CHAPTER 12 FINANCIAL STATEMENT ANALYSIS PROBLEM

SOLUTIONS

Assessing Your Recall

12.1 A retrospective analysis is one in which historical data are used to
analyze the performance and liquidity of a company. A prospective
analysis is one in which data are used to forecast the future
(performance and liquidity) of a company.
12.2 A time-series analysis is one in which financial statement data for a
single
company is analyzed across time. A cross-sectional analysis is one in
which financial statement data from several companies are compared.
The companies may be from the same industry or they may be from
various sectors of the economy. Another version of the cross-sectional
analysis would be to compare the company with industry average
statistics. The cross-sectional analysis could also be conducted over
time for a combined time-series, cross-sectional analysis. So timeseries analyses are useful to study the trends of a company over time
while cross-sectional analyses are used to compare one company to
others.
12.3 The three major types of data that can be used in a time-series or a
cross-sectional analysis are:
Raw Data The raw financial statement data can be used, such as
sales revenues, expenses, etc.
Common Size Data common size data are obtained by comparing
the raw data components to some common denominator. For
instance, a common size income statement could be calculated by
comparing each line item with the sales revenue for the period. On
the balance sheet the common denominator is usually the total assets.
Ratio Data. Ratios that compare various components of the raw
financial statement data can be used as the inputs for these types of
analyses.
12.4 The formula for each ratio is as follows:
a) ROA
ROA
Rate)

Net Income + Interest Expense * (1 Tax

Average Total Assets

Net Income + Interest Expense * (1 Tax

Rate)
Sales Revenue
x

Sales Revenue

Average Total Assets

=

Profit Margin Ratio x Total Asset Turnover

b) ROE

ROE =

Net Income Preferred Dividends

Average Shareholders Equity

c) Accounts Receivable Turnover

Accounts Receivable =
Sales On Account
Turnover
Average Accounts Receivable
d) Inventory Turnover

Inventory Turnover

Cost of Goods Sold

Average Inventory

Cost of Goods Sold

Average Accounts Payable

Current Assets
Current Liabilities

e) Accounts Payable Turnover

Accounts Payable
Turnover
f) Current Ratio

Current Ratio

g) Quick Ratio

Quick Ratio

=Current Assets Inventories

Current Liabilities

h) D/E (I)

D/E (I)

=
Total Liabilities
Total Liabilities + Shareholders Equity
or

Total Liabilities
Total Assets

Total Liabilities
Total Shareholders Equity

i) D/E (II)

D/E(II)

j) D/E (III)

D/E(III)

=
Total Long-term Liabilities
Total Long-term Liabilities and Shareholders Equity

k) Times Interest Earned

Times Interest Earned =Income before Interest and Taxes

(TIE)
Interest Expense
Expense

Net Income + Taxes + Interest

Interest Expense

12.5 The amount of cash produced from operations depends upon several
factors. Three of those factors are the accounts receivable, inventory,
and accounts payable policies. The leads and lags between the cash
outflows for production and the cash inflows from collections on sales
are important in understanding the companys cash generating
capabilities. The turnover ratios, when converted into the number of
days form, provide some insight into how long these lags are for a
company. Changes in these ratios also provide information about
whether there have been significant changes in these policies or in
enforcing these policies. The accounts receivable turnover, for
instance, tells you how long, on average, it takes to collect an account
receivable. Comparing this ratio with a companys stated receivables

policy allows you to assess whether or not they are doing a good job of
collecting.

The shareholders of the company leverage their investment when they

borrow some of the money needed to invest in the assets of the company.
This works to the advantage of the shareholders if the cost to borrow the
money is less than the return that they can earn by investing in the assets of
the company. It works to their disadvantage if the cost to borrow exceeds
the return on the assets invested. ROA provides a measure of the return on
the assets of the company. As long as this return is higher than the after tax
cost of the debt the shareholders return (ROE) should be higher than the
ROA. This higher return will be evidenced by a higher ROE for the company
(higher than ROA). If the after tax, cost of borrowing exceeds the ROA then
ROE will be lower than ROA.
12.6 The ROA ratio can be broken down into two ratios: a profit margin
ratio and a total asset turnover ratio. The ratios are as follows:

ROA
Rate)

Rate)

= Net Income + Interest Expense * (1 Tax

Average Total Assets
= Net Income + Interest Expense * (1 Tax
Sales Revenue
x
=

Sales Revenue
Average Total Assets

Profit Margin Ratio x Total Asset Turnover

A retail clothing store could employ two different strategies of

obtaining a particular ROA. One strategy would be to set prices to
achieve a relatively high profit margin. Because of the high prices the
total asset turnover might not be as high as it would otherwise be
because the company may have to invest more in its stores to attract
the kind of clientele that will pay the high prices. The volume of sales
per dollar of investment (total asset turnover) may, therefore, be
lower. Another store in the same industry may adopt a different
strategy in which it charges lower prices (lower profit margin ratio) but
make up for it by not investing as much in its stores and, hopefully,
makes up for the lower profit margin with a higher volume per dollar of
investment.
12.7 The advantage of common size statements are that they make it easy
to make proportionate comparisons that are not as easy using the raw
data. For instance, in a given year both the revenues and the cost of
goods sold may increase, as evidenced by the raw data. If, however,
the cost of goods sold increases faster than the revenues the profit

margin of the company will decline. This decline could easily be seen
in a common size set of statements.

12.8 The current ratio is subject to manipulation because at year-end the

company can adjust its spending and payment patterns to produce a
current ratio that is desired. Paying off accounts payable with cash at
year-end will improve the current ratio, for instance, but may not be a
sign of improved liquidity.
12.9 The accounts payable turnover ratio is ideally calculated as follows:

Accounts Payable
Turnover

Credit Purchases
Average Accounts Payable

The problem with this calculation is that credit purchases is not a

readily available number. As a surrogate for credit purchases the cost
of goods sold number is often used. How good a surrogate this is
depends on the type of company and its credit policies. In a retail
company the cost of goods sold number will be a good surrogate for
the credit purchases if most goods are bought on credit and there is
relatively little change in the balance of accounts payable from the
beginning of the period to the end. If not all goods are purchased on
credit this surrogate will tend to overstate the turnover. There is a
further problem with this ratio in a manufacturing company. In this
case, the cost of goods sold number includes many costs other than
those associated with purchases during the period. For example
salaries, amortization, etc. Therefore, in a manufacturing company
this ratio tends to be overstated.
12.11 The earnings per share of a company is calculated by dividing the
earnings of the company by the average number of shares that were
outstanding during the period. In some companies there exists the
possibility that more shares may be issued (other than those currently
outstanding) due to agreements such as stock option plans and
convertible securities (securities such as convertible debt or
convertible preferred shares) that can, at the option of the holder, be
converted into common shares. Because of the potential to issue more
shares the calculated earnings per share based on the actual number
of shares outstanding may not truly reflect the earnings per share of
the company since it may be likely that some investors will exercise
their options or convert their debt or preferred shares into common
shares. This will have the effect of diluting earnings per share. The
purpose of basic and fully diluted earnings per share is to give the
reader of the financial statement some idea of the effect that these
conversions might have on the earnings per share number. Basic
earnings per share is a reflection of the current earnings and fully
diluted earnings per share is a reflection of the worst case scenario
assuming outstanding issuances or conversions occurred.

12.12 The lower the times interest earned ratio, the greater is the credit risk of
the
company. This relationship exists because a company that is
experiencing difficulties meeting its interest payments on existing debt
has a greater potential to default on an additional loan. From the
perspective of lenders, this greater default risk translates into a higher
assessed credit risk.

Applying Your Knowledge

12.13 a)
Year
Year
Year
Year

1:
2:
3
4

Current Ratio
$1,500 / $1,000
$2,000 / $1,250
$2,500 - $1,485
$3,000 / $1,500

=
=
=
=

1.5
1.6
1.7
2.0

Quick Ratio
($1,500 - $600) / $1,000 = 0.9
($2,000 - $1,100) / $1,250 = 0.7
($2,500 - $1,700) / $1,485 = 0.5
($3,000 - $2,200) / $1,500 = 0.5

b) The current ratio has shown an increasing trend over the four years and
can be considered respectable as seen in year 4. However, this 4 year
upward trend has been at the cost of stocking more inventory and this
has resulted in a downward trend in the quick ratio, which has become
0.5 in Year 4.
12.14 a)
Current Ratio
20x1

$300,991 / $239,789 = 1.3

20x2

$310,739 / $160,345 = 1.9

b)
Quick Ratio
20x1

($62,595 + $96,242) / $239,789

= 0.7

20x2

($67,834 + $98,666) / $160,345 = 1.0

c) Sundry incurred a net loss in 20x2 because the balance in retained

earnings decreased, although no dividends were declared. The
amount of the net loss is equal to the change in retained earnings from
the prior year, or $1,461.
d)
Debt / equity
20x1

$532,764 / $866,036 = 62%

20x2

$549,130 / $885,194 = 62%

e) Declaring a dividend is possible because the company has a

reasonable cash balance, and is in a comfortable position regarding
short-term liquidity. This can be seen from the current and quick
ratios. The debt to equity ratio is unchanged from the prior year, and
indicates that 62% of the companys assets are financed through debt.
However, because long-term debt increased in 20x2, interest
payments can be expected to rise in the future. In addition, since the
company incurred a net loss for the year, declaring a dividend is not
recommended.
12.15 a) Accounts receivable Turnover
Campton Electric:
$3,893,567 / [($542,380 + $628,132) / 2 ] = 6.65
Johnson Electrical:
$1,382,683 / [($168,553 + $143,212) / 2] = 8.87
b) Average number of days required to collect Accounts Receivable:
Campton: 365 / 6.65 = 55 days
Johnson: 365 / 8.87 = 41 days
c) Given that these companies are in the same industry, Johnson
would appear to be more efficient in collecting its accounts receivable.
d) In order to assess managements handling of the collection of
accounts receivable, it would be helpful to know the credit terms that
each company offers to its customers. This could then be compared
against the turnover in days to determine whether the credit terms are
being enforced.
12.16 a) Accounts receivable Turnover
20x0: $3,218,449 / $350,672 = 9.18
20x1: $3,585,391 / [($350,672 + $362,488) / 2] = 10.05
20x2: $3,988,432 / [($362,488 + $358,562) / 2] = 11.06
b) Average number of days required to collect Accounts Receivable:
20x0: 365 / 9.18 = 40 days
20x1: 365 / 10.05 = 36 days
20x2: 365 / 11.06 = 33 days
c) Accounts receivable turnover is increasing each year, and collection
seems to be occurring faster. To help understand these trends,
information regarding changes in credit terms, the sales mix, or the
types of customers would be helpful.

10

12.17 a)
Year
Year
Year
Year
Year

1:
2:
3
4:
5:

Inventory
$463,827
$511,125
$593,350
$679,686
$708,670

Turnover
/ $65,537 = 7.08
/ $81,560 = 6.27
/ $110,338 = 5.38
/ $166,672 = 4.08
/ $225,895 = 3.14

Number of days
365 / 7.08 = 52 days
365 / 6.27 = 58 days
365 / 5.38 = 68 days
365 / 4.08 = 89 days
365 / 3.14 = 116 days

b) The inventory Turnover has decreased over the 5 year period

suggesting a periodic increase in the time that the inventory is held.
This is not favorable. It is possible that this change could be due to a
change in the type of inventory that is being sold by the company and,
therefore, might not indicate a major problem. Information on such
changes is needed in order to comment on the management of
inventories.
12.18 a) Inventory turnover:
Green Grocers:
$8,554,921 / [($582,633 + $547,925) / 2] = 15.13
Fast Lane Foods:
$2,769,335 / [($174,725 + $195,446) / 2] = 14.96
b) Average number of days inventory is held:
Green Grocers: 365 / 15.13 = 24 days
Fast Lane Foods: 365 / 14.96 = 24 days
c) The inventory turnover for a food store should be high because
food is perishable, and must be turned over frequently so that spoilage
does not occur. Therefore, considering that inventory for these
companies is held for less than one month, this appears to be
reasonable. Both companies appear to be managing their inventory to
more or less the same degree, although Green Grocers has a slightly
higher turnover.
d) Fast inventory turnovers could be an indication that not enough
inventory is being held. Because inventory is held in order to support
the sales function, potential sales can be lost or shortages might result
in the loss of current customers if not enough inventory is maintained.

11

12.19 a) Current liabilities are $664,892, using the current ratio to compute
the amount:
Current ratio = Current assets / Current liabilities
Current ratio x Current liabilities = Current assets
Current liabilities = Current assets / Current ratio
Current liabilities = $1,462,763 / 2.20 = $664,892
b) Total debt is $2,073,399, using the debt to equity ratio (I) to
compute the amount:
Debt to equity ratio (I) = Total debt / Total assets
Total debt = Debt to equity ratio (I) x Total assets
Total debt = .58 x $3,574,825 = $2,073,399
c) Total equity is, $1,501,426 using total assets minus total liabilities
($3,574,825 - $2,073,399).
d) The company has a quick ratio of only 0.89 compared to a current
ratio of 2.20. This indicates that the company has a significant amount
of inventory or prepaid assets as a current asset on its balance sheet.
Financial institutions tend to have larger balances in cash and near
cash items, which would tend to result in a higher quick ratio and
normally do not carry large balances of inventory. This would appear
to rule out classifying the company as a financial institution. It also
appears that the company is not a service organization. Service
organizations normally do not have large amounts invested in
noncurrent assets. Since only $497,645 of the $1,431,123 increase in
total assets is attributable to an increase in current assets, $933,478
has been added to noncurrent assets during the year. Because of the
increase in noncurrent assets and the large inventory balance, it
appears the company is a merchandising or manufacturing company.
e) Net income for the year was $247,530 (1,650,200 shares x $0.15
earnings per share).
f) The companys liquidity is largely dependent upon the nature of
the inventory it holds, and the speed at which this inventory can be
sold, and the cash collected. If the inventory is liquid, then the current
ratio of 2.20 indicates that the company is in good shape for the shortterm. If the inventory is not liquid, then the quick ratio of 0.89
suggests that cash might not be present to extinguish the current
liabilities as these fall due. The overall financial position of the
company appears to be deteriorating. The quick ratio and earnings
per share have declined. The amount of debt relative to assets and
equity has increased, indicating a larger proportion of debt financing
which increases the riskiness of the company. A more thorough
analysis would be necessary to determine if the company is in serious
financial trouble.
g) Significant changes from Year 1 to Year 2 include the discrepancy
between the current and quick ratios, the use of debt to finance total
assets, the increase in noncurrent assets, and the decline in earnings
per share. The quick ratio declined although the current ratio
increased. This indicates that the company has increased its
12

investment in inventory or prepaids, also apparent from the large

increase in current assets. The companys use of debt has also
increased in Year 2 such that debt is being relied upon to a greater
extent than equity, which is not the case in Year 1. This is the result of
increased debt financing, and possible share redemptions. Noncurrent
assets also increased, and were likely financed through the issuance of
additional debt. Finally, earnings per share decreased. While the
gross margin on sales did not change significantly, the increased debt
burden undoubtedly had a major impact, resulting in a reduction in net
income and earnings per share.

12.20

a) Return on Shareholders Equity:

Year
Year
Year
Year

1:
2:
3:
4:

ROE
$200 / $6,278 = 3.2%
$503 / $9,614 = 5.2%
$1,105 / $13,619 = 8.1%
$2,913 / $24,729 = 11.8%

b) Return on assets:
Year 1:
Year 2:
Year 3:
Year 4:

Profit Margin Ratio

[$200 + $50(0.6)] / $15,472 =
1.5%
[$503 + $55(0.6)] / $19,558 =
2.7%
[$1,105 + $96(0.6)] / $21,729
= 5.4%
[$2,913 + $89(0.7)] / $28,493
= 10.4%

Total Asset Turnover

$15,472 /$19,745 = .78

ROA
1.17%

$19,558 / $25,227 = .
77
$21,729/ $33,146 = .66

2.08%

$28,493 / $67,185 = .
42

4.37%

24
25 c)

ROA and ROE have been positive and increasing over the four year
period. This would indicate improved performance over time. The
actual performance depends upon what other companies in the same
industry have been able to do in the same time period. The
improvement has come from improved profit margins for the four
years, although the asset turnover has been declining over the same
period. The company has effectively applied leverage since the ROE
exceeds the ROA in all four years.

13

3.56%

12.21

a) Return on Shareholders Equity:

ROE
$1,533 / $24,664 = 6.2%
$3,830 / $32,415 = 11.8%
$6,755 / $51,415 = 13.1%

Year 1:
Year 2:
Year 3:

b) Return on assets:
Year 1:
Year 2:
Year 3:

Profit Margin Ratio

[$1,533 + $896(0.75)] /
$42,798 = 5.2%
[$3,830 +
$1,441(0.7)] / $54,061
= 9.0%
[$6,755 +
$2,112(0.7)] / $76,023
= 10.8%

Total Asset Turnover

$42,798 / $48,744 =
0.88
$54,061 / $65,258 =
0.83

ROA
4.6%

$76,023 / $98,654 =
0.77

8.3%

7.5%

26 c)

ROA and ROE have been positive and increasing over the three
year period. This would indicate improved performance over time.
The actual performance depends upon what other companies in the
same industry have been able to do in the same time period. The
improvement has come from improved profit margins as evidenced
from the change in the profit margin ratio and the slightly declining
asset turnover. The company is also effectively applying leverage
since the ROE exceeds the ROA.

ROE

ROA

Net Income
400,000

NI + [($200,000 x 0.08) x 0.7]

$600,000

$600,000 x NI
$600,000 x NI
$200,000 x NI
Net income

=
=
=
=

$400,000 x [NI + $11,200]

$400,000 x NI + $4,480,000
$4,480,000
$22,400

b) ROE = $22,400 / $400,000 = 5.6%

c) After tax income
= $22,400
Before tax income ($22,400 / 0.7)
Interest = $200,000 x 8%
Income before interest and taxes

=
=

d) ROA

0.056 =

NI + [($300,000 x 0.06) x 0.7]

$600,000

$32,000
16,000
$48,000

NI + [Interest expense x (1 - tax rate)]

Average total assets

14

Net income =
ROE =

$21,000

$21,000 / $300,000 = 7.0%

e) Under the original assumptions, the ROA is 5.6%. In the second set
of assumptions the company can borrow at an after-tax interest cost of
4.2% (6% x 0.7). Because the company is borrowing at a cost of 4.2%
to invest in assets that generate a return of 5.6%, the ROE climbed to
7.0%.

12.23

a)
Year 1:
Year 2:
Year 3:

Year 1:
Year 2:
Year 3:

D/E (I)
$1,025 / $2,225 =
46%
$1,525 / $3,325=
46%
$2,150 / $4,350 =
49%

D/E (II)
$1,025 / $1,200 =
85%
$1,525 / $1,800 =
85%
$2,150 / $2,200 =
98%

D/E(III)
$600 / $1,800 =
33%
$1,000 / $2,800 =
36%
$1,400 / $3,600 =
39%

Times Interest Earned

$500 / $80 = 6.3
$800 / $100 = 8.0
$1,000 / $135 = 7.4

b) The company seems to be in a fairly comfortable position with

regard to its long-term debt/equity ratio (D/E III), which is increasing
slightly over the years, but not at a significant rate. There would be
some concern if this trend continues and if it accelerates. The times
interest earned ratio also indicates that the company is earning a
sufficient amount of income to meet its interest obligations. There is
no trend in either direction with the TIE ratio.

12.24

a)
Year 1:
Year 2:
Year 3:

Year 1:
Year 2:
Year 3:

D/E (I)
$1,090 / $2,590 =
42%
$1,530 / $3,030 =
51%
$1,720 / $3,520 =
49%

D/E (II)
$1,090 / $1,500 =
73%
$1,530 / $1,500 =
102%
$1,720 / $1,800 =
96%

D/E(III)
$700 / $2,200
= 32%
$1,100 / $2,600
= 42%
$1,200 / $3,000
= 40%

Times Interest Earned

$1,000 / $120 = 8.3
$1,300 / $150 = 8.7
$1,600 / $165 = 9.7

15

b) The company seems to be in a fairly comfortable position with

regard to its long-term debt/equity ratio (D/E III), which has increased
10% in Year 2 and then decreased slightly. There would be concern if
the ratio continued to increase in future years as the rate that it did in
Year 2. The times interest earned ratio also indicates that the
company is earning a sufficient amount of income to meet its interest
obligations. Since Year 1, the TIE has increased to 9.7 in Year 3, the
company can quite comfortably pay the interest out of earnings.

12.25

Key:
Increase
No Effect

Transaction
1
2
3
4
5
6
7

Decrease +
NE

Current
Ratio
*
+
*
+
+
-

Quick
Ratio
+
*
+
+
+

Inventory
Turnover
+
NE
NE
NE
NE
+

ROE

D/E(I)

NE
+
NE
NE
+
-

+
+
+

* The ratio will be affected, but the direction of the effect cannot be
determined from the information given. Since the same amount will
be added or subtracted from the numerator as well as the
denominator; the change in the ratio will depend on what the ratio was
to begin with.

12.26

Transaction
1
2
3
4
5
6
7

Current
Ratio
+
NE
*
+
NE
+

ROA
+
NE
NE
-

AR
Turnover
+
NE
NE
NE
NE
NE

ROE
+
NE
NE
NE
NE
-

D/E (I)
NE
+
+
+
NE
-

*The ratio will be affected but the direction of the effect cannot be
determined from the information given. Since the same amount will
be added or subtracted from the numerator as well as the
denominator, the change in the ratio will depend on what the ratio was
to begin with.

16

12.27
a) The amount that should be reported as basic earnings
per share for the
year is
Calculation of earnings per share:
Net income
Less preferred share dividends
[100,000 x $1.00]
Earnings available to common
Number of common shares
Earnings per share

$720,000
(100,000)
$ 620,000
900,000
$0.69

b) The convertibility of the preferred shares has relevance for

reporting earnings per share because the preferred shares might be
converted to common shares. This means that the companys net
income might have to be spread over more common shares. This
possible effect is called dilution of earnings per share. If all of the
preferred shares converted, net income would not need to be reduced
by the preferred dividends and the number of common shares would
increase by 200,000. The fully diluted earnings per share would be
$0.65 ($720,000/1,100,000).

12.28
a) Net income for 2000 = $0.46 per share x 28,500
shares = $13,110
b) Earnings per share for 2001 = $14,800 / 28,500 = $0.52 per
share
c) Earnings per share figures are usually included in the annual report
on the face of the income statement for each year reported. They are
usually reported just below net income. They could also be reported in
the notes to the financial statements although very few companies will
report earnings per share in this manner.
d) If Signal decides to split its common shares 2 for 1, then the
earnings per share must also be split in 2, because the same net
income must be spread out over twice as many shares. The 2000
earnings per share amount is also affected, because the comparative
income statement must present both earnings per share figures as
though the split had occurred in 2000. This retroactive treatment is
provided so that comparability is maintained.

17

12.29
a) Working capital = ($218,000 + $320,000 + $32,000) $165,000 = $405,000
The working capital is quite high, and indicates that there are more
than enough current assets to satisfy current liabilities. In addition,
since the company maintains a reasonably high cash balance of
$218,000, cash required to finance operations is not a concern.

b) Current ratio = $570,000 / $165,000 = 3.5

Quick ratio = ($218,000) / $165,000 = 1.3
The quick ratio assumes that the other assets are prepaid assets.
Both the current ratio and the quick ratio exceed the criteria of 2.0 and
0.8 respectively. Based on these ratios, the companys current asset
position is strong, and short-term liquidity is not a concern. In fact,
these ratios suggest that perhaps the companys investment in current
assets is more than what is required in order to support the sales
function and finance operations.
c) A change from cash to credit sales would not affect the current
ratio or quick ratio if previous cash sale customers now purchased on
account. The cash balance would decrease, and a receivable balance
would be created. In reality, if the company starts to sell on credit, its
total sales are likely to increase as it attracts new customers who
would not buy before because of the cash only policy. This would
cause both the current ratio and the quick ratio to increase. The
company will now have to manage collection of its receivables, and
establish credit terms for its customers. The accounts receivable
turnover ratio, which indicates how quickly accounts receivable are
collected, will now be affected.
d) If these balances existed following the completion of the primary
business, then most of the current assets held would be unnecessary,
and reflect poor cash and inventory management. Cash and inventory
are short-term investments that a company must make in order to
facilitate sales to customers. If sales are decreasing, then the
company should decrease its current assets.

18

12.30

a) Ratios for A-Tec and B-Sci:

A-Tech

(1)
(2)
(3)
(4)
(5)
(6)

Current ratios
Working capital
Rec. turnover
Inv. Turnover
Asset turnover
Total debt to
total assets
(7) Sh. Equity to
total assets
(8) Gross margin ratio
(9) Return on sales
(10) Return on assets
(11) Return on equity

2001
1.16
$11
31.7 times
16.6 times
2.4 times

2000
.95
($2)
45 times
22.5 times
3.2 times

Bi-Sci
2001
2.25
$30
30 times
15 times
3.6 times

86.9%

81.7%

14.2%

15.4%

13.1%
30%
10%
24.5%
186.3%

18.3%
33%
11.9%
38.5%
210.5%

85.8%
25%
10%
35.5%
41.4$

84.6%
25%
10%
38.5%
45.5%

2000
2.17
$28
30 times
15 times
3.8 times

Supporting calculations:
A-Tech:
2001
(1) Current ratio (current assets/current liabilities) 78/67
(2) Working capital (current assets current
Liabilities)
78-67
(3) Acc. receivables turnover (sales-net acc. rec.) 950/30
(4) Inventory turnover (cost of goods sold/inv.)
665/40
(5) Asset turnover (sales/total assets)
950/388
675/208
(6) Total debt to total assets (total liab./total assets)
337/388
170/208
(7) Sh. equity to total assets (Sh. equity/total assets)
38/208
(8) Gross margin ratio [(sales cost of goods sold) (950-665)
450)
/sales]
/950
(9) Return on sales (net income/sales)
95/950
(10) Return on assets (net income/total assets)
95/388
(11) Return on equity (net income/Sh. Equity)
95/51

2000
38/40

Bi-Sci:
2001
(1) Current ratio (current assets/current liabilities) 54/24
(3) Working capital (current assets current
Liabilities)
54-24
(3) Acc. receivables turnover (sales-net acc. rec.) 600/20
(4) Inventory turnover (cost of goods sold/inv.)
450/30
(5) Asset turnover (sales/total assets)
600/169
600/156
(6) Total debt to total assets (total liab./total assets)
24/156
(7) Sh. equity to total assets (Sh. equity/total assets)
145/169
132/156

2000
52/24

38-40
675/15
450/20

51/388
(675/675
80/675
80/208
80/38

52-24
600/20
450/30
24/169

19

(8) Gross margin ratio [(sales cost of goods sold) (600-450)

450)
/sales]
/600
(9) Return on sales (net income/sales)
60/600
(10) Return on assets (net income/total assets)
60/169
(11) Return on equity (net income/Sh. Equity)
60/145

(600/600
60/600
60/156
60/132

20

b) The following analysis is separated into liquidity, solvency,

leverage and profitability analysis.
Liquidity: Bi-Sci appears to be in a better liquidity position. Its current
ratio is much higher than A-Techs and its working capital is also higher.
A-Tecs current ratio and working capital have improved but they are
still lower. The accounts receivable turnover and inventory turnover
also measure liquidity because they measure the amount of time
before these items will be converted to cash in the operating cycle.
Both of these ratios remained constant for Bi-Sci in 2001. A-Tecs
ratios declined in 2001 and are now closer to Bi-Scis. It may be that
A-Tecs ratios in 2000 were unusually high and are now closer to those
of other companies.
Solvency: Bi-Sci is in a much better solvency position as measured by
the total debt to total assets and total shareholders equity to total
assets ratios. Bi-Sci is financed mostly by shares while A-Tec is
financed mostly by borrowing.
Leverage: A-Tec is using much more leverage than Bi-Sci. Since A-Tec
is financed mostly by debt, its return on equity (net
income/shareholders equity) will be much higher when the rate of
earnings exceeds the interest rate on the debt. Leverage is best
measured by comparing the return on assets to the return on equity.
With high leverage, and a return on assets in excess of interest rates,
the return on equity for a company like A-Tec will be very high. The
returns of the two companies are computed as follows:

Return on assets
Return on equity

A-Tech
2001
2000
24.5%
38.5%
186.3%
210.5%

Bi-Sci
2001
2000
35.5%
38.5%
41.4%
45.5%

Profitability: The companies are very similar in profitability measures.

The return on sales is about the same both years for both companies.
While the return on assets is the same in 2000, Bi-Sci is a little better
in 2001. However, A-Tec increased its sales by 40% in 2001 to go
along with the expansion in assets and Bi-Sci had no growth in 2001.
Determining which company is the better investment for a shareholder
depends on the amount of risk the shareholder is willing to absorb.
The return on equity for A-Tec is very high. As long as the return on
assets stays high, there will be a good return to shareholders. An
important question is will the growth in sales continue. On the other
hand, the high leverage makes A-Tec much more risky for shareholders.
Bi-Sci appears to be a much better credit risk from a lenders
standpoint. It has a much better liquidity and solvency position, less
leverage, and less risk that debts will not be paid.

21

Management Perspective Problems

12.31

The debtholder is very interested in the ability of the company

to pay off its
debts. The debt/equity ratios measure the extent to which the
company utilizes debt to finance its operations. The more debt it
incurs the higher the risk of default on a particular loan. The
debtholder would be interested in restricting the level of debt in the
company to limit the risk of default. The current ratio measures shortterm liquidity and is a measure of the companys ability to pay its
debts in the short-term. The debtholder would be very interested in
assuring that this ratio is maintained at some minimum level to insure
that payments are made on a timely basis.

12.32 Perhaps the easiest way to influence the ratio is to try to increase net
income. A change in the revenue recognition method to recognize
revenue earlier in the companys cash to cash cycle could have this
impact. Accelerating the recognition of revenue under existing
methods could also cause an increase in net income. Companies
might speed up shipments of goods, for instance, if revenues are
recognized at the time of shipment. Management could also decide to
delay the acquisition of new capital assets. When new assets replace
old ones, total assets usually increases which lowers the ROA.
12.33 From the perspective of a potential investor, the following four ratios
might be helpful:
a) ROE: This ratio indicates the rate of return that the company is
earning for its common shareholders. Potential investors should
compare the ROE for the company to the rate of return that could be
earned on a similar risk investment in another company.
b) Current ratio: This ratio tells potential investors whether the
company is likely to experience financial difficulties in the short-term.
c) Debt to equity (I): This ratio reflects the extent of debt in the
companys capital structure. Debt use imposes additional risk on
shareholders, because the company is contractually committed to
making fixed interest and principal repayments at definite points in the
future. Such commitments assume that the company is able to
generate sufficient cash from operations. In addition, as a potential
investor, a large amount of debt means that assets of the company
must first be distributed to debtholders, creating the potential that no
assets remain to satisfy the claims of shareholders. On the other
hand, the use of debt can result in increased returns to shareholders
through the use of leverage.
d) Price earnings ratio: This ratio indicates the market price of a share
per one dollar of earnings that the company generates. For a potential
investor, a high price-earnings ratio means that the market price is
based on future predicted earnings, rather than on current earnings.

22

Thus, the greater the price-earnings ratio, the higher earnings must be
in the future in order to justify the current market price.

23

12.34 From the perspective of an auditor, the following ratios might be

helpful in
identifying abnormalities:
a) ROA: This ratio reflects the rate of return that a company earns on
all assets. If this ratio is significantly different from that of other
companies in the same industry, abnormalities or fraud might exist.
This ratio should be examined through its component parts - the profit
margin ratio and the asset turnover.
b) Accounts receivable turnover: This ratio indicates the speed at
which receivables are collected. If the company has created fictitious
sales, then turnover would be much lower than expected, because the
accounts receivable associated with the fake sales are not collected.
This can alert the auditor to fraud.
c) Accounts payable turnover: This ratio reflects the speed at which
payables are paid. If the company is creating fictitious sales, then this
ratio would be much higher than expected, because the cost of goods
sold associated with the fake sales does not correspond to a portion of
accounts payable.
In general, auditors use both time-series analysis and cross-sectional
analysis to alert them to irregularities or fraud. Auditors focus on
areas where significant changes occurred from the prior year, and on
those areas that differ materially from industry averages.
12.35 Being a potential supplier that grants 30 day credit terms, you would
be most interested in the ability of the dealership to generate cash in
the short-term to satisfy its current liabilities. Thus, ratios that might
be helpful include the current ratio, quick ratio, times interest earned
ratio, and accounts payable turnover.
12.36 Ratios that would help the decision maker in arriving at a decision or to
identify areas for further analysis include:
a) Decrease in net income from:
1. a decrease in sales or an increase in cost of sales:
Gross Profit Margin
2. an increase in total operating expenses:
Gross Profit Margin and Return on Sales
Horizontal and Vertical Analysis
3. an increase in an individual operating expense:
Horizontal and Vertical Analysis
b) Sufficient cash to pay dividends and make debt payments:
Dividends to Cash Flow from Operations
Current Ratio
Quick Ratio
c) Long-term debt higher than the industry as a whole:
Debt to Equity

24

Long-term Debt to Assets

25

d) Comparison of profitability in relation to invested capital:

Return on Equity
e) Whether the decline in economic activity affected accounts
receivable collections:
Accounts Receivable Turnover
f) Whether the company was successful in reducing inventory investment:
Inventory Turnover
g) Determining which company provides more earnings per share:
Earnings Per Share
Price/earnings Ratio
h) Efficient management of inventory:
Inventory turnover

Reading and Interpreting Published Financial Statements

12.37

a)

ROA
Rate)]

Rate)]

Average Total Assets

=

Net income + [Interest expense x (1 - Tax

Sales Revenue

Sales Revenue
Average Total Assets

{[$10,105 + $27,559(1-0.43)] / $354,125} X

{$354,125 / [($616,027 + $500,748) / 2]}
0.0729 x 0.6342
4.6%

=
=
ROE

Net income + [Interest expense x (1 - Tax

Net Income - Preferred Dividends

Average shareholders equity

=
=

$10,105 / [($158,173 + $104,664) / 2]

7.7%

Inventory turnover =

$87,477) / 2]

Cost of goods sold

Average inventory

($300,935 x 50%) / [($116,770 +

1.47

Accounts receivable =
Sales
turnover
Average accounts receivable
= $354,125 / [($74,812 + $56,292) / 2]
26

= 5.4
b)

1. Current ratio
2. Quick ratio
3. D/E (I)
4. Times
interest
earned

1998
$233,793 / $141,614
= 1.65
($684 + $74,812) /
$141,614
= 0.53
($616,027 - $158,173)/
$616,027
= 74%
$46,162 / $27,559
= 1.68

1997
$169,107 / $110,710
= 1.53
($883 + $56,292) /
$110,710
= 0.52
($500,748 - $104,664) /
$500,748
= 79%
$45,391 / $26,114
= 1.74

c) CHC is using leverage to its benefit, as reflected in the fact that its
ROE exceeds its ROA. This means that the after-tax cost of borrowing
is less than the return it is able to generate through investing in
operating assets. The resulting benefit accrues to shareholders in the
form of a higher ROE.
d) The pros of investing in CHC include the fact that it is generating
cash from operations and net income has increased slightly from 1997.
The cons are that it could encounter financial difficulties in the shortterm because of its weak quick ratio and low inventory turnover.
Combined, these ratios signal that because its inventory turns over
less than 1.5 times a year, the quick ratio is a better predictor of shortterm liquidity. Also, the debt to equity ratio is high which imposes
additional long-term risk upon shareholders. Although the company
appears to be currently using leverage to the benefit of shareholders,
this could quickly change if its cost of borrowing increases or if it is
unable to generate enough of a return in order to meet debt
obligations.
e) If the Canadian dollar continues to fall relative to other currencies,
CHC can maximize profits by paying expenses in Canadian dollars and
earnings revenues in foreign currencies. Similarly CHC should hold
monetary assets in foreign currencies and owe liabilities in Canadian
dollars. Of course, financial institutions in other countries may not
want to have debt repaid in Canadian dollars. If CHC could achieve
these holdings, it would benefit from the falling Canadian dollar.

27

12.38

a)

ROA
Rate)]

Net income + [Interest expense x (1 - Tax

Average Total Assets

Rate)]

Net income + [Interest expense x (1 - Tax

Sales Revenue

$1,552,272

Sales Revenue
Average Total Assets

$324 + [$21,189 x (1 - .251)] X

$1,552,272

$734,080)/2

.01 x 2.0462

2%

($783,124 +

Tax rate was calculated from 1997 at 25% ($11,325/$45,315)

ROE

Net Income - Preferred Dividends

Average shareholders equity

$324
($228,117 + $230,931)/2

0.14%

Inventory turnover =

Cost of goods sold

Average inventory

$1,423,248
($237,312 + $182,157)/2

6.79

Accounts receivable = Sales

turnover
Average accounts receivable

b)

1. Current ratio
2. Quick ratio
3. D/E (I)

$1,552,272
($201,218 + $203,196)/2

7.68

1998
$536,038 / $383,039
= 1.40
$286,385 / $383,039
= 0.75
$555,007/ $783,124

1997
$510,024 / $309,771
= 1.65
$316,246 / $309,771
= 1.02
$503,149 / $734,080

28

4. Times
interest
earned

= 71%
$19,298 / $21,189
= 0.91

= 69%
$53,464 / $8,149
= 6.56

29

c) Western Star Trucks does not appear to be in particularly good financial

condition. The company incurred a net loss before taxes, compared to a net
income of $33,990 and $36,523 in 1997 and 1996 respectively. The reasons
for the sharp decline in income seem to be large selling and administrative
expenses and a large interest expense. The times interest earned ratio
reflects this increase in interest expense, and earnings before interest and
taxes are insufficient to make interest payments in 1998. The quick ratio has
also declined in1998, serving as a further indication of possible cash flow
problems. This is also confirmed through an examination of the cash flow
statement, which reveals a net decrease in cash of $92,027.
d) Assuming a tax rate of 25%, the ROA is 2% whereas the ROE is .
14%. The fact that the ROE is lower than the ROA is an indication of
negative leverage. Western Star Trucks is earning 2% on its assets.
Because its cost of borrowing is more than 2%, the ROE is less than
2%.
e) If the Canadian dollar were to strengthen relative to the U.S. dollar,
the Canadian production with Canadian dollar costs would increase
relative to foreign currencies. As it exports much of its products, these
products would tend to be priced higher and Western Star could lose
markets and sales. These trends would tend to be reduced by the
parts purchased outside Canada, and they would cost less in Canadian
dollar terms. If the Canadian dollar weakened relative to the U.S.
dollar, the exact opposite would occur. The Canadian production costs
would be relatively cheaper and sales in foreign currencies would be
worth more. These trends would be reduced by the parts purchased
outside Canada.

30

12.39
a)
ROA
Rate)]

Average Total Assets

=

Rate)]

Net income + [Interest expense x (1 - Tax

Net income + [Interest expense x (1 - Tax

Sales Revenue

X
=
$76,022,656

Sales Revenue
Average Total Assets
$6,754,540 + ($2,112,129 x .72) X
$76,022,656

$71,257,880)/2

ROE

($105,654,710 +

0.1089 X 0.8594

9.4%

Net Income - Preferred Dividends

Average shareholders equity

$6,754,540
($51,414,975 + $32,460,890)/2

16.1%

Inventory turnover =

Cost of goods sold

Average inventory

$34,574,580
($11,972,472 + $8,466,950)/2

3.38

Accounts receivable = Sales

turnover
Average accounts receivable
=

$76,022,656
($10,298,798 + $10,341,943)/2

= 7.37
b)

1. Current ratio
2. Quick ratio
3. D/E (I)

1998
$23,573,581 /
$24,774,714
= 0.95
$10,298,798 /
$24,774,714
= 0.42
$54,239,735/

1997
$19,281,998 / $18,131,277
= 1.06
$10,341,943 / $18,131,277
= 0.57
$38,796,990 / $71,257,880

31

4. Times
interest
earned

27

$105,654,710
= 51%
$11,448,881 / $2,112,129
= 5.42

= 54%
$6,182,659 / $1,441,847
= 4.29

c) Sleeman Breweries appears to be in very good financial condition.

It is making high profits and its net income nearly doubled from 1997
to 1998. Its risk from debt appears to be quite moderate, since it is
able to pay its interest expense 5.4 times from before-interest
operating income in 1998. It is, however, operating without any cash.
Instead, it appears to be making use of a line of credit. It is generating
a positive cash flow from operations, $6,901,849 but it is spending
more than that on acquisitions. Its debt has therefore increased. To
decide if we should invest in this company, we would want to know the
future prospects of its industry, including new products and
competition.
d) Sleeman breweries uses leverage well, as its ROE is 16.1%
compared to an ROA of 9.4%. This means that the company is able to
borrow at a lower rate than it earns through investing in operating
assets. The resulting benefit accrues to shareholders in the form of a
higher ROE. The companys average interest rate is 3.89%
($2,112,129 / $54,239,735). Since it is able to earn 9.4% on its assets,
it is beneficial for the company to include debt in its financial structure.

32

e) Big Rock Brewery

ROA
=
Net income + [Interest expense x (1 - Tax
Rate)]
Average Total Assets
Rate)]

Net income + [Interest expense x (1 - Tax

Sales Revenue

X
=
$26,466,241

Sales Revenue
Average Total Assets
($556,745) + ($661,640 x .554) X
$26,466,241

$31,919,676)/2

ROE

-0.0072 X 0.8665

-0.62%

Net Income - Preferred Dividends

Average shareholders equity

($556,745)
($16,447,657 + $17,731,383)/2

-3.3%

Inventory turnover =

($29,165,835 +

Cost of goods sold

Average inventory

$7,691,231
($2,050,703 + $2,270,909)/2

3.56

Accounts receivable = Sales

turnover
Average accounts receivable
=

$16,644,881
($1,548,486 + $1,302,336)/2

= 11.7

33

1. Current ratio
2. Quick ratio
3. D/E (I)
4. Times
interest
earned

1999
$4,115,116 / $2,294,778
= 1.79
$1,630,628 / $2,294,778
= 0.71
$12,718,178/ $29,165,835
= 44%
($123,605) / $661,640
= -0.19

1998
$4,887,382 /
= 2.48
$2,213,275 /
= 1.12
$14,188,293
= 44%
$1,347,546 /
= 1.60

$1,972,393
$1,972,393
/ $31,919,676
$841,565

Because of the loss suffered by Big Rock in 1999, its ROE and ROA are
both negative. On this measure alone, Sleeman Breweries appears to
be doing much better. The inventory turnover for the two companies is
very similar. Big Rock appears to be more efficient in its collection of
accounts receivable with a ratio of 11.7 compared to Sleemans 7.37.
Big Rocks short-term liquidity is better at 1.79 and .71 for its current
and quick ratios compared to Sleemans at .95 and .42. Both
companies carry similar amounts of debt with Big Rock at about 44%
and Sleeman just over 50%. Sleemans times interest earned ratio is
much healthier than Big Rocks although Big Rock has been trying to
remedy this situation by paying down its debt. Its interest expense
dropped approximately 25% in the last year.
At the time of the financial statements Sleeman Breweries was
healthier. It had positive earnings and a good use of leverage. Big
Rock, because of its net loss for the year, needs to do some financial
rebuilding.

34

12.40

a)

ROA
Rate)]

Average Total Assets

=

Rate)]

Net income + [Interest expense x (1 - Tax

Net income + [Interest expense x (1 - Tax

Sales Revenue

Sales Revenue
Average Total Assets

$14,455 + ($4,045 x .554) X

$328,565
$328,565
($347,339 +

0.0508 X 1.1431

5.8%

Net Income - Preferred Dividends

Average shareholders equity

$14,455
($126,456 + $114,073)/2

12%

$227,525)/2

ROE

Inventory turnover =

Cost of goods sold

Average inventory

$254,441
($45,376 + $37,082)/2

6.17

Accounts receivable = Sales

turnover
Average accounts receivable
=

$328,565
($81,394 + $56,966)/2

= 4.75
b)

1. Current ratio
2. Quick ratio
3. D/E (I)
4. Times

1998
$137,914 / $119,398
= 1.16
$89,799 / $119,398
= 0.75
$220,883/ $347,339
= 64%
$29,503 / $4,045

1997
$110,722
= 2.07
$71,946 /
= 1.35
$113,452
= 50%
$23,556 /

/ $53,432
$53,432
/ $227,525
$1,311

35

interest
earned

= 7.29

= 17.97

28 c)

Tritech appears to be in fairly good financial condition. It is earning

5.8% on total assets, which, with good use of leverage, results in a
return on shareholders equity of 12%. It does not appear to have high
risk from liabilities as evidenced by the 7.29 times interest earned
ratio. Both the current and quick ratios are reasonable, and the
operating activities are producing a net inflow of cash. Tritech has a
net cash shortage for1998 which appears to result from investing in
fixed assets. We should learn more about the companys industry, its
products, plans, markets, and competition before we decide to invest.
d) Tritech currently has positive benefits from leverage, which
increases its ROA of 5.8% to an ROE of 12%. The interest rate paid on
long-term debt in 1998 appears to be $3,652 / ($69,682 + $10,924) =
4.5%. Interest on current bank indebtedness appears to be $393 /
$39,257 = 1%.
e)
(i.) If the Canadian dollar strengthened against the US dollar by 5%,
and if the product prices remained the same, the effect would be to
lower the Canadian value of the US sales. The effect would be to lower
sales and Income before Minority Interest and Income Taxes by (75% x
$328,565) x 5% = $12,321.
(ii) If the Canadian dollar weakened against the US dollar by 5%, and
if the product prices remained the same, the effect would be to
increase the Canadian value of the US sales. The effect would be to
increase sales and Income before Minority Interest and Income Taxes
by (75% x $328,565) x 5% = $12,321.

36

12.41

a)

ROA
Rate)]

Average Total Assets

=

Rate)]

Net income + [Interest expense x (1 - Tax

Net income + [Interest expense x (1 - Tax

Sales Revenue

Sales Revenue
Average Total Assets

Note: Since interest expense is not disclosed separately, it is assumed

to be zero for the purposes of this calculation.

ROE

$22,568 x
$314,496
$314,496 ($159,506 + $142,727)/2

0.0718 X 2.0811

15%

Net Income - Preferred Dividends

Average shareholders equity

$22,568
($100,056 + $86,965)/2

24%

Inventory turnover =

Cost of goods sold

Average inventory

$244,065
($45,094 + $26,057)/2

6.86

Accounts receivable = Sales

turnover
Average accounts receivable
=

$314,496
($54,125 + $66,096)/2

= 5.23
b)

1. Current ratio
2. Quick ratio
3. D/E (I)

1998
$99,219 / $43,190
= 2.30
$54,125 / $43,190
= 1.25
$59,450/ $159,506
= 37%

1997
$111,731 / $53,760
= 2.08
$85,674 / $53,760
= 1.59
$55,762 / $142,727
= 39%

37

c) Enerflex appears to be in strong financial condition. However, net

income decreased slightly from 1997 to 1998, which is attributable to
a decline in revenues. Other than this, the company is healthy. The
current ratios and quick ratios are strong, indicating that short-term
liquidity is not a concern. The debt to equity ratios are also low, and
interest expense is more than offset from interest income on
investments. The companys cash position is negative in 1998, mainly
as the result of investments in property, plant, and equipment. Before
investing in Enerflex, we would want to know more about its markets,
products, and competitors. Furthermore, the reason for the decline in
revenues should be identified to determine whether this is a trend.
d) If Enerflex had used common shares rather than long-term debt, it
would have issued an additional 7,922,078 shares [Average issue
price is $34,678,000 / 15,019,000 = $2.31. Additional shares =
$18,300,000 / $2.31 = 7,922,078]. Total common shares would have
been 7,922,078 + 15,019,000 = 22,941,078. New earnings per share
would be $22,568,000/22,941,078 = $0.98. This compares to the
actual EPS of $1.50. With a multiple of 20, the market price per share
would have been reduced by ($1.50 - $0.98) x 20 = $10.40. Thus,
Enerflex appears to have made a decision to use some long-term debt
financing instead of common shares and that decision results in a
higher market price per share of its stock.

38

12.42

a)

ROA
Rate)]

Average Total Assets

=

Rate)]

Net income + [Interest expense x (1 - Tax

Net income + [Interest expense x (1 - Tax

Sales Revenue

Sales Revenue
Average Total Assets

Note: Since interest expense is not disclosed separately, it is assumed

to be zero for the purposes of this calculation.

ROE

$5,211
$40,672

$40,672
($60,751 + $48,456)/2

0.1281 X 0.7449

9.5%

Net Income - Preferred Dividends

Average shareholders equity

$5,211
($47,041 + $41,435)/2

11.8%

Accounts receivable = Sales

turnover
Average accounts receivable
=

$40,672
($9,489 + $11,250)/2

= 3.92
b) There is no Finished Goods Inventory as Mosaid designs for custom
orders. Thus it does not produce for inventory, it only produces for
specific orders. As soon as the chips are finished, they belong to the
customer and become expenses. Thus inventory turnover is not
meaningful. Inventory turnover is meaningful only for companies that
produce for stockpiling for later sale.
c)

1. Current ratio
2. Quick ratio
3. D/E (I)

1998
$39,105 / $7,407
= 5.28
$33,117 / $7,407
= 4.47
$13,710/ $60,751
= 23%

1997
$38,309 / $6,308
= 6.07
$33,243 / $6,308
= 5.27
$7,021 / $48,456
= 14%

39

d) Mosaid uses very little leverage, as evidenced by the ROA being

9.5% and ROE 11.8%. In contrast, Enerflex has a relatively higher
leverage, with ROA of 15% and ROE of 24%. Note that Mosaid does
not need debt as it has substantial cash and short-term marketable
securities. Enerflex is in a cash deficit position. The comparison
between the two companies may not be appropriate because they are
not manufacturing the same products.
e)
If Mosaid will earn that same ROA, it cannot pay a higher
interest rate than its ROA, so it should not pay more than 9.5% after
tax.
(i.)

To raise $10,000,000 from new shares, assuming a multiple of

20, it should be able to sell these shares at 20 x $0.73 earnings per
share = $14.60 each. Thus Mosaid would need to sell $10,000,000 /
$14.60 = 684,932 shares at $14.60.
(ii.)

New net income would be 9.5% x (60,751 + 10,000) = $6,721

with shares and $6,721 - [(10% x 10,000) x (1 - 3,012 / 8,560)] =
$6,073 with 10% debt. New ROE would be $6,721 / [(47,041 + 6,721 5,211 + 10,000) + 41,435] / 2 = $6,721 / $49,993 = 13.4% with
shares and $6,073 / [(47,041 + 6,073 - 5,211) + 41,435] / 2 = $6,073 /
$44,669 = 13.6% with debt. Thus the new debt would increase the
leverage to the benefit of shareholders. To decide if new equity or
debt should be used is not an easy choice in this case. It appears to
be slightly preferable to use debt to benefit from the additional
leverage.
(iii.)

12.43

a)

ROA
Rate)]

Rate)]

Net income + [Interest expense x (1 - Tax

Average Total Assets

Net income + [Interest expense x (1 - Tax

Sales Revenue

Sales Revenue
Average Total Assets

$13,525 + ($135,191 x .31) X

$783,800
$783,800
($3,201,224 +
=
.07 x 0.2774

1.9%

$2,450,201)/2

Accounts receivable
turnover

=
=

Sales
Average accounts receivable
$783,800

40

($59,632 + $45,550)/2
=

14.9

b) Inventory turnover would not be meaningful as Shaw Cable does

not produce for inventory. Its main business is distributing cable
television signals. Inventory turnover is meaningful only for
companies that produce for stockpiling for later sale.
c)

1. Current ratio
2. Quick ratio
3. D/E (I)

1998
$116,838 / $306,143
= 0.38
$85,686 / $306,143
= 0.28
$1,785,627/ $3,201,224
= 56%

1997
$62,582 / $261,123
= 0.24
$45,550 / $261,123
= 0.17
$1,870,825 / $2,450,201
= 76%

d) This company appears to be a risky investment from a short-term

perspective because its current and quick ratios are very poor, and
indicate that the company might experience cash flow problems when
its current liabilities become due. In particular, the total of its current
assets are insufficient to cover either accounts payable and accrued
liabilities or the current portion of long-term debt. This means that
additional short-term financing must be obtained for the company to
remain solvent. In addition, the return on assets of 1.9% is unlikely to
compensate debtholders and shareholders for the risk that they bear.
Finally, cash provided from operations of $128,737 does not even
offset the interest expense of $135,191, meaning that the company
could have difficulty meeting its contractual obligations relating to
debt.
Beyond the Book
12.44 Answers to this question will depend on the company selected.
Critical Thinking Questions
12.45 General Comments
The purpose of this question is to increase the students awareness
that the current GAAP guidelines that allow alternative ways of
recording transactions and reporting elements reduce the
comparability between entities. Students are asked to discuss the
prop and cons of comparability with reference to financial statement
analysis.
Solution Outline
One of the benefits of the comparability occurs in ratio analysis. If you
are analyzing the financial statements of two or more companies by

41

undertaking a ratio analysis, the ratios will be comparable among the

companies only if the original data are comparable. The original data
will be comparable only if they were produced using the same
accounting methods. Thus, for accounting information to be most
useful to users, companies must be forced to use the same set of
accounting methods.
However, if all companies are forced to use the same accounting
methods, the resulting accounting numbers may not give an accurate
portrayal of the underlying economic events. No two companies have
identical sets of economic transactions, so their financial statements,
which are intended to be summarized numeric portrayals of a
companys activities, cannot be expected to be identical. Different
economic transactions require different accounting treatments, so
restricting the accounting methods that companies are permitted to
use will inevitably result in some transactions not being portrayed
accurately in the financial statements. This situation would result in
comparable ratios that are misleading as the accounting information
that produced the ratios may not be properly portraying the underlying
economic events.
On the basis of this argument, regulators should not attempt to restrict
the number or types of accounting methods that companies can use.
12.46 General Comments
The purpose of this question is to require students to examine
nonfinancial issues that may impact the interpretation of the analysis
of financial statement amounts. The specific issue addressed in this
question is the creation of captive finance subsidiaries and their
impact on the leverage that the company can achieve.
A major reason that a company forms a finance subsidiary is the
potential for increasing leverage at both the time of formation and in
subsequent years. Upon forming a finance subsidiary, the probability
that a parent company will exceed the limits imposed by existing debt
covenants will be lessened. In fact, a parent company should be able
to borrow more because it is further from violating debt covenants
than before the finance subsidiary was formed. Furthermore, the initial
increase in leverage from forming a finance subsidiary is continued
beyond the term of existing debt because the parent company
transfers much of its debt (usually only short-term) and high quality
short-term receivables to the subsidiary. The parent company reduces
its debt/equity ratio in this transfer and the subsidiary is able to
sustain a high or higher than normal debt/equity ratio because it
now has higher quality assets dedicated solely to service that debt.
A captive finance subsidiary primarily finances its own parent
companys operations.

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