Chapter 13 - Measuring and Evaluating Financial Performance

Chapter 13
Measuring and Evaluating Financial Performance
ANSWERS TO MINI-EXERCISES M131
LOCKEY FENCING CORPORATION Income Statements Change in
Year Ended December 31 2010 2009 Dollars Percentage

Net Sales Cost of Goods Sold Gross Profit Selling, General, and Admin. Income from Operations Interest Expense Income before Income Tax Income Tax Expense Net Income

$ 100,000 58,000 42,000 9,000 33,000 3,000 30,000 9,000 $ 21,000

$ 75,000 45,000 30,000 4,500 25,500 3,750 21,750 6,525 $ 15,225

25,000 13,000 12,000 4,500 7,500 (750) 8,250 2,475 5,775

33.3% 28.9% 40.0% 100.0% 29.4% -20.0% 37.9% 37.9% 37.9%

M132
LOCKEY FENCING CORPORATION Income Statements
Year Ended December 31 2010 2009

Net Sales Cost of Goods Sold Gross Profit Selling, General, and Admin. Income from Operations Interest Expense Income before Income Tax Income Tax Expense Net Income

$ 100,000 58,000 42,000 9,000 33,000 3,000 30,000 9,000 $ 21,000

100.0% 58.0% 42.0% 9.0% 33.0% 3.0% 30.0% 9.0% 21.0%

$ 75,000 45,000 30,000 4,500 25,500 3,750 21,750 6,525 $ 15,225

100.0% 60.0% 40.0% 6.0% 34.0% 5.0% 29.0% 8.7% 20.3%

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M133 The two most significant year-over-year changes, in terms of dollar amounts, are the increase in net sales (+$25,000) and increase in cost of goods sold (+$13,000). In terms of percentages, the two most significant changes are the increases in gross profit (+40%) and selling, general, and administrative expenses (+100%). The dollar amount of net sales could have increased through higher selling prices or greater sales volume. The dollar amount of cost of goods sold could have increased through higher unit costs for inventory or greater sales volume. The percentage increase in gross profit could have increased through higher selling prices or lower unit costs for inventory. Selling, general, and administrative expenses could have increased for a variety of reasons, including greater depreciation (resulting from additional equipment), greater advertising expense (perhaps leading to greater sales volume), greater utilities expense, and greater salaries and wages expense (to support increased sales volume). M134 The vertical analyses include comparisons of net income to net sales (which is the net profit margin) and gross profit to net sales (which is the gross profit percentage). The increase in net profit margin (from 20.3% to 21.0%) is an improvement and the increase in gross profit percentage (from 40% to 42%) also is an improvement. M136 Sales Cost of Goods Sold (given) Gross Profit $250,000 * (150,000) $100,000

Gross Profit Percentage = Gross profit Sales x 100 = $100,000 $250,000 x 100 = 40.0%
*2010 Sales: $200,000 x 1.25 = $250,000

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Chapter 13 - Measuring and Evaluating Financial Performance

ANSWERS TO EXERCISES E136 1) 2) 3) 4) 5) 6) 7) C A D B M J L 8) 9) 10) 11) 12) 13) I H K E G F

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Chapter 13 - Measuring and Evaluating Financial Performance

ANSWERS TO GROUP A PROBLEMS PA136 Req. 1

Ratio Tests of profitability: 1. Net profit margin 2. Gross profit percentage 4. 5. Fixed asset turnover Return on equity Royale Company $80,000 $800,000 x 100 = 10.00% ($800,000 $480,000) $800,000 x 100 = 40.00% $800,000 [($550,000 + $550,000) 2] = 1.45 $80,000 [($570,000 + $570,000) 2]x 100 = 14.04% $80,000 24,000 shares = $3.33 $14.00 $3.33 = 4.20 ($800,000 x 50%) [($47,000 + $55,000) 2] = 7.84 365 7.84 = 46.56 days $480,000 [($95,000 + $110,000) 2] = 4.68 365 4.68 = 77.99 days $190,000 $120,000 = 1.58 $80,000 $120,000 = 0.67 $310,000 $880,000 = 0.35 Cavalier Company $35,000 $280,000 x 100 = 12.50% ($280,000 $150,000) $280,000 x 100 = 46.43% $280,000 [($160,000+ $160,000)2] = 1.75 $35,000 [($202,000 + $222,000)2] x 100 = 16.51% $35,000 10,500 shares = $3.33 $11.00 $3.33 = 3.30 ($280,000 x 25%) [($11,000 + $5,000) 2] = 8.75 365 8.75 = 41.71 days $150,000 [($38,000 + $25,000) 2] = 4.76 365 4.76 = 76.68 days $75,000 $15,000 = 5.00 $50,000 $15,000 = 3.33 $70,000 $292,000 = 0.24

6. Earnings per share 8. Price/earnings ratio Tests of liquidity: 9. Receivables turnover Days to collect 10. Inventory turnover Days to sell 11. Current ratio 12. Quick ratio Tests of Solvency: 13. Debt-to-assets

Req. 2 Preferable loan: Cavalier Company Basis for recommendation: 1. 2. Each set of financial statements is audited and each received an unqualified opinion; therefore, there is no preference in terms of credibility of information. ProfitabilityCavalier Company had a higher gross profit percentage (46.43% versus 40.00%) and net profit margin than Royale Company (12.50% versus 10.00%). The earnings per share amounts were the same. Cavalier Company earned a return on equity of 16.51% compared with 14.04% for Royale Company. Overall, Cavalier Company appears to be more profitable than Royale Company. LiquidityCavalier Company has higher liquidity than Royale Company as evidenced by the current ratio (5.00 compared with 1.58), quick ratio (3.33 vs. 0.67), receivables turnover (8.75 versus 7.84, which is 42 days versus 47 days), and inventory turnover (4.76 versus 4.68, which is 77 days versus 78 days). Thus, on the basis of liquidity, a two-year loan to Cavalier Company would be somewhat preferable.

3.

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4.

SolvencyCavalier Company clearly is in a less risky position on this factor. Cavalier Company financed its operations by obtaining only 24% of its total assets using debt. The remaining 76% came from stockholders equity, which is much less risky because dividends do not have to be paid each period (interest does) and there is no maturity date for shares (which debt has). Therefore, on the basis of this analysis, a loan of $30,000 to Cavalier Company clearly is preferable to a loan of $75,000 to Royale Company (assuming the two companies would be charged the same interest rate). The price/earnings ratio provides little evidence in favor of either company. ConstraintThe above analysis is based on only one year (2010). Although this year is relevant (it is the most recent), it limits the ability to conduct trend analyses. Selected detailed data for the prior year should be analyzed in a similar manner. A five- to ten-year summary of selected values also would be quite useful. Other particularly important data should be evaluated such as security for the loan, management experience and stability, cash flow projections, and anticipated changes in industry and economic conditions. Accounting decisionsCavaliers higher bad debt estimates reduced its profitability ratios (net profit margin, return on equity, earnings per share) relative to Royale. Despite this, the company still appeared more profitable. The higher bad debt estimates would make Cavaliers receivables turnover look somewhat stronger but understate its current ratio relative to Royale. On balance, Cavalier appears more liquid than Royale. Because receivables are a small part of total assets (about 6 percent for Royale and 2 percent for Cavalier), the impact of accounting differences on the debt-to-assets ratio is likely to be small. Thus, any conclusion about solvency is not materially affected by the accounting difference involving bad debt estimates.

5. 6.

7.

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ANSWERS TO SKILLS DEVELOPMENT CASES S135 The current ratio for Capital Investments Corporation (CIC) increased as the result of paying $420,000 to the trade creditors: Current assets Current liabilities Before $1,900,000 = 1.77 $1,075,000 After $1,480,000 $655,000 = 2.26

The current ratio has increased to an amount which is considered to be acceptable by First Federal Bank, but it appears that the increase is mere window dressing. In the process of improving the current ratio, CIC created a potential cash crisis. The cash balance was reduced to $10,000 ($430,000 $420,000) compared with current liabilities of $655,000. In light of this cash shortage, First Federal should not loan further money to CIC for purposes of acquiring additional property that is unlikely to produce a return for many months. 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. Usually a rigid cut-off point is not advisable for ratio analysis. The controllers actions are typical of many controllers who are responsible for ensuring the business operates within established constraints. The actions would be considered unethical if the consequences were not legitimate business transactions, were not fairly reported or were taken with the goal of misleading users. For example, if a controller were to report revenues before goods are shipped or fail to accrue expenses that have been incurred, then they would clearly be unethical. In this instance, however, it appears the controller is taking legitimate steps to ensure the business operates within the establish constraints (of its loan covenants) and that the impact of these actions are fairly reported in the financial statements.

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