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Chapter 2: Financial Statements And Analysis

1. Principles of Managerial Finance Solution Lawrence J. Gitman find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui19 CHAPTER 2…
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  • 1. Principles of Managerial Finance Solution Lawrence J. Gitman find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui19 CHAPTER 2 Financial Statements And Analysis INSTRUCTOR’S RESOURCES Overview This chapter examines the key components to the stockholders' report: the income statement, balance sheet, statement of retained earnings, and the statement of cash flows. On the income statement and balance sheet, the major accounts/balances are reviewed for the student. The rules for consolidating a company's foreign and domestic financial statements (FASB No. 52) are described. Following the financial statement coverage the chapter covers the evaluation of financial statements using the technique of ratio analysis. Ratio analysis is used by prospective shareholders, creditors, and the firm's own management to measure the firm's operating and financial health. Three types of comparative analysis are defined: cross-sectional analysis, time-series analysis, and combined analysis. The ratios are divided into five basic categories: liquidity, activity, debt, profitability, and market. Each ratio is defined and calculated using the financial statements of the Bartlett Company. A brief explanation of the implications of deviation from industry standard ratios is offered, with a complete (cross- sectional and time-series) ratio analysis of Bartlett Company ending the chapter. The Dupont system of analysis is also integrated into the example. PMF Tutor: Financial Ratios This section of the Gitman Tutor generates problems to give the student practice calculating liquidity, activity, debt, profitability, and market ratios. PMF Problem-Solver: Financial Ratios This module allows the student to compute all the financial ratios described in the text. There are three options: all ratios, families of ratios, and individual ratios.
  • 2. Principles of Managerial Finance Solution Lawrence J. Gitman find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui20 PMF Templates Spreadsheet templates are provided for the following problems: Problem Topic Problem 2-4 Calculation of EPS and retained earnings Problem 2-5 Balance sheet preparation Problem 2-6 Impact of net income on a firm’s balance sheet Problem 2-8 Statement of retained earnings Problem 2-15 Debt analysis Study Guide Suggested Study Guide examples for classroom presentation: Example Topic 1 Basic ratio calculation 2 Common-size income statement 3 Evaluating ratios
  • 3. Chapter 2 Financial Statements and Analysis find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui21 ANSWERS TO REVIEW QUESTIONS 2-1 The purpose of each of the 4 major financial statements are: Income Statement - The purpose of the income statement is to provide a financial summary of the firm’s operating results during a specified time period. It includes both the sales for the firm and the costs incurred in generating those sales. Other expenses, such as taxes, are also included on this statement. Balance Sheet – The purpose of the balance sheet is to present a summary of the assets owned by the firm, the liabilities owed by the firm, and the net financial position of the owners as of a given point in time. The assets are often referred to as investments and the liabilities and owners equity as financing. Statement of Retained Earnings - This statement reconciles the net income earned during the year, and any cash dividends paid, with the change in retained earnings during the year. Statement of Cash Flows - This statement provides a summary of the cash inflows and the cash outflows experienced by the firm during the period of concern. The inflows and outflows are grouped into the cash flow areas of operations, investment, and financing. 2-2 The notes to the financial statements are important because they provide detailed information not directly available in the financial statements. The footnotes provide information on accounting policies, procedures, calculation, and transactions underlying entries in the financial statements. 2-3 Financial Accounting Standards Board Statement No. 52 describes the rules for consolidating a company's foreign and domestic financial statements. It requires U.S.-based companies to translate foreign-currency- denominated assets and liabilities into U.S. dollars using the current rate (translation) method. This method uses the exchange rate prevailing on the date the fiscal year ends (the current rate). Income statement items can be translated using either the current rate or an average exchange rate for the period covered by the statement. Equity accounts are converted at the exchange rate on the date of the investment. In the retained earnings account any gains and losses from currency fluctuations are stated separately in an equity reserve account⎯the cumulative translation adjustment account⎯and not realized until the parent company sells or closes the foreign operations. 2-4 Current and prospective shareholders place primary emphasis on the firm's current and future level of risk and return as measures of profitability, while creditors are more concerned with short-term liquidity measures of debt. Stockholders are, therefore, most interested in income statement measures, and creditors are most concerned with balance sheet measures. Management is concerned with all ratio measures, since they recognize that stockholders and creditors must see good ratios in order to keep the stock price up and raise new funds. 2-5 Cross-sectional comparisons are made by comparing similar ratios for firms within the same industry, or to an industry average, as of some point in time. Time-series comparisons are made by comparing similar ratios for a firm measured at various points in time. Benchmarking is the term used to describe this cross-sectional comparison with competitor firms. 2-6 The analyst should devote primary attention to any significant deviations from the norm, whether above or below. Positive deviations from the norm are not necessarily favorable. An above-normal inventory turnover ratio may indicate highly efficient inventory management but may also reveal excessively low inventory levels resulting in stock outs. Further examination into the deviation would be required.
  • 4. Chapter 2 Financial Statements and Analysis find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui22 2-7 Comparing financial statements from different points in the year can result in inaccurate and misleading analysis due to the effects of seasonality. Levels of current assets can fluctuate significantly, depending on a company's business, so statements from the same month or year end should be used in the analysis to ensure valid comparisons of performance. 2-8 The current ratio proves to be the better liquidity measure when all of the firm’s current assets are reasonably liquid. The quick ratios would prove to be the superior measure if the inventory of the firm is considered to lack the ability to be easily converted into cash. 2-9 Additional information is necessary to assess how well a firm collects receivables and meets payables. The average collection period of receivables should be compared to a firm's own credit terms. The average payment period should be compared to the creditors' credit terms. 2-10 Financial leverage is the term used to describe the magnification of risk and return introduced through the use of fixed-cost financing, such as debt and preferred stock. 2-11 The debt ratio and the debt-equity ratio may be used to measure the firm's degree of indebtedness. The times- interest-earned and the fixed-payment coverage ratios can be used to assess the firm's ability to meet fixed payments associated with debt. 2-12 Three ratios of profitability found on a common-size income statement are: (1) the gross profit margin, (2) the operating profit margin, and (3) the net profit margin. 2-13 Firms that have high gross profit margins and low net profit margins have high levels of expenses other than cost of goods sold. In this case, the high expenses more than compensate for the low cost of goods sold (i.e., high gross profit margin) thereby resulting in a low net profit margin. 2-14 The owners are probably most interested in the Return on Equity (ROE) since it indicates the rate of return they earn on their investment in the firm. ROE is calculated by taking net profits after taxes and dividing by stockholders' equity. 2-15 The price-earnings ratio (P/E) is the market price per share of common stock divided by the earnings per share. It indicates the amount the investor is willing to pay for each dollar of earnings. It is used to assess the owner's appraisal of the value of the firm's earnings. The level of the P/E ratio indicates the degree of confidence that investors have in the firm's future. The market/book (M/B) ratio is the market price per of common stock divided by the firm’s book value per share. Firms with high M/B ratios are expected to perform better than firms with lower relative M/B values. 2-16 Liquidity ratios measure how well the firm can meet its current (short-term) obligations when they come due. Activity ratios are used to measure the speed with which various accounts are converted (or could be converted) into cash or sales. Debt ratios measure how much of the firm is financed with other people's money and the firm's ability to meet fixed charges. Profitability ratios measure a firm's return with respect to sales, assets, or equity (overall performance).
  • 5. Chapter 2 Financial Statements and Analysis find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui23 Market ratios give insight into how well investors in the marketplace feel the firm are doing in terms of return and risk. The liquidity and debt ratios are most important to present and prospective creditors. 2-17 The analyst may approach a complete ratio analysis on either a cross-sectional or time-series basis by summarizing the ratios into their five key areas: liquidity, activity, debt, profitability, and market. Each of the key areas could then be summarized, highlighting specific ratios that should be investigated. 2-18 The Dupont system of analysis combines profitability (the net profit margin), asset efficiency (the total asset turnover) and leverage (the debt ratio). The division of ROE among these three ratios allows the analyst to the segregate the specific factors that are contributing to the ROE into profitability, asset efficiency, or the use of debt.
  • 6. Chapter 2 Financial Statements and Analysis find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui24 SOLUTIONS TO PROBLEMS 2-1 LG 1: Reviewing Basic Financial Statements Income statement: In this one-year summary of the firm's operations, Technica, Inc. showed a net profit for 2003 and the ability to pay cash dividends to its stockholders. Balance sheet: The financial condition of Technica, Inc. at December 31, 2002 and 2003 is shown as a summary of assets and liabilities. Technica, Inc. has an excess of current assets over current liabilities, demonstrating liquidity. The firm's fixed assets represent over one-half of total assets ($270,000 of $408,300). The firm is financed by short-term debt, long-term debt, common stock, and retained earnings. It appears that it repurchased 500 shares of common stock in 2003. Statement of retained earnings: Technica, Inc. earned a net profit of $42,900 in 2003 and paid out $20,000 in cash dividends. The reconciliation of the retained earnings account from $50,200 to $73,100 shows the net amount ($22,900) retained by the firm. 2-2 LG 1: Financial Statement Account Identification a. b. Account Name Statement Type of Account Accounts payable BS CL Accounts receivable BS CA Accruals BS CL Accumulated depreciation BS FA* Administrative expense IS E Buildings BS FA Cash BS CA Common stock (at par) BS SE Cost of goods sold IS E Depreciation IS E Equipment BS FA General expense IS E Interest expense IS E Inventories BS CA Land BS FA Long-term debt BS LTD Machinery BS FA Marketable securities BS CA Notes payable BS CL Operating expense IS E Paid-in capital in excess of par BS SE a. b. Account Name Statement Type of Account Preferred stock BS SE Preferred stock dividends IS E Retained earnings BS SE Sales revenue IS R Selling expense IS E
  • 7. Chapter 2 Financial Statements and Analysis find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui25 Taxes IS E Vehicles BS FA * This is really not a fixed asset, but a charge against a fixed asset, better known as a contra-asset. 2-3 LG 1: Income Statement Preparation a. Cathy Chen, CPA Income Statement for the Year Ended December 31, 2003 Sales revenue $180,000 Less: Operating expenses Salaries 90,000 Employment taxes and benefits 17,300 Supplies 5,200 Travel & entertainment 8,500 Lease payment 16,200 Depreciation expense 7,800 Total operating expense 145,000 Operating profits $ 35,000 Less: Interest expense 7,500 Net profits before taxes $ 27,500 Less: Taxes (30%) 8,250 Net profits after taxes $ 19,250 b. In her first year of business, Cathy Chen covered all her operating expenses and earned a net profit of $19,250 on revenues of $180,000. 2-4 LG 1: Calculation of EPS and Retained Earnings a. Earnings per share: Net profit before taxes $218,000 Less: Taxes at 40% 87,200 Net profit after tax $130,800 Less: Preferred stock dividends 32,000 Earnings available to common stockholders $ 98,800 Earnings per share: 162.1$ 000,85 800,98$ goutstandinsharesTotal rsstockholdecommontoavailableEarning == b. Amount to retained earnings: 85,000 shares x $0.80 = $68,000 common stock dividends Earnings available to common shareholders $98,800 Less: Common stock dividends 68,000
  • 8. Chapter 2 Financial Statements and Analysis find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui26 To retained earnings $30,800 2-5 LG 1: Balance Sheet Preparation Owen Davis Company Balance Sheet December 31, 2003 Assets Current assets: Cash $ 215,000 Marketable securities 75,000 Accounts receivable 450,000 Inventories 375,000 Total current assets $1,115,000 Gross fixed assets Land and buildings $ 325,000 Machinery and equipment 560,000 Furniture and fixtures 170,000 Vehicles 25,000 Total gross fixed assets $1,080,000 Less: Accumulated depreciation 265,000 Net fixed assets $ 815,000 Total assets $1,930,000 Liabilities and stockholders' equity Current liabilities: Accounts payable $ 220,000 Notes payables 475,000 Accruals 55,000 Total current liabilities $ 750,000 Long-term debt 420,000 Total liabilities $1,170,000 Stockholders' equity Preferred stock $ 100,000 Common stock (at par) 90,000 Paid-in capital in excess of par 360,000 Retained earnings 210,000 Total stockholders' equity $ 760,000 Total liabilities and stockholders' equity $1,930,000 2-6 LG 1: Impact of Net Income on a Firm's Balance Sheet Account Beginning Value Change Ending Value a. Marketable securities $ 35,000 + $1,365,000 $1,400,000 Retained earnings $1,575,000 + $1,365,000 $2,940,000 b. Long-term debt $2,700,000 - $ 865,000 $1,835,000
  • 9. Chapter 2 Financial Statements and Analysis find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui27 Retained earnings $1,575,000 + $ 865,000 $2,440,000 c. Buildings $1,600,000 + $ 865,000 $2,465,000 Retained earnings $1,575,000 + $ 865,000 $2,440,000 d. No net change in any accounts 2-7 LG 1: Initial Sale Price of Common Stock shareper50.9$ 300,000 $2,625,000$225,000 pricesalesInitial goutstandinsharescommonofNumber par)ofexcessincapitalinPaid stockcommonof(Par value pricesalesInitial = + = + =
  • 10. Chapter 2 Financial Statements and Analysis find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui28 2-8 LG 1: Statement of Retained Earnings a. Cash dividends paid on common stock = Net profits after taxes - preferred dividends - change in retained earnings = $377,000 - $47,000 - (1,048,000 - $928,000) = $210,000 Hayes Enterprises Statement of Retained Earnings for the Year Ended December 31, 2003 Retained earnings balance (January 1, 2003) $928,000 Plus: Net profits after taxes (for 2003) 377,000 Less:Cash dividends (paid during 2003) Preferred stock (47,000) Common stock (210,000) Retained earnings (December 31, 2003) $1,048,000 b. goutstandinsharescommonofNumber (EACS*)dividendsPreferred-after taxprofitNet =shareperEarnings 36.2$ 140,000 $47,000-$377,000 =shareperEarnings = * Earnings available to common stockholders c. shares# dividendcashTotal =shareperdividendCash 50.1$ 140,000 a)part(from$210,000 =shareperdividendCash = 2-9 LG 1: Changes in Stockholders' Equity a. Net income for 2003 = change in retained earnings + dividends paid Net income for 2003 = ($1,500,000 – $1,000,000) + $200,000 = $700,000 b. New shares issued = outstanding share 2003 – outstanding shares 2002 New shares issued = 1,500,000 – 500,000 = 1,000,000 c. 00.5$ 1,000,000 $1,000,000$4,000,000 priceissuanceAverage goutstandinshares stockommonCcapital-in-Paid priceissuanceAverage = + = ∆ ∆+∆ =
  • 11. Chapter 2 Financial Statements and Analysis find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui29 d. 00.2$ 500,000 $500,000$500,000 priceissuanceOriginal issuedsharesofNumber stockommonCcapital-in-Paid priceissuanceriginalO = + = + = 2-10 LG 2, 3, 4, 5: Ratio Comparisons a. The four companies are in very different industries. The operating characteristics of firms across different industries vary significantly resulting in very different ratio values. b. The explanation for the lower current and quick ratios most likely rests on the fact that these two industries operate primarily on a cash basis. Their accounts receivable balances are going to be much lower than for the other two companies. c. High level of debt can be maintained if the firm has a large, predictable, and steady cash flow. Utilities tend to meet these cash flow requirements. The software firm will have very uncertain and changing cash flow. The software industry is subject to greater competition resulting in more volatile cash flow. d. Although the software industry has potentially high profits and investment return performance, it also has a large amount of uncertainty associated with the profits. Also, by placing all of the money in one stock, the benefits of reduced risk associated with diversification are lost. 2-11 LG 3: Liquidity Management a 2000 2001 2002 2003 Current Ratio 1.88 1.74 1.79 1.55 Quick Ratio 1.22 1.19 1.24 1.14 Net Working Capital $7,950 $9,300 $9,900 $9,600 b. The pattern indicates a deteriorating liquidity position. c. The low inventory turnover suggests that liquidity is even worse than the declining liquidity measures indicate. Slow inventory turnover may indicate obsolete inventory. 2-12 LG 3: Inventory Management a. Sales $4,000,000 100% Cost of Goods Sold ? 60% Gross Profit $1,600,000 40% CGS $2,400,000 Average Inventory = $650,000 Inventory Turnover = $2,400,000 ÷ $650,000 Inventory Turnover = 3.69 times Average Age of Inventory = 360 ÷ 3.69 Average Age of Inventory = 97.6 days
  • 12. Chapter 2 Financial Statements and Analysis find out more at www.kawsarbd1.weebly.com Last saved and edited by Md.Kawsar Siddiqui30 b. The Wilkins Manufacturing inventory turnover ratio significantly exceeds the industry. Although this may represent efficient inventory management, it may also represent low inventory levels resulting in stockouts. 2-13 LG 3: Accounts Receivable Management a. Average Collection Period = Accounts Receivable ÷ Average Sales per Day 45 Days = $300,000 ÷ ($2,400,000 ÷ 360) Since the av
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