Chapter 13

Analyzing Financial Statements

ANSWERS TO QUESTIONS
1. Published financial statements are designed primarily to meet the needs of
external decision makers, including present and potential owners,
investment analysts, and creditors.
2. The three factors are: Economy-wide factors, industry factors, and individual
company factors.
3. Under a product differentiation strategy, companies offer products with
unique features, which typically allows them to charge higher prices. Under a
cost differentiation strategy, companies focus on minimizing operating costs,
which typically allows them to offer products or services at a lower price.
4. The two general methods are comparing across time and comparing across
companies. When comparing across time, analysts evaluate a company and
how it has changed over several years. When comparing across companies,
analysts compare a firm to its competitors at a point in time.

5. Component percentages express each item on a financial statement as a

percentage of a single base amount. The base amount on the income
statement is net sales. To compute component percentages on the income
statement each amount reported is divided by net sales. The base amount
on the balance sheet is total assets. To compute component percentages
on the balance sheet each amount is divided by total assets. Component
percentages are useful because they reveal relative relationships that are
not readily apparent from absolute dollar amounts.

6. Ratios express the proportionate relationship between two amounts. Ratio

analysis is useful because it may reveal critical relationships that are not
readily apparent from absolute dollar amounts.

7. Profitability ratios focus on net income and how it compares to other

amounts reported on the financial statements. Return on equity, return on
assets, financial leverage percentage, net profit margin, earnings per share,
and earnings quality are examples discussed in Chapter 13. Formulas for
these ratios are provided in Exhibit 13.3.
8. Turnover ratios focus on capturing how efficiently a company uses its
assets. Total asset turnover, fixed asset turnover, receivables turnover, and

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 inventory turnover are examples discussed in Chapter 13. Formulas for
these ratios are provided in Exhibit 13.3.
9. Liquidity ratios focus on assessing a company’s ability to meet its short-term
obligations. The current ratio, quick ratio, and cash ratio are examples
discussed in Chapter 13. Formulas for these ratios are provided in Exhibit
13.3.
10. Solvency ratios focus on assessing a company’s ability to meet its long-term
obligations. Times interest earned, cash coverage, and debt-to-equity are
examples discussed in Chapter 13. Formulas for these ratios are provided in
Exhibit 13.3.
11. Market ratios focus on the relationship between the current price per share
of a company’s stock and the return that accrues to stockholders.
Price/earnings and dividend yield are examples discussed in Chapter 13.
Formulas for these ratios are provided in Exhibit 13.3.
12. Accounting policy choices influence ratios This is important because different
companies rarely use exactly the same accounting policies. For example,
two companies that purchase the exact same asset, but one uses
accelerated deprecation while the other uses straight-line depreciation, will
report different net income amounts. These different amounts will influence
any ratios that include net income. Analysts who do not understand how a
company's accounting choices influence its ratios could draw inappropriate
conclusions.
13. Total sales can increase as a result of a company selling more at its existing
stores, or it can increase as a result of a company opening new stores.
Growth driven by new-store sales might obscure the fact that existing stores
are not meeting customer needs and are experiencing declining sales.
Analysts should evaluate sales to determine what is driving any changes
from period to period. They should not assume that an increase is always
good news.

ANSWERS TO MULTIPLE CHOICE

1. c) 2. c) 3. c) 4. c) 5. d)
6. c) 7. a) 8. a) 9. b) 10. d)

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 Authors’ Recommended Solution Time
(Time in minutes)

Alternate Cases and

Mini-exercises Exercises Problems Problems Projects
No. Time No. Time No. Time No. Time No. Time
1 5 1 15 1 20 1 20 1 50
2 5 2 15 2 20 2 20 2 50
3 5 3 15 3 40 3 40 3 60
4 5 4 15 4 60 4 60 4 45
5 5 5 20 5 40 5 40 5 20
6 5 6 20 6 40 6 40 6 30
7 5 7 15 7 40 7 *
8 5 8 15 8 30
9 5 9 15 9 60
10 5 10 20 10 15
11 15
12 30
13 10

* Due to the nature of this project, it is very difficult to estimate the amount of
time students will need to complete the assignment. As with any open-ended
project, it is possible for students to devote a large amount of time to these
assignments. While students often benefit from the extra effort, we find that
some become frustrated by the perceived difficulty of the task. You can reduce
student frustration and anxiety by making your expectations clear. For example,
when our goal is to sharpen research skills, we devote class time to discussing
research strategies. When we want the students to focus on a real accounting
issue, we offer suggestions about possible companies or industries.

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MINI-EXERCISES
M13–1.
Sales – Cost of Goods Sold = Gross Profit
$1,665,000 – Cost of Goods Sold = $732,600 ($1,665,000 x .44)
Cost of Goods Sold = $932,400

An alternate way to solve this problem is :

1.00 – 0.44 = 0.56
0.56 x $1,665,000 = $932,400

M13–2.

Sales – Cost of Goods Sold = Gross Profit

Sales in 2015 : $29,600 x 1.054 = $31,198
$31,198 – $9,107 = Gross Profit
Gross Profit = $22,091
Gross Profit Percentage : $22,091 / $31,198 = 70.81%

M13–3.

$183,000 / [($1,100,000 + $1,250,000) ÷ 2] = 15.57%

M13–4.

21% - 6% = 15%

M13–5.

If sales remain the same, then cost of goods sold will also remain the same.
So the numerator of the ratio will not change. If inventory decreases by
25%, then the denominator will decrease so the inventory turnover ratio will
increase.

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M13–6.
Total Assets – Noncurrent Assets = Current Assets
$1,400,000 - $480,000 = Current Assets
Current Assets = $920,000
Current Ratio = Current Assets ÷ Current Liabilities
3.5 = $920,000 ÷ Current Liabilities
Current Liabilities = 262,857

M13–7.

Current Assets
Current Ratio =
Current Liabilities

Quick Assets
Quick Ratio =
Current Liabilities

Purely by definition, the quick ratio must always be less than or equal to the
current ratio. We know that a mistake has been made in this case because
the quick ratio is greater than the current ratio and that is not possible.

M13–8.

Times Interest Earned = (Net Income + Interest Expense + Income Tax

Expense) ÷ Interest Expense

Times Interest Earned = ($52,000 + $12,000 + $13,000) ÷ $12,000

Times Interest Earned = 6.42

M13–9.

Dividend Yield = Dividends per Share ÷ Market Price per Share

5% = $3.50 ÷ Market Price per Share

Market Price per Share = $70.00

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M13–10.

All else equal, if prices have been increasing then the most expensive
inventory is the newest inventory. Switching from FIFO to LIFO will result in
higher costs being transferred to cost of goods sold. This will result in lower
costs remaining in inventory, and hence, lower inventory amount on the
balance sheet. In summary, switching from FIFO to LIFO will:

 Increase cost of goods sold on the income statement.

 Decrease inventory on the balance sheet.

The ratio effects are:

 Net Profit Margin: Numerator will decrease. Denominator will

stay the same. Overall effect is that ratio will decrease.

 Fixed Asset Turnover: Neither the numerator or denominator will

be affected. Overall effect is that the ratio will not change.

 Current Ratio: Numerator will decrease. Denominator will stay

the same. Overall effect is that ratio will decrease.

 Quick Ratio: Neither the numerator or denominator will be

affected. Overall effect is that the ratio will not change.

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EXERCISES
E13–1.

1. COMPANY 1: Car manufacturer

a. Key indicators: High inventory; high property & equipment; low
inventory turnover
2. COMPANY 2: Wholesale candy company
a. Key indicators: High property & equipment; low gross profit; low
profit before taxes; high inventory turnover
3. COMPANY 3: High-end clothing store
a. Key indicators: High inventory; low inventory turnover; high gross
profit
4. COMPANY 4: Advertising agency
a. Key indicators: No inventory; no cost of goods sold

E13–2.

1. COMPANY 1: Meat processing company

a. Key indicators: High inventory turnover; low gross profit
2. COMPANY 2: Travel agency
a. Key indicators: No cost of good sold; zero inventory turnover; high
receivables
3. COMPANY 3: Hotel
a. Key indicators: High property & equipment; no gross profit; zero
inventory turnover
4. COMPANY 4: Drug company
a. Key indicators: High gross profit, High profit before taxes; high
inventory

E13–3.

1. COMPANY 1: Cable TV Company

a. Key indicators: No cost of goods sold; zero inventory turnover; high
property & equipment
2. COMPANY 2: Accounting firm
a. Key indicators: High receivables; no cost of goods sold; high profit
before taxes; zero inventory turnover
3. COMPANY 3: High-end jewelry store
a. High inventory; low inventory turnover; high gross profit
4. COMPANY 4: Grocery Store

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 a. Key indicators: High inventory; high inventory turnover; high
property & equipment; low profit before taxes

E13–4.

COMPANY 1: Restaurant
Key indicators: High inventory turnover; high property & equipment
COMPANY 2: Full-line department store
Key indicators: High inventory; low inventory turnover
COMPANY 3: Automobile dealer (low priced used cars)
Key indicators: High inventory; low inventory turnover; low gross
profit; low property & equipment
COMPANY 4: Wholesale fish company
Key indicators: High inventory turnover; low gross profit; high
receivables

E13–5.
Table of Contents

Lowe's Companies, Inc.

Consolidated Statements of Earnings
(In millions, except per share and percentage data)

January 30, January 31, February 1,

Fiscal years ended on 2015 % Sales 2014 % Sales 2013 % Sales
Net sales $ 56,223 100.00% $ 53,417 100.00% $ 50,521 100.00%
Cost of sales 36,665 65.21 34,941 65.41 33,194 65.70
Gross margin 19,558 34.79 18,476 34.59 17,327 34.30
Expenses:
Selling, general and administrative 13,281 23.62 12,865 24.08 12,244 24.24
Depreciation 1,485 2.64 1,462 2.74 1,523 3.01
Interest - net 516 0.92 476 0.89 423 0.84
Total expenses 15,282 27.18 14,803 27.71 14,190 28.09
Pre-tax earnings 4,276 7.61 3,673 6.88 3,137 6.21
Income tax provision 1,578 2.81 1,387 2.60 1,178 2.33
Net earnings $ 2,698 4.80% $ 2,286 4.28% $ 1,959 3.88%

Basic earnings per common share $ 2.71 $ 2.14 $ 1.69

Net
Dilutedearnings have
earnings per common slightly improved
share $ over the three-year
2.71 $ 2.14 period. Analyzing
$ 1.69 the
component percentages, it appears that the slight increase is mainly driven
Cash dividends per share $ 0.87 $ 0.70 $ 0.62 by
decreases (as
Lowe's Companies, Inc.
a percent of sales) in selling, general and administrative expense
as well as
Consolidated depreciation
Statements of Comprehensiveexpense.
Income
(In millions, except percentage data)

January 30, January 31, February 1,

Fiscal years ended on 2015 % Sales 2014 % Sales 2013 % Sales
Net earnings $ 2,698 4.80 % $ 2,286 4.28 % $ 1,959 3.88%
Foreign currency translation adjustments - net of tax (86) (0.15) (68) (0.13) 6 0.01
Net unrealized investment losses - net of tax — — (1) — — —
Other comprehensive income/(loss) (86) (0.15) (69) (0.13) 6 0.01
Comprehensive income $ 2,612 4.65 % $ 2,217 4.15 % $ 1,965 3.89%

See accompanying notes to consolidated financial statements.

34

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E13–6.
1. A Net profit margin
2. H Inventory turnover ratio
3. B Average days to collect
4. L Dividend yield ratio
5. C Return on equity
6. G Current ratio
7. K Debt/equity ratio
8. M Price/earnings ratio
9. E Financial leverage percentage
10. I Receivable turnover ratio
11. J Average days to sell inventory
12. D Earnings per share
13. N Return on assets
14. F Quick ratio
15. Q Times interest earned
16. O Cash coverage ratio
17. P Fixed asset turnover ratio

E13–7.
Turnover Ratios:
Receivable: $74,756* ÷ [($6,386 + $6,508) ÷ 2] = 11.60
Inventory: $42,362** ÷ [($6,759 + $6,909) ÷ 2] = 6.20
*$83,062 x 0.90 = $74,756
**$83,062 x 0.51 = $42,362
Days:
Receivable: 365 days ÷ 11.60 = 31.47 days
Inventory: 365 days ÷ 6.20 = 58.87 days

E13–8.
Turnover Ratios:
Receivable: $700,000* ÷ [($60,000 + $45,000) ÷ 2] = 13.33
Inventory: $600,000** ÷ [($25,000 + $70,000) ÷ 2] = 12.63
*$1,000,000 x .70 = $700,000
**$1,000,000 x .60 = $600,000
Days:
Receivable: 365 days ÷ 13.33 = 27.38 days
Inventory: 365 days ÷ 12.63 = 28.90 days

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E13–9.

Current
Current Assets Current Liabilities Ratio
(1) (2) (1 ÷ 2)
Before
transactions $120,000 ($120,000 ÷ 1.5) $80,000 1.50
Transaction (1) Inventory + 40,000 Accts. Pay. + 40,000
New
balances 160,000 120,000 1.33

Transaction (2)*
Cash – 3,000
$157,000 $120,000 1.31

*Truck is a long-term asset. Two-year note is a long-term liability. Neither affect

the current ratio.

E13–10.

Effect on Current Ratio:

1. Increase: Current assets increase. Current liabilities stay the same.

2. Decrease: Current assets stay the same. Current liabilities increase.

3. Decrease: Current assets decrease. Current liabilities stay the same.

4. Increase: Current assets increase. Current liabilities stay the same.

E13–11.

Inventory turnover ratio = Cost of Goods Sold ÷ Average Inventory

8.0 = Cost of Goods Sold ÷ $1,668 million
Cost of Goods Sold = $13,344 million

Fixed asset turnover = Net Sales Revenue ÷ Average Net Fixed Assets
9.0 = Net Sales Revenue ÷ $2,098
Net Sales Revenue = $18,882

Net Sales Revenue – Cost of Goods Sold = Gross Profit

$18,882 - $13,344 = Gross Profit
Gross Profit = $5,538

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E13–12.

$4,552 ÷ $506.50*
Receivable Turnover = 8.99
*($508 + $505) ÷ 2

$2,637 ÷ $245.50*
Inventory Turnover = 10.74
*($251 + $240) ÷ 2
$1,298* ÷ $630**
Current Ratio = 2.06
*$513 + $508 + $251 + $26
**$150 + $377 + $1 + $102

$513 ÷ $630
Cash Ratio = 0.81

($374 + $72 + $233) ÷ $72

Times Int. earned = 9.43

$608 ÷ $65
Cash Coverage = 9.35

E13–13.

Dividend Yield = Dividends per Share ÷ Market Price per Share

3% = $0.75 ÷ Market Price per Share

Market Price per Share = $25.00

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PROBLEMS
P13–1.
Based on the ratios provided, Company Y appears to be the better
investment. Company Y has a higher gross profit margin, which means that
they make more gross profit on each dollar of sales than does Company X.
This is very significant since the two companies are in the same business,
and operate in the same way. The higher gross profit for Company Y is also
reflected in its higher profit margin and stronger return on assets and return
on equity. The capital structure of Company Y includes more debt, which
gives the company a higher degree of financial leverage. Though there is
risk in carrying too much debt, it appears Company Y is easily able to cover
its interest payments as reflected in in its cash coverage ratio. This is not the
case for Company X. Lastly Company Y is paying dividends while Company
X is not. This means that Company Y’s investors can earn returns both
through price appreciation and through the receipt of dividend payments.

P13–2.

Company A dominates Company B on all ratios. It is important to note that

higher ratios are generally good, but there are some exceptions. For
example, having a high debt-to-equity ratio can signal that a company has
taken on too much debt in their capital structure and may have trouble
making interest and principle payments in the future.

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P13–3.

$6,345 ÷ $10,922*
Return on equity = 58.09%
*($9,322 + $12,522) ÷ 2
$6,345 ÷ $40,232*
Return on assets = 15.77%
*($39,946 + $40,518) ÷ 2
$83,176 ÷ $40,232**
Total asset turnover = 2.07
*($39,946 + $40,518) ÷ 2
$54,222 ÷ $11,068*
Inventory turnover = 4.90
*($11,079 + $11,057) ÷ 2
$15,302 ÷ $11,269
Current ratio = 1.36

($1,723 + $1,484 + $0) ÷ $11,269

Quick ratio = 0.28

$8,242 ÷ $782
Cash coverage ratio = 10.54

$30,624 ÷ $9,322
Debt-to-equity ratio = 3.29

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P13–4.
Req. 1

Ratio Blue Water Company Prime Fish Company

Profitability ratios:
1. Return on equity $45,000 ÷ $238,000* = 18.91% $91,000 ÷ $689,000* = 13.21%
*($148,000 + $29,000 + $61,000) *($512,000 + $106,000 + $71,000)
2. Return on assets $45,000 ÷ $402,000 = 11.19% $91,000 ÷ $798,000 = 11.40%
3. Financial leverage percentage 18.91% – 11.19% = 7.72% 13.21% – 11.40% = 1.81%
4. Net profit margin $45,000 ÷ $447,000 = 10.07% $91,000 ÷ $802,000 = 11.35%
5. Earnings per share $45,000 ÷ 14,800* sh. = $3.04 $91,000 ÷ 51,200* sh. = $1.78
*$148,000 / $10 *$512,000 ÷ $10

Turnover ratios:
7. Total asset turnover $447,000 ÷ $402,000 = 1.11 $802,000 ÷ $798,000 = 1.01
8. Fixed asset turnover $447,000 ÷ $140,000 = 3.19 $802,000 ÷ $401,000 = 2.00
9. Receivable turnover $149,000* ÷ $38,000 = 3.92 $267,333* ÷ $31,000= 8.62
*$447,000 x 1/3 *$802,000 x 1/3
10. Inventory turnover $241,000 ÷ $99,000 = 2.43 $400,000 ÷ $40,000 = 10.00
Liquidity ratios:
11. Current ratio $178,000* ÷ $99,000 = 1.80 $92,000* ÷ $49,000 = 1.88
*$41,000 + $38,000 + $99,000 *$21,000 + $31,000 + $40,000
12. Quick ratio $79,000* ÷ $99,000 = .80 $52,000* ÷ $49,000 = 1.06
*$41,000 + $38,000 *$21,000 + $31,000
13. Cash ratio $41,000 ÷ $99,000 = .41 $21,000 ÷ $49,000 = .43
Solvency ratios:
16. Debt/equity ratio $164,000* ÷ $238,000** = .69 $109,000* ÷ $689,000** = .16
*$99,000 + $65,000 *49,000 + $60,000
**$148,000 + $29,000 + $61,000 **$512,000 + $106,000 + $71,000

Market ratios:
17. Price/earnings ratio $22 ÷ $3.04* = 7.24 $15 ÷ $1.78* = 8.43
*$45,000 ÷ 14,800 shares *$91,000 ÷ 51,200 shares
18. Dividend yield ratio $2.23* ÷ $22 = 10.14% $2.89 ÷ $15 = 19.27%
*$33,000 ÷ 14,800 shares *$148,000 ÷ 51,200 shares

Req. 2
On average, Prime Fish collects its accounts receivable balance 8.62 times a
year and turns over its inventory 10.00 times a year. Blue Waters collects its
accounts receivable balance 3.92 times a year and turns over its inventory
2.43 times a year. Prime Fish is more efficient at collecting its receivables
and turning over its inventory.

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P13–5.

Req. 1

Increase (Decrease)
from Year 1 to Year 2
Income Statement Year 2 Year 1 Amount Percent
Sales revenue $190,000 $167,000 $ 23,000 13.77
Cost of goods sold 112,000 100,000 12,000 12.00

Gross profit 78,000 67,000 11,000 16.42

Operating expenses and interest expense 56,000 53,000 3,000 5.66

Pretax income 22,000 14,000 8,000 57.14

Income tax 8,000 4,000 4,000 100.00

Net income 14,000 10,000 $ 4,000 40.00

Balance Sheet
Cash $4,000 $7,000 $ -3,000 -42.86
Accounts receivable (net) 14,000 18,000 -4,000 -22.22
Inventory 40,000 34,000 6,000 17.65
Property & equipment (net) 45,000 38,000 7,000 18.42

Total assets 103,000 97,000 $ 6,000 6.19

Current liabilities (no interest) $16,000 $17,000 $ -1,000 -5.88

Long-term liabilities (interest: 10%) 45,000 45,000 0 0.00
Common stock ($5 par value) 30,000 30,000 0 0.00
Retained earnings 12,000 5,000 7,000 140.00

Total liabilities & equity 103,000 97,000 $ 6,000 6.19

Year 2 current ratio: ($4,000 + $14,000 + $40,000) ÷ $16,000 = 3.63

Year 1 current ratio: ($7,000 + $18,000 + $34,000) ÷ $17,000 = 3.47
Change from Year 1 to Year 2: 3.63 – 3.47 = 0.16 increase

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P13–6.

Req. 1

.
Component Percentages 2015
Income statement:
Sales revenue (the base amount) 100.00
Cost of goods sold 58.95

Gross profit on sales 41.05

Operating expenses 29.47

Pretax income 11.58

Income taxes 4.21

Net income 7.37

Balance sheet:
Cash 3.88
Accounts receivable (net) 13.59
Inventory 38.83
Operational assets (net) 43.69

Total assets (the base amount) 100.00

(rounded)

Current liabilities 15.53

Long-term liabilities (10% interest) 43.69
Common stock ($5 par) 29.13
Retained earnings 11.65

Total liabilities and owners' equity (the base amount) 100.00

Req. 2
$14,000 ÷ $38,500*
Return on equity = 36.36%
*[($30,000 + $12,000) + ($30,000 + $5,000)] ÷ 2

$14,000 ÷ $100,000*
Return on assets = 14.00%
*($103,000 + $97,000) ÷ 2

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 $190,000 ÷ $100,000*
Total asset turnover = 1.90
*($103,000 + $97,000) ÷ 2

$14,000 ÷ $190,000
Net profit margin = 7.37%

$100,000 ÷ $38,500
Financial leverage = 2.60

P13–7.

$14,000 ÷ 6,000* shares

Earnings per share = 2.33
*$30,000 ÷ $5 par value

$58,000* ÷ $16,000
Current ratio = 3.63
*$4,000 + $14,000 + $40,000

$18,000* ÷ $16,000
Quick ratio = 1.13
*$4,000 + $14,000

$4,000 ÷ $16,000
Cash ratio = 0.25

$28 ÷ $2.33
P/E ratio = 12.02

$3.50 ÷ $28
Dividend yield ratio = 12.5%

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P13–8.

For two companies that are exactly alike, in times of rising prices and inventory
levels, choosing different inventory costing methods will result in:

 Inventory: LIFO results in lower inventory on the balance sheet. FIFO

results in higher inventory on the balance sheet.

 Cost of goods sold: LIFO results in higher cost of goods sold on the
income statement. FIFO results in lower cost of goods sold on the income
statement.

 Net income: LIFO results in lower net income on the income statement.
FIFO results in higher net income on the income statement.

 Retained earnings: LIFO results in lower retained earnings on the income

statement. FIFO results in higher retained earnings on the income
statement.

The effects on the ratios are:

1. Net profit margin—LIFO results in lower net income (with no effect on
revenues) so Company’s B’s net profit margin will be lower than Company
A’s net profit margin.

2. Earnings per share--LIFO results in lower net income (with no effect on

shares outstanding) so Company’s B’s EPS will be lower than Company A’s
EPS.

3. Inventory turnover—A company’s choice of costing methods affect both the

numerator (cost of goods sold) and denominator (average inventory) of this
ratio. The numerator is higher under LIFO and the denominator is lower.
This means that Company B’s ratio will be higher than Company A’s ratio.

4. Current ratio— LIFO results in lower inventory (with no effect on current

liabilities) so Company’s B’s current ratio will be lower than Company A’s
current ratio.

5. Quick ratio— Since the quick ratio excludes inventory, the choice of LIFO
versus FIFO does not affect the quick ratio.

6. Debt-to-equity ratio— LIFO results in lower retained earnings (with no effect

on liabilities) so Company’s B’s Debt-to-equity ratio will be higher.

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P13–9.

Req. 1

$(406) ÷ $191,831*
Return on equity = (0.21)%
*($194,411 +$189,250) ÷ 2
$(406) ÷ $642,231
Net profit margin = (0.06)%

$528,285 ÷ $5,692*
Inventory turnover = 92.81
*($5,827 + $5,557) ÷ 2
$49,625 ÷ $93,151
Current ratio = 0.53

$32,824* ÷ $93,151
Quick ratio = 0.35
*$21,230 + $11,594
$136,533* ÷ $194,411
Debt-to-equity ratio = 0.70
*$93,151 + $9,886 + $33,177 + $319
$1.12 ÷ $(0.02)
P/E ratio = (56.00)
*$(0.02) is taken from the bottom of the Income
Statement

Req. 2

The inventory turnover ratio is high (92.81), but given that California Pizza
Kitchen is in the business of purchasing, preparing, and selling fresh food to
customers on a daily basis it makes sense that their inventory turnover ratio
would be high.

P13–10.

American Airlines C. 10

Facebook A. 77

Starbucks B. 29

Yahoo E. 5

Patriot Coal D. 1

Financial Accounting, 9/e 13–19

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ALTERNATE PROBLEMS

AP13–1.

Many of the ratios between the two companies are quite similar. However,
on the ones that differ, Coca-Cola appears to dominate. The biggest
differences are seen in the P/E ratio, ROA, gross profit margin, and net profit
margin. Coca-Cola has a higher P/E ratio, meaning that the market sees
Coca-Cola as having more potential for growth than Pepsi. Also, the
companies have similar (but not identical) businesses, but Coca-Cola’s
gross profit and net profit margins are higher than Pepsi’s. Coca-Cola earns
more profit per dollar of sales than Pepsi does. The return on assets ratio
for Coke is also higher than that for Pepsi.

AP13–2.

Company B is slightly better than Company A on several measures (inventory

turnover, P/E and dividend yield). However, it is important to note that both
companies underperform relative to the industry on ALL measures. Given a
choice, it might be better to invest your $10,000 elsewhere.

AP13–3.
$6,345 ÷ $83,176
Net profit margin = 7.63%

$8,242 ÷ $6,345
Earnings quality = 1.30

$83,176 ÷ $1,441*
Receivable turnover = 57.72
*($1,484 + $1,398) ÷ 2
$1,723 ÷ $11,269
Cash ratio = 0.15

$10,806* ÷ $830
Times interest earned = 13.02
*$6,345 + $830 + $3,631
$100 ÷ $4.74
P/E ratio = 21.10

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AP13–4.

Req. 1

$110,000 ÷ $199,750*
Total asset turnover = 0.55
*($206,500 + $193,000) ÷ 2
$110,000 ÷ $100,000*
Fixed asset turnover = 1.10
*($95,000 + $105,000) ÷ 2
$55,000* ÷ $34,500**
Receivable turnover = 1.59
*$110,000 x 50%
**($37,000 + $32,000) ÷ 2

$52,000 ÷ $31,500*
Inventory turnover = 1.65
*($25,000 + $38,000) ÷ 2
$111,500 ÷ $43,000**
Current ratio = 2.59
*$49,500 + $37,000 + $25,000
**$42,000 + $1,000
$86,500 ÷ $43,000
Quick ratio = 2.01
*$49,500 + $37,000

$49,500 ÷ $43,000
Cash ratio = 1.15

$22,000* ÷ $4,000
Times interest earned = 5.50
*$12,600 + $4,000 + $5,400
$14,600 ÷ $3,800
Cash coverage = 3.84

$83,000 ÷ $123,500
Debt-to-equity = 0.67
*$42,000 + $1,000 + $40,000
**$90,000 + $33,500

Req. 2

The average collection period is very long. On average, it takes Tabor 229.56
days (365 days ÷ 1.59) to collect its receivable. In addition, the average
days to sell inventory is long. On average, it takes Tabor 221.21 days
(365 days ÷ 1.65) to sell its inventory. Both of these numbers are
troubling and require additional inquiry.

Financial Accounting, 9/e 13–21

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AP13–5.

Req. 1

Increase (Decrease)
from Year 1 to Year 2
Income Statement Year 2 Year 1 Amount Percent
Sales revenue $453,000 $447,000 $ 6,000 1.34
Cost of goods sold 250,000 241,000 9,000 3.73

Gross profit 203,000 206,000 -3,000 -1.46

Operating expenses (including interest) 167,000 168,000 -1,000 -0.60

Pretax income 36,000 38,000 -2,000 -5.26

Income tax 10,800 11,400 -600 -5.26

Net income 25,200 26,600 $- 1,400 -5.26

Balance Sheet
Cash $6,800 $3,900 $ 2,900 74.36
Accounts receivable (net) 42,000 29,000 13,000 44.83
Merchandise inventory 25,000 18,000 7,000 38.89
Prepaid expenses 200 100 100 100.00
Property & equipment (net) 130,000 120,000 10,000 8.33

Total assets 204,000 171,000 $ 33,000 19.30

Accounts payable $17,000 $18,000 $ -1,000 -5.56

Income taxes payable 1,000 1,000 0 0.00

Bonds payable (interest rate: 10%) 70,000 50,000 20,000 40.00

Common stock ($10 par value) 100,000 100,000 0 0.00
Retained earnings 16,000 2,000 14,000 700.00

Total liabilities & equity 204,000 171,000 $ 33,000 19.30

Year 2 current ratio: ($6,800 + $42,000 + $25,000 + $200) ÷ ($17,000 + $1,000)

= 4.11
Year 1 current ratio: ($3,900 + $29,000 + $18,000 + $100) ÷ ($18,000 + $1,000)
= 2.68
Change from Year 1 to Year 2: 4.11 – 2.68 = 1.43 increase

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AP13–6.

Component
Income Statement
Percentages
Sales revenue (base amount) 100.00
Cost of goods sold 55.19

Gross profit 44.81

Operating expenses (including 36.87
interest)

Pretax income 7.95

Income tax 2.38

Net income 5.56

Balance Sheet
Cash 3.33
Accounts receivable (net) 20.59
Merchandise inventory 12.25
Prepaid expenses 0.10
Property & equipment (net) 63.73

Total assets (base amount) 100.00

Accounts payable 8.33

Income taxes payable 0.49

Bonds payable (interest rate: 34.31

10%)
Common stock ($10 par value) 49.02
Retained earnings 7.84

Total liabilities & equity 100.00

Financial Accounting, 9/e 13–23

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AP13–6 (continued).

Req. 2
$25,200 ÷ $109,000*
Return on equity = 23.12%
*[($100,000 + $16,000) ÷ 2] +
[($100,000 + $2,000) ÷ 2] / 2

$25,200 ÷ $187,500*
Return on assets = 13.44%
*($204,000 + $171,000) ÷ 2
$453,000 ÷ $187,500
Total asset turnover = 2.42

$25,200 ÷ $453,000
Net profit margin = 5.56%

$187,500 ÷ $109,000
Financial leverage = 1.72

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CASES AND PROJECTS
CONTINUING PROBLEM

CON13–1.

This case is designed to give students experience in looking up financial

information and using it for analysis. Because the students are instructed to use
the current Pool report, we cannot provide a solution.

FINANCIAL REPORTING AND ANALYSIS CASES

CP13–1.

American Eagle

Return on equity:
$80,322 = 6.97%
($1,139,746 + $1,166,178) ÷ 2

Earnings per share:

As reported $0.42

Net profit margin:

$80,322 = 2.45%
$3,282,867

Inventory turnover:
$2,128,193 = 7.46
($278,972 + $291,541)  2

Current ratio:
$890,513 = 1.94
$459,093

Debt-to-equity
$459,093 + $98,069 = 0.49
$1,139,746

Financial Accounting, 9/e 13–25

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CP13–1 (continued).

Price earnings:
$16 = 38.10
$0.42

Dividend yield:
$0.50 = 3.13%
$16

CP13–2.

Urban Outfitters

Return on equity:
$232,428 = 15.38%
($1,327,969 + $1,694,170)  2

Earnings per share:

As reported $1.70

Net profit margin:

$232,428 = 7.00%
$3,323,077

Inventory turnover:
$2,148,147 = 6.42
($358,237 + $311,207)  2

Current ratio:
$809,117 = 2.29
$353,740

Debt-to-equity:
$560,772 = 0.42
$1,327,969

Price/earnings:
$40 = 23.53
$1.70

Dividend yield: 0% (No dividends were paid)

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CP13–3.

For calculations, see CP13–1, CP13–2, and Appendix D.

Urban Outfitters American Eagle Industry Average

Return on equity 15.38% 6.97% 11.34%
Earnings per share $1.70 $0.42 N/A
Net profit margin 7.00% 2.47% 3.75%
Inventory turnover 6.42 7.46 5.03
Current ratio 2.29 1.94 2.03
Debt-to-Equity 0.42 0.49 0.43
Price earnings 23.53 38.10 22.06
Dividend yield 0% 3.13% 1.41%

In general, the ratios indicate that Urban Outfitters is outperforming the industry
and American Eagle is underperforming the industry. The one noticeable ratio
where this is not the case is the price/earnings ratios. American Eagle has a high
price/earnings ratio relative to Urban Outfitters and the industry average. This
means that relative to current earnings, investors have higher expectations for
American Eagle in the future than they do for Urban Outfitters or the industry on
average.

CP13–4.

The two areas where we would expect the largest difference are profit margin
and total asset turnover. We would expect the high-end company to have a
higher net profit margin and a lower total asset turnover ratio. We would expect
the low cost company to have a lower net profit margin and a higher total asset
turnover ratio. It is important to note, that the two firms could have the same
ROE, but for very different reasons. For example, if we assume that financial
leverage is constant across the two companies:

High-end company:
ROE = 20.00%
(10% profit margin x 2.0 total asset turnover x 1.0 financial leverage)

Low cost company:

ROE = 20.00%
(5% profit margin x 4.0 total asset turnover x 1.0 financial leverage)

Financial Accounting, 9/e 13–27

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CP13–5.

Case 1:
Net Income
ROE =
Average Stockholders’ Equity

$200,000
10% =
Average Stockholders’ Equity
Average Stockholders’ Equity = $2,000,000

Case 2:
Net Sales
Total Asset Turnover =
Average Total Assets

$8,000,000
8 =
Average Total Assets
Average Total Assets = $1,000,000

Case 3:
Net Sales
Total asset Turnover =
Average Total Assets

Net Sales
5 =
$1,000,000
Net Sales = $5,000,000

Net Profit Margin = Net Income

Net Sales

10% = Net Income

$5,000,000
Net Income = $500,000

Net Income
ROE =
Average Stockholders’ Equity

$500,000
15% =
Average Stockholders’ Equity

Average Stockholders’ Equity = $3,333,333

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 Case 4:

Total asset Turnover = Net Sales

Average Total Assets

5 = $1,000,000
Average Total Assets
Average Assets = $200,000

CRITICAL THINKING CASES

CP13–6.

The controller’s actions will increase the current ratio:

Before After
Current assets $1,900,000 = 1.77 $1,480,000 = 2.26
Current liabilities $1,075,000 $655,000

Working capital $ 825,000 $825,000

The current ratio has increased to an amount that is considered to be acceptable

by First Federal Bank, but it appears that the increase is mere “window dressing.”
Total working capital (current assets less current liabilities) was unaffected by the
transaction. In the process of improving the current ratio, Barton Company
created a potential cash crisis. The cash balance was reduced to $10,000
($430,000 – $420,000) compared with current liabilities of $655,000. First
Federal should not automatically grant the loan now that Barton’s current ratio is
above 2:1. It is quite possible that Barton will have cash flow issues in the short
term given the actions taken by the controller.

A more fundamental point concerns the validity of the 2:1 criterion imposed by
First Federal. The case illustrates the ease with which some ratios can be
manipulated, and highlights the need to understand how a company operates
and the inputs to each ratio before analyzing and using the ratio to make
decisions.

Finally, are the controller’s actions ethical? There is nothing unethical about
paying trade creditors, however, if the controller initiated the payments merely to
“window dress” the current ratio and was not forthcoming in revealing this
information the controller’s actions would likely be deemed unethical.

Financial Accounting, 9/e 13–29

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FINANCIAL REPORTING AND ANALYSIS PROJECTS

CP13–7.

The response to this question will depend on the companies selected by the
students.

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