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5-15
6. The main ratio used by many financial analysts to examine a company's short-term liquidity risk is the
current ratio. However, there are a number of problems that arise when this ratio is used to examine
short-term liquidity risk that may make the current ratio less useful than initially thought. Discuss the
interpretative problems of using the current ratio.
7. For each of the following factors, determine if the given change or level of that factor would lead an
analyst to believe that managers of a firm are more or less likely to engage in earnings manipulation:
Earnings Manipulation
More likely/less likely
1. Days Sales in Receivable Index increases
2. Gross Margin index decreases below 1
3. Asset Quality index increases
4. Depreciation index decreases to below 1
5. Leverage Index increases
8. One criticism of the interest and fixed charges coverage ratios as measures of long-term solvency risk
is that they use earnings rather than cash flows in the numerator. Detail how the interest coverage ratio
and fixed charges coverage ratio are calculated. In addition, discuss why using earnings in the
numerator is a problem and what method could be used to alleviate this problem.
ANS:
9. For each of the following scenarios, determine if it is an indicator of potential cash flow problems:
Potential future cash
flow problems
Yes/No
a.
Growth in accounts receivable or inventories that is less
the growth rate in sales.
b.
Increases in accounts payable that exceed the increase in
inventories.
c.
Capital expenditures that substantially exceed cash flow
from operations.
d.
Sales of marketable securities are less than purchases of
marketable securities.
e.
Other operating current liabilities that grow at a lesser
rate than sales.
f.
A reduction or elimination of dividend payments
g.
A substantial shift from long-term borrowing to short-
term borrowing.
10. Discuss the differences between Chapter 7 and Chapter 11 bankruptcy filings?
11. What is the effect of the declaration of diviends have on the liquidity of a corporation?
PROBLEM
1. Given the following information, calculate for Year 2 the number of days of working capital financing
the firm will need to obtain from other sources?
Year 1
Year 2
Accounts Receivable, net
$ 518
$ 562
Accounts Payable
203
192
Inventory
535
564
Credit Sales
3,205
3,636
Cost of Goods Sold
2,037
2,294
Selling and Admin. Expense
1,081
1,131
5-18
2. Refer to the financial statement data for Patriot Corp. for 2011 and 2010. Complete the table by
computing the ratios.
Patriot Corp.
Balance Sheet
As of December 31,
2011
2010
Assets:
Cash and Cash Equivalents
$ 69,000
$ 55,250
Accounts Receivable
126,500
80,750
Inventory
92,000
63,750
Current Assets
287,500
199,750
Equipment
194,063
148,750
Less: Accumulated depreciation
-38,813
-29,750
Equipment-Net
155,250
119,000
Land
132,250
106,250
Total assets:
$575,000
$425,000
Liabilities:
Accounts Payable
$ 69,000
$ 42,500
Accrued Salaries Payable
51,750
42,500
Rent Expense Payable
35,750
28,500
Income Tax Payable
4,788
1,250
Current Liabilities
161,288
114,750
Long-term note payable
172,500
102,000
Total Liabilities
333,788
216,750
Stockholders’ Equity:
Common stock
115,000
89,250
Retained earnings
126,212
119,000
Total liabilities and stockholders’ equity:
$575,000
$425,000
Patriot Corp.
Income Statement
For the year ended December 31, 2011
Revenues
$ 373,750
Cost of goods sold
(224,250)
Gross Profit
$149,500
Operating Expenses
Depreciation expense
(9,062)
Salary expense
(56,063)
Insurance Expense
(44,850)
Rent Expense
(18,688)
Interest Expense
(6,120)
5-19
Total Operating Expenses
(134,783)
Income from Operations
14,717
Income Tax Expense
(4415)
Net income
$ 10,302
Dividends paid to Common Shareholders
$ 3,090
Financial Ratio to be calculated:
2011
2010
Current Ratio
Quick Ratio
Days Accounts Receivable
N/A
Days Inventory
N/A
Days Accounts Payable
N/A
Net Days Working Capital
N/A
Long-term Debt to Long-term Capital Ratio
Long-term Debt to Shareholders’ Equity ratio
Liabilities to Total Assets
Interest Coverage ratio
N/A
N/A - Not Applicable for the given year
3. Below is information from Darren Company’s 2012 financial statements.
As of Dec. 31, 2012
Dec. 31, 2011
Cash and short-term investments
$ 958,245
$ 745,800
Accounts Receivable (net)
125,850
135,400
Inventories
195,650
175,840
Prepaid Expenses and other current assets
45,300
30,860
Total Current Assets
$1,325,045
$1,087,900
Plant, Property and Equipment, net
1,478,320
1,358,700
Intangible Assets
125,600
120,400
5-20
Total Assets
$2,928,965
$2,567,000
Short-term borrowings
$ 25,190
$ 38,108
Current portion of long-term debt
45,000
40,000
Accounts payable
285,400
325,900
Accrued liabilities
916,722
705,891
Income taxes payable
125400
115600
Total Current Liabilities
$1,397,712
$1,225,499
Long-term Debt
450,000
430,000
Total Liabilities
$1,847,712
$1,655,499
Shareholders' Equity
$1,081,253
$911,501
Total Liabilities and Shareholders' Equity
$2,928,965
$2,567,000
Selected Income Statement Data - for the year ending December 31, 2012:
Net Sales
$3,210,645
Cost of Goods Sold
(2,310,210)
Operating Income
900,435
Net Income
324,850
Selected Statement of Cash Flow Data - for the year ending December 31, 2012:
Cash Flows from Operations
$584,750
Interest Expense
42,400
Income Tax Expense
114,200
Using this information calculate the following ratios:
2012
2011
Liabilities to Assets Ratio
Liabilities to Shareholders' Equity Ratio
LT Debt to LT Capital Ratio
LT Debt to Shareholders' Equity Ratio
Interest Coverage Ratio
N/A
Operating Cash Flow to Total Liabilities Ratio
N/A
4. Falcon Corporation has current assets of $400,000 and current liabilities of $275,000.
5-21
Required:
Compute the effect of each of the following transactions on Falcon's current ratio:
a. Refinanced a $60,000 long-term mortgage with a short-term note.
b. Purchasing $108,000 of merchandise inventory with short-term accounts payable.
c. Paying $50,000 of short-term accounts payable.
d. Collecting $90,000 of short-term accounts receivable.
5 A. Hammer Corporation wrote off $185,000 of obsolete inventory at December 31, 2011.
Required:
What effect did this write-off have on the company's 2011 current and quick ratios?
6. Selected risk ratios are presented for 2011 and 2010 for Techtron Company. Also, refer to the
financial statement data for the company.
2011
2010
Revenues to Cash Ratio
6.8
7.7
Days Revenues Held in Cash
54
47
Current Ratio
1.5
1.5
Quick Ratio
1.1
1.1
Operating Cash Flow to Average Current Liabilities
Ratio
47.3%
55.7%
Days Accounts Receivable
68
73
5-22
Days Inventory
51
68
Days Accounts Payable
47
49
Net Days Working Capital
72
91
Liabilities to Assets Ratio
0.559
0.621
Liabilities to Shareholders’ Equity Ratio
1.266
1.639
Long-Term Debt to Long-Term Capital Ratio
0.330
0.418
Long-Term Debt to Shareholders’ Equity Ratio
0.492
0.720
Operating Cash Flow to Total Liabilities Ratio
0.243
0.242
Interest Coverage Ratio
5.6
2.3
Financial Statements
INCOME STATEMENT (in millions)
Fiscal year end
2012
2011
2010
Sales
$2,500
$ 3,139
$ 2,816
Cost of Goods Sold
(1,252)
(1,288)
(1,099)
Selling, General & Admin. Exp.
Advertising
(387)
(364)
(297)
Research and Development
(157)
(143)
(154)
Royalty Expense
(223)
(248)
(296)
Other Selling and Administrative
(385)
(799)
(788)
Interest expense
(32)
(53)
(78)
Income tax expense
(64)
(69)
(29)
Net income
$ 196
$ 175
$ 75
Balance Sheet
Fiscal year end
2012
2011
2010
2009
ASSETS (in millions)
Cash
$ 625
$421
$ 496
$233
Accounts Receivable
579
607
555
572
Inventories
195
169
190
217
Prepayments
219
212
191
346
Total current assets
$1,618
$1,409
$1,432
$1,368
Property, plant & equipment
207
200
213
236
Other Assets
1,416
1,554
1,498
1,765
Total assets
$3,241
$3,163
$3,143
$3,369
LIABILITIES
Accounts payable
$ 168
$ 159
$ 166
$ 123
Short-term borrowing
342
24
223
36
Other current liabilities
584
749
578
599
Total current liabilities
$1,094
$ 939
$ 967
$ 758
Long term debt
303
687
857
1,166
Other noncurrent liabilities
149
141
128
92
Total liabilities
$1,546
$1,767
$1,952
$2,016
Common stock
$ 105
$ 105
$ 105
$ 105
Additional Paid-in Capital
381
398
458
455
Retained earnings
1,776
1,558
1,430
1,622
Accumulated Other Comprehensive Income
82
30
(47)
(68)
Treasury Stock
(649)
(695)
(755)
(761)
Total Shareholders' equity
$1,695
$1,396
$1,191
$1,353
Total Liabilities & Shareholders’ Equity
$3,241
$3,163
$3,143
$3,369
STATEMENT OF CASH FLOWS (in millions)
Operations
2012
2011
2010
Net Income
$ 196
$ 175
$ 75
Depreciation & Amortization
146
164
184
(Increase) Decrease Accounts Receivables
28
(52)
17
(Increase) Decrease Inventories
(26)
21
27
(Increase) Decrease Prepayments
7
(21)
155
(Decrease) Increase Accounts Payable & Other
Current Liabilities
(90)
17
23
Net Addbacks and Subtractions from operations
(147)
112
221
Cash flows from operations
$ 195
$451
$480
Investing
Property Plant and Equipment acquired
($79)
($63)
($59)
Other Investing Transactions
(6)
(2)
(3)
Cash Flows from Investing
($85)
($65)
($62)
Financing
Increase in Common Stock
0
0
0
Increase (Decrease) in Short-term Borrowing
(318)
199
(187)
Increase (Decrease) in Long-term Borrowing
(384)
(170)
309
Acquisition of Common Stock
(46)
60
(6)
Dividends
(37)
(21)
(21)
Other Financing Transactions
879
243
(250)
Cash flow from Financing
$94
($311)
($155)
Change in Cash
$204
$75
$263
Cash - Beginning of Year
421
496
233
Cash - End of Year
$ 625
$ 421
$ 496
Required:
a. Calculate the amounts of these ratios for 2012.
b. Assess the changes in the short-term liquidity risk of Techtron between 2010 and
2012 and the level of that risk at the end of 2012.
c. Assess the changes in the long-term solvency risk of Techtron between 2010 and
2012 and the level of that risk at the end of 2012.
5-24
7. Below is selected data of Pronto Company:
Balance Sheet Data
As of December 31:
2012
2011
Accounts receivable
$671,000
$642,000
Allowance for doubtful accounts
31,000
22,000
Net accounts receivable
$640,000
$620,000
Inventories - LCM
$542,500
$642,500
Income Statement Data
Net credit sales
$3,150,000
$3,000,000
Net cash sales
800,000
600,000
Net sales
$3,950,000
$3,600,000
Cost of goods sold
$2,370,000
$2,160,000
Selling, general and adm. expenses
475,000
350,000
Other
150,000
125,000
Total operating expenses
$2,995,000
$2,635,000
Net income
$ 955,000
$ 965,000
Required:
a. What is the accounts receivable turnover for 2012?
b. What is the inventory turnover for 2012?
5-26
8. On January 1, 2012, Deputron Company's beginning inventory was $600,000. During 2012,
the company purchased $2,600,000 of additional inventory, and on December 31, 2012
Creek's ending inventory was $565,000.
Required:
What was Deputron’s inventory turnover for 2012?
9. Caraway Company's net accounts receivable was $300,000 at December 31, 2012 and
$450,000 at December 31, 2013. Net cash sales for 2008 were $425,000. The accounts
receivable turnover for 2013 was 7.0, and this turnover figure was computed from net credit
sales for the year.
Required:
What were Caraway’s total net sales for 2013?
10. Foxmoor Company's merchandise inventory and other related accounts for 2012 follow:
Sales
$3,100,000
Cost of Goods Sold
2,153,200
Merchandise Inventory
Beginning of Year
850,000
End of Year
995,000
5-27
Required:
Calculate Foxmoor’s inventory turnover during 2012 assuming that the merchandise inventory buildup
was relatively constant during the year.
11. Bragdon Company is consistently profitable. Its normal financial statement relationships are as
follows:
Current ratio
3.5:1
Inventory turnover
4.5 times
Liabilities to assets ratio
0.8: 1
Required: Determine whether each transaction or event that follows increased, decreased or had no
effect on each ratio.
1. Bragdon declared but did not pay a cash dividend.
2. Customers returned invoiced goods for which they had not paid.
3.Accounts payable were paid at year-end.
4. Bragdon recorded both a receivable from an insurance company and a loss on a building due to fire
damage.
5. Early in the year, Bragdon increased the selling price of one of its products because customer
demand far exceeded production capacity. The number of units sold this year was the same as last
year.
ANS:
