Beruflich Dokumente
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Solutions to Questions
17-1 Horizontal analysis involves examining high rate of return; thus, one would expect it to
how a particular item on a financial statement have a low dividend payout ratio.
such as sales revenues behaves over time.
Vertical analysis involves analysis of items on an 17-5 The dividend yield is the return on an
income statement or balance sheet for a single investment from simply collecting dividends. The
year. In vertical analysis, all the items on the other source of return on an investment is
financial statement are stated as a percentage increases in market value. The dividend yield is
of a single item such as sales revenues or total computed by dividing the dividend per share by
assets. the current market price per share of common
stock.
17-2 By looking at trends, an analyst hopes
to get some idea of whether a situation is 17-6 Financial leverage results from
improving, remaining the same, or deteriorating. borrowing funds at an interest rate that differs
Such analyses can provide insight into what is from the rate of return on assets acquired using
likely to happen in the future. Rather than those funds. If the rate of return on the assets is
looking at trends, an analyst may compare one higher than the interest rate at which the funds
company to another or to industry averages were borrowed, financial leverage is positive and
using common-size financial statements. stockholders gain. If the return on the assets is
lower than the interest rate, then financial
17-3 Price-earnings ratios are influenced by leverage is negative and the stockholders lose.
how investors see a firms future prospects.
Current reported earnings are generally 17-7 How a stockholder would feel would
considered to be useful only so far as they can depend in large part on the stability of the firm
assist investors in judging what will happen in and its industry. If the firm is in an industry that
the future. For this reason, two firms might have experiences wide fluctuations in earnings, then
the same current earnings, but one might have stockholders might be very pleased that no
a much higher price-earnings ratio if investors interest-paying debt exists in the firms capital
believe it has superior future prospects. In some structure. In hard times, interest payments
cases, firms with very small current earnings might be very difficult to meet, or earnings
enjoy very high price-earnings ratios. This is might be so poor that negative leverage would
simply because investors view these firms as result.
having very favorable prospects for earnings in On the other hand, firms with stable
future years. By definition, a stock with current earnings that do not take on interest-paying
earnings of $4 and a price-earnings ratio of 20 debt may be shortchanging their stockholders. If
would be selling for $80 per share. the assets in which debt sources of funds are
invested can earn at a rate greater than the cost
17-4 A company in a rapidly growing of the debt, then the stockholders can enjoy the
technological industry probably would have benefits of positive leverage. In rapidly
many opportunities to invest its earnings at a expanding industries, profits are often very
good, thereby minimizing the possibility of
The McGraw-Hill Companies, Inc., 2003. All rights reserved.
Solutions Manual, Chapter 17 923
negative leverage. A company with reasonable 17-10 The current ratio would probably be
prospects for good earnings that will not take on highest during January, when both current
interest-bearing debt also places heavy assets and current liabilities are at a minimum.
limitations on its own ability to grow, due to the During peak operating periods, current liabilities
fact that its sources of new investment funds generally include short-term borrowings that are
will be limited to current earnings and new used to temporarily finance inventories and
issues of stock. receivables. As the peak periods end, these
short-term borrowings are paid off, thereby
17-8 It is more difficult to obtain positive enhancing the current ratio.
financial leverage from preferred stock than
from long-term debt due to the fact that interest 17-11 A 2-to-1 current ratio might not be
on long-term debt is tax deductible, whereas adequate for several reasons. First, the
dividends paid on preferred stock are not tax composition of the current assets may be
deductible. heavily weighted toward slow-turning inventory,
or the inventory may consist of large amounts of
17-9 No, the stock is not necessarily obsolete goods. Second, the receivables may be
overpriced. Book value represents the large and of doubtful collectibility, or the
cumulative effects on the balance sheet of past receivables may be turning very slowly due to
activities, evaluated using historical prices. The poor collection procedures.
market value of the stock reflects investors
beliefs about the companys future earning
prospects. For most companies market value
exceeds book value because investors anticipate
future growth in earnings.
1. 2002 2001
Sales .............................................................................
100.0% 100.0 %
Less cost of goods sold ...................................................
63.2 60.0
Gross margin .................................................................
36.8 40.0
Selling expenses.............................................................
18.0 17.5
Administrative expenses ................................................. 13.6 14.6
Total expenses ...............................................................
31.6 32.1
Net operating income ..................................................... 5.2 7.9
Interest expense ............................................................
1.4 1.0
Net income before taxes ................................................. 3.8% 6.9 %
1. Current assets
($80,000 + $460,000 + $750,000 + $10,000) ...............$1,300,000
Current liabilities ($1,300,000 2.5) ............................... 520,000
Working capital ..............................................................$ 780,000
$533,000
= =10.9% (rounded)
$4,900,000
2. Return on common stockholders equity:
Net income as reported ..................................................
$ 470,000
Less preferred dividends: 7% $800,000 ....................... 56,000
Net income remaining for common (a) ............................$ 414,000
Average stockholders equity:
1/2 ($3,100,000 + $2,900,000) ....................................
$3,000,000
Less average preferred stock ..........................................
800,000
Average common stockholders equity (b) ........................
$2,200,000
Return on common stockholders equity (a) (b) ............
18.8% (rounded)
365 days
=26.1 days (rounded)
14 times
5. Inventory turnover:
Cost of goods sold $1,260,000
= =4.5 times
Average inventory $280,000
365 days
=81.1 days to turn (rounded)
4.5 times
6. Debt-to-equity ratio:
Total liabilities $500,000
= =0.63 to 1 (rounded)
Total stockholders' equity $800,000
7. Times interest earned:
Earnings before interest
and income taxes $180,000
= = 6.0 times
Interest expense $30,000
$126,000
= =10.5%
$1,200,000
2. Return on common stockholders equity:
Return on common = Net income - Preferred dividends
stockholders' equity Average common stockholders' equity
$105,000
=
1/2 ($725,000+$800,000)
$105,000
= =13.8% (rounded)
$762,500
3. Financial leverage was positive, since the rate of return to the common
stockholders (13.8%) was greater than the rate of return on total assets
(10.5%). This positive leverage is traceable in part to the companys
current liabilities, which may carry no interest cost, and to the bonds
payable, which have an after-tax interest cost of only 7%.
10% interest rate (1 0.30) = 7% after-tax cost.
2. The Effect on
Working Current Acid-Test
Transaction Capital Ratio Ratio
(a) Declared a cash dividend ................................................
Decrease Decrease Decrease
(b) Paid accounts payable ....................................................
None Increase Increase
(c) Collected cash on accounts
receivable ...................................................................
None None None
(d) Purchased equipment for
cash ...........................................................................
Decrease Decrease Decrease
(e) Paid a cash dividend
previously declared ......................................................
None Increase Increase
(f) Borrowed cash on a short-
term note ...................................................................
None Decrease Decrease
(g) Sold inventory at a profit ................................................
Increase Increase Increase
(h) Wrote off uncollectible
accounts .....................................................................
None None None
(i) Sold marketable securities at
a loss..........................................................................
Decrease Decrease Decrease
(j) Issued capital stock for cash Increase Increase Increase
(k) Paid off short-term notes ................................................
None Increase Increase
3. The following points can be made from the analytical work in parts (1)
and (2) above:
The company has improved its profit margin from last year. This is
attributable to an increase in gross margin, which is offset somewhat by
an increase in operating expenses. In both years the companys net
income as a percentage of sales equals or exceeds the industry average
of 4%.
Although the companys working capital has increased, its current
position actually has deteriorated significantly since last year. Both the
current ratio and the acid-test ratio are well below the industry average,
and both are trending downward. (This shows the importance of not
just looking at the working capital in assessing the financial strength of
a company.) Given the present trend, it soon will be impossible for the
company to pay its bills as they come due.
c. Leverage is positive for this year, since the return on common equity
(9.2%) is greater than the return on total assets (6.8%). For last
year, leverage is negative since the return on the common equity
(4.9%) is less than the return on total assets (5.1%).
1. HEDRICK COMPANY
Comparative Balance Sheets
This Year Last Year
Current assets:
Cash ...........................................................................
5.6% 8.5%
Marketable securities....................................................
0.0 2.0
Accounts receivable, net ...............................................
15.8 12.1
Inventory ....................................................................
22.8 16.1
Prepaid expenses .........................................................
1.4 1.2
Total current assets ........................................................
45.6 39.9
Plant and equipment, net ................................................
54.4 60.1
Total assets ....................................................................
100.0% 100.0%
Current liabilities ............................................................
22.8% 18.5%
Bonds payable, 10% .......................................................
21.1 20.2
Total liabilities ................................................................
43.9 38.7
Stockholders equity:
Preferred stock, 8%, $30 par value ...............................
10.5 12.1
Common stock, $40 par value.......................................
35.1 40.3
Retained earnings ........................................................
10.5 8.9
Total stockholders equity ................................................
56.1 61.3
Total liabilities and equity ................................................
100.0% 100.0%
Note: Columns do not total down in all cases due to rounding.
2. HEDRICK COMPANY
Comparative Income Statements
This Year Last Year
Sales .............................................................................
100.0 % 100.0%
Less cost of goods sold .....................................................
80.0 79.3
Gross margin ....................................................................
20.0 20.7
Less operating expenses ...................................................
10.1 12.5
Net operating income........................................................
9.9 8.2
Less interest expense........................................................
2.3 2.4
Net income before taxes ...................................................
7.6 5.8
Less income taxes (30%) ..................................................
2.3 1.7
Net income.......................................................................
5.3 % 4.0%*
*Column does not total down due to rounding.
2. a.
Net income ....................................................................
$525,000 $420,000
Add after-tax cost of interest paid:
$120,000 (1 0.30) .................................................
84,000 84,000
Total (a) ........................................................................
$609,000 $504,000
Average total assets (b) ..................................................
$4,467,500 $3,600,000
Return on total assets (a) (b) ......................................
13.6% 14.0%
a. The working capital is increasing, but both the current ratio and the
acid-test ratio have deteriorated significantly over the last year. (This
shows the danger of relying on working capital alone in assessing the
well-being of a company.) With an acid-test ratio of only 0.68 to 1, it
is not surprising that the company is having difficulty paying its bills.
The company may be only months away from being forced into
bankruptcy.
3. Despite the problems noted in (2) above, the authors would approve the
loan. With the help of the $250,000 in new funds, the company should
have breathing room to tighten up the collection of its accounts
receivable and reduce its inventory. If the receivables and inventory are
brought under control, then several hundred thousand dollars should
become available either to pay off the loan or to further strengthen the
companys current financial condition. This is not a hopeless situation; it
is simply a situation where a good company has allowed control over
certain key assets to slip over the last year or so.
TANNER COMPANY
Income Statement
For the Year Ended December 31
Key
Sales .............................................................................
$2,700,000
Less cost of goods sold ..................................................
1,800,000 (h)
Gross margin .................................................................
900,000 (i)
Less operating expenses ................................................
585,000 (j)
Net operating income .....................................................
315,000 (a)
Less interest expense .....................................................
45,000
Net income before taxes ................................................
270,000 (b)
Less income taxes (40%) ...............................................
108,000 (c)
Net income ....................................................................
$ 162,000 (d)
TANNER COMPANY
Balance Sheet
December 31
Current assets:
Cash...........................................................................
$ 80,000 (f)
Accounts receivable, net ..............................................
200,000 (e)
Inventory....................................................................
320,000 (g)
Total current assets........................................................
600,000 (g)
Plant and equipment ......................................................
900,000 (q)
Total assets ...................................................................
$1,500,000 (p)
Current liabilities ............................................................
$ 250,000
Bonds payable, 10% ......................................................
450,000 (k)
Total liabilities ................................................................
700,000 (l)
Stockholders equity:
Common stock, $2.50 par value ................................... 100,000 (m)
Retained earnings .......................................................
700,000 (o)
Total stockholders equity ...............................................
800,000 (n)
Total liabilities and equity ...............................................
$1,500,000 (p)
a. Earnings before interest and taxes Earnings before interest and taxes
=
Interest expense $45,000
$2,700,000
= = 15.0 times
Average accounts receivable balance
Average accounts = $2,700,00015.0 = $180,000
receivable balance
Therefore, the average accounts receivable balance for the year must
have been $180,000. Since the beginning balance was $160,000, the
ending balance must have been $200,000.
Therefore, the total quick assets must be $280,000. Since there are no
marketable securities and since the accounts receivable are $200,000,
the cash must be $80,000.
g. Current assets
Current ratio=
Current liabilities
Current assets
= =2.4 to 1 ratio
$250,000
Current assets=$250,0002.4=$600,000
Therefore, the current assets must total $600,000. Since the quick
assets (cash and accounts receivable) total $280,000 of this amount, the
inventory must be $320,000.
k. Since the interest expense for the year was $45,000 and the interest
rate was 10%, the bonds payable must total $450,000.
$162,000
= =$4.05
Average number of
common shares outstanding
=40,000 shares
n. Total liabilities
Debt-to-equity ratio=
Stockholders' equity
$700,000
= = 0.875
Stockholders' equity
Stockholders' equity=$700,0000.875=$800,000
$162,000+[$45,000(1 - 0.40)]
=
Average total assets
$189,000
= =14.0%
Average total assets
Average total assets=$189,0000.14=$1,350,000
Therefore the average total assets must be $1,350,000. Since the total
assets at the beginning of the year were $1,200,000, the total assets at
the end of the year must have been $1,500,000 (which would also equal
the total of the liabilities and the stockholders equity).
The company would fail to qualify for the loan because both its current
ratio and its acid-test ratio are too low.
However, other options may be available. After all, the old equipment is
being used to relieve bottlenecks in the heat-treating process and it
would be desirable to keep this standby capacity. We would advise
Jurgen to fully and honestly explain the situation to the loan officer. The
loan officer might insist that the equipment be sold before any loan is
approved, but she might instead grant a waiver of the current ratio and
acid-test ratio requirements on the basis that they could be satisfied by
selling the old equipment. Or she may approve the loan on the condition
that the equipment is pledged as collateral. In that case, Jurgen would
only have to sell the equipment if he would otherwise be unable to pay
back the loan.