CHAPTER 3
WORKING WITH FINANCIAL
STATEMENTS
Answers to Concepts Review and Critical Thinking Questions
1. a. If inventory is purchased with cash, then there is no change in the current ratio. If inventory is
purchased on credit, then there is a decrease in the current ratio if it was initially greater than 1.0.
b. Reducing accounts payable with cash increases the current ratio if it was initially greater than 1.0.
3. A current ratio of .50 means that the firm has twice as much in current liabilities as it does in current
assets; the firm potentially has poor liquidity. If pressed by its short-term creditors and suppliers for
4. a. Quick ratio provides a measure of the short-term liquidity of the firm, after removing the effects
of inventory, generally the least liquid of the firm’s current assets.
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f. Times interest earned ratio provides a relative measure of how well the firm’s operating earnings
can cover current interest obligations.
5. Common-size financial statements express all balance sheet accounts as a percentage of total assets
and all income statement accounts as a percentage of total sales. Using these percentage values
6. Peer group analysis involves comparing the financial ratios and operating performance of a
particular firm to a set of peer group firms in the same industry or line of business. Comparing a firm
7. Return on equity is probably the most important accounting ratio that measures the bottom-line
performance of the firm with respect to the equity shareholders. The DuPont identity emphasizes the
8. The book-to-bill ratio is intended to measure whether demand is growing or falling. It is closely
9. If a company is growing by opening new stores, then presumably total revenues would be rising.
10. a. For an electric utility such as Con Ed, expressing costs on a per-kilowatt-hour basis would be a
way to compare costs with other utilities of different sizes.
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d. For an online service provider such as Comcast, using a cost per internet session would allow for
e. For a hospital such as Holy Cross, revenues and costs expressed on a per-bed basis would be
f. For a college textbook publisher such as McGraw-Hill Education, the leading publisher of
11. Reporting the sale of Treasury securities as cash flow from operations is an accounting “trick,” and
as such, should constitute a possible red flag about the companies accounting practices. For most
12. Increasing the payables period increases the cash flow from operations. This could be beneficial for
Solutions to Questions and Problems
NOTE: All end of chapter problems were solved using a spreadsheet. Many problems require multiple
steps. Due to space and readability constraints, when these intermediate steps are included in this
solutions manual, rounding may appear to have occurred. However, the final answer for each problem is
found without rounding during any step in the problem.
Basic
1. Using the formula for NWC, we get:
NWC = CA – CL
So, the current ratio is:
Current ratio = CA/CL
And the quick ratio is:
Quick ratio = (CA – Inventory)/CL
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2. We need to find net income first. So:
Profit margin = Net income/Sales
Net income = Profit margin(Sales)
ROA = Net income/TA
To find ROE, we need to find total equity. Since TL & OE equals TA:
TA = TD + TE
TE = TA – TD
ROE = Net income/TE
3. Receivables turnover = Sales/Receivables
Days’ sales in receivables = 365 days/Receivables turnover
On average, the company’s customers paid off their accounts in 35.86 days.
4. Inventory turnover = COGS/Inventory
Days’ sales in inventory = 365 days/Inventory turnover
5. Total debt ratio = .46 = TD/TA
Substituting total debt plus total equity for total assets, we get:
Solving this equation yields:
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6. Net income = Addition to RE + Dividends = $415,000 + 220,000 = $635,000
Earnings per share = NI/Shares = $635,000/170,000 = $3.74 per share
7. ROE = (PM)(TAT)(EM)
8. This question gives all of the necessary ratios for the DuPont Identity except the equity multiplier, so,
using the DuPont Identity:
ROE = (PM)(TAT)(EM)
D/E = EM – 1
9. Decrease in inventory is a source of cash.
Decrease in accounts payable is a use of cash.
Increase in notes payable is a source of cash.
Increase in accounts receivable is a use of cash.
Change in cash = Sources – Uses
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10. The average time to pay suppliers is the days’ sales in payables, so:
Payables turnover = COGS/Accounts payable
Days’ sales in payables = 365 days/Payables turnover
The company left its bills to suppliers outstanding for 82.74 days on average. A large value for this
11. First, we need the enterprise value, which is:
Enterprise value = Market capitalization + Debt – Cash
And EBITDA is:
EBITDA = EBIT + Depreciation & Amortization
So, the enterprise value-EBITDA multiple is:
12. The equity multiplier is:
EM = 1 + D/E
One formula to calculate return on equity is:
ROE = ROA(EM)
ROE can also be calculated as:
ROE = NI/TE
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So, net income is:
Net income = ROE(TE)
13. through 15:
2017 #13 2018 #13 #14 #15
Assets
Current assets
Cash $12,157 2.62% $14,105 2.94% 1.1602 1.1202
Liabilities and Owners’ Equity
Current liabilities
Accounts payable $46,382 10.01% $49,276 10.27% 1.0624 1.0258
Owners’ equity
Common stock and paid-in
surplus $50,000 10.79% $50,000 10.42% 1.0000 .9655
The common-size balance sheet answers are found by dividing each category by total assets. For
example, the cash percentage for 2017 is:
The common-base year answers for Question 14 are found by dividing each category value for 2018
by the same category value for 2017. For example, the cash common-base year number is found by:
This means the cash balance in 2018 is 1.1602 times as large as the cash balance in 2017.
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The common-size, common-base year answers for Question 15 are found by dividing the common-
size percentage for 2018 by the common-size percentage for 2017. For example, the cash calculation
is found by:
This tells us that cash, as a percentage of assets, increased by 12.02%.
16. 2017
Sources/Us
es 2018
Assets
Current assets
Cash $12,157 $1,948 U $14,105
Liabilities and Owners’ Equity
Current liabilities
Owners’ equity
Common stock and paid-in surplus $50,000 0 $50,000
The firm used $16,542 in cash to acquire new assets. It raised this amount of cash by increasing
17. a. Current ratio = Current assets/Current liabilities
b. Quick ratio = (Current assets – Inventory)/Current liabilities
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c. Cash ratio = Cash/Current liabilities
d. NWC ratio = NWC/Total assets
e. Debt-equity ratio = Total debt/Total equity
Equity multiplier = 1 + D/E
f. Total debt ratio = (Total assets – Total equity)/Total assets
Long-term debt ratio = Long-term debt/(Long-term debt + Total equity)
Intermediate
18. This is a multistep problem involving several ratios. The ratios given are all part of the DuPont
ROE = .11 = (PM)(TAT)(EM) = (PM)(S/TA)(1 + D/E)
Solving the DuPont Identity for profit margin, we get:
PM = [(ROE)(TA)]/[(1 + D/E)(S)]
Now that we have the profit margin, we can use this number and the given sales figure to solve for
net income:
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19. This is a multistep problem involving several ratios. It is often easier to look backward to determine
PM = .068 = NI/Sales
Days’ sales in receivables = 365 days/Receivables turnover