Chapter 12 Financial Statements Analysis Review Questions A ratio is a mathematical expression of the relation of one figure to another The purpose in computing a ratio is simply to draw attention to this relationship The reader of a financial statement may observe, for example, that sales were P12 million and accounts receivable P1 million If he or she states this relationship as a ratio—that is, that receivables turn over about 12 times per year—the information may become more useful Measures of liquidity include the following (three required): Current ratio (current assets divided by current liabilities) Quick ratio (quick assets divided by current liabilities) Working capital (current assets less current liabilities) Net cash provided by operating activities (appears in a statement of cash flows) Current assets are expected to be converted into cash (or substituted for cash) within one year or an operating cycle, whichever is the longer period of time The receivables of a company that regularly sells merchandise on 24- or 36month installment plans are current assets, because the collection of these receivables is part of the company’s operating cycle The quick ratio is quick assets (cash, marketable securities, and receivables) divided by current liabilities Short-term creditors may consider the quick ratio more useful than the current ratio if inventories consist of slow-moving merchandise, or are unusually large in peso amount The debt ratio is computed by dividing total liabilities by total assets It is considered a measure of the long-term safety of creditors’ claims, rather than a measure of short-term liquidity 2 Chapter 12 Ratios and other measures used in evaluating profitability include (four required): Percentage change in net income from the prior year (peso amount of the change divided by the amount in the prior year) Gross profit rate (peso gross profit divided by net sales) Operating income (revenue from primary business activities less the cost of goods sold and operating expenses) Net income as a percentage of net sales (net income divided by net sales) Earnings per share (in the simplest case, net income divided by the number of shares of share capital outstanding) Return on assets (operating income divided by average total assets) Return on equity (net income divided by average equity) A large corporation may have thousands or even millions of individual shareholders The extent of each shareholder’s ownership of the business is determined by the number of shares that he or she owns Thus, the earnings per share measurement helps shareholders relate the total earnings of the business to their ownership investments If the company’s earnings are very low, they may become almost insignificant in relation to share price While this means that the p/e ratio becomes very high, it does not necessarily mean that investors are optimistic In fact, they may be valuing the company at its liquidation value rather than a value based upon expected future earnings A corporate net income of P1 million would be unreasonably low for a large corporation, with, say, P100 million in sales, P50 million in assets, and P40 million in equity A return of only P1 million for a company of this size would suggest that the owners could much better by investing in insured bank savings accounts or in government bonds which would be virtually riskfree and would pay a higher return 10 The current ratio would probably be higher during July At this time the amount of both current assets and current liabilities are likely to be at a minimum, and the ratio of current assets to current liabilities is thus likely to be larger In general, it would be advisable for the company to end its fiscal year as of July 31 At this time inventories and receivables will be at a minimum; therefore, the chance of error in arriving at a valuation for these Financial Statements Analysis assets will be minimized, the work of taking inventories will be reduced, and a more accurate determination of net income is probable Exercises Exercise (Pesos in Millions) a (1) Quick assets: Cash and short-term investments P 94.6 Receivables  319.4 Total quick assets P414.0 (2) Current assets: Quick assets [part a (1)] P414.0 Inventories 144.6 Prepaid expenses and other current assets   64.0 Total current assets P622.6 b (1) Quick ratio: Total quick assets (part a) P414.0 Current liabilities  260.2 1.6 to Quick ratio (P414  P260.2) (2) Current ratio: Total current assets (part a) P622.6 Current liabilities  260.2 2.4 to Current ratio (P622.6  P260.2) (3) Working capital: Total current assets (part a) P622.6 Less: Current liabilities  260.2 Working capital P362.4 c By traditional standards, Shin Toys seems to be quite solvent Both its quick ratio and current ratio are well above rule-of-thumb levels, and its working capital balance is substantial As a large and well-established company, it is quite possible that Shin Toys might be able to remain solvent even if its liquidity measures became lower than normal 4 Chapter 12 Exercise Requirement (a) (Pesos in thousands, except per share amounts) WANSO, INC Statement of Earnings For the Year Ended December 31, 2007 Net sales P 8,790,506 Less: Cost of goods sold 5,642,910 Gross profit P 3,147,596 Less: Operating expenses 2,008,792 Operating income P1,138,804 Nonoperating items: Interest revenue P 31,594 Income taxes (462,320) (430,726) Net earnings P 708,078 Earnings per share P3.16 Requirement (b) (1) Gross profit rate: Gross profit Net sales Gross profit rate (P3,147,596  P8,790,506) (2) Net income as a percentage of net sales: Net income Net sales Net income as a percentage of net sales (P708,078  P8,790,506) (3) Return on assets: Operating income Average total assets Return on assets (P1,138,804  P4,686,136) (4) Return on equity: Net income Average equity P3,147,596 P8,790,506 35.8% P 708,078 P8,790,506 8.1% P1,138,804 P4,686,136 24.3% P 708,078 P3,280,874 Financial Statements Analysis Return on equity (P 708,078  P3,280,874) 21.6% Requirement (c) The sale of retail clothing represents the company’s primary source of revenue from operations Thus, interest revenue is a nonoperating source of revenue To include interest revenue in the gross profit computation would overstate both gross profit and operating income Exercise a Percentage change in earnings per share: In 2007: Peso change from prior year (P9.06 – P6.16) +P2.90 Earnings per share in 2006 P6.16 +47.1% Percentage change (+P2.90  P6.16) In 2008: Peso change from prior year (P10.96 – P9.06) +P1.90 Earnings per share in 1987 P9.06 +21.0% Percentage change (+P1.90  P9.06) b 2.5 to (P27.50 market price divided by P10.96 earnings per share.) c The low p/e ratio, especially in the face of rapidly accelerating earnings, indicates that investors expected Auto Max’s future earnings to decline from the 2008 levels It appears that the market was right, as earnings per share levels for 2009 through 2013 were far below the 2008 level Note to instructor: All earnings per share figures shown in the problem have been adjusted to reflect the effect of a 2-for-1 share split which occurred subsequent to 2008 6 Chapter 12 Exercise Requirement (a) Return on assets = Operating income Average total assets P4,844 = P4,844 = 16.3% = [(P29,096 + P30,392)  2] P29,744 Requirement (b) Return on equity = = Net income Average total equity P698 = P698 = 7.6% P9,236 [(P9,124 + P9,348)  2] Requirement (c) Equity figures shown in the balance sheet are reported at book value, not market value Thus, the increase in Happy Talk’s total equity for the year did not result from an increase in the market value of the company’s shares Exercise a (1) Gross profit percentage: 2007: 32% [(P1,200,000  P816,000)  P1,200,000] 2008: 34% [(P1,500,000 – P990,000)  P1,500,000] (2) Inventory turnover: 2007: times (P816,000  P204,000 average inventory) 2008: 4.5 times (P990,000  P220,000 average inventory) (3) Accounts receivable turnover: 2007: times (P1,200,000  P200,000 average accounts receivable) 2008: times (P1,500,000  P300,000 average accounts receivable) b There are three highly favorable trends First, the growth in net sales from Financial Statements Analysis P1,200,000 to P1,500,000 This represents an increase of 25% (P300,000 increase, divided by P1,200,000 in the prior year) Next, the gross profit rate increased from 32% in 2007 to 34% in 2008 Not only is Spectrum’s selling more, but it is selling its merchandise at a higher profit margin Finally, the inventory turnover has increased, indicating that the company has increased its sales without having to proportionately increase its investment in inventories There is only one negative trend The accounts receivable turnover rate has declined One question immediately should come to mind: Has Spectrum’s liberalized its credit policies as part of its strategy to increase sales? If so, the “slowdown” in the receivables turnover may have been expected and be no cause for concern On the other hand, if the company has not changed its credit policies, it apparently is encountering more difficulty in collecting its accounts receivable on a timely basis Exercise a b c d e f g Current ratio: 3.6 to (P1,080,000  P300,000) Quick ratio: 1.4 to (P420,000  P300,000) Working capital: P780,000 (P1,080,000 – P300,000) Debt ratio: 40% (P960,000  P2,400,000) Accounts receivable turnover: 18 times (P5,580,000  P310,000) Inventory turnover: 6.2 times (P3,348,000  P540,000) Book value per share of capital stock: P24.00 (P1,440,000  60,000 shares) Exercise a Current assets: Cash Marketable securities Accounts receivable Inventory Unexpired insurance Total current assets Current liabilities: Notes payable Accounts payable P 95,200 350,080 460,900 359,200 9,000 P1,274,380 P 140,000 250,860 Chapter 12 Salaries payable Income taxes payable Unearned revenue Total current liabilities 15,140 29,200 20,000 P 455,200 b The current ratio is 2.8 to It is computed by dividing the current assets of P1,274,380 by the current liabilities of P455,200 The amount of working capital is P819,180, computed by subtracting the current liabilities of P455,200 from the current assets of P1,274,380 The company appears to be in a strong position as to short-run debt-paying ability It has almost three pesos of current assets for each peso of current liabilities Even if some losses should be sustained in the sale of the merchandise on hand or in the collection of the accounts receivable, it appears probable that the company would still be able to pay its debts as they fall due in the near future Of course, additional information, such as the credit terms on the accounts receivable, would be helpful in a careful evaluation of the company’s current position Exercise (Pesos in Millions) a Current assets: Cash Receivables Merchandise inventories Prepaid expenses Total current assets Quick assets: Cash Receivables Total quick assets b (1) (2) P 149.6 305.4 2,383.6 191.1 P3,029.6 P149.6 305.4 P455.0 Current ratio: Current assets (part a) Current liabilities Current ratio (P3,029.6  P3,878.0) P3,029.6 P3,878.0 0.8 to Quick ratio: Quick assets (part a) Current liabilities P455.0 P3,878.0 Financial Statements Analysis Quick ratio (P455  P3,878.0) 0.1 to (3) c Working capital: Current assets (part a) P3,029.6 Less: Current liabilities 3,878.0 Working capital P(848.4) No It is difficult to draw conclusions from the above ratios Makati’s current ratio and quick ratio are well below “safe” levels, according to traditional rules of thumb On the other hand, some large companies with steady cash flows are able to operate successfully with current ratios lower than Makati’s d Due to characteristics of the industry, supermarkets tend to have smaller amounts of current assets and quick assets than other types of merchandising companies An inventory of food has a short shelf life Therefore, the inventory of a supermarket usually represents only a few weeks’ sales Other merchandising companies may stock inventories representing several months’ sales Also, supermarkets sell primarily for cash Thus, they have relatively few receivables Although supermarkets may generate large amounts of cash, it is not profitable for them to hold assets in this form Therefore, they are likely to reinvest their cash flows in business operations as quickly as possible e In evaluating Makati’s liquidity, it would be useful to review the company’s financial position in prior years, statements of cash flows, and the financial ratios of other supermarket chains One might also ascertain the company’s credit rating from an agency such as Dun & Bradstreet Exercise Requirement a Net income Less preference dividends Net income remaining for ordinary (a) This Year P324,000 16,000 Last Year P240,000 16,000 P308,000 P224,000 50,000 P6.16 50,000 P4.48 Average number of ordinary shares (b) Earnings per share (a) ÷ (b) 10 b Chapter 12 Ordinary dividend per share (a)* Market price per share (b) Dividend yield ratio (a) ÷ (b) P2.16 P45.00 4.8% P1.20 P36.00 3.33% This Year P2.16 P6.16 35.1% Last Year P1.20 P4.48 26.8% P45.00 P6.16 7.3 P36.00 P4.48 8.0 *P108,000 ÷ 50,000 shares = P2.16; P60,000 ÷ 50,000 shares = P1.20 c Ordinary dividend per share (a) Earnings per share (b) Dividend payout ratio (a) ÷ (b) d Market price per share (a) Earnings per share (b) Price-earnings ratio (a) ÷ (b) Investors regard Metro Building Supply less favorably than other firms in the industry This is evidenced by the fact that they are willing to pay only 7.3 times current earnings for a share of the company’s stock, as compared to times current earnings for the average of all stocks in the industry If investors were willing to pay times current earnings for Metro Building Supply’s stock, then it would be selling for about P55 per share (9 × P6.16), rather than for only P45 per share e This Year Last Year Equity P2,150,000 P1,950,000 Less preference shares 200,000 200,000 Ordinary equity (a) P1,950,000 P1,750,000 Number of ordinary shares (b) 50,000 50,000 Book value per share (a) ÷ (b) P39.00 P35.00 A market price in excess of book value does not mean that the price of a stock is too high Market value is an indication of investors’ perceptions of future earnings and/or dividends, whereas book value is a result of already completed transactions and is geared to the past Requirement a This Year Last Year P  324,000 P  240,000 Net income Financial Statements Analysis 11 Add after-tax cost of interest paid: [P90,000 × (1 – 0.40)] 54,000 54,000 P  294,000 Total (a) P 378,000 b Average total assets (b) P3,650,000 P3,000,000 Return on total assets (a) ÷ (b) 10.4% 9.8% This Year Last Year P  324,000 P  240,000 Net income Less preference dividends 16,000 16,000 Net income remaining for ordinary P  308,000 P  224,000 shareholders (a) Average total equity* P2,050,000 P1,868,000 Less average preference shares 200,000 200,000 Average ordinary equity (b) P1,850,000 P1,668,000 *1/2(P2,150,000 + P1,950,000); 1/2(P1,950,000 + P1,786,000) Return on ordinary equity (a) ÷ (b) 16.6% 13.4% c Financial leverage is positive in both years, since the return on ordinary equity is greater than the return on total assets This positive financial leverage is due to three factors: the preference shares, which has a dividend of only 8%; the bonds, which have an after-tax interest cost of only 7.2% [12% interest rate × (1 – 0.40) = 7.2%]; and the accounts payable, which may bear no interest cost Requirement We would recommend keeping the stock The stock’s downside risk seems small, since it is selling for only 7.3 times current earnings as compared to times earnings for the average firm in the industry In addition, its earnings are strong and trending upward, and its return on ordinary equity (16.6%) is extremely good Its return on total assets (10.4%) compares favorably with that of the industry The risk, of course, is whether the company can get its cash problem under control Conceivably, the cash problem could worsen, leading to an eventual reduction in profits through inability to operate, a reduction in dividends, and a precipitous drop in the market price of the company’s stock This does not seem likely, however, since the company can easily control its cash problem through more careful management of accounts receivable and inventory If this problem 12 Chapter 12 is brought under control, the price of the stock could rise sharply over the next few years, making it an excellent investment Test Materials Test Material 12-1 (Peso Amounts in Thousands) a Current ratio: (1) Beginning of year (P108,260  P126,962) 0.85 to End of year (P185,184  P166,714) 1.11 to Working capital: (1) Beginning of year (P108,260 – P126,962) P(18,702) (2) b d (2) End of year (P185,184 – P166,714) (1) Return on average total assets: Operating income Average total assets [(P469,396 + P834,826)  2] Return on average total assets (P152,282  P652,112) (2) Return on average equity: Net income Average equity [(P248,116 + P416,378)  2] Return on average equity (P88,304  P332,247) P18,470 P152,282 P1,304,222 23% P88,304 P332,247 27% c and e c Box Office Video’s short-term debt-paying ability appears to be improving In the course of the year, the company’s current ratio has improved, and its working capital has increased from a negative amount of more than P18 million to a positive amount of more than P18 million (an P36 million turnaround) Financial Statements Analysis 13 While Box Office’s solvency has been increasing and its current ratio at yearend exceeds that of Digicom, Box Office is not as good a credit risk Box Office and Digicom are both service companies As a regional telephone company, however, Digicom has an extremely reliable source of monthly earnings and cash flows Box Office, in contrast, offers a less essential service and operates in a more competitive marketplace As mentioned in this chapter, major telephone companies often operate with current ratios of less than to Therefore, a current ratio of to does not indicate any specific financial difficulties for Digicom Unless Digicom were to encounter some very unusual financial problems, it will always be viewed as a better credit risk than (relatively) small companies engaging in highly competitive business activities e Box Office’s management appears to be utilizing the company’s resources in more than a “reasonably efficient” manner The company’s return on assets and return on equity both are well above the company’s cost of borrowing money, the “norms” in many industries, and the rates of return that investors can safely achieve from, say, putting their money in a bank Test Material 12-2 Requirement (a) (1) Inventory turnover: Cost of Goods Sold, P3,510,000 = times Average Inventory, P702,000 (2) Accounts receivable turnover: Credit Sales, P5,400,000 = times Average Accounts Receivable, P600,000 (3) Total operating expenses: Sales Less: Cost of goods sold Gross profit Less: Interest expense (non-operating item) Income taxes (non-operating item) Net income Operating expenses P5,400,000 3,510,000 P1,890,000 P 90,000 168,000 318,000 576,000 P1,314,000 14 Chapter 12 (4) Gross profit percentage: Sales, P5,400,000  cost of goods sold, P3,510,000 = gross profit, P1,890,000 P1,890,000  P5,400,00 = 35% (5) Return on average equity, P318,000  P1,590,000 = 20% (6) Return on average assets: Operating income: Sales Cost of goods sold Gross profit Operating expenses Operating income Average investment in assets Return on average assets (P576,000  P3,600,000) P5,400,000 3,510,000 P1,890,000 1,314,000 P 576,000 P3,600,000 16% Requirement (b) Obtaining the loan will be desirable to stockholders because the return on average assets (16%) is greater than the prospective rate of payment to creditors (12%) In other words, the stockholders will gain from applying leverage, which is a form of financing using fixed-return securities as capital Of course the assumption of long-term debt would increase the risk to the stockholders In the event of a business downturn, the earnings of the company might fall far below the present levels and the company might be unable to meet the interest payments on the loan, which could entitle the creditor to take control of the company Use of money borrowed at a rate of 12% will be beneficial to stockholders if we can assume that the company will continue to earn more than a 12% return on assets Test Material 12-3 a JH Corp (1) Working capital: (P51,000 + P75,000 + P84,000 - P105,000) P105,000 EH Imports, Inc Financial Statements Analysis (P20,000 + P70,000 + P160,000 - P100,000) P150,000 JH Corp (2) Current ratio: (P51,000 + P75,000 + P84,000)  P105,000 (P20,000 + P70,000 + P160,000)  P100,000 2.5 to 1.2 to (4) Number of times inventory turned over during the year: (P504,000 cost of goods sold  P84,000 inventory) (P480,000 cost of goods sold  P160,000 inventory) times Average number of days required to turn over inventory: (365 days  times) (365 days  times) 61 days Average number of days required to collect accounts receivable: (365 days  times) (365 days  times) (6) Operating cycle: (61 days + 41 days) (122 days + 46 days) b EH Imports, Inc to (3) Quick ratio: (P51,000 + P75,000)  P105,000 (P20,000 + P70,000)  P100,000 (5) Number of times accounts receivable turned over: (P675,000 credit sales  P75,000 accounts receivable) (P560,000 credit sales  P70,000 accounts receivable) 15 to times 122 days times times 41 days 46 days 102 days 168 days Although EH Imports, Inc., has a large peso amount of working capital and a higher current ratio, JH Corp has the higher-quality working capital The quality of working capital is determined by the nature of the current assets comprising the working capital and the length of time required to convert these assets into cash Over half of JH Corp.’s current assets consist of cash and receivables Most of EH Imports, Inc.’s working capital is inventory, which is a less liquid asset The computation of each company’s quick ratio 16 Chapter 12 shows that JH Corp has highly liquid assets (cash and receivables) in excess of its current liabilities, whereas EH Imports, Inc., does not JH Corp is also able to sell its inventory and to collect its receivables more quickly than EH Imports, Inc JH Corp requires only 61 days to sell its average inventory, while EH Imports, Inc., requires 122 days The overall operating cycle for JH Corp is over two months shorter than for EH Imports, Inc Thus, JH Corp is able to convert its current assets into cash more quickly than EH Imports, Inc A supplier should prefer selling P20,000 in merchandise on a 30-day open account to JH Corp rather than to EH Imports, Inc JH Corp clearly has a greater potential for paying off this account when it becomes due  ... assets of P1,274,380 by the current liabilities of P455,200 The amount of working capital is P819,180, computed by subtracting the current liabilities of P455,200 from the current assets of P1,274,380... divided by average equity) A large corporation may have thousands or even millions of individual shareholders The extent of each shareholder’s ownership of the business is determined by the number of. .. (1) Beginning of year (P108,260  P126,962) 0.85 to End of year (P185,184  P166,714) 1.11 to Working capital: (1) Beginning of year (P108,260 – P126,962) P(18,702) (2) b d (2) End of year (P185,184