Exam Prep Financial Statement Analysis Solution Ch18 - Accounting Principles Vol 2 8e Canadian Complete Test Bank by Jerry J. Weygandt. DOCX document preview.
CHAPTER 18
financial statement analysis
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 trend percent is calculated by dividing the amount for the specific period under analysis by a base-period amount multiplied by 100%. 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 is calculated by dividing the financial statement amount under analysis by the base amount multiplied by 100% 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 18-21.
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 18-27.
6. Identify and use ratios to analyze profitability. Profitability ratios include the gross profit margin, prof t 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 18-38.
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:
2022 2021
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 2021 to 2022 with 2021 as the base year.
Exercise 2
Cook Corporation had a profit of $ 3,500,000 in 2020. Using 2020 as the base year, profit decreased by 45% in 2021 and increased by 180% in 2022.
Instructions
Calculate the profit reported by Cook Corporation for 2021 and 2022.
Exercise 3
The following items were taken from the financial statements of Mike Inc., over a five-year period:
Item 2022 2021 2020 2019 22018
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 2018 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:
2022 | 2021 | 2020 | 2019 | 2018 | |
Revenue | $ 19,690 | $ 10,350 | $ 9,692 | $ 9,984 | $ 9,496 |
Instructions
a) Using horizontal analysis, calculate the percentage of change from the base year amount, assuming 2018 is the base year.
b) Using horizontal analysis, calculate the percentage change for each year.
2022 | 2021 | 2020 | 2019 | 2018 | |
Revenue | $ 19,690 | $ 10,350 | $ 9,692 | $ 9,984 | $ 9,496 |
| 207% | 109% | 102% | 105% | 100% |
b) % change between years | 90.24% | 6.79% | -2.92% | 5.14% | 0.00% |
Exercise 5
Below is the partial balance sheet for Gabi Gold Limited:
December 31, 2021 December 31, 2020
Accounts Receivable $ 110,000 $ 140,000
Inventory 80,000 95,000
Total Assets 335,000 376,000
Instructions
Using the items from the comparative balance sheet of Gabi Gold Limited, illustrate horizontal and vertical analysis. Discuss the results of each type of analysis.
Exercise 6
The comparative balance sheet of Alto Communications Corporation appears below:
ALTO COMMUNICATIONS CORPORATION
Comparative Balance Sheet
December 31
2021 2020
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 2020 as a base year.
b) Using vertical analysis, prepare a common size comparative balance sheet.
c) Comment on your analysis.
Exercise 7
Below is the partial balance sheet for Chantal Channel Limited:
December 31, 2021 December 31, 2020
Accounts Receivable $ 960,000 $ 600,000
Inventory 920,000 750,000
Total Assets 4,000,000 3,000,000
Instructions
Using the items from the comparative balance sheet of Chantal Channel Limited, illustrate horizontal and vertical analysis. Discuss the results of each type of analysis.
Exercise 8
The income statements for the first three years of operations of Carol’s Music Ltd. are provided below:
2022 2021 2020
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 2020 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 9
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.
Balance Sheets | ||
Alpha Co. | Beta Co. | |
Assets | ||
Current assets | $ 218,000 | $ 200,000 |
Property plant, and equipment | 1,090,000 | 825,000 |
Accumulated depreciation | (279,000) | (425,000) |
Total assets | $ 1,029,000 | $ 600,000 |
Liabilities and shareholders’ equity | ||
Current liabilities | $ 103,000 | $ 28,000 |
Non- current liabilities | 611,000 | 150,000 |
Share capital | 100,000 | 150,000 |
Retained earnings | 215,000 | 572,000 |
Total liabilities and shareholders’ equity | $ 1,029,000 | $ 600,000 |
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 10
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.
Balance Sheets | ||
Company X | Company Y | |
Assets | ||
Current assets | $ 36,400 | $ 38,000 |
Property plant, and equipment | 920,000 | 625,000 |
Accumulated depreciation | (75,000) | (125,000) |
Total assets | $ 881,400 | $ 538,000 |
Liabilities and shareholders’ equity | ||
Current liabilities | $ 76,000 | $ 120,000 |
Non- current liabilities | 480,000 | 165,000 |
Share capital | 250,000 | 100,000 |
Retained earnings | 75,400 | 153,000 |
Total liabilities and shareholders’ equity | $ 881,400 | $ 538,000 |
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 11
Balance Sheets
December 31, 2021
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 12
The income statements for MGM Manufacturing Inc. are provided for two recent years:
2021 2020
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 MGM.
b) Using the analysis completed in part a), identify the reason for MGM’s decreasing profit at the same time that revenue is increasing.
Exercise 13
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, 2021.
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.
Company A | Company B | |||
Revenue | $ 100,000 | 100% | $ 6,000 | 100% |
Cost of goods sold | 35,000 | 35.0% | 2,080 | 34.7% |
Gross profit | 65,000 | 65.0% | 3,920 | 65.3% |
Expenses | ||||
Labour expenses | 15,000 | 15.0% | 905 | 15.1% |
Utilities expenses | 1,950 | 2.0% | 140 | 2.3% |
Other operating expenses | 33,000 | 33.0% | 1,970 | 32.8% |
Total operating expenses | 49,950 | 50.0% | 3,015 | 50.2% |
Profit from operations | 15,050 | 15.1% | 905 | 15.1% |
Interest expense | 2,100 | 2.1% | 475 | 7.9% |
Income tax expense | 4,400 | 4.4% | 21 | 0.4% |
Profit | $ 8,550 | 8.6% | $ 409 | 6.8% |
Exercise 14
The 2021 income statements for two different companies are provided below:
Company M | Company S | |
Revenue | $ 750,000 | $ 750,000 |
Cost of goods sold | 420,000 | 125,000 |
Gross profit | 330,000 | 625,000 |
Expenses | ||
Salaries | 75,000 | 425,000 |
Depreciation expense | 100,000 | 15,000 |
Other operating expenses | 44,000 | 87,000 |
Total operating expenses | 219,000 | 527,000 |
Profit from operations | 111,000 | 98,000 |
Interest expense | (15,000) | (2,000) |
Income tax expense | (19,000) | (19,000) |
Profit | $ 77,000 | $ 77,000 |
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).
Company M | Company S | |||
Revenue | $ 750,000 | 100.0% | $ 750,000 | 100.0% |
Cost of goods sold | 420,000 | 56.0% | 125,000 | 16.7% |
Gross profit | 330,000 | 44.0% | 625,000 | 83.3% |
Expenses | ||||
Salaries | 75,000 | 10.0% | 425,000 | 56.7% |
Depreciation expense | 100,000 | 13.3% | 15,000 | 2.0% |
Other operating expenses | 44,000 | 5.9% | 87,000 | 11.6% |
Total operating expenses | 219,000 | 29.2% | 527,000 | 70.3% |
Profit from operations | 111,000 | 14.8% | 98,000 | 13.1% |
Interest expense | (15,000) | -2.0% | (2,000) | -0.3% |
Income tax expense | (19,000) | -2.5% | (19,000) | -2.5% |
Profit | $ 77,000 | 10.3% | $ 77,000 | 10.3% |
Exercise 15
Chum Lee 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, Chum Lee has had difficulty in achieving this target, but management is confident that in 2022 they will have met the bank’s requirement. Chum Lee’s accountant provides you with the following information taken from their most recent three years of financial statements.
2022 | 2021 | 2020 | |
Current assets | |||
Cash | $ 26,505 | $ 28,500 | $ 30,000 |
Accounts receivable | 83,504 | 68,446 | 60,040 |
Inventory | 189,266 | 146,718 | 125,400 |
$ 299,275 | $ 243,664 | $ 215,440 | |
Current liabilities | |||
Accounts payable | $ 91,000 | $ 89,000 | $ 86,000 |
Salaries payable | 4,900 | 5,200 | 5,000 |
Current portion of long-term debt | 24,000 | 36,000 | 36,000 |
$ 119,900 | $ 130,200 | $ 127,000 | |
Other information: | |||
Credit sales in the year | $ 782,775 | $ 745,500 | $ 710,000 |
Cost of goods sold | 469,665 | 447,300 | 426,000 |
Instructions
a) Calculate Chum Lee’s current ratio for each of the three years in order to demonstrate that management’s expectation has been met.
b) Calculate Cum Lee’s accounts receivable turnover for 2022 and 2021.
c) Calculate Cum Lee’s inventory turnover for 2022 and 2021.
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?
Current ratio | |
2022 = 2.5 | ($ 299,275 ÷ $ 119,900) |
2021 = 1.87 | ($ 243,664 ÷ $ 130,200) |
2020 = 1.70 | ($ 215,440 ÷ $ 127,000) |
AR turnover | |
2022 = 10.3 | $ 782,775 ÷ ($ 83,504 + $ 68,446)÷2 |
2021 = 11.6 | $ 745,500 ÷ ($ 68,446 + $ 60,040)÷2 |
Inventory turnover | ||
2022 = 2.8 | $ 469,665 ÷ ($ 189,266 + $ 146,718)÷2 | |
2021 = 3.3 | $ 447,300 ÷ ($ 146,718 + $ 125,400)÷2 | |
Exercise 16
Susa Corporation had the following comparative current assets and current liabilities:
Dec. 31, 2021 Dec. 31, 2020
Current assets
Cash $ 30,000 $ 30,000
Short-term investments 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 2021, credit sales and cost of goods sold were $ 260,000 and $ 192,000, respectively.
Instructions
Calculate the following liquidity measures for 2021:
a) Current ratio
b) Acid-test ratio
c) Receivables turnover
d) Inventory turnover
Exercise 17
The following data are taken from the financial statements of Stuffy Limited:
2021 2020
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 18
Selected information from the comparative financial statements of Patrick Parker Inc. for the year ended December 31, appears below:
2021 2020
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, 2021. Show calculations.
a) The inventory turnover for 2021 is ______.
b) The interest coverage in 2021 is ______.
c) The debt to total assets for 2021 is ______.
d) The receivables turnover for 2021 is ______.
e) The return on assets for 2021 is ______.
Exercise 19
The financial statements of Diana Dining Inc. appear below:
DIANA DINING INC.
Comparative Balance Sheet
December 31
Assets 2021 2020
Cash $ 25,000 $ 40,000
Investments at fair value through profit or loss 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
DIANA DINING INC.
Income Statement
Year Ended December 31, 2021
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 2021.
2. Weighted average number of shares during 2021 was 60,000 shares.
3. Market value of common shares on December 31, 2021, was $ 18 per share.
4. Depreciation expense was $ 40,000 in 2021.
Instructions
Using the financial statements and additional information, calculate the following ratios for Diana Dining Inc. for 2021. 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 20
Selected information from the comparative financial statements of Montero Corporation for the year ended December 31, appears below:
2021 2020
Accounts receivable $ 35,000 $ 20,000
Inventory 50,000 42,000
Total assets 285,000 259,000
Current liabilities 44,000 52,000
Non-current liabilities 150,000 100,000
Net credit sales 450,000 478,000
Cost of goods sold 218,000 242,000
Interest expense 18,000 9,000
Income tax expense 25,000 29,000
Profit 68,000 77,000
Instructions
Answer the following questions relating to the year ended December 31, 2021. Show calculations.
a) The inventory turnover for 2021 is ______.
b) The interest coverage in 2021 is ______.
c) The debt to total assets for 2021 is ______.
d) The receivables turnover for 2021 is ______.
e) The return on assets for 2021 is ______.
Exercise 21
The following ratios have been calculated for Peters Limited for 2021:
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 2021 financial statements for Peters Limited with missing information follows:
PETERS LIMITED
Comparative Balance Sheet
December 31, 2021
Assets 2021 2020
Cash $ 25,000 $ 35,000
Short-term investments 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, 2021
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
Document Information
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Accounting Principles Vol 2 8e Canadian Complete Test Bank
By Jerry J. Weygandt
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