Chapter 13

CHAPTER 13
Financial Statement Analysis

OVERVIEW OF EXERCISES, PROBLEMS, AND CASES
Estimated
Time in
Learning Outcomes Exercises Minutes Level
1. Explain the various limitations and considerations in financial
statement analysis.
2. Use comparative financial statements to analyze a company 12* 45 Mod

over time (horizontal analysis). 13* 30 Mod
3. Use common-size financial statements to compare various 12* 45 Mod

financial statement items (vertical analysis). 13* 30 Mod
4. Compute and use various ratios to assess liquidity. 1 15 Mod

2 15 Mod
3 30 Mod
4 20 Mod
5 30 Mod
5. Compute and use various ratios to assess solvency. 6 20 Mod

7 20 Mod
6. Compute and use various ratios to assess profitability. 8 20 Mod

9 20 Mod
10 15 Mod
11 10 Mod
7. Explain how to report on and analyze other income statement

items (Appendix).
*Exercise, problem, or case covers two or more learning outcomes

Level = Difficulty levels: Easy; Moderate (Mod); Difficult (Diff)
13-1
13-2 FINANCIAL ACCOUNTING SOLUTIONS MANUAL
Problems Estimated
and Time in
Learning Outcomes Alternates Minutes Level
statement analysis.
2. Use comparative financial statements to analyze a company

over time (horizontal analysis).
3. Use common-size financial statements to compare various

financial statement items (vertical analysis).
4. Compute and use various ratios to assess liquidity. 1 40 Mod

2 40 Mod
5* 30 Mod
7* 40 Mod
5. Compute and use various ratios to assess solvency. 1# 30 Mod

2# 30 Mod
5* 30 Mod
6* 40 Diff
7* 40 Mod
6. Compute and use various ratios to assess profitability. 3 20 Mod

4 60 Diff
5* 30 Mod
6* 40 Diff
7* 40 Mod

items (Appendix).

#Alternate problem only
CHAPTER 13 • FINANCIAL STATEMENT ANALYSIS 13-3
Estimated
Time in
Learning Outcomes Cases Minutes Level
statement analysis.
2. Use comparative financial statements to analyze a company 1 45 Mod

over time (horizontal analysis).
3. Use common-size financial statements to compare various 2 60 Mod

financial statement items (vertical analysis). 3 60 Mod
6 45 Mod
4. Compute and use various ratios to assess liquidity. 4* 45 Mod

5* 45 Mod
7* 45 Diff
8 20 Mod
5. Compute and use various ratios to assess solvency. 4* 45 Mod

5* 45 Mod
7* 45 Diff
6. Compute and use various ratios to assess profitability. 4* 45 Mod

5* 45 Mod

items (Appendix).

QUESTIONS
1. The inventory valuation method used by a company will have a significant effect on
many ratios. Depending on the relative movement of prices, the choice between
LIFO and FIFO will result in significantly different amounts reported for inventory. For
example, in a period of rising prices, the use of LIFO will reduce inventory (relative to
what it would have been under FIFO) and thus reduce the current ratio and the acid-
test ratio. The inventory turnover ratio will differ as well, because LIFO will result in
more cost of goods sold expense. Thus, all other things being equal, in a period of
rising prices, a LIFO company will report a higher turnover of inventory than a FIFO
company. The LIFO company’s cash flow will be better because it will pay less in
taxes. Thus, the various ratios that involve cash from operations will be affected.
Finally, the profitability ratios will be affected by the choice of an inventory method.
For example, the LIFO company will report lower profits and thus have a lower profit
margin.
2. One of the difficulties in comparing a company’s ratios with industry standards is that
the standards are an average for all companies surveyed. First, your company may
be much larger or smaller than the average company in the survey. Second, many
large companies today are conglomerates, and their operations cross over the
traditional boundaries of any one industry. This makes comparison with industry
standards difficult. Finally, your company may use different accounting methods than
most others in the survey. If your company uses straight-line depreciation but a
majority of the sample companies use accelerated depreciation, comparisons can be
difficult.
3. Published financial statements, as well as those often used by management, are
based on historical costs and have not been adjusted for inflation. Trend analysis is
one type of analysis that must be performed with particular caution if inflation is
significant. An increase in sales, for example, may be due to an increase in prices,
rather than to an increase in the number of units sold. Inflation affects the various
financial statements differently. Some period expenses, such as advertising, are
usually not seriously misstated in historical cost terms. However, depreciation based
on costs paid for assets that are fifty years old will be much different from
depreciation adjusted for the effects of inflation.
4. The analysis of financial statements over a series of years is called horizontal
analysis. For example, by looking for trends in certain costs over a series of years
(thus the name trend analysis), the analyst is able to more accurately predict future
costs. Common-size financial statements are statements in which all amounts are
stated as a percentage of one selected item on the statement, such as net sales.
Thus, vertical analysis of a single year’s income statement will help the analyst
discern the relative amounts incurred for various costs.
5. Rising costs to either manufacture or purchase inventory could be responsible for a

decline in gross profit in the face of an increase in sales. Assume that 1,000 units of
a product are sold with a unit cost of $80 and a selling price of $100. Sales total
$100,000, and gross profit is $20,000. Assume that in the following year, the
company raises the selling price to $115 because of rising costs. If the cost to make
a unit goes up to $96 and the company sells another 1,000 units, sales will increase
by 15% to $115,000, but gross profit will decrease to 1,000 × ($115 – $96), or
$19,000—a decrease in gross profit of 5%.
6. The composition of current assets indicates the relative size of cash, accounts
receivable, inventory, and other short-term assets. A relatively large balance in
inventory may indicate that a company is not turning over its products quickly
enough. Similarly, a large accounts receivable balance could signal a problem in the
collection department. Finally, a large cash balance may be a sign that the company
is not taking advantage of short-term investment opportunities.
7. Ratios can be categorized according to their use in performing three types of
analysis: (1) liquidity analysis, (2) solvency analysis, and (3) profitability analysis.
8. The first stage in the operating cycle for a manufacturer is the purchase of raw
material and its transformation into a final product. The second step is the sale of the
product, and the third is the collection of any receivable from credit granted to the
customer. The operating cycle differs for a retailer in that a finished product is
purchased from a wholesaler and there is not the time involved in production.
9. Current assets are reported on a balance sheet in the order of their nearness to
cash, or liquidity. Cash is obviously presented first, followed by short-term
investments. Accounts receivable, one step removed from cash, are shown next,
and then inventory. Because prepaid assets, such as supplies or insurance paid for
in advance, will not be converted into cash, they are normally reported last in the
current asset section of the balance sheet.
10. A relatively low acid-test or quick ratio compared with the current ratio probably
indicates a large inventory balance. Large amounts of inventory may be normal for a
company, but on the other hand they could signal problems in moving obsolete
items. The inventory turnover ratio for the most recent period should be compared
with those of prior periods to determine whether there has been a decrease in the
number of turns per year. A less likely explanation for a low quick ratio compared
with the current ratio would be large balances in various prepayments, such as
supplies and insurance.
11. All turnover ratios are a measure of the activity for a period compared with the
investment necessary to carry on that activity. For example, the inventory turnover
ratio measures the relationship between inventory sold, on a cost basis, and the
average amount of inventory on hand during that time period. The base is the
average inventory because it is divided into an activity measure for the entire period
—that is, cost of goods sold.
12. An accounts receivable turnover of nine times translates to an average number of

days in receivables of 40 (360/9). If the credit department extends terms of 2/10, net
30, investigation of the company’s actual credit policies is warranted. For example,
the department may routinely give customers up to 40 or 50 days to pay. If this
policy does not create any cash flow problems, why have terms of 2/10, net 30?
Alternatively, the average time to collect may be an indication that the credit
department is extending credit to customers who are not good credit risks.
13. One possible explanation for a decrease in inventory turnover is slow-moving items.
Caution must be used, however, because a low inventory turnover may simply be a
seasonal phenomenon. For example, the ratio for the third quarter of the year should
be compared with that of the third quarter of the prior year. Problems in the sales
department may also partially explain a low turnover of inventory. Or, the company
may be pricing itself out of the market and need to consider lowering its prices to
meet the competition.
14. A manufacturer’s operating cycle runs from the purchase of raw materials, to the
transformation of the materials into a final product, to sale, to the collection of any
receivable. This differs from the operating cycle of a service business because the
latter does not technically sell a product. Service businesses must look for
alternative measures of efficiency. For example, an airline would be interested in the
average amount of time elapsed between the sale of a ticket and collection from the
passenger. A public accounting firm might want to know the average length of time
that passes after an audit is finished before the client pays the bill.
15. Liquidity analysis is concerned with the ability of the company to pay its debts as
they are due and thus focuses on the current assets and liabilities. Solvency is the
ability to stay in business over the long run. The debt-to-equity ratio and the debt
service coverage ratio are two measures of the firm’s solvency.
16. The debt service coverage ratio is superior to the times interest earned ratio as a
measure of solvency for two reasons. First, the ratio considers the need to pay both
interest and principal, whereas the times interest earned ratio deals only with
interest. Second, the necessary payments to service debt are compared with the
cash available to pay the debt, while the times interest earned ratio uses an accrual
income number in its numerator.
17. Both are right. Many different ratios are used to assess the relative mix of a
company’s capital structure. The debt-to-equity ratio measures the amount of
outstanding debt relative to the amount of stockholders’ equity. An alternative
measure is to divide the same debt by the total assets of the company. A different
ratio will obviously result, but as long as the same measure is used consistently,
either ratio is an indicator of solvency.
18. The debt service coverage ratio measures the amount of cash generated from
operating activities that is available to repay the interest and any maturing debt. A
loan officer is primarily concerned with the company’s ability to meet interest and
principal payments on time and, therefore, would be very interested in this ratio.
19. Dividends are not a legal obligation, but they often become an expectation on the
part of stockholders. Therefore, when computing the cash available to make capital
acquisitions, it is helpful to take into account the normal dividend requirements.
20. The numerator in any rate of return ratio must match the investment or base in the
denominator. If total assets is the base, the numerator must be a measure of the
income available to all providers of capital. Interest expense, net of tax, is added
back to net income because the creditors are one of the sources of capital, and we
want to consider the income available before any of the sources of funds are given a
distribution. Interest must be on a net or after-tax basis to be consistent with net
income, which is on an after-tax basis.
21. A return on stockholders’ equity that is lower than the return on assets means that
the company is not successfully using borrowed funds. Return on assets measures
the return to all providers of capital, whereas return on equity is concerned only with
common stockholders. The company has not been able to earn an overall return that
is as high as what is being paid to creditors and preferred stockholders. Leverage
deals with the use of someone else’s money to earn a favorable return. Presently,
this company is not successfully employing financial leverage.
22. The price/earnings ratio is sometimes used as an indicator of the quality of a
company’s earnings because it combines a measure of the company’s performance,
based on its earnings, and the company’s worth as measured by the market price of
its stock. The ratio of price to earnings is an indication of the market’s assessment of
the company’s performance. For example, the use of different accounting methods
can cause the market to value the price of one company’s stock higher than another
company’s stock, even though they report similar earnings. This could be the case if
one defers taxes by using LIFO whereas the other uses FIFO. This differing
treatment of the two stocks is a statement by the market about the “quality” of the
two company’s earnings.
23. Most of the liquidity ratios are primarily suited to use by management. For example,
the investor would not normally place major emphasis on the turnover of either
inventory or receivables. On the other hand, turnover ratios must be constantly
monitored by management. The stockholder will be very interested in both the
dividend payout ratio and the dividend yield. A banker would rely partially on a
company’s debt service coverage in the past as an indication of its ability to repay a
potential loan in the future.
24. The inventory turnover ratio is meaningless to a service business such as a law firm
or a public accounting firm. These firms do not sell a tangible product; instead, they
sell their professional expertise and thus must rely on alternative measures of their
efficiency in marketing their services. An accounting firm, for example, might keep
detailed records on the number of clients served, the average annual billings to each
client, and the ratio of these billings to the average costs incurred on each audit.
25. Separate reporting of discontinued operations, extraordinary items and the

cumulative effect of a change in accounting principle assists the reader of the
statements in making predictions about the future profitability of the business. For
example, users of the income statement may want to ignore these items when
assessing the future prospects for the company because these items by their nature
are not likely to reoccur in the future.
EXERCISES
LO 4 EXERCISE 13-1 ACCOUNTS RECEIVABLE ANALYSIS
1. Accounts receivable turnover:

Net credit sales/Average accounts receivable:
2007: $600,000/[($150,000 + $100,000)/2] = $600,000/$125,000 = 4.8 times
2006: $540,000/[($100,000 + $80,000)/2] = $540,000/$90,000 = 6 times
2. Number of days sales in receivables:

2007: 360/4.8 = 75 days
2006: 360/6 = 60 days
3. The average age of a receivable in 2006 was the same number of days as the
maximum credit period of 60 days. The average age in 2007 of 75 days, however, is
significantly in excess of the credit period. The company needs to investigate this
increase and decide whether efforts are needed to speed up the collection process.
The company may decide that allowing customers more liberal payment terms has
had a positive effect on sales, as evidenced by the increase in sales, and not want to
press its customers for earlier payment. Conversely, the company may find that
allowing an extra 15 days for payment causes cash flow problems.
LO 4 EXERCISE 13-2 INVENTORY ANALYSIS
1. Inventory turnover:
Cost of goods sold/Average inventory:
2007: $7,100,000/[($200,000 + $150,000)/2] = $7,100,000/$175,000
= 40.57 times
2006: $8,100,000/[($150,000 + $120,000)/2] = $8,100,000/$135,000
= 60 times
2. Number of days sales in inventory:

2007: 360/40.57 = 8.9 days
2006: 360/60 = 6 days
EXERCISE 13-2 (Concluded)
3. Inventory turnover has declined dramatically from the prior year. Many different
explanations are possible for this decline, such as problems in the sales effort, over-
pricing of the products relative to the competition, or inferior produce. Management
needs to investigate the problem and decide who should be held responsible for the
slow movement. The company may find that no one department or individual is
totally responsible and that many different parts of the business need to work
together to improve the turnover of inventory.
LO 4 EXERCISE 13-3 ACCOUNTS RECEIVABLE AND INVENTORY ANALYSES FOR

COCA-COLA AND PEPSICO
1. Calculations (all dollar amounts in millions):

a. Accounts Receivable Turnover Ratio:
Coca-Cola Company
$21,962/[($2,171 + $2,091)/2] = $21,962/$2,131 = 10.31 times
PepsiCo, Inc.
$29,261/[($2,999 + $2,830)/2] = $29,261/$2,914.5 = 10.04 times
b. Number of Days’ Sales in Receivables:
Coca-Cola Company
360/10.31 = 34.9 days
PepsiCo, Inc.
360/10.04 = 35.9 days
c. Inventory Turnover Ratio:
Coca-Cola Company
$7,638/[($1,420 + $1,252)/2] = $7,638/$1,336 = 5.72 times
PepsiCo, Inc.
$13,406/[($1,541 + $1,412/2] = $13,406/$1,476.5 = 9.08 times
d. Number of Days’ Sales in Inventory:
Coca-Cola Company
360/5.72 = 62.9 days
PepsiCo, Inc.
360/9.08 = 39.6 days
e. Cash to Cash Operating Cycle:
Coca-Cola Company
34.9 + 62.9 = 97.8 days
PepsiCo, Inc.
35.9 + 39.6 = 75.5 days
2. The two companies’ accounts receivable turnover ratios are similar, and therefore
their numbers of days’ sales in receivables are about the same. PepsiCo, Inc. has a
higher inventory turnover ratio and, accordingly, a lower number of days’ sales in
inventory. The result is that PepsiCo, Inc. also has a lower cash to cash operating
cycle.
LO 4 EXERCISE 13-4 LIQUIDITY ANALYSES FOR COCA-COLA AND PEPSICO
1. Calculations (all dollar amounts in millions):

Coca-Cola Company PepsiCo, Inc.
a. Current ratio $12,094/$10,971 = 1.10 to 1 $8,639/$6,752 = 1.28 to 1
b. Quick assets $6,707 + $61 + $2,171 $1,280 + $2,165 + $2,999
= $8,939 = $6,444
Acid-test or
Quick ratio $8,939/$10,971 = 0.81 to 1 $6,444/$6,752 = 0.95 to 1
2. PepsiCo’s current and acid-test (or quick) ratios are higher than Coca-Cola’s. Based
on these measures, PepsiCo appears to be more liquid than Coca-Cola.
3. Other ratios that can be used to more fully assess the liquidity of these two
companies are these: cash flow from operations to current liabilities ratio, accounts
receivable turnover ratio, number of days’ sales in receivables, inventory turnover
ratio, number of days’ sales in inventory, and cash to cash operating cycle.
LO 4 EXERCISE 13-5 LIQUIDITY ANALYSES FOR MCDONALD’S AND WENDY’S
1. Calculations:
McDonald’s Wendy’s
(In millions) (In thousands)
a. Working capital $2,857.8 – $3,520.5 $458,844 – $688,387
= $(662.7) = $(229,543)
b. Current ratio $2,857.8/$3,520.5 $458,844/$688,387
= 0.81 = 0.67
c. Quick assets $1,379.8 + $745.5 $176,749 + $127,158 + $11,626
= $2,125.3 = $315,533
Acid-test or
Quick ratio $2,125.3/$3,520.5 $315,533/$688,387
= 0.60 = 0.46
2. Both McDonald’s and Wendy’s have negative working capital. Wendy’s current and
acid-test (or quick) ratios are slightly lower than McDonald’s. Based on these
measures, McDonald’s appears to be slightly more liquid than Wendy’s.
3. Calculations of cash flow from operations to current liabilities ratios:
McDonald’s (in millions)
$3,903.6/[($3,520.5 + $2,748.5)/2] = $3,903.6/$3,134.5 = 124.5%
Wendy’s (in thousands)
$502,352/[($688,387 + $528,473)/2] = $502,352/$608,430 = 82.6%
This ratio overcomes the two limitations of the current and the quick ratios, because
it focuses on cash and cash flows. McDonald’s cash flow from operations to current
liabilities ratio is higher than Wendy’s. As a result, even though the two companies’
current and quick ratios are very similar, this ratio appears to indicate that
McDonald’s is more liquid.
4. McDonald’s has negative working capital but a very strong cash flow from operations
to current liabilities ratio. As such, McDonald’s might be able to cover its short-term
cash requirements through short-term borrowings.
LO 5 EXERCISE 13-6 SOLVENCY ANALYSES FOR IBM
1. 2004 2003
a. Debt-to-equity ratio $79,436/$29,747 $76,593/$27,864
= 2.67 to 1 = 2.75 to 1
b. Times interest earned ($8,430 + $139 + ($7,583 + $145 +
$3,580)/$139 $3,261)/$145
= $12,149/$139 = $10,989/$145
= 87.4 to 1 = 75.8 to 1
c. Debt service
coverage ratio* ($15,406 + $139 + ($14,569 + $145 +
$3,580)/($139 + $4,538) $3,261)/($145 + $5,831)
= $19,125/$4,677 = $17,975/$5,976
= 4.1 times = 3.0 times
*The amounts for interest and taxes represent interest expense and income tax
expense rather than the amounts paid.
d. Cash flow from
operations to capital
expenditures ratio ($15,406 – $1,174)/$4,368 ($14,569 – $1,085)/$4,393
= $14,232/$4,368 = $13,484/$4,393
= 325.8% = 306.9%
2. All of the measures in requirement 1 suggest that IBM was more solvent at the end
of 2004 than at the end of 2003.
LO 5 EXERCISE 13-7 SOLVENCY ANALYSIS
1. a. Debt-to-equity ratio: Total liabilities/Total stockholders’ equity

At 12/31/07: ($350,000 + $600,000)/$1,650,000
= $950,000/$1,650,000 = 0.58 to 1
At 12/31/06: ($405,000 + $800,000)/$1,500,000
= $1,205,000/$1,500,000 = 0.80 to 1
b. Times interest earned for 2007 (Net income + Interest expense + Income tax
expense)/Interest expense:
($150,000 + $89,000 + $111,000)/$89,000 = $350,000/$89,000 =
3.93 to 1
c. Debt service coverage for 2007 (Cash flows from operations before interest and
tax payments)/Interest and principal payments:
($185,000 + $89,000 + $96,000*)/($89,000 + $275,000**) =
$370,000/$364,000 = 1.02 times
*Taxes payable, 12/31/06 $ 45,000
Add: Tax expense 111,000
Less: Taxes payable 12/31/07 60,000
Taxes paid during 2007 $ 96,000
**Principal payments:
a. Short-term notes payable $ 75,000
b. Serial bonds 200,000
Total $275,000
2. The company’s debt-to-equity ratio has decreased because of the repayment of the
short-term notes and the installment payment on the serial bonds. The ratio at the
end of 2007 of almost 0.6 to 1 indicates a relatively conservative balance of debt to
stockholders’ equity. The times interest earned ratio indicates that Impact’s profits
before interest and taxes were almost four times the amount of interest expense.
Two problems arise, however, in using the times interest earned ratio as the sole
measure of solvency. First, it considers the payment of only interest, not principal.
Second, principal and interest payments must be made with cash, not profits. The
debt service coverage ratio is a much better indication of the company’s ability to
meet its obligations. A ratio of 1.02 times indicates that Impact generated just
enough cash from operations to meet its principal and interest payments in 2007.
LO 6 EXERCISE 13-8 RETURN RATIOS AND LEVERAGE
1. Ratios:
a. Return on sales = (Net income + Interest expense, net of tax)/Net sales
[$60,000 + ($50,000 × 60%)]/$650,000
= $90,000/$650,000 = 13.85%
b. Asset turnover = Net sales/Average total assets
$650,000/[($1,600,000 + $2,000,000*)/2]
= $650,000/$1,800,000 = 0.36 times
*Total assets at end of year are the same as total liabilities and stockholders’
equity (given).
c. Return on assets = (Net income + Interest expense, net of tax)/Average total
assets
$90,000 (from Part a.)/$1,800,000 (from Part b.) = 5%
d. Return on common stockholders’ equity = (Net income – Preferred dividends)/
Average common stockholders’ equity
($60,000 – $25,000*)/[($950,000 + $915,000**)/2]
= $35,000/$932,500 = 3.75%
*Preferred dividends: $250,000 par value × 10%
**Stockholders’ equity at beginning of year:
Common stock $600,000
Retained earnings $350,000 at end of
year less $60,000 net income plus
$25,000 dividends 315,000
Stockholders’ equity at beginning of year $915,000
2. Evergreen has not been successful in using outside funds because the return on
stockholders’ equity of 3.75% is less than the return to all providers of capital, as
measured by the return on assets of 5%.
Evidence that Evergreen has not successfully employed leverage is found by
looking closer at the cost of outside funds. The average cost of borrowed funds is
$50,000 in interest expense divided by $650,000 in short-term loans payable and
long-term bonds. This cost of 7.7% times 1 minus the tax rate, or 60%, translates to
an after-tax borrowing rate of 4.62%. The return paid to the preferred stockholders is
10%. Both of these rates exceed the return to the common stockholder of 3.75% and
indicate that Evergreen is not successfully employing leverage.
LO 6 EXERCISE 13-9 RELATIONSHIPS AMONG RETURN ON ASSETS, RETURN ON

SALES, AND ASSET TURNOVER
Case 1. Return on assets = Net income (assuming no interest expense)/Average

total assets = $10,000/$60,000 = 16.67%
Case 2. Return on sales = Net income/Net sales

2% = $25,000/X
Net sales = $1,250,000
Case 3. Return on assets = Return on sales × Asset turnover

X = 6% × 1.5
Return on assets = 9%
Case 4. Asset turnover = Net sales/Average total assets

1.25 = $50,000/X
Average total assets = $40,000
Return on assets = Net income (assuming no interest expense)/Average
total assets
10% = X/$40,000
Net income = $4,000
Case 5. Return on assets = Net income (assuming no interest expense)/Average

total assets
15% = $20,000/X
Average total assets = $133,333
LO 6 EXERCISE 13-10 EPS, P/E RATIO, AND DIVIDEND RATIOS
1. Ratios:
a. Earnings per common share = (Net income less preferred dividends)/Number of
common shares outstanding:
[$1,300,000 – 8%($5,000,000)]/400,000 shares
= ($1,300,000 – $400,000)/400,000
= $900,000/400,000 = $2.25 per share
b. Price/earnings ratio = Current market price/EPS
= $24.75/$2.25 = 11 to 1
c. Dividend payout ratio = Common dividends per share/EPS
= ($0.40 × 4 quarters)/$2.25
= $1.60/$2.25 = 71.11%
d. Dividend yield ratio = Common dividends per share/Market price
= $1.60 (from Part c.)/$24.75 = 6.46%
2. An investment advisor needs to be aware of industry trends, the general economic

environment, the historical performance of the company, the investor’s attitudes
about risk, and any other relevant data needed to make an informed decision.
LO 6 EXERCISE 13-11 EARNINGS PER SHARE AND EXTRAORDINARY ITEMS
1. Earnings per share before extraordinary items = (Net income before extraordinary
loss less preferred dividends)/Number of common shares outstanding:
[$5,850,000 – 9%($2,000,000)]/1,500,000 shares
= ($5,850,000 – $180,000)/1,500,000 shares
= $5,670,000/1,500,000 shares = $3.78 per share
2. Earnings per share (after the extraordinary loss) = (Net income – preferred
dividends)/Number of common shares outstanding:
($2,130,000 – $180,000)/1,500,000 shares
= $1,950,000/1,500,000 = $1.30 per share
3. Management is accountable for the overall operation of the company and thus, to
some extent, must be evaluated on the basis of the “bottom line” as measured by
the earnings per share after the extraordinary loss from the flood. In attempting to
forecast future profits, however, both management and a potential stockholder would
be much more concerned with EPS exclusive of any extraordinary items, because
these gains and losses are unusual in nature and infrequent in occurrence.
M U LT I - C O N C E P T E X E R C I S E S
LO 2,3 EXERCISE 13-12 COMMON-SIZE BALANCE SHEETS AND HORIZONTAL

ANALYSIS
1. FARINET COMPANY
COMMON-SIZE COMPARATIVE BALANCE SHEETS
DECEMBER 31, 2007 AND 2006
12/31/07 12/31/06
Dollars Percent Dollars Percent
Cash $ 16,000 1.7%* $ 20,000 2.5%*
Accounts receivable 40,000 4.3 30,000 3.8
Inventory 30,000 3.3 50,000 6.2
Prepaid rent 18,000 2.0 12,000 1.5
Total current assets $ 104,000 11.3% $112,000 14.0%
Land $ 150,000 16.2% $150,000 18.7%
Plant and equipment 800,000 86.6 600,000 74.8
Accumulated depreciation (130,000) (14.1) (60,000) (7.5)
Total long-term assets $ 820,000 88.7% $690,000 86.0%
Total assets $ 924,000 100.0% $802,000 100.0%
Accounts payable $ 24,000 2.6% $ 20,000 2.5%
Income taxes payable 6,000 0.6 10,000 1.3
Short-term notes payable 70,000 7.6 50,000 6.2
Total current liabilities $ 100,000 10.8% $ 80,000 10.0%
Bonds payable $ 150,000 16.2% $200,000 24.9%
Common stock $ 400,000 43.3% $300,000 37.4%
Retained earnings 274,000 29.7 222,000 27.7
Total stockholders’ equity $ 674,000 73.0%* $522,000 65.1%
Total liabilities and
stockholders’ equity $ 924,000 100.0% $802,000 100.0%
*Rounded to total.
EXERCISE 13-12 (Continued)

2. Observations from Farinet’s common-size balance sheets:
a. Current assets as a percentage of total assets has decreased. At the same time,
current liabilities has accounted for about the same percentage of total equities in
the two years.
b. The relative mix of current assets has changed from one year to the next. Cash
now accounts for a smaller share of total assets, as does inventory, whereas
accounts receivable accounts for a slightly higher percentage of total assets.
c. Major investments in plant and equipment have been made in 2007. At the end of
2006, plant and equipment accounted for three-fourths of the total assets, and
now it accounts for over 86% of the total.
d. Bonds payable now make up a smaller share of the capital structure with the
retirement of $50,000 during 2007.
e. Short-term borrowings increased and now represent a larger share of the current
liabilities (from $50,000/$80,000, or 62.5%, to $70,000/$100,000, or 70%).
3. FARINET COMPANY
COMPARATIVE BALANCE SHEETS
DECEMBER 31, 2007 AND 2006
December 31 Increase (Decrease)
2007 2006 Dollars Percent
Cash $ 16,000 $ 20,000 $ (4,000) (20)%
Accounts receivable 40,000 30,000 10,000 33
Inventory 30,000 50,000 (20,000) (40)
Prepaid rent 18,000 12,000 6,000 50
Total current assets $ 104,000 $112,000 $ (8,000) (7)%
Land $ 150,000 $150,000 $ 0 0%
Plant and equipment 800,000 600,000 200,000 33
Accumulated depreciation (130,000) (60,000) (70,000) (117)
Total long-term assets $ 820,000 $690,000 $130,000 19%
Total assets $ 924,000 $802,000 $122,000 15%
Accounts payable $ 24,000 $ 20,000 $ 4,000 20%
Income tax payable 6,000 10,000 (4,000) (40)
Short-term notes payable 70,000 50,000 20,000 40
Total current liabilities $ 100,000 $ 80,000 $ 20,000 25%
Bonds payable $ 150,000 $200,000 $ (50,000) (25)%
Common stock $ 400,000 $300,000 $100,000 33%
Retained earnings 274,000 222,000 52,000 23
Total stockholders’ equity $ 674,000 $522,000 $152,000 29%
Total liabilities and
stockholders’ equity $ 924,000 $802,000 $122,000 15%
4. Largest changes Refer to

a. Accumulated depreciation Fixed asset records, showing
additions to plant and equipment
and depreciation calculations
b. Prepaid rent Rental agreements
c. Inventory Purchase orders, sales records
d. Income tax payable Income tax return and
supporting records
e. Short-term notes payable Loan agreements
LO 2,3 EXERCISE 13-13 COMMON-SIZE INCOME STATEMENTS AND HORIZONTAL

ANALYSIS
1. MARINERS CORP.
COMMON-SIZE COMPARATIVE INCOME STATEMENTS
FOR THE YEARS ENDED DECEMBER 31, 2007 AND 2006
(IN THOUSANDS OF DOLLARS)
2007 2006
Dollars Percent Dollars Percent
Sales revenue $60,000 100.0% $50,000 100.0%
Cost of goods sold 42,000 70.0 30,000 60.0
Gross profit $18,000 30.0% $20,000 40.0%
Selling and administrative
expense 9,000 15.0 5,000 10.0
Operating income $ 9,000 15.0% $15,000 30.0%
Interest expense 2,000 3.3 2,000 4.0
Income before tax $ 7,000 11.7% $13,000 26.0%
Income tax expense 2,000 3.3 4,000 8.0
Net income $ 5,000 8.4%* $ 9,000 18.0%
*Rounded to total.
2. Observations from Mariners’ common-size statements:

a. Although sales increased in absolute dollars, the gross profit percentage has
decreased significantly because of a higher ratio of cost of goods sold to sales:
from 60% to 70%.
b. Selling and administrative expenses have increased both in absolute dollars and
as a percentage of sales. An increase from 10% to 15% of sales is a drastic
increase in the importance of this cost relative to sales.
c. Interest expense remained the same in absolute dollars, but because sales
increased, it decreased slightly from 4% to 3.3% of sales.
d. The bottom line net income decreased both in absolute dollars and as a
percentage of sales. The solid increase in sales is more than offset by the large
increases in both product costs and selling and administrative expenses.
3. MARINERS CORP.
COMPARATIVE STATEMENTS OF INCOME
FOR THE YEARS ENDED DECEMBER 31, 2007 AND 2006
December 31 Increase (Decrease)
2007 2006 Dollars Percent
Sales revenue $60,000 $50,000 $10,000 20%
Cost of goods sold 42,000 30,000 12,000 40
Gross profit $18,000 $20,000 $(2,000) (10)%
Selling and administrative
expense 9,000 5,000 4,000 80
Operating income $ 9,000 $15,000 $ (6,000) (40)%
Interest expense 2,000 2,000 0 0
Income before tax $ 7,000 $13,000 $ (6,000) (46)%
Income tax expense 2,000 4,000 (2,000) (50)
Net income $ 5,000 $ 9,000 $ (4,000) (44)%
4. Largest changes Refer to

Selling and administrative Individual records, for the
expenses various expenses
Income tax expense Income tax return and supporting
records
PROBLEMS
LO 4 PROBLEM 13-1 EFFECT OF TRANSACTIONS ON WORKING CAPITAL, CURRENT

RATIO, AND QUICK RATIO
1. Calculation of working capital, current ratio, and quick ratio (dollar amounts in
thousands):
Working capital
($70 + $60 + $80 + $100 + $10) – ($75 + $25 + $40 + $60)
= $320 – $200 = $120
Current ratio
$320/$200 = 1.600 to 1
Quick ratio
($70 + $60 + $80)/$200 = $210/$200 = 1.050 to 1
PROBLEM 13-1 (Concluded)
2. Effect of transactions on working capital, current ratio, and quick ratio:

Working Effect Effect Effect
Capital of of of
(in Thou- Trans- Current Trans- Quick Trans-
Transaction sands) action Ratio action Ratio action
a. Purchased inventory
on account for
$20,000 $120 none 1.545 decrease 0.955 decrease
b. Purchased inventory
for cash, $15,000 $120 none 1.600 none 0.975 decrease
c. Paid suppliers on
account, $30,000 $120 none 1.706 increase 1.059 increase
d. Received cash on
account, $40,000 $120 none 1.600 none 1.050 none
e. Paid insurance for
next year, $20,000 $120 none 1.600 none 0.950 decrease
f. Made sales on
account, $60,000 $180 increase 1.900 increase 1.350 increase
g. Repaid short-term
loans at bank,
$25,000 $120 none 1.686 increase 1.057 increase
h. Borrowed $40,000
at bank for 90 days $120 none 1.500 decrease 1.042 decrease
i. Declared and paid
$45,000 cash
dividend $ 75 decrease 1.375 decrease 0.825 decrease
j. Purchased $20,000
of short-term
investments $120 none 1.600 none 1.050 none
k. Paid $30,000 in
salaries $ 90 decrease 1.450 decrease 0.900 decrease
l. Accrued additional
$15,000 in taxes $105 decrease 1.488 decrease 0.977 decrease
LO 4 PROBLEM 13-2 EFFECT OF TRANSACTIONS ON WORKING CAPITAL, CURRENT

RATIO, AND QUICK RATIO
1. Calculation of working capital, current ratio and quick ratio (dollar amounts in
thousands):
Working capital
($70 + $60 + $80 + $100 + $10) – ($75 + $25 + $40 + $210)
= $320 – $350 = $(30)
Current ratio
$320/$350 = 0.914 to 1
Quick ratio
($70 + $60 + $80)/$350 = $210/$350 = 0.600 to 1
2. Effect of transactions on working capital, current ratio, and quick ratio:

Working Effect Effect Effect
Capital of of of
(in Thou- Trans- Current Trans- Quick Trans-
Transaction sands) action Ratio action Ratio action
a. Purchased inventory
on account for
$20,000 $(30) none 0.919 increase 0.568 decrease
b. Purchased inventory
for cash, $15,000 $(30) none 0.914 none 0.557 decrease
account, $30,000 $(30) none 0.906 decrease 0.563 decrease
d. Received cash on
account, $40,000 $(30) none 0.914 none 0.600 none
e. Paid insurance for
next year, $20,000 $(30) none 0.914 none 0.543 decrease
f. Made sales on
account, $60,000 $30 increase 1.086 increase 0.771 increase
g. Repaid short-term
loans at bank,
$25,000 $(30) none 0.908 decrease 0.569 decrease
h. Borrowed $40,000
at bank for 90 days $(30) none 0.923 increase 0.641 increase
$45,000 cash
dividend $(75) decrease 0.786 decrease 0.471 decrease
j. Purchased $20,000
of short-term
investments $(30) none 0.914 none 0.600 none
k. Paid $30,000 in
salaries $(60) decrease 0.829 decrease 0.514 decrease
$15,000 in taxes $(45) decrease 0.877 decrease 0.575 decrease
LO 6 PROBLEM 13-3 GOALS FOR SALES AND RETURN ON ASSETS
1. a. Return on sales = Net income after adding back interest expense, net of tax/Net
sales
= $5,000,000/$60,000,000 = 8.33%
= $60,000,000/$40,000,000 = 1.5 times
c. Return on assets = Return on sales × Asset turnover
= 8.33% × 1.5 = 12.5%
2. Asset turnover = ($60,000,000 × 120%)/($40,000,000 × 112.5%)

= $72,000,000/$45,000,000 = 1.6 times
3. If average total assets are $45,000,000 and the goal is a 15% return on assets, net
income will need to be 15% of $45,000,000, or $6,750,000.
4. Income will have to increase by 35%, ($6,750,000 – $5,000,000)/$5,000,000, to

achieve the goal of a 15% return on assets. The president has set a goal for an
increase in sales of only 20%. To increase income by a larger percentage than the
increase in sales will require cost cutting in the various departments of the business.
The company may want to look for cheaper sources of supply for its materials, as
long as the quality of the product is maintained. Efforts will need to be made to cut
selling, general, and administrative expenses as well.
LO 6 PROBLEM 13-4 GOALS FOR SALES AND INCOME GROWTH
1. Selected financial data (in millions of dollars):

2010 2009 2008
1. Sales* 266.200 242.00 220.0
2. Net income (sales × 3%)* 7.986 7.26 6.6
3. Dividends declared and paid (greater of
$3,000,000 or 50% of net income) 3.993 3.63 3.3
4. Owners’ equity, December 31 balance
(prior years’ balance + net income
less dividends) 80.923 76.93 73.3
5. Debt, Dec. 31 balance** 52.177 44.07 36.7
Selected ratios:
6. Return on owners’ equity (Item 2/Item 4) 9.9% 9.4% 9.0%
Note: The return on owners’ equity ratios in the problem for 2005–2007 are
based on year-end owners’ equity rather than the average for each year.
Therefore, to be consistent, year-end balances are used for 2008–2010.
7. Debt to total assets [Item 5/(Item 4 + Item 5)] 39.2% 36.4% 33.4%
*Sales and net income increase at the rate of 10% per year.
**Calculation of total debt balance:
Total assets (sales/asset
turnover rate of 2) $133.100 $121.00 $110.0
Less: Owners’ equity (Item 4) 80.923 76.93 73.3
Debt $ 52.177 $ 44.07 $ 36.7
2. No, the CEO will not be able to meet all her requirements if a 10% per year growth in
income and sales is achieved. If under the stated assumptions that the net income to
sales ratio be maintained at 3% with annual sales growth of 10%, and the asset
turnover ratio be maintained at 2, the goal of holding debt to 35% of total assets will
be met only in 2008. The debt will increase to 36.4% of total assets in 2009 and to
39.2% of total assets in 2010 under the proposed plan. The calculations assume that
all other factors remain constant. Because some of the factors that affect stock
prices are outside the company’s control, it cannot be determined whether the main
requirement of improving the stock price can be met if the expected performance is
accomplished.
3. Alternative actions to be considered to improve the return on equity and support the
increased dividend payments:
a. Improve the return on assets by
reducing the asset base through better asset management.
improving asset quality to generate higher returns per dollar invested, including the
acquisition of a subsidiary or a more profitable line of business.
b. Improve profits by
concentrating production and sales on high profit-producing lines.
cost control efforts to maintain and reduce both variable and fixed costs.
4. The CEO is probably concerned with the potential impact that greater debt would
have on the company’s cost of capital. Increasing debt relative to owners’ equity
creates added risk, which translates to higher returns required by investors in the
company’s stocks and bonds. If investors perceive that the company’s financial risks
have increased, the market prices for its long-term debt issues will fall (interest rates
will rise), and greater dividend payments will be necessary to maintain the market
price of the stock.
M U LT I - C O N C E P T P R O B L E M S
LO 4,5,6 PROBLEM 13-5 BASIC FINANCIAL RATIOS
1. Financial ratios for 2007 for CCB Enterprises (thousands omitted):

a. Times interest earned = (Net income + Income tax expense + Interest
expense)/Interest expense
= ($72,000 + $48,000 + $20,000)/$20,000
= $140,000/$20,000 = 7 to 1
b. Return on total assets = (Net income + Interest expense, net of tax)/Average total
assets
= {$72,000 + [$20,000 × (1 – 40%*)]}/[($540,000 + $510,000)/2]
= $84,000/$525,000 = 16%
*Tax rate = Income taxes/Income before tax = $48,000/$120,000 = 40%.
c. Return on common stockholders’ equity = (Net income – Preferred
dividends)/Average common stockholders’ equity
= $72,000/[($260,000 + $217,000)/2]
= $72,000/$238,500 = 30.19%
d. Debt/equity ratio = Total liabilities/Total stockholders’ equity
= $280,000/$260,000 = 1.08 to 1
e. Current ratio = Current assets/Current liabilities
= $144,000/$120,000 = 1.2 to 1
f. Quick (acid-test) ratio = (Cash + Marketable securities + Short-term
receivables)/Current liabilities
= ($26,000 + $48,000)/$120,000
= $74,000/$120,000 = 0.62 to 1
g. Accounts receivable turnover ratio = Net credit sales/Average accounts
receivable
= $800,000/[($48,000 + $50,000)/2]
= $800,000/$49,000 = 16.3 times
h. Number of days’ sales in receivables = Number of days in period/Accounts
receivable turnover
= 360 days/16.3 times = 22 days
i. Inventory turnover ratio = Cost of goods sold/Average inventory
= $540,000/[($65,000 + $62,000)/2]
= $540,000/$63,500 = 8.5 times
j. Number of days’ sales in inventory = Number of days in period/Inventory turnover
k. Number of days in cash operating cycle = Days’ sales in inventory + Days’ sales
in receivables
= 42 days + 22 days = 64 days
2. Comments on the overall financial health of CCB Enterprises:
The current ratio indicates a fairly strong liquidity position, although the significantly
smaller quick ratio may signal a problem with excess inventory. Whether or not the
quick ratio is indicative of a liquidity problem could be determined more accurately
by comparing this ratio with prior years, as well as with an industry average.
Inventory turnover of 8.5 times may not be a problem area (see discussion of
quick ratio above), but it should be compared with those of prior years and with an
industry average—turning over inventory every 42 days may be normal for the
industry.
The length of time that receivables are outstanding, 22 days, appears to be
relatively short. It may indicate that the credit department is doing a good job in
screening customers for credit. On the other hand, if the credit terms are too
stringent, the company may be losing good customers. Comparison of this statistic
with those of other companies in the same line of business would help to determine
whether there is a problem in the credit department.
The company appears to be successfully using outside capital, as is evidenced
by a return on assets of 16%, but a return on stockholders’ equity of almost double
this—30.2%. Further evidence of the company’s use of leverage could be found by
examining the exact cost of each individual source of capital. For example, what are
the terms of the instruments that make up long-term debt, and what is the effective
interest cost of each?
The times interest earned ratio indicates that earnings are seven times the
amount of interest expense—what appears to be excellent coverage. However, how
much cash is generated from operations? Is this cash sufficient to cover not only
interest payments but also maturing principal amounts? Calculation of the debt
service coverage ratio, with information found on a cash flows statement, would
provide further evidence of the company’s solvency.
Finally, to fully evaluate the company’s financial health, it would be necessary to
know more about its plans for the long run. Does it plan to expand plant and
equipment? Are there any plans to take on additional products or acquire another
company? Are any additional debt issues being contemplated?
LO 5,6 PROBLEM 13-6 PROJECTED RESULTS TO MEET CORPORATE OBJECTIVES
1. Projected results for the four objectives for Tablon Inc. (in thousands of dollars):
 Sales growth of 20% will be achieved:

Sales increase for the year $30,000 $25,000
= = 20%
Sales for 2007 $25,000
 Return on stockholders’ equity of 15% will not be met:

Net income preferred dividends $1,200 $0 *
Average stockholders' equity
=
($9,300 + $8,700)/2
= $1,200/$9,000
= 13.3%
*No preferred stock
 Long-term debt-to-equity ratio of not more than 1 will not be achieved:

Long term debt at 5/31/08 $10,000
=
Stockholders' equity at 5/31/08 ($5,000 + $4,300)
= $10,000/$9,300
= 1.08 to 1
 A cash dividend of 50% of net income, with a minimum payment of at least

$400,000 will be met:
50% × 2008 net income = 0.50 × $1,200 = $600
($600 is the forecasted dividend payment)
2. Contributing factors to Tablon’s failure to meet all its objectives include the following:
 Each of the three expenses, cost of goods sold, selling expenses, and
administrative expenses and interest, as a percentage of sales, are expected to
increase in 2008 from 2007:
2007 2008
Cost of goods sold 52% 53.33%
Selling expenses 20% 23.33%
Administrative expenses and interest 16% 16.67%
 Accounts receivable will increase by $3,000,000 during the year—a 73%
increase, compared with an increase in sales of only 20%. This could cause a
cash flow problem and possibly an increase in bad debts.
 Production will exceed sales needs, as is evidenced by the 23% expected
increase in the amount of inventory. This will result in additional carrying costs for
the year.
 Long-term borrowing increased by 50% in the first six months of 2007, and for
the full year it is expected to be up by 66.67% from the beginning of the year.
3. Possible actions that the controller could recommend to the president in response to
the problems cited above include the following:
 Review the accounts receivable collection process to determine ways to speed
up collection and to determine whether credit is being extended to high-risk
customers.
 Slow down the production during the remainder of the year.
 Examine the reasons for an increase in the ratio of cost of goods sold to sales.
 Review the selling and administrative expenses to determine whether certain
areas can be cut back and still provide necessary services.
 Review the continuing increases in long-term debt and decide whether they are
necessary. Consider the issuance of preferred stock as an alternative form of
financing.
LO 4,5,6 PROBLEM 13-7 COMPARISON WITH INDUSTRY AVERAGES
1. Industry
Ratio Average Heartland Inc.
Current ratio 1.23 0.92
Acid-test (quick) ratio 0.75 0.53
Accounts receivable turnover 33 times 39 times
Inventory turnover 29 times 31 times
Debt-to-equity ratio 0.53 0.69
Times interest earned 8.65 times 4.43 times
Return on sales 6.57% 4.54%
Asset turnover 1.95 times 1.98 times
Return on assets 12.81% 8.97%
Return on common stockholders’ equity 17.67% 11.78%
Calculations for Heartland’s ratios (thousands omitted):
Current ratio = Current assets/Current liabilities
$31,100/$33,945 = 0.92 to 1
Acid-test ratio = (Cash + Marketable securities + Accounts receivable)/Current
liabilities
($1,135 + $1,250 + $15,650)/$33,945 = $18,035/$33,945 = 0.53 to 1
Accounts receivable turnover ratio = Sales/Average accounts receivable
$542,750/[($15,650 + $12,380)/2] = $542,750/$14,015 = 39 times
Inventory turnover ratio = Cost of goods sold/Average inventory
$435,650/[($12,680 + $15,870)/2] = $435,650/$14,275 = 31 times
Debt-to-equity ratio = Total liabilities/Total stockholders’ equity
($33,945 + $80,000)/$165,580 = $113,945/$165,580 = 0.69 to 1
Times interest earned = (Net income + Interest expense + Income tax
($19,095 + $9,275 + $12,730)/$9,275 = $41,100/$9,275 = 4.43 times
Return on sales = (Net income + Interest expense, net of tax)/Net sales
[$19,095 + $9,275(1 – 0.40*)]/$542,750 = ($19,095 + $5,565)/$542,750 =
$24,660/$542,750 = 4.54%
*Tax rate is $12,730/$31,825 = 40%.
Asset turnover = Net sales/Average total assets
$542,750/[($279,525 + $270,095)/2] = $542,750/$274,810 = 1.98 times
Return on assets = (Net income + Interest expense, net of tax)/Average total assets
$24,660 (above)/$274,810 (above) = 8.97%
Return on common stockholders’ equity = (Net income – Preferred dividends)/
$19,095/[($165,580 + $158,485)/2] = $19,095/$162,032.5 = 11.78%
2. Heartland is not as liquid as the average company in the industry, as is evidenced by

its lower current and quick ratios. The inventory turnover ratio is very close to the
industry average, whereas the accounts receivable turnover is significantly better.
Note, however, that the industry has a very high turnover—in fact, the average
number of days in receivables for the industry is 360/33, or 11 days. Heartland’s
accounts payable has increased significantly during a year in which inventory has
actually decreased.
The company is not as solvent as the rest of the industry, either, as is indicated
by its higher debt-to-equity ratio and lower times interest earned ratio. The heavy
reliance on outside funds is also reflected in the profitability of the company. Even
though Heartland’s return on equity is higher than its return on assets, both ratios
are significantly lower than the comparable industry averages. Its asset turnover is
slightly higher than the industry norm.
3. If the bank’s primary consideration in making the loan decision is the company’s
relative performance compared with that of the competition, it probably will not
approve the loan. Heartland is already more highly leveraged than the average
company in the industry, and it is not nearly as profitable. However, the loan decision
will depend on other factors in addition to the company’s relative standing in its
industry. For example, the bank will look at how Heartland’s ratios this year compare
with those of prior years. Maybe the company is smaller than others in the industry
and has always performed at its current level. If the bank approves the loan, it will
probably require a higher interest rate to compensate for any perceived additional
risk.
A LT E R N AT E P R O B L E M S
LO 5 PROBLEM 13-1A EFFECT OF TRANSACTIONS ON DEBT-TO-EQUITY RATIO
1. Calculation of debt-to-equity ratio (000’s omitted):

($150 + $375)/$400 = $525/$400 = 1.313 to 1
2. Effect of transactions on debt-to-equity ratio:
Debt-to-Equity Effect of
Transaction Ratio Transaction
a. Purchased inventory on
account for $20,000 1.363 increase
b. Purchased inventory for
cash, $15,000 1.313 none
account, $30,000 1.238 decrease
d. Received cash on
account, $40,000 1.313 none
e. Paid insurance for next
year, $20,000 1.313 none
f. Made sales on account,
$60,000 1.141 decrease
g. Repaid short-term loans
at bank, $25,000 1.250 decrease
h. Borrowed $40,000 at
bank for 90 days 1.413 increase
$45,000 cash dividend 1.479 increase
j. Purchased $20,000 of
short-term investments 1.313 none
k. Paid $30,000 in salaries 1.419 increase
$15,000 in taxes 1.403 increase
LO 5 PROBLEM 13-2A EFFECT OF TRANSACTIONS ON DEBT-TO-EQUITY RATIO
1. Calculation of debt-to-equity ratio (000’s omitted):

($25 + $125)/$400 = $150/$400 = 0.375 to 1
2. Effect of transactions on debt-to-equity ratio:
Debt-to-Equity Effect of
Transaction Ratio Transaction
a. Purchased inventory on
account for $20,000 0.425 increase
b. Purchased inventory for
cash, $15,000 0.375 none
account, $30,000 0.300 decrease
d. Received cash on
account, $40,000 0.375 none
e. Paid insurance for next
year, $20,000 0.375 none
f. Made sales on account,
$60,000 0.326 decrease
g. Repaid short-term loans
at bank, $25,000 0.313 decrease
h. Borrowed $40,000 at
bank for 90 days 0.475 increase
$45,000 cash dividend 0.423 increase
j. Purchased $20,000 of
short-term investments 0.375 none
k. Paid $30,000 in salaries 0.405 increase
$15,000 in taxes 0.429 increase
LO 6 PROBLEM 13-3A GOALS FOR SALES AND RETURN ON ASSETS
1. a. Return on sales = Net income after adding back interest expense,

net of tax/Net sales
= $60,000/$750,000 = 8%
= $750,000/$400,000 = 1.88 times
c. Return on assets = Return on sales × Asset turnover
= 8% × 1.88 = 15.04%
PROBLEM 13-3A (Concluded)
2. Asset turnover = ($750,000 × 115%)/($400,000 × 110%)

= $862,500/$440,000 = 1.96 times
3. If average total assets are $440,000 and the goal is a 20% return on assets, net
income will need to be 20% of $440,000, or $88,000.
4. Income will have to increase by 47%, ($88,000 – $60,000)/$60,000, to achieve the
goal of a 20% return on assets. The president has set a goal for an increase in sales
of only 15%. To increase income by a larger percentage than the increase in sales
will require cost cutting in the various departments of the business. The company
may want to look for cheaper sources of supply for its materials as long as the
quality of the product is maintained. Efforts will need to be made to cut selling,
general, and administrative expenses as well.
LO 6 PROBLEM 13-4A GOALS FOR SALES AND INCOME GROWTH
1. Selected financial data (in millions of dollars):

2010 2009 2008
1. Sales* 133.1000 121.000 110.0
2. Net income (sales × 3%)* 3.9930 3.630 3.3
3. Dividends declared and paid
(greater of $2,000,000
or 60% of net income) 2.3958 2.178 2.0
4. Owners’ equity, December 31
balance (prior years’
balance + net income less
dividends) 44.3492 42.752 41.3
5. Debt, Dec. 31 balance** 22.2008 17.748 13.7
Selected ratios:
6. Return on owners’ equity
(Item 2/Item 4) 9.0% 8.5% 8.0%
Note: The return on owners’ equity ratios in the problem for 2005–2007 are
based on year-end owners’ equity rather than the average for each year.
Therefore, to be consistent, year-end balances are used for 2008–2010.
7. Debt to total assets
[Item 5/(Item 4 + Item 5)] 33.36% 29.3% 24.9%
*Sales and net income increase at the rate of 10% per year.
**Calculation of total debt balance:
Total assets (sales/asset
turnover rate of 2) $66.5500 $60.500 $55.0
Less: Owners’ equity (Item 4) 44.3492 42.752 41.3
Debt $22.2008 $17.748 $13.7
2. No, the CEO will not be able to meet all his requirements if a 10% per year growth in
income and sales is achieved. If under the stated assumptions that the net income to
sales ratio be maintained at 3% with annual sales growth of 10%, and the asset
turnover ratio be maintained at 2, the goal of holding debt to 25% of total assets will
only be met in 2008. The debt will increase to 29.3% of total assets in 2009 and to
33.36% of total assets in 2010 under the proposed plan. The calculations assume
that all other factors remain constant. Because some of the factors that affect stock
prices are outside the company’s control, it cannot be determined whether the main
requirement of improving the stock price can be met if the expected performance is
accomplished.
3. Alternative actions to be considered to improve the return on equity and support the
increased dividend payments:
a. Improve the return on assets by
reducing the asset base through better asset management.
improving asset quality to generate higher returns per dollar invested, including the
acquisition of a subsidiary or a more profitable line of business.
b. Improve profits by
concentrating production and sales on high profit-producing lines.
cost control efforts to maintain and reduce both variable and fixed costs.
A LT E R N AT E M U LT I - C O N C E P T P R O B L E M S
LO 4,5,6 PROBLEM 13-5A BASIC FINANCIAL RATIOS
1. Financial ratios for 2007 for SST Enterprises (thousands omitted):

a. Times interest earned = (Net income + Income tax expense + Interest
= ($60,000 + $27,000 + $15,000)/$15,000
= $102,000/$15,000 = 6.8 times
b. Return on total assets = (Net income + Interest expense, net of tax)/Average total
assets
= {$60,000 + [$15,000 × (1 – 31%*)]}/[($300,000 + $295,000)/2]
= $70,350/$297,500 = 23.65%
*Tax rate = Income taxes/Income before tax = $27,000/$87,000 = 31%.
c. Return on common stockholders’ equity = (Net income – Preferred dividends)/
= $60,000/[($180,000 + $165,000)/2]
= $60,000/$172,500 = 34.78%
d. Debt/equity ratio = Total liabilities/Total stockholders’ equity
= $120,000/$180,000 = 0.67 to 1
e. Current ratio = Current assets/Current liabilities
= $100,000/$105,000 = 0.95 to 1
f. Quick (acid-test) ratio = (Cash + Marketable securities + Short-term
receivables)/Current liabilities
= ($27,000 + $36,000)/$105,000
= $63,000/$105,000 = 0.6 to 1
PROBLEM 13-5A (Continued)
g. Accounts receivable turnover ratio = Net credit sales/Average accounts

receivable
= $600,000/[($36,000 + $37,000)/2]
= $600,000/$36,500 = 16.4 times
h. Number of days’ sales in receivables = Number of days in period/Accounts
receivable turnover
i. Inventory turnover ratio = Cost of goods sold/Average inventory
= $405,000/[($35,000 + $42,000)/2]
= $405,000/$38,500 = 10.52 times
j. Number of days’ sales in inventory = Number of days in period/Inventory turnover
k. Number of days in cash operating cycle = Days’ sales in inventory + Days’ sales
in receivables
= 34 days + 22 days = 56 days
2. Comments on the overall financial health of SST Enterprises:
The current ratio is slightly less than 1 to 1, and the significantly smaller quick ratio
may signal a problem with excess inventory. Whether or not the quick ratio is
indicative of a liquidity problem could be determined more accurately by comparing
this ratio with those of prior years, as well as with an industry average.
Inventory turnover of 10.52 times may not be a problem area (see discussion of
quick ratio above), but it should be compared with those of prior years and with an
industry average—turning over inventory every 34 days may be normal for the
industry.
The length of time that receivables are outstanding, 22 days, appears to be
relatively short. It may be an indication that the credit department is doing a good job
in screening customers for credit. On the other hand, if the credit terms are too
stringent, the company may be losing good customers. Comparison of this statistic
with other companies in the same line of business would help to determine whether
there is a problem in the credit department.
The company appears to be successfully using outside capital, as is evidenced
by a return on assets of 23.65% but a much higher return on stockholders’ equity of
34.78%. Further evidence of the company’s use of leverage could be found by
examining the exact cost of each individual source of capital. For example, what are
the terms of the instruments that make up long-term debt and what is the effective
interest cost of each?
The times interest earned ratio indicates that earnings are nearly seven times the
amount of interest expense—that would appear to be excellent coverage. However,
how much cash is generated from operations? Is this cash sufficient to cover not
only interest payments but also maturing principal amounts? Calculation of the debt
service coverage ratio, with information found on a cash flows statement, would
provide further evidence of the company’s solvency.
Finally, to fully evaluate the company’s financial health, it would be necessary to
know more about its plans for the long run. Does it plan to expand plant and
equipment? Are there any plans to take on additional products or acquire another
company? Are any additional debt issues being contemplated?
LO 5,6 PROBLEM 13-6A PROJECTED RESULTS TO MEET CORPORATE OBJECTIVES
1. Projected results for the four objectives for Grout Inc. (in thousands of dollars):
 Sales growth of 10% will be exceeded:

Sales increase for the year $12,000 $10,000
= = 20%
Sales for 2007 $10,000
 Return on stockholders’ equity of 20% will not be met:

Net income preferred dividends $400 $0 *
Average stockholders' equity
=
($5,000 + $5,000)/2
= $400/$5,000
= 8%
*No preferred stock.
 Long-term debt-to-equity ratio of not more than 1 will not be achieved:

Long term debt at 9/30/08 $5,500
=
Stockholders' equity at 9/30/08 ($4,000 + $1,000)
= $5,500/$5,000
= 1.1 to 1
 A cash dividend of 50% of net income will be met (dividends of 100% of net
income are projected), but a minimum dividend payment of $500,000 will not be
met (the projected dividends are only $400,000).
2. Contributing factors to Grout’s failure to meet all its objectives include the following:
 Cost of goods sold, as a percentage of sales, is expected to increase in 2008

from 2007, and the other two operating expenses are expected to remain the
same:
2007
Cost of goods sold 60% 66.67%
Selling expenses 15% 15.00%
Administrative expenses and interest 10% 10.00%
 Accounts receivable will increase by $500,000 during the year—a 24% increase
compared with an increase in sales of 20%. The potential for an increase in bad
debts will need to be monitored.
 Production will exceed sales needs, as is evidenced by the 20% expected
increase in the amount of inventory. This will result in additional carrying costs for
the year.
 Long-term borrowing increased by 37.5% in the first six months of 2008, and it is
expected to stay at this level at the end of the year.
3. Possible actions that the controller could recommend to the president in response to
the problems cited above include the following:
 Review the accounts receivable collection process to determine ways to speed

up collection and to determine whether or not credit is being extended to high-
risk customers.
 Slow down the production during the remainder of the year.
 Examine the reasons for an increase in the ratio of cost of goods sold to sales.
 Review the continuing increases in long-term debt and decide whether or not
they are necessary. Consider the issuance of preferred stock as an alternative
form of financing.
LO 4,5,6 PROBLEM 13-7A A COMPARISON WITH INDUSTRY AVERAGES
1. Industry
Ratio Average Midwest Inc.
Current ratio 1.20 1.26
Acid-test (quick) ratio 0.50 0.34
Inventory turnover 35 times 37.27 times
Debt-to-equity ratio 0.50 0.69
Times interest earned 25 times 4.13 times
Return on sales 3% 4.68%
Asset turnover 3.5 times 3.82 times
Return on common stockholders’ equity 20% 23.19%
Calculations for Midwest’s ratios (thousands omitted):

$12,440/$9,900 = 1.26 to 1
Acid-test ratio = (Cash + Marketable securities + Accounts receivable)/Current
liabilities
($1,790 + $1,200 + $400)/$9,900 = $3,390/$9,900 = 0.34 to 1
Inventory turnover ratio = Cost of goods sold/Average inventory
$300,000/[($7,400 + $8,700)/2] = $300,000/$8,050 = 37.27 times
Debt-to-equity ratio = Total liabilities/Total stockholders’ equity
($9,900 + $36,000)/$66,100 = $45,900/$66,100 = 0.69 to 1
Times interest earned = (Net income + Interest expense + Income tax
($14,900 + $8,600 + $12,000)/$8,600 = $35,500/$8,600 = 4.13 times
Return on sales = (Net income + Interest expense, net of tax)/Net sales
[$14,900 + $8,600(1 – 0.446*)]/$420,500 = ($14,900 + $4,764)/$420,500 =
$19,664/$420,500 = 4.68%
*Tax rate is $12,000/$26,900 = 44.6%.
Asset turnover = Net sales/Average total assets
$420,500/[($108,000 + $112,000)/2] = $420,500/$110,000 = 3.82 times
Return on common stockholders’ equity = (Net income – Preferred dividends)/
$14,900/[($62,400 + $66,100)/2]
= $14,900/$64,250 = 23.19%
2. Midwest is not quite as liquid as the average company in the industry, as is

evidenced by its lower quick ratio. The inventory turnover ratio is very similar to the
industry average. Midwest’s accounts payable has decreased during the year,
although this is offset by increases in each of the other three current liabilities.
The company is not as solvent as the rest of the industry either, as is indicated by
its higher debt-to-equity ratio and lower times interest earned ratio. The heavy
reliance on outside funds, however, has not been a detriment to the company’s
profitability. Midwest’s return on equity is higher than the industry average.
3. Midwest is already more highly leveraged than the average company in the industry,
but as was indicated earlier, has used borrowed money effectively. However, the
loan decision will depend on other factors in addition to the company’s relative
standing in its industry. For example, the bank will look at how Midwest’s ratios this
year compare with those of prior years. Maybe the company is smaller than others in
the industry and has always performed at its current level. If the bank approves the
loan, it will probably require a higher interest rate to compensate for any perceived
additional risk.
DECISION CASES
READING AND INTERPRETING FINANCIAL STATEMENTS
LO 2 DECISION CASE 13-1 HORIZONTAL ANALYSIS FOR FINISH LINE
1. and 2. (In millions of dollars)

Increase (Decrease) from:
2005 to 2006 2004 to 2005
Income Statement Accounts Dollars % Dollars %
Net sales $139.3 11.9% $180.9 18.3%
Cost of sales (including
occupancy costs) 96.7 12.1 116.5 17.1
Gross profit 42.6 11.5 64.4 21.2
Selling, general, and
administrative expenses 42.0 15.4 42.1 18.3
Insurance settlement 0.1 100.0 1.1 90.7
Asset impairment charge 2.5 100.0 0.0 0.0
Operating income (2.0) (2.1) 21.2 28.0
Interest income, net 0.9 86.6 0.4 65.3
Income before income taxes (1.1) (1.1) 21.7 28.4
Income taxes (0.4) (1.0) 7.7 26.7
Net income $ (0.7) (1.2) $ 13.9 29.4
3. Both net sales and gross profit have increased significantly over the three year
period. In addition, net income has increased from $47.3 million in 2004 to $60.5
million in 2006, or a net amount of $13.2 million ($13.9 million – $0.7 million).
LO 3 DECISION CASE 13-2 VERTICAL ANALYSIS FOR FINISH LINE
1. Common-size comparative income statements:
THE FINISH LINE, INC.

COMMON-SIZE CONSOLIDATED STATEMENTS OF INCOME
FOR THE YEARS ENDED FEBRUARY 25, 2006 AND FEBRUARY 26, 2005
(IN MILLIONS OF DOLLARS)
2006 2005
Dollars % Dollars %
Net sales $1,306.0 100.0% $1,166.7 100.0%
Cost of sales (including
occupancy costs) 894.7 68.5 798.0 68.4
Gross profit 411.3 31.5 368.7 31.6
administrative expenses 313.9 24.0 271.9 23.3
Insurance settlement 0.0 0.0 (0.1) (0.0)
Asset impairment charge 2.5 0.2 0.0 0.0
Operating income 94.9 7.3 96.9 8.3
Interest income, net 2.0 0.1 1.1 0.1
Income before income taxes 96.9 7.4 98.0 8.4
Income taxes 36.4 2.8 36.8 3.1
Net income $ 60.5 4.6% $ 61.2 5.3%
2. Cost of sales as a percentage of net sales remained nearly the same from 2005 to
2006; as a result, the gross profit ratio was also about the same. Also, selling,
general and administrative expenses remained relatively constant as a percentage
of net sales from one year to the next. Finally, the profit margin, that is net income as
a percentage of net sales, remained relatively stable at about 5 percent.
DECISION CASE 13-2 (Continued)
3. Common-size comparative balance sheets

THE FINISH LINE, INC.
COMMON-SIZE CONSOLIDATED BALANCE SHEETS
AT FEBRUARY 25, 2006 AND FEBRUARY 26, 2005
2/25/06 2/26/05
Dollars % Dollars %
Cash and cash equivalents $ 47.5 7.6% $ 56.0 9.7%
Marketable securities 49.1 7.8 57.2 9.9
Accounts receivable, net 12.0 1.9 14.2 2.5
Merchandise inventories, net 268.6 42.8 241.2 42.0
Other 4.3 0.7 3.2 0.5
Total current assets 381.5 60.8 371.8 64.6
Land 1.5 0.2 0.3 0.1
Building 33.8 5.4 23.3 4.1
Leasehold improvements 243.3 38.8 217.4 37.8
Furniture, fixtures, and equipment 93.2 14.8 78.0 13.6
Construction in progress 10.8 1.7 10.6 1.8
Less: Accumulated depreciation (161.4) (25.7) (141.3) (24.6)
Deferred income taxes 11.1 1.8 3.6 0.6
Goodwill and intangible assets 14.0 2.2 11.3 2.0
Total assets $ 627.8 100.0% $ 575.0 100.0%
Accounts payable $ 84.0 13.4% $ 92.4 16.1%

Employee compensation 12.0 1.9 12.9 2.2
Accrued property and sales tax 8.3 1.3 6.9 1.2
Deferred income taxes 12.4 2.0 7.6 1.3
Other liabilities and accrued
expenses 25.7 4.1 17.2 3.0
Total current liabilities 142.4 22.7 137.0 23.8
Deferred credits from landlords 56.9 9.0 50.5 8.8
Other long-term liabilities 0.0 0.0 1.5 0.3
Class A Common stock 0.5 0.1 0.5 0.1

Class B Common stock 0.1 0.0 0.1 0.0
Additional paid-in capital 142.6 22.7 138.1 24.0
Retained earnings 319.6 50.9 264.0 45.9
Treasury stock (34.3) (5.4) (16.7) (2.9)
Total shareholders’ equity 428.5 68.3 386.0 67.1
Total liabilities and shareholders’
equities $ 627.8 100.0% $ 575.0 100.0%
DECISION CASE 13-2 (Concluded)
4. Within the current asset category, cash and cash equivalents, accounts receivable
and marketable securities decreased in relative importance from the prior year,
while merchandise inventories increased by a small percentage. Total current
assets decreased as a percentage of total and this was counterbalanced by an
increase in long-term assets as a percentage of total assets. Total current liabilities
decreased slightly as a percentage of total liabilities and shareholders’ equities
while shareholders’ equity increased by a small percentage.
LO 3 DECISION CASE 13-3 COMPARING TWO COMPANIES IN THE SAME INDUSTRY:

FINISH LINE AND FOOT LOCKER
1. Common-size comparative income statements:
FOOT LOCKER, INC.

COMMON-SIZE CONSOLIDATED STATEMENTS OF OPERATIONS
FOR THE YEARS ENDED JANUARY 28, 2006 AND JANUARY 29, 2005
2005 2004
Dollars % Dollars %
Sales $ 5,653 100.0% $ 5,355 100.0%
Cost of sales 3,944 69.8 3,722 69.5
Gross profit 1,709 30.2 1,633 30.5
administrative expenses 1,129 20.0 1,088 20.3
Depreciation and amortization 171 3.0 154 2.9
Restructuring charges 0 0.0 2 0.0
Interest expense, net 10 0.1 15 0.3
Other income (6) (0.1) 0 (0.0)
Income from continuing operations
before income taxes 405 7.2 374 7.0
Income tax expense 142 2.5 119 2.2
Income from continuing operations 263 4.7 255 4.8
Income on disposal of discontinued
operations, net of income tax
benefit 1 0.0 38 0.7
Net income $ 264 4.7% $ 293 5.5%
2. Cost of sales as a percentage of sales remained nearly the same from 2004 to 2005;
as a result, the gross profit ratio was also about the same. Also, selling, general and
administrative expenses remained relatively constant as a percentage of sales from
one year to the next. Finally, the profit margin, that is net income as a percentage of
net sales, remained relatively stable at about 5 percent. The gross profit ratios for
Finish Line and Foot Locker are similar as are the profit margin ratios.
3. Common-size comparative balance sheets
FOOT LOCKER, INC.

COMMON-SIZE CONSOLIDATED BALANCE SHEETS
AT JANUARY 28, 2006 AND JANUARY 29, 2005
1/28/06 1/29/05
Dollars % Dollars %
Cash and cash equivalents $ 289 8.7% $ 225 7.0%
Short-term investments 298 9.0 267 8.2
Merchandise inventories 1,254 37.9 1,151 35.6
Other current assets 173 5.2 189 5.8
Total current assets 2,014 60.8 1,832 56.6
Property and equipment, net 675 20.4 715 22.1
Deferred taxes 147 4.4 180 5.5
Goodwill 263 8.0 271 8.4
Intangible assets, net 117 3.5 135 4.2
Other assets 96 2.9 104 3.2
Total assets $ 3,312 100.0% $ 3,237 100.0%
Accounts payable $ 361 10.9 $ 381 11.8%

Accrued and other liabilities 305 9.2 285 8.8
Current portion of long-term debt and
obligations under capital leases 51 1.5 18 0.6
Total current liabilities 717 21.6 684 21.2
Long-term debt and obligations
under capital leases 275 8.3 347 10.7
Other liabilities 293 8.9 376 11.6
Total liabilities 1,285 38.8 1,407 43.5
Shareholders’ equity 2,027 61.2 1,830 56.5
Total liabilities and shareholders’
equities $ 3,312 100.0% $ 3,237 100.0%
4. Foot Locker’s current assets as a percentage of total assets increased during 2005.
Current liabilities remained relatively stable as a percentage, while total liabilities
decreased as a percentage due to decreases in the two long-term liabilities.
Shareholders’ equity increased as a percentage of the total. The relative
percentages in current assets are the same for Finish Line and Foot Locker at the
end of the most recent year and the relative percentages in current liabilities are
similar. Because Foot Locker has more long-term debt, its shareholders’ equity as a
percentage of total liabilities and shareholders’ equity is less than for Finish Line.
LO 4,5,6 DECISION CASE 13-4 RATIO ANALYSIS FOR FINISH LINE
1. Ratios and other amounts for Finish Line (all dollar amounts in thousands):
a. Working capital = Current assets – Current liabilities
2006: $381,527 – $142,415 = $239,112
2005: $371,800 – $137,016 = $234,784
b. Current ratio = Current assets/Current liabilities
2006: $381,527/$142,415 = 2.7 to 1
2005: $371,800/$137,016 = 2.7 to 1
c. Acid-test ratio = (Cash and cash equivalents + Marketable securities +
Accounts receivables, net) /Current liabilities
2006: ($47,488 + $49,075 + $11,999)/$142,415 = $108,562/$142,415
= 0.8 to 1
2005: ($55,991 + $57,175 + $14,230)/$137,016 = $127,396/$137,016
= 0.9 to 1
d. Cash flow from operations to current liabilities = Net cash provided by operating
activities/Average current liabilities
2006: $74,027/$142,415 = 52.0%
2005: $87,147/$137,016 = 63.6%
e. Number of days’ sales in receivables = Number of days in the period/Accounts
receivable turnover (Net sales/Average Accounts receivables*)
2006: Turnover = $1,306,045/($11,999) = 108.8
Number of days = 360 days/108.8 = 3.3 days
2005: Turnover = $1,166,767/($14,230) = 82.0
*Year-end balances used in lieu of available amounts to compute an average.
f. Number of days’ sales in inventory = Number of days in the period/Inventory
turnover (Cost of sales, including occupancy costs/Average merchandise
inventories, net*)
2006: Turnover = $894,724/$268,590 = 3.3
2005: Turnover = $798,033/$241,242 = 3.3
*Year-end balances used in lieu of available amounts to compute an average.
g. Debt-to-equity ratio = Total liabilities/Total stockholders’ equity
2006: ($142,415 + $56,859)/$428,542 = $199,274/$428,542
= 0.47 to 1
2005: ($137,016 + $50,532 + $1,500)/$385,971 = $189,048/$385,971
= 0.49 to 1
h. Cash flow from operations to capital expenditures = (Net cash provided by

operating activities – Total dividends paid)/Capital expenditures
2006: ($74,027 − $4,864)/$70,126 = 98.6%
2005: ($87,147 − $2,415)/$58,172 = 145.7%
i. Asset turnover = Net sales/Total assets

2006: $1,306,045/$627,816 = 2.1 times
2005: $1,166,767/$575,019 = 2.0 times
j. Return on sales = (Net income + Interest expense,* net of tax)/Net sales

2006: $60,533 /$1,306,045 = 4.6%
2005: $61,263/$1,166,767 = 5.3%
*Interest expense is not listed separately on the income statement.
k. Return on assets = (Net income + Interest expense*, net of tax)/Total assets

2006: $60,533/$627,816 = 9.6%
2005: $61,263/$575,019 = 10.7 %
*Interest expense is not listed separately on the income statement.
l. Return on common stockholders’ equity = (Net income – preferred

dividends)/Common stockholders’ equity
2006: ($60,533 − $0/$428,542 = 14.1%
2005: ($61,263 − $0) /$385,971 = 15.9%
2. Finish Line appears to be relatively liquid over the two-year period, with its current
ratio remaining unchanged at 2.7. The company has negligible long-term debt and it
has a relatively low debt to equity ratio of less than 0.5 to 1 at the end of each of the
two years.
Asset turnover remained stable at about 2 to 1 and return on sales averaged about
5% per year over the two years. This resulted in a return on assets that averaged
about 10% per year over the two years.
MAKING FINANCIAL DECISIONS
LO 4,5,6 DECISION CASE 13-5 ACQUISITION DECISION
1. Several measures give an indication as to the company’s liquidity:
 Working capital has nearly doubled over the two-year period, from $88,930,000
in 2006 to $161,820,000 in 2007.
 Both the current ratio and the quick ratio have also increased:
2007: $324,120/$162,300 = 2.00 to 1
2006: $215,180/$126,250 = 1.70 to 1
Quick ratio = (Cash + Marketable securities + Short-term receivables)/
Current liabilities
2007: ($48,500 + $3,750 + $128,420)/$162,300 = 1.11 to 1
2006: ($24,980 +$0 + $84,120)/$126,250 = 0.86 to 1
 The accounts receivable turnover for 2007 = Net credit sales/Average accounts
receivable: $875,250/[($128,420 + $84,120)/2] = 8.24 times, or an average
collection period of 360/8.24 = 44 days
Whether this is a reasonable number of days outstanding could be partially
determined by an examination of the company’s credit terms.
 The inventory turnover for 2007 = Cost of goods sold/Average inventory:
$542,750/[($135,850 + $96,780)/2] = 4.67 times, or an average number of days
sales in inventory of 360/4.67 = 77 days
 The cash operating cycle for 2007 is 44 + 77 = 121 days
Conclusion: The company appears on the surface to be fairly liquid, but each of the
above measures of liquidity should be compared with industry averages. One area
of concern is the large increase in both receivables and inventories from the prior
year. The company could be experiencing collection problems. The inventory should
be examined more closely for possible obsolescence and slow-moving items.
DECISION CASE 13-5 (Continued)
2. The company’s solvency can be examined by looking at the following factors:
 The debt-to-equity ratio has increased slightly from the prior year: Total
liabilities/Total stockholders’ equity
2007: ($162,300 + $275,000)/$532,710 = 0.82 to 1
2006: ($126,250 + $275,000)/$519,820 = 0.77 to 1
 The times interest earned ratio = Operating income*/Interest expense:
$68,140/$45,000, or 1.51 times
*The ratio is normally calculated as net income + income tax expense + interest
expense, divided by interest expense. Because the company has an extraordinary
gain to take into account, the easiest approach is to use the income number before
taking all of these items into account, i.e., operating income.
Conclusion: The company is carrying a heavy debt burden even though the bonds
are not due until 2014. It will continue to have large interest payments for the next
seven years. Further information on the operating cash flows is necessary to see
whether funds will be available to service the debt currently outstanding. Interest
payments not only will be a significant cash drain but also will affect the company’s
profitability.
3. Profitability can be assessed by looking at a number of ratios for 2007. The

extraordinary gain should be ignored in assessing profitability for our purposes
because we are interested in the future performance of the company and this gain is
not expected to recur in the future.
 Return on assets = (Net income + Interest expense, net of tax)/Average total
assets: [$13,890 + ($45,000)(1 – 0.40*)] divided by ($970,010 + $921,070)/2 =
$40,890/$945,540 = 4.3%
*The tax rate can be approximated by dividing income tax expense of $9,250 by net
income before taxes and extraordinary items of $23,140.
 Return on sales = (Net income + Interest expense, net of tax)/Net sales:
$40,890/$875,250 = 4.7%
 Asset turnover = Net sales/Average total assets: $875,250/$945,540 = 0.93
times
 Return on common stockholders’ equity = (Net income – Preferred
dividends)/Average common stockholders’ equity: $13,890/[($532,710 +
$519,820)/2] = $13,890/$526,265 = 2.6%
 The average cost of borrowed funds can be approximated: $45,000 in interest
expense divided by an average of short-term notes and bonds combined of
[($80,000 + $275,000) + ($60,000 + $275,000)]/2 = $45,000/$345,000 = 13%.
The after-tax cost of these borrowed funds is 13% × (1 – 0.40) = 7.8%.
4. It would be difficult to recommend to the vice-president of acquisitions that Heavy-

Duty be acquired. It has not demonstrated the ability to be a profitable member of
the Diversified family over the long run. Disregarding the extraordinary gain, the
profit margin before interest and taxes was only 7.8%. Heavy-Duty relies on a
considerable amount of outside debt for funding, but it is proving to be too costly at
an after-tax cost of 7.8%. This is further evidenced by an overall return on assets,
4.3%, which is higher than the return to the stockholder of only 2.6%. While Heavy-
Duty is at least profitable, it is unlikely that the president and board of directors of
Diversified will be satisfied with a company that yields such a low return. In addition,
it may prove very difficult for Heavy-Duty to generate the necessary funds to repay
the bonds in 2014.
LO 3 DECISION CASE 13-6 PRICING DECISION
1. BPO
COMMON-SIZE COMPARATIVE INCOME STATEMENTS
FOR YEARS 1–3
Year 3 Year 2 Year 1
$ % $ % $ %
Sales $125 100.0% $110 100.0% $100 100.0%
Cost of goods sold 62 49.6 49 44.5 40 40.0
Gross profit $ 63 50.4% $ 61 55.5% $ 60 60.0%
Operating expenses 53 42.4 49 44.5 45 45.0
Net income $ 10 8.0% $ 12 11.0% $ 15 15.0%
2. Net income has decreased while sales have increased because BPO has not held
the line on its product costs. The gross profit ratio has declined significantly, because
of the increase in cost of goods sold relative to sales, from 40% to nearly 50%.
3. BPO
INCOME STATEMENT
YEAR 4
Sales: $125,000 × 1.10 $137,500
Cost of goods sold: $62,000 × 1.08 66,960
Gross profit $ 70,540
Operating expenses $53,000 × 1.08 57,240
Net income $ 13,300
4. With a 10% increase in volume, BPO will not need to increase its prices. On the
basis of the projections, it will report an increase in net income of 33%.
ETHICAL DECISION MAKING
LO 4,5 DECISION CASE 13-7 PROVISIONS IN A LOAN AGREEMENT
1. No, Midwest is not in violation of its existing loan agreement. The current ratio is
$16/$10, or 1.6 to 1, which is above the minimum requirement of 1.5. The debt-to-
equity ratio is $25/$55, or 0.45 to 1, which is below the maximum of 0.5.
2. Jackson has handled each of the two items incorrectly, and the controller has the
responsibility to make corrections before the statements are released. The treatment
of both items is in violation of accounting standards. First, the $5 million note should
be included in current liabilities, since it is due in six months. The mere intent of the
company to roll over or refinance the note does not by itself justify the exclusion of it
from current liabilities. [Note: The instructor may want to use this opportunity to point
out that an accounting standard (SFAS No. 6) requires a company to demonstrate
the ability to refinance an obligation before classifying it as long-term.] Second, the
controller should not have recorded the deposit from the state as revenue. Instead, it
is a liability until the work is completed.
3. Revised balance sheet:

Current assets $16 Current liabilities $17
Long-term assets 64 Long-term debt 10
Stockholders’ equity 53
Total $80 Total $80
Current liabilities should be $10, as reported, plus $5 for the note due in six months
and $2 for the deposit from the state. Long-term debt is reduced by $5 for the note
that is reclassified as short-term. Stockholders’ equity is reduced by $2 because the
deposit should be included in current liabilities rather than revenue as recorded by
Jackson.
Revised ratios:
Current ratio: $16/$17 = 0.94 to 1
Debt-to-equity ratio: $27/$53 = 0.51 to 1
These revisions will put Midwest in violation of its loan agreement with Southern
National Bank. The current ratio is significantly below the minimum level of 1.5, while
the debt-to-equity ratio is slightly above the maximum of 0.5.
LO 4 DECISION CASE 13-8 INVENTORY TURNOVER
1. The president calculated the inventory turnover ratio of 90 times by dividing sales
revenue of $3,690,000 by the average inventory balance of $41,000 (the average of
$40,000 at the end of 2007 and $42,000 at the end of 2006).
2. The president has erroneously used sales rather than cost of goods sold to calculate
inventory turnover. Because inventory is stated at cost, cost of goods sold must be
used in the numerator, not sales. The correct calculation is
($3,690,000 × 1 – 0.40*)/$41,000 = $2,214,000/$41,000 = 54 times
*The gross profit ratio is 40%. Therefore, cost of goods sold is 1 – 40%, or 60% of
sales.
3. It is understandable why the president would prefer to report an inventory turnover of

90 times, rather than 54 times. In the fruits and vegetables business, the company
needs to be able to show that it turns the inventory frequently to maintain freshness.
As controller, you have a responsibility to the public not to intentionally misrepresent
the company. You must tell the president that his calculations are incorrect and
explain to him how the ratio should be computed.
REAL WORLD PRACTICE 13.1
All three of these accounts increased during the year ended February 25, 2006:
Merchandise inventories, net: ($268,590 – $241,242)/$241,242 = 11.3% increase

Leasehold improvements: ($243,312 – $217,371)/$217,371 = 11.9% increase
Furniture, fixtures, and equipment: ($93,221 – $77,945)/$77,945 = 19.6% increase
One of the factors that would cause these accounts to increase during the year would
be the addition of new stores, given that each new store would require an investment in
each of these types of assets.
REAL WORLD PRACTICE 13.2
Wrigley’s gross profit ratio for each year is as follows:

2004: 55.9% 2000: 56.1% 1996: 53.2%
2003: 57.1% 1999: 54.8% 1995: 53.2%
2002: 56.8% 1998: 55.0% 1994: 53.8%
2001: 57.1% 1997: 53.6%
Over this time period, the ratio has seen only mild variation, from a low of 53.2% in both
1995 and 1996 to a high of 57.1% in both 2001 and 2003.
SOLUTION TO INTEGRATIVE PROBLEM
1. GALLAGHER, INC.
STATEMENT OF CASH FLOWS
FOR THE YEAR ENDED DECEMBER 31, 2007
Cash Flows from Operating Activities
Net income $ 3,440
Adjustments to reconcile net income to net
cash provided by operating activities:
Depreciation expense 700
Increase in accounts receivable (3,500)
Increase in inventories (2,500)
Decrease in prepaid insurance 300
Increase in accounts payable 2,300
Increase in taxes payable 400
Net cash provided by operating activities $ 1,140
Cash Flows from Investing Activities
Acquisition of buildings and equipment $(3,000)
Net cash used by investing activities $(3,000)
Cash Flows from Financing Activities
Issuance of additional notes payable $ 800
Payment of cash dividends (600)
Payment of bonds (200)
Net cash provided by financing activities $ 0
Net decrease in cash $(1,860)
Cash balance, December 31, 2006 2,700
Cash balance, December 31, 2007 $ 840
2. a. Current ratio = Current assets/Current liabilities

= $21,440/$14,500 = 1.48 to 1
b. Acid-test ratio = (Cash + Accounts receivable)/Current liabilities
= ($840 + $12,500)/$14,500 = $13,340/$14,500 = 0.92 to 1
c. Cash flow from operations to current liabilities ratio = Net cash provided by
operating activities/Average current liabilities
= $1,140/[($14,500 + $11,000)/2] = $1,140/$12,750 = 9%
d. Accounts receivable turnover ratio = Net credit sales/Average accounts
receivable
= $48,000/[($12,500 + $9,000)/2] = $48,000/$10,750 = 4.47
e. Number of days’ sales in receivables = Number of days in the period/Accounts
receivable turnover ratio = 360/4.47 = 80.54
INTEGRATIVE PROBLEM (Concluded)
f. Inventory turnover ratio = Cost of goods sold/Average inventory

= $36,000/[($8,000 + $5,500)/2] = $36,000/$6,750 = 5.33
g. Number of days’ sales in inventory = Number of days in period/Inventory turnover
ratio = 360/5.33 = 67.54
h. Debt-to-equity ratio = Total liabilities/Total stockholders’ equity
= $15,900/$17,840 = 0.9 to 1
i. Debt service coverage ratio = Cash flow from operations, before interest and tax
payments/Interest and principal payments
= ($1,140 + $280 + $2,280 – $400*)/($280 + $200) = $3,300/$480 = 6.88 to 1
*Increase in taxes payable account.
j. Cash flow from operations to capital expenditures ratio = (Cash flow from
operations – Total dividends paid)/Cash paid from acquisitions
= ($1,140 – $600)/$3,000 = $540/$3,000 = 18%
3. Gallagher’s current ratio decreased from 1.6 in 2006 to 1.48 in 2007 and its acid-test
ratio also decreased from 1.06 in 2006 to 0.92 in 2007. For many companies, an
acid-test ratio below 1 is not desirable because it may signal the need to liquidate
marketable securities to pay bills, regardless of the current trading price of the
securities. Gallagher currently doesn’t own marketable securities and therefore it
may have difficulty in paying its bills. Its cash flow from operations to current
liabilities ratio is low also. The number of days’ sales in receivable indicates it should
increase collection efforts while the number of days’ sales in inventory may indicate
a large amount of obsolete inventory or problems in the sales department.
Gallagher’s debt-to-equity ratio indicates that for every $1 of capital that
stockholders provided, creditors provided $0.90. Gallagher generated almost $7 of
cash from operations during 2007 to “cover” every $1 of required interest and
principal payments. The cash flow from operations to capital expenditures ratio
(18%) of less than 100% indicates that it is not able to finance all of its capital
expenditures from operations and cover its dividend payments. Overall, Gallagher
appears to have low liquidity and solvency ratios. However, these ratios should be
compared to ratios in its industry as well as to ratios from prior years to get a better
idea of how it is doing. Its credit policies should also be examined to determine its
policy on collections. It should consider putting off future dividend payments until it
gets its liquidity problems under control.

Chapter 13

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Chapter 13

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CHAPTER 13

Financial Statement Analysis

2. Use comparative financial statements to analyze a company 12* 45 Mod

3. Use common-size financial statements to compare various 12* 45 Mod

4. Compute and use various ratios to assess liquidity. 1 15 Mod

5. Compute and use various ratios to assess solvency. 6 20 Mod

6. Compute and use various ratios to assess profitability. 8 20 Mod

7. Explain how to report on and analyze other income statement

*Exercise, problem, or case covers two or more learning outcomes

2. Use comparative financial statements to analyze a company

3. Use common-size financial statements to compare various

4. Compute and use various ratios to assess liquidity. 1 40 Mod

5. Compute and use various ratios to assess solvency. 1# 30 Mod

6. Compute and use various ratios to assess profitability. 3 20 Mod

7. Explain how to report on and analyze other income statement

*Exercise, problem, or case covers two or more learning outcomes

2. Use comparative financial statements to analyze a company 1 45 Mod

3. Use common-size financial statements to compare various 2 60 Mod

4. Compute and use various ratios to assess liquidity. 4* 45 Mod

5. Compute and use various ratios to assess solvency. 4* 45 Mod

6. Compute and use various ratios to assess profitability. 4* 45 Mod

7. Explain how to report on and analyze other income statement

*Exercise, problem, or case covers two or more learning outcomes

5. Rising costs to either manufacture or purchase inventory could be responsible for a

12. An accounts receivable turnover of nine times translates to an average number of

25. Separate reporting of discontinued operations, extraordinary items and the

LO 4 EXERCISE 13-1 ACCOUNTS RECEIVABLE ANALYSIS

1. Accounts receivable turnover:

2. Number of days sales in receivables:

LO 4 EXERCISE 13-2 INVENTORY ANALYSIS

2. Number of days sales in inventory:

EXERCISE 13-2 (Concluded)

LO 4 EXERCISE 13-3 ACCOUNTS RECEIVABLE AND INVENTORY ANALYSES FOR

1. Calculations (all dollar amounts in millions):

EXERCISE 13-3 (Concluded)

LO 4 EXERCISE 13-4 LIQUIDITY ANALYSES FOR COCA-COLA AND PEPSICO

1. Calculations (all dollar amounts in millions):

LO 4 EXERCISE 13-5 LIQUIDITY ANALYSES FOR MCDONALD’S AND WENDY’S

EXERCISE 13-5 (Concluded)

LO 5 EXERCISE 13-6 SOLVENCY ANALYSES FOR IBM

EXERCISE 13-6 (Concluded)

LO 5 EXERCISE 13-7 SOLVENCY ANALYSIS

1. a. Debt-to-equity ratio: Total liabilities/Total stockholders’ equity

LO 6 EXERCISE 13-8 RETURN RATIOS AND LEVERAGE

LO 6 EXERCISE 13-9 RELATIONSHIPS AMONG RETURN ON ASSETS, RETURN ON

Case 1. Return on assets = Net income (assuming no interest expense)/Average

Case 2. Return on sales = Net income/Net sales

Case 3. Return on assets = Return on sales × Asset turnover

Case 4. Asset turnover = Net sales/Average total assets

Case 5. Return on assets = Net income (assuming no interest expense)/Average

LO 6 EXERCISE 13-10 EPS, P/E RATIO, AND DIVIDEND RATIOS

EXERCISE 13-10 (Concluded)

2. An investment advisor needs to be aware of industry trends, the general economic

LO 6 EXERCISE 13-11 EARNINGS PER SHARE AND EXTRAORDINARY ITEMS

LO 2,3 EXERCISE 13-12 COMMON-SIZE BALANCE SHEETS AND HORIZONTAL

EXERCISE 13-12 (Continued)

EXERCISE 13-12 (Concluded)

4. Largest changes Refer to

LO 2,3 EXERCISE 13-13 COMMON-SIZE INCOME STATEMENTS AND HORIZONTAL

2. Observations from Mariners’ common-size statements:

EXERCISE 13-13 (Concluded)

4. Largest changes Refer to

LO 4 PROBLEM 13-1 EFFECT OF TRANSACTIONS ON WORKING CAPITAL, CURRENT

PROBLEM 13-1 (Concluded)