of debt "ould suest hiher interest costs is contributin to the decreasedprofitability. %ote that the definition used for (># in this chapter is different from thatused in the chapter "here the numerator is net income plus the after tax cost of interest.6his "as done to simplify the exercise.

+12-25.6he information suests that usiness # is in a better li!uidity position then usiness . #t firstlance the s current ratio of 1.@= suests a stron li!uidity position, but the lo" !uick ratio of:.0B compared "ith :.@= for # indicates that has more less li!uid assets, such as inventory. #has fe"er current assets relative to current liabilities than but more of its current assets arehihly li!uidTcash, investments, and receivables. &ts not surprisin that both businesses have!uick ratios belo" 1 because as retailers they have to carry a lot of inventory. #n important!uestion is, "hat is the nature of s inventoryV #n inventory thats easy to sell "ould be less ofli!uidity concern than inventory thats hard to sell. 6he inventory turnover ratio indicates that turns its inventory over 2.? times per year or in 15: days, meanin that it takes on averae 15:days to sell inventory and convert it to cash assumin it doesnt offer its o"n credit. &n contrast,# holds its inventory on averae for 11B days, "hich means it ets its cash 22 days sooner than. Finally, # pays its payable much faster than , on averae payin its bills in B: days, versus1:: days for . 6his suest that # has is able to meet its obliations on a more timely basis than althouh difference in the payable period could be due to many factors.



36/83

+12-2=usiness # has a ross marin of 5:A, "hich means that for every dollar of sales it has its ableto enerate M:.5: per dollar of sales to cover costs other than the cost of inventory and provideprofit to its shareholderso"ners. 6his is more than "hat enerates. 6he hiher marin couldbe the result of # facin less competition or providin better service to its customers. o"ever,

has a hiher profit marin and a hiher return on assets than #. 6he hiher profit marinmeans there is more profit per dollar of sales available to the o"ners of than to the o"ners of#. 6his means that costs other than the cost of oods sold are reater for # than for . Forexample, # may have hiher rent, advertisin, or "aes and salaries. 6he hiher return on assetsmeans that is able to enerate more income per dollar invested in assets than #. 6his meansthat can enerate a certain amount of income "ith less investment in assets by the company.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-0?)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


37/83

PRO$>E0S

*12-1.yn"c:s Inc!

$alance S%eets#s of Gecember 01,

2:1@ 2*1-

8ash M@=,::: M11:,::: 12#ccountsreceivable

12=,::: 1:=,::: 11

&nventory 0::,::: 25B,::: B8apital assetsnet

D0:,::: 15?,::: 10

6otal assetsL M1,50:,::: M?:D,::: 10#ccounts

payable

M22=,::: M1B5,::: D


38/83

)teps to solve this !uestion. %ote that there are different "ays that the missin values can be determined.

1 (evenue R 8ost of sales1 P ross marin percentae

R M1,=::,:::1-.5:

R M2,=::,:::

ross arin R )ales - 8ost of )ales

R M1,:::,:::

2 %et income R (evenue x profit marin R M2,=::,::: x .2:

R M=::,:::

0 &ncome before taxes R %et income1 P tax rate R M=5?,:::1 P.2:?0

R M?2D,D?1 RM?0:,:::

&ncome tax expense R &ncome before taxes P %et income R M?0:,::: P M=::,:::

R M10:,:::

5 (etained +arnins R >penin (etained +arnins O%et &ncome - Gividends R M2=:,:::O M=::,::: - :

R M@=:,:::

= &nterest coverae ratio R ?.2:B=

?.2:B= R %et income O interest expense O income tax expenseinterest expense

?.2:B= R =::,::: O interest expense O 10:,:::interest expense

&nterest +xpense R M12:,D=? RM121,:::

? )ellin, eneral and administrative R ross marin P &ncome before taxes P &nterest +xpense

R M25D,:::

@ %umber of shares outstandin

R %et income+*) R M=::,:::M:.5:

1,2=:,:::

B &nventory 6urnover (atio R 8ost of )ales #verae &nventory

=.5@5 R M1,=::,:::+ndin inventory O M25B,:::2

M0,:::,:::=.5@5 R +ndin inventory O M25B,:::

M=5B,:5= R +ndin inventory O M25B,:::

+ndin inventory R M0::,:5= RM0::,:::



39/83

D #ccounts payable turnover R 8redit *urchases#verae #ccounts payable

@.=BD R 8redit purchases#verae accounts payable

8redit purchases R 8>) P einnin inventory O +ndin inventory

8redit purchases R M1,==2,:::

#verae accounts payable R M1,==2,:::@.=BD

#verae accounts payable R M2:5,=12

+ndin accounts payable R M22=,:25 RM22=,:::

1: 6otal e!uity R MB2=,:::

Gebte!uity R :.@00 R


40/83

*12-2

?"ligny Inc!

$alance S%eets

#s of Gecember 01,

2:1@ 2:1?8ash M0=,::: M2=,::: 11

#ccounts receivable 15:,::: 12=,::: 8

&nventory 22:,::: 1B=,::: 7

8apital assets net D0@,::: D2=,::: 12

6otal #ssets M1,002,::: M1,2?:,::: 12

#ccounts payable MD2,::: M@:,::: 8


41/83

)teps to solve this !uestion. %ote that there are different "ays that the missin values can be determined.

1 %et income R M1::,::: R (evenue x profit marin R (evenue x .1:

R M1,:::,::: R(evenue

ross arin R (evenue x ross marin percentae

R M1,:::,::: x .5=

R M5=:,:::

8ost of )ales R )ales - ross arin

R M==:,:::

2 &ncome before taxes R %et income1 P tax rate R M1::,:::1 P.2:

R M12=,:::

&ncome tax expense R &ncome before taxes P %et income R M12=,::: P M1::,:::

R M2=,:::

0 (etained +arnins R >penin (etained +arnins O%et &ncome - Gividends R M=5:,:::O M1::,::: - :

R M?5:,:::

5 %umber of shares outstandin

R %et income+*) R M1::,::::.@=

R 100,000

= &nterest coverae ratio R 5.D:?

5.D:? R %et income O interest expense O income tax expenseinterest expense

5.D:? R M1::,::: O interest expense O M2=,:::interest expense



42/83

&nterest +xpense R M02,::2 RM02,:::

? )ellin, eneral and administrative R ross marin P &ncome before taxes P &nterest +xpense

R M2D0,:::

@ &nventory 6urnover (atio R 8ost of )ales #verae &nventory

2.@1? R M==:,:::+ndin inventory O M1B=,:::2

M1,1::,:::2.@1? R +ndin inventory O M1B=,:::

M5:=,::@ R +ndin inventory O M1B=,:::

+ndin inventory R M22:,::@ RM22:,:::

B #ccounts payable turnover R 8redit *urchases#verae #ccounts payable

@.222 R 8redit purchases#verae accounts payable

8redit purchases R 8>) P einnin inventory O +ndin inventory

8redit purchases R M=B=,:::

#verae accounts payable R M=B=,:::@.222

#verae accounts payable R MB1,::2

+ndin accounts payable R MD2,::5 RMD2,:::

D 6otal e!uity R MB5:,:::

Gebte!uity R :.=B? R


43/83

*12-06he ans"ers belo" are enerali$ations. 6he current ratio can be affected by short-termborro"in arranements and available lines of credit. 6his problem is ood for discussionpurposes to help students think about the nature of different types of businesses.

a. (oers manaes to operate successfully "ith a current ratio consistently belo" one. &thas reliable cash flo"s from its cable and "ireless operations as "ell as available lines ofcredit so it does not have to maintain lare amounts of cash to meet obliations. &t haslo" inventories its a service business thouh it does have sinificant receivables.

b. #irlines, like other service businesses "ill tend to have lo"er current ratios becausethey dont have inventory. o"ever, there "ill be sinificant payables for operatin coststhat are not offset by current assets. #irlines often have a lot of cash available, "hichincreases the current ratio. )ince manymost customer transactions are for cash creditcard, accounts receivable "ill be also be lo", tendin to reduce the current ratio. 6helevel of current ratio "ill be affected by "hat the airline does "ith its cash.

c. # furniture retailer "ould likely have a hih current ratio because of the lare amountof inventory it "ould have. )ome of the inventory "ould have been already paid for sopayables "ould be lo"er than inventory. >n the other hand many furniture retailers "onthave much accounts receivable since most purchases are for cash or on ma/or credit cardsalthouh the bier chains do offer financin.

d. )oft"are developers should have lo"er current ratios because they dont haveinventory. 6hey "ill still have sinificant payables that are not offset aainst currentassets e.. they have soft"are development costs that are enerally expensed asincurred. o"ever, soft"are companies often have a lot of cash if theyre stable, "hich"ill result in an increased current ratio. )oft"are developers "ill have accountsreceivable since sales to customers "ill usually be on credit.

e. (eal estate developers "ould have lo" current ratios because they "ill tend to havefe" current assets. ost current assets "ould be receivables and cash "hereas there "illbe accounts payable for current operatin costs, taxes payable, and short-term operatinloans.

f. 8ar manufacturers "ill have hih inventory and hih accounts receivable, "hich "illlead to a hiher current ratio. 6hey "ill have hih amounts of payables as "ell because oftheir inventory, but there "ill also be other sinificant operatin costs that "ill befinanced in the short term throuh payables.



44/83

*12-5.a.

C%"rtitz >td!

Inc"me Statements

F"r t%e @ears Ended B/ne )*

2*1, 2*1- 2*1

(evenues M250,@:5 M1B?,0?: M1=2,?B?

8ost of revenuesL


45/83

b.

Epense Researc% and Capitalize and Am"rtize

'e3el"pment Researc% and 'e3el"pment

2*1, 2*1- 2*1 2*1, 2*1- 2*1

*rofit marin :.:@: -:.:0D :.11@ :.115 :.::5 :.10?

&nterest coverae ratio 11.=DB -5.BBB 22.D=2 1?.D0? :.00= 2=.@D=

+*) :.52? -:.1?0 :.52@ :.?D5 :.:1= :.5D=

Gebt-to-e!uity ratio :.@1: :.B:1 :.=:2 :.=5B :.?5= :.505(>#ad/usted for after tax cost ofinteresttax rate based on actual taxexpense D.0A -0.5A 12.:A 12.@A -:.2A 12.=A(># not ad/usted for after tax costof interest B.=A -5.:A 11.=A 12.:A :.0A 12.:A

(>+ 15.DA -?.@A [email protected] 1D.1A :.=A [email protected]

c.Ehen research and development is capitali$ed and amorti$ed, 8hortit$s performance andsolvency appears better. >f course, the actual performance and solvency of the company arentaffected by the numbers since the numbers are representations of the actual but unobservableeconomic situation. ecause 8hortit$ is expandin its (HG investments, expenses are lo"er andincome, assets, and shareholders e!uity hiher "hen the costs are capitali$ed. ecause the totalcosts have to be the same under both methods, eventually the expensin method "ill yield hiherincome than the capitali$in approach. 6he results in part b. of the !uestion sho" that allindicators are better under the capitali$e approach. 6he &F() treatment of (HG is controversial.6he outcome of (HG expenditures can be very uncertain, "hich is an important reason for the&F() re!uirement that these costs research in particular be expensed as incurred. iven the

tendency for manaers to manae earnins, there is added credibility to the approach since theuncertainty makes the /udment of the manaers more important. >n the other hand, (HG isclearly a valuable resource to a company. >ther"ise, companies "ould not invest in it. (e!uirinthat (HG costs be expensed, ho"ever, still provides no information about the prospects for the(HG.

'sers "ould find it useful if manaers had to assess the future benefits associated "ith researchand development expenditures since such an evaluation "ould ive some information about cashflo"s that "ould be enerated by the expenditures in the future.



46/83

*12-=.a. and b.

2*1,

)ales MB@=,:::

#verae total assets 5B@,=::%et income =:,:::&nterest expense 1=,:::&ncome tax rate :.2:#fter-tax interest cost 12,:::

%oteL 6he book uses t"o different measures of profit marin in this chapter. 6he solutionis provided usin both. Eith the first considerin the after tax cost of interest.

*rofit marin R M=:,::: O M12,:::MB@=,::: R @.:D A

>r *rofit marin R M=:,:::MB@=,::: R =.@1 A

#sset turnover R MB@=,:::M5B@,=::R 1.@D

(eturn on assets R WM=:,:::O M1=,::: 1-.2XM5B@,=:: R :.12@

b. &f averae assets increase by 1:A to M=0?,2=:, and sales increase 12A to MDB:,::: theasset turnover ratio re!uired "ould be 1.B0 assumin the profit marin stays the same(>#profit marin R 2:A@.:D. "ill be 2.B2.

6he profit marin re!uired to achieve the presidents ob/ectives assumin asset turnoverof 1.B0 MDB:,:::M=0?,2=: "ould be 1:.DA, :.2: R 1.B0 x profit marin

Eith a profit marin of 1:.DA net income "ould have to be MD5,B2:.MB@=,:::J1.12J1:.DA - M12,:::

c. 6he tarets that she has set re!uire an increase in sales of 12A "hile increasin the profitmarin by 0.B5 percentae points to 1:.DA or asset turnover to 2.B2, an increase of =@A,seems a difficult challene. 6o increase profit marin the company "ould have to be ableto raise its prices or increase salesto increase ross marin and decrease expenses by asinificant amount. 6o increase asset turnover it "ould have to reduce assets not increasethem.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-5?)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


47/83


48/83

*12-@

2*1, Pr"p"sed

8ash M?=,::: M1@?,05:

#verae (eceivables 0@=,::: 02?,@?0

#verae &nventory ?1:,::: =5?,BD?(evenue 2,B0D,@0: 2,B0D,@0:

8ost of )ales 1,=0=,=1@ 1,=0=,=1@

&nventory 6urnover 2.=1@ 2.B:B

Gays in inventory 15=.: 10:

(eceivables 6urnover @.=@0 B.?D:

8ollection period days 5B.2 52

#ssumin all inventory is paid "ith cash and all other accounts remain unaffected the companyscash position "ould improve by M111,05: if it reduced inventory holdin period and receivablescollection period.

)ome methods manaement can use to achieve these tarets include offerin discounts for earlypayment of receivables penalties for late payment may also be enforced, be more active inpursuin overdue receivables, and tihtenin credit re!uirements althouh this miht decreasesales. 6he inventory holdin period could be shortened by eliminatin unprofitable products anddiscountin slo" movin items.



49/83

*12-Ba. to c.

2:1= 2:1? 2:1@ 2:1B

#ccounts receivable M0::,::: M01=,::: M00:,@=: M05@,2BB

&nventory 2::,::: 21:,::: 22:,=:: 201,=2?

#ccounts payable 1=:,::: 1=@,=:: 1?=,0@? 1@0,?55

(evenue 2,:::,::: 2,1::,::: 2,01:,::: 2,=51,:::

8ost of sales 1,1::,::: 1,1==,::: 1,2B2,:=: 1,520,:@?ross marin A 5=.:A 5=.:A 55.=A 55.:A

#ccounts receivable turnover ?.B2D @.1=5 @.5D=#verae collection period =0.5= =1.:2 5B.@:&nventory turnover =.?05 =.D=? ?.2D?Gays inventory on hand ?5.@B ?1.2B [email protected]@*urchases M1,1?=,::: M1,2D2,==: M1,505,1:2#ccounts payable turnover @.=@@ B.::? B.5?:#verae payment period 5B.1@ 5=.=D 50.158ash la @:.1 ??.@ ?0.=

d. +verells business has been improvin over the four years. )ales have ro"n steadilyalthouh the ross marin percentae has decreased slihtly, by 1A. From theinformation provided, its not possible to tell ho" other costs have been manaed and theoverall profitability of the enterprise. &nventory and receivables have been "ell manaedover the period. Ehile sales have ro"n by about 2@A, receivables and inventory havero"n by less than 1?A. 6his demonstrates ood li!uidity manaement. >ver the threeyear period, the collection period has decreased by almost five days and the daysinventory on hand has decreased by almost seven days. +verell has also paid its suppliersmore !uickly. opefully this has resulted in the company bein able to take advantae ofdiscounts for prompt payment. #s a result, the cash la has decreased by seven days from@:.1 days to ?0.= days. 6he implication is that +verell "ill have more cash available tomeet its needs.

e. 6he improvements in the presented results suest ood manaement. 6he reduction inthe collection period for receivables could be due to more aressive collectiontechni!ues, chanes in credit terms that either re"ard customers for more promptpayments or provide for penalties for late payment, or elimination of poorer credit risks.6he reduction in the number of days inventory on hand reflects improved inventorycontrol procedures. &t could also indicate streamlinin of the inventory on hand so less

obsolete inventory lines are kept on hand. 6he increase in the speed in "hich payables aremade could indicate that the company is takin advantae of more prompt paymentdiscounts or is meetin supplier deadlines for payment because of cash flo"improvements.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-5D)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


50/83

f. &ts not possible to come to a conclusion as to "hether a line of credit should be offered to+verell based on the information iven. o"ever, the information provided is positive.>ther than the decline in the ross marin percentae, the company has improved itsli!uidity and manaement of li!uidity over the last three years. 6hat said, there is a lotmore to kno" before a decision could be reached.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-=:)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


51/83

*12-D.a. to c.

2*1; 2*1 2*1- 2*1,

#ccounts receivable M2,B?B,@=: M0,:DB,2=: M0,2=0,1?0M0,51=,B2

2

&nventory =,?2=,::: =,B=:,::: ?,152,=:: =,B0=,0@=#ccounts payable @2=,::: @0B,D2: @?:,0=1 @:@,BB0

(evenue 22,=::,::: 20,?2=,::: 20,1=2,=::21,DD5,B@

=

8ost of sales D,:::,::: D,5:2,@=: D,1?B,?22 B,???,?5:

#ccounts receivable turnover @.D1D @.2D1 ?.=D?

#verae collection period 5?.:D5 =:.:?= ==.00=

&nventory turnover 1.?0D 1.=2D 1.55@

Gays inventory on hand 222.@21 20B.@:D 2=2.22@

*urchases D,?2@,@=: D,5?1,122 B,0=D,=1=

#ccounts payable turnover 10.1=0 12.?21 11.0B@

#verae payment period 2@.@=: 2B.D2: 02.:=5

8ash la number of days 251.1 2=D.D 2@=.=

d. 6he companys li!uidity has been deterioratin over the last three years. 6he averaecollection period has increased by over nine days since 2:1? and the holdin period forinventory has increased by 0: days. 6he lon collection period suests that customersarent payin promptlyV &t "ill be useful to kno" if they are collectin interest. 6he time+verell is takin to pays its bills has increased by over four days. Ehile the companyappears to be payin in ood time, the information suests that itsnt takin advantaeof discounts for prompt payment. 6hese should be taken if possible. 6he net effect is that

the cash la has increased sinificantly over the three years. 6he company "ill beincurrin hih carryin costs for its inventory and receivables since they are self-financedfor such a lon time. 6his all suests a decline in li!uidity as the company takes lonerto collect from customers and holds its inventory loner "hile payin its bills in the samelenth of time. &ts recommended that the company take steps to improve their cashreserve, line of credit, or other inflo" of cash, as the path the company is on is adanerous one for li!uidity.

)ales have declined from 2:15 throuh 2:1@ "hile accounts receivable and inventoryhave increased. 6his indicates that manaement have not been dilient in collectinreceivables and controllin inventory levels. &t also raises the possibility that the

collectability of some of the receivables is in doubt and that inventory may be obsolete.6his situation may also suest poor manaement and plannin if there has been achane in the market and economic conditions faced by the company. 6he increasininventory coupled "ith the declinin sales suests manaement "as expectin ro"thbut did not et it. &nventory "as reduced in 2:1@ but even so sales declined more !uicklythan inventory. &s manaement still bein too optimisticV 6he steady increase inreceivables suests manaement is extendin credit terms to maintain business or is /ust

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-=1)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


52/83

doin a poor /ob ettin customers to pay. 6he entire situation is suestive of a "eakbusiness environment.

>ver all the company may not be enforcin their interest penalties resultin in latepayments. #lso the company should take on a more riorous credit check to extend credit

to those that are "orthy. &nventory that is movin slo" should be "ritten-off or sold at adiscount to help improve the companys cash position. #s for payables if payment is notmade "ithin the 1: days then the company should stretch their payables as lon aspossible or neotiate better terms "ith their existin vender. 6he ob/ective is to reduce thero"in cash la the company is currently experiencin as a result of theirmismanaement of these accounts.

e. #s a banker, & "ould be concerned "ith the manaement of receivables and inventory. >nthe other hand, the company is able to pay its suppliers. &f the bank "as to provide a lineof credit, it should be linked to receivables and, to a minor deree, inventory. 6here maybe sinificant obsolete inventory "e need to kno" more about the business so acceptin

the inventory as collateral may be risky. # loan secured by receivables "ould bereasonable, thouh "e "ould need to have an ain schedule so that "e lend only aainstreceivables "ith a sinificant probability of collection. >f course, "e need to find out"hether the receivables have been pleded to other creditors. Eithout kno"in thebalance in cash and havin access to a statement of cash flo"s, its difficult to assess theability of the company to meet its financial obliations in the future.

7ohn Friedlan,Financial Accounting: A Critical Approach, 5thedition *ae 1-=2)olutions anual 8opyriht 9 2:10 cra"-ill (yerson


53/83

*12-1:a.

C"mpany A C"mpany $ C"mpany C

2*1, 2*1+ 2*1, 2*1+ 2*1, 2*1+

&ncome before int. and taxes M22,5:: M2,5:: M22,5:: M2,5:: M22,5:: M2,5::

&nterest expense - - 2,5:: 2,5:: =,?:: =,?::

&ncome before taxes M22,5:: M2,5:: 2:,::: : 1?,B:: 0,2::

&ncome tax expense 5,D2B =2B 5,5:: : 0,?D? @:5

%et income loss M1@,5@2 M1,B@2 M1=,?:: M: M10,1:5 M2,5D?

Gividends paid MB,::: M5,0?B M?,12B M2,5D? M0,?02 M:

6otal assets MBD,5@2 MB?,D@? MBD,5@2 MB?,D@? MBD,5@2 MB?,D@?

)hareholdersU e!uity BD,5@2 B?,D@? ?=,5@2 ?2,D@? 00,5@2 0:,D@?

6ax rate :.22 :.22 :.22 :.22 :.22 :.22

#verae 6otal #ssets B5,@0? BB,225 B5,@0? BB,225 B5,@0? BB,225(>#

%et income O interest 1-taxaverae assets :.2:? :.:21 :.2:? :.:21 :.2:? :.:21#verae 8ommon )hareholdersU+!uity B5,@0? BB,225 ?:,@0? ?5,225 2B,@0? 02,225

(>+ :.2:? :.:21 :.2=@ : :.5=? -:.:@@

b. 6he (># of the three companies is exactly the same "hen the effects of the differentfinancin are eliminated. +ach had a profitable 2:1@ but a much less profitable 2:1B. 6hekey difference is that the results across the three companies for (>+ "ont be the same.6he effect of the financin is that the companies "ith more debt perform better than thecompany "ith no debt "hen profitability is hih and "orse "hen profitability is lo". &fthe debt costs more than the return earned on the borro"ed funds, (>+ is better "ith lessdebt. &f the borro"ed funds enerate a return larer than the cost of the debt, the moredebt the entity has the better the (>+.

c. 6he interest rate that companies and 8 are payin on their debt is 1:A. &n 2:1@, thereturn on a

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Friedlan4e SM Ch12