ch12 SM Carlon 5e

Solutions Manual
to accompany
Financial
Accounting:
Recording, Analysis
and Decision Making
Fifth Edition
Prepared by
Lily Wong
John Wiley & Sons Australia, Ltd 2016

Chapter 12: Financial statement analysis and decision making
CHAPTER 12 – FINANCIAL STATEMENT ANALYSIS AND DECISION MAKING
ASSIGNMENT CLASSIFICATION TABLE
Brief
Learning Objectives Exercises Exercises Problems
1. Discuss the need for comparative 1
analysis and identify the
tools of financial statement analysis.
2. Explain and apply horizontal analysis. 1, 2, 4 2, 3, 6, 7
3. Explain and apply vertical analysis. 3 4, 5, 6, 7 1A, 1B
4. Identify and calculate ratios and 5, 6, 7 1, 8, 9, 10, 1A, 2A, 3A, 4A,
describe their purpose 11, 12, 13 5A, 6A, 7A, 8A,
and use in analysing the liquidity, 1B, 2B, 3B, 4B,
solvency and 5B, 6B, 7B, 8B,
profitability of a business. 9B
5. Discuss the limitations of financial 9A, 10B

statement analysis.
© John Wiley and Sons Australia Ltd, 2016 12.1

Solutions manual to accompany Financial Accounting: Reporting, Analysis and Decision Making 5e
CHAPTER 12 – FINANCIAL STATEMENT ANALYSIS AND DECISION MAKING
ANSWERS TO QUESTIONS
1.
(a)
Intra-Entity. This is a comparison within an entity. For example, Coca Cola’s cash
balance as of 31 Dec 2016 is compared with its cash balance as of 31 Dec 2017.
Industry Averages. This is a comparison between a company and industry average.
For example, Coca Cola’s financial data is compared with beverage industry’s
financial data. The beverage industry’s financial data is calculated from all beverage
companies’ financial data.
Inter-Entity. This is a comparison between different entities. For example, Coca
Cola’s total sales for the year of 2016 is compared with Pepsi’s total sales for the
year of 2016.
(b)
The purpose of an Intra-Entity Basis comparison is to detect changes in financial
relationships and significant trends.
The purpose of an Industry Averages comparison is to provide information about an
entity’s relative position within the industry.
The purpose of an Inter-Entity Basis comparison is to provide insight into an entity’s
competitive position.
2. Horizontal analysis is a technique for evaluating a series of financial statement data

over a period of time. Its purpose is to determine the increase or decrease that has
taken place, expressed as either an amount or a percentage. For example, if Alpha
Ltd has the following data:
Year 2017 2016 2015
Net Sales 132,000 120,000 100,000
132% 120% 100%
We can conclude that the Alpha Ltd has an increase of 20% in Net Sales in 2016 and
an increase of 10% in Net Sales from 2016 t0 2017.
Vertical Analysis is a technique for evaluating financial statement data that expresses
each item in a financial statement as a percentage of a base amount. When
analysing a statement of profit or loss, expenses are expressed as a percentage of
sales revenue. For example, selling expenses are 20% of sales revenue. When
analysing a statement of financial position, each item is expressed as a percentage
of total assets or total liabilities and equity, both totals are the same. For example,
current assets are 48% of total assets.
Horizontal analysis uses data from more than one period of time while vertical
analysis uses data from only one period of time.

3. Current Ratio is Current Asset/Current Liabilities. Quick Ratio is (Cash + Marketable

Securities + Net Receivable)/Current Liabilities. Quick Ratio calculation does not
include Inventory and Prepaid Expense. Cash, marketable securities (current) and
receivables (net) are more liquid when compared with inventory and prepaid
expenses. The inventory may not be readily saleable and the prepaid expenses may
not be transferable to others. For this reason, the Quick Ratio provides a better
picture of a company’s short-term liquidity than the Current Ratio.
4. A disadvantage of the Current Ratio and Quick Ratios is that they use year-end
balances of current asset and current liability accounts. These year-end balances
may not be representative of the entity’s current position during most of the year. The
Current Cash Debt Coverage partially corrects this problem by using net cash
provided by operating activities and average current liabilities. Net cash provided by
operating activities is from the whole year’s operating activities. Average current
liabilities are also obviously better than year-end balance of current liabilities because
it has the component of both beginning of year balance and year-end balance.
5. The average collection period of receivables is useful to assess the effectiveness of

an entity’s credit and collection policies. The general rule is that the collection period
should not greatly exceed the credit term period (i.e. the time allowed for payment). If
the collection period is significantly higher than the credit term period, then there is a
problem with its receivables collection. For example, if an entity offers 30-day credit
terms and has an average collection period of 27 days, this provides an indication
that the firm’s credit policy is appropriate and the monitoring of receivables collection
is effective. A company whose average collection period is significantly above its
credit terms suggests that it may be granting credit to customers who are not credit
worthy or need to change their credit policies or collection procedures.
6. Megasonic Ltd’s inventory turnover is much slower than the industry average; its
inventory stays on the shelf approximately 46 days compared with 26 days, on
average, for the industry. Megasonic may be carrying excessive inventory relative to
its sales volume.
7. (a) Asset turnover.

(b) Average collection period.
(c) Profit margin.
(d) Current ratio, Quick ratio or Current ash debt coverage.
8. The price-earnings (P/E) ratio is a reflection of investors’ assessments of a ompany’s

future earnings. The P/E ratio takes into account such factors as relative risk,
stability or profits, trends in profits, and the market’s perception of the company’s
growth potential. In this case, investors favour Domino's as it has the higher P/E
ratio of 54.8 compared to Telstra’s P/E ratio of 16.4 The investors feel that Domino's
will be able to generate even higher future profits and so the investors are willing to
pay more for its shares.

9. (a) The decrease in gross profit margin is bad news because it means that a
lower percentage of net sales remains as gross profit after deducting cost of
sales.
(b) The decrease in inventory turnover signals bad news because the company is
taking longer to sell the inventory and consequently there is a greater chance
of inventory obsolescence.
(c) A decrease in the quick ratio signals bad news because the company’s ability
to meet maturing short-term obligations has declined.
(d) The increase in return on assets is good news for the company because it
could mean an increase in profit; or that the company needs to invest less in
assets to generate profit.
(e) The increase in the price-earnings ratio is generally good news because it
means that the market price per share has increased (relative to profit) and
investors are willing to pay more multiples of profit per share.
(f) From a solvency perspective, the increase in debt to total assets ratio is bad
news because it means that the company has increased its obligations to
creditors and has lowered its equity ‘buffer’.
(g) The increase in current cash debt coverage is good news because it means
that the company’s ability to meet current liabilities from the cash generated
by operations has improved.
10. (a) Estimates

Financial statements contain numerous estimates. Estimates are used, for example,
in determining the allowance for uncollectable receivables, periodic depreciation and
the costs of warranties. To the extent that these estimates are inaccurate, the
financial ratios and percentages are also inaccurate.
(b) Cost
Traditional financial statements are based on cost and are not adjusted for price-level
changes. Comparisons of unadjusted financial data from different periods may be
rendered invalid by significant inflation or deflation. For example, if a 5-year
comparison of revenues shows a growth of 24%, and the general price level also
increased by 24%, the entity’s real growth would be nil. Also, some assets such as
property, plant and equipment might be many years old. The carrying amount (cost
less accumulated depreciation) at which they are shown on the statement of financial
position might be significantly lower than their current market value. Thus, ratios such
as return on investment would appear more favourable than if the entity had new
assets.
(c) Alternative Accounting Methods

Variations among entities in the application of generally accepted accounting
principles may hamper comparability. For example, one entity may use the straight-
line method of depreciation, whereas another entity in the same industry may use the
diminishing balance method. This would affect ratios that use profit and, to a lesser
extent, ratios that use total assets.

(d) Atypical Data

Financial year-end data may not be typical of an entity’s financial condition during the
year. In such cases, certain account balances (cash, receivables, payables and
inventories) may not be representative of the balances in the accounts during the
year.
(e) Diversification
Diversification within entities also limits the usefulness of financial statement analysis
as it hampers comparison with competitors and industry statistics. Many entities
today are so diversified that they cannot be classified by industry. Others appear to
be comparable but are not.

SOLUTIONS TO BRIEF EXERCISES
BRIEF EXERCISE 12.1
(a) Intra-entity
(b) Intra-entity
(c) Inter-entity
(d) Industry averages
(e) Intra-entity
(f) Inter-entity
BRIEF EXERCISE 12.2
Horizontal analysis:
30 June 30 June 30 June

2017 2016 2015
Accounts receivable 800 000 600 000 700 000
Inventory 950 000 420 000 530 000
Total assets 4 600 000 3 800 000 2 400 000

Base year 700 000 700 000 700 000
114.3% 85.7% 100.0%
Inventory 950 000 420 000 530 000

Base year 530 000 530 000 530 000
179.2% 79.2% 100.0%
Total assets 4 600 000 3 800 000 2400000

Base year 2 400 000 2 400 000 2 400 000
191.7% 158.3% 100.0%

BRIEF EXERCISE 12.3
Vertical analysis:
30 June 30 June 30 June

2017 2016 2015
Accounts receivable 800 000 17.4% 600 000 15.8% 700 000 29.2%
Inventory 950 000 20.7% 420 000 11.1% 530 000 22.1%
Total assets 4 600 000 100.0% 3 800 000 100.0% 2 400 000 100.0%

Total assets 4 600 000 17.4% 3 800 000 15.8% 2 400 000 29.2%
Inventory 950 000 420 000 530 000

Total assets 4 600 000 20.7% 3 800 000 11.1% 2 400 000 22.1%
Total assets 4 600 000 3 800 000 2 400 000

Total assets 4 600 000 100.0% 3 800 000 100.0% 2 400 000 100.0%
BRIEF EXERCISE 12.4
Horizontal analysis percentages for Jayden Ltd’s sales, cost of sales and expenses
are presented below:
Horizontal analysis 2017 2016 2015

Sales 92% 105% 100%
Cost of sales 105% 93% 100%
Expenses 107% 96% 100%
Explain whether Jayden Ltd’s net profit increased, decreased or remained unchanged
over the 3-year period.
Comparing the percentages presented results in the following conclusions:
The profit increased in 2016 due to the combination of an increase in sales and a decrease
in both cost of sales and expenses.
However in 2017 sales decreased while both cost of sales and expenses increased which
resulted in an overall decrease in profit.

BRIEF EXERCISE 12.5
Sunnydale Ltd
Cash* 640,000
Marketable securities* 84,500
Accounts receivable* 106,300
Inventories 924,000
Other current assets 375,000
Total current assets 2,129,800
Total current liabilities 1,810,000
Current ratio CA 2,129,800

CL 1,810,000 1.18
Quick ratio* QA* 830,800

CL 1,810,000 0.46
QA*
Cash* 640,000
Marketable securities* 84,500
Accounts receivable* 106,300 830,800

BRIEF EXERCISE 12.6
Bristol Ltd
Net credit sales

Accounts receivable turnover =
Average net receivable s
2017 2016
(a) $6,600,000 $4,920,000

1 0.68 times  8.54 times
$618,000 $576,000
(b) Average collection period:
365 365
 34.2 days  42.7 days
10.68 8.54
Bristol Ltd’s results are evident of the entity’s effectiveness in managing its credit and
collection policies. It has decreased the average collection period by over 8 days and the
collection period of approximately 34 days is well within the 45 days allowed in the credit
terms.
BRIEF EXERCISE 12.7
Madison Ltd
(a) Current cash debt coverage:
$912,000
 3.62 times
$216,000  $288,000
2
(b) Cash return on sales:
$912,000
 11.1%
$8,232,000
(c) Cash debt coverage:
$912,000
 .543 times
$1,800,000  $1,560,000
2

SOLUTIONS TO EXERCISES
EXERCISE 12.1
(a) White 2016
Ratios for 2016
Current Ratio = Current Asset / Current Liabilities = 9,998,000/7,770,000 = 1.29 :1
Quick Ratio = (Cash + Marketable Securities + Net Receivables)/Current Liabilities

= 6,800,000/7,770,000 = 0.88:1
Inventory Turnover = Cost of Sales/Average Inventory

= 17,988,000/ [(3,100,000 + 2,290,000)/2]
= 6.67 times
Average Days in Inventory = 365 days/Inventory Turnover

= 365 days/6.67 = 54.72 days
Ratios for 2015
Current Ratio = Current Asset/Current Liabilities = 10,151,000/7,753,000 = 1.31:1
Quick Ratio = (Cash + Marketable Securities + Net Receivables)/Current Liabilities

= 6,870,000/7,753,000 = 0.89:1
Intra-entity comparison
 Cost of Sales has decreased by 0.28% from 2015 to 2016

 Current Assets has decreased by 1.51% from 2015 to 2016
 The sum of cash, net receivables and marketable securities has decreased by 1.02%
from 2015 to 2016
 Net receivables has decreased by 8.98% from 2015 to 2016
 Inventory has increased by 35.37% from 2015 to 2016
 Current Liabilities has increased by 4.81% from 2015 to 2016
 Current Ratio has decreased by about 0.02 from 2015 to 2016.
 This means White is a little less liquid in 2016 compared 2015
 Quick Ratio has decreased by about 0.01 from 2012 to 2013.
 This means White is a little less liquid in in 2016 compared 2015
 Changes in the current and quick ratios are insignificant so that the entity has
essentially remained the same
(b)
Intra-entity comparisons (comparisons within an entity) are often useful to detect changes in
financial relationships and significant trends. Inter-entity comparisons (comparisons made
between different entities) provide insights into an entity’s competitive position. Industry
comparisons provide information about an entity’s relative position within the industry.

EXERCISE 12.2
Spencer Ltd
Condensed Statement of Financial Position
as at 30 June
Horizontal Analysis
change
30-Jun-17 30-Jun-16 $ %
Current assets 150 000 103 000 47 000 46%
Property, plant and equip. (net) 380 000 315 000 65 000 21%
Total Assets 530 000 418 000 112 000 66%
Current liabilities 85 000 72 000 13 000 18%
Non-current liabilities 140 000 104 000 36 000 35%
Total Liabilities 225 000 176 000 49 000 53%
Share capital, $1 each 175 000 100 000 75 000 75%
Retained earnings 130 000 142 000 -12 000 -8%
Total Equity 305 000 242 000 63 000 67%
Total Liabilities and Equity 530 000 418 000 112 000 58%
EXERCISE 12.3
(a)
Forrester Ltd
Partial Statement of Financial Position
as at 30 June
Horizontal Analysis
change
30-Jun-17 30-Jun-16 $ %
Current assets 96 000 88 000 8 000 9%
Property, plant and equip. (net) 680 000 630 000 50 000 8%
Total Assets 776 000 718 000 58 000 17%
Current liabilities 45 000 50 000 -5 000 -10%
Non-current liabilities 72 000 78 000 -6 000 -8%
Total Liabilities 117 000 128 000 -11 000 -18%
Share capital, $1 each 450 000 365 000 85 000 23%
Retained earnings 209 000 225 000 -16 000 -7%
Total Equity 659 000 590 000 69 000 16%
Total Equity and Liabilities 776 000 718 000 58 000 9%
(b) Although Forrester Ltd’s overall increase in total assets was financed by an increase
in equity therefore making the company more financially stable than it was in the
previous year.

EXERCISE 12.4
(a)
Spectre Ltd
Statement of Financial Performance
Vertical Analysis
2017 2016
$ % $ %
Sales 900 000 100.0% 870 000 100.0%
Cost of sales 520 000 57.8% 460 000 52.9%
Gross profit 380 000 42.2% 410 000 47.1%
Selling expenses 140 000 15.6% 93 000 10.7%
Administrative expenses 65 000 7.2% 61 000 7.0%
Total operating expenses 205 000 22.8% 154 000 17.7%
Profit before income tax 175 000 19.4% 256 000 29.4%
Income tax expense 52 500 5.8% 76 800 8.8%
Profit 122 500 13.6% 179 200 20.6%
(b) Horizontal analysis can provide insights into underlying conditions for entities that
may not be apparent from the individual components presented in financial
statements. Horizontal analysis is even more meaning if it is supplemented with
further information such as inter-company comparisons with a competitor in the same
industry as well as other relevant information such as general economic conditions,
industry trends or averages, information from directors’ reports and media releases.
Like horizontal analysis, vertical analysis can provide insights into underlying
conditions for entities that may not be apparent from the individual components
presented in financial statements. However, vertical analysis is even more meaning if
it is supplemented with further information such as general economic conditions,
industry trends or averages, information from directors’ reports and media releases.
Vertical analysis enables you to compare entities in the same industry even if they
are different sizes.

EXERCISE 12.5
Ridge Ltd
Income Statement
Vertical Analysis
(a)
2016 2015
$ % $ %
Sales 1 500 000 100.0% 1 350 000 100.0%
Cost of sales 745 000 49.7% 738 000 54.7%
Gross profit 755 000 50.3% 612 000 45.3%
Selling expenses 123 000 8.2% 105 000 7.8%
Administrative expenses 92 000 6.1% 81 000 6.0%
Profit 378 000 25.2% 298 200 22.1%
(b) Profit for the period as a percentage of sales increased by 3.1% from 2015 to 2016.
Although the selling expenses as a percentage of sales increased slightly by 0.4%
over the period, the cost of sales as a percentage of sales decreased by 5%.
As the cost of sales is a much larger proportion of Ridge Ltd’s expenses,

management’s ability to reduce this expense more than offset the increase in selling
expenses to explain the increase in profit.

EXERCISE 12.6
Jai’s Jeans Ltd
Partial Statement of Financial Position
as at 30 June 2017
Horizontal Analysis
(a)
30-Jun-17 30-Jun-16 change %

Current assets 13000 18000 -5000 -27.80%
Property, plant and equip. (net) 951000 862000 89000 10.30%
Intangibles 56000 52000 4000 7.70%

Total Assets 1034000 950000 84000 8.80%
Current liabilities 45000 50000 -5000 -10.00%
Non-current liabilities 320000 311000 9000 2.90%
Total Liabilities 365000 361000 4000 1.10%
Total Equity 669000 589000 80000 13.60%
Total Equity and Liabilities 1034000 950000 84000 8.80%
(b) Jai’s Jeans Ltd

as at 30 June 2017
Vertical Analysis
30-Jun-17 30-Jun-16
Current assets 13000 1.30% 18000 1.80%
Property, plant and equip.
951000 92.00% 862000 86.20%
(net)
Intangibles 56000 5.40% 52000 5.20%
Total Assets 1034000 100.00% 950000 100.00%
Current liabilities 45000 4.40% 50000 5.30%
Non-current liabilities 320000 30.90% 311000 32.70%
Total Liabilities 365000 35.30% 361000 38.00%
Total Equity 669000 64.70% 589000 62.00%
Total Equity and Liabilities 1034000 100.00% 950000 100.00%
(c) Horizontal analysis gives an investor useful information about trends in an entity’s
(intra-entity) performance or financial position. Vertical analyses provide information
on the significance of financial statement items as a function of some total on the
financial statement. Both types of calculations can be compared with industry
averages or companies in the same industry. Because vertical and horizontal
analyses are complementary, both are useful when making the investment decision.

EXERCISE 12.7
(a)
Bondi Ltd
as at 30 June 2017
Horizontal Analysis
Percentage
Increase Change
2017 2016 (Decrease) from 2013
Current assets $88,000 $80,000 $8,000 10%

Property, plant & equipment (net) 81,000 90,000 (9,000) (10.0%)
Intangibles 31,000 40,000 (9,000) (22.5%)
Total assets $200,000 $210,000 ($10,000) (4.8%)
Current liabilities $52,000 $48,000 $4,000 8.3%

Non-current liabilities 135,000 150,000 (15,000) (10.0%)
Equity 13,000 12,000 1,000 8.3%
Total liabilities & equity $200,000 $210,000 ($10,000) (4.8%)
(b)
Bondi Ltd
as at 30 June 2017
Vertical Analysis
2017 2016
$ Percent $ Percent
Current assets $88,000 44.0% $80,000 38.1%

Property, plant & equipment (net) 81,000 40.5% 90,000 42.9%
Intangibles 31,000 15.5% 40,000 19.0%
Total assets $200,000 100.0% $210,000 100%
Current liabilities $52,000 26.0% 48,000 22.9%

Non-current liabilities 135,000 67.5% 150,000 71.4%
Equity 13,000 6.5% 12,000 5.7%
Total liabilities & equity $200,000 100.0% $210,000 100%

EXERCISE 12.8
Grayson Ltd
Current ratio = 1.59:1.0 ($1,100 ÷ $690)
Quick ratio = 0.60:1.0 ($411 ÷ $690)
Current cash debt coverage = .33 times ($215 ÷ $658.5)
Receivables turnover = 12.0 times ($3,894 ÷ $324.5)
Average collection period = 30.4 days (365 days ÷ 12.0)
Inventory turnover = 4.3 times ($2,600 ÷ $607)
Average days in inventory = 85. days (365 days ÷ 4.3)
EXERCISE 12.9
Global Ltd
(a) Current ratio as of 1 February 2016 = 2 or 2.0:1.0 ($200,000 ÷ $100,000).
Feb. 3 2.0 No change in total current assets or liabilities.
7 1.75 ($175,000 ÷ $100,000). Current assets decrease by

$25,000.
11 1.75 No change in total current assets or liabilities.
14 1.87 ($161,000 ÷ $86,000). Current assets and current liabilities

decrease by $14,000
18 1.75 ($161,000 ÷ $92,000). Current liabilities increase by $6,000.
(b) Quick ratio as of 1 February 2016= 1.7 or 1.7:1.0 ($170,000 ÷ $100,000).
Feb. 3 2.4 No change in total quick assets or current liabilities.
7 1.45 ($145,000 ÷ $100,000). Quick assets decrease by $25,000
11 1.42 ($142,000 ÷ $100,000). Quick assets decrease by $3,000.
14 1.49 ($128, 000 ÷ $86,000). Quick assets and current liabilities

decrease by $14,000.
18 1.39 ($128,000 ÷ $92,000). Current liabilities increase by $6,000.

EXERCISE 12.10
Sonic Ltd
(a) $145, 000

Current ratio:  2.9 :1.0
$50, 000
(b) $85,000
Quick ratio: 1.7 : 1.0
$50,000
(c) $350, 000 $65,000  $60,000

Receivables turnover:  5.6 times (1)
$62,500 (1) 2
(d) Average collection period: 365 days ÷ 5.6 = 65.2 days.
(e) $200, 000 $60,000  $50,000

Inventory turnover:  3.6 times (2)
$55, 000 (2) 2
(f) Average days in inventory: 365 days ÷ 3.6 = 101 days
(g) $50, 000

Cash return on sales:  14.3%
$350, 000
(h) $50, 000

Cash debt coverage:  .323 times
$160, 000  $150, 000
2
(i) $50, 000

Current cash debt coverage:  .91 times
$60, 000  $50, 000
2

EXERCISE 12.11
Cyber Ltd
2017
a. Profit margin
Profit 164 000

Net credit sales 950 000
17.3%
b. Asset turnover

Average total assets (710 000+670 000) / 2 690 000
137.7%
c. Return on assets
Profit 164 000

23.8%
d. Return on ordinary shareholders’ equity
Profit 164 000

Average total equity (610000+580,000) / 2 595 000
27.6%
e Cash return on sales
Net cash flows from operating activities 95 000

10.0%
f. Gross profit margin
Gross profit 416 000

43.8%

EXERCISE 12.12
Centro Ltd
2016
a. EPS
Profit available to ordinary shareholders 118 800

Weighted average no. of ordinary shares 20 000
$5.94
b. P/E ratio
Share price $23.00

Earnings per share $5.94
3.9 times
c. Dividend payout rate.
Dividends to ord. shareholders 15 000

Profit 121 800
Cash dividend payout ratio includes dividends paid to

ordinary shareholders only. 12.3%
d. Times interest earned.
Profit before income tax and interest expense 210,000

Interest expense 36 000
5.8
e Cash return on sales
Net cash flows from operating activities 95 000

16.4%

EXERCISE 12.13
Xander Ltd
(a) Inventory turnover = 3.6 = Cost of sales

$200,000+$180,000
2
3.6 x $190,000 = cost of sales

Cost of sales = $684,000
(b) Net sales (credit)

Receivables turnover = 9.4 =
 $126,000  $72,500 
 
 2 
Net sales (all on credit) = 9.4 x $99,250 = $932,950
(c) Return on ordinary shareholders’ equity = 22% =

Profit
$400, 000  $113,500  $400, 000  $101, 000 
2
Profit = .22 x $507,250 = $111,595
(d) $111,595 [see (c) above]

Return on assets = 12.5% =
Average assets
$111,595
Average assets =  $892, 760
.125
(Total assets June 2016 + Total assets June 2015) = Average assets
2
(Total assets June 2016 + $805,000) = $892,760

2
Total assets June 2016 = ($892,760 x 2) - $805,000 = $980,520.

SOLUTIONS TO PROBLEM
SET A
PROBLEM SET A 12.1
(a)
Spencer Ltd and Forrester Ltd
Condensed Statement of profit or loss
for the year ended 30 June 2016
Vertical Analysis
Spencer Ltd Forrester Ltd

$ % $ %
Sales 1 250 000 100.0% 410 000 100.0%
Cost of sales 690 000 55.2% 257 000 62.7%
Gross profit 560 000 44.8% 153 000 37.3%
EBIT 239 000 19.1% 91 000 22.2%
interest expense 6 000 0.5% 1 200 0.3%
Profit 163 100 13.0% 62 860 15.3%
(b)
Spencer Ltd has a lower relative profitability after tax. However it’s gross profitability is higher
relative to Forrester Ltd. This is due to Spencer’s lower cost of sales. The major difference is the
relatively greater operating expenses, lowering Spencer’s EBIT which flows through to the other
profit measures.
Return on assets
Profit 163 100 62 860

Average total assets (847 285+812 410) / 2 829 847.5 (428 000+396 000) / 2 412 000
19.7% 15.3%
Return on ordinary shareholders’ equity
Profit 163 100 62 860

Average total equity (659 190+646 595) / 2 652 892.5 (365 000+340 000) / 2 352,500
25.0% 17.8%
Although Spencer Ltd’s profit margin was lower than Forrester Ltd, it has a higher Return on assets
and Return on ordinary shareholders’ equity.

Details provided below for show

calculations for :
average total assets *
and average total equity **

Current assets 325 975 312 410 188 000 180 000
Non-current assets 521 310 500 000 240 000 216 000
Total Assets 847 285 812 410 428 000 396 000
Current liabilities 79 595 7 5815 36 000 32 000
Non-current liabilities 108 500 90 000 27 000 24 000
Total Liabilities 188 095 165 815 63 000 56 000
Share capital, $10 each 500 000 500 000 320 000 300 000
Retained earnings 159 190 146 595 45 000 40 000
Total Equity 659 190 646 595 365 000 340 000

PROBLEM SET A 12.2
Bayview Ltd
(a) $202,300
Earnings per share =  $2.52 per share
80,137
(b) $202,300
 $465, 400  $736, 700 
Return on ordinary shareholders’ equity =  2 
$202,300
  33.7%
$601, 050
(c) $202,300 $202,300

Return on assets =   20.3%
 $852,800  $1,140, 200  $996,500
 2 
(d) $514,900
Current ratio =  2.7 :1.0
$193,500
(e) $314,900
Quick ratio =  1.6 :1.0
$193,500
(f) $1,818,500 $1,818,500

Receivables turnover =   14.4 times
 $102,800  $150, 000  $126, 400
 2 
(g) Average collection period = 365 days ÷ 14.4 = 25.4 days.
(h) $1, 005,500 $1, 005,500

Inventory turnover =   6.4 times
 $115,500  $200, 000  $157,500
 2 
(i) Average days in inventory = 365 days ÷ 6.4 = 57.3 days.
(j) $307,000
Times interest earned = $18,000
= 17.0 times

(k) $1,818,500
Asset turnover =  1.8 times
$996,500
(l) $403,500
Debt to total assets =  35.4%
$1,140, 200
(m) $280,000
Current cash debt coverage ratio =  1.47 times
$187,400  $193,500
2
(n) $280,000
Cash return on sales =  15.4%
$1,818,500
(o) $280,000
Cash debt coverage =  .708 times
$387,400  $403,500
2

PROBLEM SET A 12.3
(a) Comparative analysis is performed to evaluate an entity’s short-term liquidity,

profitability and long-term solvency. Comparisons can detect changes in financial
relationships and significant trends, and can provide insight into an entity’s
competitive position within its industry. Financial statements may be analysed
horizontally, vertically, and with ratios.
Metro Ltd
(b) 2017 2016
(1) Profit margin ratio:
$44,000 $32,000
 6 .3 %  4 .9 %
$700,000 $650,000
(2) Gross profit ratio:
$280,000 $250,000
 40%  38%
$700,000 $650,000
(3) Asset turnover.
$700,000 $650,000
 1.1times  1.2 times
 $590,000  $640,000   $533,000  $590,000 
   
 2   2 
(4) Earnings per share.
$44,000 $32,000
 $1.38 per share  $1.07 per share
 4,000  30,000
30,000  2 
 
(5) Price-earnings ratio.
$7.95 $5.00
 5.8 times  4.7 times
$1.38 $1.07
(6) Cash dividend payout ratio.
$24,000 * * $20,000 *
 54.5%  62.5%
$44,000 $32,000
**($125,000 + $44,000 - $145,0000) *($113,000 + $32,000 - $125,000)
(7) Debt to total assets.
$155,000 $165,000
 24.2%  28%
$640,000 $590,000

(c) The underlying profitability of the company appears to have improved. For example, profit
margin and earnings per share have both increased. In addition, the company’s price-
earnings ratio has increased, which suggests that investors may be looking more
favourably at the company. Also, the company appears to be involved in attempting to
reduce its debt burden as its debt to total assets has decreased. Similarly, its cash
dividend payout ratio has decreased, which should help its overall solvency.
PROBLEM SET A 12.4
Digimax Ltd
Liquidity 2016 2015 Change
Current $364,000 $343,000 Decrease

 1.1 :1.0  1.9 :1.0
$335,000 $182,000
Quick $209,000 $195,000 Decrease

 0.6 :1.0  1.1 :1.0
$335,000 $182,000
Receivables turnover $850,000 $790,000 Increase

$92,000 $89,000
Inventory turnover $620,000 $575,000 Increase

$127,500 $120,000
Although the amount of current and quick assets to cover current liabilities has declined, in relative
terms, the turnover of receivables and inventory has improved. The decline in the current and quick
ratios is caused by the notes payable due March 2014, becoming a current liability.
Profitability 2016 2015 Change
Profit margin $36,000 $35,000 Decrease

 4 .2 %  4 .4 %
$850,000 $790,000
Asset turnover $850,000 $790,000 Increase

$666,000 $639,000
Return on assets $36,000 $35,000 Decrease

 5.4%  5.5%
$666,000 $639,000
Earnings per share $36,000 $35,000 Increase

20,000 20,000
Profitability has remained relatively the same.

PROBLEM SET A 12.5
Eastco Ltd and Westco Ltd
(a)
Ratio Eastco Ltd Westco Ltd
(1) Current ratio 2.0:1 ($11,000 ÷ $5,500) 1.2:1 ($11,000 ÷ $9,000)
(2) Receivables 7.3 times ($40,000 ÷ $5,500) 37.3 times ($82,000 ÷ $2,200)
turnover
(3) Average 50 days (365 ÷ 7.3) 9.8 days (365 ÷ 37.3)
collection period
(4) Inventory turnover 6.4 times ($32,000 ÷ $5,000) 8.1 times ($65,000 ÷ $8,000)
(5) Average days in 57 days (365 ÷ 6.4) 45 days (365 ÷ 8.1)

inventory
(6) Profit margin 1.8% ($700 ÷ $40,000) 2.4% ($2,000 ÷ $82,000)
(7) Asset turnover 2.1 ($40,000 ÷ $18,752) 3.0 ($82,000 ÷ $27,461)
(8) Return on assets 3.7% ($700 ÷ $18,752) 7.3% ($2,000 ÷ $27,461)
(9) Return on 11.3% ($700 ÷ $6,196.5) 20.8% ($2,000 ÷ $9,617)

ordinary
shareholders’
equity
(10) Debt to total 68.5% ($13,700 ÷ $20,000) 70.2% ($20,000 ÷ $28,481)
assets
(11) Times interest 2.7 times ($1,600 ÷ $600) 4.2 times ($4,200 ÷ $1,000)
earned
(12) Current cash debt 0.18 times [$1,000÷($5,500+$5,698) ÷2] 0.26 times [$2,500 ÷ ($9,000+$9,981) ÷ 2]
coverage
(13) Cash return on 2.5% ($1,000 ÷ $40,000) 3.0% ($2,500 ÷ $82,000)
sales
(14) Cash debt .08 times [$1,000 ÷ ($13,700 + $11,411)/2] .14 [$2,500 ÷ ($20,000 + $15,688)/2]
coverage*
* Beginning of the year total liabilities can be determined from beginning-of-year figures for
total assets and shareholders’ equity as for:
Eastco Ltd Westco Ltd

$17,504 - $6,093 = $11,411;: $26,441 - $10,753 = $15,688.
(b) A simple comparison of current ratios would suggest that Eastco is more liquid.
However, Eastco takes 107 days to convert inventory to cash (sum of average days in
inventory and average collection period) whereas Westco takes only 55 days. Westco also
has higher current cash debt coverage.
While Eastco has a lower debt to total assets ratio, indicating better solvency, Westco has a
higher cash debt coverage and times interest earned, indicating that it is more able to
service its debt.
Westco was more profitable in the year of this analysis. It has both a higher asset turnover
and a higher profit margin contributing to the greater return on assets. Westco also has a
higher return on shareholders equity and generates more cash with each dollar of sales.

PROBLEM SET A 12.6
Diva Ltd
(a) $209, 000

$135, 000
Should be 1.54 8 to 1. So rounding is off. Should be 1.5, if to one decimal.
(b) Quick ratio =

$15, 000  $18, 000  $92, 000
 0.9 :1.0
$135, 000
(c) $580, 000

Receivables turnover =  7.0 times
 $92, 000  $74, 000 
 2 
(d) Average collection period = 365 ÷ 7.0 = 52 days
(e) $400, 000

Inventory turnover =  5.2 times
 $84, 000  $70, 000 
 2 
(f) Average days in inventory = 365 ÷ 5.2 = 70 days
(g) $34, 000

Profit margin ratio =  5.9%
$580, 000
(h) Asset turnover =

$580, 000
 1.0 times
 $632, 000  $560, 000 
 2 
(i) $34, 000

Return on assets =  5.7%
 $632, 000  $560, 000 
 2 
(j) $34, 000

Return on ordinary shareholders’ equity =  9.5%
 $367, 000  $350, 000 
 2 
(k) $34, 000

Earnings per share =  $1.13 per share
30, 000 (1)
(1) $150,000  $5.00
(l) $19.50
Price-earnings ratio =  17.2 times
$1.13

(m) $17, 000 (2)

Cash dividend payout ratio =  50%
$34, 000
(2) $200,000 + $34,000 - $217,000
(n) $265, 000

$632, 000
(o) $59, 200 (3)

Times interest earned =  8.2 times
$7, 200
(3) $34,000 + $18,000 + $7,200

PROBLEM SET A 12.7
Ascot Ltd
$11,000,000
Receivables turnover = 10 =
Average receivable s
$11,000,000
Average receivables =  $1,100,000
10
(Receivables 30 June 12 + $950, 000)

= $1,100,000
2
Receivables 30/6/12 = $2,200,000 - $950,000 = $1,250,000
Profit
Profit margin = 14.5% = .145 =
$11, 000, 000
Profit = $11,000,000 x .145 = $1,595,000
Profit before income taxes = $1,595,000 + $560,000 = $2,155,000
$1,595,000
Return on assets = 22% = .22 =
Average assets
$1,595,000
Average assets = .22
= $7,250,000
(Assets (30/6/12) + $7,000,000)

= $7,250,000
2
Assets (30/6/12) = $14,500,000 - $7,000,000 = $7,500,000
Total current assets = $7,500,000 - $4,620,000 = $2,880,000
Inventory = $2,880,000 - $1,250,000 - $450,000 = $1,180,000
Total liabilities and shareholders’ equity = $7,500,000
Total liabilities = $7,500,000 - $3,400,000 = $4,100,000
$2,880, 000
Current ratio = 3:1 =
Current liabilities
$2,880,000
Current liabilities = = $960,000
3

Non-current liabilities = $4,100,000 - $960,000 = $3,140,000
Inventory turnover = 4.8 = Cost of sales

$1,720,000+$1,180,000
2
Cost of sales = $1,450,000 x 4.8 = $6,960,000
Gross profit = $11,000,000 - $6,960,000 = $4,040,000
Gross profit - operating expenses – interest expense = profit before income tax
$4,040,000 - $1,665,000 – interest expense = $2,155,000
Interest expense = $2,375,000 - $2,155,000 = $220,000

PROBLEM SET A 12.8
Calgary Ltd
(a)
1. Free cash flow = net cash from operating activities – capital expenditure
= 101,344 – 32,560 = 68,784
2. Capital expenditure ratio

net cash flow from operating activities
=
capital expenditure
101,344
= 3.1: 1
32,560
3. Current cash debt coverage

=
average current liabilities
101,344
= = 0.5 times
[(202,680 + 203,500) ÷ 2]
4. Cash debt coverage

=
average total liabilities
101,344
= = 0.25 times
[(505,000 + 306,500) / 2]
5. Cash return on sales ratio =

net sales
=
101,344
= 0.17 times
608,000
(b) Traditionally, to evaluate an entity, the ratios most commonly used by investors and
creditors have been based on accrual accounting. In this question some cash-based
ratios are explored that are gaining increasing acceptance among analysts.
FREE CASH FLOW
In the statement of cash flows, cash provided by operating activities is intended to

indicate the cash-generating capability of the entity. Analysts have noted, however,
that net cash provided by operating activities fails to take into account that an entity
must invest in new property, plant and equipment just to maintain its current level of
operations, and it may need to maintain dividends at current or minimum levels to
satisfy investors. Free cash flow is the term used to describe the cash from
operations available for expansion or the payment of dividends. It is the amount of
cash flow from operating activities remaining after deducting investing expenditure
necessary to maintain the current level of operations. For Calgary Ltd Free cash flow

of $68,784 is available for the acquisition of new assets, the retirement of debt, or the
payment of dividends.
CAPITAL EXPENDITURE RATIO
Another indicator of an entity’s ability to generate sufficient cash to finance the purchase of
new property, plant and equipment is the capital expenditure ratio — net cash provided by
operating activities divided by capital expenditures. This measure is similar to free cash flow,
except that free cash flow reveals the amount of cash available for discretionary use by
management, whereas the capital expenditure ratio provides a relative measure of cash
provided by operations compared with cash used for the purchase of productive assets.
Amounts spent on capital expenditures are listed in the investing activities section of the
statement of cash flows. Using the information from Calgary Ltd the calculations reveal its
capital expenditure ratio 3.1: 1
The ratio of 3.1:1 suggests that Calgary Ltd could have purchased more than three times as
much property, plant and equipment as it did without requiring any additional outside
financing. This ratio will vary across industries depending on the capital intensity of the
industry. That is, we would expect a manufacturing entity to have a lower ratio (because it has
higher capital expenditures) than a software entity, which spends less of its money on non-
current assets and more on ‘intellectual’ capital. The phase of an entity’s life cycle will also
affect the expected capital expenditure ratio. It is likely to be lower in the introductory and
growth phases and higher in the maturity and decline phases.
LIQUIDITY
Liquidity is the ability of an entity to meet its immediate obligations. One measure of liquidity is
the current ratio: current assets divided by current liabilities. A disadvantage of the current
ratio is that it uses year-end balances of current asset and current liability accounts, and
these year-end balances may not be representative of the entity’s position during most of the
year.
CURRENT CASH COVERAGE
A measure that partially corrects this problem is the current cash debt coverage which is the
net cash provided by operating activities divided by average current liabilities. Because net
cash provided by operating activities involves the entire year rather than a balance at one
point in time, it is often considered a better representation of liquidity.
Calgary Ltd net cash provided by operating activities in 1 year is 0.5:1. That is, it generates 50
cents of net cash provided by operating activities for every $1 of current liabilities. It generates
enough cash from operating activities in 1 year to meet 50% of the obligations that are due
within 1 year. A ratio closer to 1:1 would indicate that it generates 100 cents of net cash
provided by operating activities for every $1 of current liabilities.
SOLVENCY
Solvency is the ability of an entity to survive over the long term.
CASH DEBT COVERAGE
A measure of solvency that uses cash figures is the cash debt coverage which is measured
as the net cash provided by operating activities divided by total debt as represented by
average total liabilities. This measure indicates an entity’s ability to repay its liabilities from
cash generated from operations, i.e. without having to liquidate productive assets such as
property, plant and equipment. The cash debt coverage for Calgary Ltd is 0.25 times. Calgary
Ltd’s net cash provided by operating activities is 0.25:1. This means that the entity has 25
cents net cash provided by operating activities for every $1 of average total liabilities. Hence,
Calgary Ltd net cash provided by operating activities is 25% of its total liabilities. Another way
to consider this measure is to look at the reciprocal, which is 4. It would take Calgary Ltd 4
years to repay all of its liabilities from cash provided by operating activities at the current level.

PROFITABILITY
Profitability refers to an entity’s ability to generate a reasonable return. Accrual-based ratios

that measure profitability are discussed, such as gross profit rate, profit margin and return on
assets. In measures of profitability the potential differences between cash accounting and
accrual accounting are most pronounced. Although some differences are expected because
of the difference in the timing of revenue and expense recognition under cash versus accrual
accounting, significant differences should be investigated. A cash-based measure of
performance is the cash return on sales ratio.
CASH RETURN ON SALES RATIO
The cash return on sales ratio is calculated as net cash provided by operating activities
divided by net sales. This ratio indicates the entity’s ability to turn sales into dollars. The cash
return on sales ratio can be compared with the corresponding accrual-based ratio. A lower
cash return on sales ratio should be investigated because it might indicate that the entity is
recognising sales that are not really sales (i.e. sales it will never collect), or incurring a lot of
expenditure relative to revenue. Alternatively, it may reflect payments for increased inventory
and other lags occurring in the growth phase. The cash return on sales ratio for Calgary Ltd is
0.17,0.17:1 or 17%.
Overall it appears that Calgary Limited ratios indicate the business is profitable and solvent,
can replace its assets as needed and has free cash flow. However, further investigation is
needed into the liquidity of the business to ensure that there is adequate cash flow to met
short term debts as they fall due.

PROBLEM SET A 12.9
Yin Ltd and Yan Ltd

(a)
Ratio Yin Ltd Yan Ltd
(1) Return on assets 39.0% ($276,000 ÷ $708,000) 30.3% ($188,000 ÷ $620,000)
(2) Return on 67.6% ($276,000 ÷ $408,000) 58.7% ($188,000 ÷ $320,000)

ordinary
shareholders’
equity
(3) Profit margin 27.6% ($276,000 ÷ $1,000,000) 18.8% ($188,000 ÷ $1,000,000)
(4) Current ratio 4.1:1 ($488,000 ÷ $120,000) 3.7:1 ($440,000 ÷ $120,000)
(5) Receivables 5 times ($1,000,000 ÷ $200,000) 5 times ($1,000,000 ÷ $200,000)

turnover
Inventory turnover 2.7 times ($552,000 ÷ $208,000) 3.8 times ($600,000 ÷ $160,000)
(7) Debt to equity 73.5% ($300,000 ÷ $408,000) 93.8% ($300,000 ÷ $320,00)
(b) Using different accounting methods has affected all measures except the receivables
turnover ratio. The use by Yan Ltd of weighted average valuation and reducing
balance depreciation has increased their expenses, reduced their profit and therefore
decreased their total asset and equity values. This in turn causes their return on
assets, return on equity, profit margin, current ratio, and debt to equity ratio to be
considerably lower than Yin Ltd.; however, Yan Ltd’s inventory turnover was better
because the weighted average inventory method (in a period of rising prices) results
in a higher cost of sales and a lower ending inventory value than does the FIFO
inventory method.

SOLUTIONS TO PROBLEM SET B
PROBLEM SET B 12.1
(a)
Black Ltd and White Ltd
Condensed Statement of profit or loss
for the year ended 31 December 2016
Vertical Analysis
Black White
$ % $ %
Sales 430 000 100.0% 750 000 100.0%
Cost of sales 185 000 43.0% 392 500 52.3%
Gross profit 245 000 57.0% 357 500 47.7%
EBIT 148 000 34.4% 184 500 24.6%
interest expense 4 500 1.0% 8 000 1.1%
Profit 100 450 23.4% 123 550 16.5%
(b)
Return on assets Black White
Profit 100 450 123 550

Average total assets * 1 050 000 566 500
9.6% 21.8%
Return on ordinary shareholders’ equity

(ROE)
Profit 100 450 123 550

Average total equity ** 647 000 353 500
15.5% 35.0%
Although White Ltd has more profit in dollar terms it has been less profitable than Black Ltd
during 2016. White Ltd incurs greater cost of sales and operating expenses, relative to sales,
than Black Ltd and therefore achieves a lower profit margin. Black’s return on assets of 9.6%
is lower than White’s return on assets of 21.8% Black’s return on equity of 29.1% is lower
than White’s return on equity of 35%

Details provided below for show calculations for:

average total assets * and average total equity **
Black White
Current assets 94 000 97 000 60 000 47 000
Non-current assets 971 000 938 000 520 000 506 000
Total Assets 1 065 000 1 035 000 580 000 553 000
Current liabilities 81 000 76 000 38 000 32 000
Non-current liabilities 349 000 300 000 175 000 181 000
Total Liabilities 430 000 376 000 213 000 213 000
Share capital, $10 each 500 000 494 000 320 000 300 000
Retained earnings 135 000 165 000 47 000 40 000
Total Equity 635 000 659 000 367 000 340 000
Average total assets * (1 065 000 +1 035 000) / 2 (580 000 + 553 000) / 2
Average total equity ** (635 000 + 659 000) / 2 (367 000 + 340 000) / 2

PROBLEM SET B 12.2
Halifax Ltd
(a) Gross profit rate = $340,000 = 43.6%

$780,000
(b) $157, 200

Return on ordinary shareholders’ equity =  39.0%
 $410,300  $396, 000 
 2 
(c) $157, 200

Return on assets =  22.3%
 $735,800  $672, 000 
 2 
(d) $280,500
$193,500
(e) Receivables turnover =

$780, 000
 7.8 times
 $106, 200  $93,800 
 2 
(f) Average collection period = 365 ÷ 7.8 = 46.8 days
(g) Inventory turnover =

$440, 000
 4.9 times
 $116, 400  $64, 000 
 2 
(h) Average days in inventory = 365 ÷ 4.9 = 75 days
(i) $186, 200  $9,920

Times interest earned =  19.8 times
$9,920

(j) Asset turnover =

$780, 000
 1.1 times
 $735,800  $672, 000 
 2 
(k) $325,500
$735,800
(l) Current cash debt coverage =

$41, 000
 0.235times
 $193, 500  $156, 000 
 2 
(m) $41, 000

Cash debt coverage =  0.136times
 $325,500  $276, 000 
 2 

PROBLEM SET B 12.3
Jasmine Ltd
(a) 2016 2015
(1) Profit margin ratio:
$120, 000 $100, 000

 16.2%  15.2%
$740, 000 $660, 000
(2) Gross profit ratio:
$320, 000 $210, 000

 43.2%  31.8%
$740, 000 $660, 000
(3) Asset turnover.
$740, 000 $660, 000

 $795, 000  $665, 000   $533, 000  $665, 000 
 2   2 
(4) Earnings per share.
$120,000 $100, 000

31,984 30, 000
(5) Price-earnings ratio.
$15.00 $10.00
$3.75 $3.33
(6) Cash dividend payout ratio.
$20, 000** $13, 000*

 17%  13%
$120, 000 $100, 000
**($200,000 + $120,000 - $300,0000) *($113,000 + $100,000 - $200,000)
(7) Debt to total assets.
$155, 000 $165, 000

 19.5%  24.8%
$795, 000 $665, 000

(b) The underlying profitability of the company appears to have improved. For example,
profit margin and gross profit ratio have both increased. The earnings per share has
increased even though there are more shares in the denominator. In addition, the
company’s price-earnings ratio has increased, which suggests that investors may be
looking more favourably at the company. Also, the company appears to be involved
in attempting to reduce its debt burden as its debt to total assets has decreased.
(c) The usefulness of analytical tools is limited by the use of estimates, the cost basis,
the application of alternative accounting methods, atypical data at year-end, and the
diversification of entities.

PROBLEM SET B 12.4
Multimedia Ltd
(a)
Liquidity 2016 2015 Change
Current $695,000 = 2.1: 1.0 $510,000 = 3.1:1.0

$335,000 $165,000 Decrease
Quick $230,000 = 0.7: 1.0 $179,000 = 1.1: 1.0

$335,000 $165,000 Decrease
Receivables turnover $1,000,000 = 10.7 times $940,000 = 11.3 times

$93,500 $83,500 Decrease
Inventory turnover $650,000 = 1.8 times $635,000 = 2.0 times

$370,000 $325,000 Decrease
The current ratio and the quick ratio declined indicating lower liquidity. There are relatively fewer
current assets for every dollar of current liabilities in 2016 than there were in 2015. This decline
is exacerbated by the slower turnover of both receivables and inventory.
Profitability 2016 2015 Change
Profit margin $115,000 = 11.5% $80,000 = 8.5%

$1,000,000 $940,000 Increase
$1,000,000 = 0.9 times $940,000 _ = 0.9 times

Asset turnover ($1,340,000+$985,000)/2 ($985,000+$1,175,000)/2 Stable
Return on $115,000 = 9.9% $80,000 _ = 7.4% Increase

assets ($1,340,000+$985,000)/2 ($985,000+$1,175,000)/2
Earnings per $115,000 = $1.15 per share $80,000 = $0.80 per share
share 100,000 100,000 Increase
Profitability has improved. The improved profitability was driven by the greater profitability of
each dollar of sales, rather than efficiency in asset turnover, which remained stable.

(b) Current Ratio is Current Asset divided by Current Liabilities. Higher ratio means
better short-term liquidity. Current Ratio of 2.1 means, for every dollar of current
liabilities, there is $2.10 of current assets in the company’s statement of financial
position.
Quick Ratio is calculated as follows:
(Cash + Marketable Securities + Net Receivables)/Current Liabilities

Current Ratio, higher ratio means better short-term liquidity. Quick Ratio calculation,
however, does not include inventory and prepaid expense. For this reason, Quick
Ratio is considered better than Current Ratio. Cash, marketable securities and net
receivables are more liquid when compared with inventory and prepaid expenses.
The inventory may not be readily saleable and the prepaid expenses may not be
transferable to others.
Receivables Turnover is Net Credit Sales divided by Average Net Trade

Receivables. Receivables Turnover measures the number of times, on average, that
receivables are collected during the period. The higher the receivables turnover, the
shorter the period of time between an entity making a credit sale and collecting the
cash for the receivable. The higher the receivables turnover, the more liquid the
receivables of an entity.
Inventory Turnover is Cost of Sales divided by Average Inventory. Inventory Turnover

measures the number of times on average the inventory is sold during the period. Its
purpose is to measure the liquidity of the inventory. Further, the higher the turnover,
the less chance inventory will be slow moving or become obsolete and un-saleable.
Profit Margin is a measure of the amount of each dollar of sales that results in profit.
It is calculated by dividing profit by net sales for the period. A Profit Margin of 11.5%
means that net sales of $1 results in profit of 11.5 cents.
Asset Turnover measures how efficiently an entity uses its asset to generate sales.
The higher the number, the more efficient. Asset Turnover is calculated by dividing
net sales by average total assets for the period.
Return on Assets is Profit divided by Average Total Asset. Return on Assets

measures the overall profitability of assets in terms of the rate earned on each dollar
invested in assets.
Earnings per share is a measure of the profit earned on each ordinary share. It is
calculated by dividing profit available to ordinary shareholders by the weighted
average number of ordinary shares issued.

PROBLEM SET B 12.5
Angel Ltd and Buffy Ltd
(a)
Ratio Angel Ltd Buffy Ltd
(1) Current 1.6:1 ($9,187 ÷ $5,626) 1.5:1 ($15,338 ÷ $9,973)
(2) Receivables turnover 21.7 times ($34,025 ÷ $1,570) 118.7 times ($82,494 ÷ $695)
(3) Average collection 16.8 days (365 ÷ 21.7) 3.1 days (365 ÷ 118.7)
period
(4) Inventory turnover 3.6 times ($25,992 ÷ $7,317) 5.2 times ($65,586 ÷ $12,539)
(5) Average days in 101.4 days (365 ÷ 3.6) 70.2 days (365 ÷ 5.2)
inventory
(6) Profit margin 0.9% ($296 ÷ $34,025) 3.2% ($2,681 ÷ $82,494)
(7) Asset turnover 2.0 ($34,025 ÷ $17,267) 2.8 ($82,494 ÷ $29,630)
(8) Return on assets 1.7% ($296 ÷ $17,267) 9.0% ($2,681 ÷ $29,630)
(9) Return on ordinary

shareholders’ equity 4.9% ($296 ÷ $6,063) 22.8% ($2,681 ÷ $11,740
(10) Debt to total assets 64.6% ($10,997 ÷ $17,029) 61.2% ($20,093 ÷ $32,819)
(11) Times interest earned 1.8 times ($904 ÷ $494) 7.0 times ($4,968 ÷ $706)
(12) Current cash debt .062 ($351 ÷ $5,626) .311 ($3,106 ÷ $9,973)
coverage*
(13) Cash return on sales 1% ($351 ÷ $34,025) 3.8% ($3,106 ÷ $82,494)
(14) Cash debt .032 [$351 ÷ ($5,626 + $5,371)] .155 [$3,106 ÷ ($9,973 + $10,120)]
coverage**
*using year-end amounts because beginning of year data is not available.

** using year-end amounts. Alternatively, beginning of the year total liabilities can be determined
from beginning-of-year figures for total assets and shareholders’ equity as for
Angel Ltd:
$11,411 ($17,504 - $6,093): [$351 ÷ ($10,997 + $11,411)/2] = .031;
Buffy Ltd
$15,688 ($26,441 - $10,753): [$3,106 ÷ ($20,093 + $15,688)/2] = .174.

(b) A simple comparison of current ratios would suggest that Angel is more liquid. However,
Angel takes 118 days to convert inventory to cash (sum of average days in inventory of
101 days and average collection period of 17 days) whereas Buffy takes only 73days for
the same. Buffy also has higher current cash debt coverage.
Buffy has a lower debt to total assets ratio, indicating better solvency, Buffy also has a
higher cash debt coverage and times interest earned, indicating that it is more able to
service its debt.
Buffy was more profitable in the year of this analysis. It has both a higher asset turnover
and a higher profit margin contributing to the greater return on assets. Buffy also has a
much higher return on shareholders’ equity and generates more cash with each dollar of
sales.

PROBLEM SET B 12.6
Beachcombers Ltd
a. Current ratio
CA 240 600
CL 111 600
b. Quick ratio 2.16
QA = (cash 25,000 + MS 15 600 + Acc. Rec. 110 000) 150 600

CL 111 600
1.35
c. Receivables turnover

Net receivables 102 500
6.9 times
d. Average collection period
days in year 365

Receivables turnover. 6.9
52.9 days
e. Inventory turnover
Cost of sales 376 000

Inventory 84 000
4.5 times
f. days in inventory
days in year 365

inventory turnover 4.5
81.1 days
g. Profit margin ratio
Profit 121 450

17.3%
h. Asset turnover

97.7%
i. Return on assets
Profit 121 450

16.9%

j. Return on ordinary shareholders’ equity
Profit 121 450

Average total equity (465 000+ 425 000) / 2 445 000
27.3%
k. Earnings per share
Profit 121 450

Weighted average no. of ordinary shares 40 000
$3.04
l. Price/earnings ratio
Share price 28.5

Earnings per share $3.04
9.4 times
m. Cash dividend payout ratio
Dividends 101 450*

Profit 121 450
83.5%
n. Debt to total assets
Total liabilities 295 600

41.0%
o. Times interest earned
Profit before income tax and interest expense 183 000

Interest expense 9 500
19.3 times
Retained Earnings
$ $
Dividends 101 450* 1/1 Bal. 245 000
Profit 121 450
31/12 bal 265 000

366 450 366 450
31/12 bal. 265 000

PROBLEM SET B 12.7
Jade Ltd
$5,500,000
Receivables turnover = 10 =
Average receivables
$5,500,000
Average receivables = = 550,000
10
(Receivables 30/6/12 + $475,000)

= $550,000
2
Receivables 30/6/12 = $1,100,000 - $475,000 = $625,000
Profit
$5,500,000
Profit = $5,500,000 x .145 = $797,500
Profit before income taxes = $797,500 + $280,000 = $1,077,500
$797,500
Return on assets = 22% = .22 =
average assets
$797,500
Average assets = = $3,625,000
.22
(Assets (30/6/12) + $3,500,000)

= $3,625,000
2
Assets (30/6/12) = $7,250,000 - $3,500,000 = $3,750,000
Total current assets = $3,750,000 - $2,310,000 = $1,440,000
Inventory = $1,440,000 - $625,000 - $225,000 = $590,000
Total liabilities = $3,750,000 - $1,700,000 = $2,050,000
$1,440,000
Current ratio = 3:1 =
current liabilities
$1,440,000
Current liabilities = = $480,000
3
Non-current liabilities = $2,050,000 - $480,000 = $1,570,000
COGS
Inventory turnover = 4.8 =
[(860,000 + 590,000) / 2]
Cost of sales = $725,000 x 4.8 = $3,480,000
Gross profit = $5,500,000 - $3,480,000 = $2,020,000
$2,020,000 - $832,500 – interest expense = $1,077,500
Interest expense = $1,187,500 - $1,077,500 = $110,000

PROBLEM SET B 12.8

Kalamata Ltd
(a)
$2,750,000
Receivables turnover = 10 = Average receivables
$2,750,000
Average receivables = 10
= 275,000
(Receivables 30/6/15 + $237,500)

= $275,000
2
Receivables 30/6/15 = $550,000 - $237,500 = $312,500
Profit
$2,750,000
Profit = $2,750,000 x .145 = $398,750
Profit before income taxes = $398,750 + $140,000 = $538,750
$398,750
Return on assets = 22% = .22 = average assets
$398,750
Average assets = = $1,812,500
.22
(Assets (30/6/15) + $1,750,000)

= $1,812,500
2
Assets (30/6/15) = $3,625,000 - $1,750,000 = $1,875,000
Total current assets = $1,875,000 - $1,155,000 = $720,000
Inventory = $720,000 - $312,500 - $112,500 = $295,000
Total liabilities = $1,875,000 - $850,000 = $1,025,000
$720,000
Current ratio = 3:1 = current liabilities
$720,000
Current liabilities = 3
= $240,000
Non-current liabilities = $1,025,000 - $240,000 = $785,000
COGS
Inventory turnover = 4.8 = [(430,000 + 295,000)÷ 2]
Cost of sales = $362,500 x 4.8 = $1,740,000

Gross profit = $2,750,000 - $1,740,000 = $1,010,000
$1,010,000 - $416,250 – interest expense = $538,750
Interest expense = $593,750 - $538,750 = $55,000
(b) Based on the ratios provided above, Kalamata Ltd would appear to be a reasonable
investment. The profitability ratios appear strong. And the current ratio suggests that
the entity does not have a liquidity problem. The only ratio of concern is the inventory
turnover which suggests that inventory is slow to sell. Before making any investment
decision, comparisons with industry averages and trend analysis would be advisable.

PROBLEM SET B 12.9
Spectre Ltd
(a)
1. Free cash flow = net cash from operating activities – capital expenditure
= 202,688 – 65,120 = 137,568
Net cash flow from operating activities

2. Capital expenditure ratio =
capital expenditure
202,688
= = 3.1: 1
65,120

3. Current cash debt coverage = /
average current liabilities
202,688
= = 0.5 times
[(403,000 + 406,500) ÷ 2]

4. Cash debt coverage = /
average total liabilities
202,688
= = 0.25 times
[(990,800 + 608,500) ÷ 2]

5. Cash return on sales ratio =
net sales
202,688
= = 0.17 times
1,216,000
(b) Traditionally, to evaluate an entity, the ratios most commonly used by investors and creditors
have been based on accrual accounting. In this question some cash-based ratios are
explored that are gaining increasing acceptance among analysts.
FREE CASH FLOW
In the statement of cash flows, cash provided by operating activities is intended to indicate the
cash-generating capability of the entity. Analysts have noted, however, that net cash provided
by operating activities fails to take into account that an entity must invest in new property,
plant and equipment just to maintain its current level of operations, and it may need to
maintain dividends at current or minimum levels to satisfy investors. Free cash flow is the
term used to describe the cash from operations available for expansion or the payment of
dividends. It is the amount of cash flow from operating activities remaining after deducting
investing expenditure necessary to maintain the current level of operations. For Spectre Ltd
Free cash flow of $137 568 is available for the acquisition of new assets, the retirement of
debt, or the payment of dividends.
CAPITAL EXPENDITURE RATIO
Another indicator of an entity’s ability to generate sufficient cash to finance the purchase of
new property, plant and equipment is the capital expenditure ratio — net cash provided by
operating activities divided by capital expenditures. This measure is similar to free cash flow,
except that free cash flow reveals the amount of cash available for discretionary use by
management, whereas the capital expenditure ratio provides a relative measure of cash
provided by operations compared with cash used for the purchase of productive assets.
Amounts spent on capital expenditures are listed in the investing activities section of the
statement of cash flows. Using the information from Spectre Ltd the calculations reveal its
capital expenditure ratio 3.1: 1 The ratio of 3.1:1 suggests that Spectre Ltd could have
purchased more than three times as much property, plant and equipment as it did without
requiring any additional outside financing. This ratio will vary across industries depending on
the capital intensity of the industry. That is, we would expect a manufacturing entity to have a
lower ratio (because it has higher capital expenditures) than a software entity, which spends
less of its money on non-current assets and more on ‘intellectual’ capital. The phase of an
entity’s life cycle will also affect the expected capital expenditure ratio. It is likely to be lower in
the introductory and growth phases and higher in the maturity and decline phases.

LIQUIDITY
Liquidity is the ability of an entity to meet its immediate obligations. One measure of liquidity is
the current ratio: current assets divided by current liabilities. A disadvantage of the current
ratio is that it uses year-end balances of current asset and current liability accounts, and
these year-end balances may not be representative of the entity’s position during most of the
year.
CURRENT CASH COVERAGE
A measure that partially corrects this problem is the current cash debt coverage which is the
net cash provided by operating activities divided by average current liabilities. Because net
cash provided by operating activities involves the entire year rather than a balance at one
point in time, it is often considered a better representation of liquidity.
Spectre Ltd net cash provided by operating activities in 1 year is 0.5:1. That is, it generates 50
cents of net cash provided by operating activities for every $1 of current liabilities. It generates
enough cash from operating activities in 1 year to meet 50% of the obligations that are due
within 1 year. A ratio closer to 1:1 would indicate that it generates 100 cents of net cash
provided by operating activities for every $1 of current liabilities.
SOLVENCY
Solvency is the ability of an entity to survive over the long term.
CASH DEBT COVERAGE
A measure of solvency that uses cash figures is the cash debt coverage which is measured
as the net cash provided by operating activities divided by total debt as represented by
average total liabilities. This measure indicates an entity’s ability to repay its liabilities from
cash generated from operations, i.e. without having to liquidate productive assets such as
property, plant and equipment. The cash debt coverage for Spectre Ltd is 0.25 times. Spectre
Ltd’s net cash provided by operating activities is 0.25:1. This means that the entity has 25
cents net cash provided by operating activities for every $1 of average total liabilities. Hence,
Spectre Ltd net cash provided by operating activities is 25% of its total liabilities. Another way
to consider this measure is to look at the reciprocal, which is 4. It would take Spectre Ltd 4
years to repay all of its liabilities from cash provided by operating activities at the current level.
PROFITABILITY
Profitability refers to an entity’s ability to generate a reasonable return. Accrual-based ratios

that measure profitability are discussed, such as gross profit rate, profit margin and return on
assets. In measures of profitability the potential differences between cash accounting and
accrual accounting are most pronounced. Although some differences are expected because
of the difference in the timing of revenue and expense recognition under cash versus accrual
accounting, significant differences should be investigated. A cash-based measure of
performance is the cash return on sales ratio.
CASH RETURN ON SALES RATIO
The cash return on sales ratio is calculated as net cash provided by operating activities
divided by net sales. This ratio indicates the entity’s ability to turn sales into dollars. The cash
return on sales ratio can be compared with the corresponding accrual-based ratio. A lower
cash return on sales ratio should be investigated because it might indicate that the entity is
recognising sales that are not really sales (i.e. sales it will never collect), or incurring a lot of
expenditure relative to revenue. Alternatively, it may reflect payments for increased inventory
and other lags occurring in the growth phase. The cash return on sales ratio for Spectre Ltd is
0.17, 0.17:1 or 17%. This means the entity generates 17 cents in cash for every $1 of sales.
Overall it appears that Spectre Ltd ‘s ratios indicate the business is profitable and solvent, can
replace its assets as needed and has free cash flow. However, further investigation is needed
into the liquidity of the business to ensure that there is adequate cash flow to met short term
debts as they fall due.

PROBLEM SET B 12.10
Victoria Ltd and Conrad Ltd

(a)
Ratio Victoria Ltd Conrad Ltd
(1) Return on assets 39.0% $138,000 ÷ 354,000 30.3% ($94,000 ÷ $310,000)
(2) Return on 67.6% ($138,000 ÷ $204,000) 58.7% ($94,000 ÷ $160,000)

ordinary
shareholders’
equity
(3) Profit margin 27.6% ($138,000 ÷ $500,000) 18.8% ($94,000 ÷ $500,000)
(4) Current ratio 4.1:1 ($244,000 ÷ $60,000) 3.7:1 ($220,000 ÷ $60,000)
(5) Receivables 5 times ($500,000 ÷ $100,000) 5 times ($500,000 ÷ $100,000)

turnover
Inventory turnover 2.7 times ($276,000 ÷ $104,000) 3.8 times ($300,000 ÷ $80,000)
(7) Debt to equity 73.5% ($150,000 ÷ $204,000) 93.8% ($150,000 ÷ $160,000)
(b) Using different accounting methods has affected all measures except the receivables turnover
ratio. The use by Conrad Ltd of weighted average valuation and reducing balance
depreciation has increased their expenses, reduced their profit and therefore decreased their
total asset and equity values. This in turn causes their return on assets, return on equity, profit
margin, current ratio, and debt to equity ratio to be considerably lower than Victoria Ltd;
however, Conrad Ltd’s inventory turnover was better because the weighted average inventory
method (in a period of rising prices) results in a higher cost of sales and a lower ending
inventory value than does the FIFO inventory method.

BUILDING BUSINESS SKILLS
FINANCIAL REPORTING AND ANALYSIS
BUILDING BUSINESS SKILLS 12.1 FINANCIAL REPORTING PROBLEM
(a) DAVID JONES LTD

Five Year Summary 2009–2013
All figures are in $’000’s
2013 2012 2011 2010 2009

Sales 1,845,012 1,867,817 1,961,744 2,053,087 1,985,490
93% 94% 99% 103% 100%
Gross Profit 706,144 699,830 767,269 815,729 786,146
90% 89% 98% 104% 100%
Department Store – EBIT 99,532 104,995 199,003 204,798 184,377
54% 57% 108% 111% 100%
Financial Services – EBIT 49,466 49,418 47,707 44,379 41,274
120% 120% 116% 108% 100%
PROFIT AFTER TAX 101,554 101,103 168,139 170,766 156,522
65% 65% 107% 109% 100%
Total Assets 1,237,785 1,240,897 1,214,550 1,194,921 1,124,674

Total Liabilities 436,689 465,193 429,070 450,683 439,832
Total Equity 801,096 775,704 785,480 744,238 684,842
Basic earnings per share (cents) 19.2 19.4 33.0 34.0 31.5
Dividends per share (cents) 17.0 17.5 28.0 30.0 28.0
Return on shareholder equity (%) 12.70% 13.00% 21.40% 22.90% 22.90%
This trend analysis of DJS shows an unfavourable trend with continual decline in sales revenue over
the past five years, with the exception of 2010. A similar trend can be seen with gross profit. A
concern is the significant drop of 46% in Department Store EBIT by 2013 compared to the base year
of 2009. This is offset to some extent by the growth in the Financial Services EBIT in 2013 which
has increased by 20% since the base year. Overall profitability has declined substantially since 2009
with the 2013 profit after tax decreasing to 65% of the base year.
.
DJS profit has decreased significantly since 2009 with a significant downturn in Department
Store EBIT. Although there is an increase in the Financial Services EBIT, this is not
sufficient to avert the overall decline in profit after tax

(b) Calculate the following ratios for 2013 and 2013.
2013 2012
Debt to total assets ratio
Total liabilities 436 689 465 193

Total assets 1 237 785 1 240 897
35.3% 37.5%
Profit margin
Profit after tax 10 1554 101 103

Sales 1 845 012 1 867 817
5.5% 5.4%
Asset turnover
Sales 1 845 012 1 867 817

Average total assets * 1 239 341 1 227 724
1.49 1.52
Return on shareholders’ equity
Profit after tax 101 554 101 103

Average total equity ** 788 400 780 592
12.9% 13.0%
Dividend payout
Dividends per share (cents) 17.0 17.5

Basic earnings per share (cents) 19.2 19.4
88.5% 90.2%
* Average total assets (1 237 785 + 1 240 897) / 2 (1 240 897 + 1 214 550) / 2
** Average total equity (801 096 +775 704) / 2 (775 704 + 785 480) / 2

(c) Evaluate David Jones Ltd s profitability, solvency and investment potential based on
the ratios calculated.
A slightly lower level of debt used to finance

Debt to total assets ratio assets, decreasing from 37.5 cents to 35.3 cents
for each dollar of assets in 2013.
Despite the drop in sales, there was a marginal
Profit margin increase in the profit margin from 5.4% to 5.5%
in 2013
Sales generated from DJS’ assets was slightly
lower due to a decrease in profit with a
Asset turnover concurrent increase in the asset base. This
reduced the asset turnover from 1.52 down to
1.49 in 2013
The lower profit and concurrent increase in
equity also impacted on lowering the ROE. This
Return on shareholders’
dropped slightly from 13% to 12.9% in 2013. This
equity
return has dropped substantially since 2009
when the ROE was at its highest at 22.9%.
This can be calculated by comparing the DPS to
the EPS. The payout ratio has dropped from 90.2
Dividend payout
to 88.5%. This may also be related to the lower
profit in 2013.
(d) What other information may be useful to making a decision about investing in David
Jones Ltd shares.
Further information about the management outlook and future direction of David
Jones Ltd would be helpful in understanding the 2013 performance and assessing
potential for profitability in future. Further, substantial amounts of important
information about a company are not in its financial statements. Events involving
such things as industry changes, management changes, competitors’ actions,
technological developments, governmental actions, and union activities are often
critical to the successful operations of a company.
Financial reports in the media, disclosures to the Stock Exchange and publications of
financial service firms (Standard & Poor’s, Dun & Bradstreet) will provide additional
relevant information not usually found in the annual report.

BUILDING BUSINESS SKILLS 12.2 INTERPRETING FINANCIAL STATEMENTS
Digitech Ltd
Financial Statement Analysis
(a) all figures in $’000.
2016 2015
(1) Profit margin:
$6723 $3119
1.1%  0.6%
$624,576 $548,864
Sales revenue = $627,708 - $39-$470-$823- Sales revenue = $550324 - $60-$600-$300-$500
$1800 = $624,576 = $548,864
(2) Return on Shareholders’ Equity – profit

from continuing operations:
$6,723 $3,119
 5.4%  2.5%
 ($123,874  $125,623)  /2 $125,623  124,000 /2
Return on Shareholders’ Equity using profit

for the period: $2,619
$1,500  2.1%
$123,874  $125,623 /2
 1.2%  $125,623 $124,000  /2
(3) Return on Assets using profit after tax
from continuing operations:
$6,723 $3,119
 2.2%  0.9%
 ($291,680  $333,352  /2 ($333,352  $330,000 /2
Return on Assets using profit for the period:
$1,500 $2,619
 0.5%  0.8%
 ($291,680  $333,352  /2  ($333,352  $333,000  /2
(4) Times Interest Earned using profit
from continuing operations before finance
cost and tax expense:
$11,723  $8,529 $5,830  $6,440
$8,529 $6,440
A comparison of Digitech Ltd’s profitability ratios for 2015 and 2016 could be quite
misleading if the effect of the discontinuing operations were not taken into account. Using
profit for the period gives the impression that Digitech’s profitability is declining as the return
on shareholders’ equity and return on assets decline. However, when profit from continuing
operations is used the reverse trend is observed, that is, profitability is improving as
evidenced by the increase in the return on shareholders’ equity and the return on assets.
The profit margin also shows improvement during this period.

(b) all figures in $’000
(1) Inventory Turnover:
$279,519
 3.9 times
($55,117  $88,853)/2
(2) Receivables Turnover:
$624,576
 11.2 times
($47,583  $63,908)/2
(3) Gross Profit Rate
$548,864  $233,313
$624,576  $279,519  57.5%
 55.2% $548,864
$624,576
(c) Profitability has been improving and this has contributed to an improvement in
Digitech Ltd’s ability to cover its interest expense. Although the gross profit rate
decreased in 2013, this was offset by an increase in sales revenue which resulted in
an increase in the dollar amount of gross profit. Digitech Ltd has discontinued some
operations that appear to have been draining profitability. Although improved, interest
cover is still low and should be monitored closely. Also, the inventory turnover is
slow, indicating that Digitech has enough inventory in stock to cover approximately
three months sales. Unless there is a long lead time for inventory acquisition or
uncertainties about sources of supply, there may be scope for more efficient
inventory policies.

BUILDING BUSINESS SKILLS 12.3 MANAGERIAL ANALYSIS
Grayson Global Ltd
(a) Grayson Global Ltd ‘s customers are paying their invoices faster in 2017 than in
2013. The evidence for this is the accounts receivable turnover of 7.2 times in 2017,
compared with only 6.8 times in 2015. The average collection period in 2017 was
50.7 days compared with 53.7 days in 2015.
(b) It is becoming harder for Grayson Global Ltd to pay its invoices as they come due.
Although the current ratio has improved from 1.3 to 2.0 to 2.5 over the three years,
the quick ratio has deteriorated steadily from 1.4 to 0.9 to 0.5. Additionally, inventory
is turning over more slowly (inventory turnover decreased from 7.6 times to 6.1
times), indicating that a greater proportion of current assets is tied up in inventory,
thus increasing reliance on creditors to finance current assets.
(c) The balance in accounts receivable is increasing. This is a result of increasing sales
(121% in 2016; 142% in 2017) at a greater rate than the increasing receivables
turnover. In 2015 receivables were 14.7% of sales revenue (inverse of the
turnover). In 2017 the receivables were only 13.9% of the sales revenue. As sales
in 2017 were 1.42 times the sales in 2015, receivables in 2017 must be 19.7%
(13.9% x 1.42 times) of the 2015 sales revenue. .
(d) The amount carried in inventory must be increasing. Inventory turnover is decreasing
and sales (along with cost of sales) are increasing. Cost of sales has remained at
60% of sales each year. This combination has to result in a larger amount of
inventory.
(e) The amount of earnings per share is increasing. The dividends per share have
remained the same ($3.00) for the three-year period, while the dividend payout ratio
is decreasing. For the dividend payout ratio to be decreasing, the earnings per share
must be increasing as there has been no change in the number of shares
outstanding.
(f) In 2017 and 2016, Grayson Global Ltd used leverage to the advantage of its
shareholders because it was able to achieve a before-tax return on assets in excess
of the rate of interest paid on borrowed funds. However, in 2016 Grayson Global Ltd
traded on the equity at a loss as the before tax return on total assets was less than
the rate of interest paid on borrowed funds.

BUILDING BUSINESS SKILLS 12.4 FINANCIAL ANALYSIS ON THE WEB
For consistency with IBM’s Guide, the US terminology is retained.
(a) The purpose of the annual report is to provide a means by which a company can
report on its performance to its shareholders and others. Any of the following could
be answered as an optional element of US annual reports: financial highlights; letter
to stockholders; corporate message; report of management; Board of Directors and
management; and stockholder information.
(b) The auditor’s report is a summary of the findings of an independent firm of certified
public accountants (US), showing whether the financial statements are complete,
reasonable and prepared in accordance with generally accepted accounting
principles.
(c) The required elements are the Statement of Earnings, which summarises revenues,
expenses and results; statement of financial position, which reports on assets,
liabilities and stockholders’ equity; and statement of cash flows. Key numbers in the
statement of earnings are revenue, gross profit, operating income (operating profit),
net earnings (net income or net profit) and earnings per share.
(d) Students may choose any two of the following (1–6 are suggestion by a business
school dean, and 7-11 are suggestions by a business executive, and 12-14 were
suggested by a high-school economics teacher, and some suggestions were made
by more than one person but not duplicated below):
1. Look at changes from year to year in terms of raw changes and percentages
to identify trends that are useful in assessing a company. Most large
companies report up to three years historic data but a longer period is
recommended for analysis.
2. Find out information about the company’s products, people and technology
and other resources that may give it a competitive advantage in the market
place.
3. Look at the ratio of operating income to total revenue (sales). Ideally this
should be growing in absolute and percentage terms.
4. Look at total stockholders’ equity and the ratio of total liabilities to total
stockholders. Generally a lower ratio means a lower risk for creditors and
lower borrowing costs.
5. Check the notes for liabilities. You may find environmental liabilities, contin-
gencies and additional lease liabilities. Not all liabilities can be measured in
financial terms. Statements of financial position may also omit certain assets,
such as those that do not result from transactions.
6. Look at cash provided/used by operating activities. This is the most critical

number and represents the most basic business of the company.

7. For young companies, particularly technology companies, speak to experts

who understand the technology and markets.
8. Look at sales and sales growth and compare it to inflation.
9. Look at earnings, earnings growth, earnings growth compared with growth in

sales.
10. Look at the Price Earnings ratio. Some companies include this in the annual
report. Compare this ratio to that of the company’s major competitors.
Comparison should be at the same point in time.
11. Look at the year-end figure for ‘backlog’. This is the dollar amount of
unshipped customer orders for sales in the coming year. This can be a good
indicator of what might happen in the next year.
12. Analyse why profit has been made (this may involve looking at its website),
e.g. new product, management style, which would indicate it is a healthy
growing company. Profit made from cost-cutting may have serious long-term
consequences if it is at the expense of quality.
13. Investigate losses. A loss may have explanations that indicate future
profitability, such as expenses on research and development that can benefit
future years.
14. Look at the movement in owners’ equity. If a large percentage of profits is

declared as dividends, it could indicate that the company is not planning for
expansion and innovation. It could indicate that the company will not grow in
the future.

BUILDING BUSINESS SKILLS 12.5
COMPREHENSIVE FINANCIAL ANALYSIS EXERCISE WITH WEB SEARCH
The Coca-Cola Company and PepsiCo Inc.
(a) Liquidity
Liquidity ratios measure the short-term ability of the entity to pay its maturing obligations and
to meet unexpected needs for cash.
Coca-Cola Coca-Cola PepsiCo

Ratio Formula
2013 2012 2013
1. Current ratio:
Current assets 31,304

1.13 1.09 1.24
27,811
Current liabilities
2. Quick Ratio
Cash  Marketable securities 25,141

0.90 0.77 0.93
 Net receivables 27,811
Current liabilities
3. Current cash debt coverage
Net cash provided by operating activities

10,542
Average current liabilities 0.25 0.27 0.37
27,816*
*(27,821+27,811) / 2
4. Receivables turnover (times)
Net credit sales 46,854

Average net trade receivables 4,816* 9.73 9.92 9.49
*(4,759 + 4,873) / 2
5. Average collection period (days)
365 days 365

37.52 days 36.79 days 38.46 days
9.73
Receivables turnover
6. Inventory turnover
(times per year)
18,421
Cost of sales
3,271* 5.63 6.00 8.94
Average Inventory
*(3,264+ 3,277) / 2
7. Days in Inventory
365
64.80 days 60.88 days 40.83 days
365 5.63
Inventory Turnover

Coca-Cola’s current ratio increased from 1.09:1 in 2012 to 1.13:1 in 2013 as the increase in
current assets was greater than the increase in current liabilities. Coca-Cola’s competitor,
PepsiCo, reported a current ratio of 1.24:1 in 2013, which is significantly higher than Coca-
Cola’s ratio of 1.13 in 2013. What is considered to be an acceptable ratio may vary from
industry to industry; however, around 1.5:1 is generally considered to be an acceptable
current ratio for most industries. Although Coca-Cola’s ratio is below 1.5:1, it still has more
current assets than current liabilities. This suggests that it can meet its current obligations
when they fall due.
Coca-Cola’s quick ratio has improved from 0.77:1 in 2012 to 0.90:1 in 2013 which is slightly
lower than PepsiCo’s quick ratio of 0.93. As a rule of thumb, some analysts suggest that a
quick ratio of approximately 1:1 is adequate however this is arbitrary and subject to debate
and exception. Coca-Cola s quick ratio for both years in below 1:1, which suggests that it
may have difficulties in meeting its current obligations when they fall due.
Coca-Cola’s current cash debt coverage has decreased from 0.27:1 in 2012 to 0.25:1 in
2013. The acceptable level for current cash debt coverage may vary between industries
however a value below 0.40:1 is considered cause for additional investigation of an entity’s
liquidity. Coca-Cola’s current cash debt coverage is well below this benchmark which
indicates that it is not in a strong position to meet its current liabilities. In contrast, PepsiCo’s
current cash debt coverage of 0.37:1 in 2013 is considerably higher but also below the
required benchmark of 0.40:1.
Coca-Cola’s receivables turnover decreased slightly from 9.92 in 2012 to 9.73 times per year
in 2013. To assess the effectiveness of an entity’s credit and collection policies, the average
collection period should be calculated. The general rule is that the collection period should
not greatly exceed the credit term period; the time allowed for payment. Coca-Cola’s
average collection period remained relatively unchanged from 36.79 days in 2012 to 37.52
days in 2013.To assess this ratio we need to know Coca-Cola’s credit policy but their 10-K
report does not reveal the company’s credit terms so we cannot comment on the adequacy
of their collection. However, we can compare it to PepsiCo’s credit policy which is explained
under the Accounting Policies section of PepsiCo’s 2013 annual report which indicates that
payment required within 30 days of delivery in the United States and within 30 to 90 days
internationally and discounts may be allowed for early payment. To evaluate Coca-Cola’s
credit and collection policies more accurately we would need the break-up between
international and local receivables.
As this data is not available in the information provided above, we need to evaluate the
results with caution. PepsiCo’s average collection period of 38.46 days in 2013 is similar to
The Coca Cola Company’s 37.52 days, which is close to the 30-day credit terms for its US
customers, indicates the company’s credit policy is appropriate and its monitoring of
receivables collection is effective.
The inventory turnover measures the number of times on average the inventory is sold
during the period. Its purpose is to measure the liquidity of the inventory. The higher the
turnover the less chance stock will be slow moving or become obsolete or spoiled and
unsaleable. It is important to monitor the amount of resources invested in inventory as part of
managing the business. Entities do not want to unnecessarily have too much cash tied up in
inventories. At the same time, they do not want to be understocked and miss out on sales
be-cause of a lack of stock. Coca-Cola’s inventory turnover was slightly slower dropping
from 6.00 times in 2012 to 5.63 times per year in 2013.

The days in inventory ratio converts the inventory turnover into days. Coca-Cola’s days in
inventory increased slightly from 60.88 days in 2012 and 64.80 days in 2013. Although the
cost of sales had decreased in 2013, there was a higher level of inventory held. Although
these figures are considerably higher than PepsiCo’s inventory turnover of 40.83 days, they
are quite acceptable when we consider the goods that the Coca Cola Company sells soft
drinks, juices, energy drinks and water are items that normally have expiry dates longer than
one year. If The Coca Cola Company can sell its inventories within 70 days, the Coca Cola
Company manages its inventory well.
Summary – Liquidity
From the analysis of the liquidity ratios along comparisons with competitor PepsiCo, it
appears that Coca-Cola has effective credit and collection policies for receivables and is
adequately turning its inventory over to avoid stock spoilage and wasted resources invested
in inventory but maintain adequate supplies to meet product demand. It is noted that Coca-
Cola’s current ratio, quick ratio and current cash debt coverage are below expected
benchmarks. This may be an indication that it may experience difficulties in paying its debts
as they fall due. To minimise the risk of future liquidity problems, these measures should be
monitored and investigated further if the decline continues.

(b) Solvency
Solvency ratios measure the financial stability of the entity and its ability to survive over a
long period of time. Long-term creditors and shareholders are interested in a company’s
long-term solvency, particularly its ability to pay interest as it falls due and to repay the face
value of debts at maturity. The debt to total assets, times interest earned and cash debt
coverage provide information about debt-paying ability. The higher the percentage of total
liabilities to total assets, the greater the financial risk that the entity may be unable to meet
its maturing obligations. The lower the ratio, the more equity ‘buffer’ is available to creditors
if the entity becomes insolvent. Therefore, from the creditors’ point of view, a low ratio of
debt to total assets is usually desirable.

Ratio Formula
2013 2012 2013
8. Debt to total assets ratio

56 615 0.63 0.62 0.69
Total liabilities
90 055
Total assets
9. Times interest earned

11 940
Earnings Before Interest and Tax 25.8 times 30.8 times 10.8 times
463
Interest Expense
10. Cash debt coverage
Net cash provided by operating activities 10,542

Average total liabilities 54 811* 0.19 0.21 0.18
(53 089+52 239) / 2
11. Free cash flow ($ millions)
Net cash provided by operating activities  10,542 - 2,550 7,992 7 865 6 893
Capital expenditures

Coca-Cola’s debt to total assets ratio indicates a marginal increase in the level of debt used
to finance assets from 0.62:1 in 2012 to 0.63:1 in 2013. These figures are significantly lower
than PepsiCo’s debt to total assets ratio of 0.69:1 in 2013 As the amount of debt increases,
long-term creditors become more concerned if the company is less able to repay their long
term obligations.
To assess whether the entity’s profit is adequate to meet interest payments we can calculate
the times interest earned. Coca-Cola’s times interest earned dropped substantially from 30.8
times in 2012 to 25.8 times in 2013. This was attributed to the combination of a decrease in
Coca-Cola’s EBIT with a higher interest expense. Despite Coca-Cola’s lower interest
coverage in 2013, it is very strong in comparison to PepsiCo’s coverage of 10.8 times. The
interest coverage for both companies is extremely high and well exceeds the rule of thumb
of 3 to 4 times interest coverage.
The cash debt coverage ratio provides additional insight into an entity’s ability to repay its
liabilities from cash generated from operating activities without having to liquidate the assets
used in its operations. Coca-Cola’s cash debt coverage decreased slightly from 0.21:1 in
2012 to 0.19:1 in 2013. These figures are slightly higher than PepsiCo’s coverage ratio of
0.18:1 in 2013. The general rule of thumb indicates that a cash debt coverage ratio below
0.20:1 is considered cause for additional investigation. Both companies fall within this range.
Free cash flow provides information about the company’s solvency and its ability to pay
dividends or invest in new projects. Coca-Cola’s free cash flow has increased from $7,865
million in 2012 to $7,992 million in 2013. In 2013 Coca-Cola spent $2,550 million on capital
expenditures.
Summary – Solvency
Based on the solvency ratios, it appears that Coca-Cola is solvent with the ability to meet its
long-term obligations as they fall due and can meet its planned capital expenditures

(c) Profitability
Profitability ratios measure the profit or operating success of an entity for a given period of
time. An entity’s profit affects its ability to obtain debt and equity financing, its liquidity
position and its ability to grow. As a consequence, creditors and investors alike are
interested in evaluating profitability. Profitability is frequently used as the ultimate test of
management’s operating effectiveness.

Ratio Formula
2013 2012 2013
12. Return on ord. shareholders’ equity
Profit available to ord. shareholders
8,584 25.8 cents 27.7 cents 28.8 cents
Average ordinary shareholders equity
33,304*
*(33,168+33,440) / 2
13. Return on assets:
Profit after tax 8,626
Average total assets 88,115* 9.7 cents 10.9 cents 8.9 cents
*(86,174+90,055) / 2
14. Profit margin: 8,626

Profit after tax 46,854 18.4 cents 18.9 cents 10.2 cents
Sales
15. Asset turnover

Net sales
46,854
Average total assets 53 cents 58 cents 87 cents
88,115*
*(86,174+90,055) / 2
16. Gross profit margin
Gross profit 28,433
60.7 cents 60.3 cents 60.9 cents
46,854
Net sales
17. Operating expenses to sales
Operating expenses 18,205 38.9% 37.9% 38.3%
Net sales 46,854
18. Cash return on sales

Net cash provided by operating activities 10,542
22.5% 22.2% 14.6%
46,854
Net sales
19. Earnings per share (EPS) 8,584

Profit available to ordinary shareholders 4,425 $1.94 $2.00 $4.37
Weighted average no. of ordinary shares
20. Price/Earnings ratio (times)

Share price $41.31
21.3 18.1 19.0
$1.94
Earning per share
21. Dividend payout

4 969
Dividends 58% 51% 51%
8,584
Profit available to ordinary shareholders

The return on ordinary shareholders’ equity (ROE) shows the amount of profit earned for
each dollar invested by the shareholders. Coca-Cola’s return increased marginally from 27.7
cents in 2012 to 25.8 cents in 2013. These results are reflective of a drop in the profit
available to ordinary shareholders and an increase in the average ordinary shareholders
equity in 2013. Coca-Cola’s ROE of 25.8 cents in 2013 is lower than PepsiCo’s 28.8 cents.
The higher the ROE, the more attractive investment in the company is as it indicates a
greater return on shareholder funds invested.
The return on assets measures the overall profitability of assets in terms of the profit earned
on each dollar invested in assets. It is a measure of management’s effectiveness based on
normal business activities. Coca-Cola’s return on assets decreased slightly from 10.9 cents
in 2012 to 9.7 cents in 2013. This was due to a decrease in Coca-Cola’s profit after tax in
2013 and an increase in the asset base. Coca-Cola’s return on assets over the 2 years is
slightly higher than PepsiCo’s return on assets of 8.9 cents in 2013.
Coca-Cola’s profit margin showed a slight drop from 18.9 cents in 2012 to 18.4 cents in
2013. The increase in profit after tax was marginally greater than the increase in sales. As
Coca-Cola’s results over the 2 years are much higher than PepsiCo’s 10.2 cents in 2013,
this suggests that it had better control over its expenses in 2013.
The asset turnover decreased slightly over the 2 year period. In 2013 Coca-Cola generated
53 cents in sales for every dollar invested in assets compared to 58 cents in 2012. These
figures are significantly lower than PepsiCo’s asset turnover of 87 cents in 2013 which
suggest that it is much more effective than Coca-Cola in using its assets to generate sales.
Coca-Cola’s gross profit margin showed a slight improvement from 60.3 cents in 2012 to
60.7 cents in 2013. As the increase in gross profit was marginally higher than the increase in
sales, Coca-Cola had better control over its cost of sales in 2013. These results are similar
to PepsiCo’s gross profit margin of 60.9 cents.
Coca-Cola’s operating expenses to sales ratio has increased slightly from 37.9% in 2012 to
38.9% in 2013. These results are similar to PepsiCo’s operating expenses to sales of 38.3
cents.
The cash return on sales ratio focuses on the cash generated from operating activities and
therefore eliminates the impact of non-cash expenses such as depreciation which are
included in the calculation of profit based ratios. Coca-Cola’s cash return on sales show a
slight increase from 22.2% in 2012 to 22.5% in 2013. PepsiCo’s cash return on sales of 14.6
% is well below this range.
The Earnings Per Share, also referred to as the EPS, is a measure of the profit earned on
each ordinary share. Coca-Cola’s EPS decreased from $2.00 in 2012 to $1.94 in 2013. This
was mainly due to a substantial decrease in profit available to ordinary shareholders. These
results are significantly lower than PepsiCo’s EPS of $4.37.
Coca-Cola’s P/E ratio increased from 18.1 times in 2012 to 21.3 times in 2013. This is
mainly due to the large increase in share price from $36.25 in 2012 to $41.31 in 2013. At the
2013 reporting date, Coca-Cola’s shares were selling for $41.31, and its EPS was $1.94,
therefore the share price is approximately 21.3 times higher than the EPS of $1.94. Coca-
Cola’s P/E ratio was slightly higher than PepsiCo’s P/E ratio of 19 times in 2013. The higher
the P/E ratio, the more confident the shareholder is about the future earning capacity of the
company. Both companies would be considered profitable investments.

The dividend payout ratio measures the percentage of profits distributed in the form of
dividends. Coca-Cola’s dividend payout ratio increased from 51% in 2012 to 58% in 2013.
Coca-Cola has a relatively high dividend payout ratio which is indicative of a company in
maturity; however, it also recognises that to maintain innovation and effectiveness it needs
to reinvest funds into the business. Both Coca-Cola and PepsiCo appear to have a
balanced approach to distributing funds to shareholders and reinvesting funds into the
business.
Summary – Profitability
Based on the ratios calculated and discussed in this section as well as the information
sourced from the annual report, Coca-Cola is a profitable entity. Profitability is frequently
used as the ultimate test of management’s operating effectiveness. It appears that
management is operating Coca-Cola’s assets efficiently and controlling prices and expenses
adequately. This enables Coca-Cola to generate sufficient cash to continue its investments
in innovation as well as pay out generous dividends to shareholders.

Ratio Formula 2013
Coca
Liquidity Pepsi
Cola
Current Assets
1. Current Ratio 1.13:1 1.24:1
Current Liabilities
Cash + Marketable Securities + Net Rec.
2. Quick Ratio 0.90:1 0.93:1
Current Liabilities
3. Current Cash Debt Net cash provided by op. activities
0.25:1 0.37:1
Coverage Average current liabilities
4. Receivables Net credit sales 9.73 9.49
Turnover Average net trade receivables times times
5. Average Collection 365 days 37.52 38.46
Period Receivables Turnover days days
Cost of Sales 5.63 8.94
6. Inventory Turnover
Average Inventory times times
7. Average Days in 365 days 64.80 40.83
Inventory Inventory Turnover days days
Solvency
8. Debt to Total Total Liabilities
0.63:1 0.69:1
Assets Total Assets
9. Times Interest Earnings before inc. tax + Interest exp. 25.79 10.76
Earned interest Expense times times
10. Cash Debt Net cash provided by op. activities
0.19:1 0.18:1
Coverage Average Total Liabilities
Net cash provided by op. activities $7 992 $6 893
11. Free Cash Flow
Capital expenditures million million
Profitability
12. Return on Ord. Profit avail.to ordinary shareholders

26 cents 29cents
Shareholder Equity Average ordinary shareholders’ equity
Profit
13. Return on Assets 10 cents 9 cents
Average Total Assets
Profit
14. Profit Margin 18 cents 10 cents
Net Sales
Net Sales
15. Asset Turnover 53 cents 87 cents
Average Total Assets
Gross Profit
16. Gross Profit Margin 61% 61%
Net Sales
17. Operating Exp. Operating Expenses
0.39:1 0.38:1
to Sales Net Sales
18. Cash Return on Net cash provided by op. activities
0.22:1 0.15:1
Sales Net Sales
Profit avail.to ordinary shareholders
19. Earnings per share $1.94 $4.37
Weighted average no. of ord.. shares
20. Price/earnings Share price 21.29 18.96
Ratio Earnings per share times times
Dividends
21. Dividend Payout 58% 51%
Profit

LIQUIDITY
Based on the current ratio, quick ratio and current cash debt coverage, PepsiCo appears to
be more liquid than Coca Cola. The receivables turnover and average collection period are
similar for both companies. Coca Cola has higher average days in inventory of almost 64.80
days compared to 40.83 days for PepsiCo. This suggests that PepsiCo can sell its inventory
significantly faster than its competitor. Overall, PepsiCo is in a better position to pay their
debts as they fall due.
SOLVENCY
PepsiCo has a slightly higher debt to total assets ratio that Coca Cola so PepsiCo has more
debt funding. The Cash debt coverage ratio is similar across both companies. Coca Cola’s
Times Interest Earned is much higher than PepsiCo’s. However, the both PepsiCo’s and
Coca Cola’s interest coverage figures are well above the general rule of thumb that profits
should be approximately 3–4 times interest expense. Finally both companies have significant
free cash flow with Coca Cola’s higher by $1 099 million. Overall, based on these ratios it
appears that both companies are solvent.
PROFITABILITY
Gross profit margin is 61% for Coca Cola and PepsiCo which suggest that both companies
have similar cost of sales. The profit margin is 18 cents for Coca Cola and 10 cents for
PepsiCo which suggests that. Coca Cola is more effective in generating sales and managing
its expenses. However, the return on ordinary shareholders’ equity is similar with a ROE of
26 cents for Coca Cola and 29 cents for PepsiCo, which indicates that there is slightly more
profit is available to ordinary shareholders of PepsiCo.
The asset turnover and return on assets may be used to evaluate the ability of each entity’s
to generate profits and sales from its assets. The asset turnover is much higher for PepsiCo
at 87 cents compared to 53 cents for Coca Cola. However, this significant difference is lost
when we look at the return on assets as they are very similar at 10 cents for Coca Cola and
9 cents PepsiCo. Both companies have the same dividend payout of 61% which indicates a
significant portion of their profits are paid out as dividends to its shareholders. Overall both
companies appear to be sound and profitable investments.

CRITICAL THINKING
BUILDING BUSINESS SKILLS 12.6 GROUP DECISION CASE
2016 2015
Current ratio 3.1 2.1
Quick ratio 0.8 1.4
Asset turnover 2.8 2.2
Cash debt coverage 0.1 0.2
Profit Up 32% Down 8%
Earnings per share $3.30 $2.50
(a)
Lenders prefer that financial statements are audited because an audit gives independent
assurance that the financial statements give a true and fair representation of the company’s
financial position and results of operations. With this independent assurance we feel more
comfortable making a decision.
(b)
The current ratio increase is a favourable indication as to liquidity, but alone tells little about
the going concern prospects of the client. From this ratio alone, it is impossible to know the
amount and direction of the changes in individual accounts, total current assets, and total
current liabilities. Also unknown are the reasons for the changes.
The decline in the quick ratio to 0.8 is an unfavourable indication as to immediate liquidity,
especially when the current-ratio increase is also considered. This decline is also
unfavourable because it reflects a declining cash position and raises questions as to reasons
for the increases in other current assets, such as inventories.
The cash debt coverage ratio is a solvency ratio that indicates a company’s ability to repay
its liabilities from cash generated by operations. Since this ratio declined during 2016, it
indicates that the company’s cash provided by operations decreased and/or its liabilities
increased. At the current level of cash generated by operations, Leverage Ltd would take 10
years to repay its existing liabilities.
The asset turnover and earnings per share ratio indicate profitability. Since both ratios are
higher in 2016 and profit has increased, it is most likely that the company’s sales revenue is
increasing. Increases in sales and profit are favourable for going-concern prospects.
The 32 per cent increase in earnings per ordinary share, which is identical to the percentage
increase in net profit, is an indication there has probably been no change in the number of
issued ordinary shares. This, in turn, indicates that financing was not obtained through the
issue of ordinary shares.

The collective implications of these data alone are that the client entity is about as solvent at
the end of the current year as it was at the beginning, although there may be a need for
short-term operating cash. Creditors should however seek further information.
Although a quick evaluation of a reporting entity can be made using only a few ratios and
comparing these with past ratios and industry statistics, the creditors should realise the
limitations of such analysis even from the best prepared statements carrying a CPA’s
unqualified opinion.
It is not possible to reach conclusions about solvency and gong-concern prospects without
additional information about the nature and extent of financing.
When evaluating changes in ratio or percentages, the evaluation should be directed to the
nature of the item being evaluated because very small differences in ratios or percentages
can represent significant changes in dollar amounts or trends.
The creditors should evaluate conclusions drawn from ratio analysis in light of the current
status of, and expected changes in, such things as general economic conditions, the client’s
competitive position, the public’s demand (for the product itself, increased quality of the
product, control of noise and pollution, etc.), and the client’s specific plans.
(c)
(1) Current cash debt coverage ratio – indicates liquidity.
(2) Debt to total assets ratio – indicates insolvency.
(3) Times interest earned ratio – indicates ability to repay interest when due.
Other answers are possible.
(d)
The usefulness of analytical tools is limited by the use of estimates, the cost basis, the
application of alternative accounting methods, atypical data at year-end, and the
diversification of companies, making industry comparisons difficult. Different accounting
methods affect the analysis of trends and comparisons with industry statistics or other
companies within the industry.

BUILDING BUSINESS SKILLS 12.7 COMMUNICATION ACTIVITY
Digital Designs Ltd
To: Shannon Leahy
From: Accounting Student
Re: Financial Statement Analysis
Date: DD/MM/YY
There are two fundamental considerations in financial statement analysis:
(1) the bases of comparison and

(2) the limitations of financial statement analysis.
Each of these considerations is explained below.
1. Bases of Comparison. The bases of comparison are:
(a) Intra-company – this basis compares an item or financial relationship within a

company in the current year with the same item or relationship in one or more
prior years.
(b) Inter-company – this basis compares an item or financial relationship of one
company with the same item or relationship in one or more competing
companies.
(c) Industry averages – this basis compares an item or financial relationship of a
company with industry averages (or norms).
2. Limitations in financial statement analysis are:
(a) Estimates – financial statements contain estimates that may be inaccurate.
(b) Cost – financial statements are based on cost, which may be affected by
significant inflation or deflation. This affects comparisons over time and
between companies with assets purchased in different periods.
(c) Alternative accounting methods – variations among companies in the

application of generally accepted accounting principles may hamper
comparability.
(d) Atypical data – fiscal year-end data may not be typical of the financial
condition during the year. For instance, if the company’s year-end falls
immediately after the peak of its sales (e.g. after Christmas sales in a
department store), its inventory in the statement of financial position may be
below normal levels.
(e) Diversification of firms – many firms are so diversified they cannot be

classified by industry.

BUILDING BUSINESS SKILLS 12.8 ETHICS CASE
Positive Perception Ltd
(a) The internal stakeholders in this case are Positive Perception Ltd’s:
 managing director
 other directors
 public relations officer
 you, as the chief accountant
 shareholders
 potential investors
 creditors
 potential creditors
The external stakeholders would be any readers of the press release.

.
(b) The managing director’s press release is deceptive and incomplete and to that
extent, his action is unethical. While inflating the share price may provide a benefit to
existing shareholders if they are selling their shares, this is at the expense of a
stakeholder who buys the shares at an overstated price. Further, the biased press
release may cause investors to make decisions (such as retaining their shares or
buying more shares) that would be different if they were provided with unbiased and
complete information.
(c) As chief accountant, you should at least inform the public relations (PR) officer, about
the biased content of the release. The PR officer should be aware that the
information to be released, while factually accurate, is deceptive and incomplete. The
chief accountant has the responsibility to inform the managing director (and other
directors) of the bias of the about-to-be-released information.
(d) Immediately, it would be appropriate to speak/write to the PR officer and then the
managing director. Students may be encouraged to discuss how this should be done
(whether in writing) and what could and/or should be done if the managing director
refuses to alter the press release. Suggestions include: other directors; the recipient
of the press release; and the audit committee (if one exists).

BUILDING BUSINESS SKILLS 12.9 SUSTAINABILTY
Download PepsiCo’s 2013 annual report and summarise the key initiatives outlined for
ensuring sustainable growth in relation to:
• its products.
• the marketplace.
• communities.
Extracts from PepsiCo’s 2013 annual report
P.9 How We “Future-Proof” PepsiCo: Performance with Purpose
As long as Performance with Purpose is our guide, I believe PepsiCo will continue to deliver
long-term, sustainable growth.
Performance with Purpose is PepsiCo’s recognition that the company’s success is

inextricably linked to society’s success. In order to do well by our shareholders, we also have
to take into account the needs and concerns of a wide range of stakeholders. If our financial
success comes at the expense of the environment, our consumers or our communities, we
will not be viable in the long run.
In practice, Performance with Purpose means we provide a range of foods and beverages
from treats to healthy eats; we find innovative ways to minimize our impact on the
environment and lower our costs through energy and water conservation as well as reduced
use of packaging material; we provide a safe and inclusive workplace for our employees
globally; and we respect, support and invest in the local communities in which we operate.
Performance with Purpose remains our true north, and it is more important than ever. I
encourage you to please take the time to read our latest Sustainability Report, which
details our work and progress toward our goals around the world.
As 2014 begins, every PepsiCo associate feels an incredible sense of duty and responsibility
to those who depend on us to offer sustainable financial returns over the long term.
It is for these long-term investors that we run PepsiCo.

Specific goals on Human sustainability Page 10

“Products:
Provide more food and beverage choices made with wholesome ingredients that contribute
to healthier eating and drinking.
• increase the amount of whole grains, fruits, vegetables, nuts, seeds and low-fat dairy in
our global product portfolio.
• reduce the average amount of sodium per serving in key global food brands by 25
percent.
• reduce the average amount of saturated fat per serving in key global food brands by 15
percent.
• reduce the average amount of added sugar per serving in key global beverage brands
by 25 percent.
Market Place:
Encourage people to make informed choices and live healthier.

• display calorie count and key nutrients on our food and beverage packaging by 2012.
• advertise to children under 12 only products that meet our global science-based nutrition
standards.
• eliminate the direct sale of full-sugar soft drinks in primary and secondary schools
around the globe by 2012.
• increase the range of foods and beverages that offer solutions for managing calories,
like portion sizes.
Community:
• actively work with global and local partners to help address global nutrition challenges.
• invest in our business and research and development to expand our offerings of more
affordable, nutritionally relevant products for underserved and lower-income
communities.
• expand Pepsico Foundation and Pepsico corporate contribution initiatives to promote
healthier communities, including enhancing
• diet and physical activity programs integrate our policies and actions on human health,
agriculture and the environment to make sure that they support each other.

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Solutions Manual

John Wiley & Sons Australia, Ltd 2016

CHAPTER 12 – FINANCIAL STATEMENT ANALYSIS AND DECISION MAKING

ASSIGNMENT CLASSIFICATION TABLE

2. Explain and apply horizontal analysis. 1, 2, 4 2, 3, 6, 7

3. Explain and apply vertical analysis. 3 4, 5, 6, 7 1A, 1B

5. Discuss the limitations of financial 9A, 10B

© John Wiley and Sons Australia Ltd, 2016 12.1

CHAPTER 12 – FINANCIAL STATEMENT ANALYSIS AND DECISION MAKING

2. Horizontal analysis is a technique for evaluating a series of financial statement data

© John Wiley and Sons Australia Ltd, 2016 12.2

3. Current Ratio is Current Asset/Current Liabilities. Quick Ratio is (Cash + Marketable

5. The average collection period of receivables is useful to assess the effectiveness of

7. (a) Asset turnover.

8. The price-earnings (P/E) ratio is a reflection of investors’ assessments of a ompany’s

© John Wiley and Sons Australia Ltd, 2016 12.3

10. (a) Estimates

(c) Alternative Accounting Methods

© John Wiley and Sons Australia Ltd, 2016 12.4

(d) Atypical Data

© John Wiley and Sons Australia Ltd, 2016 12.5

SOLUTIONS TO BRIEF EXERCISES

BRIEF EXERCISE 12.1

BRIEF EXERCISE 12.2

30 June 30 June 30 June

Accounts receivable 800 000 600 000 700 000

114.3% 85.7% 100.0%

Inventory 950 000 420 000 530 000

179.2% 79.2% 100.0%

Total assets 4 600 000 3 800 000 2400000

191.7% 158.3% 100.0%

© John Wiley and Sons Australia Ltd, 2016 12.6

BRIEF EXERCISE 12.3

30 June 30 June 30 June

Accounts receivable 800 000 600 000 700 000

Inventory 950 000 420 000 530 000

Total assets 4 600 000 3 800 000 2 400 000

BRIEF EXERCISE 12.4

Horizontal analysis 2017 2016 2015

Comparing the percentages presented results in the following conclusions:

© John Wiley and Sons Australia Ltd, 2016 12.7

BRIEF EXERCISE 12.5

Current ratio CA 2,129,800

Quick ratio* QA* 830,800

© John Wiley and Sons Australia Ltd, 2016 12.8

BRIEF EXERCISE 12.6

Net credit sales

(a) $6,600,000 $4,920,000

(b) Average collection period:

BRIEF EXERCISE 12.7

(a) Current cash debt coverage:

(b) Cash return on sales:

(c) Cash debt coverage:

© John Wiley and Sons Australia Ltd, 2016 12.9

(a) White 2016

Ratios for 2016

Current Ratio = Current Asset / Current Liabilities = 9,998,000/7,770,000 = 1.29 :1

Quick Ratio = (Cash + Marketable Securities + Net Receivables)/Current Liabilities

Inventory Turnover = Cost of Sales/Average Inventory

Average Days in Inventory = 365 days/Inventory Turnover

Ratios for 2015

Current Ratio = Current Asset/Current Liabilities = 10,151,000/7,753,000 = 1.31:1

Quick Ratio = (Cash + Marketable Securities + Net Receivables)/Current Liabilities