Entrepreneurship Chapter 4 Homework The purpose of financial statement analysis is to generate information, which can be used internally by the business itself and externally by potential creditors and investors

Chapter 4 Analysis of Financial Statements

CHAPTER OUTLINE

Learning Objectives

Vertical Analysis

Horizontal Analysis

Ratio Analysis

Types of Business Ratios

Liquidity Ratios

Activity Ratios

REVIEW AND DISCUSSION QUESTIONS

1. What is the purpose of financial statement analysis? The purpose of financial statement analysis is to generate

information, which can be used internally by the business itself and externally by potential creditors and investors.

2. Give an example of how financial statements can be used internally by the managers of a company. Financial

3. List and briefly describe the three types of financial statement analysis. Vertical analysis is the process of

using a single variable such as net sales as a constant and determining how all other variables relate to this single

4. If a company had sales of $2,587,643 in 2008 and sales of $3,213,456 in 2013, by what percentage did sales

change during this time period?

5. If the company in question 4 had set a goal of increasing sales by 28% during the next five years, what should

be the sales goal for 2018?

6. List and briefly describe the five categories of business ratios.

Liquidity ratios are used to measure the ability of the firm to meet its short-term creditors’ claims.

7. If a company computes its current ratio to be 3.56, what does this mean in terms of the company’s current

assets and current liabilities? For every dollar of current liabilities or short-term creditor’s claims, the company

has $3.56 of current assets in order to meet these claims.

8. Why might a company have a high current ratio but a low quick ratio (acid test ratio)? A company having a

9. If a company has beginning inventory of $30,000 and ending inventory of $55,000, compute its average

inventory. If the COGS is $140,000, compute its inventory turnover and determine how many days the

average item is in stock.

x100

amount period timeOld

amount period timeOld –amount period timeNew

Change Percentage

=

100

amount period timeOld

amount period timeOld –amount period timeNew

Change Percentage

=

x

+

=

2

Inventory Ending Inventory Beginning

Inventory Average

10. A company computes its accounts receivable turnover to be 20. Based on this information, find the average

collection period. If the company has a credit collection period of 30 days, explain the relationship between

the credit collection period and the average collection period.

The average collection period is found by taking the days per year and dividing it by the accounts receivable

11. If a company finds that its fixed asset turnover (net sales/fixed assets) has fallen to less than 1, what does this

indicate?

If fixed asset turnover falls below one, it indicates that for every dollar of fixed assets committed by the company, it

12. If a company has $181,000 in total liabilities and $225,000 in total assets, what percentage of total assets is

being financed with the use of other people’s money?

sliabilitie Total

ratioasset –total–to–Debt

=

13. Distinguish between gross profit margin, operating profit margin, and net profit margin and provide the

formula for each ratio?

Gross Profit Margin is used to determine how much gross profit is generated by each dollar in net sales. To

calculate gross profit margin we use the following formula:

salesnet Average

profit Gross

=MarginProfit Gross

.

14. Why is the operating return on assets ratio also referred to as the operating return on investment? A

company’s investment is in the form of its total assets, therefore any return on its total assets can also be taken as a

15. If a company’s stock is currently selling for $12 per share and its price earnings ratio is 6, what are its

earnings per share? What does this figure mean?

Shareper Earnings

PriceMarket

ratio PE

=

EXERCISES AND PROBLEMS

1. Samantha Knight is applying for a small-business loan. She provides the bank with the following

information: cash in checking accounts, $5,000; cash in savings, $10,350; home market value, $145,500; first

mortgage on house, $25,000; home equity loan limit, $70,000; home equity loan, $10,000; automobile market

value, $19,000; automobile loan outstanding, $15,000; credit card debt, $1,500.

a. Calculate the debt–to-asset ratio. Debt is equal to mortgage, $25,000; home equity loan, $10,000; automobile loan,

$15,000; and credit card, $1,500; for a total debt of $51,500.

b. Calculate the debt–to-equity ratio. The debt remains the same at $51,500, which must be subtracted from the

c. What percentage of Samantha’s assets are owned by others? This is the same as the debt to asset ratio, which is

28.63%.

2. You receive the following partial balance sheet (Table 4-5) for 2013 and 2012 for a company that you are

considering making an investing in. Perform a vertical analysis for each year on these accounts. Compare the

two years, and in a sentence describe those changes that were beneficial or detrimental to this company. The

Table 4-5 Balance Sheet, Sample Company

Vertical

Category

2012

Analysis 2012

2013

Analysis 2013

Current assets

$ 7,000,000

46.67%

$ 9,000,000

60.00%

Total fixed assets

53.33%

40.00%

Total assets

Current liabilities

$ 3,000,000

20.00%

$ 1,000,000

Long term debt

26.67%

53.33%

66.67%

Total liabilities &

3. You were not totally satisfied with the vertical analysis, so you now want to run a horizontal analysis of this

company. Complete table 4-6. Perform a horizontal analysis on these accounts. Compare the changes in

accounts, and in a sentence describe those changes that were beneficial or detrimental to this company. While

reducing our current liabilities and fixed assets, current assets increased and additionally our owner’s equity

increased which are all benefits.

Table 4-6 Sample Balance Sheet

2012

2013

Horizontal Analysis

Current assets

$ 7,000,000

$ 9,000,000

28.57%

Total fixed assets

8,000,000

6,000,000

-25.00%

Total assets

15,000,000

0.00%

Current liabilities

$ 3,000,000

-66.67%

8,000,000

10,000,000

Total liabilities &

$ 15,000,000

0.00%

4. Last month you were vacationing in Phoenix and noticed that there were several Starbucks coffee locations.

You don’t have any coffee locations in your city, except for a few local cafes. You also have a large college in

your town and believe that, if Starbucks opened a location, they would be very successful. If you went to your

public library, what sources would you use to find out more information about this company? If you are on

the Internet, how can you obtain additional information on this company? Public library sources would include

Dun’s Review, Value Line Investment Survey, Moody’s, Standard & Poors, New York Times archives, Wall Street

Table 4-4 Moderately Large Corporation Consolidated Balance Sheet

Fiscal Year Ended Dec. 31, 2013 Dec. 31, 2012

Current assets:

Cash and cash equivalents 1,369$ 1,427$

Accounts receivable, net 1,008 876

Prepaid expenses and other current assets 157 126

Deferred income taxes, net 44 40

TOTAL ASSETS 7,371$ 5,398$

Current liabilities:

Accounts payable 429$ 242$

Accrued compensation and related costs 104 98

Accrued taxes 132 141

Current portion of long-term debt 89 82

4,000,000 shares; issued and outstanding, 3,500,000.

Paid-in capital in excess of par 2,415 2,415

Moderately Large Corporation Consolidaed Balance Sheet

(in thousands except share data)

ASSETS

LIABILITIES AND SHAREHOLDERS’ EQUITY

5. Given the balance sheet for Moderately Large Corporation (Table 4-4) answer the following:

a. For each year calculate the following ratios: current, quick, debt–to-asset and debt-to-equity.

For 2013

Current Ratio=$4,066÷$754=5.39

Quick ratio = ($4,066-$1,489–$157-$44) ÷ $754 = $2,376 ÷ $754 = 3.15

b. In a written explanation, state what each of these ratios mean. The current ratio is the relationship between the

current assets and current liabilities. For MLC they have $5.39 in current assets to cover each dollar of current

c. Compare the ratios for the two-year period and determine if the MLC is sufficiently liquid. They are definitely

liquid as they have a current ratio which is more than twice the recommended ratio. They appear to becoming more

d. How well is the MLC managing its debt? They currently are managing debt very well. They appear to be getting

6. Perform a horizontal analysis of the MLC balance sheet (Table 4-4).

a. Compare assets, liabilities, and owner’s equity from one year to the next. Assets increased by 36.57 percent,

liabilities increased by 41.46 percent and owner’s equity increased by 32.63 percent between December 31, 2012

and December 31, 2013.

b. Is the corporation better off in 2013 or in 2012? Although assets and owner’s equity have increased, there is a

disturbing trend in current assets because cash decreased by 4.04 percent, accounts receivable increased by 15.03

Table 4-4 Moderately Large Corporation Consolidated Balance Sheet

Fiscal Year Ended Dec. 31, 2013 Dec. 31, 2012

Horizontal

Analysis

Current assets:

Cash and cash equivalents 1,369$ 1,427$ -4.04%

Accounts receivable, net 1,008 876 15.03%

Inventories 1,489 481 209.60%

Prepaid expenses and other current assets 157 126 24.54%

TOTAL ASSETS 7,371$ 5,398$ 36.57%

Current liabilities:

Accounts payable 429$ 242$ 77.22%

Accrued compensation and related costs 104 98 6.34%

Accrued taxes 132 141 -6.21%

issued and outstanding, 3,500,000.

Paid-in capital in excess of par 2,415 2,415 0.00%

Moderately Large Corporation Consolidaed Balance Sheet

(in thousands except share data)

ASSETS

LIABILITIES AND SHAREHOLDERS’ EQUITY

7. Perform a vertical analysis of MLC balance sheet (Table 4-4) for December 31, 2012.

Inventories 1,489 481 8.91%

Prepaid expenses and other current assets 157 126 2.33%

Other assets 168 161 2.98%

TOTAL ASSETS 7,371$ 5,398$ 100.00%

Current liabilities:

Accounts payable 429$ 242$ 4.48%

Accrued compensation and related costs 104 98 1.82%

issued and outstanding, 3,500,000.

Paid-in capital in excess of par 2,415 2,415 44.74%

LIABILITIES AND SHAREHOLDERS’ EQUITY

8. Given the income statement for the MLC (Table 4-7) and balance sheet (Table 4-4), answer the following:

a. Calculate the following ratios for 2013: operating profit margin, net profit margin, operating return on

assets, net return on assets, and return on equity.

Ratio

2013

Operating profit margin =

($1,522÷$8,935)x100=17.03%

($983÷$8,935)x100=11.00%

b.In a written explanation, describe what each of these ratios means. Operating profit margin means that for

c. In a brief paragraph, describe the overall profitability of the MLC. Moderately Large Corporation’s operating

profit margin and net profit margin both increased.. They still have very good return on equity for the stockholders.

9. Perform a horizontal analysis for the MLC income statement (Table 4-7) for 2011 and 2012. Write an

explanation of this analysis. While revenue increased by 13.95%, cost of goods increased more rapidly (18.25%)

Table 4-7 Moderately Large Corporation Consolidated Statement of Earnings

Fiscal year ended: Dec. 31, 2013 Dec. 31, 2012 Dec. 31, 2011

Horizontal

Analysis

2011-12

Net revenues

Cash Sales 2,888$ 2,751$ 2,456$ 12.00%

Credit Sales 6,046 5,258 4,572 15.00%

Total Net Revenues 8,935 8,009 7,028 13.95%

Cost of Sales 5,361 4,405 3,725 18.25%

Gross Profit 3,574 3,604 3,303 9.10%

General and administrative expenses 489 479 361 32.69%

Interest expense 10 11 11 0.00%

Income taxes 529 588 562 4.67%

Net Earnings 983$ 1,092$ 1,043$ 4.67%

Consolidated Statement of Earnings

(in thousands, except earning per share)

10. Using both the balance sheet (Table 4-4) and the income statement (Table 4-7) for the MLC, answer the

following:

a. Calculate the following ratios for 2013: inventory turnover, fixed asset turnover, and total asset turnover.

Ratio

2013

b. In a written explanation, describe what each of these ratios means. The inventory turnover ratio means that

inventory is used up on the average of 5.44 times per year in 2013or every 67 days. Total asset turnover indicates

c. In a brief paragraph, describe how well you believe the MLC is managing its assets. The student paragraph

should incorporate the data from both a) and b) above.

Table 4-8 Financial Statements for Sam’s Sandwich Delivery

Revenues

Retail Sales 68,283$

Wholesale Sales 104,417

Total Revenues 172,700$

Cost of Sales 52,067

Assets

Current Assets

Change Fund 569$

Cash in Bank-Checking 8,612

Cash in Bank-Savings 9,622

Accounts Receivable 6,843

Inventories 2,607

Total Current Assets 28,253$

Current Liabilities

Accounts Payable Trade 6,208

Accrued Payroll Taxes 3,464

Accrued Sales Taxes 987

Total Current Liabilities 10,659$

Balance Sheet as of 06-30-2013

Profit Loss (Income Statement) for Six Months Ending 06-30-2013

11. Given the profit loss (income statement) and balance sheet for Sam’s Sandwich Delivery (Table 4-8), answer

the following:

a. Calculate the following ratios: current, quick, accounts receivable turnover, fixed asset turnover.

Current Ratio = 28,253/10,659 = 2.65

b. Using the inventory figure on the balance sheet as average inventory, calculate the inventory turnover ratio.

Inventory Turnover Ration = 52,067/2,607 = 19.97

c. Calculate the debt–to-equity ratio, debt–to-total asset ratio, and operating profit margin ratio.

Debt-to-equity = 29,285/19,319 = 1.52

d. Perform a vertical analysis of the income statement.

Vertical

Analysis

Revenues

Retail Sales 68,283$ 39.54%

Wholesale Sales 104,417 60.46%

Profit Loss (Income Statement) for Six Months Ending 06-30-2013

e. Perform a vertical analysis of the balance sheet.

Assets

Current Assets

Change Fund 569$ 1.17%

Net Furniture and Fixtures 186$ 0.38%

Equipment 68,293 140.51%

Less: Accum Depreciation 67,725 139.34%

Net Equipment 568$ 1.17%

Transportation Equipment 31,168 64.13%

Less: Accum Depreciation 11,571 23.81%

Net Transportation Equipment 19,597$ 40.32%

Total Fixed Assets 20,351$ 41.87%

Total Assets 48,604$ 100.00%

Current Liabilities

Common Stock 83,081 170.93%

Retained Earnings (72,376) -148.91%

Net Profit/Loss 8,614 17.72%

Total Equity 19,319$ 39.75%

Total Liabilities and Equity 48,604$ 100.00%

Balance Sheet as of 06-30-2013

f. Based on your analysis, would you consider investing in Sam’s Sandwich Delivery? Yes, if he is pulling a

sufficient salary out of the operating expenses.

12. Go to your local library or the Internet and look up the industry averages for the following groups of ratios:

liquidity, activity, debt utilization, and profitability.

a. Compare these ratios to Starbucks’ ratios. There is no answer provided here as the student is asked to do research.

determine if student answers are sufficient.

13. The Handy Dandy Corporation has an income statement that indicates that Operating Income is $2,375,486

and Net Profit is $1,375,486. In 2011, the corporation had 1 million shares of common stock outstanding; in

2012, they had 3 million shares of common stock outstanding. What is this corporation’s approximate

earnings per share?

14. The Namleda Corporation has an income statement that indicates that Operating Income is $2,375,486 and

pays interest of $100,000 and taxes of $900,000. The Corporation currently has 3 million shares of common

stock outstanding and 1 million shares of preferred stock, which pays a dividend of $1.00 per share. What is

the corporation’s approximate Earnings per Share?

RECOMMENDED TEAM ASSIGNMENT

These are Internet research questions that can’t be answered here.

1. Find the best publically traded company that is a competitor in the industry where you

would like to start a business.

a. Do a complete ratio analysis of this corporation. Based on the numbers, explain what the

future looks like for this company.

2. Evaluate the cash flow statement of the company in question. Explain why the numbers

on the cash flow statement are more feasible than the numbers on the income statement

for a potential investor. CASE STUDY QUESTIONS

1. Using Table 4–9, perform a vertical analysis of the Mosbacher Insurance Agency.

a. Using the Internet, obtain the income statement for the insurance company where you insure your

b. Compare and contrast the two companies.

Table 4-9 Income Statement for Mosbacher Insurance Agency