Chapter 05 - Answer

MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual
CHAPTER 5
FINANCIAL STATEMENTS ANALYSIS - II
I. Questions
1. By looking at trends, an analyst hopes to get some idea of whether a

situation is improving, remaining the same, or deteriorating. Such
analyses can provide insight into what is likely to happen in the future.
Rather than looking at trends, an analyst may compare one company to
another or to industry averages using common-size financial statements.
2. Ratios highlight relationships, movements, and trends that are very

difficult to perceive looking at the raw underlying data standing alone.
Also, ratios make financial data easier to grasp by putting the data into
perspective. As to the limitation in the use of ratios, refer to page 129.
3. Price-earnings ratios are determined by how investors see a firm’s future

prospects. Current reported earnings are generally considered to be
useful only so far as they can assist investors in judging what will
happen in the future. For this reason, two firms might have the same
current earnings, but one might have a much higher price-earnings ratio
if investors view it to have superior future prospects. In some cases,
firms with very small current earnings enjoy very high price-earnings
ratios. This is simply because investors view these firms as having very
favorable prospects for earnings in future years. By definition, a stock
with current earnings of P4 and a price-earnings ratio of 20 would be
selling for P80 per share.
4. A manager’s financing responsibilities relate to the acquisition of assets

for use in his or her company. The acquisition of assets can be financed
in a number of ways, including through issue of ordinary shares, through
issue of preference shares, through issue of long-term debt, through
leasing, etc. A manager’s operating responsibilities relate to how these
assets are used once they have been acquired. The return on total assets
ratio is designed to measure how well a manager is discharging his or
her operating responsibilities. It does this by looking at a company’s
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Chapter 5 Financial Statement Analysis –II
income before any consideration is given as to how the income will be

distributed among capital resources, i.e., before interest deductions.
5. Financial leverage, as the term is used in business practice, means

obtaining funds from investment sources that require a fixed annual rate
of return, in the hope of enhancing the well-being of the ordinary
shareholders. If the assets in which these funds are invested earn at a
rate greater that the return required by the suppliers of the funds, then
leverage is positive in the sense that the excess accrues to the benefit of
the ordinary shareholders. If the return on assets is less than the return
required by the suppliers of the funds, then leverage is negative in the
sense that part of the earnings from the assets provided by the ordinary
shareholders will have to go to make up the deficiency.
6. How a shareholder would feel would depend in large part on the stability
of the firm and its industry. If the firm is in an industry that experiences
wide fluctuations in earnings, then shareholders might be very pleased
that no interest-paying debt exists in the firm’s capital structure. In hard
times, interest payments might be very difficult to meet, or earnings
might be so poor that negative leverage would result.
7. No, the stock is not necessarily overpriced. Book value represents the
cumulative effects on the balance sheet of past activities evaluated using
historical prices. The market value of the stock reflects investors’
beliefs about the company’s future earning prospects. For most
companies market value exceeds book value because investors anticipate
future growth in earnings.
8. A company in a rapidly growing technological industry probably would

have many opportunities to invest its earnings at a high rate of return;
thus, one would expect it to have a low dividend payout ratio.
9. It is more difficult to obtain positive financial leverage from preference

shares than from long-term debt due to the fact that interest on long-term
debt is tax deductible, whereas dividends paid on preference shares are
not tax deductible.
10. The current ratio would probably be highest during January, when both
current assets and current liabilities are at a minimum. During peak
operating periods, current liabilities generally include short-term
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Financial Statement Analysis –II Chapter 5
borrowings that are used to temporarily finance inventories and

receivables. As the peak periods end, these short-term borrowings are
paid off, thereby enhancing the current ratio.
11. A 2-to-1 current ratio might not be adequate for several reasons. First,
the composition of the current assets may be heavily weighted toward
slow-turning inventory, or the inventory may consist of large amounts of
obsolete goods. Second, the receivables may be large and of doubtful
collectibility, or the receivables may be turning very slowly due to poor
collection procedures.
12. Expenses (including the cost of goods sold) have been increasing at an
even faster rate than net sales. Thus Sunday is apparently having
difficulty in effectively controlling its expenses.
13. If the company’s earnings are very low, they may become almost
insignificant in relation to stock price. While this means that the p/e
ratio becomes very high, it does not necessarily mean that investors are
optimistic. In fact, they may be valuing the company at its liquidation
value rather than a value based upon expected future earnings.
14. From the viewpoint of the company’s shareholders, this situation

represents a favorable use of leverage. It is probable that little interest, if
any, is paid for the use of funds supplied by current creditors, and only
11% interest is being paid to long-term bondholders. Together these two
sources supply 40% of the total assets. Since the firm earns an average
return of 16% on all assets, the amount by which the return on 40% of
the assets exceeds the fixed-interest requirements on liabilities will
accrue to the residual equity holders – the ordinary shareholders –
raising the return on equity.
15. The length of operating cycle of the two companies cannot be

determined from the fact the one company’s current ratio is higher. The
operating cycle depends on the relationships between receivables and
sales, and between inventories and cost of goods sold. The company
with the higher current ratio might have either small amounts of
receivables and inventories, or large sales and cost of sales, either of
which would tend to produce a relatively short operating cycle.
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16. The investor is calculating the rate of return by dividing the dividend by
the purchase price of the investment (P5  P50 = 10%). A more
meaningful figure for rate of return on investment is determined by
relating dividends to current market price, since the investor at the
present time is faced with the alternative of selling the stock for P100
and investing the proceeds elsewhere or keeping the investment. A
decision to retain the stock constitutes, in effect, a decision to continue
to invest P100 in it, at a return of 5%. It is true that in a historical sense
the investor is earning 10% on the original investment, but this is
interesting history rather than useful decision-making information.
17. A corporate net income of P1 million would be unreasonably low for a
large corporation, with, say, P100 million in sales, P50 million in assets,
and P40 million in equity. A return of only P1 million for a company of
this size would suggest that the owners could do much better by
investing in insured bank savings accounts or in government bonds
which would be virtually risk-free and would pay a higher return.
On the other hand, a profit of P1 million would be unreasonably high for
a corporation which had sales of only P5 million, assets of, say, P3
million, and equity of perhaps one-half million pesos. In other words,
the net income of a corporation must be judged in relation to the scale of
operations and the amount invested.
II. True or False
1. True 3. True 5. True 7. True 9. False

2. True 4. False 6. True 8. True 10. False
III. Problems
Problem 1 (Common Size Income Statements)
Common size income statements for 2005 and 2006:

2006 2005
Sales.................................................. 100% 100%
Cost of goods sold ............................ 66 67
Gross profit ....................................... 34% 33%
Operating expenses........................... 28 29
Net income........................................ 6% 4%
5-4
The changes from 2005 to 2006 are all favorable. Sales increased and the
gross profit per peso of sales also increased. These two factors led to a
substantial increase in gross profit. Although operating expenses increased
in peso amount, the operating expenses per peso of sales decreased from 29
cents to 28 cents. The combination of these three favorable factors caused
net income to rise from 4 cents to 6 cents out of each peso of sales.
Problem 2 (Measures of Liquidity)
Requirement (a)
Current assets:
Cash P 47,600
Marketable securities 175,040
Accounts receivable 230,540
Inventory 179,600
Unexpired insurance 4,500
Total current assets P637,280
Current liabilities:
Notes payable P 70,000
Accounts payable 125,430
Salaries payable 7,570
Income taxes payable 14,600
Unearned revenue 10,000
Total current liabilities P227,600
Requirement (b)
The current ratio is 2.8 to 1. It is computed by dividing the current assets of

P637,280 by the current liabilities of P227,600. The amount of working
capital is P409,680, computed by subtracting the current liabilities of
P227,600 from the current assets of P637,280.
The company appears to be in a strong position as to short-run debt-paying

ability. It has almost three pesos of current assets for each peso of current
liabilities. Even if some losses should be sustained in the sale of the
merchandise on hand or in the collection of the accounts receivable, it
appears probable that the company would still be able to pay its debts as they
fall due in the near future. Of course, additional information, such as the
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credit terms on the accounts receivable, would be helpful in a careful

evaluation of the company’s current position.
Problem 3 (Common-Size Income Statement)
Requirement 1
2006 2005
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 %
Requirement 2
The company’s major problem seems to be the increase in cost of goods

sold, which increased from 60.0% of sales in 2005 to 63.2% of sales in
2006. This suggests that the company is not passing the increases in costs of
its products on to its customers. As a result, cost of goods sold as a
percentage of sales has increased and gross margin has decreased. Selling
expenses and interest expense have both increased slightly during the year,
which suggests that costs generally are going up in the company. The only
exception is the administrative expenses, which have decreased from 14.6%
of sales in 2005 to 13.6% of sales in 2006. This probably is a result of the
company’s efforts to reduce administrative expenses during the year.
Problem 4 (Comparing Operating Results with Average Performance in

the Industry)
Requirement (a)
Ms. Freeze, Industry
Inc. Average
Sales (net) 100% 100%
Cost of goods sold 49 57
Gross profit on sales 51% 43%
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Operating expenses:
Selling 21% 16%
General and administrative 17 20
Total operating expenses 38% 36%
Operating income 13% 7%
Income taxes 6 3
Net income........................................ 7% 4%
Requirement (b)
Ms. Freeze’s operating results are significantly better than the average
performance within the industry. As a percentage of sales revenue, Ms.
Freeze’s operating income and net income after nearly twice the average for
the industry. As a percentage of total assets, Ms. Freeze’s profits amount to
an impressive 23% as compared to 14% for the industry.
The key to Ms. Freeze’s success seems to be its ability to earn a relatively
high rate of gross profit. Ms. Freeze’s exceptional gross profit rate (51%)
probably results from a combination of factors, such as an ability to
command a premium price for the company’s products and production
efficiencies which lead to lower manufacturing costs.
As a percentage of sales, Ms. Freeze’s selling expenses are five points higher
than the industry average (21% compared to 16%). However, these higher
expenses may explain Ms. Freeze’s ability to command a premium price for
its products. Since the company’s gross profit rate exceeds the industry
average by 8 percentage points, the higher-than-average selling costs may be
part of a successful marketing strategy. The company’s general and
administrative expenses are significantly lower than the industry average,
which indicates that Ms. Freeze’s management is able to control expenses
effectively.
Problem 5 (Common-Size Statements)
Requirement 1
The income statement in common-size form would be:

2006 2005
Sales......................................................... 100.0% 100.0%
Less cost of goods sold ............................ 65.0 60.0
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Gross margin............................................ 35.0 40.0

Less operating expenses .......................... 26.3 30.4
Net operating income............................... 8.7 9.6
Less interest expense ............................... 1.2 1.6
Net income before taxes .......................... 7.5 8.0
Less income taxes (30%) ......................... 2.3 2.4
Net income............................................... 5.3% 5.6%
The balance sheet in common-size form would be:
2006 2005
Current assets:
Cash................................................... 2.0% 5.1%
Accounts receivable, net ................... 15.0 10.1
Inventory ........................................... 30.1 15.2
Prepaid expenses ............................... 1.0 1.3
Total current assets ..................... 48.1 31.6
Plant and equipment ................................ 51.9 68.4
Total assets .............................................. 100.0% 100.0%
Liabilities:
Current liabilities............................... 25.1% 12.7%
Bonds payable, 12%.......................... 20.1 25.3
Total liabilities............................ 45.1 38.0
Equity:
Preference shares, 8%, P10 par ......... 15.0 19.0
Ordinary shares, P5 par ..................... 10.0 12.7
Retained earnings .............................. 29.8 30.4
Total equity................................. 54.9 62.0
Total liabilities and equity ....................... 100.0% 100.0%
Note: Columns do not total down in all cases due to rounding differences.
Requirement 2
The company’s cost of goods sold has increased from 60 percent of sales in
2005 to 65 percent of sales in 2006. This appears to be the major reason the
company’s profits showed so little increase between the two years. Some
benefits were realized from the company’s cost-cutting efforts, as evidenced
by the fact that operating expenses were only 26.3 percent of sales in 2006 as
compared to 30.4 percent in 2005. Unfortunately, this reduction in operating
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expenses was not enough to offset the increase in cost of goods sold. As a
result, the company’s net income declined from 5.6 percent of sales in 2005
to 5.3 percent of sales in 2006.
Problem 6 (Solvency of Alabang Supermarket)
Requirement (a)
(Pesos in
Millions)
Current assets:
Cash P 74.8
Receivables 152.7
Merchandise inventories 1,191.8
Prepaid expenses 95.5
Total current assets P1,514.8
Quick assets:
Cash P 74.8
Receivables 152.7
Total quick assets P 227.5
Requirement (b)
(1) Current ratio:

Current assets (Req. a) P1,514.8
Current liabilities P1,939.0
Current ratio (P1,514.8  P1,939.0) 0.8 to 1
(2) Quick ratio:

Quick assets (Req. a) P 227.5
Current liabilities P1,939.0
Quick ratio (P227.5  P1,939.0) 0.1 to 1
(3) Working capital:

Current assets (Req. a) P1,514.8
Less: Current liabilities P1,939.0
Working capital P(424.2)
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Requirement (c)
No. It is difficult to draw conclusions from the above ratios. Alabang

Supermarket’s current ratio and quick ratio are well below “safe” levels,
according to traditional rules of thumb. On the other hand, some large
companies with steady ash flows are able to operate successfully with
current ratios lower than Alabang Supermarket’s.
Requirement (d)
Due to characteristics of the industry, supermarkets tend to have smaller

amounts of current assets and quick assets than other types of merchandising
companies. An inventory of food has a short shelf life. Therefore, the
inventory of a supermarket usually represents only a few weeks’ sales.
Other merchandising companies may stock inventories representing several
months’ sales. Also, supermarkets sell primarily for cash. Thus, they have
relatively few receivables. Although supermarkets may generate large
amounts of cash, it is not profitable for them to hold assets in this form.
Therefore, they are likely to reinvest their cash flows in business operations
as quickly as possible.
Requirement (e)
In evaluating Alabang Supermarket’s liquidity, it would be useful to review

the company’s financial position in prior years, statements of cash flows, and
the financial ratios of other supermarket chains. One might also ascertain
the company’s credit rating from an agency such as Dun & Bradstreet.
Note to Instructor: Prior to the year in which the data for this problem was
collected, Alabang Supermarket had reported a negative retained earnings
balance in its balance sheet for several consecutive periods. The fact that
Alabang Supermarket has only recently removed the deficit from its
financial statements is also worrisome.
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Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk)
Requirement (a)
(1) Quick assets:

Cash P 47,524
Marketable securities (short-term) 55,926
Total quick assets P127,003
(2) Current assets:

Cash P 47,524
Marketable securities (short-term) 55,926
Inventories 32,210
Prepaid expenses 5,736
Total current assets P164,949
(3) Current liabilities:

Notes payable to banks (due within one year) P 20,000
Accounts payable 5,912
Dividends payable 1,424
Accrued liabilities (short-term) 21,532
Income taxes payable 6,438
Total current liabilities P 55,306
Requirement (b)
(1) Quick ratio:

Quick assets (Req. a) P127,003
Current liabilities (Req. a) P 55,306
Quick ratio (P127,003  P55,306) 2.3 to 1
(2) Current ratio:

Current assets (Req. a) P164,949
Current liabilities (Req. a) P 55,306
Current ratio (P164,949  P55,306) 3.0 to 1
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(3) Working capital:

Current assets (Req. a) P164,949
Less: Current liabilities (Req. a) 55,306
Working capital P109,643
(4) Debt ratio:

Total liabilities (given) P 81,630
Total assets (given) P353,816
Debt ratio (P81,630  P353,816) 23.1%
Requirement (c)
(1) From the viewpoint of short-term creditors, Bonbon Sweets’ appear

highly liquid. Its quick and current ratios are well above normal rules of
thumb, and the company’s cash and marketable securities alone are
almost twice its current liabilities.
(2) Long-term creditors also have little to worry about. Not only is the
company highly liquid, but creditors’ claims amount to only 23.1% of
total assets. If Bonbon Sweets’ were to go out of business and liquidate
its assets, it would have to raise only 23 cents from every peso of assets
for creditors to emerge intact.
(3) From the viewpoint of shareholders, Bonbon Sweets’ appears overly

liquid. Current assets generally do not generate high rates of return.
Thus, the company’s relatively large holdings of current assets dilutes its
return on total assets. This should be of concern to shareholders. If
Bonbon Sweets is unable to invest its highly liquid assets more
productively in its business, shareholders probably would like to see the
money distributed as dividends.
Problem 8 (Selected Financial Measures for Short-term Creditors)
Requirement 1
Current assets (P80,000 + P460,000 + P750,000 +

P10,000)................................................................................................
P1,300,000
Current liabilities (P1,300,000 ÷ 2.5) ................................................................
520,000
Working capital ................................................................................................
P 780,000
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Requirement 2
Cash + Marketable securities + Accounts receivable
Acid-test ratio =
Current liabilities
P80,000 + P0 + P460,000
Acid-test ratio = = 1.04 to 1 (rounded)
P520,000
Requirement 3
a. Working capital would not be affected:
Current assets (P1,300,000 – P100,000)................................P1,200,000

Current liabilities (P520,000 – P100,000) ................................ 420,000
Working capital................................................................................................
P 780,000
b. The current ratio would rise:

Current assets
Current ratio =
Current liabilities
P1,200,000
Current rate = = 2.9 to 1 (rounded)
P420,000
Problem 9 (Selected Financial Ratios)
1. Gross margin percentage:

Gross margin P840,000
= = 40%
Sales P2,100,000
2. Current ratio:
Current assets P490,000
= = 2.45 to 1
Current liabilities P200,000
3. Acid-test ratio:
Quick assets P181,000
= = 0.91 to 1 (rounded)
Current liabilities P200,000
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4. Accounts receivable turnover:
Sales P2,100,000
= = 14 times
Average accounts receivables P150,000
365 days
= 26.1 days (rounded)
14 times
5. Inventory turnover:
Cost of goods sold P1,260,000
= = 4.5 times
Average inventory P280,000
365 days
= 81.1 days to turn (rounded)
4.5 times
6. Debt-to-equity ratio:
Total liabilities P500,000
= = 0.63 to 1 (rounded)
Total equity P800,000
7. Times interest earned:
Earnings before interest

and income taxes P180,000
= = 6.0 times
Interest expense P30,000
8. Book value per share:

Equity P800,000
= = P40 per share
Ordinary shares outstanding 20,000 shares*
* P100,000 total par value ÷ P5 par value per share = 20,000 shares
Problem 10 (Selected Financial Ratios for Ordinary Shareholders)
1. Earnings per share:
Net income to ordinary shares P105,000

= = P5.25 per share
Average ordinary shares 20,000 shares
outstanding
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2. Dividend payout ratio:

Dividends paid per share P3.15
= = 60%
Earnings per share P5.25
3. Dividend yield ratio:

Dividends paid per share P3.15
= = 5%
Market price per share P63.00
4. Price-earnings ratio:
Market price per share P63.00
= = 12.0
Earnings per share P5.25
Problem 11 (Selected Financial Ratios for Ordinary Shareholders)
1. Return on total assets:
Return on Net income + [Interest expense x (1 – Tax rate)]

=
total assets Average total assets
P105,000 + [P30,000 x (1 – 0.30)]

=
½ (P1,100,000 + P1,300,000)
P126,000
= = 10.5%
P1,200,000
2. Return on ordinary shareholders’ equity:
Return on ordinary Net income – preference dividends

=
shareholders’ equity Average ordinary shareholders’ equity
P105,000
=
½ (P725,000 + P800,000)
P105,000
= = 13.8% (rounded)
P762,500
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3. Financial leverage was positive, since the rate of return to the ordinary
shareholders (13.8%) was greater than the rate of return on total assets
(10.5%). This positive leverage is traceable in part to the company’s
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.
IV. Cases
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
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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
g. Net income before interest and 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 %
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Note: Columns do not total down in all cases due to rounding.
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
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 company’s net income as a
percentage of sales equals or exceeds the industry average of 4%.
Although the company’s 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.
The drain on the cash account seems to be a result mostly of a large buildup
in accounts receivable and inventory. This is evident both from the
common-size balance sheet and from the financial ratios. Notice that the
average age of the receivables has increased by 5 days since last year, and
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that it is now 9 days over the industry average. Many of the company’s
customers are not taking their discounts, since the average collection period
is 27 days and collection terms are 2/10, n/30. This suggests financial
weakness on the part of these customers, or sales to customers who are poor
credit risks. Perhaps the company has been too aggressive in expanding its
sales.
The inventory turned only 5 times this year as compared to over 6 times last
year. It takes three weeks longer for the company to turn its inventory than
the average for the industry (71 days as compared to 50 days for the
industry). This suggests that inventory stocks are higher than they need to
be.
In the authors’ opinion, the loan should be approved on the condition that
the company take immediate steps to get its accounts receivable and
inventory back under control. This would mean more rigorous checks of
creditworthiness before sales are made and perhaps paring out of slow
paying customers. It would also mean a sharp reduction of inventory levels
to a more manageable size. If these steps are taken, it appears that sufficient
funds could be generated 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
5-19
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

Price-earnings ratio (a) ÷ (b) ................................ 7.3 8.0
Investors regard Metro Building Supply less favorably than other firms
in the industry. This is evidenced by the fact that they are willing to pay
only 7.3 times current earnings for a share of the company’s stock, as
compared to 9 times current earnings for the average of all stocks in the
industry. If investors were willing to pay 9 times current earnings for
Metro Building Supply’s stock, then it would be selling for about P55
per share (9 × P6.16), rather than for only P45 per share.
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
A market price in excess of book value does not mean that the price of a
stock is too high. Market value is an indication of investors’ perceptions
of future earnings and/or dividends, whereas book value is a result of
already completed transactions and is geared 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
5-20
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
We would recommend keeping the stock. The stock’s downside risk seems
small, since it is selling for only 7.3 times current earnings as compared to 9
times earnings for the average firm in the industry. In addition, its earnings
are strong and trending upward, and its return on ordinary equity (16.6%) is
extremely good. Its return on total assets (10.4%) compares favorably with
that of the industry.
The risk, of course, is whether the company can get its cash problem under
control. Conceivably, the cash problem could worsen, leading to an
eventual reduction in profits through inability to operate, a reduction in
5-21
dividends, and a precipitous drop in the market price of the company’s

stock. This does not seem likely, however, since the company can easily
control its cash problem through more careful management of accounts
receivable and inventory. If this problem is brought under control, the price
of the stock could rise sharply over the next few years, making it an
excellent investment.
Case 3 (Comprehensive Ratio Analysis)
Requirement 1
This Year Last Year
a. Net income ................................................................
P 280,000 P 168,000
Add after-tax cost of interest:
P120,000 × (1 – 0.30) ................................ 84,000
P100,000 × (1 – 0.30) ................................ 70,000
Total (a)................................................................
P 364,000 P 238,000
Average total assets (b) ................................ P5,330,000 P4,640,000

Return on total assets (a) ÷ (b) ................................ 6.8% 5.1%
b. Net income ................................................................

P 280,000 P 168,000
Less preference dividends ................................ 48,000 48,000
Net income remaining for ordinary (a) ................................
P 232,000 P 120,000
Average total equity ................................................................

P3,120,000 P3,028,000
Less average preference shares ................................ 600,000 600,000
Average ordinary equity (b) ................................P2,520,000 P2,428,000
Return on ordinary equity (a) ÷ (b) ................................

9.2% 4.9%
c. Leverage is positive for this year, since the return on ordinary equity
(9.2%) is greater than the return on total assets (6.8%). For last year,
leverage is negative since the return on the ordinary equity (4.9%) is less
than the return on total assets (5.1%).
Requirement 2
5-22
a. Net income remaining for ordinary (a) ................................

P 232,000 P 120,000
Average number of ordinary shares (b)................................
50,000 50,000
Earnings per share (a) ÷ (b)................................ P4.64 P2.40
b. Ordinary dividend per share (a)................................P1.44 P0.72

Market price per share (b) ................................ P36.00 P20.00
Dividend yield ratio (a) ÷ (b) ................................ 4.0% 3.6%
This Year Last Year

c. Ordinary dividend per share (a)................................P1.44 P0.72
Dividend payout ratio (a) ÷ (b)................................31.0% 30.0%
d. Market price per share (a) ................................ P36.00 P20.00

Price-earnings ratio (a) ÷ (b) ................................ 7.8 8.3
Notice from the data given in the problem that the average P/E ratio for
companies in Helix’s industry is 10. Since Helix Company presently has
a P/E ratio of only 7.8, investors appear to regard it less well than they
do other companies in the industry. That is, investors are willing to pay
only 7.8 times current earnings for a share of Helix Company’s stock, as
compared to 10 times current earnings for a share of stock for the
average company in the industry.
e. Equity................................................................
P3,200,000 P3,040,000
Less preference shares ................................ 600,000 600,000
Ordinary equity (a)................................................................
P2,600,000 P2,440,000
Number of ordinary shares (b) ................................50,000 50,000

Book value per share (a) ÷ (b)................................P52.00 P48.80
Note that the book value of Helix Company’s stock is greater than the
market value for both years. This does not necessarily indicate that the
stock is selling at a bargain price. Market value is an indication of
investors’ perceptions of future earnings and/or dividends, whereas book
value is a result of already completed transactions and is geared to the
past.
5-23
f. Gross margin (a) ................................................................

P1,050,000 P860,000
Sales (b) ................................................................
P5,250,000 P4,160,000
Gross margin percentage (a) ÷ (b)................................ 20.0% 20.7%
Requirement 3
This Year Last Year
a. Current assets ................................................................
P2,600,000 P1,980,000
Current liabilities................................................................
1,300,000 920,000
Working capital ................................................................
P1,300,000 P1,060,000
b. Current assets (a) ................................................................

P2,600,000 P1,980,000
Current liabilities (b) ................................ P1,300,000 P920,000
Current ratio (a) ÷ (b) ................................ 2.0 to 1 2.15 to 1
c. Quick assets (a) ................................................................

P1,220,000 P1,120,000
Current liabilities (b) ................................ P1,300,000 P920,000
Acid-test ratio (a) ÷ (b) ................................ 0.94 to 1 1.22 to 1
d. Sales on account (a)................................ P5,250,000 P4,160,000

Average receivables (b)................................ P750,000 P560,000
Accounts receivable turnover (a) ÷ (b) ................................
7.0 times 7.4 times
Average age of receivables,
365 ÷ turnover ................................................................
52 days 49 days
e. Cost of goods sold (a) ................................ P4,200,000 P3,300,000

Average inventory (b) ................................ P1,050,000 P720,000
Inventory turnover (a) ÷ (b) ................................4.0 times 4.6 times
Number of days to turn inventory,
365 days ÷ turnover (rounded) ................................
91 days 79 days
f. Total liabilities (a) ................................................................

P2,500,000 P1,920,000
Equity (b) ................................................................
P3,200,000 P3,040,000
Debt-to-equity ratio (a) ÷ (b)................................0.78 to 1 0.63 to 1
5-24
g. Net income before interest and taxes (a) ................................

P520,000 P340,000
Interest expense (b)................................................................
P120,000 P100,000
Times interest earned (a) ÷ (b) ................................4.3 times 3.4 times
Requirement 4
As stated by Meri Ramos, both net income and sales are up from last year.
The return on total assets has improved from 5.1% last year to 6.8% this
year, and the return on ordinary equity is up to 9.2% from 4.9% the year
before. But this appears to be the only bright spot in the company’s
operating picture. Virtually all other ratios are below the industry average,
and, more important, they are trending downward. The deterioration in the
gross margin percentage, while not large, is worrisome. Sales and
inventories have increased substantially, which should ordinarily result in an
improvement in the gross margin percentage as fixed costs are spread over
more units. However, the gross margin percentage has declined.
Notice particularly that the average age of receivables has lengthened to 52

days—about three weeks over the industry average—and that the inventory
turnover is 50% longer than the industry average. One wonders if the
increase in sales was obtained at least in part by extending credit to high-risk
customers. Also notice that the debt-to-equity ratio is rising rapidly. If the
P1,000,000 loan is granted, the ratio will rise further to 1.09 to 1.
In the author’s opinion, what the company needs is more equity—not more
debt. Therefore, the loan should not be approved. The company should be
encouraged to make another issue of ordinary stock in order to provide a
broader equity base on which to operate.
Case 4 (Statement Reconstruction Using Ratios)
Bulacan Company
Income Statement
For the Year Ended December 31, 2005
Sales P140,800
Less: Cost of Sales (4) 84,480
Gross Profit P 56,320
5-25
Less: Expenses 46,320

Net Income (1) P 10,000
Bulacan Company
Balance Sheet
December 31, 2005
Assets
Current Assets:
Cash P 27,720
Accounts Receivable (5) 28,160
Merchandise Inventory (3) 21,120
Total Current Assets (2) P 77,000
Fixed Assets (8) 55,000
Total Assets P132,000
Liabilities and Equity
Current Liabilities:
Accounts Payable (2) P 44,000
Equity:
Share Capital (issued 20,000
shares) (6) P40,000
Retained Earnings 48,000 88,000
Total Liabilities and Equity P132,000
Supporting Computations:
Net Income
(1) Earnings Per Share =
Ordinary Shares Outstanding
X
P0.50 =
20,000
5-26
X (Net Income) = P10,000
(2) Current Assets Pxx 1.75

Current Liabilities xx 1
Working Capital P33,000 0.75
Current Liabilities = P33,000  0.75
= P44,000
Current Assets
(3) Current Ratio =
Current Liabilities
X
1.27 =
44,000
X (Current Assets) = P77,000
Quick Assets
Quick Ratio =
Current Liabilities
X
1.27 =
44,000
X (Current Assets) = P55,880
Current Assets P77,000

Quick Assets 55,800
Inventory P21,120
Cost of Sales
(4) Inventory turnover = Ave. Inventory
X
4 =
P21,120
X (Cost of Sales) = P84,480
Quick Assets
(5) Average age of outstanding =
Current Liabilities
Accounts Receivable
365
= 73 days (Average age of
5
5-27
receivables)
Net Sales
Average Receivables = 5
P140,800
X = 5
X (Receivables) = P28,160
Another Method:
P140,800
365 = 73 days = P28,160 Accounts receivable
(6) Earnings for the year as a percentage of Share Capital

P10,000
= 25%
Share Capital
Share Capital = P40,000
(7) Current Fixed Current Liabilities +

Assets + Assets = Equity
P77,000 + 0.625X = P44,000 + X
0.375X = P33,000
X = P88,000 Equity
(8) Fixed Assets to Equity

Fixed Assets
= 0.625
Equity
X
= 0.625
P140,800
X (Fixed Assets) = P55,000
Case 5 (Ethics and the Manager)
Requirement 1
5-28
The loan officer stipulated that the current ratio prior to obtaining the loan
must be higher than 2.0, the acid-test ratio must be higher than 1.0, and the
interest on the loan must be no more than four times net operating income.
These ratios are computed below:
Current assets
Current ratio =
Current liabilities
P290,000
Current rate = = 1.8 (rounded)
P164,000
Cash + Marketable securities + Accounts receivable

Acid-test ratio =
Current liabilities
P70,000 + P0 + P50,000
Acid-test ratio = = 0.70 (rounded)
P164,000
Net operating income P20,000
= = 5.0
Interest on the loan P80,000 x 0.10 x (6/12)
The company would fail to qualify for the loan because both its current ratio
and its acid-test ratio are too low.
Requirement 2
By reclassifying the P45 thousand net book value of the old machine as
inventory, the current ratio would improve, but there would be no effect on
the acid-test ratio. This happens because inventory is considered to be a
current asset but is not included in the numerator when computing the acid-
test ratio.
Current assets
Current ratio =
Current liabilities
P290,000 + P45,000
P164,000
Cash + Marketable securities + Current receivables

Acid-test ratio =
Current liabilities
P70,000 + P0 + P50,000
P164,000
Even if this tactic had succeeded in qualifying the company for the loan, we
5-29
strongly advise against it. Inventories are assets the company has acquired
for the sole purpose of selling them to outsiders in the normal course of
business. Used production equipment is not considered to be inventory—
even if there is a clear intention to sell it in the near future. Since the loan
officer would not expect used equipment to be included in inventories, doing
so would be intentionally misleading.
Nevertheless, the old equipment is an asset that could be turned into cash. If
this were done, the company would immediately qualify for the loan since
the P45 thousand in cash would be included in the numerator in both the
current ratio and in the acid-test ratio.
Current assets
Current ratio =
Current liabilities
P290,000 + P45,000
P164,000
Cash + Marketable securities + Current receivables

Acid-test ratio =
Current liabilities
P70,000 + P0 + P50,000 + P45,000
P164,000
However, other options may be available. After all, the old machine is
being used to relieve bottlenecks in the plastic injection molding process and
it would be desirable to keep this standby capacity. We would advise Rome
to fully and honestly explain the situation to the loan officer. The loan
officer might insist that the machine be sold before any loan is approved, but
he 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
machine. Or he may approve the loan on the condition that the equipment is
pledged as collateral. In that case, Rome would only have to sell the
machine if he would otherwise be unable to pay back the loan.
V. Multiple Choice Questions
1. A 11. C 21. B 31. C 41. C

2. C 12. A 22. D 32. D
3. D 13. C 23. A 33. C
4. B 14. B 24. C 34. A
5. A 15. D 25. A 35. A
5-30
6. D 16. B 26. C 36. C

7. C 17. A 27. D 37. A
8. D 18. C 28. A 38. A
9. A 19. A 29. D 39. C
10. B 20. C 30. A 40. C
5-31

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MANAGEMENT ACCOUNTING (VOLUME I) - Solutions Manual

FINANCIAL STATEMENTS ANALYSIS - II

1. By looking at trends, an analyst hopes to get some idea of whether a

2. Ratios highlight relationships, movements, and trends that are very

3. Price-earnings ratios are determined by how investors see a firm’s future

4. A manager’s financing responsibilities relate to the acquisition of assets

income before any consideration is given as to how the income will be

5. Financial leverage, as the term is used in business practice, means

8. A company in a rapidly growing technological industry probably would

9. It is more difficult to obtain positive financial leverage from preference

borrowings that are used to temporarily finance inventories and

14. From the viewpoint of the company’s shareholders, this situation

15. The length of operating cycle of the two companies cannot be

II. True or False

1. True 3. True 5. True 7. True 9. False

Problem 1 (Common Size Income Statements)

Common size income statements for 2005 and 2006:

Problem 2 (Measures of Liquidity)

The current ratio is 2.8 to 1. It is computed by dividing the current assets of

The company appears to be in a strong position as to short-run debt-paying

credit terms on the accounts receivable, would be helpful in a careful

Problem 3 (Common-Size Income Statement)

The company’s major problem seems to be the increase in cost of goods

Problem 4 (Comparing Operating Results with Average Performance in

Problem 5 (Common-Size Statements)

The income statement in common-size form would be:

Gross margin............................................ 35.0 40.0

The balance sheet in common-size form would be:

Problem 6 (Solvency of Alabang Supermarket)

(1) Current ratio:

(2) Quick ratio:

(3) Working capital:

No. It is difficult to draw conclusions from the above ratios. Alabang

Due to characteristics of the industry, supermarkets tend to have smaller

In evaluating Alabang Supermarket’s liquidity, it would be useful to review

Problem 7 (Balance Sheet Measures of Liquidity and Credit Risk)

(1) Quick assets:

(2) Current assets:

(3) Current liabilities:

(1) Quick ratio:

(2) Current ratio:

(3) Working capital:

(4) Debt ratio:

(1) From the viewpoint of short-term creditors, Bonbon Sweets’ appear

(3) From the viewpoint of shareholders, Bonbon Sweets’ appears overly

Problem 8 (Selected Financial Measures for Short-term Creditors)

Current assets (P80,000 + P460,000 + P750,000 +

a. Working capital would not be affected:

Current assets (P1,300,000 – P100,000)................................P1,200,000

b. The current ratio would rise:

Problem 9 (Selected Financial Ratios)

1. Gross margin percentage:

4. Accounts receivable turnover:

7. Times interest earned:

Earnings before interest

8. Book value per share:

Problem 10 (Selected Financial Ratios for Ordinary Shareholders)

1. Earnings per share:

Net income to ordinary shares P105,000

2. Dividend payout ratio:

3. Dividend yield ratio:

Problem 11 (Selected Financial Ratios for Ordinary Shareholders)

1. Return on total assets:

Return on Net income + [Interest expense x (1 – Tax rate)]