Problem 13-18A (continued)
b.
Sabin Electronics
Common-Size Income Statements
This Year
Last Year
Sales ……………………………………………..
100.0
%
100.0
%
Cost of goods sold …………………………….
77.5
79.3
Gross margin …………………………………..
22.5
20.7
Selling and administrative expenses ……..
13.1
12.6
Net operating income ………………………..
9.4
8.1
Interest expense ………………………………
1.4
1.7
Net income before taxes …………………….
8.0
6.4
Income taxes …………………………………..
2.4
1.9
Net income ……………………………………..
5.6
%
4.5
%
3. The following points can be made from the analytical work in parts (1)
and (2) above:
a. The company’s current position has deteriorated significantly since
last year. Both the current ratio and the acid-test ratio are well below
the industry average and are trending downward. At the present rate,
Problem 13-18A (continued)
c. The inventory turned only five times this year as compared to over six
times last year. It takes nearly two weeks longer for the company to
turn its inventory than the average for the industry (73 days as
Problem 13-19A (45 minutes)
This Year
Last Year
1.
a.
Net income (a) ……………………………….
$280,000
$196,000
Average number of common shares (b) .
50,000
50,000
Earnings per share (a) ÷ (b) ……………..
$5.60
$3.92
b.
Dividends per share (a) ……………………
$2.20
$1.90
Market price per share (b) ………………..
$40.00
$36.00
Dividend yield ratio (a) ÷ (b)……………..
5.5%
5.3%
c.
Dividends per share (a) ……………………
$2.20
$1.90
Earnings per share (b) ……………………..
$5.60
$3.92
Dividend payout ratio (a) ÷ (b) ………….
39.3%
48.5%
d.
Market price per share (a)…………………
$40.00
$36.00
Earnings per share (b) ……………………..
$5.60
$3.92
Price-earnings ratio (a) ÷ (b) …………….
7.14
9.18
Investors regard Sabin Electronics less favorably than other
companies in the industry. This is evidenced by the fact that they are
willing to pay only 7.14 times current earnings for a share of Sabin’s
stock, as compared to 12 times current earnings for other companies
in the industry. If investors were willing to pay 12 times current
earnings for Sabin’s stock, it would be selling for about $67.20 per
share (12 × $5.60), rather than for only $40 per share.
Problem 13-19A (continued)
This Year
Last Year
e.
Total stockholders’ equity (a) ………………..
$1,600,000
$1,430,000
Number of common shares outstanding
(b) ………………………………………………..
50,000
50,000
Book value per share (a) ÷ (b) ………………
$32.00
$28.60
The market value is above book value for both years. However, this
does not necessarily indicate that the stock is overpriced. Market
value reflects investors’ perceptions of future earnings, whereas book
value is a result of already completed transactions.
This Year
Last Year
2.
a.
Gross margin (a) ……………………………..
$1,125,000
$900,000
Sales (b) ………………………………………..
$5,000,000
$4,350,000
Gross margin percentage (a) ÷ (b) ………
22.5%
20.7%
b.
Net income (a) ………………………………..
$280,000
$196,000
Sales (b) ………………………………………..
$5,000,000
$4,350,000
Net profit margin percentage (a) ÷ (b) …
5.6%
4.5%
c.
Net income …………………………………….
$ 280,000
$ 196,000
Add after-tax cost of interest paid:
[$72,000 × (1 – 0.30)] ……………………
50,400
50,400
Total (a) …………………………………………
$ 330,400
$ 246,400
Average total assets (b) …………………….
$2,730,000
$2,440,000
Return on total assets (a) ÷ (b) …………..
12.1%
10.1%
d.
Net income (a) ………………………………..
$ 280,000
$ 196,000
Average stockholders’ equity (b) ………….
$1,515,000
$1,425,000
Return on equity (a) ÷ (b) …………………
18.5%
13.8%
Problem 13-19A (continued)
e. Financial leverage is positive in both years because the return on
3. All profitability measures and the earnings per share are trending
upwards, which is a good sign. However, the price-earnings ratio has
dropped from 9.18 to 7.14. This decline indicates investor concerns
growth.
Ethics Challenge (45 minutes)
1. The loan officer stipulated that the current ratio prior to obtaining the
loan must be higher than 2.0, the acid-test ratio must be higher than
1.0, and the interest on the loan must be less than four times net
operating income. These ratios are computed below:
Current assets
Current ratio =
Current liabilities
$290,000
= = 1.8 (rounded)
$164,000
Acid-test ratio = Cash + Marketable securities + Current receivables
Current liabilities
$70,000 + $0 + $50,000
= = 0.7 (rounded)
$164,000
Net operating income $20,000
= = 5.0
Interest on the loan $80,000 × 0.10 × (6/12)
The company would fail to qualify for the loan because both its current
ratio and its acid-test ratio are too low.
Ethics Challenge (continued)
2. By reclassifying the $45 thousand net book value of the old machine as
inventory, the current ratio would improve, but the acid-test ratio would
be unaffected. Inventory is considered a current asset for purposes of
computing the current ratio, but is not included in the numerator when
computing the acid-test ratio.
Current assets
Current ratio =
Current liabilities
we strongly advise against it. Inventories are assets the company has
Ethics Challenge (continued)
Nevertheless, the old machine is an asset that could be turned into
cash. If this were done, the company would immediately qualify for the
loan because the $45 thousand in cash would be included in the
numerator in both the current ratio and in the acid-test ratio.
Current assets
Current ratio =
Current liabilities
$290,000 + $45,000
= = 2.0 (rounded)
$164,000
Acid-test ratio = Cash + Marketable securities + Current receivables
Current liabilities
$70,000 + $0 + $50,000 + $45,000
= = 1.0 (rounded)
$164,000
the loan.
Analytical Thinking (60 minutes or longer)
Pepper Industries
Income Statement
For the Year Ended March 31
Key to
Computation
Sales …………………………………………
$4,200,000
Cost of goods sold ……………………….
2,730,000
(h)
Gross margin …………………………..….
1,470,000
(i)
Selling and administrative expenses …
930,000
(j)
Net operating income ……………………
540,000
(a)
Interest expense ………………………….
80,000
Net income before taxes ……………….
460,000
(b)
Income taxes (30%) …………………….
138,000
(c)
Net income …………………………………
$ 322,000
(d)
Pepper Industries
Balance Sheet
March 31
Current assets:
Cash ……………………………………….
$ 70,000
(f)
Accounts receivable, net ……………..
330,000
(e)
Inventory …………………………………
480,000
(g)
Total current assets ………………………
880,000
(g)
Plant and equipment …………………….
1,520,000
(q)
Total assets …………………………..……
$2,400,000
(p)
Current liabilities ………………………….
$ 320,000
Bonds payable, 10% …………………….
800,000
(k)
Total liabilities ……………………………..
1,120,000
(l)
Stockholders’ equity:
Common stock, $5 par value ………..
700,000
(m)
Retained earnings ……………………..
580,000
(o)
Total stockholders’ equity ………………
1,280,000
(n)
Total liabilities and equity ………………
$2,400,000
(p)
Analytical Thinking (continued)
Computation of missing amounts:
a.
Earnings before interest and taxes
Times interest earned = Interest expense
Earnings before interest and taxes
= $80,000
= 6.75
Therefore, the earnings before interest and taxes for the year must be
$540,000.
b. Net income before taxes = $540,000 – $80,000 = $460,000
f.
Cash + Marketable securities + Current receivables
Acid-test ratio= Current liabilities
Cash + Marketable securities + Current receivables
= $320,000
= 1.25
Analytical Thinking (continued)
Therefore, the total quick assets must be $400,000. Because there are
no marketable securities and the accounts receivable are $330,000, the
cash must be $70,000.
g.
Current assets
Current ratio = Current liabilities
Current assets
= $320,000
= 2.75
Therefore, the current assets must total $880,000. Because the quick
assets (cash and accounts receivable) total $400,000 of this amount, the
inventory must be $480,000.
h.
Cost of goods sold
Inventory turnover = Average inventory
Cost of goods sold
= ($360,000 + $480,000)/2
Cost of goods sold
= $420,000
= 6.5
Therefore, the cost of goods sold for the year must be $2,730,000.
i. Gross margin = $4,200,000 – $2,730,000 = $1,470,000.
j.
Net operating income = Gross margin – Operating expenses
Operating expenses = Gross margin – Net operating income
= $1,470,000 – $540,000
= $930,000
Analytical Thinking (continued)
k. The interest expense for the year was $80,000 and the interest rate was
10%, the bonds payable must total $800,000.
m.
Net income – Preferred dividends
Earnings per share = Average number of common shares outstanding
$322,000
=
Average number of common shares outstanding
= $2.30
The stock is $5 par value per share, so the total common stock must be
$700,000 ($5 × 140,000 shares).
n.
Total liabilities
Debt-to-equity ratio = Stockholders’ equity
$1,120,000
= Stockholders’ equity
= 0.875
Therefore, the total stockholders’ equity must be $1,280,000.
o.
Total stockholders’ equity = Common stock + Retained earnings
Retained earnings = Total stockholders’ equity – Common Stock
= $1,280,000 – $700,000 = $580,000
Analytical Thinking (continued)
p.
Total assets = Liabilities + Stockholders’ equity
= $1,120,000 + $1,280,000 = $2,400,000
This answer can also be obtained using the return on total assets:
Net income + [Interest expense × (1 – Tax rate)]
Return on =
total assets Average total assets
$322,000 + [$80,000 × (1 – 0.30)]
= Average total assets
$378,000
= Average total assets
= 18.0%
Therefore the average total assets must be $2,100,000. Since the total
q.
Total assets = Current assets + Plant and equipment
$2,400,000 = $880,000 + Plant and equipment
Plant and equipment = $2,400,000 – $880,000
= $1,520,000
Teamwork in Action
The answer to this question will depend on the company that the students
analyze.