Case 1 (Common-Size Statements and Financial Ratios for Creditors)

Requirement 1

This Year Last Year

a. Current assets ............................. P2,060,000 P1,470,000
Current liabilities .......................... 1,100,000 600,000
Working capital ............................ P 960,000 P 870,000

b. Current assets (a) ........................ P2,060,000 P1,470,000

Current liabilities (b) ..................... P1,100,000 P600,000
Current ratio (a) ÷ (b) ................... 1.87 to 1 2.45 to 1

c. Quick assets (a) ........................... P740,000 P650,000

Current liabilities (b) ..................... P1,100,000 P600,000
Acid-test ratio (a) ÷ (b) ................. 0.67 to 1 1.08 to 1

d. Sales on account (a) .................... P7,000,000 P6,000,000

Average receivables (b) ............... P525,000 P375,000
Turnover of receivables (a) ÷ (b) .. 13.3 times 16.0 times

Average age of receivables:

365 ÷ turnover .............................. 27.4 days 22.8 days

e. Cost of goods sold (a) .................. P5,400,000 P4,800,000

Average inventory (b) ................... P1,050,000 P760,000
Inventory turnover (a) ÷ (b) .......... 5.1 times 6.3 times

Turnover in days: 365 ÷ turnover . 71.6 days 57.9 days

f. Total liabilities (a) ......................... P1,850,000 P1,350,000
Equity (b) ..................................... P2,150,000 P1,950,000
Debt-to-equity ratio (a) ÷ (b) ......... 0.86 to 1 0.69 to 1

Net income before interest and

g. taxes (a) ....................................... P630,000 P490,000
Interest expense (b) ..................... P90,000 P90,000
Times interest earned (a) ÷ (b) ..... 7.0 times 5.4 times
Requirement 2

a. METRO BUILDING SUPPLY

Common-Size Balance Sheets

This Year Last Year

Current assets:
Cash ......................................... 2.3 % 6.1 %
Marketable securities ............... 0.0 1.5
Accounts receivable, net .......... 16.3 12.1
Inventory .................................. 32.5 24.2
Prepaid expenses..................... 0.5 0.6
Total current assets ..................... 51.5 44.5
Plant and equipment, net ............. 48.5 55.5
Total assets ................................. 100.0 % 100.0 %

Liabilities:
Current liabilities ....................... 27.5 % 18.2 %
Bonds payable, 12% ................ 18.8 22.7
Total liabilities .............................. 46.3 40.9
Equity:
Preference shares, P50 par,
8% 5.0 6.1
Ordinary shares, P10 par ......... 12.5 15.2
Retained earnings .................... 36.3 37.9
Total equity .................................. 53.8 59.1
Total liabilities and equity ............. 100.0 % 100.0 %

b. METRO BUILDING SUPPLY

Common-Size Income Statements

This Year Last Year

Sales............................................ 100.0 % 100.0 %
Less cost of goods sold ............... 77.1 80.0
Gross margin ............................... 22.9 20.0
Less operating expenses ............. 13.9 11.8
Net operating income................... 9.0 8.2
Less interest expense .................. 1.3 1.5
Net income before taxes .............. 7.7 6.7
Less income taxes ....................... 3.1 2.7
Net income .................................. 4.6 % 4.0 %
 Requirement 3

As a result of an increase in its profit margin form last year, its gross margin
has also increased but was offset by the increase in operating expenses. From
last year, the company exceeds the industry’s average (4%) in net income as a
percentage of sales.

Even though the company’s working capital has increased, its current position
has declined significantly since last year. Its current ratio and acid-test ratio are
trending downward and also are below the industry average. With these trends,
in the near future, the company not be able to pay its bills as they come due.

An increase in company’s accounts receivable and inventory may be the reason

of the decrease in its cash. This can be proven by looking at its financial ratios
and its common-size balance sheet. As an example, we can see that its
receivables’ average age increased from 5 days last year and now it is 9 days
over the industry average. These may be the result of being too aggressive of the
company in expanding its sales. This suggests that the company had sales with
the customers with fragile financial condition or customers with poor credit risks.
One more evident reason is that customers are not taking their discounts, since
the average collection period is 27 days and collection terms are 2/10, n/30.

The inventory turnover has been deteriorated from 5 times last year to 6 times
this year. While the industry’s average is able to turn its inventory in 50 days, the
company takes 71 days in turning its inventory. This shows that the company
may be having inventory stocks higher than they need to be.

The loan should be approved on the condition that the company takes immediate
actions to get its accounts receivable and inventory back under control. Some of
these actions would be: checking of creditworthiness before sales are made to
customers and pairing out slow customers who are paying slowly. These would
result to a reduction of inventory levels to a more manageable size. These
actions would help to generate funds to repay the loan in a reasonable period of
time.
 Case 2 (Financial Ratios for Ordinary Shareholders)

Requirement 1

a. This Year Last Year

Net income .................................. P324,000 P240,000
Less preference dividends .......... 16,000 16,000
Net income remaining for
ordinary (a) .................................. P308,000 P224,000
Average number of ordinary
shares (b) .................................... 50,000 50,000
Earnings per share (a) ÷ (b) ........ P6.16 P4.48

b. Ordinary dividend per share (a)* . P2.16 P1.20

Market price per share (b) ........... P45.00 P36.00
Dividend yield ratio (a) ÷ (b) ........ 4.8% 3.33%
*P108,000 ÷ 50,000 shares = P2.16;
P60,000 ÷ 50,000 shares = P1.20

c. Ordinary dividend per share (a) .... P2.16 P1.20

Earnings per share (b) .................. P6.16 P4.48
Dividend payout ratio (a) ÷ (b) ...... 35.1% 26.8%

d. Market price per share (a) ............ P45.00 P36.00

Earnings per share (b) .................. P6.16 P4.48
Price-earnings ratio (a) ÷ (b) ......... 7.3 8.0

Metro Building Supply's investors are willing to pay only 7.3 current earnings for
a share of company's stock as compared to 9 times current earnings average of
the industry. If their investors were willing to pay of what is the industry's average
or higher, then their stock price would be P55 or higher.
 e. This Year Last Year
Equity ........................................... P2,150,000 P1,950,000
Less preference shares ................ 200,000 200,000
Ordinary equity (a)........................ P1,950,000 P1,750,000

Number of ordinary shares (b) ..... 50,000 50,000

Book value per share (a) ÷ (b) ...... P39.00 P35.00

No, the difference between book value and the market value of ordinary share
does not mean that the current price of stock is too high. It only shows the
perception of the investors regarding the profitability and ability to pay dividends of
the company in the near future, whereas book value is the result of completed
transactions and is only connected to the past.

Requirement 2

a. This Year Last Year

Net income ................................... P 324,000 P 240,000
Add after-tax cost of interest paid:
[P90,000 × (1 – 0.40)] ............... 54,000 54,000
Total (a) ........................................ P 378,000 P 294,000

Average total assets (b) ................ P3,650,000 P3,000,000

Return on total assets (a) ÷ (b) ..... 10.4% 9.8%

b. This Year Last Year

Net income ................................... P 324,000 P 240,000
Less preference dividends............ 16,000 16,000
Net income remaining for ordinary
shareholders (a) ........................ P 308,000 P 224,000

Average total equity* .................... P2,050,000 P1,868,000

Less average preference shares .. 200,000 200,000
Average ordinary equity (b) .......... P1,850,000 P1,668,000
*1/2(P2,150,000 + P1,950,000); 1/2(P1,950,000 +
P1,786,000).

Return on ordinary equity (a) ÷

(b) 16.6% 13.4%
 c. Financial leverage is positive in both years, since the return on ordinary
equity is greater than the return on total assets. This positive financial
leverage is due to three factors: the preference shares, which has a
dividend of only 8%; the bonds, which have an after-tax interest cost of only
7.2% [12% interest rate × (1 – 0.40) = 7.2%]; and the accounts payable,
which may bear no interest cost.

Requirement 3

I would recommend keeping the stock since its downside risk seems to be small
and it is to be selling for only 7.3 times current earnings as compared to 9 times
earnings for the average firm in the industry. Additionally, with its return on total
assets which is 10.4% we could say that it is favorably comparable with that of
industry. Moreover, its earnings are trending upward while its return on ordinary
equity was 16.6% which is really good.

The risk here is on the ability of the company to get its cash under control. If the
company’s cash problem has worsen, it may not be able to fund its operations,
thus leading to a decrease in profits, that may lead to reduction in dividends and
possibly, a drop in the market price of the company’s stock. However, this may
not happen since the company is able to control its cash problem through careful
management of account receivable and inventory. With great control in its cash,
the company’s stock price may increase in succeeding periods, thus reflecting a
great investment for the company’s existing and potential investors.