Chapter 17 – Understanding Accounting and Financial Information
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Wheatley International
Balance Sheet
December 31, 201X
ASSETS
Current Assets
Cash $ 72,000
Accounts Receivable 120,600
Notes Receivable 61,200
Inventory 126,600
Total Current Assets $380,400
Fixed Assets
Land $1,500,000
Buildings 1,050,000
Equipment & Vehicles 1,066,000
Depreciation − 400,000
Total Fixed Assets $3,216,000
Other Assets
Goodwill $90,000
Total Other Assets $90,000
TOTAL ASSETS $3,686,400
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Accounts Payable $45,000
Short-Term Notes Payable 15,600
Total Current Liabilities $60,600
Long-Term Liabilities
Notes Payable (Long-Term) $210,000
Bonds 60,000
Total Long-Term Liabilities $270,000
Total Liabilities $330,600
Owner’s Equity
Common Stock $1,896,000
Retained Earnings 1,459,800
Total Owners’ Equity $3,355,800
TOTAL LIABILITIES AND
STOCKHOLDERS’ EQUITY $3,686,400
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Name: ___________________________
Date: ___________________________
critical thinking exercise 17-4
CALCULATING FINANCIAL RATIOS (ADVANCED)
You are considering investing in Acme Incorporated. The company has provided you with the
balance sheet and income statement for the previous year. The current price of one share of stock is
$46.25. Earning per share last year was $1.86.
1. Calculate the requested financial ratios:
a. Current ratio
b. Debt-to-equity ratio
c. Return on sales (use net income AFTER taxes)
d. Return on equity (use net income AFTER taxes)
e. Earnings per share (use net income AFTER taxes)
2. Would you invest in Acme Incorporated? Why or why not?
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Acme Incorporated
Statement of Income
FY 201X
REVENUES
Net Sales $4,090,970
Other Income +104,227
Total Revenue $4,195,197
COST OF GOODS SOLD $2,673,129
GROSS PROFIT (GROSS MARGIN) $1,522,068
OPERATING EXPENSES
Total Selling Expenses $333,300
Total General Expenses + 306,036
Total Operating Expenses $639,336
NET INCOME BEFORE TAXES $882,732
Income Tax Paid (25%) $220,683
NET INCOME AFTER TAXES $662,049
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Acme Incorporated
Balance Sheet
December 31, 201X
ASSETS
Current Assets
Cash $280,928
Marketable Securities 514,800
Accounts Receivable 108,694
Notes Receivable 855,771
Inventories 218,156
Prepaid Expenses and Other 88,237
Current Assets
Total Current Assets $2,066,586
Fixed Assets
Land $510,000
Plant and Buildings 304,096
Equipment 218,500
Total Fixed Assets $1,744,701
Other Assets
Goodwill, Net $ 49,930
Total Other Assets $ 49,930
TOTAL ASSETS $3,861,217
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current Liabilities
Accounts Payable $226,977
Accrued Expenses and Other 380,496
Current Liabilities
Current Portion of Finance Debt 382,579
Total Current Liabilities $990,052
Long-Term Liabilities
Notes Payable $228,772
Bonds 380,000
Other Long-Term Liabilities 29,478
Total Long-Term Liabilities $ 638,250
Total Liabilities $1,628,303
Owner’s Equity
Common Stock $ 389,538
(342,196 Shares Outstanding)
Retained Earnings 1,843,377
Total Owners’ Equity $2,232,915
TOTAL LIABILITIES AND
STOCKHOLDERS’ EQUITY $3,861,217
Chapter 17 – Understanding Accounting and Financial Information
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notes on critical thinking exercise 17-4
1. Calculate the requested financial ratios.
a. Current ratio. The current ratio is the ratio of the firm’s current assets to its current liabil-
ities, calculated as follows:
Current ratio =
Current assets s or $2,066,586
Current liabilities $ 990,520
2.086:1
b. Debt-to–equity ratio. The debt-to–equity ratio measures the degree to which the company
is financed by borrowed funds that must be repaid. It is calculated as follows:
Debt-to-equity ratio =
e. Earnings per share. Earnings per share measures the amount of profit earned by a com-
pany for each share of common stock it has outstanding:
Earnings per share =
Net income or $662,049
Number of shares outstanding 342,196
$1.935 per share
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2. Would you invest in Acme Incorporated? Why or why not?
The current ratio of 2.086 means that $2.086 in current assets is available for every $1.00 of cur-
rent liabilities. The firms should be able to meet short-term debt payments easily.
from $1.86 to $1.935.
Overall, the company seems to be profitable, with a healthy debt–to-equity ratio.
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Name: ___________________________
Date: ___________________________
critical thinking exercise 17-5
COMPARING INDUSTRY RATIOS (BASIC)
You are interested in investing in a regional hotel company and have investigated the fi-
nancial statements of four potential investments. Use the information in the table below to answer the
questions at the bottom of the page.
Hotel N
Hotel J
Hotel C
Hotel W
Information from the income statement
Total revenue
$10,099,000
$3,816,000
$428,806
$1,277,550
Total expenses
9,503,000
3,618,000
354,461
1,822,748
Information from the balance sheet
Current assets
1,946,000
1,020,000
68,629
526,549
Total assets
8,668,000
8,183,000
262,388
3,783,127
Current liabilities
2,356,000
895,000
101,091
693,809
Total liabilities
4,587,000
5,944,000
456,441
3,089,318
Total number of common
stock outstanding
225,800
389,000
32,312
168,238
(Use the table on the following page for your answers.)
1. What is the net profit (or net loss) for each company?
2. Calculate the return on sales for each company.
3. Calculate the total stockholders’ equity for each company.
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4. What is the current ratio for each company?
5. Calculate the return on equity ratio for each company.
6. What is the debt-to-equity ratio for each company?
7. Calculate the basic earnings per share for each company.
Hotel N
Hotel C
Hotel W
1. Net income (net profit or
net loss)
2. Return on sales
3. Current ratio
4. Stockholders’ equity
5. Return on equity
6. Debt-to-equity ratio
7. Earnings per share
(basic)
8. Which company would you rather invest in? Why?
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notes on critical thinking exercise 17-5
The requested financial information and ratios are given below.
Hotel N
Hotel J
Hotel C
Hotel W
1. Net income (net profit or
net loss)
$ 596,000
$ 198,000
$ 74,345
($545,198)
2. Return on sales
5.9%
5.2%
17.3%
(42.7%)
3. Current ratio
0.83
1.13
0.68
0.76
4. Stockholders’ equity
4,081,000
2,239,000
(194,053)
693,809
5. Return on equity
14.6%
8.8%
Not meaningful
(78.5%)
6. Debt-to-equity ratio
112%
265%
Not meaningful
445%
7. Earnings per share
(basic)
$2.64
$0.51
$2.30
($3.24)
Hotel N. Return on sales is in the midrange for the industry. The current ratio, while less than the ideal
2.0, is in line with two of the other three companies. Return on equity is healthy and at the top of
the industry, showing that the company has made good use of the funds invested by the investors.
The debt-to-equity is much higher than the ideal ratio of 100%. However, when compared to the
other companies in the industry, a 112% debt-to-equity ratio looks good. Earnings per share are
also at the top range in the industry.
Hotel J. Return on sales is in the midrange. Current ratio is at the top of the industry, showing a better
than average liquidity. Return on equity is not exceptional, but in the midrange for the industry.
Hotels C and W are horrible investment candidates. That leaves Hotels N and J. Hotel J is heavily
leveraged and would be more risky. Hotel N is a steady, safe performer. Knowing that there is a direct
relationship between risk and return, the investment decision would depend on the investors’ tolerance for
risk.
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bonus
cases
bonus case 17–1
THE BEST-LAID PLANS OFTEN GO AWRY
How you report revenues on the income statement makes a big difference in how profitable a
company looks. The problem is that stockholders are often fooled into investing in a firm that is not near-
ly as profitable as they think. A good example is that of Thousand Trails of Seattle. It sold campground
memberships for owners of recreation vehicles. It used the usual expensive promotions to get potential
buyers to come to the campgrounds. Once a potential customer was at the site, there was much pressure to
buy now, and the campgrounds were quite attractive. Once a customer got home and reconsidered the
investment, though, some backed out of the commitment, and that is where Thousand Trails got into dif-
ficulty.
The company recorded the full price of a membership (about $7,500) as revenue, even though
members paid only 40% down on average. Marketing expenses were running higher than payments, so
more cash flowed out than flowed in. To get cash, Thousand Trails sold its receivables.
In one year, Thousand Trails used $52 million more cash than it produced, a definite cash flow
problem. Nevertheless, it reported record earnings of $19.1 million, and the stock price went up to over
$29.
Two years later, the stock had fallen to less than $5, reflecting a 90% drop in earnings reported
(from $19 million to less than $2 million). What happened was that a lot of campground members
dropped out before paying in full. So Thousand Trails had to write off $11 million in paper revenues.
Marketing expenses were two times greater than down payments. Debt reached a horrendous 244% of
stockholders’ equity.
Meanwhile, stockholders were left wondering what happened to the company that was growing
so fast and making such good profits (at least on the income statement).
discussion questions for bonus case 17-1
1. Thousand Trails did nothing illegal in its reporting of revenues and profits. What does that tell
you about the need to carefully read and analyze income statements before you invest?
2. Can you see how cash flow problems can grow to unbelievable proportions in just a short time,
even when profits look good?
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notes on discussion questions for bonus case 17-1
1. Thousand Trails did nothing illegal in its reporting of revenues and profits. What does that tell
you about the need to carefully read and analyze income statements before you invest?
The fact is that income statements and balance sheets are very hard to analyze. Auditors go over
2. Can you see how cash flow problems can grow to unbelievable proportions in just a short time,
even when profits look good?
Yes, cash flow problems plague businesses, especially the ones that grow rapidly. The problem is
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bonus case 17–2
MANAGING BY THE NUMBERS
Katherine Potter knew a good thing when she saw it. At least, it seemed so at first. She was trav-
eling in Italy when she spotted pottery shops that made beautiful products ranging from ashtrays to lamps.
Some of the pottery was stunning in design.
Katherine began importing the products to the United States, and sales took off. Customers im-
mediately realized the quality of the items and were willing to pay top price. Katherine decided to keep
prices moderate to expand rapidly, and she did. Sales in the second three months were double those of the
first few months. Sales in the second year were double those of the first year.
Every few months, Katherine had to run to the bank to borrow more money. She didn’t really dis-
cuss her financial situation with her banker because she had no problems getting larger loans. You see,
she always paid promptly. To save on the cost of buying goods, Katherine always took trade discounts.
That is, she paid all bills within 10 days to save the 2% offered by her suppliers for paying so quickly.
Most customers bought Katherine’s products on credit. They would buy a couple of lamps and a
pot, and Katherine would allow them to pay over time. Some were very slow in paying her, taking six
months or more.
After three years, Katherine noticed a small drop in her business. The local economy was not do-
ing well, and many people were being laid off from their jobs. Nonetheless, Katherine’s business stayed
level. One day, the bank called Katherine and told her she was late in her payments. She told them she
had been so busy that she didn’t notice the bills. The problem was that Katherine had no cash available to
pay the bank. She frantically called several customers for payment, but they were not able to pay her, ei-
ther. Katherine was in a classic cash flow bind.
Katherine immediately raised her prices and refused to make sales on credit. She started delaying
payment on her bills and paid the extra costs. Then she went to the bank and went over her financial con-
dition with the banker. The banker noted her accounts receivable and assets. He then prepared a cash
budget and loaned Katherine more money. Her import business grew much more slowly thereafter, but
her financial condition improved greatly. Katherine had nearly gone bankrupt, but she recovered at the
last minute.
discussion questions for bonus case 17-2
1. How is it possible to have high sales and high profits and run out of cash?
2. Why did Katherine do better when she raised her prices and refused to sell on credit?
3. What was the nature of Katherine’s problem? Was she correct to go to the banker for help, even
though she owed the bank money? How could she have prevented some of the problems she
eventually found herself faced with?
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notes on discussion questions for bonus case 17-2
1. How is it possible to have high sales and high profits and run out of cash?
That is the classic description of a poor cash flow. A firm sells lots of merchandise on credit and
buys more, paying promptly. Credit sales are great, and the firm buys more merchandise on credit. One
2. Why did Katherine do better when she raised her prices and refused to sell on credit?
3. What was the nature of Katherine’s problem? Was she correct to go to the banker for help, even
though she owed the bank money? How could she have prevented some of the problems she even-
tually found herself faced with?
Katherine had a classic cash flow problem, and, yes, a bank is an excellent place to turn for help.
The bank can provide funds, help in designing a cash budget, and provide further guidance to avoid cash
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endnotes
i Source: Jody Heymann, “Bootstrapping Profits by Opening the Books,” Bloomberg Businessweek, September 23,
2010.
ii Source: Karthik Ramanna, “Why Fair Value Is the Rule,” Harvard Business Review, March 2013.
iii Lecture enhancer created by Michael McHugh.
iv Sources: Brady Dennis, “Congress Passes Financial Reform Bill,” The Washington Post, July 16, 2010; Paul Da-
vidson, Paul Wiseman, and John Waggoner, “Will New Financial Regulations Prevent Future Meltdowns?” USA
Today, June 25, 2010.
v Source: Scott Waller, “Whistleblower Tells Her Story,” The Clarion-Ledger, April 29, 2006.
vi The Internet is a dynamic, changing information source. Web links noted of this manual were checked at the time
of publication, but content may change over time. Please review the website before recommending it to your stu-
dents.