CHAPTER 17

financial statement analysis

Summary of Questions by STUDY Objectives
and Bloom’s Taxonomy

Note: AN = Analysis AP = Application

summary of questions by level of difficulty (lod)

Note: E = Easy M = Medium H=Hard

CHAPTER STUDY OBJECTIVES

1. Identify the need for, and tools of, financial statement analysis. Users of financial statements make comparisons in order to evaluate a company’s past, current, and future performance and position. There are two commonly used bases of comparison: intracompany (within a company) and intercompany (between companies). The tools of financial analysis include horizontal, vertical, and ratio analysis.

2. Explain and apply horizontal analysis. Horizontal analysis is a technique for evaluating a series of data, such as line items in a company’s financial statements, by expressing them as percentage increases or decreases over two or more periods of time. The horizontal percentage of a base-period amount is calculated by dividing the amount for the specific period under analysis by a base-period amount. This percentage calculation normally covers multiple periods. The horizontal percentage change for a period is calculated by dividing the dollar amount of the change between the specific period under analysis and the prior period by the prior-period amount. This percentage calculation normally covers two periods only.

3. Explain and apply vertical analysis. Vertical analysis is a technique for evaluating data within one period by expressing each item in a financial statement as a percentage of a relevant total (base amount) in the same financial statement. The vertical percentage of a base-period amount is calculated by dividing the financial statement amount under analysis by the base amount for that particular financial statement, which is usually total assets for the balance sheet and revenues or net sales for the income statement.

4. Identify and use ratios to analyze liquidity. Liquidity ratios include the current ratio, acid-test ratio, receivables turnover, collection period, inventory turnover, days sales in inventory, and operating cycle. The formula, purpose, and desired result for each liquidity ratio are presented in Illustration 18-12.

5. Identify and use ratios to analyze solvency. Solvency ratios include debt to total assets, interest coverage, and free cash flow. The formula, purpose, and desired result for each solvency ratio are presented in Illustration 18-15.

6. Identify and use ratios to analyze profitability. Profitability ratios include the gross profit margin, profit margin, asset turnover, return on assets, return on equity, earnings per share, price-earnings, and payout ratios. The formula, purpose, and desired result for each profitability ratio are presented in Illustration 18-18.

7. Recognize the limitations of financial statement analysis. The usefulness of analytical tools can be limited by (1) the use of alternative accounting policies, (2) significant amounts of other comprehensive income, (3) the quality of the information provided, and (4) economic factors.

Exercises

Exercise 1

Comparative information taken from the London Antiques Corporation financial statements is shown below:

2014 2013

1. Notes receivable $ 80,000 $ -0-

2. Accounts receivable 182,000 140,000

3. Retained earnings 49,000 (40,000)

4. Sales 930,000 750,000

5. Operating expenses 170,000 200,000

6. Income taxes payable 95,000 70,000

Instructions

Using horizontal analysis, show the percentage change from 2013 to 2014 with 2013 as the base year.

Exercise 2

Buford Corporation had a profit of $3,500,000 in 2012. Using 2012 as the base year, profit decreased by 45% in 2013 and increased by 180% in 2014.

Instructions

Calculate the profit reported by Buford Corporation for 2013 and 2014.

Exercise 3

The following items were taken from the financial statements of Smalley, Inc., over a five-year period:

Item 2014 2013 2012 2011 2010

Net Sales $980,000 $900,000 $650,000 $550,000 $500,000

Cost of Goods Sold 700,000 640,000 480,000 420,000 400,000

Gross Profit $280,000 $260,000 $170,000 $130,000 $100,000

Instructions

Using horizontal analysis and 2010 as the base year, calculate the trend percentages for net sales, cost of goods sold, and gross profit. Explain whether the trends are favourable or unfavourable for each item.

Exercise 4

The total revenue figures for Dabous & Sons Construction Company are as follows:

Instructions

a. Using Horizontal analysis calculate the percentage of change from the base year amount, assuming 2010 is the base year.

b. Using Horizontal analysis, calculate the percentage change for each year.

Exercise 5

The comparative balance sheet of Alto Communications Corporation appears below:

ALTO COMMUNICATIONS CORPORATION

Comparative Balance Sheet

December 31

——————————————————————————————————————————

2014 2013

Assets

Current assets $ 322 $280

Property, plant, and equipment 678 520

Total assets $1,000 $800

Liabilities and shareholders' equity

Current liabilities $ 180 $120

Non-current liabilities 200 160

Common shares 320 320

Retained earnings 300 200

Total liabilities and shareholders' equity $1,000 $800

Instructions

a. Using horizontal analysis, show the percentage change for each balance sheet item using 2013 as a base year.

b. Using vertical analysis, prepare a common size comparative balance sheet.

c. Comment on your analysis.

Exercise 6

Below is the partial balance sheet for Abbott Limited:

December 31, 2014 December 31, 2013

Accounts Receivable $ 960,000 $ 600,000

Inventory 920,000 750,000

Total Assets 4,000,000 3,000,000

Instructions

Using the following selected items from the comparative balance sheet of Abbott Limited, illustrate horizontal and vertical analysis. Discuss the results of each type of analysis.

Exercise 7

The income statements for the first three years of operations of Carol’s Music Ltd. are provided below:

2015 2014 2013

Revenue $ 143,750 $ 115,000 $ 100,000

Cost of goods sold 68,350 53,820 46,000

Gross profit 75,400 61,180 54,000

Expenses

Salaries 19,000 15,080 13,000

Depreciation expense 22,000 15,000 4,000

Other operating expenses 27,360 22,800 20,000

Total operating expenses 68,360 52,880 37,000

Profit from operations 7,040 8,300 17,000

Interest expense (5,000) (3,000) (1,000)

Income tax expense (600) (980) (2,000)

Profit $ 1,440 $ 4,320 $ 14,000

Instructions

a. Is Carol’s gross profit improving over the three years or not? Use horizontal analysis, with 2013 as the base year, to support your answer.

b. Provide one explanation for the decline in income from operations other than changes in gross profit. Support your answer using vertical analysis.

c. Although profit is decreasing, Carol has not been concerned because her cash flows have increased from year to year. Using the information available in the income statements, explain why this is so.

Exercise 8

The balance sheets of two competing companies in the same industry are provided below. The companies have approximately the same volume of sales and similar operating capacities.

Instructions

a. Calculate the Debt to Total Assets ratio for both companies. Which company is more solvent?

b. Based on the information provided, can horizontal analysis be used to determine which company is more profitable?

Exercise 9

Balance Sheets

December 31, 2014

Amounts in 000’s

Food Auto

Wholesale Co. Leasing Co.

Assets

Current assets $ 50,000 $ 2,500

Property plant, and equipment 320,000 965,000

Total assets $370,000 $967,500

Liabilities and shareholders’ equity

Current liabilities $ 31,000 $ 4,800

Non-current liabilities 228,000 782,000

Share capital 50,000 250,000

Retained earnings 61,000 (69,300)

Total liabilities and shareholders’ equity $370,000 $967,500

Other information: Profit for the year: $10,000 $20,000

Instructions

a. Does horizontal analysis provide a useful tool to compare the above companies? Explain your answer using an example to demonstrate how it is useful or not useful.

b. Suggest a ratio that could be used as an alternative to evaluate the profitability of the two companies and calculate the ratio. Compare the companies’ profitability based on your calculations.

Exercise 10

The income statements for Davis Manufacturing Inc. are provided for two recent years:

2014 2013

Revenue $1,100,000 $1,050,000

Cost of goods sold 340,000 300,000

Gross profit 760,000 750,000

Expenses

Salaries 221,000 165,000

Depreciation expense 37,500 37,500

Other operating expenses 161,500 142,500

Total operating expenses 420,000 345,000

Profit from operations 340,000 405,000

Interest expense (15,000) (15,000)

Income tax expense (22,500) (27,000)

Profit $ 302,500 $ 363,000

Instructions

a. Using the above information to prepare a vertical analysis for Davis.

b. Using the analysis completed in part a., identify the reason for Davis’s decreasing profit at the same time that revenue is increasing.

Exercise 11

The following are income statements of two companies that are both in the fast food industry. All amounts are in 000’s and are for the year ended December 31, 2014.

Company A Company B

(public company) (private company)

Revenue $100,000 $ 6,000

Cost of goods sold 35,000 2,080

Gross profit 65,000 3,920

Expenses

Labour expenses 15,000 905

Utilities expenses 1,950 140

Other operating expenses 33,000 1,970

Total operating expenses 49,950 3,015

Profit from operations 15,050 905

Interest expense 2,100 475

Income tax expense 4,400 21

Profit $ 8,550 $ 409

Instructions

Using vertical analysis determine which corporation is the more profitable and identify the most significant cause of the difference.

Exercise 12

The 2014 income statements for two different companies are provided below:

Instructions

a. Are the two companies in the same or different industries? Use vertical analysis to support your answer.

b. Can vertical analysis be used to compare the profitability of the two companies that are in different industries to each other? Support your answer with examples based on your calculations in part a.

Exercise 13

Shan Tung Merchandising Ltd. is required by its primary lender to maintain a current ratio of 2:1 in order to comply with its loan covenants. In the past, Shan Tung has had difficulty in achieving this target, but management is confident that in 2015 they will have met the bank’s requirement. Shan Tung’s accountant provides you with the following information taken from their most recent three years of financial statements.

Instructions

a. Calculate Shan Tung’s current ratio for each of the three years in order to demonstrate that management’s expectation has been met.

b. Calculate Shan Tung’s accounts receivable turnover for 2015 and 2014.

c. Calculate Shan Tung’s inventory turnover for 2015 and 2014.

d. Using the outcome of b. and c., evaluate whether the achievement of the current ratio targets indicates an improved liquidity or not. Identify any other change that has contributed to meeting this goal and evaluate the impact.

e. Calculate the Acid Test Ratio. Will this ratio always be lower than the current ratio?

Exercise 14

Bradley Corporation had the following comparative current assets and current liabilities:

Dec. 31, 2014 Dec. 31, 2013

Current assets

Cash $ 30,000 $ 30,000

Trading securities 40,000 10,000

Accounts receivable 55,000 95,000

Inventory 98,000 79,000

Prepaid expenses 35,000 20,000

Total current assets $258,000 $234,000

Current liabilities

Accounts payable $120,000 $110,000

Salaries payable 40,000 30,000

Income tax payable 20,000 15,000

Total current liabilities $180,000 $155,000

During 2014, credit sales and cost of goods sold were $260,000 and $192,000, respectively.

Instructions

Calculate the following liquidity measures for 2014:

a. Current ratio

b. Acid-test ratio

c. Receivables turnover

d. Inventory turnover

Exercise 15

The following data are taken from the financial statements of Duffy Limited:

2014 2013

Monthly average accounts receivable $ 520,000 $ 550,000

Net sales on account 5,980,000 4,950,000

Terms for all sales are n/30

Instructions

a. Calculate the receivables turnover and the collection period for both years.

b. What conclusion can an analyst draw about the management of the accounts receivable?

Exercise 16

Selected information from the comparative financial statements of Wong Inc. for the year ended December 31, appears below:

2014 2013

Accounts receivable $ 380,000 $ 320,000

Inventory 130,000 145,000

Total assets 1,800,000 1,650,000

Current liabilities 196,000 105,000

Non-current liabilities 400,000 322,000

Net credit sales 1,900,000 1,250,000

Cost of goods sold 700,000 619,000

Interest expense 75,000 30,000

Income tax expense 60,000 44,000

Profit 210,000 97,000

Instructions

Answer the following questions relating to the year ended December 31, 2014. Show calculations.

a. The inventory turnover for 2014 is __________.

b. The interest coverage in 2014 is __________.

c. The debt to total assets for 2014 is __________.

d. The receivables turnover for 2014 is __________.

e. The return on assets for 2014 is __________.

Exercise 17

The financial statements of Keans Plumbing Inc. appear below:

KEANS PLUMBING INC.

Comparative Balance Sheet

December 31

——————————————————————————————————————————

Assets 2014 2013

Cash $ 25,000 $ 40,000

Trading securities 15,000 60,000

Accounts receivable 50,000 30,000

Inventory 170,000 120,000

Property, plant, and equipment (net) 160,000 200,000

Total assets $420,000 $450,000

Liabilities and shareholders' equity

Accounts payable $ 20,000 $ 30,000

Short-term notes payable 40,000 40,000

Bonds payable 100,000 160,000

Common shares 170,000 145,000

Retained earnings 90,000 75,000

Total liabilities and shareholders' equity $420,000 $450,000

KEANS PLUMBING INC.

Income Statement

Year Ended December 31, 2014

Net sales $360,000

Cost of goods sold 184,000

Gross profit 176,000

Expenses

Interest expense $24,000

Operating expenses 50,000

Total expenses 74,000

Profit before income taxes 102,000

Income tax expense 30,000

Profit $ 72,000

Additional information:

1. Cash dividends of $36,000 were declared and paid in 2014

2. Weighted average number of shares during 2014 was 60,000 shares.

3. Market value of common shares on December 31, 2014, was $18 per share.

4. Depreciation expense was $40,000 in 2014.

Instructions

Using the financial statements and additional information, calculate the following ratios for Keans Plumbing Inc. for 2014. Show all calculations.

Calculations

a. Current ratio _________

b. Return on equity _________

c. Price-earnings _________

d. Debt to total assets

e. Receivables turnover _________

f. Interest coverage _________

g. Profit margin _________

h. Days sales in inventory _________

i. Payout ratio _________

j. Return on assets _________

Exercise 18

The following ratios have been calculated for Peters Limited for 2014:

Profit margin 20%

Interest coverage 12 times

Receivables turnover 5 times

Current ratio 2.5:1

Acid-test ratio 1.4:1

Debt to total assets 24%

The 2014 financial statements for Peters Limited with missing information follows:

PETERS LIMITED

Comparative Balance Sheet

December 31, 2014

——————————————————————————————————————————

Assets 2014 2013

Cash $ 25,000 $ 35,000

Trading securities 15,000 15,000

Accounts receivable ? (6) 50,000

Inventory ? (8) 50,000

Property, plant, and equipment (net) 200,000 160,000

Total assets $ ? (9) $310,000

Liabilities and shareholders' equity

Accounts payable $ ? (7) $ 25,000

Short-term notes payable 35,000 30,000

Bonds payable ? (10) 20,000

Common shares 200,000 200,000

Retained earnings 47,000 35,000

Total liabilities and shareholders' equity $ ? (11) $310,000

PETERS LIMITED

Income Statement

Year Ended December 31, 2014

——————————————————————————————————————————

Net sales $200,000

Cost of goods sold 100,000

Gross profit 100,000

Expenses:

Depreciation expense $ ? (5)

Interest expense 5,000

Operating expenses 25,000

Total expenses ? (4)

Profit before income taxes ? (2)

Income tax expense ? (3)

Profit $ ? (1)

Instructions

Use the above ratios and information from the Peters Limited financial statements to fill in the missing information on the financial statements. Follow the sequence indicated. Show calculations that support your answers.

Exercise 19

The following information is based on the financial statements of Floyd Distributing Ltd., which has a December 31, year end:

Return on equity, 2013 8.1%

Return on equity, 2014 8.4%

Profit margin, 2013 10.1%

Profit margin, 2014 10.3%

Debt to assets ratio, 2013 3:5

Debt to assets ratio, 2014 1:2

Current ratio, 2013 1.8:1

Current ratio, 2014 2:1

Other events that recently occurred at Floyd’s:

• Five out of six members of the board of directors resigned. Four of these individuals have launched a lawsuit on behalf of shareholders in an attempt to terminate the employment of senior management.
• In February 2015, a major spill from Floyd’s heating fuel tanks damaged the fruit trees of a commercial orchard next door to Floyd’s warehouse.

Instructions

Using the information about Floyd Distributing Ltd., explain how use of ratio analysis alone may not lead to the optimum investment decision.

Exercise 20

Winnipeg Corporation has issued common shares only. The company produces and sells down-filled winter coats and has credit terms of net 30. Winnipeg has been successful and has a gross profit margin of 20%. The information shown below was taken from the company's financial statements.

Beginning inventory $ 482,000

Purchases 4,146,000

Ending inventory ?

Average accounts receivable 700,000

Average shareholders' equity 3,500,000

Sales (all on credit) 5,110,000

Profit 420,000

Instructions

Calculate and comment on the following:

a. Receivables turnover and the collection period.

b. The inventory turnover and the days sales in inventory.

c. Return on equity.

Exercise 21

The following selected ratios are available for Rainbow Corporation for the three most recent years:

2015 2014 2013

Debt to total assets 48% 52% 60%

Interest coverage 2.5 times 2.6 times 2.0 times

Free cash flow $600,000 $590,000 $200,000

Instructions

Using each of the three ratios above to support your answer, explain whether or not Rainbow’s solvency has improved over the last three years.

Exercise 22

The balance sheets and income statements for two competing companies in the same industry are presented below:

Company L Company S

Assets

Current assets $ 50,000 $ 20,000

Property plant, and equipment 640,000 190,000

Intangible assets 10,000 200

$ 700,000 $ 210,200

Liabilities and shareholders' equity

Current liabilities $ 30,000 $ 12,000

Non-current liabilities 300,000 170,000

Common shares 200,000 200

Retained earnings 170,000 28,000

$ 700,000 $ 210,200

Revenue $ 161,000 $ 80,500

Cost of goods sold 56,350 40,250

Gross profit 104,650 40,250

Expenses

Salaries expense 37,000 15,300

Depreciation expense 30,000 10,000

Other operating expenses 8,000 2,980

Total operating expenses 75,000 28,280

Profit from operations 29,650 11,970

Interest expense (14,000) (8,800)

Income tax expense (3,500) (500)

Profit $ 12,150 $ 2,670

Instructions

a. Calculate both companies’ Debt to Total Assets ratio.

b. Calculate both companies’ Interest Coverage ratio.

c. Comment on the two companies’ solvency in comparison to each other.

d. One of the companies is a public company, and the other is a private company. Identify which of the two companies appears to be the public company and explain your conclusion. Describe how that affects the extent to which it is financed by debt in comparison to the other company.

Exercise 23

The income statement for Woodford Corporation for the year ended December 31, 2014 appears below:

Sales $610,000

Cost of goods sold 380,000

Gross profit 230,000

Expenses 180,000*

Profit $ 50,000

*Includes $30,000 of interest expense and $16,000 of income tax expense.

Additional information:

1. The weighted average number of common shares issued on December 31, 2014 were 50,000 shares.

2. The market price of Woodford's shares was $18 at the end of 2014.

3. Cash dividends of $10,000 were paid, $6,000 of which were paid to preferred shareholders.

Instructions

a. Calculate the following ratios for 2014:

i. earnings per share

ii. price-earnings

iii. interest coverage

iv. total dividend payout

b. Comment on the above ratios, assuming the averages for the industry in which Woodford operates are as follows:

(i) earnings per share $1.20

(ii) price-earnings 10 times

(iii) interest coverage 2.2 times

(iv) dividend payout ratio 15%

Exercise 24

The following information was taken from the financial statements of Larkin Corporation:

2014 2013

Gross profit $109,000 $89,500

Profit before income taxes 54,000 11,500

Profit 132,000 116,000

Profit margin 17% 24%

Instructions

a. Calculate the net sales for each year.

b. Calculate the cost of goods sold in dollars and as a percentage of net sales for each year.

c. Calculate operating expenses in dollars and as a percentage of net sales for each year. (Income taxes are not operating expenses).

Exercise 25

The following information for 2014 is provided for two public companies in the same industry:

Flora Inc. Fauna Ltd.

Earnings per share $10.50 $3.25

Dividends paid per share 2.50 1.50

Market price per share 120.00 28.00

Net sales (in 000’s) 100,000 10,000

Gross profit 46,000 35,000

Profit 8,100 970

Instructions

Answer the following questions about the two companies. Use the information provided to calculate the ratios needed to support your answers.

a. Based on the above information, which company is more profitable?

b. About which company are investors more optimistic?

c. In which company would investors prefer to buy shares for growth potential? In which company would they prefer to buy shares if their goal is dividend income?

Exercise 26

Certain information from the financial records of Companies Z and A are presented below for the year ended December 31. The two companies are in the same industry.

Company Z Company A

Net sales revenue $105,000 $ 65,400

Profit $10,200 $ 6,900

Average shareholders' equity $160,000 $100,000

Weighted average number of common shares 1,400 23,000

December 31 common shares market value $87.50 $7.25

Included in the shareholders’ equity of Company Z is $75,000 of cumulative preferred shares with a 5% annual dividend entitlement ($3,750 per year).

Instructions

a. Calculate the following for each company:

(i) Profit margin

(ii) Return on equity to common shareholders

b. Based on the ratios calculated in part a., which company is more profitable for its common shareholders?

c. Calculate the following for each company:

(i) Earnings per share

(ii) Price-earnings ratio

d. Based on the ratios calculated in part c., which company’s investors appear to be more optimistic about the future of the company? Explain your answer by reference to the ratios calculated.

Exercise 27

Selected data from O'Brien Ltd. are presented below:

Total assets $1,600,000

Average assets 1,750,000

Profit 245,000

Net sales 1,400,000

Cost of goods sold 745,000

Average shareholders' equity 1,000,000

Instructions

Calculate the profitability ratios that can be derived from the above information.

Exercise 28

The balance sheet for Finley Corporation at the end of the current year indicates the following:

Bonds payable, 8% $4,000,000

$6 Preferred shares, $100 issue price 1,000,000

Common shares, $10 issue price 2,000,000

Profit before income taxes was $960,000 and income taxes expense for the current year amounted to $288,000. Cash dividends paid on common shares were $300,000, and the common shares were selling for $45 per share at the end of the year. There were no ownership changes during the year.

Instructions

Determine each of the following:

a. number of times that bond interest was covered.

b. earnings per share.

c. price-earnings ratio.

d. payout ratio on common shares.